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Solar Losers: Euro, Margins Exact Toll

First Solar's earnings beat on Thursday was expected by the market, but investors aren't rewarding the solar company or its peers on Friday morning.

(Solar losers story updated for analyst comments, closing info)

TEMPE, Ariz. (

TheStreet

) --

First Solar

(FSLR) - Get Report

beat expectations in its fourth quarter earnings, on both earnings per share and revenue counts, and the solar company's reward for its outperformance: its shares were down 6% in the after-market on Thursday and were down another 8% on Friday, with twice its average daily volume of shares traded -- 5.5 million shares versus 2.7 million on an average day.

The reaction to the First Solar outperformance was in stark contrast to the reaction from solar investors last week after

JA Solar

(JASO)

reported a strong fourth quarter, which rallied the solar sector.

First Solar is always pitted in competition versus the Chinese low-cost polysilicon-based solar players, from JA Solar to the more integrated Chinese solar companies like

Yingli Green Energy

(YEG)

and

Trina Solar

(TSL)

.

On Friday, however, all the solar companies traded down. Trina Solar was down by 5.5% at the close, while Yingli was down just short of 4%. After the JA Solar earnings brought shares up across the sector, a pullback for the sector is not surprising. Where shares go next week, however, will be interesting to watch.

The fact that all the solar players were down on Friday shows that the bearish outlook from investors on First Solar shares after its earnings was not just the same old industry thesis that First Solar faces continued pressure from the low-cost Asian solar pack in a declining feed-in tariff environment.

Instead, analysts were focused on the fact that a euro devaluation in 2010 could weaken solar sales power in Europe.

It's the euro devaluation story that cuts across the entire solar sector. Fears about the Euro slide and its impact on solar sales in Europe could assume a higher profile in the 2010 solar outlook as we head deeper into solar season.

A big issue is that many street models will have to be revised across all the solar companies to factor in the extent to which foreign exchange (FX) risk poses a threat to financial assumptions. At this point, solar companies are vague in their guidance on foreign currency risk, and it is not yet clear to what extent each solar stock is exposed to European sales and the potential for a previous currency tailwind to be transformed into a 2010 headwind.

"If you look at the magnitude of the FX effect quarter to quarter, it has become bigger and bigger as these companies report higher revenue numbers and are all expanding globally and selling into more markets," said Wedbush Securities analyst Christine Hersey.

A Chinese solar company, for example, could be selling in the U.S. dollar and euro with a cost structure in renminbi, and it is hard to pinpoint solar company hedging strategies and the FX risks.

"Several brave analysts have tried to pin down companies on the euro risk and hedging strategies, yet most answers from solar management have been generic," the Wedbush analyst said, adding that First Solar is the only company that provides hedging information as it relates to revenues and assumptions for currency risk.

First Solar has noted in its investor presentation on Thursday the importance of European markets such as Italy and France as Germany declines as the world's leading solar market. A deterioration in the Euro in 2010 was all the talk in Friday morning after the Federal Reserves decision to start moving interest rates back up again.

Solar analysts are expected to revise earnings guidance based on foreign currency risk in the days to come.

In the case of First Solar, gross margin disappointment is also driving investor selling. First Solar's gross margins were down 9.4% in the fourth quarter versus the third quarter 2009, while its operating expenses were up.

First Solar's guidance for 2010 is gross margins of 38%, down from the 41% achieved in the fourth quarter. Gross margin by quarter in 2010 is expected to plummet, not surprisingly, in the third quarter 2010, after the German feed-in tariff cuts would theoretically go into effect. First Solar projects that gross margins will drop to 32% in the second half of 2010.

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First Solar's operating margins dropped to 22.6% in the fourth quarter, from 33.9% in the third quarter, while operating expenses increased by $40 million. While a portion of the operating expense increase was related to one-time senior management compensation items, the real margin issue is that First Solar has guided operating margins to 23% to 24% in 2010, regardless of one-time charges.

Solar investors knew this margin drop was coming, but Wedbush's Hersey thinks that the 8% drop on Friday in First Solar shares may indicate that some investors were not prepared for that 23% operating margin nadir to be hit so soon.

