LDK Solar: A Conversation with Piper Jaffray's Jesse Pichel

On October 4, 2007 I was at a trading conference hosted by Fidelity for active traders in San Francisco when I decided to check on a new solar stock I had bought that morning, LDK Solar (LDK). I was happy to see it was up $6 in the early morning trade, took another sip on my coffee, and thought about what a good day it was going to be. I clicked off the site and went to a one-hour lecture by William O'Neill, the founder of IBD. When I came out of the lecture LDK was down $10 on another news release by its former financial controller, Charley Situ. Thousands of my dollars had flown out the window in single whiff.

As I watched in holy terror as the saga unfolded over the next few days, I researched every atom of the story I could find to get at the truth of the matter (losses can do that to you), and published articles of my findings through Seeking Alpha and the Chipstocktrader website over the next three months.

The articles must have hit a nerve, because thousands of investors clicked on them, read them and circulated them. A ground swell of strong reactions rose up, striking back at the way the company was so-easily maligned by Situ, the Wall Street Journal, and especially Barron's. It seemed that no one in the financial press believed LDK. The stock gyrated up and down 16% a day for weeks on end.

My commentaries were gleaned from known available information. But at the end of the day they were still just suppositions, based on available facts. I did not have any direct sources to verify my viewpoints (always the best course, yes?), nor did I think anyone from the professional community would be interested in responding. LDK has a way of polarizing adherents into two camps: believers and non-believers, with not much in between.

On the last CC I detected a strong note of disbelief on the part of two analysts, Adam Hinckley and Jesse Pichel, and said so in my December article. And to boot, both analysts soon enough downgraded the stock after what looked like a stellar earnings report. LDK fell 25% overnight. I was dismayed. It made no sense, especially in light of the billions ($) of new contracts and the clean slate given by the independent audit. The "guilty until proven innocent" and "guilty when proven innocent" theme continued - so carefully reprised by Bill Alpert of Barron's infamy - and reared its pit bull head again and again. After that call, furious shareholders went after the two analysts, Situ, and anyone else they thought was targeting the stock for short sellers.

But that's when a surprise came my way. One of the analysts, Jesse Pichel, contacted me to tell his side of the story. He related what actually happened between Charley Situ and him, the manner in which Piper made the allegations public, and the reasoning behind his two downgrades: first to neutral, and later to sell after the conference call. He sent me his research notes (available at the end of this article) and we discussed them at length over three phone calls. The rest of this missive is a summary of our conversations.

The Charley Situ story

During the week of September 23, 2007, Jesse Pichel was at Solar Power 2007 in Long Beach, listening to the LDK presentation, when the company re-released previously announced information about the scope and size of their newly planned poly plant. When the next presenter, a poly producer from Norway, took the stage, they seemed challenged. REC Group has a unique position in the solar energy industry because it makes silicon, wafers and cells. REC Silicon and REC Wafer are the world's largest producer of solar grade silicon and wafers for solar applications. Their silicon division holds the rights to a unique and proprietary closed-loop polysilicon production technology and has made substantial investments in it. They are a direct competitor of LDK.

REC flatly stated that Fluor only builds to a design, and that if LDK copied the plans of their new poly plant (or process) they would take issue with that (Note: since this time LDK has hired their own design team to work on their poly plant in addition to Fluor and CDI, so it's a moot point).

Then at the airport, waiting to fly home, Mr. Pichel got the fateful email from Charley Situ accusing the company of cooking the books. In the email Mr. Situ informed him of the allegations, stated that he was the company's controller, and that he had contacted the SEC.

Mr. Situ alleged that LDK had some questionable inventory. Inventory was rising faster than their sales (even though demand was astronomical), so it appeared that only the good stuff was being processed and going out the door. LDK had an average cost of poly that was a $100 a kilo lower than their competitors. If you buy good stuff at $250/kg and poor quality silicon at $50/kg and use a cost-averaging form of accounting (adding up the beans and finding a mean cost) then you can have profit margins bigger than your competitors. But is that a fair representation? A $150/kg average cost did not make sense to Mr. Pichel compared to the prices paid by Yingli Green Energy (YGE), Solarfun (SOLF), Suntech Power (STP), China Sunergy (CSUN), Trina Solar (TSL) (and many others) for their silicon. Though it was legal to account for costs in this manner; it meant that the average cost of poly would soon be going higher.

