Markets

China Sunergy's M&A Strategy a Win -- For China Sunergy's Chairman

By David Phillips

Updated on: March 22, 2010 / 11:14 AM EDT / MoneyWatch

Tingxiu Lu, chairman of China Sunergy, said the solar-cell maker would become a stronger competitor after its purchase of two solar power module makers. Lu's insight is self-serving, as this downstream vertical integration strategy serves only to further enrich the chairman and fundamentally weaken the company.

China Sunergy (CSUN) is spending $47 million to acquire two affiliated module makers with production capacity of about 200 megawatts (MW): CEEG (Shanghai) Solar Science & Technology and CEEG (Nan Jing) New Energy are beneficially owned by the chairman through his controlling interest in China Electric Equipment Group (CEEG).

Headquartered in Nanjing, China Sunergy's product portfolio includes mono and multi-crystalline silicon solar cells and emitter cells. By controlling more of the solar chain itself, China Sunergy is seeking to gain leverage over module pricing -- and position itself among the lowest cost producers in a falling average selling price (ASP) environment. Ergo, supported by a more aggressive pricing policy, management believes the (CEEG) aqcuisitons will help secure markets for its premium, high conversion rate panels (2010 target rate is 19 percent +) in emerging markets such as Eastern Europe and China.

At the end of 2009, China Sunergy had total production capacity of 320MW, exceeding the production needs of its two acquisitions. A huge risk to the company's downstream strategy is the loss of third-party, private-label business: OEMs that currently integrate China Sunergy's photovoltaic (PV) cells into their solar panels and other PV systems include Ontario-based Opsun and Renergies Italia. Sales to third parties totaled $66.1 million in the fourth-quarter 2009, or about 68 percent of total sales. Revocation of existing MW contracts could drain off this critical source of cash flow.

Most industry observers expect a substantial turnaround in end-user demand by 2012 -- when the U.S. and China are finally expected to get national subsidy policies ironed out. Amidst falling ASP, the name of the game until then is to stay solvent -- scaling capacity through market share expansion and delivering on performance promises. Of concern, there is noted lack of visibility in how the CEEG acquisitions will actually help China Sunergy stay afloat:

For the fourth quarter, sales to these related parties totaled $31.4 million, or about 32 percent of total revenue. Aside from the purchase of captive business and the cash grab by chairman Lu, who also beneficially owns about 15 percent of China Sunergy stock, the company hasn't disclosed assets or liabilities the two CEEG companies are bringing to China Sunergy's balance sheet.
At year-end 2009, the acquired CEEG entities (controlled by Lu) accounted for roughly 40 percent of total accounts receivables of $15.3 million. As one cannot owe money to oneself, the $7 million write-down will lead to a reduction in-kind of stockholder equity of $166.5 million.

With its domestic market becoming even more crowded with silicon, solar cell, and module makers, the company is looking abroad to stabilize margins. In first-quarter 2010, management expects domestic shipments to be only 35 percent of forecasted 68 - 75 MW (down from 56 percent of total 2008 shipments).

Adding scale and market share -- at least near-term -- will pressure margins. It is difficult to comprehend how the acquisitions will stabilize margins -- as predicted by chairman Lu. Positioning itself as a player in new markets, like Ontario and Italy, will require even more aggressive price breakpoints: Blended ASP during the fourth quarter declined year-on-year 57.5 percent to US$1.26 per watt.

Gross profit margin improved 140 basis points during 2009 to 5.8 percent, mostly due to the sharp decline in silicon costs: Wafer costs in 2009 declined 66 percent to US$0.95 per watt; wafer costs per watt as a percentage of total production costs per watt declined to 76.6 percent, from 90.2 percent in 2008.

Whereas consensus is ASP will continue to decline in 2010, forecasts differ on forward pricing of solar wafers, with iSupply calling for an additional decline, on average, of 18.2 percent, compared with a firming in prices projected by other market analysts. To avoid margin contraction, China Sunergy had better come through with promised improvements in throughput rates off their assembly lines and higher solar conversion efficiency rates (PV performance).

In the midst of great joy, do not promise anyone anything. ~ Chinese proverb

Management's promise of a lower cost structure by second half of 2010 is being met by more skepticism than joy. In a volatile environment, liquidity is a must. I predict cash burn will accelerate faster than cash inflow from operations, likely resulting in a dilutive convertible bond offering (so popular with Chinese solar companies) later this year:

Again, management misled investors -- announcing that the payment of the $47 million would occur "in a series of installments." A closer read of the regulatory filing with the SEC suggests, however, that approximately $38 million will be paid to chairman Lu (and company) this year.
Long-term debt to equity ratio of 26 percent is deceptive, too. The company relies on short-term bank financing to fund working capital and capacity expansion needs (recourse backed by CEEG). Short-term bank borrowings cast a long shadow -- almost 62 percent of stockholder equity.
In October 2009, management announced the resolution of a shareholder class action lawsuit (which alleged the company failed to disclose actual feedstock inventory risks in its May 2007 IPO prospectus). Settlement terms have yet to be finalized, but similar litigation recently resolved by LDK Solar led to payment of $16 million to its plaintiffs (unknown how much of this amount its insurance carriers paid).
The company has contractual obligations totaling approximately $433 million for raw material commitments (mostly silicon) through 2012.
Plans call for breaking ground on a new manufacturing facility in Shanghai come second-half 2010. Management did not return my email queries as to the total estimated construction costs of the project.

Most of the company's third-party solar-cell sales agreements are fixed price (with a quarterly option by the buyer to reduce offer price if ASPs decline). If silicon wafer prices reverse direction, gross margins and cash flow will be squeezed, as China Sunergy buys most of its silicon on the spot market.

Pick the flower when it is ready to be picked. ~ Chinese proverb

With material costs expected to decline less than the ASP of both PV cell and modules this year, it looks like chairman Lu knew when to pick that ripe flower.