For LDK Solar (NYSE:LDK), the difference in corporate profitability in just a quarter was dramatic as night and day. The company went from a net income of $135.4m in the first quarter to a loss of $87.7m in the second quarter of 2011 as average selling prices across all major crystalline verticals declined drastically since the start of May. As primarily a silicon wafer producer similar to Renesola (NYSE:SOL), LDK was especially vulnerable as a mid-market component supplier.
LDK’s dramatic shift in profitability also demonstrated the importance of a fully integrated business model as branded module peers such as Yingli Green Energy (NYSE:YGE), Trina Solar (NYSE:TSL), and JinkoSolar (NYSE:JKS) were able to remain profitable at higher shipment volumes while fragmented single verticals not only lost money but also market share.
While the current distressed pricing environment may not represent longer-term sustainable levels, it should be clear industry gross profit levels may only be high enough to support large-scale, fully integrated manufacturers. While LDK Solar recognized this necessity last year as it integrated into downstream solar cell and module production, LDK’s near-term profitability will remain vulnerable until the majority of its business shifts to a fully integrated module structure.
Despite industry wide asp declines, LDK’s second-quarter gross margin was still higher than many peers. Although consolidated gross margins were only 2.2% due to a $52.9m inventory write-down, gross margin excluding this charge was 12.8%. This compares to integrated module peers like JKS, YGE, and TSL, which posted 25.4%, 22.1%, and 17% respectively.
While quarterly gross margin for any single quarter may not be a fair representation of more normalized levels, since there are many moving factors, it should be clear that the largest and most integrated companies in the solar sector have also been the most profitable. These results may not be good compared to record levels seen a couple quarters ago, but are much better relative to an industry where many companies have already started to fail as detailed in my Trina Solar second-quarter review. In the current consolidation period for the solar industry where the vast majority of individual firms may fail, the survivors become the winners.
Thus rather than scrutinize quarterly results for any single period when metrics represent unsustainable, distressed states, it is more informative to look at the bigger picture to determine which companies are better positioned to succeed. As I noted in my latest LDK Solar review, the company is in the process of fully integrating its already installed polysilicon and silicon wafer verticals.
At the end of 2010, LDK’s fully integrated module capacity was less than 10% of its primary wafer manufacturing business. By the end of 2011, the company hopes to reach 2.0-2.2GW of solar cell capacity compared to a planned 4GW of wafer capacity. Thus, despite a large-scale solar cell ramp this year, LDK may only reach 50% integrated levels. Full integration may not be achieved for another one or two years depending on overall industry demand levels.
Increasing solar module sales volume is entirely a different picture from just expanding capacity. Photovoltaic (PV) modules are the end product in the value chain, where consumption can depend on factors other than pricing, unlike more commoditized upstream verticals. Since modules are expected to perform at a certain level for 20 years or greater, brand bankability has been among the greatest driver of sales. In this regard, LDK Solar falls well behind established peers such as Trina Solar, Yingli, and Suntech Power (NYSE:STP), which all have spent years developing brand and distribution channels. For example, TSL, YGE, and STP all increased module unit shipments in the second quarter, while lesser branded suppliers, such as LDK, posted a sequential shipment decline.
How well LDK can establish itself as a module supplier will depend on a number of factors. Unlike many module peers which only produce and sell modules, LDK has also integrated further downstream to include a systems business division. As a result, it has the ability to place its own modules in system projects, much like higher-cost US peers such as MEMC Electronic Materials (WFR) and Sunpower (SPWRA), which may otherwise find it more difficult to sell a higher-cost-premium product in the current business environment.
Although LDK has not yet drawn on a large 60b RMB ($9.4b USD) credit framework agreement with China Development Bank made in 2010, the company has indicated future projects could be funded by this facility, dependent on certain qualifications. Like other US-listed Chinese solar companies have already confirmed, LDK also indicated in its second-quarter conference call it has already successfully arranged financing from Chinese bank for Western solar projects.
Where LDK Solar’s branding may fall behind established rivals in the solar industry’s largest market, Europe, it may enter newer markets outside of Europe on a more level playing field. Most notably, as solar demand increases in China following the country’s unified FIT announcement, LDK’s scale and brand within China may put the company on an equal level with the country’s larger manufacturers, such as STP, YGE, and TSL, which have been more concentrated on export markets.
