LDK Solar's Losses Increase In Q3 2011

| About: LDK Solar (LDK)

Similar to Canadian Solar's (NASDAQ:CSIQ) large quarterly earnings per share("EPS") loss, LDK Solar's (NYSE:LDK) third quarter 2011 loss overshadows continual improvements which should ensure its survival in the industry. Often a controversial company due to its high debt load, even analysts who pegged LDK for bankruptcy have come to realize because of the company's large scale, revolving its debt would unlikely be an issue due to continual support from local and provincial banks. While LDK Solar has sought additional financing through various channels for capacity expansion, its management has repeatedly stressed in quarterly earnings conference calls that extending current credit facilities from domestic sources has never been a problem. Nevertheless, those less familiar with LDK's financial situation may continue to question the company's survivability. For those who do not view the company's debt as an issue, then its ability to generate earnings and cash flow under normalized conditions should be the primary concern.

Although LDK's large third quarter loss does not tell the entire story, the company has been extremely guilty as with many peers for overly aggressive guidance which has led to dramatic downward revisions on quarterly earnings forecasts. Its own Q3 warning was sharply lower than its original guidance. Granted the company was not alone and dramatic changes in the industry were beyond its control, failed realistic near term operational guidance did little to improve LDK's image among skeptics.

For the third quarter of 2011, LDK's revenues declined to $471.9m from $499.4m on a sequential basis. While the decline was understandable given the steep pricing erosion across all silicon based photovoltaic("PV") verticals, actual results were a far cry from the company's original $630-680m estimate. Although lower than originally expected average selling prices("asp") were part of the issue, LDK as well as many other peers also experienced much lower than planned unit shipments as liquidations accelerated from defunct rivals. LDK's quarterly silicon wafer shipments dropped to 292.5MW from 429.2MW, or almost a decline of 32%.

As noted in my Q2 summary, declines in wafer shipments were expected as the company slowly transitioned from a single vertical wafer supplier to a fully integrated module manufacturer. Although the company's module shipments grew dramatically on a sequential basis from 79.4MW in Q2 to 192.1MW in Q3 representing a 142% increase, it still fell well short of its original unrevised guidance of 250-300MW. As a result of this ongoing transition, LDK was able to curve its sequential revenue decline to 5% compared to its closest structural rival Renesola (NYSE:SOL) which reported a 24% sequential revenue decline due to its higher single vertical dependence.

Gross margin shrank further to negative 3.6% in the third quarter, down from 2.2% in the prior quarter. Similar to the second quarter, LDK took an additional inventory provision to adjust to the rapidly declining asps across all PV verticals. Excluding a $47.3m inventory write down, adjusted gross margin was 6.4%. Much of the write down was due to a nearly 50% drop in silicon wafer pricing in just two quarters. By my estimation and prior to the inventory charge, LDK Solar sold its silicon wafers at cost while maintaining a 4-5% margin for modules and a 40% margin for polysilicon. Had the company remained primarily a single vertical wafer supplier, its corporate losses would have been much greater.

Needless to say, margins in the industry's current environment make it difficult for most companies to be profitable at the corporate level. U.S. GAAP accounting requirements for inventory write downs further compound headline results. Net loss in the third quarter amounted to $114.5m for LDK, or -0.87 in EPS. This compares to my revised estimate of $120m and -0.89 in EPS loss, respectively. As noted in my LDK Q2 summary, losses during the current consolidation period for the industry are inevitable such that investors should focus on operational structures for each company to determine profitability levels once conditions normalize to sustainable levels.

In terms of LDK Solar's structural shift from a single vertical silicon wafer manufacturer to a fully integrated solar module supplier, progress has been gradual. Perhaps in a less challenging period for the industry, LDK may have been able to transition more quickly but nevertheless the company has been able to make significant progress in the past year. For the third quarter and for the first time in the company's history, LDK's module revenue surpassed its wafer revenue. In fact, overall revenue for its module segments almost doubled revenue for its wafer segments. The gap should widen further in the fourth quarter where I estimate module related sales could be as much as three times the company's wafer sales.

