Canadian Solar - Earnings Call - Q3 2020

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by. Welcome to Canadian Solar's Third Quarter 2020 Earnings Conference Call. My name is Rachel, and I will be your operator for today. At this time, all participants are in the listen-only mode. Later, we will conduct a question-and-answer session. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Isabel Zhang, IR Manager at Canadian Solar. Please go ahead.

Isabel Zhang (IR Manager)

Thank you, Operator. Welcome, everyone, to Canadian Solar's Third Quarter 2020 Conference Call. Please note that we have provided slides to accompany today's conference call, which are available on Canadian Solar's Investor Relations website. Joining us today are Dr. Shawn (Xiaohua) Qu, Chairman and CEO; Dr. Huifeng Chang, Senior VP and CFO; Ismael Guerrero, Corporate VP and President of Canadian Solar's wholly-owned energy business; and Yan Zhuang, President of Canadian Solar's majority-owned subsidiary, CSI Solar Co., Ltd. All company executives will participate in the Q&A session after management's formal remarks. On this call, Shawn will go through an overview of Canadian Solar's strategy and provide an update on the listing of CSI Solar. Yan and Ismael will respectively review the highlights of the module and system solution for MSS and energy businesses, followed by Huifeng, who will go through the financial results.

Shawn will conclude the prepared remarks with the business outlook, after which we will have time for questions. Before we begin, may I remind listeners that management's prepared remarks today, as well as their answers to questions, will contain forward-looking statements that are subject to risks and uncertainties. The company claims the protection of the safe harbor for forward-looking statements that is contained in the Private Securities Litigation Reform Act of 1995. Actual results may differ from management's current expectations. Any projections of the company's future performance represent management's estimate as of today. Canadian Solar assumes no obligation to update these projections in the future unless otherwise required by applicable law. A more detailed discussion of the risks and uncertainties can be found in the company's annual report on Form 20F, filed with the Securities and Exchange Commission.

Management's prepared remarks will be presented within the requirements of SEC Regulation G regarding Generally Accepted Accounting Principles or GAAP. Some financial information presented during the call will be provided on both a GAAP and a non-GAAP basis. By disclosing certain non-GAAP information, management intends to provide investors with additional information to permit further analysis of the company's performance and underlying trends. Management uses non-GAAP measures to better assess operating performance and to establish operational goals. non-GAAP information should not be viewed by investors as a substitute for data prepared in accordance with GAAP. At this time, I would like to turn over the call to Canadian Solar's Chairman and CEO, Dr. Shawn Qu. Shawn, please go ahead.

Shawn Qu (Chairman and CEO)

Thank you, Isabel, and hi everyone. Welcome, and thanks for joining us today. I'm pleased to report a strong set of third-quarter results as we achieved 3.2 GW in module shipments, achieved total revenue of $940 million, and gross margin of 19.5%, which were all ahead of our expectations. Turning to slide three, let me give you a quick update on the progress of the planned China listing of our MSS subsidiary. We successfully completed the pre-IPO equity raising in Q3. This was on schedule, and it brought us one step closer towards qualifying for the IPO in China from a regulatory standpoint. The transaction also brought in important strategic partners and the capital to immediately expand our capacity with the latest solar technology. In terms of timeline, we remain well within our planned schedule, targeting for the IPO next year.

We feel good about where we are in the process and believe we are on track to submit the official IPO application by the second quarter of next year. Now, moving to slide four. While the solar market has been volatile over the past year as a result of COVID-19, I want to congratulate the Canadian Solar team for its focus, execution, and results. We continue to achieve long-term sustainable growth and returns for shareholders. Our long-term strategy is three-pronged. First, on the MSS side, we focus on expanding capacity and increasing the level of vertical integration. This will allow us to gain global market share, enhance pricing power, better control costs, and improve profitability. Yan will expand on this point later on. Second, we're expanding our market presence and have identified opportunities in localized large-scale project investment vehicles.

These vehicles would hold great connected solar energy storage and other clean energy projects developed by our energy business. Leveraging the experience we gained through the publicly listed Canadian Solar Infrastructure Fund in Japan, we target to launch similar vehicles in Latin America and Europe within the next 12 to 24 months. Ismael will expand on this point. Third, we continue to execute our strategic growth areas. An example of this is the solar PV-plus storage market segment, where we are reaching key milestones, including recently signing our first large-scale energy storage system supply and service agreement, the 300 MWh milestone project in California. There are more to come. On the development side, we also have a large backlog of 1.2 GWh and an additional pipeline of 4.8 GWh in storage projects under development.