With the recent declines in module pricing, all in solar system costs in China are approaching levels directly rivaling wind power costs. It would not be unreasonably to assume as this cost gap further narrows, solar demand in China could eventually approach the 16GW of wind power capacity China added in 2010. Since external suppliers would most likely be unable to compete with large-scale, low-cost Chinese module producers, the vast majority of Chinese demand may fall onto its domestic companies. For the second half of 2011, LDK expects to ship around 100MW within China which may represent 20% of its overall module shipments for this period.
With fully integrated capacity from polysilicon to modules, LDK Solar would become the largest and most fully integrated crystalline PV company when it achieves its year end target of 2.0-2.2GW of cell capacity. While LDK’s solar cell and module processing costs may not yet be as streamlined as direct peers such as TSL or YGE, its additional level of polysilicon capacity could make up for the difference at normalized levels.
In the company’s September 2011 presentation, LDK noted its module unit costs using all internally produced components had already reached below 1.00/watt levels with a 2011 year end target of 0.90/watt. If expectations on internal polysilicon production costs of $25/kg as well as non-silicon processing costs can be reached, LDK’s internally produced modules could reach a unit cost of 0.80-0.85/watt. With potential cost structures among if not the lowest in the crystalline PV sector, LDK could also use price as a leverage to gain module market share moving forward.
How well and how fast LDK Solar can transition away from silicon wafer to solar modules remains unclear at present time. Uncertainty was further increased after LDK lowered guidance for the second quarter, despite offering its original guidance with less than a month remaining in the quarter. Had the revision been small in proportion to the time uncertainty left before the close of the second quarter, LDK’s warning would have been more understandable, especially since many companies also witnessed the same challenging business conditions. However, the downward revision LDK issued was extremely severe relative to its original guidance.
LDK Solar Q2 2011 Updated Guidance vs. Original Guidance:
- Revenues: $480-500m vs. prior $710-760m
- Wafer Shipments: 410-430MW vs. prior 500-550MW
- Module Shipments: 75-80MW vs. prior 200-220MW
The dramatic shortfall from original expectations suggests LDK’s quarter was extremely back-end-loaded and/or something extremely dramatic occurred in the final three weeks that drove business to a halt. In its defense, the company explained portions of its module shipments were moved forward into the third quarter due to timing and revenue recognition issues when questioned about increased inventory levels. Despite badly misguiding investors for the second quarter, LDK appears equally bold with its 250-300MW module shipment guidance for the third quarter. For 2011, LDK still kept a high module shipment target of 750-800MW.
If the second quarter was just a timing hiccup and LDK can achieve its implied second-half module shipments of 550-600MW, then 2011 could be considered a successful transition year for the company, especially under the industry’s current destructive consolidation cycle. Module shipments of 750-800MW this year would represent as much as a 140% annual shipment increase over 2010 levels. With many higher cost structured peers withdrawing from the industry, LDK may become among the top 10 global branded module suppliers.
Why it is so important for LDK to successfully integrate and shift its focus to end products, such as solar modules, is clearly evident in the current pricing environment for the crystalline segment of the solar industry. Recent spot market pricing spreads between individual verticals suggest that most, if not all, fragmented silicon wafer or solar cell single verticals cannot produce a gross profit. Had LDK Solar remained solely a wafer supplier, it would have seen its silicon wafer per watt gross profit shrink by over 90% in just the span of two quarters. For the third quarter, I estimate LDK would only earn $0.02/watt wafer gross margin, compared to $0.20-0.30/watt the company enjoyed in the past several quarters.
Despite being one of the largest-scale wafer producers in the world, LDK would not be able to generate operating earnings as a standalone wafer supplier. Smaller-scale or higher-cost-structured single vertical silicon wafer or solar cell manufacturers would be in worse shape. Not only would most single verticals be unable to generate profits at the current spot market spreads, it would also be increasingly difficult to place products when buyers -- who may also be a fragmented single vertical -- could not even generate gross profits.