This shift is extremely important for LDK's corporate profitability because the current pricing spreads between individual verticals is so narrow such that only fully integrated module producers can generate gross profits. Based on the information provided in LDK's Q3 earnings conference call, the company's silicon wafer unit cost was around .52/watt during the quarter. Factoring out implied gross profits from LDK's other business divisions, the company made little or even lost money with its wafer business divisions. This suggests a quarterly wafer asp of around .52/watt which is also inline with spot market pricing during the period. Without other business divisions which helped generate $30.3m in pre-inventory write downs, LDK's corporate losses would have been larger.

A large portion of LDK's adjusted gross profit in the third quarter came from polysilicon sales. The company noted polysilicon revenue was $35.7m at 40.3% gross margin which equates to $14.4m in gross profits. Based on the company's stated .70/watt fully integrated module processing cost, and an internal module unit cost of .89/watt during the quarter, LDK's internal polysilicon production cost was around $32/kg in the third quarter. This is inline with management's comments of production costs "in the low 30s." It also suggests polysilicon asp of roughly $54/kg during the quarter, inline with spot market trends as well as ranges referenced by direct peers quoting $50-55/kg, and slightly higher than my $52/kg estimate.

While extremely robust at 40.3% gross margin, even this single vertical polysilicon segment was vulnerable to the overall industry pricing contraction. Quotes for polysilicon have recently ranged around $30/kg give or take $5/kg depending on product quality and proximity to suppliers. Essentially LDK's 40.3% gross margin for its polysilicon division vanished in just one quarter. For another U.S. listed Chinese solar peer more single vertical oriented in polysilicon production, Daqo New Energy (NYSE:DQ), swings in quarterly fortunes will be more pronounced as almost 90% of its revenues came from polysilicon sales. Luckily for LDK Solar, the continued transition into a fully integrated module manufacturer should help the company return to profitability much more quickly than less integrated peers.

Although LDK's Q3 blended module unit cost was higher than its stated .89/watt real time production cost due to lag effects of cost average accounting, gross margin by my estimation was still positive in the third quarter. Again, it is more important to recognize a company's potential normalized earnings power than earnings at any instance in time. While I estimate LDK only generated an adjusted[pre-inventory provision] module segment gross margin around 4-5%, the company's real time per watt gross profit spread in the third quarter was actually .35/watt, or 28.2%. Granted .35/watt is much lower than .50-.60/watt fully integrated gross profit generated by the industry's most efficient players such as Trina Solar (NYSE:TSL) and Yingli Green Energy (NYSE:YGE) in 2010's boom, it is also much higher than the .05-.10/watt gross profits recorded by LDK as well as many peers during the third quarter of 2011.

As LDK Solar ramped its fully integrated production capacity, costs have come down quickly. Fully integrated module processing costs noted in 2010 were around $1.00/watt. This has been brought down to .70/watt with targets slightly lower. Including polysilicon which is normally excluded from fully integrated processing costs since it is more regarded as a raw material, LDK hopes to reach a module unit cost of .80/watt by the end of 2011 or early 2012. Unlike less integrated peers such as CSIQ which noted a real time module unit cost of .76/watt in Q4 2011, LDK's target goal would more accurately represent a sustainable normalized level. This is because some companies may be benefiting from product procurement at depressed liquated pricing levels which are unsustainable. With a truly fully integrated platform of polysilicon, wafer, cell, and module production, LDK Solar would be one of the few companies in the industry that can maintain consistent and low manufacturing costs.

Fully integrated capacity at high utilization levels may still be several quarters off for LDK Solar. The company's volume in the third quarter represent only a fraction of its overall capacity. By mid-2012, LDK's quarterly polysilicon production run rate may be double levels witnessed in the third quarter of 2011 while wafer and module capacity may be roughly 400MW and 600MW respectively. With a wide Q4 2011 guidance of 200-270MW in wafer shipments and 180-270MW in module shipments, the company would only be operating around half capacity. As a result and as warned in my last LDK update, large losses would most likely be repeated.

