China’s 2001 entry into the WTO marked the beginning of the golden age of globalization. This was the catalyst that led to the global outsourcing of domestic manufacturing capacity to lower costs regions in the world. As a result, world economies became more interlinked. In 2016, President Trump began his administration by imposing tariffs on China, one of the United States’ largest trading partners. This signaled globalization’s peak and the beginning of a shift downward. This shift has continued with the Biden administration and the passing of the Bipartisan Infrastructure Law (BIL) ($550B) and the CHIPS and Science Act ($53B). The legislative goal is to improve US economic competitive, innovation, and industrial productivity.
On August 16, 2022, Biden signed the Inflation Reduction Act (IRA). It directs new federal spending toward reducing carbon emissions, lowering healthcare costs, funding the IRS and improving taxpayer compliance. The IRA’s primary objective is to spur investments in US domestic manufacturing capacity. This most recent legislative action is another step toward the “Made in America” goal and increasing manufacturing national security. We have written about it and its key provisions here and here.
Here in Part One, we’ll go into more detail on the key characteristics of the IRA and the earnings impact by examining one company – First Solar (FSLR). Next week, in Part Two, we’ll discuss other companies that may benefit.
What is the IRA?
Based on an analysis by Mckinsey and Company , the IRA directs nearly $400B in federal funding to clean energy, with the goal of substantially lowering the US’s carbon emission by the end of this decade. The funds will be dispersed via a mix of tax incentives, grants and loan guarantees. Clean electricity and transmission will receive the highest funding, followed by clean transportation, including electric-vehicle (EV) incentives.
In the past, the US has generally relied on imports for solar equipment. This law will encourage more production at home with incentives for domestic solar panels and inverter manufacturing. It is also designed to support the construction of renewable electricity plats.
Who benefits from it the most?
The majority of the $394B in energy and climate funding will be in the form of tax credits. Corporations with US manufacturing capacity are the biggest beneficiaries with an estimated $216 billion worth of tax credits available. The tax credits are meant to provide an incentive for private domestic investment in clean energy, transport and manufacturing. Many of the tax incentives are direct pay, meaning they can claim their credit in that tax year and be paid the following year.
In addition to higher energy prices, the IRA’s corporate tax incentive has contributed to the Solar sector’s outperformance.
How does this impact earnings?
The IRA has created a tailwind for the clean energy sector. Companies are now just beginning to discuss the potential earnings impact in their most recent Q4 commentary. Some have provided more details than others.
From an investment perspective, the key is to identify companies with US based manufacturing capacity that can collect these tax credits and whose earnings will benefit in a meaningful way.
We’ve identified First Solar (FSLR) as one of the biggest beneficiaries of the IRA. Due in no part to the fact that they have provided the most visibility as to how the IRA will impact their earnings. In doing so, they have provided a useful investment framework to assess how other companies may benefit. We will discuss this next week and cover Enphase and Tesla, just to name a few.
We also want to emphasize that tech will see very few tailwinds this year, so it makes sense to take our time and to drill deep into one tailwind we have identified.
How does the IRA Tax Credit (IRATC) work?
This is how First Solar described how the IRATC will work.
“And finally, a few words on the Inflation Reduction Act. The IRA offers, amongst other incentives, production tax credits for solar modules and solar module components manufactured in the U.S. and sold to third parties. Although we continue to await guidance from the IRS and Treasury regarding these credits under Section 45X of the statute, based on our view of both the intention of the credit and the language of the legislation, we intend to begin recording a corresponding benefit in our financial statements in Q1 of 2023. Following consultation review with outside advisers, our auditors and the SEC, we expect to recognize these credits as a reduction to cost of sales in the period such modules and the integrated eligible components are sold to customers.”
In their 2023 guidance, they went on to say
“I’ll now cover the full year 2023 guidance ranges. Our net sales guidance is between $3.4 billion and $3.6 billion; gross margin is expected to be between $1.2 billion and $1.3 billion, which includes $660 million to $710 million of advanced manufacturing production tax credits under Section 45X of the IRA; and $110 million to $130 million of ramp and underutilization costs.
