A Cloudy View on LDK Solar

Shares tumbled Thurdsay amid expectations higher polysilicon costs will squeeze the company's margins

LDK Solar (LDK), which makes the key component for solar panels, is taking a beating from investors who think it's being overly sunny in its price estimates for raw materials and in the projected rampup of its own production plant.

After the market close on Dec. 19, the Chinese manufacturer of multicrystalline solar wafers reported a third-quarter profit of $41.6 million, or 37 cents per American Depositary Share (ADS), compared with $5.0 million, or four cents per ADS, a year ago. Net sales surged more than five times higher from a year ago to $158.7 million in the latest period.

Multicrystalline solar wafers are the primary raw material used to produce solar cells.

The latest results were in line with Wall Street analysts' average estimate.

LDK, based in Xinyu City, China, and Sunnyvale, Cal., said that its gross margin for the third quarter dropped to 30.8% from 35.2% in the second quarter and was down from 39.4% in the year-ago period. It said it expects to earn between 40 and 43 cents per ADS in the fourth quarter on estimated revenue of $180 million to $185 million for wafer shipments. That's in line with analysts' average forecast of 41 cents per ADS.

Equity analyst Jesse Pichel at Piper Jaffray & Co. downgraded the shares to a sell from a hold rating, citing a high valuation and questions concerning the company's exposure to spot polysilicon prices and its overly aggressive outlook for bringing its own polysilicon production online. (Piper Jaffray has provided investment banking services for LDK within the past 12 months and makes a market in its securities.)

LDK shares were trading 26.7% lower at $48.45 on Dec. 20.

Analysts believe LDK will face further margin compression due to the rising price of silicon scrap, which has virtually eliminated any discount it had to the price of virgin polysilicon.

"Any benefit they could have had from using scrap has disappeared because they're exposed to the same spot polysilicon market as anybody else," said Sanjay Shrestha, an equity analyst at Lazard Capital Markets in New York, who said he's had a negative bias on the stock for quite some time.

Shrestha said he expects LDK's margin to fall below 30% in the fourth quarter and to hover around 27% next year. In 2009, the margin will drop further if the company isn't able to produce its own polysilicon by then. But he estimates a 3% gain in the margin in 2009 if the polysilicon plant it's building in China is up and running by then.

In a Dec. 20 research note, Needham & Co. analyst Pierre Maccagno reaffirmed his strong buy rating on the stock, however, viewing it as undervalued at 19 times estimated earnings for 2009. He expects revenue to grow at a compounded annual rate of over 80% between 2007 and 2010, and said LDK is well-positioned in the photovoltaic value chain with high-end margins and potential to expand them by 2009 once it starts producing its own raw polysilicon. Maccagno's note also cited "an impressive customer base" that's growing and becoming more diverse geographically and whose output for this 2007 and 2008 is completely sold out on robust demand. (Needham expects to receive compensation for investment banking services from LDK within the next three months.)

By securing 75% of its 2008 polysilicon supply needs – roughly 4,400 metric tons – at a fixed price of $130 to $150 per kilogram through contracts with its top suppliers, the company has addressed investors' worries about ongoing hikes in polysilicon prices, which will help stabilize costs and margins next year, the Needham note said.

But other analysts say they've yet to see proof that LDK has secured contracts for three-quarters of its polysilicon needs. In his note, Pichel at Piper Jaffray questioned the comparatively low cost LDK says it's paying for polysilicon – around $155 per kilogram vs. $200 to $250 for competitors.

"[We] suspect it may include very low-quality scrap in its inventory, resulting in off-spec wafers sold at premium prices," Pichel said, adding that it's unlikely that LDK is getting preferential treatment from polysilicon suppliers.

LDK currently produces no polysilicon. To think it can go from zero to producing a projected 7,000 metric tons by the end of 2008 is a stretch, Shrestha said. Once the plant is operating, LDK's raw material costs would probably be around the $80 per kilogram that other producers have, he said.

Besides his doubts about the timing of the production rampup, he said there are questions about the company's ability to produce trichlorosilane gas, or TCS, in-house, a critical component in making polysilicon.

If LDK isn't able to recycle TCS through a closed-loop system, it would have to source it from outside the company, which would raise production costs and safety hazards, Shrestha said.

LDK's Audit Committee recently completed its independent investigation into allegations by a former employee that the company incorrectly reported its inventories of silicon feedstock. The investigation found no material errors in the stated silicon inventory numbers and concluded that the employee's claims of an inventory discrepancy were incorrect because he hadn't taken into account all locations in which LDK's silicon feedstock is stored.

In a statement, chairman and chief executive Xiaofeng Peng said the resolution of the investigation has enabled management to turn its focus back to expanding the business. He said the company signed four long-term wafer supply contracts during the third quarter and has signed five additional ones since the quarter closed.

Despite his sell rating, Lazard's Shrestha boosted his price target to $35 from $25 per ADS to reflect "reconciliation of the independent inventory investigation and the removal of that negative overhang." The new price target also reflects a mid-teens multiple on Lazard's upwardly adjusted profit forecast of $2.35 for 2009, which is in line with the recently increased multiples on Chinese solar ADRs, he said in a Dec. 20 research note.

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