3 Stocks That Can Survive the Solar Shakeout

Here's how to separate the winners from the losers in this hot sector.

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There seems little doubt that the solar-power industry has a bright future. In the drive to decrease dependence on fossil fuels, solar is often touted as the most promising renewable-energy solution. Venture capital investment in the industry grew from $150 million in 2005 to more than $1 billion in 2007, Greentech Media Research reports. Greentech expects that number to jump an additional $2.5 billion by 2010.

More money may also come flooding in from Uncle Sam: A bill currently before the Senate could shift about $18 billion of subsidies for big oil companies into wind and solar energy. The bill, approved by the House of Representatives last week, would extend the 30 percent investment tax credit for solar projects.

That's the bullish case. But a closer look shows that the near-term outlook is getting a bit cloudy for solar companies. At Piper Jaffray's Clean Technology and Renewables Conference in late February, senior research analyst Jesse Pichel said the industry is headed for a shakeout. Banc of America Securities analyst Eric Brown recently turned cautious on the group on grounds that "industry fundamentals are increasingly difficult."

At issue is the worldwide shortage of polysilicon, a vital ingredient in photovoltaic cells, which has dogged the industry by pushing spot prices of the material sky high. Yet a turning point will come when capacity exceeds demand, as polysilicon makers have been ramping up production. In a recent report, Citigroup says that could happen as early as the second half of 2009: "A significant increase in new polysilicon capacity would likely cause industry oversupply, resulting in a potential industry cyclical correction which could drive down both polysilicon and module prices." Citigroup analysts expect the industry to be 33 percent oversupplied in 2010.

Another dark cloud for solar, says Brown, is slowing demand in Spain and Germany, both considered key markets because of government incentives that have sped solar development. Brown sees decelerating demand in the two countries over the next six to 12 months because of declining subsidies, according to a recent research note.

So how do you separate the winners from the losers among solar stocks, which have suffered steep losses this year? (Among the casualties: SunPower is down 49 percent in 2008, Evergreen Solar 55 percent, and Solarfun 65 percent.) According to Citigroup, companies best positioned to survive a potential industry downturn are low-cost providers with "superior scale." Here are a few suggestions from the experts:

The current industry darling is Suntech Power Holdings, which Citigroup analysts recently crowned "the best positioned solar company in China." The company is expected to pass Japan's Sharp Corp. this year to become the world's largest maker of solar cells. On February 20, investors punished Suntech's shares with a 12 percent sell-off (the stock is down 55 percent so far this year). Suntech maintained its initial 2008 production outlook of 530 megawatts of power. Most analysts had expected the company to boost its shipments to 600 to 700 megawatts.

But with polysilicon prices on the rise, Suntech is focusing on preserving its bottom line rather than expanding production. The company has shifted more production to the second half of the year in hopes that prices for polysilicon will fall. "This has resulted in what we believe is a healthy re-rating of street numbers as well as the stock price...we believe estimates are conservative enough that upside to estimates is likely," Citigroup analysts wrote in a note to clients February 27. Citigroup sees Suntech's shares, recently $37, hitting $55 within the next 12 months.

Given the bottleneck in polysilicon supply, Jerry Jordan of the Jordan Opportunity fund is bullish on MEMC Electronic Materials, a leading supplier of silicon wafers to the solar and semiconductor industries. As one of the few companies that make silicon wafers, MEMC has actually benefited from the silicon shortage. "Others are trying to ramp up capacity, but they appear to be hitting snags," Jordan says. The shares of this St. Peters, Mo.-based company, recently $78, are down from $94 in December. Jordan thinks they're worth $100.