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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on our management’s beliefs and assumptions and on information currently available to our management. Forward-looking statements include all statements other than statements of historical fact contained in this Quarterly Report on Form 10-Q.
In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Quarterly Report on Form 10-Q in greater detail in Part II, Item IA. “Risk Factors.” Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date hereof. We hereby qualify all of our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.
The following discussion should be read in conjunction with our financial statements and the related notes contained elsewhere in this Quarterly Report on Form 10-Q and with our financial statements and notes thereto for the fiscal year ended March 31, 2011, contained in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 15, 2011.
Overview
Hoku Corporation is a solar energy products and services company. We were incorporated in Hawaii in March 2001, as Pacific Energy Group, Inc. and changed our name to Hoku Scientific, Inc. in July 2001. In December 2004, we were reincorporated in Delaware. In March 2010, we changed our name from Hoku Scientific, Inc. to Hoku Corporation.
We originally focused our efforts on the design and development of fuel cell technologies, including our Hoku membrane electrode assemblies, or MEA’s, and Hoku Membranes. In May 2006, we announced our plans to form an integrated photovoltaic, or PV, module business, and our plans to manufacture polysilicon, a primary material used in the manufacture of PV modules, at our polysilicon manufacturing plant in Pocatello, Idaho, or the Polysilicon Plant. In fiscal 2007, we reorganized our business into three business units: Hoku Materials, Hoku Solar and Hoku Fuel Cells. In February and March 2007, we incorporated Hoku Materials, Inc. and Hoku Solar, Inc., respectively, as wholly owned subsidiaries to operate our polysilicon and solar businesses, respectively.
In September 2010, we elected to discontinue the operations of Hoku Fuel Cells. However, we will maintain ownership of its intellectual property including patents. Accordingly, the results of operations of Hoku Fuel Cells for the three months ended June 30, 2010 have been reported as discontinued operations in the consolidated statements of operations.
Hoku Materials
Construction Update
Hoku Materials was incorporated to manufacture polysilicon, a key material used in PV modules. In May 2007, we commenced construction of our planned Polysilicon Plant which would be capable of producing up to 4,000 metric tons of polysilicon per year. We previously estimated the total cost for construction of approximately $410 million; however, we have determined that the total costs will be greater than our previous estimates. Based on recent construction progress and discussions with our vendors, we now expect to incur approximately $600 million of costs before we can commence operation of the first 2,500 metric tons of production capacity. We also expect to invest up to an additional $100 million to complete the second phase of construction, which will add an additional 1,500 metric tons of manufacturing capacity, and allow us to complete our planned on-site trichlorosilane, or TCS, plant. Thus, our revised estimate for the full, planned 4,000 metric ton plant is now approximately $700 million.
The primary driver of the increase in costs is related to our engineering contract with Stone & Webster, Inc., and our construction contract with JH Kelly LLC as they are cost-plus contracts, rather than lump sum, or fixed cost contracts. As such, there is no guaranteed maximum cost. In addition, the estimated total cost increased in part by the fact that the construction schedule was expected to be approximately two years, but has instead been spread over four years with numerous starts and stops as a result of earlier challenges obtaining adequate financing in a timely manner. Furthermore, construction of the Polysilicon Plant commenced prior to the completion of the detailed engineering work, which caused numerous changes in the design of the facility, further contributing to the increase in delays and construction costs.
In an effort to control costs, we have strengthened our internal management team to enable more detailed reviews and audits of all project expenses. Any significant increase in the cost to complete the Polysilicon Plant could have a material adverse effect on our business, financial condition and results of operations.
We received 16 Siemens-process reactors at the Polysilicon Plant and in April 2010 successfully produced polysilicon using two of the reactors. We produced the material after completing a comprehensive system commissioning protocol, which culminated in deposition runs in a select number of our installed polysilicon reactors. The primary purpose of the testing was to confirm system integrity and validate operating procedures.
Contingent on securing additional financing, we expect to commission our reactors capable of producing 2,500 metric tons of polysilicon per annum and begin our first commercial shipment in the second half of calendar year 2011. We intend to ramp-up production throughout calendar year 2012, during which we expect to reach full production capability.
In order to avoid price adjustments and/or breaching our supply contracts, we may purchase polysilicon from third parties if we do not produce sufficient amounts to meet our customer obligations. We estimate that we will need to purchase between 1,000 to 1,500 metric tons of polysilicon during fiscal 2012 to avoid any breaches of our contracts. As of June 30, 2011, we have not entered into any agreements to purchase polysilicon and the current spot market prices are significantly greater than the prices at which our customers will be obligated to pay us.
During the three months ended June 30, 2011 Hoku Materials incurred an operating loss of $10.0 million, which mainly consisted of payroll, including stock compensation, professional fees and payments made to Idaho Power pursuant to the Electric Service Agreement. In addition, as of June 30, 2011, Hoku Materials has capitalized $512.1 million related to construction costs for the Polysilicon Plant and had received $140.2 million in customer deposits as prepayments under long-term polysilicon supply agreements.
Financing Update
During the three months ended June 30, 2011, we obtained an aggregate of $39.7 million of debt financing through two credit agreements with the New York Branch of Industrial and Commercial Bank of China, Ltd., New York Branch to support our operations. Both of these credit agreements are secured by letters of credit provided by our majority stockholder, Tianwei New Energy Holding Co. Ltd., or Tianwei. In addition, as of June 30, 2011, we are also expecting an additional $8.2 million in customer prepayments from our existing customers, which are payable on polysilicon delivery milestones. As of June 30, 2011, we have funded approximately $495.7 million of our Polysilicon Plant. The following describes in more detail the terms of our outstanding credit agreements as of June 30, 2011:
China Merchants Bank – New York Branch
In May 2010, we entered into a $20.0 million credit agreement with the New York branch of China Merchants Bank. We borrowed the entire $20.0 million in May 2010 and this principal amount of the loan and any unpaid interest must be paid in full two years after the effective date of the credit agreement. We may prepay the loan at any time without penalty. Funds provided pursuant to the credit agreement are for general corporate purposes, including capital expenditures related to the Polysilicon Plant. The loan under the credit agreement is secured by a standby letter of credit drawn by Tianwei in Chengdu, China and issued to China Merchants Bank, as collateral. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2% or, if we elect, any portion of the loan that is not less than $1.0 million may bear interest at an annual rate equal to the rate of interest announced by the lender as its “prime rate.” The principal amount and any unpaid interest thereon must be paid in full by May 2012. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $20.0 million was outstanding.
In August 2010, we entered into two credit agreements with the New York branch of China Merchants Bank Co., Ltd. to borrow $10 million and $5 million. The loans under these credit agreements are secured by standby letters of credit drawn by Tianwei in Chengdu, China and issued to China Merchants Bank, as collateral. The loans bear interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2% or, if we elect, any portion of the loans that is not less than $1.0 million may bear interest at an annual rate equal to the rate of interest announced by the lender as its “prime rate.” The principal amount and any unpaid interest thereon must be paid in full by August 2012. We entered into reimbursement agreements with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letters of credit. As of June 30, 2011 the entire $15.0 million was outstanding.