These were some of the questions that were swirling around the company before the audit. Now an allegation is not a fact, it's not proof, and you can't base an analytic opinion on something like that. In his October 3rd comments accompanying the news release, Mr. Pichel said:

We have spoken to the LDK CFO about these claims and have found no reason/proof to dispute management's claim of 1000MT of polysilicon in inventory or work in progress. News of the departure may pressure the stock near term.

He maintained his outperform rating (buy) and $52 price target.

But he eventually had to take into consideration the larger picture of LDK's plans, especially after he'd traveled to poly plants and solar fabs all over the world and knew what's involved in making polysilicon. It's not easy to do. Polysilicon production is a difficult industrial process to master, involving a perfect mix of TCS gas, thermal heating at very high temperatures, and the right durations of time to grow silicon under extreme conditions and on a massive scale. Even the best poly producers - with decades of experience - take 3 years to build a fab and master the process technology, especially the TCS gas re-circulation. If LDK was planning on doing it in a year, building the largest scale process in the world, and basing their forward earnings on that, then maybe they're attempting the impossible, he thought. The experience of others doing the exact same thing says it can't be done.

Jesse delivered Situ's emails to Piper's compliance department for review. All stock analysts are bound by the "Selective Disclosure of a Material fact" law. If material information about a company gets leaked to clients before public review, the analyst will be fired and the firm investigated. You leak and you're toast. That's the bottom line. So the letters never left Piper, were never sent to anyone from Mr. Pichel's office, nor were discussed with any clients prior to the October 3rd research note.

I was obliged to notify our compliance department immediately, and subsequently - at no time - were Situ's emails sent to clients or discussed over the phone with them. I conducted an investigation by talking to Situ and the company (LDK), and could not find any proof of his allegations. I was obligated to make my findings public that 1) Mr. Situ, the controller, had left the company; 2) he'd made allegations; and 3) he had contacted the SEC. I became aware about an hour before the story broke that it was already out there.

In the meantime, Charley Situ had sent the same information to the SEC and several other sources, and this information began to circulate in the Wall Street underground. This is another reason why Piper had to act and break the story. Mr. Situ is entirely responsible for the notoriety he received and the sensational selling and short-selling that followed.

When Jesse asked him about the stock-options money he passed up by blowing the whistle on the company, he said it wasn't enough to make him change his mind. He seemed competent and honest; and as far as Mr. Pichel knew, left LDK of his own volition. I'm assuming that virtually all the information in the Barron's articles had to come from Situ (or from someone else he had sent it to) in concert with Bill Alpert as a ghost writer, and Alpert's juxtaposition of Jesse Pichel as a leaker on a par with Henry Blodget is not true. And the editors of Barron's never spoke to Mr. Pichel to verify this statement. The institutional clients that utilize Piper received their information at the same time as everyone else in line who played it straight (unless, of course, you were on Mr. Situ's "privileged list"). Barron's put their own assumptions on what had happened and never talked to Pichel for comment. Yes, Mr. Pichel broke the story, but it had already become whisper knowledge on the Street and Piper acted to protect their own clients from a broadside. There was no selective "pre-announcement" to privileged clients, which, as stated above, is illegal.

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Some other anecdotal information to add to this. Mr. Pichel said he does not have an adversarial role with the company. In fact, a member of his team introduced Jack Lai to Mr. Peng as a suggested CFO, and Pichel believes Jack Lai is competent and honest. Piper was the first to launch on the solar space in 2005. And the company does not take positions in stocks. They buy and sell stocks for funds.

Piper Downgrades to Hold then Sell; The Year Ahead, Plus 2009 - 2010

Two things led to the downgrades:

First, LDK had told analysts to expect a 1-2% percent margin decline per quarter continuing on through the audit. When they came in at 29%, Mr. Pichel was surprised by the deterioration. LDK had missed their own guidance. He believed the decline had been caused by the rise in scrap silicon prices in conjunction with poly prices.

Three-quarters of the scrap market is drying up because fabs that used to sell their cast-offs are now going into the recycling business themselves. Instead of paying others to haul it away, they're going to sell it at a premium.

LDK's previous cost advantage from purchasing re-cycled scrap has vanished.

