Shedding Light on Solar

 | May 02, 2012 | 9:30 AM EDT
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The best place to look for multi-bagger stock ideas is often in cyclical industries that are flat on their backs, completely out of favor. So horrific that even the deepest-value managers hold their noses to buy the stocks. So bad that investors think the stocks will never come back. So awful that the stocks are down 90% or more off their highs. You get the idea.

One such ugly sector is solar, which was clocked by a confluence of factors that have destroyed sales and margins. The group experienced rapid growth over the past few years as government incentives, mostly in Europe, drove rapid growth of installations. The Germans were so aggressive about subsidies that solar now generates 26% of domestic electricity -- and it's not even a "sun" country. Italy and Spain were also aggressive about Feed-in Tariffs (FiTs) that subsidized solar energy. Companies such as First Solar (FSLR) blossomed. Its stock appreciated to $150 from $27 last year on exceptionally strong sales and earnings growth.

But a funny thing happened on the way to the bank. The Chinese decided that renewable energy was a strategic industry, and fostered a number of competitors that are now world-class manufacturers of solar panels. Yingli Green Energy (YGE), Trina Solar (TSL) and a host of others entered the market with good products and aggressive pricing. The industry quickly moved to overcapacity. At the same time, the European debt crisis hit, dampening the willingness to sustain subsidies. Solar panel volume growth slowed as capacity surged, bombing prices and squeezing margins. Some of the Chinese manufacturers are operating in single-digit gross margins -- more appropriate for a grocery store than a presumptively "high-tech" product.

Capacity is finally exiting the industry. First Solar announced this week that it is reducing global capacity by 700 megawatts, and several European panel vendors, such as Solon and Q.Cells, are seeking bankruptcy protection. But most of the stocks are down 70% or more off recent peaks.

So is now the time to buy? Most analysts are still bearish, which is a good sign, but after Citi analyst Timothy Arcuri upgraded the group Tuesday, solar names surged. Obviously, a one-day pop is not a reason to buy, but Arcuri lays out the case that volumes may be poised to accelerate due to price elasticity. The cost per watt has declined substantially, to around a dollar per watt. Projects are getting done and renewed panel volumes can restore margins as important new markets like China and India pick up some of Europe's slack. There is risk in the call, as the early evidence of a pick-up is anecdotal and the recovery will be backend-loaded this year. Arcuri says that product sell-through has increased significantly recently and utilization rates of certain cell producers have spiked higher. This could be a head fake -- but if the turn has arrived, this is the activity one would expect.

As in any turn in a cyclical sector, follow George Soros' strategy and buy the leaders and the laggards. No sector will recover unless the leader leads it out of the doldrums. In solar, it's First Solar or Trina. And buy the worst names in the group -- the ones that have declined the most have the most upside leverage in a recovery.  Another way to play a turn is through the suppliers, such as MEMC (WFR), which are levered to volume recovery even if price recovery lags.

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