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Why First Solar's Shrinking Profit Margins Could Rebound

First Solar (NASDAQ: FSLR) has become shockingly less profitable over the past eight years.

Despite its status as the current leader in utility-scale solar installation in the U.S., First Solar's gross profit margin has slid dramatically over the past decade:

FSLR Gross Profit Margin (Annual) Chart
FSLR Gross Profit Margin (Annual) Chart

FSLR Gross Profit Margin (Annual) data by YCharts.

You can calculate a company's gross profit by taking its total revenue and subtracting the cost of goods sold (ignoring things like marketing expenses and depreciation). Express the result as a percentage of revenue and you get gross profit margin. It shouldn't be the only metric considered, but it's a good way to analyze a business's efficiency. Its trend over the long term signals (1) whether a company is getting better or worse at making its products at a reasonable cost and/or (2) whether the company is experiencing pricing pressures from the competition.

Two solar technicians walk along a utility-scale solar project.
Two solar technicians walk along a utility-scale solar project.

Image source: First Solar.

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First Solar's gross margins are sloping downward, but bulls are of the belief that this won't always be the case. As time goes on, they say, its lead in the U.S. utility-scale solar market will generate ever-greater economies of scale, pricing power, and profits.

First Solar leads the industry in total installed capacity as of 2016.
First Solar leads the industry in total installed capacity as of 2016.

Image source: Statista.

Unfortunately, it's not that simple. First Solar may maintain its utility-project leadership position. But profitability isn't guaranteed.

First Solar bears are nervous that solar-module manufacturing is a race to the bottom. Prices for solar cells have continued to fall thanks to technological gains, and analysts at GTM Research estimate a 4.4% average annual project-price drop for utility-scale solar projects through 2022. Companies like JinkoSolar (NYSE: JKS) have also been flooding the market (and suffering sizable losses) in an attempt to grab market share.

A ray of hope

First Solar's management is more than aware of its gross-margin slide. Worsening profitability was one of the many reasons that led to its decision to skip its Series 5 module rollout and go right to Series 6. This surprise move (which led to the company's first-ever loss in fiscal 2016) is proceeding as planned and production will begin by year-end. Once this occurs, First Solar hopes to command premium prices once again.

The company may very well get its wish. One of the things that makes First Solar stand out is its use of cadmium telluride (CdTe) for its cells, while practically every other manufacturer uses silicon. Each material has its pluses and minuses. First Solar chose CdTe because of its ability to absorb a wide range of light frequencies, its superior performance in less-than-optimal sunlight conditions (as opposed to ideal conditions that occur in labs, where cells earn their "sticker" efficiency statistics), and lower total-material requirements. In other words, First Solar's modules are "thin film," which means they're faster to produce.

The First Solar empire strikes back

By shifting to its Series 6, which will more or less match the efficiency of today's best silicon-based modules, First Solar has gone on the offense. Not only is it back in the efficiency game, but it can now offer all the advantages of CdTe listed above as icing on the cake. There is a strong chance that First Solar's pricing power (and solid gross margins) will return.

It should be noted that First Solar's management has not projected gross margins for next year just yet. This is wise. There's just too much uncertainty in the marketplace surrounding possible Section 201 tariffs on imported solar cells.

Nonetheless, should a tariff be imposed, it would only bolster First Solar's position.

What you need to know

The weight of the evidence supports giving the company the benefit of the doubt -- for now. First Solar remains the only consistently profitable solar manufacturer in the U.S. -- no small feat. Even last year's loss was a product of noncash charges as the company shifted to Series 6 production (the company was cash flow neutral).

First Solar's CdTe-based modules have unique advantages. Thanks to its products' comparable efficiency to silicon modules, the company may very well be the long-term winner in the solar industry.

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Sean O'Reilly owns shares of First Solar. The Motley Fool recommends First Solar. The Motley Fool has a disclosure policy.