Amid the blind rush to combat global warming, solar energy was seen as a slam dunk growth industry. Investors rushed to risk speculative capital. Governments rushed to spunk taxpayers' cash up against the wall. And now it is all ending in tears. The only way to make money from solar now is to look for stocks to short before the situation becomes near terminal. In that vein, I offer up LDK Solar (LDK) at $1.38 and JA Solar (JASO) at $0.96. In both cases, my target price is more or less nothing. I am sure that there are other shorts out there in this sector, and I will move on to others at a later point.
I start with these two as they are essentially Chinese companies, and given my views on the way Chinese companies behave and any statistics produced in that country (which you can read more about here and here), I simply do not believe that any U.S. or U.K. listed Chinese companies qualify as investment grade material. I outlined the case for shorting another U.S. listed Chinese stock here on Seeking Alpha yesterday. This area offers rich pickings for us bears.
But LDK and JA offer two other attractions for the shorter. Firstly, their financial statements show they are in a dreadful mess. And secondly, the industry in which they operate is collapsing. I'll start with the macro picture.
I personally do not believe that there is a shred of evidence for man-made climate change. But the political elites embraced the idea with an almost religious fervor. That is to say they could not accept that there was any doubt about the idea, even though there is actually no evidence for it at all. Consequently, whatever the cost implications, policy agendas across the west were set accordingly. The countries of the European Union were at the forefront of this process, offering vast subsidies to folks to purchase or invest in solar energy production (to offset the fact that underlying non-subsidized payback on such projects takes an incredibly long time). But even in Greece, those leaders are now waking up to the fact that bankrupt or near bankrupt countries cannot afford to subsidize schemes, especially ones that create very few local jobs. And so, that bandwagon has stopped dead in its tracks. Demand for panels is not growing anywhere as quickly as had been anticipated.
But in anticipation of exponential growth, numerous companies were established to produce such panels. The implicit assumption was that this was a "new growth industry" not, as it in fact is, a dull manufacturing commodity business. Some of these companies obtained funding from private investors and the equity markets. Others received state backing, most notably from the Government of the People's Republic of China (although your own President Obama was keen to demonstrate that, like all politicians, he too cannot pick winners with other folks' cash). The Chinese identified this as a key growth industry to back and invested heavily. The result is that the industry now suffers from chronic overcapacity, with more or less every single company of size now operating at a loss, burning cash, or both. If, charitably, we assume that demand stabilizes, the only way that this situation can be resolved is by a large number of firms going to the wall.
As this report from today's Daily Telegraph makes clear, firms like LDK and JA Solar will get a helping hand from the Government pro tem, but for how long? The allegations made in the piece are specifically about the two firms I am covering here and should cause real alarm for investors.
LDK is capitalized at $185 million. On June 26, 2012, it reported its results for the quarter ended March 31, and they were dire. I reproduce them below:
- Net sales for the first quarter of fiscal 2012 were $200.1 million, compared to $420.2 million for the fourth quarter of fiscal 2011, and $766.3 million for the first quarter of fiscal 2011.
- Gross loss for the first quarter of fiscal 2012 was $131.0 million, compared to gross loss of $275.2 million in the fourth quarter of fiscal 2011, and gross profit of $241.6 million for the first quarter of fiscal 2011.
- Gross margin for the first quarter of fiscal 2012 was negative 65.5%, compared to negative 65.5% in the fourth quarter of fiscal 2011, and positive 31.5% in the first quarter of fiscal 2011.
During the preparation of its first quarter 2012 financial results, LDK Solar's management determined that an inventory write-down and a provision for firm purchase commitment totaling $91.1 million was required as a result of the relatively high production cost of polysilicon in the first quarter and continuous drop in market price for polysilicon, wafers, and modules. An additional provision was required for potential countervailing and anti-dumping duties, totaling $5.7 million. As a result, gross margin and results from operations were negatively impacted in the first quarter of fiscal 2012.
- Loss from operations for the first quarter of fiscal 2012 was $135.8 million, compared to loss from operations of $531.4 million for the fourth quarter of fiscal 2011.
- Income from operations of $196.1 million for the first quarter of fiscal 2011.
- Operating margin for the first quarter of fiscal 2012 was negative 67.9% compared to negative 126.5% in the fourth quarter of fiscal 2011, and positive 25.6% in the first quarter of fiscal 2011.
But if the P&L is a train wreck (and would have looked even worse, had $43 million of provisions for doubtful receivables been reversed), the balance sheet is worse. The company stated that: "LDK Solar ended the first quarter of fiscal 2012 with $135.7 million in cash and cash equivalents and $603.3 million in short-term pledged bank deposits."
