TWST: In your last interview with us, you said that the U.S. is the biggest growth driver for solar right now, and financial incentives in the form of tax credits for installation were in place until the end of 2011. How did that play out, and how much of a boost did investors see?

Mr. Kettenmann: You can say that the U.S. market grew about 100% in 2011. A lot of that was back-end loaded in front of the federal cash grant expiration, which was in lieu of the tax credits that still are in place until 2016. So basically, investors lined up to monetize the cash that the government had promised them for the 30% ITC. A lot of that volume was utility-based, larger-scale deployments in the U.S. Southwest, California, some in the U.S. Southeast, and also ironically, New Jersey happens to be a very growthy market. It was a very growthy market in 2011 because of a production incentive offered at the state level. So I think that our forecast played out. The growth was as expected. Numbers are still being tallied, but I think roughly 2 gigawatts are what people are looking at for what was put in the ground in 2011.

TWST: Where do we go from here? What is the outlook for 2012?

Mr. Kettenmann: With these tax credits still in place, I think there's still a meaningful appetite for solar in the U.S. The cost of solar modules declined about 40% to 50% depending on who you talk to over 2011, so the capex requirement is much less than it was a year ago with the same tax incentive in place. For large institutional funds, you can point to Warren Buffett's MidAmerican Energy, for example, who can really monetize these tax credits; on a dollar basis, it's almost the same as the cash grant. The utility pipeline in the U.S. is still a very robust multigigawatt. I think we could see another 2 gigawatts installed in 2012. That's a conservative outlook, I would say. With projects, it gets a little tricky to forecast timing on the utility-scale side since weather delays can be an issue in some of the places they're putting these projects in, and in-field execution is always a risk. But I think the growth is still there in the U.S. for 2012 and beyond.

TWST: What are your thoughts at this point about when solar will reach grid parity?

Mr. Kettenmann: I'll start off by saying two years ago, natural gas was more than double where it lies today. Right now, gas is roughly $2.50 per million Btu. Actually, five minutes before I picked up the phone, the consensus for 2013 was just brought down by $1 to $3.99 from $4.93. With cheaper gas, grid is decreasing and the power markets are becoming more and more competitive. With subsidies, many markets in the world, they are already there, however, and a lot of these markets have already begun to ramp. I can point to Italy, who imports LNG from North Africa and who doesn't have a meaningful coal resource. Commercial retail rates there are 21 euro cents, so you've seen a strong push for solar in the last two years in Italy. In markets like Hawaii and Japan, who again have to import higher liquids fuels for baseload power gen, you can see a steady push toward solar as well. In markets in Asia, where so much of the GDP growth is fueled by low-cost energy consumption, coal being the primary driver there, the push for economic growth has actually driven the price of coal up. In markets like India, energy has actually gotten more expensive, and it's made the bidding process for solar projects a little more economic. The market there is also very fragmented though in terms of the actual utility grid reliability, so solar because of its distributed footprint makes reasonable sense.

Also, the off-grid diesel power generation that a lot of markets, like India and places in Southeast Asia, rely on make for good solar comps at current diesel prices. Solar is already competitive with diesel generation without subsidies, so that's been a strong positive for off-grid demand and a proliferation of demand throughout Southeast Asia.
For more mature energy markets like the U.S., I think it's going to take a little more time to get the grid parity, especially with the peaking profile of solar competing directly with natural gas and gas prices haven't pulled in.

But we're still very bullish on the broader cost-reduction trends in solar. All companies, thin film and crystalline, have shown incredible strides over the last two years in getting those costs down and not just the module manufacturers. We've actually seen cost reductions throughout the entire value chain where financing, the cost of money, has come down with more mature players coming to the space. Financing solutions from downstream players and more efficiencies in terms of installation methods have taken cost out of the balance of systems so all the components that go into the module side.
Permitting and regulatory costs are also being streamlined as markets mature. So I think you're seeing just the whole industry push toward a more efficient model, and we expect to see cost continue to come out of the delivered energy cost. I think 2015 is a reasonable timeline for competitiveness with grid parity in these more mature markets.

