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First Solar, Inc. (NASDAQ: FSLR) reported its Q2 2012 earnings after the markets closed on August 1st. Non-GAAP EPS came in at $1.65, beating estimates by 75 cents (GAAP EPS was $1.27). Revenue was $957M, also ahead of estimates. FSLR raised the annual sales and EPS target, largely thanks to its strong project business.

The upbeat earnings report is a sharp contrast to its previous two, which were tarnished by product quality issues addressed on 18 April, 2012 in article CdTe Thin Film Panel Degradation - a Time Bomb for FSLR?and by the major reorganization described in FSLR's restructuring Plan.It also dispelled the doubt casted by some sell-side analysts, notably Maxim’s Chew, on whether pending issues might prevent some of its large projects from being actually built.

In this article, we will focus on FSLR’s project development business and follow up later on its module manufacturing. The conclusion is that FSLR is still the undisputed king of solar, despite being largely caught up in the module business. While there are uncertainties on its future, especially the project pipeline, overall First Solar is best positioned to be successful in the solar industry, well ahead of its competitors.

Due to the fast decline in module price, all the module manufacturers were plunged into deep losses for the last several quarters. The brutal price war shows no sign of abatement, meaning losses will continue. On the other hand, in the U.S. downstream project development sector is less crowded and supported by large project pipelines. The margin in the project development used to be as high as 30% though it has come down somewhat. Still project development is the only sector that shines in the whole chain. Hence it is not surprising for companies with large project-development arms to fare better in this painful period for solar companies.

A brief history

First Solar started out as a module manufacturing company using its proprietary CdTe thin-film technology. In 2007, the company moved into downstream by acquiring Turner Renewable Energy for about $34.4 million. The purchase was generally favored by analysts as FSLR’s revenue relied too much on module shipments to Germany. Going downstream provided much needed diversification and it is also acted as a channel to move its modules. In 2009 First Solar bought OptiSolar's project pipeline for about $400 million, including a 550 MW deal with PG&E. In early 2010, FSLR again bought a portion of Edison Mission Group's (EMG) solar project development pipeline. In April 2010, First Solar acquired Nextlight Renewable Power for about $285 million, adding 750 MW to its existing pipeline. In doing so, it combined the largest utility-scale PV project pipeline in the U.S. with the second largest. At one time in 2011, its project pipeline grew to over 5 GW.

Project development is a capital intensive business. Despite its financial strength and strong brand, obtaining necessary loans to move forward all its large projects became evidently difficult in 2011. Therefore FSLR sold off some of its large projects: 660-MW Desert Sunlight to NextEra Energy Resources and General Electric; 348-MW Agua Caliente to NRG; 280-MW Antelope Valley（Nebraska）to Exelon Generation; 550-MW Topaz to MidAmerican, totaling 1.84GW. After selling the projects, FSLR remained to be the EPC (engineering, procurement and construction) company for those projects.

Large Utility Scale Projects

FSLR specializes in large utility scale solar farms. Many of its solar farms are over 100 MW, a segment with only a few players qualified to bid. Among the top 10 solar PV projects in the world, 6 belong to First Solar. These large projects usually are more lucrative than smaller sized ones. Therefore, the large projects with signed power-purchase-agreement (PPA) in its portfolio can guarantee FSLR will be profitable in the next few quarters no matter how the industry changed.

This year, FSLR announced two new large 100 MW plus contracts: one 159 MW with Australia’s AGL energy and one 139 MW Campo Verde with PPA signed by San Diego G&E. Financial strength and EPC experience for large solar farms mean FSLR is the natural choice for such important and sensitive projects.

While the reputation for large projects is certainly a plus, the exposure also brings certain risks. The initial wave of large projects for bidding, which started in 2009, seems to be waning. There are voices in the industry saying those giant solar farms are likely a thing in the past, most future projects in the sweet spot will be in the range of 20 to 60 MW. Of course, FSLR have projects in the range and its reputation as giant project developer can scale down to this range, however, there is no doubt that First Solar will meet more competition.

5-Year Plan

In Q1 2012 conference call, First Solar announced a 5-year plan to transition itself from subsidized utility markets to more sustainable markets without government subsidy. The target is a 3 GW annual installation by the year 2016. The plan for transitioning is a natural response to the declining government support and a steady decline in the cost of solar PV as a viable competitor in the utility market. No surprise there. On the other hand, despite the target is not overly ambitious as 3 GW is less than 10% of projected annual installation by 2016, analysts still grilled then CEO Ahearn on how FSLR can achieve the goal. Since FSLR is in retreat at Europe, and many other world markets have not matured yet, it is indeed hard to judge whether FSLR can reach its goal. On FSLR’s credit, it said it will aggressively drive down the system cost, to about $1.15-1.20 per watt by 2016. The targeted system cost is quite aggressive and FSLR will be enormously competitive if it can get there. In the follow up article, we will illustrate that FSLR is likely to maintain its module cost competitive edge. Therefore, while its future success in the project development space is not guaranteed, the probability is high given its cost, brand and financial edge.

In the same conference call, First Solar announced that James Hughes will replace Michael Ahearn as the new CEO. Given Hughes’s experience in the utility industry, one has to agree that First Solar is moving to the direction it outlined.

