Cypress Semiconductor

(CY) - Get Report

has prepared its

SunPower

unit for an initial public offering, but tough times are ahead for the silicon solar company as it tries to secure the basic building materials for its products.

SunPower, which makes silicon solar cells that convert sunlight into electricity,

wants to raise $100 million in a stock sale in order to fund a capacity expansion in the red-hot silicon solar market. But that expansion could be in jeopardy -- regardless of how much money is raised -- because of shortages of polysilicon, the raw material used to make silicon wafers that in turn are used to make semiconductors.

The polysilicon supply-and-demand situation has played itself out in the form of higher wafer prices during the past year. Polysilicon contract prices are up to $45 a kilogram from the mid-$30s one year ago, with bidding expected to reach $60 a kilogram next year as shortages become more dire. While the entire semiconductor industry is affected, silicon solar companies are especially vulnerable because of the specialized poly they require.

Indeed, it's the silicon solar market that has helped create the current shortage.

Demand for solar power is booming thanks to higher energy prices, government subsidies to promote solar power, and improved solar-power efficiencies. The amount of silicon devoted to solar power, in terms of wafer area, outstripped that of silicon for traditional semiconductors last year. Further, the demand surge has caught poly producers short, and capacity additions likely won't catch up to supply for at least 18 months.

"The solar market has grown to the point where it is consuming all of what was excess silicon supply," said Richard Winegarner, a principal with Sage Concepts who has been researching the silicon market for 20 years. "For the next three years at least, there will be a shortage of capacity to supply both the semiconductor market and the solar market."

Winegarner sees the primary impact on smaller solar silicon solar producers like SunPower. "They probably have good enough relationships to maintain their current level of supply, but they want to grow rapidly and those growth spurts might be delayed for a couple of years until material becomes plentiful," he said.

During the first six months of this year, SunPower reported a loss of $13.6 million on sales of $27.5 million. During the three months ended June 30, SunPower's loss narrowed to $6.3 million from $7.2 million in the first quarter while sales rose to $16.4 million from $11.1 million.

SunPower's expansion projections and current supply deals would have its sales increasing rapidly through 2006. Also, the company has predicted gross margin expansion stemming from improved manufacturing methods and leverage of fixed costs.

However, SunPower's two largest customers are on fixed-price agreements, leaving SunPower to incur the risks of rising raw materials prices. An agreement with

Conergy

, which accounted for 53% of SunPower's sales in the first six months of this year, expires at the end of this year and negotiations are ongoing regarding a renewal.

Solon

, which has accounted for 18% of sales this year, is fixed for the deal's first two years. A $300 million, five-year deal was announced in April.

Factors in the company's favor are its production efficiency. SunPower says it can make solar cells with 50% more power per unit area than its competitors, which means that its solar panels require fewer silicon cells. SunPower also uses thinner wafers, which in turn require less poly. To reduce costs further, SunPower has started slicing its own wafers.

Still, the company has aggressive expansion plans. It now operates one production line that produces 25 megawatts of power. A second 25-megawatt line is ramping to full production and a third line is expected to be brought up to speed in early 2006. A fourth line is currently being considered, as is an entire other production facility.

Analyst Doug Freedman with American Technology Research posits that any disruptions caused in SunPower's supply chain "is a high-class problem that will only offer longer-term investors a discount to own of the strongest brands in the solar industry," according to a recent research note. Freedman has no disclosures related to SunPower or Cypress.

SunPower said in its IPO registration filing with the

Securities and Exchange Commission

that it had adequate arrangements for polysilicon through the rest of this year, but that an industrywide shortage of poly is expected to continue for the foreseeable future. "Since we have committed to significantly increase our manufacturing output, an inadequate allocation of polysilicon would harm us more than it would harm our competitors." (A SunPower spokeswoman said she was unable to comment about information contained within the company's registration statement due to SEC rules.)

That risk is partly because SunPower's primary competitors rank among the world's largest corporations. Even though SunPower claims competitive advantages in manufacturing, aesthetics and efficiency, its competitors are substantial:

Mitsubishi

,

Sanyo

,

Sharp

and BP Solar, a unit of

British Petroleum

(BP) - Get Report

.

While the silicon solar market has shown signs of sustainable and robust growth, players in this sector could find themselves victims of their own success. SunPower's

potential has carried Cypress' stock 30% higher this year, but investors shouldn't discard the potential impact of supply shortages.