In September 2010, we entered into a $10.0 million credit agreement with the New York branch of China Merchants Bank Co., Ltd. The loan under this credit agreement is secured by a standby letter of credit drawn by Tianwei in Chengdu, China and issued to China Merchants Bank, as collateral. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2% or, if we elect, any portion of the loan that is not less than $1.0 million may bear interest at an annual rate equal to the rate of interest announced by the lender as its “prime rate.” The principal amount and any unpaid interest thereon must be paid in full by September 2013. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $10.0 million was outstanding.
In October 2010, we entered into a $13.0 million credit agreement with the New York branch of China Merchants Bank Co., Ltd. We received $13.0 million under this credit agreement, which is secured by a standby letter of credit drawn by Tianwei in Chengdu, China and issued to China Merchants Bank, as collateral. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2% or, if we elect, any portion of the loan that is not less than $1.0 million may bear interest at an annual rate equal to the rate of interest announced by the lender as its “prime rate.” The principal amount and any unpaid interest thereon must be paid in full by October 2013. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011 the entire $13.0 million was outstanding.
In December 2010, we entered into a $10.0 million credit agreement with the New York branch of China Merchants Bank Co., Ltd. We received the entire $10.0 million under this credit agreement, which is secured by cash collateral of 110% of the principal amount of the credit agreement in Renminbi provided by Tianwei. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2% or, if the Company elects, any portion of the loan that is not less than $1.0 million may bear interest at an annual rate equal to the rate of interest announced by the lender as its “prime rate.” The principal amount and any unpaid interest thereon must be paid in full by December 2013. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with providing the cash collateral. As of June 30, 2011 the entire $10.0 million was outstanding.
China Construction Bank – New York Branch
In June 2010, we entered into a $28.3 million credit agreement with the New York branch of China Construction Bank. The loan under this credit agreement is secured by a standby letter of credit drawn by Tianwei and issued by the Sichuan branch of China Construction Bank in favor of the New York branch. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 1.875% or, if the Company elects, and if the bank agrees, any portion of the loan that is not less than $1.0 million may bear interest at an annual rate equal to the highest “Prime Rate” as published in the “Money Rates” column of the Eastern Edition of the Wall Street Journal from time to time. The principal amount and any unpaid interest thereon must be paid in full by June 2012. We also entered into a reimbursement agreement with Tianwei pursuant to which the Company agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011 the entire $28.3 million was outstanding.
China Construction Bank – Singapore Branch
In October 2010, we entered into a $29.0 million credit agreement with the Singapore branch of China Construction Bank. The Company received the entire $29.0 million under this credit agreement which is secured by standby letters of credit drawn by Tianwei in Chengdu, China and issued to China Construction Bank Corporation, Sichuan Branch in favor of China Construction Bank – Singapore Branch. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2%. The principal amount and any unpaid interest thereon must be paid in full by October 2013. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $29.0 million was outstanding.
Industrial and Commercial Bank of China – New York Branch
In December 2010, we entered into a $15.5 million credit agreement with the New York Branch of Industrial and Commercial Bank of China, Ltd. The loans are secured by a standby letter of credit issued by the Sichuan Branch of Industrial and Commercial Bank of China and procured by Tianwei in favor of the lender and which has an aggregate availability of $17.0 million. The loans bear interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2.6%. The principal amount and any unpaid interest thereon must be paid in full by December 2013. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $15.5 million was outstanding.
In January 2011, we entered into a $19.5 million credit agreement with the New York Branch of Industrial and Commercial Bank of China, Ltd. The loans are secured by a standby letter of credit issued by the Sichuan Branch of Industrial and Commercial Bank of China and procured by Tianwei in favor of the lender and which has an aggregate drawable amount of $22.0 million. The loans bear interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2.6%. The principal amount and any unpaid interest of the loans must be paid in full by January 2014. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $19.5 million was outstanding.
In April 2011, we entered into a $15.0 million credit agreement with the New York Branch of Industrial and Commercial Bank of China, Ltd., New York Branch (the “Lender”). The loans are secured by a standby letter of credit issued by the Sichuan Branch of Industrial and Commercial Bank of China and procured by Tianwei in favor of the lender and which has an aggregate drawable amount of $16.5 million. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2.7%. The principal amount of and any unpaid interest of the loan must be paid in full by April 6, 2014 or the tenth business day prior to the date on which the letter of credit expires or otherwise terminates, whichever is earlier. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $15.0 million was outstanding.
In June 2011, we entered into a $24.7 million credit agreement with the New York Branch of Industrial and Commercial Bank of China, Ltd., New York Branch (the “Lender”). The loan is secured by a standby letter of credit issued by the Sichuan Branch of Industrial and Commercial Bank of China and procured by Tianwei in favor of the lender and which has an aggregate drawable amount of $30.1 million. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 3.8%. The principal amount of and any unpaid interest of the loan must be paid in full by June 2, 2016 or the tenth business day prior to the date on which the letter of credit expires or otherwise terminates, whichever is earlier. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letter of credit. As of June 30, 2011, the entire $24.7 million was outstanding.
CITIC Bank International Limited – New York Branch
On February 7, 2011, we entered into a $19.0 million credit agreement with the New York Branch of CITIC Bank International Limited. The loan is secured by standby letters of credit issued by China Branch of CITIC Bank International Limited and procured by Tianwei in favor of CITIC Bank International Limited. The loan bears interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2.5%. The principal amount and any unpaid interest thereon must be paid in full by the earlier of (i) February 4, 2013 or (ii) the 15th business day prior to the date on which the first letter of credit expires or terminates. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letters of credit. As of June 30, 2011, $17.9 million was outstanding under this loan.
Bank of China, New York Branch
On February 25, 2011, we and our subsidiary Hoku Materials entered into a credit agreement with the New York Branch of Bank of China that provides for one or more revolving loans in an aggregate principal amount not to exceed the lesser of (i) $30.0 million or (ii) the aggregate amount of the letters of credit procured by Tianwei. As of June 30, 2011, Tianwei has procured a letter of credit issued by the Sichuan Branch of Bank of China in favor of the lender. The loans bear interest at a per annum rate equal to the LIBOR Rate for the applicable interest period plus 2.4%. The principal amount of the loans and any unpaid interest must be paid in full by the earlier of (i) February 25, 2014 or (ii) the 15th business day prior to the date on which the letters of credit expires or terminates. We may prepay the loans, in whole or in part, at any time without penalty. We also entered into a reimbursement agreement with Tianwei pursuant to which we agreed to reimburse Tianwei for all interest, fees and expenses incurred by Tianwei in connection with the negotiation, execution and performance of the standby letters of credit. As of June 30, 2011, $25.0 million was outstanding under this loan. In July 2011, we received an additional $5.0 million under this credit agreement.
As of June 30, 2011, we are also expecting an additional $8.2 million in customer prepayments from our existing customers, which are payable on polysilicon delivery milestones. We will need to raise additional capital to complete construction and meet our working capital needs. We plan on raising this money through one or more subsequent debt and/or equity offerings and possibly prepayments from new customer contracts. Tianwei has also committed to assist us in obtaining additional financing that may be required by us to construct and operate the Polysilicon Plant with the understanding that it will receive fair compensation for the financial services it provides us. We cannot be certain that we will reach an agreement with Tianwei regarding the amount or method of compensation, which could affect Tianwei's willingness to continue to assist us in obtaining necessary additional financing.