This results in a full year 2023 earnings per diluted share guidance range of $7 to $8”
FSLR’s guidance provides insight on the impact of the IRATC. To simplify the analysis, we’ve taken the mid-point and excluded the ramp-up related costs.
In the case of First Solar, the IRATC has a significant impact on profitability – gross margins double. Another way to look at it is that in addition to the estimated 2023 average sales price of $0.29 per watt, First Solar will receive $0.17 per watt in the form of the IRATC. This is how FSLR breaks down the IRATC:
“Given our fully integrated thin film manufacturing process, we expect that this guidance will entitle us to integrated tax credits for wafers, cells and module assembly, which we estimate will equal approximately $0.17 per watt for modules produced in the United States and sold to a third-party.”
First Solar has been advised to treat the IRCTC as a reduction in costs of sales. As a result, it’s important to focus on their growth in earnings per share. Assuming other companies adopt the same reporting standard, the same investment parameters will apply.
Consensus earnings are expected to increase 80% from 2023 to 2024. Comparing it to 2022 is not an apples-to-apples comparison as there was no IRCTC benefit in 2022 while gross margins were impacted by higher-than-expected logistic related costs. There were mainly penalty costs related to exceeding dock waiting times due to Covid supply-chain issues. FSLR has indicated that these and other costs will trend back down toward pre-pandemic levels over the course of the year.
Not every company will capture a similar level of profitability uplift. Generally speaking, those with higher domestic content can claim more of the IRATC. Companies will seek to capture as much of the IRATC as possible. And from an investment perspective, companies that have existing domestic capacity and can claim the IRATC in 2023 will be the stocks that benefit the most in the short-term.
FSLR provided insights on domestic capacity expansion as it relates to collecting the IRATC.
“… we believe that the intent of IRA is to create enduring long-term supply chains, which would therefore motivate and align the incentives to true manufacturing in the U.S., more than just final module assembly with all the build material being sourced from international locations.
And if everything lines up along those lines, then that sort of helps inform our view there as it relates to the inherent value of more domestic manufacturing, plus we want to make sure that, while we believe we're fully entitled to the vertically integrated manufacturing tax credit, to the extent that we can get confirmation through guidance from IRS and Treasury, that would be very beneficial as we think about factory expansion.”
The key word is “vertically integrated”. The more that a company’s US based manufacturing is vertically integrated, the more of the IRATC it can claim
Making of a National Champion
We’ll now take a closer look at FSLR and examine how they will benefit. But first let’s see how FLSR spoke about IRA after it was signed into legislation. This is what FSLR said in their Q322 call.
“I would like to discuss the U.S. policy environment, which has evolved significantly over the past quarter. As you may recall, the joint announcement from Senators Manchin and Schumer regarding the Inflation Reduction Act preceded in our last earnings call by just 1 day. Since then, we have seen the Act signed into law and First Solar had the privilege to be part of the White House event in September, celebrating the groundbreaking piece of legislation.
In our view, by passing and enacting the Inflation Reduction Act of 2022, Congress and the Biden-Harris administration has entrusted our industry with responsibility of enabling and securing America's clean energy future, and we recognize the need to meet the moment in a manner that is both timely and sustainable. Thanks to our strong foundation, including a repeatable, vertically integrated manufacturing template, proven technology platform and solid balance sheet, we were able to respond rapidly to enact — to act by accelerating the decision to expand our U.S. manufacturing base.”
“Broadly speaking, 2022 placed us on the cusp of significant growth in domestic solar manufacturing within our core markets.”
It goes without saying that IRA is an important piece of legislature. First Solar is positioning themselves as one of the National Champions to help IRA’s implementation. As we’ve seen internationally, National Champions typically get to provide input into and receive beneficial treatment from the government and other regulatory bodies. We believe the amount of IRATC visibility that FSLR has provided, in contrast to others thus far, is a reflection of that.
What does FLSR do?
