Solar is hot - no pun intended. When a company within the solar industry posts quarterly earnings of .72 EPS vs. Wall Street consensus expectations of .43 EPS, one can really get an indication on how strong the sector is currently. That’s exactly what LDK Solar (NYSE: LDK) did when it reported its third quarter 2010 earnings yesterday. In part, the large earnings surprise was partly due to Wall Street’s underestimation of the company’s earnings power, since not many quarters ago LDK was at death’s door. The dramatic turn in global solar demand combined with LDK’s ability to restructure their balance sheet a year ago bought the company enough time to make it one of the most dramatic turnaround stories in the solar industry.
Rather than go through the finer points of LDK’s earnings report, which one can review at their own leisure, this article will concentrate on where LDK is in its turnaround story. One of the key reasons which makes LDK interesting is that its valuation heavily discounted the company’s installed assets, namely their production capacity. A large part of this discount was due to the fact that many feared the company could have gone insolvent a year ago.
However, if liquidity risks were ruled out, then LDK represented a tremendous value since the company could leverage their installed capacity to maximize earnings and cash flow, a point I made in a prior article. Some viewed LDK’s large debt as a negative. In industry down cycles where corporate losses could spark liquidity concerns, debt is a huge negative. However, in up cycles debt also equates to higher earnings leverage, and that is exactly what LDK is in the stages of doing currently. Given the company's large new credit facility along with projections of operating cash flow exceeding capital expenditure requirements for the next year, liquidity and cash flow concerns should be mostly removed.
Much of LDK’s fixed assets is its 18,000 metric ton polysilicon plant. Although the plant is currently operating at low utilization, roughly 90% of the investment has already been made. In short, the company had already committed huge resources in this facility while up until recently received low levels of return. This under utilization of such a large part of their fixed assets heavily skewed LDK’s earnings and cash flow generating capabilities to the point some on wall street discounted it as an asset. Some even viewed the company’s polysilicon plant as a liability because at low utilization and high production costs, it could actually dilute earnings from the company’s other businesses.
Recent news should change this perception. LDK had already announced very impressive initial production ramps for this plant in prior earnings reports, but in their Q3 conference call, LDK stated that 11,000 metric tons of this facility would be operating at full utilization by the end of this year with the remaining capacity coming online by the end of next year. Just from the company’s higher end guidance for 2011 polysilicon production targets which excludes the remaining capacity due online next year, 10,000 metric tons of polysilicon production could yield around 200m in annual gross profits and greater amounts in cash flow after depreciation is factored out of fully loaded production costs. This amount alone could rival some of Wall Street’s 2011 EPS forecast for the company.
LDK’s core business of wafer production is also doing well. Although production costs took a slight hiccup higher during the quarter due to equipment fine tuning and upgrades, the company was still able to post nearly 28% margins for their wafer division. Processing costs are expected to resume its steady path lower which is fairly inline with industry averages when efficiency assumptions between companies are normalized. At .30/watt processing costs LDK isn’t the most efficient producer but isn’t more than .02-.03/watt higher than industry leading metrics when equal comparisons are made.
Despite this, the company should still see their wafer gross margin expand above 30% for the current quarter. Their wafer business will be a large part of their gross profits for the next several quarters.
A new and potentially very large gross profit driver next year is LDK’s module business. Currently the company is experiencing extremely low margins because it’s an entirely new business segment. Procurement within the vertical hasn’t been optimized and the company currently has to outsource cells due to low internal cell capacity. LDK is quickly ramping up their cell capacity which was nil in the first half of this year, to 120mw ending Q3, to 180mw by the end of this year, with an additional 1gw by the end of Q2 2011. As cell capacity is ramped up, LDK would slowly be transformed from once a wafer supplier to a fully integrated module producer.
It may take a few quarters for the company to optimize operations to reach metrics many direct Chinese peers currently enjoy, but the company’s cost roadmap is very reasonable if not conservative. For example, for Q4 LDK is guiding cell and module processing costs to be .24/watt and .35/watt respectively. Many industry leading cell producers in China have achieved under .20/watt processing costs. Most major cell and module producers in China also have combined processing costs of .55/watt or under currently. Hence given LDK’s scale, their current cost and incremental improvement guidance seems easily achievable. At current module selling prices, any fully integrated potion of LDK’s module capacity should yield gross margin above 30% which is in line with other top tier Chinese providers.