In addition, we are in discussions with our other customers, including Wuxi Suntech Power Co., Ltd., Tianwei New Energy (Chengdu) Wafer Co., Ltd., regarding the extension of delivery dates that began in June 2011 in our supply agreements. Under the terms of all of our supply agreements, the failure to deliver polysilicon by the stated delivery dates will allow the customers to terminate the supply agreements, require the repayments of the deposits under the agreements, which in the aggregate amount to $140 million, which in turn could result in an event of default under our existing credit agreements with our third-party lenders. The event of default under our existing credit agreements could result in our lenders accelerating repayment of our third-party debt, which we do not have the ability to repay. The third-party credit agreements are all secured by standby letters of credit drawn by our majority shareholder, Tianwei, as collateral. To the extent that the third-party lenders accelerate repayment of the debt, Tianwei has provided a letter of commitment to us that it would not demand repayment from us until the original due dates of the third party credit agreements ranging from May 2012 through June 2016.
Polysilicon Supply Agreement Updates
Wuxi Suntech Power Co. Ltd.
In June 2007, we entered into a fixed price, fixed volume supply agreement with Wuxi Suntech Power Co., Ltd., or Suntech, for the sale and delivery of polysilicon. The supply agreement was subsequently amended in June 2010, pursuant to which we revised the first delivery of polysilicon products to Suntech in June 2011, and Suntech waived certain milestones required under the agreement. We also agreed to waive our right to prepayment of an additional $30.0 million, and Suntech may terminate the $30.0 million stand-by letter of credit previously issued by a bank in China. The term of the agreement was shortened to one year and pricing was fixed for the term of the agreement. The agreement will automatically renew with the same terms unless either party terminates the agreement. We did not make any shipments to Suntech in June 2011 and we are in discussion with Suntech regarding a possible amendment of the agreement.
Upon Suntech’s termination of the agreement under certain circumstances, we are required to refund to Suntech all prepayments, which were $2.0 million as of June 30, 2011, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement. Upon termination of the agreement for cause by us, we generally may retain the entire amount of prepayments made as of the date of such termination as liquidated damages, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement.
Pursuant to the agreement, we granted to Suntech a security interest in all of our tangible and intangible assets related to our polysilicon business. This security interest is subordinated to the Tianwei financing and any third-party debt secured to finance construction of the Polysilicon Plant.
Hanwha SolarOne, formerly Solarfun Power Hong Kong Limited.
In November 2007, we entered into a fixed price, fixed volume supply agreement with Hanwha SolarOne, or SolarOne, formerly known as Solarfun Power Hong Kong Limited, a subsidiary of Solarfun Power Holdings Co., Ltd., for the sale of polysilicon. As of June 30, 2011, SolarOne has paid to us $49.0 million as a prepayment for future polysilicon product deliveries, and it is obligated to pay us an additional $6.0 million in prepayments.
The supply agreement was subsequently amended in November 2010, to provide that we will sell approximately 7,300 metric tons of polysilicon over an 11-year term, approximately 6,750 metric tons of which are to be shipped during the second through tenth year of the agreement. The pricing under the agreement was adjusted such that it is fixed for the first five years and thereafter will then vary from year to year based on market pricing and negotiations between us and SolarOne. The fixed pricing for the first five years of the supply agreement was a few dollars above the long-term contract prices then prevailing in the market and below the spot prices by a dollar amount that is in the low double digits. If SolarOne fails to make any of the $6.0 million prepayment under the agreement, then the pricing adjustments shall not be effective. We also agreed that the initial delivery date to avoid breach and termination would be extended to June 2011. We did not make any shipments to SolarOne by the June 2011 deadline, and we are in discussions with SolarOne regarding a possible amendment to the supply agreement.
Upon SolarOne’s termination of the agreement under certain circumstances, we are required to refund to SolarOne all prepayments made as of the date of termination, which were $49.0 million as of June 30, 2011, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement. Upon termination of the agreement by us, we generally may retain the entire amount of prepayments made as of the date of such termination as liquidated damages, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement.
Pursuant to our agreement with SolarOne, we also granted to SolarOne a security interest in all of our tangible and intangible assets related to our polysilicon business. This security interest is subordinated to the Tianwei financing and any third-party debt secured to finance construction of the Polysilicon Plant.
Jinko Solar Co., Ltd.
In July 2008, we entered into a supply agreement with Jinko Solar Co., Ltd., formerly known as Jiangxi Jinko Solar Co., Ltd., or Jinko, for the sale and delivery of polysilicon. In December 2010, we amended the supply agreement under which we will sell approximately 1,800 metric tons of polysilicon over a nine-year term. The pricing under the agreement was adjusted such that it is fixed for the first five years and thereafter will vary from year to year based on market pricing and negotiations between us and Jinko. The fixed pricing for the first five years of the supply agreement was a few dollars above the long-term contract prices then prevailing in the market and below the spot prices by a dollar amount that is in the low double digits. We also agreed that the initial delivery date to avoid breach and termination would be extended to August 31, 2011. We do not anticipate making any shipments to Jinko by August 2011, and we are in discussions with Jinko regarding a possible amendment of the agreement. As of June 30, 2011, Jinko has paid us a total cash deposit of $20.0 million as prepayment for future product deliveries.
Pursuant to the agreement, we have granted to Jinko a security interest in all of our tangible and intangible assets related to our polysilicon business. This security interest is subordinated to the Tianwei financing and any third-party debt secured to finance construction of the Polysilicon Plant.
Tianwei New Energy (Chengdu) Wafer Co., Ltd.
In fiscal 2009, we entered into two fixed price, fixed volume supply agreements with Tianwei New Energy (Chengdu) Wafer Co., Ltd., or Tianwei Wafer, for the sale and delivery of polysilicon. In December 2009, we amended the agreements pursuant to which we converted $50.0 million of the total $79.0 million of prepayments previously paid into shares of our common stock and reduced the price at which Tianwei Wafer purchases polysilicon by approximately 11% per year. The amount of polysilicon to be delivered remains unchanged and Tianwei Wafer is required to pay us an additional $2.0 million in prepayments; however, the total revenue for the polysilicon to be sold by us to Tianwei Wafer has been modified such that up to approximately $418.0 million may be payable to us during the ten-year term (exclusive of amounts Tianwei Wafer may purchase pursuant to its right of first refusal), subject to acceptance of product deliveries and other conditions. Our failure to commence shipments of polysilicon by June 2011 constituted a material breach by us under the terms of the agreement, among other circumstances. However, in June 2011, Tianwei Wafer agreed that we are not required to commence shipments of polysilicon in the calendar year 2012 unless there is excess product available beyond our current customer commitment.
Upon Tianwei Wafer’s termination of the agreements under certain circumstances, we are required to refund to Tianwei Wafer the $29.0 million in prepayments made as of June 30, 2011, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreements. Upon a termination of the agreements by us, we generally may retain the entire amount of prepayments made as of the date of such termination as liquidated damages, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreements.
