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LDK, and several other Chinese PV manufacturers, will likely have an equity value of zero. Solar stocks currently represent one of the most speculative areas in the market, with the stocks rallying of late.

I apologize that this idea is probably not very actionable for most people, but maybe a small position in a couple of the stocks might make a combined position worth the time and effort.  Most of the stocks mentioned have options, and you may even be able to find some debt or convertibles to short.

These stocks used to be high flyers and have already seen massive price declines over the last couple of years. So it could be said that why bother with these companies now as the shorts have already made the big gains? To repurpose a quote by David Einhorn:

Q: What do you call a stock that’s down 99%?

A: A stock that was down 96% and got reduced by ¾.

The premise of shorting these stocks is not based on in-depth research on the nature of the solar industry or its near-term prospects but based on the fact that these stocks are either currently bankrupt or will be shortly. While the market caps of these stocks are small, the enterprise values are still fairly sizable based on the massive debt loads of these companies.

With minimal cash on hand and looming large maturities of debt coming due, the equity value of most of these stocks looks like it will end up being zero.  Organic deleveraging will not be able to help as these companies have negative EBITDA (and some even have negative gross margins).  With the current maturities of debt looming over the companies’ heads, most of the companies’ current equity won’t be around to benefit from any potential future improvement in the solar industry that the market is pricing in.

While the stocks of most of the going concern players in the solar space are also probably good shorts based on valuation (SPWR, FSLR, WFR, SCTY, etc), this write-up will focus on the basket of near bankrupt Chinese PV manufacturers:

Even if this industry was magically able to get back up to say a 15% EBITDA margin, and the market awarded these stocks with a 8x EBITDA multiple, any stock with an EV/Sales over 1.2x would still have no equity value. This of course ignores the fact that the equity would have to survive long enough to enjoy the fruits of any potential industry improvement.

LDK and STP are already in default and are for sure bankrupt. As you move down the list some of the companies may be able to avoid bankruptcy for a year or two or escape it all together. I expect the majority of the companies will need to file within the next 1-3 years.

So these stocks will need external funding to survive another year. Equity funding is not likely an option, but even if these companies are able to raise cash this way, the massive dilution should help drive the share price down.  What these companies really need is either extensions of loan maturities, or debt/equity swaps/loan forgiveness. 

The solar industry suffers from poor economics. Like airlines or copper smelters, solar manufacturers have high fixed costs and sell a commodity product. With companies desperate to utilize their capacity to help cover their high fixed costs, companies will gladly sell the next marginal unit at a price not much more than their variable cost. This often brings the price for all units down, making it hard for the industry to cover its total costs, let alone earn an acceptable return on capital. 

The solar industry also has a problem of dealing with declining unit prices due to technological advancement. This makes it hard for a company to keep pace by lowering its unit costs without increasing its output. This unit cost arms race has inspired these companies to massively expand their capacity by a factor of 10x over the last 5 years, as prices have declined by 75%. The capacity expansion was funded by cheap short-term loans from Chinese government controlled lenders, such as the China Development Bank. For any China bears, the solar industry gives strong support to the thesis that by large extent, Chinese GDP growth has been a function of massive infrastructure investments that don’t make economic sense, fueled by cheap credit.  

The worldwide PV market was about 29GW in 2012, expected to grow to 35GW in 2013. Crystalline-silicon capacity (what these companies produce) is estimated to be about 58.8GW, while thin film PV capacity (what FSLR produces) is estimated to be about 6.6GW. While Chinese PV demand is rapidly growing, ~3.8GW in 2012 to ~9GW in 2013, it is still a minority of worldwide demand, so these companies are reliant on exports for sales. One of the largest export markets, the EU (about a 1/3 of global demand and LDK’s 2012 revenue), is considering imposing up to 67% tariffs on Chinese PV cells to combat “dumping” practices. I don’t know if this measure will pass, but if it does, it certainly won’t help these companies. Demand growth is still heavily reliant on government subsidies at this point, which may be fickle if governments look to reign in budget deficits.  

So the industry is currently massively oversupplied, but things have started getting slighlty better, causing the shares to rally on news items like forecasted gross margins that are not negative. Optimistically, none of these companies will probably be able to report an operating profit until 2015 or 2016. That is a long time for these massively indebted companies who will have to borrow more to fund operating losses in the meantime.

For fun, let’s suppose we live in a magical world where LDK could raise unlimited equity and the industry turned around overnight. In this world, the stock would still be worth much less. Let’s say LDK raises $2.9B, basically putting the company with zero net debt. If it raised this equity at $1.75/share it would then have 1.83B shares. If sales increased by 50% (ignoring the increased working capital and the funding need that would entail) and EBITDA margins increased to 15%, at an 8x EBITDA multiple the shares would be worth $.85, down 58%. If the company could sustainably support net debt/EBITDA of 5x (which it can’t), LDK would have to raise $2B even with its improved fantasy revenue and margins in order to not be distressed. Earlier in 2013, LDK was only able to raise $50M at a $1.20/share valuation.

The big hope on these stocks is that somehow the Chinese government will bail them out. Even if that happens, I doubt that the equity of these stocks will be saved. This would require the banks/government to take on billions of losses so that western investors can survive with their equity stakes intact. These companies first started getting loans to fund capacity expansion. Then funding was used to cover operating losses. Now any new loans will be used to pay off existing debt. While there is always a temptation for financial institutions to refinance to avoid recognizing bad debts (especially in China), it has gotten to the point where lending additional money to these companies will clearly increase the amount of total loss the banks will take.

