Citron Warns on Hoku Scientific

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Chasing the hot story of the day seems to be popular for Hoku Scientific (NASDAQ:HOKU). This Hawaiian based firm has done at great job over the past few years in putting together partnerships and press releases, yet they have been notably short on results. In the next few days, we will see the company’s 10-K, which will document a second year of broken promises and failed business models.

Background

Hoku’s entire corporate history has been marked with enticing claims that fall short on execution. Its IPO was predicated upon an exciting sounding cutting edge fuel cell membrane deal with Sanyo – at a time when the fuel cell story was all the rage — that has never resulted in significant business. The prospects don’t seem promising either, in light of Hoku’s recent announcement that it is abandoning the business.
Next business model, please.

Not content to be a public company without a business model, Hoku attempted to enter solar panel fabrication – and also failed and abandoned it. Now the new holy grail has been found in polysilicon manufacturing.

It has announced 3 polysilicon manufacturing contracts so far, each of which is comprised of a small initial deposit, progress payments contingent upon unspecified future milestones, which we are led to believe sufficient to fund a percentage of the manufacturing facility, and a long term supply contract upon completion and production in 2009. Its stated strategy is to structure these contracts to pay for as much of the fabrication plant capital requirement as possible. Put another way, either you believe these deals are “free money”, or it doesn’t have the capital to build this plant. By the way, these contracts are “non-binding”.

On their most recent call, they stated have no track record in industrial manufacturing, although they “know a lot about chemistry”.
They also state that they are not intending to bring any proprietary technology to the manufacturing process.
Not surprising for a science company that spent just a hair north of $1 million on Research & Development the past year..

Serious competition

The key element to this story is that Hoku proposes to manufacture and sell a commodity — and making money in commodity-based businesses is notoriously difficult – especially for the small players.

They also have some very serious competition in this business . from the likes of Hemlock Semiconductor (a joint venture of Dow Corning, Mitsubishi, and others), Wacker Chemie (Germany), REC (Norway), Tokuyama (Japan), MEMC, Mitsubishi, and Sumitomo-Titanium (Japan). Hemlock alone is gearing up for production greater than 6 times the maximum stretched size of Hoku’s plant, and it looks to be onstream earier than Hoku’s as well. Oh, and they have the capital in hand.

The problem with commodity manufacturing is simple. What is now a high margin business will soon turn into a low margin one as undercapacity givew way to overcapacity. The company is not producing natural resources, rather they are turning raw materials into a manufacturing component. Hoku doesn’t seem to have acknowledged that access to capital and lowest-cost of production rules this game. Flying in the face of these basic business dynamics doesn’t bode well for their chances.

Pricing is also a major concern. Are we to believe that Hoku’s contract partners are locking in bubble-high current prices for 2009 production? These non-binding supply contracts secured by tiny deposits will never result in windfall profits once major manufacturing comes online.
Incorrect reporting

While the most recent contract announcement sent the stock sharply higher, the press seems to have a little trouble getting its facts straight.

Just today, Forbes parroted HOKU’s “analyst” from Cowen & Co. (IPO underwriter) who opined: “HOKU stands apart from most of its competitors because it does not use fluorinated membranes, which, according to Stone, should result in lower cost, improved durability and performance, and fewer environmental issues.

Oops, wrong business! Hoku made the fluorinated membrane claim in conjunction with its fuel-cell membrane business, which they are now planning to sell off at a loss. The company made no statement that fluorinated membranes give them any advantage in the polysilicon business. In fact, they directly contradicted this when they stated their plan to use only “open technology” in manufacturing polysilicon.

He also stated,”Since Hoku’s share price is in the double digits and is worth more than $100 million, it has become possible for additional institutional ownership”.

Funny math. HOKU’s market cap was over $100 million when the stock was $6 – half today’s price.

Conclusion

You have to ask yourself what the realistic prospects are for this tiny company to succeed in mass manufacturing against this stable of world-class size competitors? As the supply / demand ratio comes back into balance from all the new production, the earnings of a small fabrication plant in Idaho just don’t project out to more than a $5 or $6 dollar stock. The excitement of day-trader volume is likely to wash out long before any of these plans come to fruition.

Judging from the capital requirements of polysilicon manufacture, and HOKU’s relatively scant balance sheet, it is Citron’s opinion that any institutions who seriously intended to take a position in HOKU would likely find receptive ears at the company’s headquarters. Instead, this runup is fueled by daytraders, who will likely exit this issue soon as violently as they have entered it. The likelihood of HOKU being able to sustain anything higher than a single-digit valuation are ..hmmmmm..cloudy.