In short, overall gross profit levels for the entire crystalline PV value chain has compressed to the point where only large-scale or low-cost, highly integrated module producers can generate operating profits. The destruction among the middle vertical suppliers has forced many companies to curtail or shut down uncompetitive capacity. In more extreme cases, a number of companies have already become insolvent and inventory liquidations among suppliers exiting the field has augmented recent ASP declines.
At least solely based on LDK’s current business guidance, silicon wafer sales are becoming an increasingly lower portion of its overall business as module sales continue to ramp. At face value, LDK’s guidance indicates a sequential wafer shipment decrease from 428MW in Q2 to 350-400MW in Q3 while module shipments are expected to dramatically increase on a sequential basis from 80MW to 250-300MW.
If this guidance holds for the third quarter, LDK would generate more revenues from its module sales than its wafer sales for the first time in the company’s history. The bulk of the company’s gross profit in the third quarter would also originate from its module business segment. However, given the fact LDK has lowered guidance for two straight quarters, it would be more prudent for investors to assume more conservative expectations and take a "show me first" mentality.
Although LDK Solar’s general third-quarter guidance of $630-680m and 11-16% gross margin can generate a US GAAP net profit, my quarterly earnings estimate below will assume lower end expectations given LDK’s recent guidance history, as well as the current difficult business environment for the solar industry in general. As usual, metrics used are within the ranges stated or implied by the company and do not speculate beyond information set by the company.
Any updates by the company, especially dramatic revisions such as LDK’s second-quarter earnings update, would obviously impact these estimates as it nullified my original Q2 earnings estimate for the company. Again, as usual, these estimates represent mostly operational earnings and exclude unannounced non-operational items, with the exception of an estimated net foreign exchange loss based on the known change in key exchange ratios at the end of the third quarter.
LDK Solar Q3 Earnings Estimate:
- Core Wafer: 375MW @ 0.55/watt = $206m
- Module: 250MW @ 1.25/watt = $313m
- OEM Module: 15MW @ 0.43/watt = $6.5m
- Polysilicon: 1300mt @ 52/kg = $67.5m
- Other: $35m
- Total Revenues: $628m
Cost of Goods:
- Core Wafer: 375MW @ 0.53/watt = $199m
- Module: 250MW @ 1.10/watt = $275m
- OEM Module: 15MW @ 0.40/watt = $6m
- Polysilicon: 1300mt @ 37/kg = $48m
- Other: $30m
- Total COGS: $558m
Gross Profit: $70m
Gross Margin: 11.2%
Operating Expenses: $60m
Operating Profit: $10m
Net Interest Expenses: $37m
- Government Subsidies/Other: $3m
- Debt Repurchase Gain: $6m
- Foreign Exchange Loss: $15m
- Net Loss: $33m
- Diluted Share Count: 135m
- EPS: -0.24
Potential Retroactive Tax Reversal: $17m or $0.13 EPS Gain
There are a number of items which may alter these estimates. First is the $15m currency loss expected for the third quarter. With the euro ending Q3 over 7% lower vs. the usd, LDK would likely post a loss on euro-denominated assets on its balance sheet, such as portions of its accounts receivables. Unlike several other US-listed Chinese solar peers, LDK does not have a history of hedging currency exposure. As a result, it has posted net currency gains as the euro appreciated, while some peers recorded hedging losses. Now, with the euro dramatically lower for the third quarter, most if not all of the net currency gains recorded in the first half of 2011 would likely be reversed. If LDK changed its hedging policy during the third quarter by actively hedging its non-functional currency exposure, then actual losses could be lower.
Secondly, LDK has paid an extremely high tax rate in the first half of 2011, as its preferential high-technology tax status is currently under the process for renewal. If or when this tax status is renewed, LDK’s effective tax rate would drop to approximately 15%, and overpaid rates would retroactively be refunded. Since I estimate an operating loss for LDK’s third quarter, I also assumed LDK would not pay taxes for the quarter. A retroactive reversal of taxes paid could generate a net tax benefit.
