By Nick Hodge

As investors, you're obviously at least aware of the now ubiquitous solar market.

But simply being aware of it is no longer enough.  To really make money in this industry—predicted to grow as much as 35% annually for the next few years—you must first fully understand how a solar panel comes to be and which companies specialize in each step of the process.

The Solar Panel Process

Long before a solar panel (called a module in the industry) can be installed on a roof there are many steps that take place.

It all starts with plain ol' sand, from which silicon is extracted via various processes.  

The refined and nearly pure silicon, called polysilicon or poly, is then heated and cast into cubes, called ingots.

Cube-shaped ingots are then sawed into square wafers.  And then the magic happens.

The polysilicon wafers are then placed on a substrate, usually glass, to make a solar cell.  A number of cells are then arranged together and set in place to form a panel.  The final package is called a module.

That's how a solar panel is made in a nutshell.  But hidden in those few steps are hundreds of companies, thousands of patents, and more than a few investment vehicles that can make those in the know a lot of money.

2009 Solar Energy Overview: Examining The Solar Profit Process

Let's take it step by step.

At the very beginning of the value chain we have polysilicon producers, of which there are a few big players and a few hope-to-be big players.  The product at this level is a commodity, so the low-cost provider wins as long as the product is pure and consistent.

Companies here include the Norwegian REC Silicon, a division of Renewable Energy Corporation (OSL: REC), the German Wacker Chemie (Frankfurt: WCH), and the private Hemlock Semiconductor Corp.

Advantages in the poly industry stem from adjustments to levels of purity, using recycled or scrap materials, and vertically integrating (more on that in a bit) to reduce operational costs and improve margins.  Remember, poly is a raw material and a commodity-any saved cost creates a competitive advantage.

There are now several companies in the wafer space, but only a few operate as pure or near-pure plays.    MEMC Electronic Materials (NYSE: WFR), whose ticker indicates its business, is a  big player here and is also a participant upstream in the poly business.  Renesola (NYSE: SOL) is also gaining traction.

These first two links in the solar chain have fallen victim to declining silicon prices, which have gone from over $400 per kilogram to $100 per kilogram in just the past few quarters, with $60 per kilogram likely soon.  The sharp decline was induced by a sudden oversupply as companies rushed to build new factories to meet rising demand.  Just as a glut of supply came online the future demand picture was muddied by the global recession, and prices plummeted.

You'll want to wait until demand visibility returns before dabbling in this sector.

The cell stage is where we begin to see a great deal of participants.  It's also where we see the most diversity in business models.

Some companies, like JA Solar (NASDAQ: JASO), focus exclusively on producing cells.  The more common approach is to vertically integrate, which means participating in the upstream and downstream segments of the solar market.

Here we have companies like Solarfun (NASDAQ: SOLF), Yingli (NYSE: YGE), SunPower (NASDAQ: SPWRA), Q-Cells (XETRA: QCE), and a number of other major players.  The idea is to control the silicon process from ingot to module, cutting costs by not having to purchase individual materials or parts at the spot price or via contract.  It also ensures consistent quality and the protection of intellectual property.

The only problem is, it's highly capital intensive to vertically integrate because you have to build factories that produce all the materials involved.  The tightening credit markets have led to companies not being able to secure financing, forcing them to stall or cancel expansion plans.

Not being able to expand means not being able to increase capacity, leading to no new sales growth and reduced stock valuations, which we're seeing now.

The last step is the production of a solar panel or module by arranging cells together, binding them, and adding the electronic components.  This is what companies get most noticed for, like Suntech (NYSE: STP) and First Solar (NASDAQ: FSLR), though the latter doesn't use silicon at all.

But as we've seen in the other segments of the solar chain, prices are falling for cells and modules too.  This excerpt from a recent Reuters article sums it up:

Analysts at HSBC forecast average selling prices for solar systems will drop by about a fifth in 2009 given oversupply and a tighter credit environment, but prices for cells and modules have so far fallen much faster than those for silicon and wafer. Several industry bellwethers, such as cell producers Q-Cells and Sharp as well as module maker Solon have had to revise outlooks.

In the long-term, price reduction is good for the industry because it allows solar to compete with the going rate for retail electricity.  But the rapid decline has left most producers holding the bag, sometimes having to sell panels at less than cost or with a negative margin.  

The industry, however, isn't going away by any stretch of the imagination.  Global installed capacity is still forecast to grow about 33% this year and about 22% in 2010.  

There is plenty of growth left for this industry that doesn't even come close to producing 1% of our energy needs yet.  Recent government mandates and incentives will ensure homeowners and financiers have good reason to put solar on their roofs or to fund large new installations.  That, coupled with a coming national renewable portfolio standard and carbon caps, will spark demand once again.

You'll want to have your traps set by the time the industry rebounds.  Many major producers are down about 50% in the last year or so, and are touching new lows this week.  

Getting in now and waiting it out could generate much higher than average gains.

Reprinted with permission from Energy and Capital