Solar Stocks' Subsidy Challenge - TheStreet

The solar industry is facing an important challenge in the form of reduced government subsidies.

Like many young industries, the solar sector depends on substantial government subsidies to fuel growth and profitability, and weaning it off this generous support will be a bumpy process.

Germany has long been at the core of the industry's growth, driving installations with generous Feed-In Tariff schemes (FIT) that reward project developers that generate solar electricity.

The country's FIT structure incorporates a yearly decline in subsidies, designed to spur technological innovation and cost cutting.

This is critical to keep in mind because Germany accounts for roughly 40% of the industry's consumption, and each of the major publicly traded solar companies, including

First Solar

(FSLR) - Get Report

,

SunPower

(SPWRA)

,

Trina Solar

(TSL)

and

Suntech

(STP)

, derives at least one-third of its sales from Germany. First Solar still derives more than 70% of its revenue from Germany.

As Germany's subsidy declined 8% over the past year, the cost of solar panels fell by more than 50%, driven in no small part by plunging raw materials costs. Selling prices have fallen at the same rate, now below $2.00 per watt vs. more than $4.00 at this time last year. With a new political party in control in Germany, the government decided that strengthening solar demand, if left unchecked, would put too much pressure on the country's treasury.

On Jan. 20, the German government proposed the following adjustments to the FIT:

A 15% one-time reduction to rooftop systems rates effective April 1.

A 15% one-time reduction to free field systems rates effective July 1.

A 25% one-time reduction to free field "farm land" systems effective July 1.

In addition, if demand surpasses 3.5 gigawatts (GW) annually, the FIT will be reduced by a further 2.5%. The next step down will occur if demand surpasses 4.5 GW, at which point the FIT will fall by another 2.5%. On the other hand, if demand is below 2.5 GW, the FIT will increase by 2.5%. These adjustments won't be finalized, however, until the end of March.

Germany's response seems to be as much a reaction to its own expense control as to the progress of the solar industry. Solar is becoming a larger part of the government's bill because it is growing so fast, and in recessionary times it is not surprising that the government would look to cut back on its subsidization.

However, the decision is not purely based on the government's fiscal needs. It is also a sign that the industry is progressing and is able to operate without training wheels. The solar industry has lowered costs dramatically over the past year as polysilicon prices fell and technology improved.

All else equal, the effect of the cuts should be felt primarily by project developers, who would be compensated at a lower rate for the electricity they sell to utilities.

Developers are currently making above-average returns on solar plants (since module prices are low), so it has been theorized that they could absorb the effect of the FIT cut without bringing about a drop in demand.

A more realistic scenario, though, is that demand will drop as the adjustments are enacted in the second quarter prompting sharp pricing declines beginning in the second half of 2010.

We think this will be exacerbated by the fact that most solar companies claimed high visibility into the first half and have built up inventories in anticipation.

In addition, the planned April subsidy cut will come three months earlier than many companies had expected, potentially sweeping the legs out from under their second-quarter estimates.

Battle Road Research is now predicting anywhere from a 15% to 30% drop in selling prices over the 2010 year, necessary to incentivize project developers and spur demand.

As Average Selling Prices (ASPs) fall, solar companies will feel pressure to reduce manufacturing costs in order maintain profitability. We will likely see increased investments in research and development to revitalize what seems to be stalled efficiency levels.

Yingli Green Energy

(YGE)

, for example, is now investing in the research of a high-efficiency solar cell in a project dubbed PANDA. Companies will also continue to absorb any leftover high-cost polysilicon and look to reduce grams used per watt in production in order to prop up gross margin levels.

It is also notable that France recently announced that it would cut its FIT by 24%, and Italy may also decrease support for the industry.P/>These cuts call into question the likelihood that recently-announced solar IPOs will come to fruition over the next year. Though the industry was poised for a strong first half predicated on robust German solar installation ahead of the feed-in tariff reduction, looming subsidy cuts in three of the largest countries may cause Daqo New Energy, Solyndra, and JinkoSolar to alter their offering plans.

The new subsidy environment will also put pressure on smaller and weaker solar players, especially those bogged down by debt, because cleaning up their balance sheets will require solid cash generation stemming from improving demand and profitability. Subsidy cuts will make this task much more difficult.

Although the reduction of solar subsidies will cause substantial near-term pressure on the industry and call into question some of the bullishness predicated on an unusually strong first half of 2010, we think it is also a sign that the industry is maturing.

What's more the reduction will separate the weaker from the stronger players.

As a temporary demand reset, we see the reduction as a speed bump in the industry's long-term development.

Battle Road Research (www.battleroad.com) an equity research firm, serves fund managers, analysts and financial advisers with an independent voice on technology, health care, solar power and education stocks. Battle Road analysts place an equal weight on industry and securities analysis in an effort to seek out stocks to buy and stocks to avoid. As an integral part of our research process, we tap into a network of industry sources who provide insight into the companies we cover. We present our conclusions in a straightforward buy, hold, sell format. As a matter of principle, we refrain from investment banking, company-paid reports, and personal investment in the stocks we research. Visit us on the Web at www.battleroad.com and www.battleroadblog.com.