We expect energy storage to start contributing to both revenue and profit over the next few quarters and become material earnings drivers going forward. Now, let me turn over the call to Yan. Yan, please go ahead.

Yan Zhuang (President)

Thank you, Shawn. On the MSS business, Q3 shipments were up 33% year over year to 3.2 GW, above guidance. Revenues and gross margin of $695 million and 18.5%, respectively, were also better than our expectations as demand came back strong and costs did not increase as fast as we anticipated. Shawn briefly talked about the strategic direction of the MSS business. Turning to slide five, please. We're making a deliberate strategic shift as we enter a new era of growth in solar energy, driven by grid parity. Historically, we took a capitalized approach that gave us the flexibility to quickly respond to unexpected policy and market changes. Today, as global decarbonization efforts intensify and solar energy continues to improve its competitiveness, we expect more stable and sustainable demand growth. This is why we're shifting our strategy towards growing market share, increasing vertical integration to better control our manufacturing costs.

Specifically, we're planning to nearly double our manufacturing capacity across the supply chain and increase our ingot sales and module capacities to 10, sorry, 11, 18, and 23 GW, respectively. By the middle of 2021, all new capacity will be in the latest technology and will produce our latest 500 and 600-watt-plus modules, which we introduced during the past Q3. The new capacity will contribute to our 2021 gross margin as soon as Q2 next year and will support our 18-20 GW shipment guidance for 2021. This is a long-term growth plan that will be supported by the China listing of CSI Solar, which includes our MSS business and the China energy business. We believe that extending access to China's deep and liquid capital markets will continue to reduce our cost of financing and boost our long-term growth opportunities.

Despite the relatively strong performance in Q3, we are facing near-term challenges driven by a combination of factors. Turning to slide six, please. To give you a sense of the magnitude, the cost of polysilicon increased by around 70% between June and September this year. While it has come down somewhat, it remains around 50% higher than where it was in June. Glass and EVA prices have also almost doubled since June. Logistic costs, mostly shipping, also doubled over the past quarter following another round of COVID lockdowns. On top of all this, between June and November, the US Dollar depreciated approximately 9% relative to the RMB. As a standalone, any of these factors would have put pressure on our gross margins. When you combine everything together, like the situation today, this is quite unprecedented.

The impact of COVID led to a weak market earlier this year, which was then followed by a massive surge in demand. This created an acute but temporary shortage of all basic materials, including aluminum, copper, glass, etc. We are still talking about the impact of COVID. However, I think we're now at the point of maximum pain or very close to it, and things should start to improve from here. Please turn to slide seven. First, we're already seeing capacity expansion in the production of shortage materials. For example, some glass manufacturers for autos or building materials are switching some of their capacity to produce solar glass to take advantage of the exceptional margins. The price of polysilicon is also already coming down as previously damaged production sites have been repaired and capacity is gradually coming back online.

Second, we're increasing our market presence in China, where relative prices are attractive for the first time in a few years. This is amplified by the fact that margins are not affected by foreign exchange and ocean shipping costs. We're seeing very strong demand in China after two transition years towards grid parity and the serious policy efforts to decarbonize the economy. In terms of the magnitude, we think China could account for approximately 25% of our shipments next year, up from approximately 10% in an average year. Third, some of our Q4 sales include very low ASP contracts that were signed in Q2 when market demand was severely suppressed. We're now working closely with our customers to educate them about the supply-side situation and will continue to raise prices.

Fourth, our investment in new capacity, especially in the mid and upstream manufacturing processes, will help us reduce costs and will contribute positively to gross margins as early as Q2 next year. Fifth, visibility into our energy storage pipeline, both in terms of the system solutions and storage project development, gives us confidence that energy storage will also contribute to next year's earnings. Finally, we are also seeing fast-growing demand for self-consumption of solar energy in the higher-margin rooftop or Distributed Generation segment. This is a market where we have a very strong market positioning. In fact, over the past few quarters, more than half of our shipments were sold to the DG segment, of which around a third was in the residential market.

We expect significant growth and sustainable profitability in this market as we deliver integrated solar-plus storage solutions by offering a differentiated and innovative customer value propositions with strong marketing support. This is one of our important strategic directions going forward. All in all, we remain very positive about our medium to long-term outlook based on more sustainable global demand, capacity expansion, increased vertical integration, and ongoing improvement in raw material supply and growth in the DG market. While we are tackling the short-term challenges, the underlying fundamentals of the industry remain very strong. As solar becomes fully market-driven and as we come closer to the bottom of the structural cost curve, we expect margins to stabilize at a healthier level. This will be driven by technology, scale, brand, and global market position, all of which are areas where we have a competitive advantage.

