The J Capital’s Dispatch Report on Daqo “See No Evil, Hear No Evil”

HFA Padded
HFA Staff
Published on
Updated on

Editor’s Note: The following report, which sheds light on issues at DQ, was originally published on J Capital’s Substack in September 2023. Subscribe to J Capital Research’s “Equity Dispatch”. It is reprinted here with permission for the readers of Hedge Fund Alpha.

J Capital, led by famed China analyst Anne Stevenson-Yang, has an impressive track record. Despite the 2024 market euphoria, their short selections have largely remained stable. Following the publication of this report, DQ’s stock has fallen by 28%. An impressive performance indeed!

As of 3/20/24 – “Equity Dispatch” reports since inception

Company Name Ticker Date of Publication Stock Price Performance To Date
Daqo New Energy DQ 9/6/2023 -27.62%
Vericell VCEL 9/20/2023 35.52%
Schlumberger SLB 10/4/2023 -7.05%
MakeMyTrip MMYT 10/18/2023 54.29%
Polestar Automotive PSNY 11/1/2023 -24.38%
Harrow Health HROW 11/15/2023 29.72%
Rekor Systems REKR 11/29/2023 -29.90%
FingerMotion, Inc. FNGR 12/13/2023 -52.44%
Opera Limited OPRA 1/11/2024 26.74%
WiseTech Global Limited WTC 1/24/2024 23.91%
Western Digital Corporation WDC 2/7/2024 2.33%
ASP Isotopes Inc. ASPI 2/21/2024 52.22%
Arm Holdings plc ARM 3/6/2024 -7.07%
Return of Covered stocks as of: 2.88%
NASDAQ Index Since 09/06/2023 16.54%

Full report below.

What is the Dispatch?

J Capital Research’s “Equity Dispatch” at this link.

This is the first of J Capital’s new, biweekly newsletter. Every other week, we will provide deep-dive research into and analysis of listed companies. Subscribe for free, because we will also send our short activist research to Substack readers. Note that we’re not suggesting how you should invest; we’re just giving you our opinion. No position in any stock we talk about in the J Capital Dispatch publication!

DQ and Chinese solar

This week, we examine a Chinese polysilicon company called something unpronounceable in Chinese, Daqo (NYSE:DQ). There is a lot wrong with DQ.

  • The U.S. government states that DQ uses forced labor to produce its polysilicon.
  • Its manufacturing process is almost certainly not “green.”
  • The company has been accused of lying about its accounts.
  • DQ’s Chairman Xu Xiang served time in China for market manipulation.[1]
  • China is in the middle of creating the mother of all solar capacity gluts, which has already crushed the price of polysilicon and has no end in sight. DQ is suffering price compression now, with no end in sight.
  • DQ insiders have sold a boatload of shares.

In January 2022, Bleecker Street Research published a devastating note on DQ. You can read it here. The market brushed it off.

DQ is on the U.S. Entities List, which means its products are restricted for import into the U.S. DQ is geographically and bureaucratically close to the Xinjiang Production and Construction Corp. (XPCC), which has been sanctioned by the Treasury for human rights abuses.

DQ also has poor environmental values. For example, on July 2, 2020, DQ had a major accident involving a leak of silicon tetrachloride and a fire.

But international investors see nothing. Why? Because polysilicon is a commodity needed for the manufacture of solar panels. If the trade-off is that members of a Muslim minority group are pressed into labor in “re-education camps,” investors (and the U.S. government) would rather not know.

Ultimately, polysilicon is a commodity and trades like coal, iron ore, copper, or any other commodity: the nature of the company that produces it is secondary. That, however, is not good news for DQ. We think the price of polysilicon will continue to trend down, despite its current low price. Polysilicon companies are under pressure not only because of a massive amount of new supply but due to a number of factors, including consistent reduction in the number of grams of polysilicon used per watt of solar energy, higher interest rates, which constrain solar installations, and overstocking in the channel, which will push down prices in the near term. A continued reduction in the price of production for some companies may lower prices but will also drive more expensive producers out of the market.

