Should You Short First Solar?

First Solar (NYSE: FSLR) is attracting the attention of short sellers -- traders who bet on a tumbling stock price by borrowing the shares from a broker, selling them, and hoping to profit by repaying the borrowed shares by buying them back at a lower price in the open market. At 23%, First Solar's shares short as a percent of total shares outstanding is at a record high. Should you bet that First Solar will fall?

To make that decision, you ought to decide whether the risks of shorting First Solar are less than the upside. And there are plenty of risks to shorting a stock. The first is that if your short bet goes bad and the price of the stock rises above where it was when you sold it, you need to write a check into your margin account with the broker. And if that stock price rises enough, the broker could force you to immediately repay your loan by buying back the stock and taking a loss.

First Solar is a $2.5 billion (most recent years' sales) Tempe, Ariz.-based maker and seller of so-called photovoltaic (PV) solar power systems -- the world's largest such manufacturer. Those systems include solar modules that convert sunlight into electricity. First Solar sells those components to project developers, system integrators, and renewable energy project operators.

Not only is First Solar big, but its sales have been growing fast, it's profitable, it has a low-risk balance sheet, and its stock is reasonably priced relative to its earnings growth. Specifically, First Solar's sales have been growing at a 122% annual rate for the last five years and it earned $608 million in profit during the last year, a 24% net profit margin.

The $10.4 billion market capitalization company has virtually no debt (a debt/equity ratio of 0.04 way below the industry's 0.3) -- which means that it is in no danger of running out of cash soon -- and it trades at a reasonable Price Earnings to Growth (PEG) ratio of 1.11 -- its P/E is 17.3 and its earnings per share are expected to grow 15.6% to $10.89 in 2012.

So why are short sellers piling in to First Solar? They believe that supply vastly exceeds demand and that will continue to produce price cuts that will cause revenues and profits to plummet. For example, according to Bloomberg, Italy and Germany slowed development of solar projects even as two of the world's solar-cell makers by capacity, China’s JA Solar Holdings Co. and Suntech, were leading "an industrywide expansion of factory capacity."

New Energy Finance estimates that this will lead to about 33% slack industry productive capacity. That's because those new manufacturing lines will account for 9.5 gigawatts of production going online by the end of 2011 -- leading to an industry total of 41.5 gigawatts -- while demand is not likely to go any higher than 28 gigawatts.

This is not a huge surprise to investors though -- an index of solar stocks lost quarter of its value since reaching a 13-month high on Feb. 18. And solar cell makers have cut prices about 21% so far in 2011 according to Bloomberg.

But it's not like this bad news is a surprise. In fact, there seems to be a Wall Street bias against solar. One curious story is that on May 4, 2011 CNBC reported on the air that First Solar missed earnings expectations. But in fact, First Solar beat expectations by 15% -- nevetheless, its stock fell 10%, according to Motley Fool.

Sure, there is excess capacity in the industry but this comes as no surprise to investors. Meanwhile, First Solar is expected to be profitable and has virtually no debt, putting it at no risk of near-term bankruptcy. Hence, the risk of a short squeeze -- where short sellers are forced to buy the stock to repay the shares they borrowed from their brokers -- is pretty high.

All it would take is earnings that are better than diminished expectations. The balance of risk and return from shorting First Solar shares suggests that you might not want to join those short sellers just now.