Before turning over the call to Ismael, let me touch on China energy as this is part of CSI Solar. This quarter, we sold two large operating projects totaling 200 MW in China. This was a key driver of the revenue and profits in the energy business. After this sale, we still have around 260 MW in our China portfolio, of which we expect to sell around half over the next year or so while maintaining ownership of the other half. The Chinese project development environment was quite tough over the past few years due to delays in subsidy payments. With grid parity, this problem has been removed. We see a lot of growth potential from a market-driven business. With that, let me pass it on to Ismael. Ismael, please go ahead.

Ismael Guerrero (Corporate VP and President of Energy Business)

Thank you, Yan. I'm pleased to join today's call. On the energy business, looking at slide eight, we made significant progress during the last quarter towards overcoming the challenges that arose from COVID-19. The availability of financing, including the availability of tax equity in the U.S., was a key challenge. We have now secured most of the necessary financing in order to execute on our projects. In the U.S., we started construction on two large projects in Texas totaling over 500 MW. In Mexico, we closed non-recourse project financing and started construction on a 126 MW project. We currently have two projects under construction in Mexico, and we are working hard to complete the interconnection on one of these projects as we speak.

In terms of business development, we secured 862 MW in new PPAs in Brazil a few days ago through a private auction with a large local utility and bilateral corporate agreement with one of the largest financial institutions in Latin America. This is in addition to the 274 MW we signed earlier in Q2. We were one of the first companies to enter the Brazilian market, both as project developer and as module supplier and systems integrator. We see significant potential as we continue to expand our leadership position in the key Brazilian market. In Japan, we announced our success in securing 22 MW in the sixth Feed-in Tariff auction. Japan is another high-project market where we continue to have a position of leadership.

While the country is transitioning from a subsidized Feed-in Tariff market to an auctions market, the recent changes in the government came with Japan's carbon neutrality pledges, review of land use planning, and interconnection infrastructure initiatives. We believe this will make Japan an even more robust market over the long run. Meanwhile, we still have a large 290 MW backlog, plus an additional 80 MW of projects in operation. Combined, these projects have a weighted average Feed-in Tariff of approximately $0.29 kWh, which is much higher than the global average PPA. We will continue to grow our Japanese pipeline and seek additional long-term growth opportunities in other East Asian markets. In Europe, our pipeline is growing strongly, and we are starting to see success in new countries where we started investing around a year ago. In Italy, despite some of COVID-related delays, our projects are progressing with permitting.

In terms of solar PV plus energy storage and standalone storage, we are solidifying our leadership position in the U.S. while internally sharing and building our expertise across our global teams. The development of storage projects is now part of our core global pipeline, and we expect to report about projects starting construction in the following quarters. In terms of project sales, in addition to the projects sold in China, which Yan mentioned, we also completed sales in Canada, Japan, and the U.S. Currently, we are on track to achieve our 2020 targets despite the tough market environment. However, we cannot rule out the possibility that certain projects may get moved into Q1 next year, but that is only a matter of time. Moving on to slide nine.

While COVID disrupted some of our near-term plans, we continue to expect 25% annual volume growth in project sales while retaining minority ownership in projects in certain markets. We expect to enrich the Canadian Solar ecosystem and capture additional value throughout project life cycles by capturing income from operations and maintenance, asset management services, storage integration, and retrofit EPC, while recycling most of the capital. Our goal is to increase the predictability of our revenues and cash flows as we unlock the company's value for investors and start to retain a bigger portion of the value we create. To do this, we are in the process of forming capital partnerships in the form of public or private vehicles with long-term investors. The next milestone should be in Brazil. We expect to form a Brazilian Participation Fund for Infrastructure Projects, or FIP-IE, in 2021.

We are also working on similar vehicles in Europe. The specific timing will depend on market conditions, but we are on track and look forward to updating you as we achieve milestones over the coming quarters. Now, let me turn the call over to Huifeng, who will go through the financial results in greater detail. Huifeng, please go ahead.