Whatever near-term wrinkles, prices are trending down, and that spells lower earnings for DQ

See no evil, hear no evil

The reality of DQ’s operations presents a great illustration of how meaningless ESG is as an investment concept. Some of the shareholders of DQ:

  • The Democracy International Fund ETF (after all, DQ has been credibly accused of effectively enslaving Muslims in the Xinjiang region of China)
  • Global X CleanTech ET (in spite of DQ’s reliance on low-cost coal mined in China)
  • ProShares S&P Kensho Cleantech ETF (fund’s remit is to invest in clean energy. See above.)
  • The Invesco Solar ETF (the fund claims that it targets investors who want companies that “align with their own values.”)

But there are few manufacturers of polysilicon worldwide and even fewer that manufacture at scale. China produces more than 80% of global solar-grade polysilicon. Most of the world’s large plants are in China, and most of those are exposed to labor abuses in Xinjiang. The solar material has to come from somewhere.

The polysilicon glut

China has created a massive glut in polysilicon manufacturing capacity. The price per kilo started surging in the second half of 2020 and rose through 2021, and everyone wanted to get onto the gravy train. Chinese polysilicon capacity is roughly tripling this year and will be about double global demand. Prices can only drop.

DQ is in on the capacity game. The company is spending $1.2 billion to add 100,000 tons/year of new polysilicon capacity, raising its total by 50%, to 305,000 tons per year, by the end of the 2023. As of August 2023, DQ polysilicon manufacturing capacity was 205,000 MT/year.

DQ’s share price is down by nearly 50% in the last year, as the selling price of its polysilicon dropped by nearly two-thirds. Cost reductions are nowhere close to matching falls in revenue. That’s not as bad as the 74% decline in polysilicon spot prices. The spot price fell from about $39 per kilo in August.

2022 to less than $10 now. As a result, the company’s Q2 2023 revenue fell nearly 50% compared to Q2 2022, while net income attributable to shareholders fell a catastrophic 83% over the same comparable periods.

Polysilicon Price

The Inner Mongolia project

DQ’s partner in building its new capacity (recently dropped from press releases) is an opportunistic Chinese player. Shuangliang (SHA: 600481) is an electronics company that makes cooling systems. Shuangliang, with no experience in solar, decided to get in on the bonanza by building a monosilicon plant (for which the feedstock is polysilicon). DQ signed a fiveyear supply agreement with Shuangliang. Here’s a video from TikTok (Douyin in China) showing the new Shuangliang facility in Baotou, Inner Mongolia.

Part of the logic for building a polysilicon plant in Inner Mongolia is to get away from Xinjiang, with the unpleasant U.S. sanctions that apply to products made there with forced labor. Because of U.S. legislation passed in 2021 (“the Uyghur Forced Labor Prevention Act”), solar manufacturers based in China now need to obtain certification documents showing that they do not make their products in Xinjiang. U.S. Customs has impounded a lot of solar panels out of China. So whether or not the Inner Mongolia plant manufactures polysilicon, it will be able to issue clean invoices showing that production is not in Xinjiang.

Historical sins

Investors are willing to forgive much, but DQ has an inordinate amount to sweep under the table.

DQ’s chairman, Xu Xiang, was arrested in 2016 and served more than five years in prison for market manipulation. Xu was released in July 2021. He had been convicted of conspiring with executives of 13 listed companies to trade on inside information. Why wouldn’t he do the same with DQ? Trading records show purchases and sales by Xu while he was in prison. Xu has recently been selling DQ shares.

Back in 2017, DQ was listed on China’s Third Board, a junior tech exchange, and the company also submitted a prospectus to regulators on the Shanghai Stock Exchange for an up-listing. The reports to these two stock exchanges had all sorts of discrepancies – over $100 million in unexplained gaps. For instance, the annual report published to the Third Board reported free cash flow of ¥1 billion for 2017, but the Shanghai prospectus reported ¥403 million over the same period. Amounts reported as invested in R&D differed radically. Both statements were audited by Deloitte.

Apart from the financial reporting discrepancies, the company has been implicated in all sorts of wrongdoing: insider trading, over-reporting the cost of goods and services, rigging a bid, and overstating staff costs just for starters. DQ supposedly stole another company’s IP. A company called Jiangsu Qinxi, which developed a process for recycling silicon slag, sued DQ, alleging theft of the technology, and in the lawsuit revealed a variety of other flags.

