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The fourth quarter was an extremely volatile period for LDK Solar (LDK). In October, the company was hit with accusations that its polysilicon inventories were grossly overstated both in reference to the quantity of material as well as the grade or quality of the stated inventory levels. There were rumors that employees from the company had leaked the information to the press and that management was intentionally inflating statements in order to appear that they had more of their material costs under control than was actually the case.

The accusations had a devastating effect on the stock with an initial hit of 45% in the first six trading days of October and an eventual 66% drop from its peak to the lowest point in November. Management initiated a third party review of their polysilicon inventory levels but kept very quiet about the issue apart from releasing an initial statement which claimed that the accusations had no merit. Many shareholders were outraged that management did not do more to dispel the rumors and instead chose to wait relatively silently for the audit team to finish its review. Uncertainty makes for a very tumultuous investing experience and far fewer buyers surfaced when key information was lacking.

December brought relief for the stock with two key data points. First, the company landed a huge contract with Q-Cells AG - a large German client. The contract was to supply 6 gigawats of solar wafers over the 2009-2018 period. Since LDK would need to significantly increase production capacity in order to meet this order, Q-Cells agreed to pay 10% of the expected contract revenue up front to help with the capital expenditures necessary to build out the productions facilities. The second data point was the release of the independent audit committee’s report which showed no material errors in the company’s accounting for polysilicon inventory levels.

The two press releases appeared to reassure investors and on December 17th, the stock nearly eclipsed its previous high as buyers quickly bid for stock. But victory was still elusive as three days later the company released its report on third quarter earnings. Investors were dismayed to find that margins were becoming significantly compressed. Gross Margins dropped from 35.2% to 30.8% due to higher polysilicon costs which were supposed to have been relatively well hedged. Management further stated that they expect margins to settle somewhere in the 25-30% level as sales prices decline, polysilicon prices continue to rise, and these factors are only partially offset by the companies ability to make more efficient use of poly than their competitors.

While CIBC maintains expectations in the low end of the gross margin guidance, the $18 drop in the stock following the Q3 report appears to be pricing in very poor expectations. While difficulty in pricing power and higher resource costs are definitely a concern, they are forces that effect all competitors in the field so LDK will simply be facing the same challenges as their competitors. LDK has somewhat of an advantage with their ability to use recycled polysilicon in the wafer production process which should give the company a bit higher margins. Furthermore, the company will be bringing its own polysilicon production facilities online in the future which will go far towards easing constraints. Finally, many of the long-term contracts the company has entered have variable prices in the later years that fluctuate with the price of poly.

While challenges continue to evolve in the solar energy sector, I believe that technology is rising to meet those constraints and LDK is on the cutting edge of that technology. With a management team committed to growth, a sales force that is winning new business, and an operating strategy that is producing efficiencies and increasing production levels, LDK appears to be well situated to take advantage of this growing economic area. The stock, while reasonably priced, is extremely volatile and so I would suggest using an option strategy that limits exposure and capitalizes on the volatility inherent in this ever expanding industry.

LDK Notes

FD: Author does not have a position in LDK

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