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by David Sterman

I recently heard from a reader who wondered aloud why shares of LDK Solar (NYSE:LDK), which have lost half of their value since early May - and 90% of their value since 2007 - are trading so poorly. After all, this major player in the solar industry has received strong financial support from the Chinese government and looks pretty cheap based on (downwardly revised) profit forecasts. "With a P/E of about two and possibly the lowest-cost producer in the industry, what's not to like?" asked the reader.

Well, plenty, in fact. LDK's management has made a series of very aggressive moves that threaten to greatly hamper the company if they don't soon bear fruit. Then again, with a few breaks, this stock has the potential to rise much higher from current levels.

Let's dig in...

Vertical Integration - At A Cost

LDK is the world's largest provider of wafers used to make solar panels. The company reached the top slot (its 8.8% market share in 2010 was roughly twice the size of other large players like REC Wafer, ReneSola (NYSE:SOL) and Glory Silicon) by pouring more than $3 billion into capital expenditures (CapEx) from 2008 through 2010.

Management has been pushing even harder in recent quarters, spending heavily to build a presence in other areas of solar power. Huge investments have quickly made the company the fifth-largest player in the world in terms of poly-silicon (the raw material used to make wafers). To get closer to end users, LDK is also ramping up production of the solar panel modules that are increasingly dotting the landscape.

The strategy looked pretty smart - for a while. LDK's fourth quarter (2010) results, which were released in mid-March, showed a company firing on all cylinders. Output in the various businesses ramped up, and pricing was quite firm. Gross margins rose 510 basis points sequentially to 27.3%, yielding per share profits of $1.09, well ahead of the $0.92 consensus. At the time, shares looked quite cheap trading at just $12, or three times annualized profits. But this low multiple was due to a growing chorus of doubters predicting far rougher times ahead.

Despite rising concerns, management appeared quite confident at an all-day meeting with analysts a month later in mid-April. Just two weeks later, LDK would issue a lowered sales forecast. This is when the wheels started to come off. Demand for solar power started to drop very quickly, largely due to fewer government incentives in Italy and Germany, which had been key markets. Analysts did some quick math and realized falling demand and the lower prices it would bring would wreak havoc on LDK's profit margins.

By late May, management announced plans to withdraw a bond offering that would have helped meet roughly $1 billion in loans coming due by the end of the year. Nonetheless, first quarter earnings (which were released in early June) were fairly respectable. Second quarter results, which were pre-released on Aug.18, were far worse. Prices for solar wafers plunged from $0.84 per watt in the first quarter to around $0.50 three months later.

Just three months ago, management expected LDK to generate roughly $730 million in second quarter sales. Instead, they likely didn't exceed $500 million. Gross margins, which had been trending toward 30%, suddenly shrank to almost zero. Add it up, and expectations for a profit of $0.30 to $0.40 a share will actually be a similarly-sized loss. And this is a company that can't afford to lose money. Analysts at Kaufman Brothers were quick to remind investors, "LDK still needs to address its plans to refinance $1 billion in debt, which comes due at the end of this year."

What (Might) Lie Ahead For Investors

So is LDK going bankrupt? Probably not. After all, the Chinese government has expressed a willingness to step in at any time and provide capital if necessary. The capital was originally intended to help expand the business - and not absorb losses - but it's unlikely the Chinese government would pull the plug now.

Despite what looks like a fairly dire situation, investors could actually profit handsomely if LDK can finesse its upcoming balance sheet efforts. The company has been hoping to raise cash by issuing an IPO in Hong Kong for part of its poly-silicon business. This is off the table for now, but management is likely talking with strategic investors about a capital infusion. And if the Chinese government provides LDK with a fresh set of loans in order to pay off soon-to-be-expiring loans, then shares will likely benefit from a relief rally as the "bankruptcy trade" fades.

What kind of rally are we talking about? Well, tangible book value stands at about $9 a share - more than 50% above the current share price. And if industry pricing stabilizes later in 2011 and industry demand rebounds in 2012, then we're still talking about EPS power in excess of $2. Might shares be worth at least four or five times that figure? Then, shares would have 40% to 70% upside.

Risks to consider: There are a lot of "ifs" here. If solar demand doesn't rebound in coming quarters, then LDK may become so constrained for capital that rivals are able to surpass the company in terms of technology leadership.

Action To Take

This is a high-risk/high-reward investment play with major upside potential. On a positive note, pricing for poly-silicon has risen in August, the first upward move in five months, and was the key catalyst behind double-digit gains for LDK and many of its peers in Tuesday, Aug. 23, trading.

Goldman Sachs, which doesn't follow LDK, is turning bullish on the broader industry. "In our view the equipment cycle is close to bottoming with order trends weak, capex spend being delayed (or even cancelled), customers profit warning and managements increasingly uncertain about the outlook. We might be a quarter or so early, but the inflection point in solar equipment is approaching and history tells us that share prices will reflect this 1-2Q's ahead of time," wrote analyst Stephen Benson in a note to clients. This is a gutsy call, but this sector has rewarded risk takers many times before.

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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

Source: LDK Solar: A High Risk, High Reward Play