As usual, my quarterly estimates only reflect information provided by the company and do not speculate outside of metrics indicated directly or implied by the company. Since LDK's Q4 guidance provided extremely wide ranges, my mid-point estimate could equally have high degrees of error in both directions. Again these estimates only reflect operational results and exclude unannounced gains or charges with the exception of a small foreign exchange loss estimated assuming a constant foreign exchange hedging strategy by the company.

LDK Q4 2011 Earnings Estimates:

Core Wafer: 235MW @ 0.37/watt = $87m
Module: 225MW @ 1.05/watt = $236m
Polysilicon: 1000mt @ 32/kg = $32m
Other: $50m
Total Revenues: $405m

Cost of Goods:
Core Wafer: 235MW @ 0.37/watt = $87m
Module: 225MW @ 1.00/watt = $225m
Polysilicon: 1000mt @ 32/kg = $32m
Other: $42m
Total COGS: $386m

Gross Profit: $19m
Gross Margin: 4.7%
Operating Expenses: $60m
Operating Loss: -$41m
Net Interest Expense: $45m
Government Subsidies/Other: $3m
Foreign Exchange Loss: $2m
Tax: $0
Net Loss: $85m
Diluted Share Count: 126m
EPS: -0.68

Although my gross margin estimate falls between LDK's official guidance of 2-7%, it assumes very little additional inventory write downs. Despite pricing across most silicon based solar verticals leveling off midway through the fourth quarter at the time guidance was given, another albeit smaller inventory provision could still result. The final quarter of a fiscal year is also often a quarter companies clean the books. As a result, other write downs such as receivables on overdue accounts could also result. In essence, gross and operating margin could still materially differ from the operating gross margin estimate above.

My revenue estimate is also well below LDK's range of $440-520m. Most likely the difference is due to the company's systems division revenue for projects recognized as completed or sold. Since the company provides almost no information for this segment, it is impossible to make any estimation. With $120m worth of projects likely to be recognized in the coming quarters, consolidated revenue would be impossible to predict without more specific disclosure on timing and value of these projects in any given quarter.

Lastly pertaining to these fourth quarter estimates, over $15m in taxes could still be refunded if LDK Solar was officially granted renewal of its "preferential high technology" tax status. Although any amount refunded would only dampen the headline losses, it could still affect the EPS estimates above by over 0.10 per share.

Much like with the rest of its peers, LDK Solar is caught in a waiting game. The company is waiting for uncompetitive peers to leave the industry and for the consequent inventory liquidations to ease the pricing pressures in the main solar verticals. Until pricing bottoms and inventory costs become fully blended down to real time levels, margin levels will continue to appear distorted. LDK's two large inventory provisions in the second and third quarters of 2011 will help quicken this inventory blend down but it may not be until early 2012 that reported costs become normalized to real time costs.

When costs become normalized to real time levels and assuming LDK reaches its internal module production cost of .80/watt target, per watt gross margin may stabilize around .20/watt or higher. Of course this assumes module pricing stabilize around 1.00/watt or costs can be lowered according on lower module asps. The reason why per watt gross margin may stabilize around .20/watt or higher is because this level would not allow for single verticals to sustain profitability. It would be a level which would force major peers to either fully integrate or eventually go out of business. Even among highly integrated producers, very few outside of large scale Chinese producers could reach such low costs. For LDK Solar, such gross margin levels could easily generate over half a billion in gross profits at higher utilization levels which would be enough for the company to return to corporate profitability.

Thus as long as global demand can support module asps around 1.00/watt or potentially slightly higher, only a handful of companies could supply at such a pricing level for any sustainable period. As noted by CSIQ's most recent January 2012 update, perhaps only 15GW of sustainable capacity could supply at module asps of 1.00/watt whereas 2011 global demand was almost double this figure as detailed in my latest CSIQ earnings review. Once inventory liquidations have been completely resolved and the inventory structure within the solar industry return to normal levels, companies with the lowest cost structure would not only reach profitability sooner, but perhaps capture a disproportionate pool of the industry's gross profits as the field shrinks from hundreds to perhaps only a couple dozen extremely large scale and low cost manufacturers such as many of the U.S. listed Chinese solar companies including LDK Solar.

Disclosure: I am long LDK, TSL, YGE. No position in CSIQ, DQ, SOL.