Feb 28, 2008

solar business

I've spent a little time recently looking at companies involved with the solar space. I talked a little about the market structure here.

There is a very obvious but nevertheless interesting aspect to the business model for the solar companies that take silicon wafers and turn them into photovoltaic (PV) cells. Let me use JA Solar as an example.

I've said before there is nothing particularly hard about making PV cells. Most of the equipment is off the shelf. Many of the largest solar companies haven't even been around for that long. JA Solar formed in May 2005 and didn't actually start operations until April 2006. Since then it has ramped up production to 175 megawatts of annual output. Let's take a look at the income statement.

Last quarter they earned about US$110M. Their cost of goods was $86M. 92% of that cost is silicon wafers. The rest is people, depreciation of their equipment, and utilities. They then spent about $3.7M on sales and $0.15M on R&D. At the end of the day they made an operating margin of 20%.

For the uninitiated, finding a company that can kick out 20% margins is actually fairly hard. The big asset managers and software companies can do this. These are businesses that have some competitive advantage or barriers to entry. These things give them some pricing power. Not anyone can become a Fidelity or Microsoft. I can't just go and raise money tomorrow to compete against these companies.

Commodity businesses, or businesses that have no competitive advantage generally have very low margins. There's nothing stopping someone from starting a distribution business or selling wheat. Hence these companies have no pricing power and prices drop until the marginal player in the marketplace can just squeak by without going broke (price = their operating cash costs). Take TechData which distributes IT related products. Margins are about 1% to 2%. A retail store like the Macy's just distributes clothing. Margins are about 8%. Even commodity companies that exhibit some temporary pricing power like Conoco Phillips (oil company) only had margins of 12% last quarter.

So why does JA Solar have 20% margins and why are they growing those margins? Are they not a commodity business and therefore are more like Microsoft? Well that just can't be. They spent $148,000 on R&D last quarter. That just blows my mind. Why even bother? There's no special sauce in their products. They use off the shelf equipment from companies like Applied Materials that anyone can buy. They have no real intellectual property to speak of. Their brand is meaningless. A solar cell is a solar cell. They look exactly like a commodity business.

So why 20% margins? The reason is Germany's solar subsidy. Germany sets a 'feed-in' tariff for solar generated energy. Currently Germany has the most attractive subsidy. I put a solar cell on the Germany electricity grid and the utility company pays me a preset amount. Therefore I can work backwards and figure out how much I'm willing to pay for the solar cell to make it economically worthwhile for me. That sets the price of the solar cell.

What that means is the price of solar cells should be much lower. If normal economic forces were at work the company's margins would probably be around 5% meaning the price of a solar cell should be 15% less. But instead Germany has an infinite appetite for solar cells at the price dictated by their feed-in tariff. End of story.

This is why subsidies for anything don't make sense. Germany is basically taxing their citizens and sending it to these companies' coffers. If Germany stopped subsidizing tomorrow the price of solar cells would drop accordingly. This will happen at some point. I just don't know when. And in the meantime, the Chinese company JA Solar is going to be rolling in it.

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