Pursuant to the agreements, we granted to Tianwei Wafer a security interest in all of our tangible and intangible assets related to our polysilicon business. This security interest is subordinated to the Tianwei financing and any third-party debt secured to finance construction of the polysilicon production facility.
Wealthy Rise International, Ltd.
In September 2008, we entered into a fixed price, fixed volume 10-year supply agreement with Wealthy Rise International, Ltd., a wholly owned subsidiary of Solargiga Energy Holdings, Ltd., or Solargiga, for the sale of polysilicon. In March 2010, we amended the agreement pursuant to which we agreed to sell to Solargiga specified volumes of polysilicon at a predetermined price over a three-year period beginning in calendar year 2011, subject to product deliveries and other conditions. In June 2011, we amended the agreement pursuant to which we agreed to sell to Solargiga specified volumes of polysilicon at a predetermined price over a five-year period beginning in fiscal 2013, subject to product deliveries and other conditions. The fixed pricing in this agreement was at the level of long-term contract prices prevailing in the market at the time of this amendment and below the spot prices by a dollar amount that is in the low double digits. The pricing for the last two years of the five-year term may be adjusted based on market prices of polysilicon and negotiations between us and Solargiga. The aggregate amount that may be paid to us over the five-year term is $92.8 million, assuming no such pricing adjustment in the last two years occurs and without taking into account the prepayments already received by us. The amendment also extended the date by which we were obligated to commence shipments of polysilicon from May 2011 to May 2012. We also granted to Solargiga a warrant to purchase 1,196,581 shares of our common stock. The terms of the warrant include: (i) a per share exercise price equal to $2.75; (ii) a five year term; and (iii) immediately exercisable. The accounting of the warrant was based on the fair value of the warrant at the date of grant and was estimated to be $1.4 million, using the Black-Scholes option pricing model.
Solargiga has the right to terminate the amended agreement and recover any prepayments made if we have not commenced polysilicon shipments by September 30, 2012. Pursuant to the agreement, Solargiga was obligated to pay us additional prepayments in the aggregate amount of $13.2 million that was payable in four increments of $3.3 million in each of April, June, August and October 2010, and a final prepayment of $200,000 upon Solargiga’s receipt of certain aggregate volumes of polysilicon product from us. We received all four prepayments from Solargiga of $13.2 million.
Upon Solargiga’s termination of the agreement under certain circumstances, we are required to refund to Solargiga all prepayments made as of the date of termination, which were $20.2 million as of June 30, 2011, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement. Upon termination of the agreement by us, we generally may retain the entire amount of prepayments made as of the date of such termination as liquidated damages, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement.
Pursuant to the agreement, we have granted to Solargiga a security interest in all of our tangible and intangible assets related to our polysilicon business. This security interest is subordinated to the Tianwei financing and any third-party debt secured to finance construction of the Polysilicon Plant.
Shanghai Alex New Energy Co., Ltd.
In February 2009, we entered into a supply agreement with Shanghai Alex New Energy Co., Ltd., or Alex, for the sale and delivery of polysilicon. In January 2011, we entered into Amendment No. 2 to Supply Agreement with Alex, or Amendment No. 2, which provides for a pricing adjustment such that pricing is fixed for the first three years and thereafter will vary from year to year based on market pricing and negotiations between us and Alex. The fixed pricing for the first three years of the supply agreement was at the level of the long-term contract prices prevailing in the market at the time of the amendment and below the spot prices by a dollar amount that is in the low double digits. Under Amendment No. 2, we have an obligation to use commercially reasonable efforts to make our first shipment to Alex by March 31, 2011, and if we did not do so within a certain number of days after the scheduled delivery date, we would provide Alex with a purchase price adjustment. As of March 31, 2011, we did not make our first shipment and as a result the purchase price was adjusted accordingly. Furthermore, if we have not made our initial shipment of product on or before September 30, 2011, Alex will have the right to terminate the Agreement. We are in discussions with Alex regarding a possible amendment to the supply agreement.
Upon Alex’s termination of the agreement under certain circumstances, we are required to refund to Alex all prepayments made as of the date of termination, which were $20.0 million as of June 30, 2011, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement. Upon termination of the agreement by us, we generally may retain the entire amount of prepayments made as of the date of such termination as liquidated damages, less any part thereof that has been applied to the purchase price of polysilicon delivered under the agreement.
Hoku Solar
Our goal is to be a leading provider in PV system installations. We plan to continue to focus on designing, engineering and installing turnkey PV systems and related services in Hawaii using solar modules purchased from third-party suppliers.
In addition to continuing to focus on our turnkey solar integration business in the coming fiscal year, we also plan to expand our focus on large-scale PV project development within Hawaii and elsewhere. This effort will be focused on leveraging our solar integration, project management and financing expertise to develop a portfolio of rooftop solar energy facilities and multiple utility-scale PV farms, which would generate solar power for sale to utilities and large industrial customers for use on their grids.
During the three months ended June 30, 2011, Hoku Solar recognized an operating loss of $179,000 from its PV system installations and sale of electricity to the Hawaii State Department of Transportation.
Financial Operations Review
During the quarter ended June 30, 2011, we derived all of our revenue through PV system installation, resale of PV modules, and ancillary services related to Hoku Solar. We expect that all of our revenue will be derived through PV system installations, resale of PV modules, and the sale of electricity until the first half of fiscal 2012, when Hoku Materials is expected to generate revenue through the sale of polysilicon manufactured at our planned polysilicon production facility in Pocatello, Idaho.
During the three months ended June 30, 2011, our revenue was $485,000, comprised of PV system installations, the resale of PV modules, and the sale of electricity.
Consolidated Results of Operations
The following analysis of the unaudited consolidated financial condition and results of operations of Hoku Corporation and its subsidiaries should be read in conjunction with the consolidated financial statements and the related notes thereto in this Quarterly Report on Form 10-Q.
Comparison of Three Months Ended June 30, 2011 and 2010
Revenue.
Revenue was $485,000 for the three months ended June 30, 2011, compared to $930,000 for the same period in fiscal 2011. Revenue in both periods was primarily comprised of PV system installations, the resale of PV modules and related services.
Cost of Revenue.
Cost of revenue was $343,000 for the three months ended June 30, 2011, compared to $565,000 for the same period in fiscal 2011. Cost of revenue primarily consisted of employee compensation and supplies and materials for the PV system installation, PV modules and related services.
Selling, General and Administrative Expenses.
Selling, general and administrative expenses were $10.3 million for the three months ended June 30, 2011, compared to $3.2 million for the same period in fiscal 2011. The increase of $7.1 million was primarily due to electricity costs related to the construction of the Polysilicon Plant of $4.8 million, the issuance of a warrant to Solargiga of $1.4 million, and an increase in payroll expense of $1.3 million, which include bonuses and stock compensation. In addition, the increase in expense included costs related to rent primarily for corporate, warehouse and storage facilities of $186,000 and office supplies and equipment of $103,000. There higher expenses were offset by a $743,000 decrease in costs related to the initial polysilicon production demonstration completed in April 2010.
Interest and Other Income/(Loss).
