August 27, 2009 ndash; LDK Solar (NYSE:LDK) announced an agreement with Yancheng City of Jiangsu Province for the development of a number of PV projects (ground-mount, roof and BIPV) totaling up to 500MW over the next five years. And Canadian Solar (Nasdaq:CSIQ) said it has signed a LOI with the Administration Committee of Baotou National Rare Earth Hi-Tech Industrial Development Zone in Baotou, Inner Mongolia, for rights to design, install, operate and maintain a 500MW solar facilitynbsp; in Baotou. The three-phase project is expected to start in September 2009 and run through December 2011 (phase 1: 100MW; phase 2 and 3: 200MW).

These announcements mark an important trend in the solar markets and one that we have been commentating on a lot lately ndash; the further move by midstream solar firms to vertically integrate downstream and even moving into operations of solar facilities.

Cowenrsquo;s Raj Seth this morning commented on the LDK announcement stating that it is a positive for the stock (100MW if 6% of 2010 shipment estimate for LDK), but he emphasized that the company remains challenged by falling ASPs, uncertainty about internal poly production and a weak balance sheet.

Massive oversupply in the upstream and midstream channels exacerbated by tight credit markets and project delays have been a thorn in the side of solar manufacturing firms and have driven ASPs down ndash; pressures persist. As a means of reacting to these pressures, firms like LDK and Energy Conversion Devices (Nasdaq:ENER) have made moves to acquire ownership in integrators. The primary rationale being that this will create further project opportunities, sales channels, and potentially provide some extra operating leverage.

The strategy makes sense and the risk is largely going to be in execution. But vertically integrating system development and installation will likely not be a silver bullet. Just look at the pure play downstream players like Real Goods Solar (Nasdaq:RSOL), Akeena (Nasdaq:AKNS) and Solar Power (SOPW.OB) who have all struggled with their business models to achieve profitability and operating efficiencies.

The biggest problems that we see with downstream business is that margins are hard to control/expand (cap intensive and labor intensive) and it is basically a one-off business. Some downstream players are trying to move upstream into manufacturing to create operational leverage of their own (pace Akeena and Solar Power) but it is difficult to compete with the kind of scale that established midstream solar manufacturers have already established, and in the current environment it is no recipe for margin expansion. Frankly, it just adds another layer of execution risk.

The model that we think is best suited to survive, and thrive, in the current environment is one that newcomer EPOD Solar (EPDS.OB) is implementing. EPOD is totally vertically integrated. It manufacturers amorphous thin film solar product and it pushes that product into solar parks that it designs, engineers, develops and operates. Its projects create the demand for the solar panels that it is making. The challenge to this model is in the financing of projects but EPOD is mitigating that issue through developing projects with partners that can help capitalize them in part, or in certain cases in full (where it sells 100% of the facility).

Canadian Solarrsquo;s announced LOI above reflects a move to this model, and First Solarrsquo;s (Nasdaq:FSLR) purchase of Optisolarrsquo;s projects does as well (note that EPOD purchased Optisolarrsquo;s manufacturing and Ramp;D facilities). And there are variations on this model ndash; pace French utilityrsquo;s EDF who recently announced a venture with First Solar to build a 100MW thin film manufacturing facility in France whereby it has rights to the facilityrsquo;s entire output for the first 10 years. EDF had 20MW installed at the end of 2008 but has plans to ramp its solar project developments.

From our perspective, in the current environment where feed in tariffs and long-term PPAs are available, it makes more sense to pursue a strategy in solar to sell electricity instead of panels. Panels will continue to get commoditized and prices will continue to trend lower. Competition will only get more stiff and there will be a shakeout amongst manufacturers. The low cost producers will survive. Attrition will displace the rest.

This is good news for solar, because lower panel prices translate into lower system costs and the ability to compete on a non-subsidized basis with conventional energy sources. And manufacturing firms that achieve economies of scale and continue to advance their technologies will make up for the lower pricing with greater efficiency.

The Energy Information Association projects that electricity demand will increase by 26 percent from 2007 to 2030, or by an average of 1.0 percent per year. The largest increase is in the commercial sector (38 percent), where service industries continue to lead demand growth, followed by the residential sector (20 percent) and the industrial sector (7nbsp;percent). Population growth and rising disposable incomes increase the demand for products, services, and floorspace, and ongoing population shifts to warmer regions increase the use of electricity for space cooling.nbsp; The EIA expects real retail electricity prices to rise to 10.4 cents per kWh in its 2030 reference case.

So with electricity prices expected to remain stable, and with the availability of feed-in-tariffs, which require electricity utilities to buy renewable energy at above market rates (set by the government) from anyone that wishes to produce renewable electricity, the economic advantage of a solar manufacturing firm moving into development and operation of solar parks ndash; electricity sales ndash; is undeniable. Under this model, lower panel costs which translate into lower system costs ultimately result in higher internal rates of return on the solar parkrsquo;s performance.

The Street may have a difficult time, initially, coming up with a way to value companies moving towards the manufacturer/independent power producer (IPP) model. Under this model, declining ASPs are meaningless. On the other hand, cost-per-watt and system installed costs are critical, as are the net capacity yield of a solar park and energy system paybacks.

At the end of the day, what matters is profitability, and in our opinion, solar manufacturers that take advantage of current market conditions to build, own and operate solar parks that house their panels will gain an advantage.

Important Disclosure: SCPEditor is managing partner of Aspire Communications whichnbsp;is engaged by EPOD Solar, and Todd Pitcher has investments in EPOD, LDK and First Solar.

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