The photovoltaic("PV") solar industry has gone through a wide range of highs and lows in the past 10 years. Solar industry investors have also similarly gone through a roller coaster where companies experienced spectacular business conditions one year to literally bust conditions the next year. LDK Solar (LDK) in its past two fiscal years is a perfect example as it experienced its most profitable year in 2010 only to follow up with a disastrous 2011. Although LDK's horrific 2011 losses were in part unavoidable consequences of an industry wide downturn, a large portion of the company's $655.5m annual loss was painfully self inflicted.
To be fair, most of LDK Solar's direct peers in one form or another also misjudged the industry's dramatic downturn last year. Trina Solar (TSL) entered 2011 as the most profitable U.S.-listed Chinese solar company through superb execution in both previous industry up and down cycles. Yet despite a strong history of under promising and over delivering, Trina Solar warned for each of its four quarters last year. The chain reaction resulting from continued average selling price ("ASP") declines across all crystalline verticals caught just about everyone within the industry off guard.
Similar to most industry peers, LDK Solar took a number of charges in 2011 which comprised the bulk of its fiscal losses. Main charges included inventory write-downs as well as provisions on accounts receivables, firm purchase commitments, and prepayments to suppliers, which totaled $557.1m on the year. Of this amount, almost $412m was taken in the fourth quarter of 2011. Direct China based rivals Yingli Green Energy (YGE) and Suntech Power (STP) also announced large charges in the fourth quarter totaling $573.8m and $571m respectively.
However unlike YGE and STP's large 2011 charges, which were mostly legacy in nature, the bulk of LDK's charges last year reflected recent business decisions. The majority of LDK's 2011 charges came from inventory write-downs totaling $305.2m of which most were recorded in the fourth quarter. While LDK was not alone in misjudging demand, the company continued to operate at high utilization despite indications of a severe supply imbalance. Second-half guidance projected in the first half assumed a large seasonal uptick in shipments but after a flood of liquidated inventory from defunct high cost structured companies hit the market, most component suppliers such as LDK missed shipment targets badly.
Essentially LDK ran full speed into the storm when it should have taken a more conservative strategy by battening down the hatches. By the end of the third quarter 2011, the company had built up a high level of inventory, which could not be moved in a market experiencing rapid pricing degradation. LDK's total 2011 inventory write-downs were 4x larger than Yingli's (YGE) $74.7m and 8x more than Suntech's (STP) $37m in comparison.
Secondly, LDK Solar took $117.3m in accounts receivable provisions in 2011. While LDK was not alone in large provisions on doubtful accounts last year, its total was the highest among similar scale U.S.-listed Chinese solar producers. Suntech Power and Trina Solar posted accounts receivable provisions of $55.3m and $45.4m in 2011 respectively. In essence, LDK compounded its mistake of operating at high utilization during an industry down cycle by doing business with higher risk customers to a higher degree than direct peers. Although not an excuse, part of an explanation for LDK's higher doubtful accounts provisions may be linked to the company's higher exposure to less integrated customers as much of the industry's recent destructive consolidation occurred among higher cost, lesser integrated companies.
These two charges accounted for more than $300m of LDK's 2011 annual losses and generally reflect business decisions made last year. While not entirely unavoidable, LDK could have limited the damage in these two areas by half or greater through more conservative management. Unlike legacy non-cash charges reflecting strategic decisions made several years ago under dramatically different industry conditions, inventory and accounts receivable provisions affect LDK where it hurts the most - cash flow. With many on Wall Street already eying LDK's stretched balance sheet, any loss of cash flow becomes magnified.
In terms of LDK Solar's operational performance in Q4 2011, results were not much better compared with the large charges taken in the quarter. Even after excluding charges that increased cost of goods sold, LDK still posted a gross loss of $42.7m. Despite surpassing my revenue expectations of $405m with $420.2m in fourth-quarter revenue, the incremental revenue upside came at negative gross margin as the company sold almost 40MW of solar cells at far below cost and spot market pricing. Most likely as witnessed by other direct peers, LDK sold off-spec products as part of an end-of-year inventory liquidation.
Non-core inventory disposal at negative margins only accounts for part of LDK's Q4 gross loss. As the company finally lowered utilization to correct its inventory build, LDK experienced rather high underutilization penalties due to its extremely large scale. Non-silicon processing costs for its once core silicon wafer business rose by almost 25% from $0.21/watt to $0.26/watt in the quarter. Solar cell processing costs also rose from $0.17/watt to $0.19/watt. As a result, revenue from silicon wafer and solar cell sales generated negative gross margin of approximately -20% and -50% respectively. Excluding the inventory provision, LDK's solar module sales once again was most likely its only profitable business segment.