Gross margin disappointment was also exacting its toll on

Canadian Solar

(CSIQ) - Get Report

shares on Friday, with the solar company down a whopping 15.7% at the close for the solar sector's biggest loser on a selloff day in solar.

Canadian Solar guided to lower gross margins than previously anticipated -- in the mid teens as opposed to high teens for the fourth quarter. Canadian Solar said the expected gross margin variance is due to higher processing costs and lower yields caused by certain defective production equipment at its new ingot and wafer plant.

While some analysts expect the Canadian Solar problem to be a one-time event, given that the market advantage that Canadian Solar has is predicated upon its low-cost Asian manufacturer profile, it is more sensitive to any cost increase. A change of a few basis points in the gross margins can have a significant impact on earnings per share. Piper Jaffray lowered its fourth quarter earnings per share guidance for Canadian Solar to 43 cents, down from 61 cents -- though Piper Jaffray maintained its outperform rating and believes the impact will be a one-time event.

Not all analysts are as confident as Piper that the Canadian Solar event will be limited to the fourth quarter. An analyst who does not cover Canadian Solar, and can't be quoted on the stock, said it seemed as if investors were voting with their feet after the 15.7% drop on Friday, and possibly voting that the earnings per share impact of the manufacturing problem could linger into the first quarter of 2010.

FBR Capital Markets analyst Mehdi Hosseini, who has been bearish on First Solar, was most struck by the fact that First Solar's gross margins came in even below his estimate, and the systems business, in particular, was beginning to show its adverse effect on the overall gross margin numbers.

The FBR analyst noted: "PPA/EPS margin profile beginning to have adverse material impact! Despite the upside to expected revenues (especially considering the positive impact of FX in 4Q09), the reported gross margin of 41.5% came in below our estimate of 41.8%, at the low end of the company's guidance range of 41% to 44%.

First Solar's earnings per share also trended down from the previous quarter, with $1.65 per share versus $1.79 in the third quarter. FBR noted there was also a much lower tax rate than previously assumed -- 5.8% versus 10% -- and that accounted for 11 cents of the earnings per share, by its calculation.

Analysts were divided in their reaction to the First Solar report overall.

Oppenheimer & Co. wrote that "despite easily beating consensus estimates, 4Q EPS were, all-in-all, unimpressive." Oppenheimer analysts cited the weak gross margins while operating expenses increased, and noted, "Even though operating expenses will return to more normal levels in 1Q 2010 and we like First Solar's exposure to the U.S. utility market and its clean balance sheet, we find it hard to recommend shares right now given: 1) German FiT uncertainty; 2) recent euro weakness; and 3) pricing pressure from Chinese vendors."

Wedbush Securities analyst Hersey continues to see margin contraction, pricing pressure, project development risks and potential feed-in-tariff changes as headwinds for First Solar in 2010. Wedbush lowered its earning per share estimates for First Solar from $6.28 to $6.01 in 2010, and from $6.74 to $6.30 for 2011.

Both Piper Jaffray and Collins Stewart reiterated buys on First Solar.

Notably, Piper Jaffray referred to First Solar as an "energy products company with a growing services/financing component", as opposed to a "high tech" company -- as solar shares are most often categorized. Piper believes that even with its business mix shifting to the lower margin systems business, beyond feed-in tariff uncertainty and market demand issues that are 2010 headwinds for First Solar, it remains "an otherwise best positioned company within the photo voltaic sector."

FBR Capital Markets's Hosseini agreed to an extent, writing that while he believed the longer-term -- 2011 and beyond -- demand prospects for both First Solar's module and systems business are improving, in the near term, there is more downward pressure to average sales price and consensus estimates than he had previously forecast.

Still, the FBR analyst is no bull on First Solar. FBR had raised its price target on First Solar to $100, from $90, not too long ago. However, on Friday, FBR took the First Solar price target back to its previous, bearish low of $90.

Solar investors took care of taking the rest of the solar share prices down -- for real -- on Friday.

-- Reported by Eric Rosenbaum in New York.

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