Bayesian Bets: First Solar And The Market’s Mispricing Of Political Risk (NASDAQ:FSLR)

Investment Thesis

First Solar (NASDAQ:FSLR) is an American Solar manufacturer headquartered in Tempe, Arizona, with research and development labs in Ohio and California and manufacturing facilities in Ohio, Alabama (expected 2024), Louisiana (expected 2025) Malaysia, Vietnam, and India.

When I last covered First Solar on July 16, 2024, I highlighted First Solar’s leading position as a domestic manufacturer of solar panels in the United States, enabling the company to benefit substantially from the Inflation Reduction Act (“IRA”). I also noted secular tailwinds from the need to increase energy production to support investments in Artificial Intelligence (“AI”) as well as trends towards electrification. Lastly, I noted cyclical tailwinds from an expected decline in interest rates, which should help drive additional demand due to the high leverage deployed in solar projects. Since publishing, the stock has dropped 4.3% outperforming the S&P 500, which has fallen 5.6% (based on closing prices from July 16, 2024, through August 9, 2024). Meanwhile, the company posted its fifth straight quarter of earnings per share (“EPS”) beats. First Solar also exceeded revenue expectations for the second quarter of 2024. At the same time, the odds of a second Trump term and by extension, a repeal of the IRA, originally blamed for the stock’s pullback from recent highs, have fallen dramatically. Although management was cautious on guidance, noting a potential near-term slowdown in demand from developers on policy uncertainty, they also suggested any slowdown would likely be resolved once policy uncertainty was removed.

I increased my price target to $317 from $307 and maintained my Buy rating. Furthermore, although I see substantial downside if the IRA were repealed, I continue to believe that this is unlikely and see the probability that the IRA is repealed as overpriced into the stock based on current betting market odds on the presidential election.

Earnings Overview and Model Updates

First Solar’s EPS came in at $3.25 per share, beating Wall Street estimates by 20% and Estimize projections by 15%. Revenue also surpassed Wall Street forecasts by 7% and the Estimize expectations by 4%. Notably, First Solar EPS has surpassed expectations for every quarter since the second quarter the IRA came into effect. First Solar recognizes the benefits of the IRA as a reduction of cost of goods sold (“COGS”) so the trend of EPS beats suggests analysts have consistently underestimated the benefits of the IRA.

Despite beating revenue and earnings expectations, the company left the full-year revenue and earnings guidance unchanged, causing Wall Street and Estimize analysts to reduce revenue estimates for Q3 2024. I reduced my projections for full-year sales from $4.7 B to $4.6 B and my full-year gross profit forecast from $2.2 B to $2.1 B, which is in line with the upper end of management guidance. I now expect $1.5 B in full-year net income. My net income forecast includes higher operating expenses (“OPEX”) than included in management guidance as OPEX appears to be trending higher despite management guidance for OPEX to be roughly flat from 2023 levels through 2026. However, I reduced my forecast for OPEX from 2025 onwards to be closer to, although still notably above, management expectations. I now see OPEX falling from 14% of revenue in 2023 to 11% of revenue for 2024, 9% of revenue for 2025 and 8% of revenue thereafter. The net effect of these changes in my base case is minimal, adding about $10 per share to my price target. The model updates add about $13 per share to my downside scenario reflecting a repeal of the IRA, where I also updated my projections for average selling prices (“ASPs”) and gross margins.

But how likely is it that the IRA will be repealed, and what is being priced into the market?

Looking at First Solar through Bayes Theorem

At the time I first published, betting markets were pricing a 66% chance that Donald Trump would win the US presidential election. If I assume my $317 price target for First Solar is accurate if the IRA is not repealed, there is a 100% chance that the IRA will be repealed given a Trump presidency, and the $221 per share was fair value for the stock based on betting market odds at that time, then the downside valuation assuming the IRA is repealed, being priced into the stock is $172 per share. That $172 per share would be reasonably close to my fair value estimate for First Solar assuming the IRA is repealed, of $182.

However, the betting market odds of a Trump presidency have dropped to 46% as of August 10th and the probability of the IRA being repealed given a Trump presidency is not 100%. It is far from certain that Republicans would also take the House and Senate or even that the manufacturing tax credit would be eliminated assuming a Republican sweep. Support for the IRA in Republican districts is growing, as illustrated by emerging excitement over green jobs being created through First Solar’s Alabama factory. The right’s rising reluctance to roll back the landmark legislation was recently revealed in 18 Republican representatives writing to speaker Mike Johnson, requesting that he refrain from repealing the IRA. If we assume a 75% probability that the IRA will be repealed given a Trump presidency (which I still contend is far too high), then based on current betting market odds for a Trump presidency and First Solar’s current stock price, the stock is only worth about $16 per share if the IRA is repealed. That is less than my projection for the value of cash less total liabilities per diluted share in 2027, the earliest I would expect the company to lose the benefits of the IRA.

Looking at this from a different angle, if we assume a 46% probability of a Trump presidency and a 75% chance that the IRA will be repealed given a Trump presidency, then the joint probability that the IRA will be repealed is 35%. If we assume my $317 price target for First Solar is accurate if the IRA is not repealed and my estimate of $182 per share is accurate if the IRA is repealed, then the stock should be trading at $269 per share. To the extent that the stock responded negatively to Biden’s debate performance and the assassination attempt of Donald Trump impacting the probability of a Trump presidency and by extension a repeal of the IRA, then the stock should have reacted positively to Biden dropping out of the race and the falling odds of a Trump presidency. I believe the relatively muted price action to the upside in the face of dramatically different odds of a Trump presidency represents an actionable mispricing.

Conservatism is a cognitive bias in which investors are slow to update their forecasts based on new data. In the wake of the assassination attempt on Donald Trump, his re-election seemed all but certain, but the Harris-Waltz campaign has reinvigorated the Democratic Party, dramatically shifting the odds. This, in my view, is yet to be incorporated into the stock. This represents an actionable opportunity to buy the stock by applying a Bayesian framework to estimate fair value ahead of the election. I don’t believe my $317 price target will be realized until there is greater certainty on the IRA. However, I expect the market will eventually price the changing odds, and by the time we have certainty on the IRA, the opportunity to buy the stock will have passed.