Solar is a sector that is in the process of bottoming, as of this writing, and which holds great promise for investors. It is obvious that how the eurozone crisis develops will have a great effect on the prospects of the sector. However, one of the other themes to consider in trying to mark the bottom in solar is a capitulation formation.
In this article I would like to apply that analysis to another stock that is in the same process of bottoming with a capitulation formation. That stock is the Chinese solar panel maker LDK Solar (NYSE:LDK). This company arguably has a very bad balance sheet as the company is way too leveraged and it would have long gone bankrupt if it weren't the leading company by revenues in its sector. However, the market cap of LDK Solar is extremely low compared to its revenues and its earning potential. My main argument is that the speculators are pushing for the bankruptcy of this stock. However, if it gets backstopped it might capitulate and further mark the bottom in the solar sector overall.
I have introduced this backstop argument as a side note in one of my previous articles about solar. I have also explored a similar situation for A123 Systems (AONE) stock in detail in another article (AONE: Shorting It Is Not A Sure Trade). A123's case is most similar to LDK Solar. My predictions about the dangers of shorting AONE based purely on the fact that company should go bankrupt have mostly come true. Investors who have shorted the stock in its latest decline in late March 2012, have failed to make any money given the amount of risk they have assumed.
Basically the reason these green energy companies don't easily cede to their fundamentals is that they are in a specialty sector. As long as there isn't fraud involved, these companies do come up with the financing to grow their businesses. Investors should note that these green companies are responsible for laying the groundwork for a wider use of green energy. Because of this special task they are doing, there is an inherent backstop in the stocks of these companies against short term difficulties. In this article, I will try to develop this argument in more detail for the LDK stock and the solar sector. I would also like to argue how this inherent backstop can be a part of a capitulation formation in the solar sector.
First Solar is the leading American company in the sector. Most of the companies carry the same characteristics. They have all declined by in excess of 75% in the last two years. They are all making losses because of price declines in solar panel prices, due to oversupply. However, compared to their operating earnings in 2010, in which solar panel pricing were more normal, these companies are all trading at 3X their operating earnings. Many of these companies also trade at about 0,2X their revenues. For a more detailed analysis of the fundamental aspects of the solar sector please check this article.
So in a sector where most of the fundamentals are in such a strong decline why would I suggest that LDK, possibly the worst company in the sector, will capitulate? Here are the reasons:
- LDK is not the worst company in the sector. It is simply the most leveraged. Leveraged investments lose value by more in a down environment. However when market sentiment improves, they are also the ones that increase the most compared to other companies in the sector.
- LDK is a Chinese company and it has a very large operation with revenues in excess of $2 Billion USD. The chances that the Chinese would let such a huge company go bankrupt are essentially zero, in my opinion. And if it doesn't go bankrupt the short speculators would lose their main culprit and the stock would at least triple in a short squeeze.
- The solar sector is mistaken for a small sector by many investors. That is absolutely not the case anymore. Solar is utilized in many large scale projects and combined revenues of solar companies are well in excess of $15 billion annually. However, the combined market cap of the 6 companies mentioned above is roughly $2 billion. There is also the fact that these companies are providing the infrastructure for a green energy mission so they should have an embedded goodwill in their balance sheets. As the failure of any of the large companies in the sector would put the others in a rough spot, many of these companies would probably be backstopped to avoid putting the green energy argument in doubt.
- The price action in the solar stocks, but especially in LDK, is indicative of the formation of a capitulation bottom. It is important to note that, as of this writing, LDK has not completed that bottom formation yet. LDK has experienced a 20% decline in a single day on May 29th' 2012. However, because it has not followed up that large decline with an even larger one (maybe 35% down in a single day) that attempt at capitulation formation has failed. Given the high-beta nature of solar stocks a capitulation formation in LDK would be established if the stock loses close to half its value in two days. That would have to be followed up by a huge increase to the upside in excess of 30% to complete the capitulation formation. My predictions about at what levels this might occur for LDK are listed at the end of this article.
- There is already evidence from China that indicates the backstop argument is already in movement. Consider this SA market news excerpt
July 3 2012 10:22 AM Some solar names are rallying after the Chinese government quadruples its 2015 domestic solar installation target to 21GW - its latest effort (previous) to prop up local vendors contending with oversupply, negative gross margins, weak Euro demand, and now anti-dumping tariffs. Remaining to be seen is how much the government will encourage local firms to consolidate.
Since LDK Solar is the leading Chinese solar panel maker, this move by China should grow the company and ease its balance sheet concerns.
In my opinion it is still early to accumulate LDK shares because the capitulation formation that I expect hasn't formed yet. I would argue a good level to start accumulating LDK shares is around $1,20 if the stock reaches that level as a result of a sudden drop rather than a gradual decline. Then investors can cost average down if the stock goes lower than that level. Such a capitulation in LDK would also mark the bottom for the solar sector as LDK is the leading company by revenues.
The fact that the my entry target for LDK is almost 30% lower than the levels LDK is trading as of this writing is not an argument to short the stock, however. As the solar stocks are very vulnerable to external developments, any good news that would benefit the solar stocks would cause a short squeeze and make the short positions lose considerably. In my opinion, that short squeeze risk is not worth taking.
In my opinion, the rewards of being able to catch the falling knife that is solar, would be in the range of 300% for lower risk stocks like First Solar and 500% for higher risk stocks like LDK.
I will try to post a follow-up article to this capitulation analysis for LDK to fine tune this trade. Investors who find my trading suggestions and analysis of good quality can use the “Follow” feature on SA to see when the article has been posted.
Disclosure: I am long AONE.