Huifeng Chang (CFO and Chief Strategy Officer)

Thank you, Ismael. Please turn to slide 10. Revenue in Q3 was $914 million, up 31% from Q2 and up 20% year over year. Gross margin Q3 was 19.5%, well above our guidance of 14-16%. If we exclude the benefits from the U.S. anti-dumping and the countervailing duty true-up in Q2, the gross margin would improve by 130 basis points quarter over quarter. Selling expenses were flat quarter over quarter, but up year over year due to higher shipping costs. G&A expenses were down 9% year over year. The quarter over quarter increase reflects one-off benefits in Q2 2020, such as insurance gain. Overall, our G&A expense relative to revenue has been declining over the recent quarters. The net foreign exchange loss in the third quarter was $13 million, a significant hit on our net income as compared to previous quarters.

This negative impact was caused by the sharp depreciation of the US Dollar relative to the RMB, around 5% during Q3, which is the largest quarterly change over the past 12 years. While we have a comprehensive hedging program in place covering more than a dozen currencies, the US Dollar RMB exposure is by far the largest since most of our revenue is earned in US Dollar, while most of our cost is spent in RMB. We have significantly reduced our US Dollar RMB exposure with higher hedging positions and expect the impact in Q4 to be much smaller despite another 4 percentage points depreciation of US Dollar since the beginning of October. Net income attributable to Canadian Solar in Q3 was $8.8 million, or $0.15 per diluted share.

This was significantly impacted by the $12.6 million withholding tax expense in China related to the special dividend distribution from the MSS business to the parent company. Excluding this one-off tax impact, net income in Q3 would have been $21.4 million, higher than our Q2 net income. Moving on to the balance sheet on slide 11. We ended Q3 with an enlarged balance sheet. While we increased our total debt to $2.3 billion this quarter, mainly driven by the convertible bond issuance, our total unrestricted cash balance was $1.1 billion, or more than double our usual average of $500 million. Note that there is an element of timing here as we closed both the convertible bond and the pre-IPO fundraising for our MSS business near the end of the quarter. Since then, we have started to deploy the capital raised to support our capital capacity expansion plans.

CapEx in the first nine months of the year was approximately $180 million. We are raising the full year 2020 CapEx plan to approximately $500 million, which includes building capacity in both mono ingot and HJT products in Q4. The higher expected CapEx is well supported by the cash we raised in Q3. For 2021, we expect CapEx to be around $700 million, which is significantly higher than in previous years. The higher level is in support of our long-term growth strategy with our level of vertical integration and continue to roll out cutting-edge products. Now, I would like to spend a few minutes going through the latest corporate structure of Canadian Solar. On slide 12, following successful close of our pre-IPO fundraising at the end of Q3, we will start reporting results for different segments next quarter.

Specifically, we will change the MSX versus energy structure to CSI Solar versus Global Energy. As Yan noted earlier, we will move relatively small China energy business from energy to CSI Solar, which makes sense from a management perspective. In terms of energy storage, we have teams on both the CSI Solar and the Global Energy business. SSES, or System Solutions and Energy Storage, delivers four integrated energy storage system solutions. This is the team behind the recent storage supply and service agreement announcement with the Mustang project in the U.S. This team is part of CSI Solar and expects to deliver around 560 MWh next year, including the Mustang project. On the energy business side, which Ismael talked about earlier, our focus is on developing solar plus storage, or standalone storage projects.

Our developers have built up a sizable backlog and a pipeline of projects over the past few quarters. This structure will allow us to benefit from the synergies of having both teams, i.e., integrator and developer, under one corporate umbrella, while also benefiting from the synergies of attaching storage into previously solar-only contracts. Meanwhile, the accounting of the revenue and the profits from the two businesses will be separate. From a modeling standpoint, it is also important to remember that we sold 20.4% of CSI Solar to minority investors. The additional 4.7% representing the ESOP platform will only be reflected after the completion of the IPO. We will continue to fully consolidate the CSI Solar business. The 20.4% minority interest will be subtracted from CSI Solar earnings and reflected as income or loss attributable to non-controlling interests.

Now, let me pass it back to Shawn, who will conclude with our guidance and the business outlook. Shawn.

Shawn Qu (Chairman and CEO)

Thanks, Huifeng. For the fourth quarter of 2020, we expect the total module shipment to be in the range of 2.9 Gw-3 GW. Total revenue is expected to be in the range of $980 million-$1.015 billion. Gross margin is expected to be between 8% and 10%. This means that for the full year 2020, we now expect total module shipment to be in the range of 11.2 GW-11.3 GW, within the prior guidance range. Meanwhile, we are reiterating our full year 2021 module shipment guidance of 18 GW-20 GW. Our updated guidance reflects the impact of the shortage and the price increase of certain raw materials. However, we expect the environment to improve in the first half of 2021 as raw material supply expands, module ASP increases, and we start production of our upstream ingot capacity, which should reduce our manufacturing costs.

