For a while, before the 2008 market crash, the hottest analysts on the street were watching solar stocks from China, the U.S. and Europe. Like the dot-com boom that came before it, solar companies are operating in a new industry with uncertain prospects for profitability. It’s possible that solar could become a much bigger industry in the future, but that was a pretty big guess and eventually the bubble popped.
In 2008, Yingli Green Energy (YGE) dropped in value from $40 per share to $2.50 as it accumulated losses, suffered a credit squeeze and the global economy dropped into recession. Stocks like this are always the first to be sold when times get bad. Because they are in such a precarious position they can often provide a warning sign that things are going to get worse again — or at least it will get worse in their industry.
We recommend a short position on YGE for three reasons.
- The company is growing — but much of that growth is in the form of very low quality assets.
- The price of the product is falling as the company continues to produce losses.
- The technicals are signaling the potential for a blowout.
You Can’t Usually Finance Your Way Out of Losses
Growth is always tricky to quantify. YGE has recently grown its bottom and top-line numbers (although profit is still negative) but this does not mean the company is actually “growing” in value. To understand why, imagine that you owned a business that created widgets but your suppliers were in bad shape and might not be able to keep supplying you the necessary materials and equipment because too many of their other customers have gone bankrupt. Is your current growth sustainable in that situation? No.
Now imagine that you make a deal with your suppliers to pre-pay for future inventory at a cheaper price so they can stay in business. That will be an asset on your balance sheet and since you got a good deal on the prepayment, your assets look like they are growing compared to debt. However, prepaying for future products that may not be delivered in order to get what you need to produce a product you sell below your own cost isn’t really a sustainable model. That is what YGE does.
The sad thing is that this isn’t hidden information, nor is it a new situation. YGE and other companies in the sector did this in 2007 as well. Assets ballooned as they borrowed cheaply, lent to suppliers and let their accounts receivable expand dramatically on looser credit terms. In addition to these credit related problems, inventory also expanded significantly.
The bottom line is that YGE could easily wind up in the same situation that LDK Solar (LDK) is in this year. LDK defaulted on their debt and are having to be bailed out (again) by the Chinese government. If YGE didn’t also have access to government funds themselves, they would already be bankrupt. The real problem with a company in that situation is that it merely delays the inevitable.
The price per unit sold and input prices for polysilicon are both falling. This is not always a problem for companies, but it is if the inventory was purchased at a much higher price. This puts the company at a distinct disadvantage and is one of the reasons why the Chinese government has turned its focus to subsidizing demand. That can work for a while, and has allowed YGE to survive as an ongoing entity but with Chinese economic growth slowing, they may not keep it up for much longer. If there are any hints that subsidies are going to be reduced, YGE will tank.
Investors Buying on Hope Are an Unstable Bunch
Finally, the technicals on YGE look bad. As you can see in the next chart, YGE paused at long term resistance (around $6.00 per share) after the stock spiked on earnings news that they lost less than expected over the last quarter. The run-up in price to resistance is particularly troubling when compared to the previous bullish trendline. This kind of breakout creates a very interesting trade entry setup.
Recommendation
Stocks tend to get sucked back towards their trendline unless the fundamentals justify the revaluation. In this case, the fundamentals look worse — not better.
Stock Trade: We recommend opening a short position at current price levels with a short term target of $4.50 per share. That target is roughly where we estimate the trendline will be by the time the stock retreats.
Short traders may want to be flexible when $4.50 is reached. A break of trendline support after a price spike like this tends to trigger selling frenzies, which could easily happen here. This is one of the reasons why an option position may be the better alternative.
Options Alternative: We recommend the YGE November $ 6 puts at current levels.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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