Alternative Energy Companies Forced to Wean Off Subsidies
TWST: Please begin with a brief overview of your coverage of the alternative energy sector, including the segments you cover within alternative energy and the specific names you follow.
Mr. Blansett: When thinking about the solar PV sector under coverage, we follow U.S.-based solar companies. We're looking at a relatively muted domestic growth outlook where U.S. solar demand is not necessarily going to be the driver for the industry, and it's a very competitive market.
The U.S.-based names we have under coverage — First Solar (FSLR), SunPower (SPWR) and MEMC (WFR) — have all moved toward a project-development type of business model, where they effectively control many of the variables of their business by going out and developing utility-scale solar projects, which they then will build themselves. So it kind of becomes a market where you don't really have to compete with anybody else on module or system pricing. It reduces the effective competitive nature of the business.
That being said, the pipelines that these companies have built out have grown to be quite large. However, we have not seen significant additions to those pipelines in a couple of years. The economics of solar PV versus conventionally produced electricity in the U.S. is not necessarily in a good place at this time. With the low price of natural gas, conventionally produced energy is very cheap right now. It's trading at least at a 10-year, possibly 20-year low, and that makes large utilities in the U.S. hesitant to sign new renewable energy contracts, especially for solar, because right now they'd be paying significantly more for that solar energy than they would for natural-gas-generated electricity. So right now, the U.S. solar PV market is really being segmented into pre-existing large utility-scale projects that had previously signed purchase contracts that were at good rates and generally a smaller rooftop-based type of market that competes with retail electricity rates.
So we kind of have a muted overall market. It's very competitive. Few companies are making money, and in general it's tough economics across the solar food chain. So we're remaining pretty bearish on the sector for the time being. The growth of the solar sector really looks like it's going to be in Asia, and our U.S. companies do not have a lot of exposure in China and Japan, where we see most of the growth happening. So we think they are going to miss out on that opportunity.
Looking at the wind sector, we cover Broadwind (BWEN), which is a wind tower, service provider and gear maker. Unfortunately, we're looking at the end of federal subsidization for the wind sector at the end of the year. So we're seeing a lot of last-minute rush work getting done this year to try to make sure wind projects are completed before the subsidy program expires. We're going to have a very strong second half of the year, but unfortunately, unless Congress does something to extend the current wind subsidy, we're going to have a very weak 2013, down easily more than 50%, and potentially more than 75% year over year. So we're looking at the next wind boom and bust, which has happened a number of times as the subsidies have come on and offline over the past 10 or 15 years.
Broadwind is going to have a pretty good second half, but a very uncertain calendear year 2013. Specifically for Broadwind, they are moving as fast as they can out of the wind-gearing business and aggressively trying to move into industrial gearing, and into metals and mining and industrial type of applications, frack pumps, heavy equipment, things like this. And so their ability to do that is going to be very important for that company to remain viable because we think 2013 is going to be a pretty tough year for anybody in the U.S. wind food chain.
The third sector we cover is the LED sector. It's the area that we are the most optimistic about longer term. Our optimism is primarily driven by the opportunity for LED-based lighting. This is a very cost-effective way to reduce operating expenses at existing buildings, and we think that this emerging technology is progressing extremely rapidly along the lines of, say, consumer electronics, where there is a semiconductor Moore's Law-type of effect going on. So we have a very fast improvement in performance and a very rapid reduction in costs. We think LED lighting will grow significantly over the next five-year horizon, and we think it will really start to supplant existing lighting technologies.
In the near term, however, the LED industry really continues to be dominated by general consumer electronics demand, and with the broad macro weakness that's out there, we think that's going to offset any growth in the lighting side. So we are looking at a fairly muted second half for the LED industry with lighting offsetting weakness in general consumer electronics demand.
So when it's all said and done, the broader view of our alternative energy universe is we are looking at a pretty tough second half. There are really not a lot of significant positive catalysts at this time on a broad basis. Conventional energy in North America is relatively cheap, making it tough for the generational technologies of solar and wind, and right now, we're having a fairly muted second half of the LED side because of the traditional businesses they feed into, even though we do see continued strong growth in LED lighting.
TWST: Which LED names do you like right now?
