Why Canadian Solar Is In For a Rough Year

It wasn't long ago that Canadian Solar was one of the most valuable companies in the solar industry. It was highly profitable, had less debt than some competitors, and had moved into the systems business more aggressively than rivals.

But 2015 hasn't been a good year for Canadian Solar, despite continued profitability. Understanding where its weakness lies is key for investors in the future.

A Canadian Solar project built in Germany.

Not all that Canadian You might think that a company called Canadian Solar would be primarily a Canadian company. But in fact, it's primarily a Chinese company with a small manufacturing plant in Canada. It even gets hundreds of millions of dollars in debt funding from Chinese state-run banks.

This poses a few problems for Canadian Solar. First, it's facing import tariffs from the U.S. and even Canada, as well as import regulations in the European Union, which reduces its competitiveness in these regions. Competitors manufacturing outside China are seeing an incremental benefit from tariffs, but even those within China are building manufacturing in other countries, so competition from non-tariff-paying manufacturers is increasing.

The other big challenge is that Canadian Solar's lead in system development is evaporating. Nearly every other large manufacturer is moving downstream into building projects 10 MW and larger, and the projects it was winning in Canada with very little competition are drying up.

The windfall is almost gone When Quebec wanted to add solar to its power mix, it opened bids to those it deemed qualified to build there. The problem is, the qualifications were set in such a restrictive way that Canadian Solar won basically every project it wanted. In 2014 and 2015 it is selling projects for as much as $6 per watt or more, projects that would be sold on the open market for $3 per watt or less in a competitive environment. This created a windfall of revenue and profits, including $53 million for a 10 MW project in the second quarter

Canada soon figured out that it was overpaying for solar, and subsequent bids were opened up to a larger pool of competitors. By 2016, tens of millions per year in project profits in Quebec will dry up, and it's not certain that the company has the type of backlog to fill the profit gap. There's one last windfall in the fourth quarter, when 71 MW of projects are expected to be completed, but don't expect high margins to continue after that.

Not all projects are created equal The acquisition of Recurrent Energy was a big addition for Canadian Solar, but not all projects are as profitable as the ones Canadian Solar built in Quebec. At best, a vertically integrated solar company building solar systems will have a gross margin of 20%-25%, and Canadian Solar's most recent gross margin of 15.2% and guidance for gross margin of 12%-14% in the third quarter shows that having a systems business doesn't guarantee profitability.

What the company is facing today is competition from hundreds of project developers and dozens of module manufacturers who are all using modules similar to Canadian Solar's to build projects. That reduces margins and negates most of the advantage of having a systems business in the first place.

The rising solar tide could lift Canadian Solar The good news for Canadian Solar is that solar demand worldwide is increasing, and that could lead to higher margins for module sales and potentially even greater profitability on systems. But right now those potential upsides aren't playing out, and operations will likely get worse before they get better.

Things aren't always what they appear in the solar industry, and Canadian Solar's rapidly evaporating profits are proof of that.

The article Why Canadian Solar Is In For a Rough Year originally appeared on Fool.com.

Travis Hoium has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.