Here comes the sun

In 2008, the clouds of pollution that clot the skies over China’s cities had officials there gasping for relief. They were even more troubled by the slowdown in China’s economy. Their solution was to promote solar energy, not only for clean energy production but also for exports and jobs. The government backed the solar panel industry with massive lending programs from state-controlled banks.

China’s solar module manufacturing capacity grew from less than 5 gigawatts in 2007 to just under 40 gigawatts in 2011, more than double the total in the rest of the world, and far in excess of demand. The market for solar modules was only 5 gigawatts in China and 30 gigawatts globally. The result was a collapse in panel prices worldwide.

Suntech’s power fails

For Suntech, China’s largest solar panel maker, prices fell from $3.72 per watt in 2007 to $1.51 per watt in 2011. In terms of volume, Suntech’s sales were strong, with sales in megawatts of generating power up 34% in 2011. But low prices coupled with above-market, take-or-pay supply contracts for raw materials short-circuited profits. Adjusted for special charges like asset impairments, operating profits were negative in 2011 and the first quarter of 2012.

Suntech’s free cash flow was negative in most years because of heavy investments in working capital and in plant and equipment. The company was able to offset operating losses with working capital efficiencies, and cash flow from operating activities went from ($30) million in 2010 to $93 million in 2011. But capital spending proved harder to cut; it actually increased from $276 million in 2010 to $367 million in 2011.

Suntech funded those persistent cash flow deficits with debt, driving leverage to very high levels in 2011. Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and other banks had loaned $1.7 billion to Suntech by the end of 2011, and there were $585 million in convertible bonds outstanding. On March 15, 2013, the company defaulted on its bonds, triggering a cross-default with its bank debt. On March 20, the company was forced into bankruptcy by the banks.

Credit lessons

Disasters come from compound risks. It took a combination of speed, darkness, and shortage of lifeboats to sink the Titanic and drown 1,502 of her passengers and crew. In credit it’s usually a mix of business and financial factors that brings a company down.

In Suntech’s case, the key business risk factor was what we call an industry cycle, something we’ve blogged about earlier using shipping as an example. They are more common in mature industries, but even an emerging business like solar panels can generate one and see prices and profits fall.

The key financial risk factor was too much debt. Suntech’s interest expense was $136 million in 2011, well above the income or cash flow available to pay it without adding more debt. With the banks unwilling to make more loans, the only solution was to try to restructure Suntech’s debt in bankruptcy.