Thus, the main takeaway from LDK’s earnings report is that the company is only halfway in achieving their business plan. Despite very low levels of utilization of their polysilicon assets and even lower levels of full vertical integration in their module business plans, LDK was still able to produce a very high level of earnings at the EPS level. Again this is a reflection on how discounted the stock price is relative to their fixed assets.
Many aspects of LDK’s business still needs to be improved. Their core business of wafer production is the closest to earnings normalization, but gross margin can still improve slightly to reach over 30% as experienced by some peers. Module gross margin was a paltry 4.6% for the past quarter, but even with conservative expectations should also reach over 30% as experienced by direct peers. Polysilicon gross margin was already above 30%, but can still go much higher since some peers enjoy 50% or higher margin at current selling prices. In essence all of LDK’s businesses have room for improvement that may only take another couple of quarters to fully normalize with metrics seem by direct Chinese peers.
When all of these small incremental improvements in each business division materialize, the overall effect should carry the company’s gross margin above what many on wall street current expect and most likely even above what LDK itself has given guidance. LDK may or may not reach industry leading metrics, but just by reaching more normalized metrics based on peer group averages, the company should experience even higher levels of realized earnings moving forward.
This now takes us to LDK’s Q4 guidance as well as expectations for 2011. Just using the low end of the company’s fourth quarter guidance, an implied Q4 EPS of around .72 can be attained. Applying the same low end guidance assumptions for 2011, LDK has essentially implied next year’s earnings to be no lower than 2.50 in EPS. These are raw operational earnings which exclude non-operational items such as currency translations, etc.
At the high end of the guidance range, numbers are considerably higher but there’s no need to examine them right now when even the low end surpasses what many on wall street expect by a mile. Below is a more detailed look at LDK’s Q4 estimates using metrics either given by the company or derived from company statements. Again the basic assumption made is that the high end of the company’s shipment guidance will be achieved since if they company states that it is selling everything it can produce with demand surpassing their ability to supply it, then any high end shipment expectation is likely to be reached.
- Core Wafer: 490mw @ .89/watt = 436.1m
- OEM Wafer: 110mw @ .50/watt = 55m
- Module: 115mw @ 1.88/watt = 216.2m
- Module OEM: 15mw @ .50/watt = 7.5m
- Polysilicon: 700mt @ 62/kg = 43.4m
- Total Revenues: 758.2m
Cost of Goods:
- Core Wafer: 490mw @ .62/watt = 303.8m
- OEM Wafer: 110mw @ .30/watt = 33m
- Module: 90mw @ 1.78/watt = 160.2m + 25mw @ 1.21/watt = 30.3m, 190.5m total
- Module OEM: 15mw @ .40/watt = 6m
- Polysilicon: 700mt @ 40/kg = 28m
- Total COGS: 561.3m
Gross Profit: 196.9m
Gross Margin: 26%
Operating Expenses: 33m
Operating Profit: 163.9m
Net Interest Expenses: 25m
Minority Interest: 3m
Net Income: 115m
Diluted Share Count: 136m
As usual this EPS only reflects operational earnings and excludes non-operational items. Likely items that may appear for the current quarter are government grants and currency translations. LDK’s government grants are somewhat impossible to predict in any given quarter since they may represent uneven lump payments such as electricity subsidies the local government grants the company. Generally grants can range up to two million per quarter but can be less than one million.
In addition, as of today the currency translation appears to be in LDK’s favor once again. The rmb has appreciated vs. the usd which should cause a gain when applied to the company’s usd denominated convertible bonds. The euro has also appreciated vs. the usd which should create gains off euro assets namely those on the accounts receivables. This is slightly offset by the rmb’s appreciation vs. the usd but the overall net result should still be a gain given current exchange rates. Outside of any additional unexpected gains or charges, the net result from government grants and currency should add an additional 4-5m or about .03 in EPS above the operational numbers given above.
While the margin in the analysis above fall within LDK’s guidance, it should be noted that the company has continually given extremely conservative estimates. For example, LDK’s revenues for the third quarter came in over 10% higher than their original high end revenue guidance.
Disclosure: Long LDK