This was the reason for the downgrade from Outperform to Market Perform (neutral) on October 31, 2007 and a new price target of $34.50. The 2008 pro-forma EPS on LDK was reduced to $1.65 (from $1.92) on revenue of $1.1B (from $943M) and gross margins of 22.6% (down from 31.3%). As stated above, Mr. Pichel anticipated "higher blended poly cost for LDK due to tightening scrap poly supply, and increased competition for scrap from competitors."

Next, the time required for construction and completion of the new fab (to be fully functional) needed to be considered. Could LDK produce its stated goals for 2008-09? It all depended on the completion of the plant because that would offset the rise in poly costs (both scrap and spot). It would be a race against time. Mr. Pichel had traveled to several poly plants worldwide and he covers WFR and REC. He met recently with several poly producers in China and none of them had ramped in less than 2.5 years. Further, since LDK has no real experience advantage with poly production, who would run the plant and who will design it? It took Shunda (in China) one year just to design their plant.

If the construction of the LDK plant is completed on schedule by year end 2008, industry professionals believe it will take an additional 2-3 quarters to ramp. That means the 5000-7000 MT production scheduled for 2009 could be cut in half and 2009 might become a terrible year for LDK. Their newly-stated margin guidance for 2H'2008 and 2009 is contingent on their poly plant becoming successfully operational. The margin erosion that would incur from likely delays was the reason for the "Sell" recommendation on December 20th.

Mr. Pichel doubts the feasibility of a one-year fab ramp. LDK's generous margin guidance for 2009 is based on a plant that has not even been built, so the fab's relationship to future earnings is a probability bet, not a fact. He has since reiterated his sell rating for three reasons: valuations (as he sees them), lack of clarity surrounding LDK's poly supply (cost), and its polysilicon ramp (the new fab). As an analyst, assessing ramp risk for the poly plant is important because his clients trust his judgment and will apportion their investment capital accordingly.

However, he's okay with LDK's projections for 100% poly supply for 2008 and the fulfilling of their current order book. If they get their reactors working by the end of the year they'll be able to make some of their own poly because they have already contracted for the required TCS gas (from a nearby province less than 40 miles away)

2009 is the stickler.

If our thesis is correct, LDK's gross margin for 2009 would be less than half its guidance. In conclusion; the press release (from LDK, January 2, 2008) does not increase our confidence in LDK's ability to source poly or make its own poly.

But for 2010 his view grows more positive, especially if anticipated bugs are worked out in the 2.5 year interim.

LDK will be in much better shape; a vertically integrated wafer supplier producing their own poly. And I think polysilicon will remain scarce; and that the industry will continue to sell out of it. If the installed price of solar comes down from $5-6/watt in Europe to $3-4/watt, and the cost of producing a kilowatt of electricity falls to 18 cents/watt, we are close to grid parity, the Holy Grail of solar. The industry could eventually need 80 to a 100 Polysilicon plants to keep up with demand.

So Where does All this Lead Us?

The story of LDK's future therefore is all about its poly plant. Although the timing of its completion is not certain, everything involved with the new plant thus far has surprisingly gone to plan and on schedule. It's an amazing feat, a mini Great Wall in Xinyu City. 6,000 construction workers working 24/7. It reminds me of the construction of NY's Empire State building as it climbed 102 stories to completion in just 60 weeks (See pictures). There's clearly a charisma, an excitement about LDK's project.

Yes, there will be detractors along the way, but this is not a mom and cookie shop commanding the landscape. Take a look at LDK construction pictures of the new poly plant and notice the square mile lot in the background.

Postscript

Analysis is both an art and a bean-counting profession: part subjective, part objective. I don't think it should become didactic and that's the mistaken approach many critics have taken to LDK. It's a new company with an aggressive approach. And yes, It could get creamed if things don't work out. But it's not a morality play and I don't think Mr. Pichel is approaching it as such, either. He just has a differing opinion, based on his 3 years of experience in solar. People have a right to their opinions. It's a free country, yes?

Twenty years ago a young software entrepreneur broke onto the world stage with a computer operating system for everyman. He was shrewd and clever, like a cat shepherding mice on a square mile of linoleum. I don't ever remember Bill Gates saying 'Pretty please" when he incorporated (err, re-engineered) the graphic user interface from Apple computer; the server platform from Sun Micro and Novell, the Internet Explorer browser from Netscape, and the Media player from Real Networks. He irrevocably blended them into his monopoly operating systems. If you used the one you had to have the others too. And after a zillion accusations, allegations, lawsuits and fines later, Microsoft is still chugging along, the most profitable corporation in the world. You can say that Bill Gates didn't "play by the rules" but in fact he did, he played by his own rules. And so did Andrew Carnegie, Henry Ford and John D. Rockefeller before him.