TWST: You expect to see consolidation in solar during 2012. What is consolidation going to look like? What types of deals and maybe possible transactions should investors be keeping an eye out for?

Mr. Kettenmann: We already started to see a little bit of it early in the year. LDK's (LDK) Sunways AG (SWW.DE) acquisition was just approved by German regulators earlier this week. I think that was strategic to take some of their technology as well as market share in what is, right now, kind of a bedrock of the solar industry in Germany.

Ultimately, I think the space is waiting for a shakeout in the Chinese names. Back in 2007-2008 there was just a string of Chinese solar IPOs, and since then every one of them has doubled capacity. One of the things pushing cost down is price coming in an oversupplied market. So I think it's going to be critical for players to keep on being focused on innovation and getting conversion efficiencies higher and people are going to pay up for that. So I think you're going to see some Chinese players buy high-quality technology to keep their efficiency high, and some of the other players fall by the wayside. I think, one, smaller downstream players are going to be acquired, and two, there's going to be a shakeout among the Chinese companies.

We also already saw Total S.A. (TOT), oil and gas major, take a majority stake in U.S.-based SunPower (SPWR). I think probably the most speculative but plausible idea is that somebody would have make a bid for First Solar (FSLR), which had a tough 2011, and at the current valuation, given the visibility they have on earnings, seems very attractive.

TWST: You don't believe the current valuations are pricing in what you believe will be a strong second half of the year from increased China and Asia Pacific demand. Please tell us the factors you believe that are going to grow increased demand in China and Asia Pacific.

Mr. Kettenmann: The China market buzz really has lifted the group off of the lows early this year. We have called it a short-covering rally year to date. I think people were covered short on the idea that the Chinese market will finally emerge as a robust demand center the second half this year and on the idea that December numbers in 2011 were very strong, so higher-price inventory will get cleared out among these, basically help rebalance the supply and demand dynamic in the industry right now.

But with a strong China in the second half, you get a couple of things. One, you get the capacity that was built to service the fast growth in Europe moving away from an oversupply in Europe back to China, so pricing in Europe won't be as aggressive. People won't be trying to stockpile channel inventories and the regional distribution levels, we believe, won't be as big of a choke point for the industry in Europe.

I guess pricing in China remains the biggest issue in terms of profitability. But in terms of moving volumes and keeping utilization rates high, which is critical for margins at these manufacturing companies, the market needs another demand center to emerge, and right now that appears to be China. Several of the CEOs of the largest public manufacturers have all pointed to China growing another 100% this year with up to 3 gigawatts or 4 gigawatts installed. Our number right now is 3 gigawatts. We're trying to be conservative, but I've heard numbers on the Street as high as 5 gigawatts. With that kind of growth, which would be 50% to 60% annually, I think that will relieve a lot of the pressure on European markets and a lot of the pressure on pricing.

In terms of consensus numbers, right now, I think what's baked into consensus numbers is continued pricing pressure and eroding margins. I think the emerging China market will help stabilize price and let costs continue to come down, and hopefully, help gross margins which would then lift the bottom line for a lot of these companies.

In terms of company specifics, I think it will be most beneficial for companies like Trina (TSL) and Suntech (STP), who have good regional exposure and downstream relationships in the western provinces that are building the utility projects we expect will grow.

TWST: It seems as if you're more positive than some others on the solar sector. What do you believe are going to be the most significant headwinds this year?

Mr. Kettenmann: We've been more positive on the group for sure - 2011 was a tough year. To be frank, I think 2012 would be a transitional year, more of a recovery year, and move toward a recovered market with China being a driving force taking pressure off of Germany and then the U.S. also adding stability to the market. In terms of headwinds, for conservative prudent investors, any industry that is hinged on policy decisions is very tough to deploy long-term capital in. With so much headline risk on the outcomes for European policy, the eurozone in general, and what that means for subsidy rates in the EU for solar, I think it keeps a lot of the smart money and large institutional money on the sidelines.