Third, LDK Solar repurchased $21.5m of two separate debt issues in the third quarter for $15.6m. As a result, the company would record a US GAAP gain on the difference in value for the repurchases vs. the par value of the debt. This $6m figure has been included in my estimates as non-operational income, but the actual amount could vary if unannounced additional debt repurchases were made at discounts to fair value.
In addition, LDK may also post revenues from solar systems sold. The company has indicated possible sales of self-developed solar plants in the past, but since exact revenue recognition can be lumpy, estimates for this business segment have been excluded from my general estimates for operational earnings. With the finalization of its US based Solar Power Inc. purchase earlier this year, LDK may realize a wider base for solar projects sales moving forward.
Other portions of LDK’s systems segment, such as EPC (engineering, procurement, construction), have been included in my estimates as other revenues. Since LDK does not offer detailed information on this business segment, my estimates assumed constant and linear figures. Additional progress in this business segment could meaningfully impact LDK’s revenues, as well as gross profit. For example, a fairly large China based EPC contract was announced to be partially completed during the quarter.
Lastly, other than LDK Solar’s actual quarterly earnings, there has also been other meaningful activity. In late June, LDK announced a $110m share repurchase program which by the time of its second quarter conference call stated the buyback had been carried out in full. During this period, the company bought back 18.7m shares at an average cost of $5.90 per share. This share count repurchase was later effectively reduced to 14.3m shares when LDK placed 4.4m common shares in a private placement at the same price of $5.90 per share. LDK’s founder and CEO, Mr. Peng, bought this private placement and increased his ownership stake from slightly under 50% at the time of LDK’s 2010 annual report to 57% at the time following the transaction and SEC filing. The overall effect of this share repurchase will reduce LDK’s fully diluted share count by almost 10%.
Finally, LDK also announced its third and final 5,000 metric ton train of its 15,000 metric ton polysilicon plant reached mechanical completion, and should be fully ramped by the end of 2011. This milestone, along with a potential de-bottlenecking effort in the first half of 2012, could bring the company’s annual polysilicon production capacity to 25,000 metric tons vs. the company’s current 12,000 metric ton annual run rate. Full utilization would not only increase internal production, but also lower the cost of production.
While polysilicon pricing may continue to trend lower to properly align to the pricing spreads experienced in the crystalline PV sector, operating its polysilicon plant would still have benefits, even if LDK’s all-in-US GAAP production costs are not much lower than external polysilicon pricing. LDK currently targets internal costs to reach $30-35/kg by the end of 2011, and potentially lower to $25/kg if de-bottlenecking efforts increase the plant’s capacity to 25,000 metric tons. With current spot market polysilicon pricing already approaching $40/kg, and the potential to go even lower towards $35/kg as predicted by some industry analysts, gross profit may only range between $5-10/kg.
Due to high depreciation, which can range anywhere from $8-12/kg, cash cost of polysilicon production is significantly lower. As I explained in my first LDK article last year, full utilization of LDK’s polysilicon plant would be a key cash flow generator for the company. With the plant already complete, very little capital expenditures would be required at this stage to reach full utilization. As a standalone business unit, any cash generated through operations would essentially be cash flow positive. Even at a small $5/kg gross profit level, depreciation would increase cash flow at the gross margin level to $13/kg or more. At full utilization, LDK’s polysilicon plant could generate in excess of $300m in annual cash flow at the gross margin level.
Similarly, because LDK’s installed capacity is so high, with fixed assets already surpassing $3.5 billion, overall depreciation levels are significant. LDK’s quarterly depreciation already reached nearly $60m at the end of Q2. This figure should increase to nearly $90m once all of the company’s new capacity such as the third 5,000 metric ton polysilicon train and new Hefei cell lines come online. Thus, assuming other balance sheet items remain neutral, LDK would still generate $90m in quarterly cash flow even if the company broke even at the US GAAP level.
This is important to realize because LDK’s depreciation levels are so much higher than many peers due to a disproportionate amount linked to its $2b polysilicon plant. Trina Solar, in comparison, had $750m in fixed assets, which would equate to quarterly depreciation levels almost 80% lower. As a result, LDK’s cash flow potential is often discounted if incorrectly compared to other industry peers.
Disclosure: I am long LDK, TSL, YGE, JKS.