Despite the near-term challenges, we remain very excited about our mid to long-term growth outlook given the strong underlying market fundamentals and Canadian Solar's leadership position across manufacturing, project development, and energy storage solution sectors. With that, I would now like to open the call to your questions, Operator.

Operator (participant)

Certainly. Ladies and gentlemen, we will now begin the question and answer session. If you wish to ask a question, please press star one on your telephone and wait for your name to be announced. If you wish to cancel your request, please press the pound or hash key. Once again, to ask a question, it's star and the number one on your telephone keypad. Your first question comes from the line of Colin Rusch of Oppenheimer. Please ask your question.

Colin Rusch (Managing Director, Senior Research Analyst, and Head of Sustainable Growth and Resource Optimization Research)

Thanks so much, guys. Historically, what you've been able to do is pass on some of these supply chain costs onto your customers. Shawn, can you talk about those dynamics, how long that might take, and how effective those efforts might be as you look at the next couple of quarters?

Shawn Qu (Chairman and CEO)

I will let Yan expand this point first and then I will supplement.

Yan Zhuang (President)

Actually, the demand came back, started to come back in August, but the cost came back even hotter. It takes time, a few rounds of negotiations with the customer to accept this market reality. We feel right now the discussion is pretty heated already at this moment for Q4 shipments. I believe at the end of Q4, after the so-called mainly year-end rush is down, and when the market realizes that the cost is not coming down, they will have to face the reality. We believe that Q1 will already be improved in terms of market acceptance about the module price adjustment. We also believe that by Q1, a few cost items will likely slowly improve, going down more mild. We believe Q1 we will see improvement, and Q2 we are going to see more significant improvement. Thank you.

Colin Rusch (Managing Director, Senior Research Analyst, and Head of Sustainable Growth and Resource Optimization Research)

Great. Looking at the energy storage business, you're talking about that becoming profitable. I guess given what we're seeing in terms of demand versus availability of supply, how should we think about the margins on that business relative to historic levels for the module and MSX business?

Yan Zhuang (President)

I cannot give you specific numbers, but I can tell you that for energy storage system integration, it's not a manufacturing business. The OpEx level is relatively much lower. The net profit level is actually much better than module business.

Colin Rusch (Managing Director, Senior Research Analyst, and Head of Sustainable Growth and Resource Optimization Research)

Okay. That's super helpful, guys. Thanks so much.

Operator (participant)

Your next question comes from the line of Brian Lee of Goldman Sachs. Please ask your question.

Brian Lee (Equity Research Analyst)

Hey, guys. Thanks for taking the questions. Maybe the first one just on gross margins, the 8%-10% for Q4, can you give us a sense for how it breaks out between modules and/or MSX and energy?

Shawn Qu (Chairman and CEO)

The MSX gross margin is slightly lower, and the energy gross margin is slightly higher. There is not so much difference. However, in terms of revenue, the MSX revenue accounts for about two-thirds or a little bit more than two-thirds in the total Q4 revenue. Therefore, the 8-10% reflects more of the MSX or the module business gross margin.

Brian Lee (Equity Research Analyst)

Okay. Thank you, Shawn. That's helpful, Colin. I guess I know you're saying that gross margin should improve in Q1 and then significantly improve in Q2. I don't want to put words in your mouth, but it's really the second half of 2021 when we start to see more of the normalized gross margins. Would you say normalized gross margins are, is this 15%-20%? Is that kind of the new normal, or do you think we're back to 20% plus gross margin across the business in the second half of 2021?

Shawn Qu (Chairman and CEO)

Oh, that's a very good question, Brian. It will be from at least about 15% as normalized gross margin. I hope it can be more than 20%, but it's too far to tell. We do have a plan that we believe that in Q1, we stand a good chance to have the gross margin go above 10%. Now, hopefully, in Q2, we will target or try to reach mid-10, and then Q3 and Q4. Since our new capacity, especially the ingot and wafer capacity, start to make significant contributions, we hope that the gross margin can further improve. Of course, there are still some unknowns. See, we can control or we can influence many of the micros, but it's difficult for us to control the macros. For example, the exchange rate between the US Dollar and the Chinese RMB and other currencies.

