LDK Solar (LDK) has been hammered in recent weeks, losing 11.57% to close Friday 5/19/2011 at 7.26. The company issued a press release that day announcing the postponement of a proposed offering of senior notes, citing recent market conditions.
"Despite the postponement of this bond offering, we still expect to generate sufficient operating cash flow to support our business plan," stated Xiaofeng Peng, Chairman and CEO of LDK Solar.
"We believe this action will enable our management team to remain focused on the day-to-day operations of our business."
The announcement is best understood in the context of the discussion of liquidity included in the company's most recent 20-F. The same language appeared in the prior year's filing, so the issue is not new.
We are operating with a significant working capital deficit; if we do not successfully execute our liquidity plan, we face the risk of not being able to continue as a going concern.
LDK's auditors, KPMG, did not include going concern issues in their unqualified opinion. The issue is conditional, the condition being that the company will need to successfully execute their liquidity plan. The postponement of a proposed offering is not an encouraging sign. Additionally, postponing the offering is going to result in considerable distractions for management, rather than improving focus. The point is, when liquidity problems become severe, management spends inordinate amounts of time chasing receivables, hand-holding creditors, and attempting to maintain confidence generally.
Taking a Loss
After reading the press release and going back over my original thinking on this situation, I elected to close my position, locking in a substantial loss. While I think solar has good long-term potential, and I believe LDK's operations are making good progress toward large-scale low-cost production, there are concerns about excess capacity in the solar industry, given that austerity has been pressuring government subsidies.
Also, my experience with liquidity situations has not been good. Even if there are good quality assets, and strong prospective cash flows, frequently those benefits are reaped by creditors, rather than by shareholders. The company's founder, Xiaofeng Peng, owns 49.7% of the shares and his interests are not necessarily aligned with those of other shareholders.
The company and Mr. Peng have in the past breached various loan covenants. Although they have secured waivers for known breaches through 12/31/2010, the company makes no assurances that there will not be additional instances.
Potential Sources of Funding
In September 2010 LDK announced an agreement of sorts with China Development Bank. From the press release:
LDK Solar Co., Ltd. ("LDK Solar") (NYSE: LDK), a leading manufacturer of multicrystalline solar wafers and PV products, today announced that it has entered into a strategic financing agreement with China Development Bank Corporation (CDB), a joint stock banking corporation wholly owned by the state of China. Under terms of the agreement, CDB will provide up to RMB 60 Billion (or approximately US$8.9 Billion) of credit facilities to LDK Solar over a five-year period. The financings will support LDK Solar's long-term growth initiatives and corporate development plans. Terms of the individual credit facilities and lending agreements will be subject to CDB's internal risk management requirements and operational regulations.
The agreement is a framework, and terms of individual agreements, if any, remain to be worked out.
There has also been ongoing discussion that LDK will monetize its polysilicon operations by doing an IPO on the subsidiary involved. This was discussed here on Seeking Alpha by FUNCTION f:. If successful, the sale of the polysilicon business would relieve the liquidity issues.
Cost of Capital
On 2/28/2011 LDK closed an offering of US$-settled 10.0% senior notes due 2014 in the aggregate principal amount of RMB 1.2 billion. That would peg the company's cost of capital at 10%, perhaps more for a longer duration. An additional offering of RMB 500 million, again at 10%, was completed on 4/11/2011, with proceeds of US$ 76.2 million destined for general corporate purposes.
If sufficient long term capital were raised to bring the company's current ratio up from .57 to 1.5, the amount required would be about $1.5 billion, before consideration of certain non-cancelable orders for production machinery. $1.5 billion at 10% per year is $150 million. Dropping that number into their income statement, earnings would not be as impressive as they have been. With operating margins already under pressure, the addition of interest costs will increase the difficulty of showing a profit.
The company also tapped US equity markets on 2/1/2011, selling 13.8 million shares and raising $164.2 million. At current prices in the 7 area further offerings would entail serious dilution for existing shareholders.
Repurchase of Convertible Notes
On April 18, the company announced the repurchase of $351.8 million of its 4.75% convertible notes due 2013, at the option of the holders. This regretfully undid all the progress made by the share offering and the 10% notes. The goal of raising long term capital remains elusive.
Cramer was asked about the company during the lightning round on 5/19, and recommended against holding it, citing financial issues.
The lightning round format is entertaining - after all, Jim very rarely draws a blank, and is at all times decisive and opinionated. However, it's also very limited, in that there's no time for supporting facts or nuanced analysis. Due to the number of opinions expressed, it's very difficult to come up with a credible batting average.
In this case, Jim's opinion reflects common sense - stay away. If and when LDK overcomes its significant working capital deficit, the company can be judged on its future prospects as a player in solar energy.
Lessons to Be Learned
The lessons here are procedural: going over my notes, I didn't complete my usual spreadsheet, which includes a certain amount of testing designed to draw analytical attention to weak balance sheets. Nor did I compute a current ratio, which currently stands at .57, well below the 2.0 I consider optimal. A more careful reading of the 20-F would have picked up the going concern language.
It would have been nice to see an analysis (by me) of the liquidity plan, together with some estimates of the probability that all necessary funds would be raised in a timely manner. Basically, something to verify that an informed risk/reward profile had been considered.
As Warren Buffett says, you don't have to get it back where you lost it. LDK may yet succeed in raising sufficient capital to ensure liquidity, leading to a recovery in the share price. But I think better odds are available elsewhere.