Interest and other income was $187,000 for the three months ended June 30, 2010. Interest and other income for the three months ended June 30, 2010 was primarily composed of a foreign currency transaction gain of $177,000 related to Euro-based invoices and the reversal of prior accruals for general excise tax reserves due to statute limitations of $9,000.
Liquidity and Capital Resources
We have incurred significant net losses since inception and we have relied on our ability to fund our operations principally through borrowings under credit agreements, prepayments on long-term polysilicon contracts and registered and unregistered offerings of our securities. Even if we are successful in securing additional long-term polysilicon contracts that could provide additional prepayments, and our existing customers fulfill their obligations to make additional prepayments when due (of which there can be no assurances), we will still need to seek additional financing to complete our Polysilicon Plant. As of June 30, 2011, we had cash and cash equivalents on hand of $17.9 million and current liabilities of $121.6 million.
Tianwei, our majority shareholder has committed to provide us financial support for our ongoing operations, planned capital expenditures and debt service requirements until at least April 1, 2012. In addition, Tianwei has provided standby letters of credit as collateral for our third-party debt with a principal amount of $243 million as of June 30, 2011.
Under the terms of all of our supply agreements, the failure to deliver polysilicon by the stated delivery dates will allow the customers to terminate the supply agreements, require the repayments of the deposits under the agreements, which in the aggregate amount to $140 million as of June 30, 2011, which in turn could result in an event of default under our existing credit agreements with third party lenders. The event of default under our existing credit agreements could result in our lenders accelerating repayment of our third-party debt, which we do not have the resources to repay. To the extent that the third-party lenders accelerate repayment of the debt, Tianwei has provided a letter of commitment to us that it would not demand repayment from us until the original due dates of the third-party credit agreement ranging from May 2012 through June 2016.
As of June 30, 2011, we obtained an aggregate of $243 million of debt financing through 14 credit agreements to support our operations. In July 2011, we also borrowed $5.0 million on our credit agreement with the New York Branch of Bank of China. All of these credit agreements are secured by letters of credit provided by our majority stockholder, Tianwei New Energy Holding Co. Ltd., or Tianwei. For a detailed description of these credit agreements, see “
Hoku Materials—Financing Update—Overview.
” In addition, as of June 30, 2011, we are expecting an additional $8.2 million in customer prepayments from our existing customers, which are payable on polysilicon delivery milestones. As of June 30, 2011, we have funded approximately $495.7 million of our Polysilicon Plant. We estimate that we still need to raise at least an additional $185 million to complete the construction of the Polysilicon Plant based upon our current estimate of $700 million to complete construction.
We expect to complete the construction of the 2,500 metric ton per year plant, or Phase I, through the use of our available cash, loan proceeds received from credit agreements and debt supported by Tianwei. Tianwei has committed to assist us in obtaining additional financing for any additional construction costs necessary to complete Phase I, for working capital needs and to purchase polysilicon from third parties to meet our upcoming commitments with the understanding that it will receive fair compensation for the financial services it provides us. We cannot be certain that we will reach an agreement with Tianwei regarding the appropriate compensation for Tianwei which could affect Tianwei's willingness to continue to assist us in obtaining necessary additional financing.
Once Phase I is completed, we expect to receive an additional $8.2 million in customer prepayments from our existing customers upon reaching certain polysilicon milestones. We expect to use the prepayments to help fund the construction costs to ramp-up to polysilicon production of 4,000 metric tons per year. We plan on raising the remaining costs to complete our Polysilicon Plant and working capital needs through debt and/or equity offerings and possibly prepayments from new customer contracts. Tianwei has also committed to assist us in obtaining additional financing that may be required by us to construct and operate the Polysilicon Plant. There is no guarantee that we will be able to obtain additional financing in terms acceptable to us or at all, even with the assistance of Tianwei. Tianwei has committed to provide us financial support for our ongoing operations, planned capital expenditures and debt service requirements until at least April 1, 2012. Furthermore, any significant increase in the cost to complete the Polysilicon Plant could have a material adverse effect on our business, financial condition and results of operations.
The additional capital we have secured since the beginning of fiscal year 2011 has enabled us to settle accounts payable and accrued capital expenditures, and is providing us with the necessary capital to sustain operations. In addition, we are reserving adequate funding for the purchase of third-party polysilicon to meet our contractual obligations with our polysilicon customers, beginning in August 2011, and for interest and other financing costs related to our loans. However, the amount we have secured is not sufficient to complete construction of the Polysilicon Plant, and should there be delays in securing additional financing, we may need to implement cost and expense reduction programs and other programs to generate cash that are not currently planned, but are responsive to our liquidity requirements. If we are unable to secure additional financing or structure credit terms with our vendors that are favorable to us, we may also need to curtail construction of the Polysilicon Plant. If we have to curtail construction, our excess capital would primarily be used to reduce our current liabilities, purchase of third-party polysilicon and for working capital needs. Tianwei has committed to assist us in obtaining additional financing for working capital needs and to purchase polysilicon from third-parties to meet our upcoming commitments with the understanding that it will receive fair compensation for the financial services it provides us.
Net Cash Used In Operating Activities.
Net cash used in operating activities was $7.4 million and $1.2 million for the three months ended June 30, 2011 and 2010, respectively. Net cash used in operating activities for the three months ended June 30, 2011 primarily reflects the net loss of $10.2 million which resulted in a cash deficit of $8.6 million when adjusted for noncash operating activities. The cash deficit was offset by net cash inflows from working capital of $1.1 million, primarily from increases in accounts payable and accrued operating expenditures and deferred revenue. In comparison, net cash used in operating activities for the three months ended June 30, 2010 primarily reflected the net loss of $2.7 million which resulted in a cash deficit of $2.3 million when adjusted for noncash operating activities. The cash deficit was offset by net cash inflows from working capital of $1.0 million, primarily from decreases in inventory and other current assets and increases in accounts payable and accrued operating expenditures and deferred revenue.
We had a working capital deficit of $101 million and $33 million as of June 30, 2011 and March 31, 2011, respectively. The working capital deficits reflect the current portion of notes payable that are due within one year, the increased deployment of funds to construct the Polysilicon Plant in Idaho and the Company’s net losses. In addition, $8.6 million and $25.3 million of deposits from long-term polysilicon contracts were classified as short-term liabilities as of June 30, 2011 and March 31, 2011, respectively, to reflect the prepayments that apply to the product deliveries that are scheduled to ship within one year.
Net Cash Used In Investing Activities.
Net cash used in investing activities was $41.6 million for the three months ended June 30, 2011, compared to $21.3 million for the same period in fiscal 2011. The net cash used in investing activities in both periods was primarily related to the continuing construction of the Polysilicon Plant.
Net Cash Provided By Fi
nancing Activities.
Net cash provided by financing activities was $48.6 million for the three months ended June 30, 2011, compared to $23.9 million for the same period in fiscal 2011. The net cash provided by financing activities during the three months ended June 30, 2011 was primarily due to loan proceeds received from Industrial and Commercial Bank of China, New York Branch of $39.7 million, and loan proceeds received from the New York Branch of CITIC Bank International Limited of $8.9 million. The net cash provided by financing activities during the three months ended June 30, 2010 was primarily due to loan proceeds from China Merchant Bank of $20.0 million and deposits received under polysilicon supply agreements of $6.6 million, offset by cash distributions to the minority investor of Hoku Solar Power I of $2.6 million.