All these assumptions are based on a reasonable foreign exchange between the US Dollar and RMB.

Brian Lee (Equity Research Analyst)

Okay. Fair enough. Maybe last question for me. I'll pass it on. I know you guys are making a strategic shift here to do more vertical integration. It should help the cost structure. Like you said, Shawn, you're kind of controlling the micro where you can. What's out of your control, like currency and the macro, that's the uncertainty. How do you think about, I guess, in the macro side of things? It seems like there's been a significant amount of module capacity addition announcements from both yourselves and your peers in Tier 1, China, manufacturing suppliers heading into the next 12 to 18 months. Does that give you pause at all in terms of potential for supply-demand imbalance heading into next year? Just would love to hear your thoughts around the macro, what you're seeing competitively around the capacity side. Thank you.

Shawn Qu (Chairman and CEO)

Thanks, Brian. Let's talk about macro and micro. I think from the macro point of view, I have lots of confidence in the growth potential of solar business. You can see that the whole world is going for renewable and going for solar. That's on the macro side. However, the demand, let's say the solar demand in a particular year also depends on some micro conditions, for example, pricing. Let's say for 2021, if the solar module price and other component price is at a reasonable level, I believe our customer can tolerate or can accept a moderate solar module price increase, I believe. However, if the module price increases too much, it will put a cap to the total demand.

Let's assume the solar module price is at a reasonable level, then most of the third-party research agencies are now expecting around 160-170 GW of capacity. You mentioned that there are some module capacity announcements and shipment target announcements recently. We are watching that as well. We are not really looking at the smaller module players. We rather pay attention to the top six or top eight. The top six and top eight altogether, the total announcement so far for next year is around 160 GW-170 GW, I believe, which means there will be some competition. Let's assume if the total market demand is indeed 160 GW, and if the total target shipment of the top six are also 160 GW-170 GW, then, well, it looks like, well, there will be some competition.

I believe that competition is still in a manageable scale. In terms of Canadian Solar, we have been looking at our channels and also our technical abilities. We decided to put out our target of 18 GW-20 GW next year. In the past 20 years or so, 19 years to be more accurate, we have almost always been achieving our target. I do believe that we will achieve our target in 2021 as well. I can't really comment on other people's target, but I do believe that whatever Canadian Solar says, we do mean it. Yan, do you want to add more comment?

Yan Zhuang (President)

I just want to add a little bit more. We feel that the demand from both China and the U.S. will be very strong next year. You know that we have a pretty sizable capacity in Southeast Asia that will help us to grab more market share in the U.S. We have a strong move right now in China to significantly enhance our market share here. We will be in a better position because of the China pricing, because of the strong demand, and also the fact the exchange rate between RMB and USD and also the ocean shipping cost difference. China pricing is now actually better, significantly better than overseas pricing. This will help us next year to gain more profit, healthier profit.

Brian Lee (Equity Research Analyst)

All right. Thank you both. I appreciate all the color and context. Thanks.

Operator (participant)

Your next question comes from the line of Philip Shen of Roth Capital. Please ask your question.

Philip Shen (Managing Director and Senior Research Analyst)

Hi everyone. Thank you for taking my questions. I have a question on your capacity expansion. If you look at the ratio of wafer to your total module capacity as of 2020, it's about 40%. I think you're maintaining that mostly the same for 2021 at about 44%. Philosophically, do you think you could ever increase that wafer to module capacity ratio? Why keep that where it is, whereas cell is increasing from 60% to 71% of your module capacity? Thanks.

Shawn Qu (Chairman and CEO)

Hi, Philip. This is Shawn speaking. Very good question. We are doing that. We are increasing the ratio of vertical integration. However, it takes time. It's not really about wafer capacity, but the ingot capacity. Because otherwise, we'll have to buy ingot and slice into wafer. It doesn't add that much to our gross margin. When we look at the principal solar value chain these days, the polysilicon stage makes the most of money, of course. The second one is the ingot. Then wafer, cell, and module. The key next year, one of the key drive, key effort next year is to increase our ingot capacity. As you can see from our chart, we are increasing our we used to be very focused on multi-crystalline wafers. We still do that. We still plan to have a reasonable amount of multi-crystalline cell and modules.