I'm not justifying their actions per se, I'm just saying it happens. Anyone who has bet against CEO Peng's tenacity and single-minded blitz into the solar sector has thus far made the wrong bet, and I think this poly plant will work out that way too. Gandhi put it like this, "First they ignore us, then they laugh at us, then they fight us, then we win."

You have to acknowledge Mr. Peng has "bet the farm" on this new poly plant, hasn't hedged that bet, and is going forward in a determined manner. No one proved he couldn't beat the odds in his previous businesses. I'm sure he thinks that way now, too. Like I've said in my previous articles: journalists and analysts manage news columns and financial reports; Mr. Peng manages a business he aims to be the biggest in the world. LDK wants to be the world leader in its niche, the one with the enduring competitive advantage. I've read a lot about solar process patents in the possession of other companies. Having a closet-full doesn't mean you have a killer business model. Just look at Stan Ovshinsky's Energy Conversion Devices with its thirty years of losses. He could have earned a Nobel prize for fund-raising (VC capital) instead of recognition for his technology improvements.

If you look at the alternative energy space carefully, you can see that solar is the future, the paradigm shift - not ethanol, wind, or waves. Solar is an electro-chemical engineering process. Ethanol is an agricultural crop; non-renewable, requiring more energy (and Midwest politicians) to make than the energy it creates. The U.S. ethanol industry hurts our ranchers, drives up our food costs, and helps sustain the 17% increase in energy costs we've suffered in the last year. It's a lose/lose proposition; not a win/win. Wind and waves - made by wind - are mechanical processes, 19th century stuff, metal on metal, windmills and buoys, grinding away, maintenance contracts as far as the eye can see off shores and on hillsides.

"Solar energy is the great leveler (unlike oil, which has been the great divider) between the haves and the have nots). No one owns the sun. It can't be drilled or mined or tied up in financial derivatives. It is the only energy source in the world that is primarily free at its source and universally available to consumers. And the closer a nation is situated towards the equator - and the bigger their deserts - the better the technology works." (See Here Comes the Sun, February 17, 2007, Commentary, Chipstocktrader.com)

" Unlike wood, coal, oil, or natural gas - you extract it electronically from the sun with the flip of a switch. You pay for the machinery that does the extracting, not for the power itself. There are no moving parts. No wells, drills, caves, miners, or gas. This is a paradigm shift as large as the movement from horses to cars, or wood to coal to oil." (See Is Akeena the Next Solar Flare?).

I'll close this missive with a quote from Rudyard Kipling that seems to sum up both sides of the analytic story on LDK.

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you
But make allowance for their doubting too....

The truth of LDK's future is indeterminate; but the manner in which we assess it is not. Due process will soon enough write the next chapter on LDK.

Addendum

LDK research notes, excerpted from Piper Jaffray - Jesse Pichel news releases, August 2, 2007 through January 2, 2008

Disclosure: Author has a long position in LDK

Comments

[David White:]

Perhaps appropriately the next line is, "If you can wait, and not be tired by waiting."

Actually I greatly enjoyed your article. Thank you. You did leave out one salient point though. LDK intends to double its production of solar in both 2008 and 2009. No one seems to have a problem with this. Also the 2008 and 2009 production are essentially sold already. Even if LDK falters as Mr. Pichel is suggesting LDK will, it should still about double its profits in 2009 over 2008. The small plant should also get done more quickly. It should provide some polysilicone. Analysts have given a range of margins for 2008. They have given estimated earnings based on not having a polysilicone plant. No one is suggesting that margins will decline further in 2009 from their 2008 levels. This means that at worst the LDK profit should double in 2009. Even if Mr. Pichel's negative scenario plays out as he has predicted, LDK should have the polysilicone plant up and running by 2010. The margins would go up then. The profits would might very well quadruple that year. LDK still looks like a good long term investment.