I am sure that it did. I will not argue that the book balance of inventories is fair, and I will accept that all outstanding invoices will be paid. That gives net current assets of $2.13 billion. But on the other side of the coin, current liabilities at the quarter end were $4.49 billion, of which debt was $2.25 billion and advance payments from customers accounted for was another $218 million. Total liabilities were $5.96 billion, of which $890 million was debt due in more than a year.
The fact that this company is valued at less than three months' sales tells you that the market has made up its mind already. Even was the balance sheet not so unbelievably weak, the ongoing losses would be a critical issue. This looks like a slam dunk sell.
And so, on to JA Solar, where the market capitalization is $187 million.
Its results for the quarter ended June 30 came out on August 29, and its statement reads:
- Net revenue was RMB 1.8 billion ($284.4 million), an increase of 12.8% from RMB 1.6 billion ($252.2 million) in the first quarter of 2012.
- Gross margin was 4.8%, compared with 2.1% in the first quarter of 2012.
- Operating loss was RMB 155.9 million ($24.5 million), compared with an operating loss of RMB 159.1 million ($25.0 million) in the first quarter of 2012
- Net loss, including a foreign exchange loss of RMB 69.8 million ($11.0 million) and tax expenses of RMB 120.0 million ($18.9 million), was RMB 457.8 million ($72.1 million), compared with net loss of RMB 250.9 million ($39.5 million) in the first quarter of 2012.
JA Solar CEO Dr. Peng Fang commented:
"Although not as severe as in previous quarters, the downward pressure on pricing continued. In light of this, we focused on sustaining a healthy balance sheet and building our footprint in key growth markets."
Well, up to a point, Dr. Fang. Your company is consistently running with a negative operating margin on a quarter on quarter basis. Any fool can deliver sales growth, the issue is can you do so profitably? And as to that healthy balance sheet, I would refer the good doctor to his own statement:
The Company maintained a strong balance sheet with cash and cash equivalents of RMB 3.7 billion ($589.1 million) and total working capital of RMB 2.0 billion ($316.6 million) at June 30, 2012. Total short-term bank borrowings and convertible notes due 2013 were RMB 2.4 billion ($374.1 million). Total long-term bank borrowings were RMB 4.3 billion ($682.3 million), among which RMB 1.6 billion ($247.3 million) were due in one year. The total face value of outstanding convertible notes due 2013 was RMB 1.4 billion ($219.7 million) at June 30, 2012.
So in fact, this company has net debt. For a loss making company, that is not a balance sheet situation that I would describe as "healthy," as we can assume with some certainty that the convertible loan notes will have to be repaid next May. And just to add to the picture, the company has pretty onerous long-term take or pay contracts entered into with suppliers when competition for raw materials was intense. The company claimed in its 2011 20-F that its existing bank facilities will be enough to support its operations for the next 12 months, but that it may need to refinance some of its longer term debts. Indeed it will. Even if it manages that, it will still have a weak balance sheet and is dependent on there being a) no further decline in general trading, b) no further reduction in the willingness of customers to provide working capital by paying in advance, and c) no problem with bad debts.
As an added negative point, this company has, by its own admission, an unusual corporate governance issue. I quote from the 2011 20-F filing:
Jinglong BVI, which is controlled by the shareholders of Hebei Jinglong, is our largest shareholder. In addition, Mr. Baofang Jin, the executive chairman of our Board of Directors, is a shareholder of Jinglong BVI and is also the chairman of Hebei Jinglong. Jinglong Group (including Hebei Jinglong) currently provides a number of products and services to us, including silicon wafer supply (on prepayment terms) and real property leases. Our transactions with Jinglong Group are governed by a number of contracts, the terms of which were negotiated at what we believe are on an arm's length basis.
In November 2011, we also completed the acquisition of Silver Age, a British Virgin Islands company controlled by Jinglong BVI. See "Item 7. Major Shareholders and Related Party Transactions - B. Related Party Transactions." However, the interest of Jinglong BVI may conflict with our own interest with respect to our transactions with Jinglong Group. As a result, we may have limited ability to negotiate with Jinglong Group over the terms of the agreements because Jinglong BVI may exert significant influence on our affairs through our Board of Directors.
In addition, Jinglong BVI may be able to prevent us from taking actions to enforce or exercise our rights under the agreements we entered into with Jinglong Group. Furthermore, we cannot assure you that our transactions with Jinglong Group will always be concluded on terms favorable to us or maintained at the current level or at all in the future. As a result, when these situations arise, our financial condition, results of operations and implementation of strategy may be materially and adversely affected."
Do you understand all of that and take any comfort from it? I do not. JA Solar is also a slam dunk sell.