However, next year, at this moment, we are building our first large-scale mono ingot factory, mono ingot workshop. It's a 3 GW ingot workshop. We'll turn it on early next year, and we'll reach full capacity by Q2 next year. That's where we see the more significant margin improvement, much more significant in the wafer. Of course, we will catch up on wafer as well. If you look at the capacity and the new capacity update in our new earnings release, we are increasing both ingot and wafer capacity. By the end of next year, both ingot and wafer capacity will be around 10%, which is significantly higher than today.

Yan Zhuang (President)

At 10 GW.

Shawn Qu (Chairman and CEO)

Oh, there. Sorry. Will be about 10 GW. Both ingot and wafers will be around 10 GW by the end of next year, which is significantly higher than today.

Philip Shen (Managing Director and Senior Research Analyst)

Great. Thanks, Shawn. As a follow-up there, I see a lot of the industry shifting to, as you were mentioning, the larger wafer and cell formats with, I guess, two camps. There is the 182-millimeter camp and then the 210. What percentage of your modules do you think will have the larger format, either 182, I believe you are on that standard versus the 210? What do you think that average is for the large format of your shipments in 2021? Do you think you can get as high as 50% of your shipments overall in 2021 to that higher 182-millimeter format, or do you think it is a little bit less than that or perhaps more?

Shawn Qu (Chairman and CEO)

Yeah. We're asking Yan to get into the detailed numbers. However, all of our new capacity, meaning new ingot and wafer capacity, also the new solar cell capacity and solar module capacity, are designed around the large wafer and large cell format. As you know, Philip, Canadian Solar is actually a leader in adopting a new and a larger cell and module format. We were the first one in the industry to introduce the 166-millimeter format. We are also one of the first to introduce the 182 and also the 210-millimeter format. You asked about which standard will become the main standard. The good news is that Canadian Solar is on both camps because we think that both camps make sense. We actually designed the product based on both standards and both sizes.

Which means that once we have all the new capacities online, we want to use all these new capacities to produce only the large format. Therefore, from the second half of next year and also 2022, you would expect that more than half of our product will be from those new formats. For 2021, it is a transition year. Some product will be introduced over Q1, Q2, and Q3, so there will be some transition process. Also, I want to mention that the smaller wafer size does not mean outdated because some of the products are designed around the smaller size. For example, some of the rooftop projects actually are better suited. The smaller wafer size may be better suited. Also, some of our customers, for example, Japanese customers, actually want us to continue and to support them with the previous format. Now, Yan?

Yan Zhuang (President)

Yes. Hi, Philip. In terms of capacity, actually, by end of 2021, we're going to have almost 10 GW of our cell line will be compatible for both 210 and 182, like 8, 9 GW already. We're going to have 10 GW of wafer and ingot, both large wafers. For module, all the new module capacity on top of whatever we have today will be compatible to either 210 or 182. We're in pretty good shape in terms of capacity upgrade. Also.

Philip Shen (Managing Director and Senior Research Analyst)

Great. Excellent.

Yan Zhuang (President)

Even the existing old capacity, even the existing capacity, or we call that the mainstream capacity of 166, actually it's a relatively not so bad capacity comparing to others in the market, which are we still see a lot of 157 and 158.75. Our 166 is actually still be able to compete in the first half of next year at least.

Philip Shen (Managing Director and Senior Research Analyst)

Thank you both for all that detail. One other very quick question on capacity. Of the new announcements that you've shared, how much of that or what percentage of that, where is that new capacity? For example, how much of that is in Southeast Asia versus perhaps even in a new country or region?

Yan Zhuang (President)

The majority of the new capacity is still in China. We have some capacity upgrade and minor expansion in Thailand. We are actually actively studying and exploring the possibilities of new capacity, new technology in other markets depending on the policy shift mainly from the U.S.

Philip Shen (Managing Director and Senior Research Analyst)

Can you share which geographies that might be? Yes.

Shawn Qu (Chairman and CEO)

Now, Philip, by the way, we already have more than 3 GW of solar cell capacity in Thailand, which is also a pretty new capacity. Looking at the total market size in the U.S., I believe that our Thailand cell capacity and also the Vietnam module capacity at this moment are more than adequate to support our U.S. customers.

Philip Shen (Managing Director and Senior Research Analyst)

Great. Thank you, guys. I'll pass it on.

Shawn Qu (Chairman and CEO)

Thank you.

Operator (participant)

Your next question comes from the line of William Grippin. Yes, ma'am, go ahead. Please go ahead.

Shawn Qu (Chairman and CEO)

William?

Operator (participant)

Can we take the next question, please? All right. Your next question comes from the line of William Grippin of UBS. Please ask your question.

