I read with great interest that Deutsche Bank is projecting a potential reduction in solar costs of around 40% in the next two years.
I’m excited to hear about this and don’t want to rain on anyone's optimism parade (because I’m an eternal optimist), however I think it’s really important to look at them in the context of local market conditions to understand how probable they are. To be clear, I am also optimistic that costs will fall, however I would argue that many of the cost reductions Deutsche Bank proposes are already in play in Australia.
I’d also like to state for the record that I really want to see lower PV prices because that’s good for market growth but if the prices and margins aren’t sustainable for businesses or aren’t built on high quality products and services, then it’s all an illusion. I don’t see every solar business but I see inside more than most people and I’m not witnessing much evidence of businesses making a sustainable profit level; especially small and medium businesses.
While there is some sound logic in their projections, I dissected the Deutsche Bank numbers in the Australian context because:
a) I think we are a special case and
b) when you take our idiosyncrasies into account, I’m not so convinced that these types of reductions are possible here.
Not a relative benchmark
Now I’m sure Deutsche Bank have read the numerous reports about the difference in international prices and soft costs, many of which we have been involved with. To me it looks like they have picked a mid-range sample as their number and I do understand that there are always a range of results within samples. However, I can say unequivocally that very few Australian solar retailers would have achieved $2.90/W in 2014, even prior to rebates as Deutsche Bank describes.
Recent sample market price data in Australia shows average (pre-rebate) prices that are 25% lower than Deutsche Bank’s numbers and at the low end of sampled prices our market is 50%, or a full $1/W lower to consumers.
So, our first comment is that the higher average prices from other parts of the world are dramatically skewing the view and most importantly the potential for reductions in Australia.
In short “Mate, catch-up will ya? While you’ve been faffing around we’ve already landed at your 2017 number.”
There are two issues that interest me in how our market (and indeed all others) are evolving which I have written about numerous times before.
The first issue is of perpetually declining revenues. Assuming you sell the same volume each year and the (cost and sale) price falls each year you get less revenue for the same effort. This in itself is a constant challenge for business to grapple with and has had profound impacts in countries like Australia where prices and cost have fallen substantially for obvious reasons. No rational person looks at a business plan with forward forecasts of perpetually declining revenues and says “excellent!”.
Managing this situation successfully has only three possible scenarios:
1. Increase the sales volume to match the lost revenue to (at a minimum) keep revenue flat; and/or
2. Reduce costs such that the gross profit is adjusted (upwards) to compensate by getting more efficient; and/or
3. Increase the gross profit by lifting retail prices to achieve the same gross profit $.
If we take Deutsche Bank’s forecasts scenarios and assume our Dealer is doing 250kW a year in 2014, he’ll earn $725,000 of revenue in 2014. However, by 2017 to earn the same revenue, he has to sell 409kW. If you are clever and your market is growing and everything goes to plan, you might achieve that. However, the reality is that as markets heat up more players enter, fighting over market share, they don’t tend to be rational and so, this is no certainty.
So, if they can’t grow what does this mean for the sustainability of the business?
This brings us to the second issue of gross profits.
If we assume that our small retailer is making 25% GP in 2014 he would have earned around $181,000 after product costs to operate, pay taxes, advertise, pay rent and wages and do some business development and planning. That’s not a hell of a lot but, for sake of a benchmark, let's assume it’s enough. By 2017 if he doesn’t increase his GP by either lifting prices or reducing costs, he’ll only make $110k per year, assuming Deutsche Bank’s cost declines are correct. That’s about enough for an owner-operator, an occasional admin assistant and a very small yellow pages ad. That’s an extraordinarily marginal business.
To correct this via gross profit and maintain the minimum fixed costs of 2014 ($181,000) he would have to lift his GP from 25% on $725,000 of sales in 2014 to 41% GP on $442,000 of sales in 2017. Finding $70,000 of inefficiencies or increasing the price to consumers aren’t particularly appealing or probable scenarios (although there are some ways).
Ironically I had a chance call from small retailer yesterday who vindicated my rationale, except that to compete, he is more often around 15% GP. “Damn” he said “That’s exactly my business. As hard as we try, to compete I have to keep prices low or sales and revenue plummets and I know I’m in a pretty typical situation. It’s a great business to be in, but if you didn’t love it, or you listened to your accountant, you wouldn’t keep doing it.”
Although larger businesses are perhaps a little less fragile in this set of scenarios the pressure and the stakes are arguably just as high. In crude terms, as an example, a 10MW solar retailer, cranking out 238 systems per month, every single month, could spend its (2014) $4.3 million GP on 58 staff at $75,000 each. But by 2017, they would have to get that down to 35 staff, or cut wages or do something else to survive; a 37% headcount reduction.
We have described how Australia’s prices are already effectively at the level that Deutsche Bank predicts for Australia.
Arguably they are on the verge of unsustainability already, and we have prolific revenue and margin compression issues here which are less relevant in other countries. So far.
Of course, we also have a foreign exchange issue to manage that is currently forcing most product prices up.
Whats the message?
There is a vitally important and simple message here for our policy makers: Deutsche Bank’s projections aren’t relevant here in Australia.
Nigel Morris is director of Solar Business Services.