LDK's Signs of Decay

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When LDK Solar (NYSE: LDK) burst onto the solar-wafer scene, the company possessed one discernable advantage.

No, it wasn't an integrated business model -- LDK's plan to move into polysilicon production only came to light this summer. Nor was it a matter of intellectual property. Whereas wafer maven REC Group reports having roughly 50 patents granted or pending, and MEMC Electronic Materials (NYSE: WFR) has hundreds, LDK claims certain "know-how and technologies," but has zero patents filed.

As I read it, LDK's sole leg up stems from cheap Chinese labor. This enables LDK to utilize a people-intensive process of sorting through silicon scraps that it fashions into wafers for solar-cell makers like Suntech Power (NYSE: STP) and Canadian Solar (Nasdaq: CSIQ).

Now that the industry is experiencing a full-court polysilicon press, LDK's edge looks less than full-fledged. Even the scrappiest of silicon is running very steep. Gross margins have skidded significantly, as this chart makes plain:

Fiscal Period	Gross Margin
Q3 2006	39.4%
Q4 2006	42.9%
Q1 2007	38.7%
Q2 2007	35.2%
Q3 2007	30.8%

All data from SEC filings.

Margins are set to march into the upper-20% range next year. Even though LDK projects capacity of 7,000 tons by the end of 2008, virgin polysilicon production won't be coming to the rescue, because "actual output will be very, very minimal."

This trend definitely isn't sitting well with those on the Wall Street beat. An analyst from Piper Jaffray cut the stock to 'sell," and his bank was one of LDK's underwriters just months ago. It's nice to see those Chinese walls holding up, even when it comes to hot Chinese stocks.

While LDK can point to a possible future wherein it's pumping out plentiful polysilicon, getting there will be no picnic. Management characterizes trichlorosilane (TCS) gas plants as "notorious" for contamination issues and other outages. A significant amount of waste and byproduct material result from TCS-derived polysilicon production, and a large volume of gas feedstock is generally required. Left unaddressed yesterday was whether LDK will be employing a closed-loop system to avoid these costly complications.

The details today are hazy enough that it's not clear to this Fool how the company aims to become "the world leader in low cost solar wafer manufacturing." Big dog REC Group has put more than a decade into its fluid-bed reactor technology, which should help to nearly halve REC Silicon's production costs per kilo. Its highly automated processes also make LDK's low labor costs look even less compelling.

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