Mr. Blansett: Long term, we think Veeco (VECO) is our top pick. That's ticker VECO. They are a capital equipment supplier. They enable LED makers to make the actual chips. It's a very difficult market for new entrants to come into. They've gained a lot of share against their primary competitor, who is based in Germany. Although Veeco's business is likely to be very cyclical, they put together a high variable cost business model that we think over time will allow them to generate significant amounts of free cash flow.
I think the key thing to look for here that investors really focus on is lack of new entrants because whether I'm making LEDs or other parts of the food chain, there seems to always be the ability for someone new to show up. But in this very critical capital equipment segment of the food chain, it's very difficult for a new entrant to come. It's one of the few places where there is a huge barrier to entry. So we like that aspect, like their variable cost model, and we like the fact that they have very low capex to revenue. So in the end, when they do generate free cash flow, they are not spending it to build a new facility. It really can just go back to the shareholders or for additional investments, say, in new technology.
TWST: In June, Germany’s parliament outlined the revised terms of its solar subsidies. Would you give us an overview of the new terms and please tell us what they will mean for the sector?
Mr. Blansett: Germany has propagated a solar subsidy program that initially was very favorable, and had very high rates for solar power. It drove an initial huge wave of demand. In subsequent years, they have made incremental reductions to that subsidy. At the beginning of 2012, there was the normal, I guess, scheduled cut to the solar subsidies. However, it really wasn't enough to bring demand levels down to a point that the government was willing to subsidize. So there have been a lot of negotiations between the solar trade group and the German parliament, and we've seen more significant changes made to the subsidies in Germany — unfortunately for the industry, significantly more cuts.
There will be no large-scale projects over 10 megawatts being subsidized going forward, and until the end of the year we will now see cuts monthly in the solar subsidies. The German government is really trying to get down to a 2.5- to 3.5-gigawatt per year installation pipeline. Last year, it was over seven gigawatts. So they are doing everything they can to get this under control.
One of the concerns they have is that because they're paying well above market rates of this power that it's going to have a disproportionate effect on the electricity rates that everybody pays in Germany. So we've already seen some uplift in the retail rates in Germany because of renewable energy in general. And so their whole strategy for renewable energy is to keep this cost uplift under control. So unfortunately for the solar industry, this is causing the economics to continue to be difficult even as the solar industry brings its own cost basis down because, simply put, these projects would not be built without subsidies. So as the subsidies come off, it's effectively negating the potential growth that could occur because the costs came down. This is going to go on for a while and it's really difficult for anybody to actually make any profit in Germany.
Most of the companies we talk to are in some form of restructuring and/or their profitability is very poor or marginal — or in many cases, they are actually losing money. So at some point in time, it's not going to be able to go on, but we do think that the first half of the year was much stronger because there was a delay before this additional subsidy cut was able to be put into place.
TWST: You do expect new solar installations in China and Japan. What portion of those could benefit the U.S.-based solar companies?
Mr. Blansett: One of the artifacts, or I guess, the characteristics, of some of the Asia-based markets is they tend to be very domestically driven. People in Japan prefer Japanese products. It's not uncommon for them to pay more to purchase Japanese products. In China, it's fairly difficult for a foreign company to do business when there is a viable domestic entity. So within the universe of our U.S.-based solar companies, it's going to be very tough to have a meaningful position in those regions.
In general, they all want to partner with somebody, to find a local entity that may not be a solar system developer per se, and get in. But so far, they've been fairly unsuccessful in executing on that. And to be honest, there are a lot of Chinese solar companies. It's going to be a very competitive market in China, and since most of the solar modules made these days are from China, that market is going to be extremely difficult, we think, for any non-Chinese company to actually have any meaningful level of business.
Japan is a little different. It's not quite as competitive there, and we do think there is an opportunity for companies such as SunPower to actually generate some revenue there. The key is can they find the right partner to do the development and to do the system installation using their modules because every market has its own development aspect. And so if you are a U.S. developer, you've got to learn how the Japanese market works first. That could take a year or more. So they need to find a developer there that they could partner with, that actually knows the local regulators, entities and how just the system works.
But that being said, if that does occur, it's likely going to be a few years at a minimum before anything meaningful comes out. So right now, they are really relegated to the U.S., to Europe and to some Middle East activity, where they've been trying to focus on region for a while.
TWST: Thank you. (MES)
Note: Opinions and recommendations are as of 07/20/12.
Senior Equity Analyst
J.P. Morgan Chase & Co.
270 Park Ave.
New York, NY 10017