FSLR manufactures solar modules based on thin film Cadmium Telluride (CadTel) photovoltaic (PV) technology demonstrated to have lower cost, superior scalability, and a higher theoretical efficiency limit over conventional technologies, like crystalline silicon (c-Si). Solar module sales represented 93% of total sales and the majority of sales were to developers and operators of systems in the United States. A few of its largest customers include Intersect Power, Lightsource BP, and NextEra Energy. FSLR will benefit as their clients have an incentive to build out their own capacity to capture the IRATC. This is how FSLR described the IRATC opportunity for its customers.
“The opportunity for everyone, whether you're the developer or whether you're the module manufacturer or whether you're the IPP or the utility who's going to own the generating asset over time, there's opportunity for everybody.”
“And so the question is, do you want to sort of secure your business plan and take risk off the table? And if you're willing to do that and do that at a fair price, then First Solar is a great option to do that. If you're trying to take some risk and you're wanting to find opportunities to avail yourself to potentially alternative supplies that maybe will still allow you to benefit to the maximum potential under IRA, then that's a risk that some may want to take and wait. But what we see right now is that we've got more than enough opportunity to engage. Yes, it's an item that is in some of our customers' thought process. But for the most part, most people aren't paying a lot of attention to it in that regard.”
Where does FSLR manufacture?
Currently, the US is 36% of their 9.8 GW manufacturing capacity. By 2024, this will expand to 50%. Total manufacturing capacity is estimated to reach 21.4 GW by 2026. FLSR will also benefit from India’s Incentive Production Scheme to encourage domestic based solar manufacturing.
Is there demand to this utilize this increase in capacity?
Below is the amount of GW has booked through 2/28/23. FSLR has booked 67.7 GW of future deliveries. Clients typically put up to 20% down payment to secure that order – the contracted backlog is 61.4 GW.
Q422 Investor Presentation
Regarding the contracted backlog, FSLR stated the following
“We had a total contracted backlog of 61.4 gigawatts with expected future revenue of $17.7 billion for a portfolio average base ASP of $0.288 per watt, before the application of potential adjusters”
Put another way, their contracted backlog is 6x their current manufacturing capacity. This is a product of FSLR’s customers preparing to build their capacity to capture the IRATC. This type of secular demand provides FSLR great visibility on future sales and pricing power. FSLR is sold out through 2025 (excluding India). FSLR’s focus is negotiating solely for 2026 volume and working with customers who are looking to secure multiyear contracts over the remainder of the decade. This is how FLSR described the current demand environment:
“We also began the year with a record contracted backlog, a significant pipeline of bookings opportunity and a robust demand in our core markets. This momentum is driven by our points of differentiation, including a unique CadTel technology, vertically integrated manufacturing process, domestic production, strong balance sheet and commitment to responsible solar, placing us in a position to respond to emerging opportunities, particularly those enabled by the rapidly evolving policy environment.
“After accounting for shipments of approximately 2.3 gigawatts during the fourth quarter, our future expected shipments, which now extend into 2029, are 67.7 gigawatts. Excluding India, and including our year-to-date bookings, we are sold out through 2025. We have, in recent months, pivoted from negotiating solely for 2026 volume to work with customers who are looking to secure multiyear contracts over the remainder of the decade.
From a commercial perspective, in 2022, we saw a precipitous shift towards long-term, multiyear module procurement. This record volume of multi-gigawatt deals spanning multiple years was driven by a combination of competitive pricing, competitive technology, agile contracting, shared values and trust in our ability to deliver the certainty that our customers are looking for. As a result, we had an excellent year from a bookings perspective, securing a record 48.3 gigawatts of net bookings in 2022. This was an increase of 30.8 gigawatts from our prior annual record of 17.5 gigawatts set in 2021. Our total backlog of future deliveries as of today's earnings call now stands at a record 67.7 gigawatts.”
“As it relates to converting the pipeline into future bookings, our record bookings in 2022 were driven by the favorable balance of near to mid-term available supply, aligned with customer demand for large volume multi-year procurement.”
“Our commercial strategy remains largely focused on supporting long-term multi-year customers who prioritize price and product availability certainty as well as ethical and transparent supply chains.”