I think the U.S. model is a little easier for people to invest in. We have the 30% investment tax credit through 2016, where I think players - again, like Warren Buffett, who can really use that tax credit - will continue to invest downstream in projects to basically decrease their tax bill. But there is also risk I think given this is an election year. To the extent that people feel like there is a real tailwind behind the GOP nominee, there is also the belief that he will try and unhinge the current policy supporting that tax credit for 2016. To be clear, we do not foresee this outcome; however, it is a risk.

I think the biggest risk is going to be policy. That said, if costs continue to come down, policy really won't matter once you start running into the lower electricity rates that are competitive head to head with natural gas and coal.

TWST: Which one or two stocks do you believe are the best way to get exposure to solar in 2012 and why?

Mr. Kettenmann: The stock of the year that we have is Suntech. I think it's already had a very strong run since the beginning of the year, and this has been one of the most distressed names in the space. It was the first Chinese solar stock to IPO, and it's the largest manufacturer of Chinese solar modules currently; great brand name, very strong regionally in China and Europe, and the only Chinese company that has domestic manufacturing in the U.S. With the current trade allegations against illegal trade practices from the U.S. companies against China, Suntech is definitely best positioned to skirt those.

It's also, we think, entering a restructuring phase. They acquired more in-house wafering capacity, which will increase their vertical integration, help increase gross margins, and they also have one of the best products in the industry. We think costs will continue to decline, and we look for margin improvement over 2012 and 2013. Also, the company has a 2013 convertible issuance, the March 2013 3% coupons. Those were priced as a distressed debt going as low as $0.37 on the dollar, I believe. I think the company is addressing those issues. They have the ability to monetize about $250 million in project assets for the Global Sun Solar Fund investment that they have. I think they'll probably take about $200 million out of working capital, and we have built a $200 million dilutive equity event in our 2012 EPS number, which we believe will likely come in the form of private placement in China with state financial institutions. So should Suntech pay back that convertible offering, we believe a material overhang is removed and the stock will move higher. STP is also an event-driven idea, which we believe should decouple the name a little bit from some of the market-moving forces that drive trading in the group.

In terms of the best-positioned stock, the one we think will respond fastest to a recovered market, I think Trina Solar is your name. They have a flexible business model where about 60% of their production is in-house and 40% is outsourced for the wafering and cell side. So if the market goes away from them, they can pull in-house and help protect their gross margins through increased vertical integration, and then, should the market expand, they have the ability to address higher demand. So they can move top line in good market conditions and protect bottom line in rough times.

Plus, they've also been the most successful in renegotiating their polysilicon contracts with their partner, GCL-Poly (3800.HK). I think polysilicon for them entering 2012 and throughout the year should approach cash costs. I think $30 per kilogram is on the table for 1Q12, and that should meaningfully help their gross margins. Also they are introducing a new product, the Honey solar module line. It's a higher-efficiency product that still has some of the lower-cost attributes of legacy modules. But we'll see how the market responds to that product. It's new and a lot of these product launches are usually a rough start, but we are optimistic.

In terms of risk/reward, we continue to really like First Solar. Management shakeup has taken a lot of the big name institutional investors away from the stock. It materially underperformed the S&P last year. The net present value of cash flows from their backlog, the discounted cash flows that we expect for 2012, and the couple of dollars per share of cash flow on the books is about $30 per share. The stock's trading about 10 times our current year estimate. I think there is still tremendous value in the name, and we like that Mike Ahearn has come back to the company. He was part of the original team that made money for investors since the IPO. I think that should bring back a lot of credibility to the name. So we look for further cost reductions from First Solar to keep their lead as the industry bellwether in the space and solid execution on their utility backlog in the U.S. Southwest.

TWST: Thank you. (MES)

Note: Opinions and recommendations are as of 01/31/12.

Chris Kettenmann

Analyst

Miller Tabak + Co., LLC

331 Madison Ave.

New York, NY 10017

(212) 370-0040

www.millertabak.com