William Grippin (VP and Equity Research Analyst)

Great. Thank you. Just wanted to ask about the capacity expansion. Historically, you guys have been committed to what you've called a reverse pyramid structure, which I think has been advantageous in a declining price environment. I'm just curious, why pivot away from that now if we think that the disruption in the market for raw materials is going to be temporary?

Yan Zhuang (President)

Shawn has mentioned that he's very confident about the sustainable growth of the industry. I share the same opinion. By looking at the LCOE of solar energy around the world and the strong policy shift towards decarbonization and whatever election in the U.S. results and the new announcement from the presidency in China, we are actually very confident about the mid to long-term growth potential. In terms of capacity and expansion, part of that is for next year, but more is for the year after or the years after next year. Next year will be somehow a transition year for the industry with very strong inherent demand on the project level with a little bottleneck on some upstream supply and some after-effect from COVID-19. The industry has realized that. The industry has realized that the demand will be very strong.

Everybody is expanding capacity to actually meet the demand after next year. This is common knowledge in our industry. This is why you see so many news about capacity expansion. Also, on top of that, the industry has become much more market-driven because the demand is less policy-driven and the cost of solar is low, coupled with the rapid cost reduction on the energy storage side. We see that more and more markets are adopting solar without subsidy. Self-consumption solar is also growing really fast. We believe the demand is less volatile and is sustainable.

Shawn Qu (Chairman and CEO)

Hi, William. This is Shawn speaking. I'm going to add a few more comments. Yes, indeed, our strategy in the past used to be the reverse pyramid, and we have benefited from that structure, from that relatively capital-light manufacturing structure. However, the business model is not something that will change. It has to change when the market changes. We believe that the market is changing, that this industry, solar industry, is getting into a consolidation phase. The winner of this consolidation phase will require more integrated capacity in order to win the competition. Therefore, we are changing our business model. That's number one. Number two, I want to just bring to your attention that even after all this environment, investment into mid and upstream, Canadian Solar's manufacturing business model is still a reverse pyramid.

Our module capacity is still larger than cell, and cell larger than wafer, and wafer larger than ingot. We are still maintaining the flexibilities to be able to respond to the market demand change.

William Grippin (VP and Equity Research Analyst)

Yep. Very helpful. Thank you. Just one other one on the third quarter specifically, but obviously, the margin was better than guidance and better than we were expecting. I'm just curious how the increase in polysilicon pricing in the quarter impacted you, if at all. I mean, are your contracts for polysilicon supply, do they sort of lag the actual spot pricing in the market, or how does that all work?

Yan Zhuang (President)

I think actually, partially, it came from the demand comeback after the lockdown, the first wave of lockdown in Q2. More than that, there are a series of explosions in Xinjiang Province in a few silicon factories that caused a pretty significant shortage on silicon. That drove up the price pretty significantly. That had a pretty strong impact on our profitability. We had cheap poly inventories coming from Q2 purchasing because there's a delay on the material purchasing. We benefited from there in Q3. That's why the cost impact on us is more mild. The demand came stronger, so that helped. The impact of silicon price up will actually be more reflected in Q4.

Shawn Qu (Chairman and CEO)

Yes. You answered, William. Yes, indeed, there's a time lag from the polysilicon material entering into our ingot factory to the module out, the module shipped out. And recognize ourselves, there can be several weeks or even one or two months of delay, no, of time difference. Also in Q3, we have seen that the polysilicon price may be coming up because usually, sometimes the polysilicon factory wants to do the machine maintenance in the summer. We strategically accumulated some stock of polysilicon at low price, which turned out to be right. Indeed, we didn't see much impact in Q3. However, we do see that impact in Q4. That's why somehow Q4 turned out to show to be our lowest gross margin quarter. Also, fortunately, as we mentioned, as Yan mentioned, we do have a plan.

We believe that our gross margin will recover in Q1 and then in Q2. We target to get it back to our normalized gross margin range by Q3 next year.

Operator (participant)

As we are now at the top of the hour, I will turn the call back to Canadian Solar's Chairman and CEO, Dr. Shawn Qu, for the closing remarks.

Shawn Qu (Chairman and CEO)

Thank you for joining today's call and for your continued support. If you have any questions or would like to set up a call, please contact our investor relationship team. We hope you and your families stay safe and healthy and enjoy the coming Thanksgiving holidays. Take care and have a nice day.

Operator (participant)

Ladies and gentlemen, this concludes our conference for today. Thank you for participating. You may now disconnect.