This is how FSLR described the positive impact on profitability as they expand capacity to meet demand.
“I’d like to reiterate our approach to growth and gross margin expansion … this strategy includes our approach of contracting out our capacity several years in advance of production. The anticipated reduction of our cost per watt produced, the expected benefits from capacity expansion through scaling a largely fixed overhead structure in order to generate incremental contribution margin and our agile contracting approach would both provides the potential realization of incremental revenue and is expected to mitigate freight and certain commodity risks.”
Assuming, a return to pre-pandemic costs inputs levels (raw materials + logistics), the key drivers of earnings will be FSLR meeting GW expansion targets, ASP per watt and the IRATC combined with positive operating leverage. US pricing in particular may benefit from positive price adjusters that they can charge their customers based on the IRATC.
Can FSLR fund this?
One of FSLR’s competitive advantages is their financial position. Clients know that they are a financially stable partner. FSLR will not require external financing.
“Operationally, in 2023, we’re expecting to produce 11.5 to 12.2 gigawatts of modules, and after taking into account reductions in inventory, fell 11.8 to 12.3 gigawatts. From a capital structure perspective, our strong balance sheet has been and remains a strategic differentiator, enabling us both to weather periods of volatility as well as providing flexibility to pursue growth opportunities including self-funding our Series 6 and Series 7 transitions.”
“We ended 2022 in a strong liquidity position. And coupled with strong forecasted operating cash flows, modular advance payments and our existing India credit facility, we expect to be able to finance our current capital programs without acquiring external financing. We are evaluating putting in place our revolving credit facility to support jurisdictional cash management as well as to provide short-term optionality and expect to address more details on our capital structure and liquidity outlook at our Analyst Day.”
Sales vs EPS
Given the accounting treatment of the IRATC, it is important to identify companies whose earnings will benefit from the IRATC. Sales will still be important, but it won’t capture the IRATC benefits. Here’s a consensus snapshot of FSLR’s EPS and Sales.
Sales are still growing at a healthy rate due to capacity expansion while earnings are forecasted to grow at more than 2x that rate because of the IRATC. Recall that 2022 had no IRATC benefits and gross margins were severely impacted by logistic costs.
“Note from an earnings cadence perspective, we anticipate our earnings profile will be higher in the second half of the year, both due to contractual delivery schedules as well as the timing of first sales of our Series 7 products, which are forecast to begin shipping in Q3 of this year. This is forecasted to result in an increase in inventory at our distribution centers in the first half of 2023, which is expected to reverse in the second half of the year. Additionally, Section 45X credits, recognized, will increase after Q1, driven by both the timing of volumes sold as well as the inventory lag, whereby products sold in the early part of 2023 may have been manufactured in 2022.”
Given the recent rally after Q4, this timing effect may provide an opportunity to enter at lower levels.
How does valuation look?
Even after the recent rally, FSLR’s valuation is not demanding based on 2024 eps. Using 2024 EPS, price and multiple sensitivity indicates the valuation potential is between $275-325. We won’t start using 2025 EPS just yet.
How do the technicals look?
We aren’t the first to appreciate the FSLR investment case. However, as long-term investors we believe this case will play out over several years and the market will provide us better entry points.
Per Knox:
FSLR is completing a symmetrical 3 wave uptrend. Note how the length of the second push higher (C wave) is nearly identical the in percentage gains from the first push higher (A wave).
The $235 region will be the exact symmetrical target for this move, and it is pushing towards this important resistance zone on weaker momentum. We will be looking for some kind of pullback from this region.
For those looking for a riskier buy, I’d look for the $175-$145 region, if we get there. The safest place to buy is if/when it can breakout above the $235 region.
Conclusion
The Inflation Reduction Act is an important piece of legislature. Winners will emerge as a result. We’ve identified FSLR as a winner over the next few years.
In Part 2, we will apply the same IRATC investment framework to assess how other companies are positioned. As a sneak peak, Enphase has indicated they will capture a portion of the IRATC benefits but more likely toward the end of 2023 into 2024. Look for a follow up next week or so.
I/O Fund analyst team contributed to this article