Operating Capital and Capital Expenditure Requirements
As we invest resources towards our polysilicon manufacturing and PV systems installation service businesses, develop our products, expand our corporate infrastructure, prepare for the increased production of our products and evaluate new markets to grow our business, we expect that our expenses will continue to increase and, as a result, we will need to generate significant revenue to achieve profitability.
We do not expect to generate significant revenue until we successfully commence the manufacture and shipment of polysilicon and begin meeting the obligations under our supply contracts. Based on recent construction progress and discussions with our vendors, we expect to incur approximately $600 million of costs before we can commence operation of the first 2,500 metric tons of production capacity. We also expect to invest up to an additional $100 million to complete the second phase of construction, which will add an additional 1,500 metric tons of manufacturing capacity, and allow us to complete our planned on-site TCS plant. Thus, our revised estimate for the full, planned 4,000 metric ton plant is now approximately $700 million.
We expect to complete the construction of the 2,500 metric ton per year plant, or Phase I, through the use of our available cash and loan proceeds and through additional debt supported by Tianwei. Tianwei has committed to assist us in obtaining additional financing for any additional construction costs necessary to complete Phase I, for working capital needs and to purchase polysilicon from third-parties to meet our upcoming commitments with the understanding that it will receive fair compensation for the financial services it provides us. We cannot be certain that we will reach an agreement with Tianwei regarding the appropriate compensation for Tianwei which could affect Tianwei's willingness to continue to assist us in obtaining necessary additional financing.
Once Phase I is completed, we expect to receive an additional $8.2 million in customer prepayments from our existing customers upon reaching certain polysilicon milestones. We expect to use the prepayments to help fund the construction costs to ramp-up to polysilicon production of 4,000 metric tons per year. We plan on raising the remaining costs to complete our Polysilicon Plant and working capital needs through debt and/or equity offerings and possibly prepayments from new customer contracts. Tianwei has also committed to assist us in obtaining additional financing that may be required by us to construct and operate the Polysilicon Plant. There is no guarantee that we will be able to obtain additional financing in terms acceptable to us or at all, even with the assistance of Tianwei.. There is no guarantee that we will be able to obtain additional financing in terms acceptable to us or at all, even with the assistance of Tianwei. Furthermore, any significant increase in the cost to complete the Polysilicon Plant could have a material adverse effect on our business, financial condition and results of operations.
The amount we have secured is not sufficient to complete construction of the Polysilicon Plant, and should there be delays in securing additional financing, we may need to implement cost and expense reduction programs and other programs to generate cash that are not currently planned, but are responsive to our liquidity requirements. If we are unable to secure additional financing or structure credit terms with our vendors that are favorable to us, we would also need to curtail construction of the Polysilicon Plant in the fourth quarter of fiscal 2011. If we have to curtail construction, our excess capital would primarily be used for interest and other financing costs related to our loans, reduce our current liabilities, purchase of third-party polysilicon and for working capital needs.
The issuance of additional equity and convertible debt instruments may result in additional dilution to our current stockholders and/or a change of control. If we raise additional funds through the issuance of convertible debt securities, these securities could have rights senior to those of our common stock and could contain covenants that would restrict our operations. We may require additional capital beyond our currently forecasted amounts. Any required additional capital may not be available on reasonable terms, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of, delay or eliminate some or all of our planned research, development and commercialization and manufacturing activities, which could harm our business. Our forecasts of the period of time through which our financial resources will be adequate to support our operations are forward-looking statements and involve risks and uncertainties. Actual results could vary as a result of a number of factors, including the factors discussed in Part II, Item 1.A. “Risk Factors.”
Contractual Obligations
The following table summarizes the contractual obligations that existed at June 30, 2011. The amounts in the table below do not include time and materials contracts and, incentive payments. In addition, the GEC Graeber Engineering Consultants GmbH, and MSA Apparatus Construction for Chemical Equipment, Ltd. contract for the purchase and sale of hydrogen reduction reactors and hydrogenation reactors is to be paid in Euros and the contractual obligation is determined based on the Euro/U.S. dollar exchange rate, which was $1.439/Euro as of June 30, 2011.
|
|
|
Payment due by Period
|
|
|
Contractual Obligations
|
|
Total
|
|
|
Less Than
One Year
|
|
|
One to
Three Years
|
|
|
Three to
Five Years
|
|
|
More Than
Five Years
|
|
|
|
|
(in thousands)
|
|
|
Construction in progress
|
|
$
|
7,264
|
|
|
|
7,264
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
Equipment purchases
|
|
|
8,300
|
|
|
|
8,300
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
Supply purchases
|
|
|
77,310
|
|
|
|
30,237
|
|
|
|
47,073
|
|
|
|
—
|
|
|
|
—
|
|
|
Leases
|
|
|
530
|
|
|
|
155
|
|
|
|
310
|
|
|
|
65
|
|
|
|
—
|
|
|
Customer deposits
|
|
|
140,200
|
|
|
|
8,611
|
|
|
|
51,813
|
|
|
|
48,422
|
|
|
|
31,354
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
233,604
|
|
|
|
54,567
|
|
|
|
99,196
|
|
|
|
48,487
|
|
|
|
31,354
|
|
City of Pocatello.
In March 2007, we entered into a 99-year ground lease with the City of Pocatello, Idaho, for approximately 67 acres of land and, in May 2007, the City of Pocatello approved an ordinance that authorizes the Pocatello Development Authority to provide us certain tax incentives related to certain necessary infrastructure costs we incur in the construction and operation of our Polysilicon Plant. In May 2009, we entered into an Economic Development Agreement, or the EDA Agreement, with the Pocatello Development Authority, or PDA, pursuant to which PDA agreed to reimburse to us amounts we actually incur in making certain infrastructure improvements consistent with the North Portneuf Urban Renewal Area and Revenue Allocation District Improvement Plan and the Idaho Urban Renewal Law, or the Infrastructure Reimbursement, and an additional amount as reimbursement for and based on the number of full time employee equivalents we create and maintain, or the Employment Reimbursement, at the Polysilicon Plant. The parties agreed that (a) the Infrastructure Reimbursement will be an amount that is equal to 95% of the tax increment payments PDA actually collects on the North Portneuf Tax Increment Financing District with respect to our real and personal property located in such district, or the TIF Revenue, up to approximately $26.0 million, less the actual Road Costs (defined below), and (b) the Employment Reimbursement will be an amount that is equal to 50% of the TIF Revenue, up to approximately $17.4 million. Each of the Infrastructure Reimbursement and the Employment Reimbursement will be made to us over time as TIF Revenue is received, and only after the costs of completing a public access road to the Polysilicon Plant, in an amount not to exceed $11.0 million, or the Road Costs, has been paid to PDA out of TIF Revenue, and up to $2.0 million in capital costs has been paid to the City of Pocatello out of TIF Revenue.
Stone & Webster, Inc.
