MMM - First Solar Could Be A Dangerous Investment In A Looming Recession

Summary

• First Solar just had a great quarter, but with a looming recession I believe it could become a dangerous investment as it struggles to pay off debt and issue shares.
• With inconsistent cash flows the last five years, I can't safely make assumptions about the future of the company.
• With seasoned competitors in the space, First Solar could face challenges securing contracts and future projects.
• First Solar is an ambitious company looking to be a competitor in the solar space.
• However, I believe it lacks the margins and favorable valuation that would warrant investing in the company.

First Solar's Financials

There are good and bad things concerning the balance sheet of First Solar (FSLR). With a strong likelihood of issuing more shares, it becomes dangerous for investors to take an interest in this name. First Solar has a good cash position , sitting at just under $2 billion. I believe this will be of great benefit for the company in the coming years when supplies might start to increase in price. But the biggest benefit this offers is the financing of some of their new factories in both Ohio and India. The Ohio factory offers them a good bridge to the American market, and the Indian factory helps them be able to supply the Asian market as well.

The main concern I have regarding the company's financial state is perhaps not its cash position, but the amount of debt. It has close to zero debt, but negative cash flows. Building new factories is expensive, and I think it's likely FSLR will have to take on new debt to stay ahead of the competition. With notably higher interest rates vs. one year ago, I believe First Solar is in a bad spot to take on new debt, as raising capital is not as cheap anymore.

If First Solar is forced to take on more debt, that could make the cash flow even more negative than it already is. I believe this would make the company start diluting shares to raise capital to pay off any short-term debt. This usually spirals down into making a company less valuable from an investor's point of view.

Now, it's not all bad news with regard to First Solar's financial state. I think some credit should be given to the company in that it has maintained a steady growth rate of its retained earnings. With $3 billion, it's safe to assume FSLR has managed to make quite the profit since its inception. Raising the retained earnings at an annual growth rate of 6.8% gives me confidence that they will weather the upcoming recession and not go bankrupt at least.

Recent Q3 Earnings Report

In all honesty, the recent Q3 earning report did not provide me with any confidence in the company. It reported a loss per share of $0.46. Compare that to last year's earnings per share of $0.42 and you can see a clear discrepancy. Consistency in earnings is incredibly important to attract investors to a company; it's one of the first things I look at when considering deploying capital in something.

The revenue topped the quarter at $629 million, giving it a YoY increase of 7.7%. It's a small win when the company managed to make just 3.3% in gross margins. Swings like these should be expected in smaller companies just starting out, not a company valued at $16 billion.

It would be unfair to not explain why changes like these are happening. In the earnings report, the company explained that it deployed a large amount of capital in order to upgrade the Ohio factory . The price tag of that came in at around $200 million. They also invested $270 million into their R&D line in Perrysburg. Becoming a larger player in the solar space comes with aggressive investments early on to scale up your business, so time will tell whether this was worth doing or not for First Solar.

Company Outlook

In its recent earnings report, First Solar narrowed in on some of its outlooks for the year. The company expects to generate between $2.6 and $2.7 billion. That's slightly down from the previously expected high of $2.8 billion.

For me, the biggest flop is the expectation the company has for profitability. It previously expected to narrowly make a profit of $0.25 per share on the high end. This has now been downgraded to a $0.35 loss per share. That's quite a large move and something that worries me about FSLR's ability to generate positive cash flows in the coming years.

Now, I think it's worth highlighting some of the positives about the company's outlook for the future. According to its investor presentation, FSLR expects to be able to double its capacity between 2020 and 2025. Much of that is thanks to increased demand for green energy sources, a product that First Solar can provide for the masses.

Looking at the solar market as a whole, there is plenty of room to grow. First Solar holds a 1.24% market share. If you believe in management's ability to be efficient in stealing away market share from some of the other larger companies - like Applied Materials ( AMAT ), 3M Company ( MMM ), or JinkoSolar ( JKS ) - then there might be a growth story here. My worry would be the amount of money the company would have to raise in order to increase capacity and production to supply that demand.