So the real question is whether the Chinese banks will make the rational response off shutting off additional lending in order to maximize recovery, or the extend and pretend response of lending to avoid taking losses now.  The later method also has the added bonus of the appearance of protecting jobs and the reputation of Chinese businesses, as well as preserving Chinese competiveness in a “strategic” industry. In reality, more jobs would be saved in the long run if the needed step of restructuring and capacity closures were taken in the short run. My guess is that the Chinese banks will soon start to make the rational response. To be fair, a lot of investors have lost a lot of money so far based on that premise (like CDB funding the Harbin Electric buyout), but there are a couple of clues out there to suggest that maybe this time is different:

http://www.bloomberg.com/news/2013-03-13/suntech-seen-not-getting-bailout-from-chinese-government.html

http://www.bloomberg.com/news/2013-03-18/china-may-cancel-some-solar-subsidies-industry-official-says.html

http://www.photon.info/photon_news_detail_en.photon?id=72847

• The government won’t intervene and shouldn’t,” - Li Junfeng, director of the climate-change strategic research division at the government’s National Development and Reform Commission. Meng Xiangan, vice chairman of the China Renewable Energy Society, a liaison between the industry and the state says, “If companies can’t survive, even if they are saved, it’s useless,” Meng said. “Our policy is very clear to encourage mergers and acquisitions. Both state- and privately-owned entities can restructure or acquire each other. Restructuring or mergers and acquisitions are in line with what the central government requires.”
• In December 2012 the State Council met and declared that “The State Council…recommends that measures be taken to expand the market for distributed PV, and it determined that widespread restructuring and mergers and acquisitions throughout the industry are needed to stabilize the industry. To that effect, the State Council revealed that the central government will ban local governments from providing financial support to failing solar manufacturers. Instead, the government will actively encourage mergers and acquisitions to ensure a stronger, consolidated Chinese PV industry."

This new non-support strategy was put to the test when Suntech Power defaulted in mid March:

• On March 18th, three days after Suntech defaulted on its $541M of dollar denominated convertible debt, eight Chinese banks filed for Suntech’s main operating  subsidiary to be declared insolvent and proceed to restructuring.

So the while PV market is currently oversupplied, if global demand will continues to grow rapidly, and the industry is going to be rationalized, does it make sense to be short all of the stocks? Won’t one or two come out as a big winner in a couple of years? Yes, this is possible, and if you are worried about this, you should probably avoid shorting anything past midway on that list. My thoughts are that these companies are either too late to save, or not worth much more than the current price even after an industry turnaround.

Suppose the Chinese government gets actively involved by nationalizing the companies as they default and operates them under private ownership to keep the industry alive and to avoid large debt write-downs. In this case, the equity of the defaulting companies will still go to zero, and the government will have incentives to acquire/merge the existing survivors at the cheapest price possible, most likely by not giving any value to the Western equity holders.

LDK:

At 12/31/2013: Total Cash $265M. Unrestricted Cash: $98M. Equity -$503M EBT loss per quarter ~$100M

• Paid $16.5M to convertible notes on April 15, 2013, defaulting on remaining $7.24M. Holders later settled for $3.7M
• $363M $ LDK Silicon preferred share redemption due  June 3, 2013
• $275M RMB senior notes due on February 28, 2014
• $1,113M of short term borrowings were renewed from January 1 to March 31, 2013. Not sure of maturity date (February and April 2014 I think). Some of the renewals could be the banks waiving the covenants which LDK is in violation of, which would just trigger the accounting reclassification from ST back to LT.
• CDB approved $71M Rmb loan for upgrade of Mahong plant. Loan is currently undrawn
• Wafer supply agreement signed to supply 500MW from May 2013-December 2014 to Realforce Power, who is developing a solar project in China. This would represent sales of $140M at 2012 price levels. At a ~0% gross margin, this contract will not be saving the company

STP:

At 3/31/2012: Total Cash $474M. EBT loss per quarter ~$150M.

• Suntech  guaranteed a E554M loan to GSF Capital, a European solar plant partnership which it owned 80% of. This guarantee was supposed to be secured by German government bonds. It was later found out that there was massive fraud at GSF and the German bonds never existed. In April 2013, Suntech settled its fraud dispute with GSF by increasing its ownership to 88%. Suntech’s founder and former CEO owns the remaining 12%. Miser861 correctly surmised in 2009 that something was fraudulent at GSF. GSF was inflating Suntech’s 2010-2012 income, so STP needs to restate its past financials and has yet to file its 2012 20-F
• On March 11, 2013 Suntech signed a forbearance agreement with 60% of convertible holders to not exercise their rights until May 15, 2013 for $541M of convertible debt due March 15, 2013
• On March 15, 2013, Suntech defaulted on $541M of US convertible notes. This default triggered cross-defaults on IFC and other Chinese debt. Suntech’s main Wuxi Suntech subsidiary was later pushed into bankruptcy by Chinese banks.
• Wuxi creditors from bankruptcy are meeting on May 22, 2013, to present and discuss potential solutions.
• On April 9, 2103 Suntech, European subsidiary, SPI, was granted a provisional moratorium for up to two months on creditor claims, and is working closely with the court-appointed administrator  to enter a definitive moratorium that would provide a platform to enter discussions with SPI’s creditors.
• On May 15,2013 Suntech signed new forbearance agreement with majority of holders of convertible notes agreeing not to exercise their rights until June 28, 2013

So while LDK and STP move wildly up and down each day on vaguely related news, they are ultimately likely to be worth zero. Unlike momentum or hype shorts, these companies have built in catalysts of future missed payments, bankruptcy proceedings, and delistings to help bring down the share prices to reality.

Catalyst