In August 2007, we entered into an Engineering, Procurement and Construction Management Contract with Stone & Webster, Inc., or S&W, a subsidiary of The Shaw Group Inc., for engineering and procurement services for the construction of our Polysilicon Plant, which was amended in October 2007 by Change Order No. 1, again in April 2008 by Change Order No. 2, again in February 2009 by Change Order No. 3, and again in February 2010 by Change Order No. 4, which are collectively the Engineering Agreement. Under the Engineering Agreement, S&W would provide the engineering services to complete the design and plan for construction of the Polysilicon Plant, along with procurement services. S&W would be paid on a time and materials basis plus a fee for its services.
During the three months ended June 30, 2011, we made payments to S&W of $476,000 million, and as of June 30, 2011, we had paid S&W an aggregate amount of $60.6 million under the Engineering Agreement.
JH Kelly LLC
. In August 2007, we entered into a Cost Plus Incentive Contract with JH Kelly LLC, or JH Kelly, for construction services for the construction of the Polysilicon Plant, which was amended in October 2007, by Change Order No. 1, and again in April 2008 by Change Order No. 2, again in March 2009 by Change Order No. 3, again in September 2009 by Change Order No. 4, and again in August 2010 by Change Order No. 5, which are collectively the JH Kelly Construction Agreement. Under the JH Kelly Construction Agreement, JH Kelly agreed to provide the construction services as our general contractor for the construction of the Polysilicon Plant with a production capacity of 4,000 metric tons per year. The target cost for the services to be provided under the JH Kelly Construction Agreement is $165.0 million, including up to $5.0 million of incentives that may be payable.
Pursuant to Change Order No. 5, we agreed among other things: (i) to confirm the plan for JH Kelly to complete construction of the Polysilicon Plant and (ii) set-up a payment schedule relating to outstanding invoices that we owed to JH Kelly and any additional expenses that JH Kelly incurred relating to the construction of the Polysilicon Plant..
During the three months ended June 30, 2011, we made payments to JH Kelly of $23.6 million, and as of June 30, 2011, we paid JH Kelly an aggregate amount of $207.7 million under the JH Kelly Construction Agreement.
Dynamic Engineering Inc.
In October 2007, the Company entered into an agreement with Dynamic Engineering Inc., or Dynamic, for design and engineering services, and a related technology license for the process to produce and purify TCS. Under the agreement with Dynamic, or the Dynamic Agreement, Dynamic is obligated to design and engineer a TCS production facility that is capable of producing 20,000 metric tons of TCS for the Polysilicon Plant. Under the Dynamic Agreement, Dynamic's engineering services are provided and invoiced on a time and materials basis, and the license fee will be calculated upon the successful completion of the TCS production facility, and demonstration of certain TCS purity and production efficiency capabilities. The maximum aggregate amount that the Company may pay Dynamic for the engineering services and the technology license is $12.5 million, which includes an incentive for Dynamic to complete the engineering services under budget. Dynamic is guaranteeing the quantity and purity of the TCS to be produced at the completed facility, and has agreed to indemnify the Company for any third-party claims of intellectual property infringement.
During the three months ended June 30, 2011, we made no payments to Dynamic, and as of June 30, 2011, we had paid Dynamic an aggregate amount of $8.4 million under the Dynamic Agreement.
GEC Graeber Engineering Consultants GmbH and MSA Apparatus Construction for Chemical Equipment Ltd.
We entered into a contract with GEC Graeber Engineering Consultants GmbH, or GEC, and MSA Apparatus Construction for Chemical Equipment Ltd., or MSA, for the purchase and sale of 16 hydrogen reduction reactors and hydrogenation reactors for the production of polysilicon, and related engineering and installation services. Under the contract, we will pay up to a total of 20.9 million Euros for the reactors. The reactors are designed and engineered to produce approximately 2,500 metric tons of polysilicon per year. The term of the contract extends until the end of the first month after the expiration date of the warranty period, but may be terminated earlier under certain circumstances.
As of June 30, 2011, pursuant to the contract with GEC and MSA, we received all 16 hydrogen reduction reactors, eight hydrogenation reactors, and related equipment, at the Polysilicon Plant.
During the three months ended June 30, 2011, we made no payments to GEC and MSA, and as of June 30, 2011, we paid GEC and MSA an aggregate amount of 19.0 million Euros or $26.7 million.
Idaho Power Company
. We entered into an agreement with Idaho Power Company, or Idaho Power, to complete the construction of the electric substation to provide power for the Polysilicon Plant, or the Idaho Power Agreement. As of March 31, 2010, we had paid an aggregate amount of $18.0 million to Idaho Power. The electric substation was completed in August 2009, and we were able to use its power during our polysilicon product demonstration in April 2010.
We also entered into an Electric Service Agreement with Idaho Power, or the ESA, for the supply of electric power and energy to us for use in the Polysilicon Plant, subject to the approval of the Idaho Public Utilities Commission, or the PUC. The term of the ESA is four years, beginning in June 2009 and will expire in May 2013. During the term of the ESA, Idaho Power agrees to make up to 82,000 kilowatts of power available to us at certain fixed rates, which are subject to change only by action of the PUC. After the initial term of the ESA expires, either we or Idaho Power may terminate the ESA without prejudice. If neither party chooses to terminate the ESA, then Idaho Power will continue to provide electric service to us. As of June 30, 2011, we were contractually obligated to pay approximately $69.8 million to Idaho Power over the term of the ESA. Beginning in May 2011, we are required to make a minimum monthly payment ranging between $1.1 million and $1.9 million per month until October 2011.
During the three months ended June 30, 2011, we made payments to Idaho Power of $5.8 million.
Polymet Alloys, Inc.
In November 2008, we entered into an agreement with Polymet Alloys, Inc., or Polymet, for the supply of silicon metal to us for use at the Polysilicon Plant. In May 2009, we entered into an amended and restated supply agreement with Polymet, or the Amended Polymet Agreement. The term of the Amended Polymet Agreement is three years, commencing in 2010. Each year during the term of the Amended Polymet Agreement, Polymet has agreed to sell to us no less than 65% of our annual silicon metal requirement. Pricing is to be negotiated annually; however, if the parties are unable to agree on pricing for any year, or the we have agreed to purchase less than the amount specified in the Amended Polymet Agreement, Polymet has a right of first refusal to match the terms offered by any third-party supplier from whom we may seek to purchase silicon metal. Either party may also terminate the Amended Polymet Agreement under certain circumstances, including a material breach by the other party. As of June 30, 2011, we have not made any payments to Polymet.
PVA Tepla Danmark.
In April 2008, we entered into an agreement with PVA Tepla Danmark, or PVA, for the purchase and sale of slim rod pullers and float zone crystal pullers. Under the agreement, PVA is obligated to manufacture and deliver the slim rod pullers and float zone crystal pullers for the Project. Slim rod pullers are used to make thin rods of polysilicon that are then transferred into polysilicon deposition reactors to be grown through a chemical vapor deposition process into polysilicon rods for commercial sale to our end customers. The float zone crystal pullers convert the slim rods into single crystal silicon for use in testing the quality and purity of the polysilicon. The total fees payable to PVA is approximately $6 million, which is payable in four installments, the first of which was made in August 2008. Either party may terminate the agreement if the other party is in material breach of the agreement and has not cured such breach within 180 days after receipt of written notice of the breach, or if the other party is bankrupt, insolvent, or unable to pay its debts. In June 2011, we amended this agreement to restructure the payment terms with PVA as follows: (i) in July 2011, we paid $318,000; (ii) in July 2011, we delivered a letter of credit in the amount of $636,000; and (iii) upon the earlier of six months after the date of commissioning and December 31, 2011, we shall pay the amount of $318,000.