Share sales

DQ insiders have seen the direction of this company’s share price for some time now. Since Q1 2022, based on Form 144s listed on S&P Global, insiders have sold over 4 million shares, valued at $264 million.

DQ Share Sales

Source: S&P Global/CapitalIQ

With all the growth in solar demand, why haven’t Chinese companies made money?

Solar demand has grown amazingly fast, compounding above 25% every single year for the last decade. China is by far the biggest supplier, with more than 80% of world capacity. You’d think Chinese solar suppliers would be intensely profitable.

In fact, most of the solar lions of years past have gone bust: LDK Solar, Suntech, Yingli. Internationally, it is a highly volatile business with ruthless price cannibalization during extended downturn periods—which is what we expect due to continued industry over-capacity. This can be credited to the Chinese, who have over-invested based on heavy subsidies at home.

Why are all the big solar companies in China? Cheap capital and, ironically, lax environmental standards. To make polysilicon, Chinese companies generally use the Siemens Method, a chemical process that was developed in the 1950s and now can be fully replicated in China. Siemens reactors create a lot of trichlorosilane (TCS), which is highly toxic. In the early days of local manufacturing, several companies claimed to be TCS recyclers but actually dumped the chemicals in fields, poisoning the local crops. “Closed-loop recycling” became the gold standard for Chinese poly plants, but some (see LDK Solar) actually made the poly in small, dirty plants while claiming the big, clean plants were operating.

Here’s the thing about China: local governments (before a consolidation that nationalized the bigger mines, but that’s another story) owned most of the coal mines. They couldn’t make money from mining coal, especially if they bothered to buy safety equipment, but they could make a bundle by taking equity in a polysilicon project and feeding it with coal priced under the market. When polysilicon spot prices were $450 a kilo, in 2008, every local government in China tried to give away its coal to someone who would open a polysilicon manufacturing plant. Since then, no doubt, the smog from all that coal has migrated across the Pacific, but the coal dust probably still covers crops in Jiangxi Province.

The poly drive jived with ostensible national industrial goals. Back when China was at work capturing world demand in solar, it was not enough to manufacture the lower-tech final-stage assembly portions of the solar value chain: the goal was to go vertical and build world-class polysilicon plants. This was consistent with China’s long-term strategy of going upstream to bring more value onshore for anything that was ultimately exported.

Each level of government supported the construction of such plants with gifted land, cheap loans, subsidized coal, and preferential infrastructure. Foreign investors responded by buying the companies’ equity and debt. DQ emerges from that era, benefiting from those policies. It is likely that DQ receives subsidies for the coal it burns to make polysilicon, not to mention low-cost labor. We believe coal subsidies are likely to be withdrawn as part of China’s ongoing local-debt challenge.

The “green” myth

China has long engaged in practices that indicate a lack of regard for the natural environment. Although DQ has nothing to do with this general disregard, it is relevant to the way in which the solar industry has focused on revenue growth over environmental values.

For three decades now, China has been exporting its natural environment to the West.

  • The West formerly sent its electronic waste to China for “recycling.” Until China grew embarrassed by its reputation as the world’s sewer, around 2018, villages on the coast presented a picture of children and poor families scrambling over heaps of ripped-up electronics to rescue bits to sell, often filling their systems with lead, cadmium, mercury, and other toxic materials.
  • China also imported discarded plastic from the rest of the world, with Germany exporting the most. Often, the “recyclers” in China would burn the plastic, creating toxic fumes. Recyclers, in a rush for profit, tend to rely on highly manual processes that are dangerous to workers.

China’s manufacture of solar panels has been highly inefficient and coalintensive. See, for example, the Institute for Energy Research’s paper, Misleading Carbon Data Benefits China’s Solar Industry.

DQ is no exception to this pattern.

[1]https://baike.baidu.com/item/%E5%BE%90%E7%BF%94%E8%A2%AB%E6%8D%95%E4%BA%8B%E4%BB%B6/18771639

Thanks for reading J Cap’s Substack! Subscribe for free to receive basic posts and pay a small annual subscription fee for detail.

See more short ideas here.

HFA Padded

The post above is drafted by the collaboration of the Hedge Fund Alpha Team.