Solar PV Projects in Hot Climate

Obviously, potential future markets for solar PV projects tend to be located in hot climate due to better solar radiation. The performance of FSLR’s CdTe solar panels is a hot contended issue. On the one hand, FSLR claims that thin-film modules tend to have a lower temperature coefficient which means they can output more power at hot climate than identically rated c-Si modules. On the other hand, FSLR’s CdTe modules may have higher degradation rate meaning they will lose more power output year after year.

This first part (lower temperature coefficient) is more established than the latter one (degradation) as large scale and long term studies on degradation are still not available.

Overall, I think the two characteristics of CdTe modules roughly neutralize the impact on the projects in the hot region. The degradation is a touchy issue, but FSLR has strong warranty for its modules so it is not likely a huge concern for potential customers.

Project Pipeline Growth

In the Q2 conference call, CEO Hughes highlighted new projects in Australia and India as well as in the U.S. Hughes said that he expected the company to win around 20% of the Indian market in 2012 and retain that share going forward. About 1 GW project is added to its pipeline in 2012, which now stands at 2.9 GW. In comparison, its pipeline is about 2.7 GW at first quarter.

For the new additions, Hughes explained that more than half were considered secured, although some were still being closed. The other 500MW were said to be deals that have a 50%-or-better probability of being realized. This was said to include both systems and third-party module deals, which were being planned for next year and beyond.

Given that FSLR finished 387 MW projects this quarter, current pipeline is enough to sustain FSLR for two more years at the same completion rate. This is a rather long cushion period for FSLR during the consolidation and maturing of the industry.

The pipeline growth is quite significant since the consensus before the earnings appears to be downbeat. This is reflected in the stock price fluctuating in the lower to mid teens for quite a while. Of course, it could be an anomaly that new projects sign-up slows down markedly later. We shall keep a close eye on it as it is the measurement for First Solar’s health.

Project Margin

One critical indicator for assessing First Solar's project business strength is its gross margin (GM). Critics frequently cite the deteriorating project margin to justify a single digit or low-teen PPS target. Maxim even came up with “normalized system prices of $1.55/watt yielding 10% gross margin”. The “$1.55/watt system price” and “10% GM” seem to be made-up numbers simply to justify its bias. If FSLR can have only 10% GM, then what kind GM other installers can enjoy? System price does come down due to 1) price decline of module and other input material, 2) improved installation efficiency, and 3) competition. Only 3) can lead to margin erosion. Given the project segment that FSLR thrives in (more lucrative) and its brand/efficiency etc, it is more likely FSLR can keep its project GM around 20% in the next two years despite that system price continues to fall.

It would be nice to know the exact project GM for FSLR at Q2. Unfortunately, First Solar does not report GM separately for its module and project business. However, we can have some rough idea from data it provided.

In Q2 2012, the company had a GM of 25.46%. While that was lower than its results a year ago (36.5%), it was an improvement from the 15.4% GM in Q1 2012. Due to the shift in FSLR’s revenue mix, the overall GM in the past is less indicative of future GM trend. In the past (before 2012), the module sales constitute the majority of FSLR’s revenue and that completely changed in Q2-2012.

In Q2, total revenue was $957 million with 387 MW projects' finished and 369 MW modules produced. Drawing down inventories likely contributed the slight difference in the project and module megawatts. The average module ASP should be slightly over 80 cents, giving a market valuation of ~$310M for produced modules. Hence the revenue from its project business (sans module costs) should be ~$647 million. Since the blended GM is 25.5% and module GM is around 10%, its project GM should be around 30%. Of course the finished projects in the quarter were mostly signed two or more years ago when system price is high, still it is hard to imagine the GM can fall to 10% area as Maxim predicted.

One major recent development in the solar industry is the heavy U.S. anti-dumping tariff imposed on modules made with Chinese cells. As a result, the module imports from China fell dramatically afterwards. Although the tariff can be circumvented by using Taiwan-made cells, there are still added costs. The total extra costs from the two duties (anti-subsidy and anti-dumping) are estimated to be 8-9 cents.

Longer term, these added costs give some advantage for installers who do not use modules imported from China, including FSLR and SunPower Corporation (NASDAQ: SPWR)

8-9 cents is over 10% of the current module ASP. FSLR is the biggest beneficiary since SPWR’s modules have higher costs despite the efficiency edge.

Recently, both SunPower and MEMC Electronic Materials, Inc. (NYSE:WFR) reported 2012-Q2 earnings, each receiving a boost from their own project business. SPWR has a reported GM 15.1% on a non-GAAP basis and 12.3% on a GAAP basis. For WFR, the GM is 13.2%. Neither gave details on GM for project development. WFR sold 169 MW projects during the quarter while SPWR did not give a megawatt number for its projects. For the year, SPWR stated it targeted to sell ~ 1GW projects.

Conclusion

FSLR is clearly the leader in the project development space in terms of installation megawatts and profit margin. It surprised us with a project pipeline growth at Q2 despite setbacks at Europe. While it remains to be seen whether it can keep the pipeline momentum, it is not nearly as dire as some sell-side analysts painted. First Solar also surprised on the upside with its project GM suggesting internal efficiency gain. Going forward, the input material cost decline (such as inverters) and efficiency gain should alleviate the margin erosion in the face of continued system price decline.