2008 Jan 22 08:54 AM

[David White:]

I should add that Mr. Peng no doubt intends to use the small polysilicone plant as a way of debugging the process before LDK gets to the same stage in the large polysilicone plant. I'm sure he is correct that this will speed the process up. I am thinking that he will make a big effort to get this plant up and running quickly to show that he meet the schedule for the larger plant. He may or may not succeed, but I believe he will come a lot closer than Mr. Pichel thinks. His top guy is a former top guy at MEMC. he should know what he is doing.

2008 Jan 22 09:16 AM

[Alpha Seeker:]

Unbelievably long article. But really good.

2008 Jan 22 10:28 AM

[David White:]

WFR reports on Thursday after the market close. It makes its own polysilicone, so this should be an indication of how LDK may do in the future (better with cheaper Chinese costs). If WFR does well, LDK's results should be decent.
Since you seem to talk to the analysts a lot, do you have any idea when LDK is reporting Q4 2007. I was guessing it would be sometime in February.

2008 Jan 22 12:26 PM

[alpha24seven:]

Here's the question

How much will LDK get in deposits from its contracts. An ACTUAL quantifiable number and no mumbling.

2008 Jan 22 01:01 PM

[SolarGuru:]

Kudos John. Excellent "missive". :-)

2008 Jan 22 01:05 PM

[solar advocate:]

Right or not (and I hope you are correct John) I appreciate your posting all your findings in both this and in prior articles. I understand it may not be entirely altruistic that you have done so, but I for one really appreciate it. Thanks again, and keep up the good work!

2008 Jan 22 04:00 PM

[carlivar:]

Probably one of the best articles I've read on Seeking Alpha. Thanks!

2008 Jan 22 07:47 PM

[SolarPro:]

There is a really good discussion in yahoo message board concerning this article. Lots of good info commenting on Pichel's arguments.

2008 Jan 22 11:15 PM

[jaytrade:]

Great work !!!
Thanks John .

2008 Jan 23 12:21 AM

[Hakan Telenius:]

Thanks a lot!

2008 Jan 23 03:09 PM

[User 68897:]

It could been better if John had some direct info in his writing.

2008 Jan 26 10:13 PM

[Hardknocks:]

Big $ loves the Golden Oil Goose look at Ford & GM losing $ year after year. There not idiots for what they get paid no one can be that dumb.

Alternate energy is pushing through. That why we'll see gas at $4 this year there last chance at greed.
What happened to "for the people" where's the government That's right there in on it... Bush=oil

2008 Mar 01 04:14 AM

[The Ditch D...:]

Great article. I bought and sold LDK based on Robert Hsu's recommendation. He recommended the sell because LDK's IR dept. did not get right back to him on the breaking story. I can see that they were a little busy, and did not have an independent audit done anyway. I am going to hold on, average down if I can, and not let it get to over 2-3% of my portfolio. And to hardknocks, I agree, Bush is Hitler, Bush is Hitler, and Cheney started the war for his oil buddys at Haliburton so they could get all the no bid contracts that are really no show contracts. Haliburton couldn't find Iraq on a map, they get paid billions a week, and never leave Houston, and 911 was an inside job, and the moon landing never happened, and yes, I just saw Elvis at the local Burger King.

2008 Mar 02 04:48 PM

[Fishr:]

Great writing in a storm. (And, defense of Bill Gates ... the shrewd nerd.) Kidding on that last.

Like your work. Its a well written. Have you considered whether or not Pichel's manner during the conference call, support the "compliance obligation" theme?

Also, has there been any follow-up on this subject since Jan 2008? I know many investors expressed concern to the SEC over Pichel. And by writing on Pichel, do you intend to take focus off Goldman Sac's analyst Cheryl Tang who issued a "conviction sell" that came out about the same time as Pichel's downgrade.

Finally, do you consider the educational background of Xiaofeng Peng as potentially creating a language barrier (right to left), where otherwise things could be explained (left to right).

Reference:
Mr. Peng graduated from Jiangxi Foreign Trade School in 1993 with a diploma in international business and from Beijing University Guanghua School of Management with an executive MBA degree in 2002. Possibly non-English speaking schools. Thus raising geniune consideration of Pichel's manner during a conference call (theater of so called professionalism if you will)

Interested in any follow-up in this subject, you know like "Pichel Three Months later," or "Celebrity Analysts: Where are They Now."

Seriously, thanks for your careful articulation in the subject.

2008 Apr 11 08:08 AM