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A controversial company in a controversial sector

|Includes: LDK Solar Co., Ltd. (LDK), TSL

     Although I have written extensively on the solar sector in the past, this will be my first article on this medium. As such, I thought I should write about a company I have often criticized in the past, instead of the company I've almost exclusively argued as one of the best investments, for those who believe in the longer term merits of the solar industry. After all the trials of the credit crisis, tsl(Trina Solar) has already proven itself and emerged as a premier name in the solar sector. It's gone from misunderstood and black sheep of the sector, to one of the more recognized names, converting many skeptics along the way. Thus, it's just too easy to write about tsl now, and perhaps even boring as they continually execute far beyond what most expected. While I still believe tsl is the single best name to invest in for those who want solar exposure, I thought a more interesting debate would be about a name often mired in controversy in the past - ldk (LDK Solar).

     Ldk started out as a single vertical solar company - a wafer producer.  Essentially they purchase polysilicon, cast ingots, and saw thin wafers from it. These wafers are then turned into cells which are consequently assembled into modules by downstream verticals.  What made ldk a more interesting name was in late 2007, they engaged in a large polysilicon project - a very expensive and long lead time project with high risks for those new and inexperienced in producing polysilicon.  It seemed a good idea at the time as prices for polysilicon were on the rise from about $200/kg to ultimately cross above $400/kg before the credit crisis sent shockwaves across the industry and sent prices across all verticals crashing down.  Current polysilicon prices are around $50-60/kg today.

     Because this project drained over 1.5 billion in very important cash flow for over two years, ldk slowly accumulated a very high level of debt. Their balance sheet became further stressed by continued and aggressive expansion in their wafer business.  The situation became more serious after the credit crisis hit in late 2008, causing prices across all verticals to drop dramatically, with the prices for polysilicon taking the highest percentage hit - from over $400/kg to below $100/kg within weeks.  The pricing correction hit ldk harder than many peers within the industry because they had a high level of inventory prior to the credit crisis.  Besides large inventory charges that followed, ldk would then need several more quarters to slowly blend their remaining inventory to reflect market prices.  The result wasn't pretty.  After several quarters of large losses, it reached a point where ldk had less than 100m of cash left, while their debt climbed to nearly 2 billion.  Many including myself, wondered if they would make it.

     As it turned out, ldk's ceo Mr. Peng, had the connections to pull off a debt restructuring which involved in part selling a stake in their polysilicon plant.  This didn't solve their debt situation, but it bought enough time for ldk as their core business started to turn around.  As a result of the falling end pricing for solar modules, demand soared in markets with high levels of subsidies such as in Europe, namely Germany, due to the high level of returns solar generated.  Solar demand worldwide continue to surge this year, with many predicting over a 50% annual growth rate.  I apologize for the long boring history, but I thought it was important to describe the situation for those new to the solar sector.  It leads to where ldk is today. 

     The basic argument that most bulls might make is that ldk's core business, the wafer vertical, has finally reached a normalized level of profitability. Input costs have been blended down closer to current market prices, while end demand continued to remain incredibly strong, resulting in gross margin expansion.  Ldk's gross margins went from negative, to low under .10/watt levels in recent quarters, to what appears to be over .15/watt levels looking forward.  Combined with higher shipment levels, ldk starting in Q2 will be extremely profitable on a corporate level.  I don't want to make an argument based on earnings here, because that's not my bull thesis on ldk.  Needless to say, ldk is most likely trading at or under 10x 2010 earnings with its stock price around 6 dollars.  I may describe in more detail all the math involved later, but since this isn't my argument today, I won't do it here.  In general, most of ldk's peers aka other Chinese solar companies, are cheap, so being cheap relative to earnings isn't a special bull case as things stand today.

     What has changed in ldk's case, which is very different from other names, is the news we heard from the company about two months ago.  Instead of promises polysilicon production that were continually pushed back, ldk finally reported a meaningful level of polysilicon for the fourth quarter of last year.  This was encouraging, but nothing that screamed out attention because output was still low, resulting in fairly high fully loaded production costs.  About six weeks later, ldk reported first quarter earnings, which had even more encouraging metrics.  Not only had ldk successfully ramped their smaller polysilicon plant to high levels, but in just the first quarter of commercialization, the first stage of their larger plant ramped quite well.  Further news suggest that they reached near full utilization less than two quarters of operation, with accretive production costs.

     In other words, that 1.8 billion high risk project that yielded no returns while draining much needed liquidity for over two years, is finally paying off.  This isn't important to ldk on an earnings level, because fully loaded costs which includes a high level of depreciation, will not be low enough to make significant contributions to ldk's bottom line.  Why this is more significant is because their polysilicon plant will add to more improtant cash flows.  Ldk already spent the money for this project.  Ldk was already paying high levels of interest for the plant.  Now, whatever level of polysilicon ldk can produce from this plant, will be positive to cash flow equal to the difference between current market prices and the cash costs for their polysilicon production.  Based on my derived numbers from their reported metrics, I estimate ldk will generate 15-20 million in cash flow per metric ton of polysilicon produced.  This will result in up to 100m in additional cash flow for 2010, and potentially 200-300m in annual cash flow once the plant is fully ramped, assuming the same spread between cash costs of production and polysilicon market pricing.

     In my opinion, because of all the controversy regarding ldk's polysilicon plant in the past, from costs to delays, the market had all but written it off.  However, despite the initial delays which were not totally unexpected for any new entrant, ldk has successfully produced polysilicon, and ramped their production rather quickly.  This suggest the final ramping of their plant should go just as efficiently, given now that they have more experience.  Because ldk will essentially consume all the polysilicon they produce, they will generate additional cash flow equal to the different in their cash cost of production, and the market prices which they would otherwise have to pay for polysilicon.  Since about 90% of the polysilicon plant has already been paid for, the cash flow generated will be free cash flow after they put in the final capex to finish the entire project.  Ldk also already has a high wafer capacity, and their wafer business should generate enough operating cash flow, based on current metrics, to cover further expansion on an annual basis.

     Thus while ldk and peers may be trading at low earnings valuations if the business environment doesn't materially change from the guidance they have given, what sets ldk apart is their high installed fixed assets, namely their polysilicon plant. This will put ldk in a positive free cash flow position that alone may justify higher valuations.  In contrast, some other peers have expansion plans that cause them to be generally cash flow neutral or negative.  It is this cash flow situation, along with what should be a good earnings year, that the markets may not have properly reflected for ldk currently.

Disclosure: Long tsl, solf, ldk, sol, and jaso