During the three months ended June 30, 2011, we made payments to PVA of $2.1 million, and as of June 30, 2011, we had paid PVA an aggregate amount of $6.0 million.
Evonik Degussa Corporation.
In March 2010, we entered into an agreement with Evonik Degussa Corporation, or Evonik, for the supply of TCS for use in the manufacturing of polysilicon for a term of approximately one year ending in February 2011. In April 2010, we paid Evonik a $100,000 deposit for the ISO containers that will transport the TCS to our facility in Pocatello, Idaho. In February 2011, we amended and restated this agreement to, among other things, extend the term of the agreement to November 2011. Under the amended agreement, Evonik has agreed to sell to us a minimum quantity of TCS during the term of the agreement. Pricing is fixed based on the quantity supplied in each calendar month and based on our frequency of payment. Commencing in May 2011, we will forecast our estimated desired monthly quantity of TCS. Pursuant to the agreement, Evonik is required to provide a minimum amount of TCS per calendar month, and it will use commercially reasonable efforts to provide additional quantities that we may request in addition to the monthly minimum amount.
In April 2010, we paid Evonik a $100,000 deposit for the ISO containers that will transport the TCS to our facility in Pocatello, Idaho. Evonik will return our deposit upon expiration of the initial term and completion of our obligations under the agreement; however, we expect the agreement to be amended.
The aggregate net value of the TCS to be purchased under the amended agreement during the term is approximately $13.5 million. As of June 30, 2011, we paid Evonik an aggregate amount of $100,000.
Critical Accounting Policies and Significant Judgments and Estimates
Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions relating to the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Our management has discussed the development and selection of these critical accounting policies and estimates with the audit committee of our board of directors and the audit committee has reviewed our disclosures relating to our critical accounting policies and estimates in this report. Actual results may differ from these estimates.
While our significant accounting policies are more fully described in Note 1 to the unaudited consolidated financial statements included in this Quarterly Report on Form 10-Q and Note 1 to the audited financial statements included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 15, 2011, we believe that the following accounting policies and estimates are critical to a full understanding and evaluation of our reported financial results.
Revenue Recognition
. Revenue from polysilicon and PV system installations and the resale of PV system installation inventory is recognized when there is evidence of an arrangement, delivery has occurred or services have been rendered, the arrangement fee is fixed or determinable, and collectability of the arrangement fee is reasonably assured. PV system installation contracts may have several different phases with corresponding progress billings.
We apply the percentage-of-completion method of revenue recognition for our PV system contracts for which we can make reasonably dependable estimates of costs. Under the percentage-of-completion method, revenue and related costs are deferred and subsequently recognized based on the progress of the installation and an estimate of remaining costs to complete the installation. We recognize revenue under the completed contract method, in which revenue and related costs are deferred and then subsequently recognized only upon completion of the contract.
We entered the PV system installation business in fiscal year 2008. Prior to April 1, 2010, due to the short period of time we were in the PV system installation business, we did not have the historical experience or the procedures in place to develop reasonably dependable estimates of costs and therefore utilized the completed contract method to record revenue for PV contracts. Subsequent to this startup period, we have developed history and reliable processes and procedures of projecting and tracking contract fulfillment costs, in order to develop reasonably dependable estimates which are required to use the percentage of completion method. In applying the percentage method, we determine the percentage of contract completion on the basis of engineering, labor, subcontractor and other installation costs and excludes material and other non-installation contract costs, which are not considered the primary cost determinants in gauging the progress of the PV system contract. Revenue and related costs are recognized proportionately based on the completion percentage of each project and considering the current estimate of remaining costs required to complete the project.
We will continue to recognize revenue under the completed contract method for PV installations contracts entered into prior to April 1, 2010.
Stock-Based Compensation
. We account for stock-based employee compensation arrangements using the fair value method, whereby the fair value of stock options granted to our employees and non-employees is determined using the Black-Scholes pricing model. The Black-Scholes pricing model requires the input of several subjective assumptions including the expected or contractual life of the option and the expected volatility of the option at the time the option is granted. The fair value of our option, as determined by the Black-Scholes pricing model, is expensed over the requisite service period, which is generally one to five years for stock options.
Prior to our initial public offering, there was an absence of an active market for our common stock, and therefore our board of directors estimated the market value of our common stock on the date of grant of the stock option based on several factors, including progress and milestones achieved in our business and sales of our preferred stock. We did not obtain contemporaneous valuations from a valuation specialist during this period. Subsequent to our initial public offering, the market value is based on the public market for our common stock. Due to our limited operating history, we have assumed a volatility of 100% based on competitive benchmarks and management’s judgment and an expected life based on the average of the typical vesting period and the option’s contractual life which ranges from 5.5 to 7.5 years.
The assumptions used in calculating the fair value of our stock options represent our management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, changes in these inputs and assumptions can materially affect the measure of the estimated fair value of our stock options. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those options and shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. Furthermore, this accounting estimate is reasonably likely to change from period to period as further stock options and restricted stock awards are granted and adjustments are made for stock option and restricted stock awards forfeitures and cancellations. We do not record any deferred stock-based compensation on our balance sheet for our stock options and restricted stock awards.
We expect our stock-based compensation expense from restricted stock awards to increase as we expand our operations and hire new employees. These expenses will increase our overall expenses and may increase our losses for the foreseeable future. As a restricted stock award is a non-cash expense, it will not have any effect upon our liquidity or capital resources.
Accounting for the Impairment or Disposal of Long Lived Assets.
As of June 30, 2011, primarily all of our long lived assets related to the construction-in-progress of our polysilicon plant and PV systems. In accounting for long-lived assets, we must make estimates about the expected useful lives of the assets, the expected residual values of the assets and the potential for impairment based on the fair value of the assets and if the cash flows they expect to generate are insufficient to support the carrying value of the assets.
Certain events or changes in circumstances in the future may indicate that the carrying amount of these assets may not be recoverable. Such events or circumstances include but are not limited to, a decline in market prices of polysilicon or a change in expected demand for polysilicon. If, in the future, we were to determine that the carrying amount of our polysilicon plant is not recoverable, we would be required to estimate the fair value of the Polysilicon Plant and, if the fair value is less than the carrying amount, record an impairment charge for the difference.
Notes Payable and Warrant.
We account for the warrant and debt agreement with Tianwei based on their relative fair values in proportion to the loan proceeds. The fair values of the warrants were calculated using the Black-Scholes option pricing model, which requires the input of several subjective assumptions including the life of the warrant and the expected volatility of the warrant at the time the warrant was granted. The fair value of the debt was based on the present value of cash flows at the estimated market interest rate.
The assumptions used in calculating the warrant and debt represent our management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. In estimating market interest rate, we relied on available marketplace information of similar transactions.