Looking forward into Q1 2012, which LDK expects to report on June 26, operating conditions are expected to get sequentially worse. Despite the first quarter already completely over by the time of LDK's Q1 guidance, the company still gave a rather wide estimate range. Revenue is expected to range between $190-230m, or potentially less than half Q4 2011's figures. Both wafer and module shipments are also expected to drop sequentially in the industry's typically weakest quarter to 140-150MW and 170-180MW respectively. LDK explained part of the shipment weakness was due to downtime during both Chinese Lunar New Year as well as for equipment upgrades. Regardless of the excuse, extremely low utilization will continue to negatively impact LDK's U.S. GAAP manufacturing costs as underutilization penalties may continue to increase sequentially.
Based on this guidance as well as comments made by LDK's management in its Q4 2011 earnings conference call, a first-quarter earnings estimate for LDK Solar has been compiled below. As usual, this estimate mainly reflects the company's operating earnings and excludes any undisclosed gains or charges with the exception of a net foreign exchange gain assuming a constant hedging strategy and the known net change of key currencies in the first quarter.
LDK Q1 2012 Earnings Estimate:
Core Wafer: 145MW @ $0.32/watt = $46m
Module: 150MW @ $0.90/watt = $135m
Polysilicon: 800mt @ $26/kg = $21m
Total Revenue: $222m
Cost of Goods:
Core Wafer: 145MW @ 0.42/watt = $61m
Module: 150MW @ 0.90/watt = $135m
Polysilicon: 800mt @ 30/kg = $24m
Total COGS: $242m
Gross Loss: -$20m
Gross Margin: -9%
Operating Expenses: $60m
Operating Loss: -$80m
Net Interest Expenses: $68m
Government Subsidies/Other: $2m
Foreign Exchange Gain: $5m
Tax Benefit: $10m
Net Loss: $131m
Diluted Share Count: 127m
As seen in recent earnings reports by direct U.S.-listed Chinese solar module manufacturers such as STP, YGE and TSL, LDK Solar may be exposed to recent U.S. Department of Commence anti-subsidy and anti-dumping rulings against solar cells made in China. Q1 2012 tariff provisions by direct peers ranged from $13.7m to $26.2m for YGE and TSL respectively. LDK's U.S.-based Solar Power Inc. subsidiary will likely cause shipments to the U.S. in one fashion or another to have one of LDK's business units as the importer on record and thus vulnerable to retroactive tariffs.
In addition and despite already large inventory provisions, additional write-downs may be required due to the continued ASP (average selling price) erosion across all crystalline verticals seen in the first quarter. Low inventory turnover as the result of low shipment volume in the first quarter will also slow LDK's blending of higher carry cost inventory lower. Any additional inventory provisions will likely be much smaller but nevertheless the potential still exists.
Looking past whatever near-term weakness LDK Solar may post due to the continued destructive industry consolidation augmented by seasonal first-half weakness, the company is still structurally positioned to be a major player within the industry. As noted in past LDK articles, large scale as well as true full vertical integration especially in the polysilicon segment allows for lower cash production cost relative to closely related competition. Thus even if LDK continues to post U.S. GAAP losses, low cash cost of production at high utilization could still generate significant cash flow for the company.
When LDK Solar can regain high levels of shipments and thus higher utilization levels is the bigger question given the company's extremely poor guidance and execution throughout 2011. At face value, the company's 2012 guidance roughly translates to 75% annualized utilization levels. Given extremely low levels of shipments in the first half, its annual guidance implies near full utilization levels in the second half of 2012. If this guidance can be met, LDK could be halfway toward breaking even sometime in either the third or fourth quarter.
The other important part of LDK's profitability is its systems division, which is expected to ramp up considerably this year. For 2012, LDK expects to recognize 270-360MW of system sales, which according to the pricing indicated in its Q4 2011 earnings call could generate $2-3/watt in revenue. If system margins are similar to what other large Chinese solar manufacturers have suggested, the company's systems division could make up half of the gross profits generated in the second half when the majority of projects are expected to be completed and sold. The revenue recognition of these sales will likely determine which quarter LDK could potentially turn a profit in the second half of 2012.
Of course given LDK Solar's checkered history and what has become an extremely stretched balance sheet even for investors who did not view the company's ability to revolve its debt as an issue, LDK is on thin ice. Structurally LDK has the tools required to survive and thrive once the industry cycle reverts positively, but continued faulty execution as witnessed in 2011 could crack the ice beneath it. Given how other leading peers have also been discounted by investors, LDK Solar at this stage is a relatively much higher risk play on the solar industry where investors may want to take a wait and see stance before over weighting the company as an investment.