First Solar's Expansion Challenges

One of the biggest positives about First Solar is its ability to scale its business efficiently. With a return on capital invested of about 30%, FSLR has a winning concept. Right now it is ahead of the curve when it comes to expanding some of its production to India, a place where companies currently are moving to reduce the risk that comes with having too much exposure to China.

Some of the challenges the company is facing, however, come down to maintaining a good ratio between generating net income and deploying capital to expand. Every business needs to grow to avoid going stale and losing market share to more eager and ambitious companies. But for me there is also an importance in actually running a profitable company. There are only so many years of continued losses I can tolerate for the sake of growing and expanding.

As I mentioned previously, there are some large companies in the space that First Solar needs to compete with. These are much more mature companies that have large amounts of capital they could deploy in order to maintain their market share. The challenge for First Solar here would be to efficiently maneuver around these capital challenges and make the most of what it has.

Investment Risks

One of the largest risks that I have identified has to be the money being spent on new factories and projects. The company has mentioned in the investor presentation that it has a set operating expense of between 80% and 90%. That's really high and doesn't leave a lot of room for mistakes.

Even though the business is highly scalable, I believe that the gross margins will likely not go higher due, in part, to these high operating expenses. Another factor I fear will weigh on any investment in the company is the current valuation. With an incredibly high P/E you are essentially wasting time having to wait for the company to catch up with the valuation. It can't trade at the current P/E of -93 forever. Eventually you will see a valuation compression, and that could crush the stock price.

In my opinion, there is also a risk of share dilution in the upcoming years. The company has gone from 104 million shares to 106 million shares outstanding in the last five years. Since the interest on debt is now higher, First Solar might see diluting shares as a viable solution to raising more capital.

The Competition

I believe that knowing how the competition is doing is just as important as knowing how your selected company is doing. The solar sector is a very capital-intensive space where companies deploy as much as possible to scale their product and take market share. What I think is good to look at then is the margins they have and the valuation that comes with that. An unprofitable company with a high P/E won't make a good investment. A company with good margins and seemingly a low P/E might be worth an extra look instead.

Looking at this table, you would think that SunPower ( SPWR ) has the best potential - revenue growth and a decreasing P/E. I didn't write this article to suggest buying First Solar since I believe its current valuation is too high and the growth prospects aren't there to validate such ratios. What First Solar is winning on, however, is the ratio between assets and liabilities. I think that number will go down, however, as it will need to take on more debt and, in turn, the balance sheet will show more liabilities.

Valuing First Solar, Setting a Price Target

With everything taken into account, First Solar is, in my opinion, too overvalued at the moment. It presents too much risk for the potential reward. Even though the solar sector and demand for the products are expected to grow at a rapid pace, realistic valuations are important.

According to SolarPowerEurope, the global market for solar products is expected to grow at a CAGR of around 20%. It's not unlikely for First Solar to be able to keep up its revenue growth with that number. But I am a long-term investor and prefer a good entry point in order to have a good margin of safety with any investment.

With the current share price of $160 the CAGR would be 8.4% until 2027 with these calculations in mind. That is barely beating an index fund's annual growth. For me, First Solar is currently a pass as the risk/reward ratio is too high. My price targets are based on whether or not the company manages to become profitable next year, when it has two new factories up and running. If there are delays along the way and FSLR sees increased operating expenses, then these price targets might need to be adjusted lower instead.

I also keep a conservative P/E of 12 all across the board. A company only really deserves a higher number if they have a good moat, which First Solar doesn't have. It's a product that can be replicated by competitors.

Conclusion

At the moment, I don't think First Solar is worth putting any money into. With negative earnings for this year (2022), the company is in a shaky spot where it needs to generate more revenues to keep up while also deploying more money to keep up with competitors. This tends to dig into earnings, and investors will have a much harder time properly valuing the company.

Realistic valuations are important if you decide to put money into something. A company growing revenues at 100 % YoY might deserve higher multiples, but that isn't FSLR. Some of the red flags I have identified are the low gross margins and the high likelihood of share dilution in order to raise more capital.

I don't hold a position in the company and do not intend to start one in the coming six months at the very least. Unless there is a compression in the current valuation of FSLR, I think investors should stay away from this one. There are plenty of other already profitable companies in the solar sector that could offer much more favorable risk/reward ratios.

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