Risks and Uncertainties
The Company’s businesses are subject to significant risks and uncertainties. These risks and uncertainties, together with certain assumptions, also underlie the forward-looking statements made in this MD&A and may cause the Company’s actual results to differ materially from its expectations. Described below are some of the more significant risks that could affect the Company’s results.
Global Economic Uncertainty
Global economic conditions have deteriorated rapidly over the last several months as a result of the financial crisis that erupted in North America, Europe and Asia during 2008. These developments, which include the collapse of certain financial institutions, significant tightening of credit, loss of consumer and investor confidence and recession, are having and will likely continue to have a broad-reaching impact on the Company’s businesses and the industries in which they operate. The severity, duration and extent of such impact are not yet fully understood. Many of the Company’s customers are experiencing financial constraints and have reduced or deferred their purchases. Such customers may continue to curtail or delay their purchases, which would reduce the Company’s revenues, or may experience even more severe financial difficulties, which could significantly increase the Company’s credit risk or reduce the Company’s liquidity. Moreover, the pace of deterioration of economic conditions has continued to accelerate since the end of fiscal 2008, particularly impacting the stock markets, which have experienced unprecedented volatility. If these circumstances persist or deteriorate further, the Company’s ability to raise capital in the debt or equity markets could be significantly limited, which could restrict the Company’s ability to pursue its strategies or financial objectives. Any one of these developments could have a material adverse effect on the Company’s financial position, results of operations and liquidity.
Risks Relating to the Silicon Group
Customer Commitments for Solar Grade Silicon
The Company has several long-term commercial contracts with customers for the supply of solar grade silicon. These contracts provide for certain volume purchase and delivery commitments by the customers and the Company, respectively, during specified periods over the term of each contract. Based on its current production capacity and expansion plans, and experience to date in fulfillment by customers of their volume purchase commitments, the Company expects to be able to satisfy all of its volume delivery commitments regarding solar grade silicon. However, actual customer fulfillment of volume purchase commitments in the future is uncertain, as many customers under long-term contracts for solar grade silicon have recently reduced their orders due to the current market downturn. A shortfall in the volumes of solar grade silicon actually purchased by these customers relative to the Company’s expectations, or changes in the timeframes within which these customers take delivery, or an inability by the Company to satisfy the volume requirements under these contracts or other purchase orders with its customers could have a material adverse effect on the Company’s financial position, results of operations and liquidity.
The Company’s contracts with customers also provide for specifications for the solar grade silicon to be delivered, and various quality control and testing methodologies to verify compliance with such specifications. Such specifications, quality controls and testing methodologies are changing and are expected to evolve as the Company and its customers continue to build experience in using the Company’s solar grade silicon for solar photovoltaic applications.
Certain contracts also provide for the customer to make advance payments, or deposits, to the Company. The Company has received $45.5 million in such deposits during fiscal 2008, and existing contractual commitments provide for additional deposits to be made by certain customers, in some cases conditional upon certain events or circumstances arising under the terms of the contract.
In the event of an early termination or completion of a supply contract, any remaining balance on the deposits would be returned to the customer within a specified time period. If the remaining amount is not repaid within the specified time period it becomes interest bearing at rates specified in the contract. In addition, the global economic downturn has negatively impacted the solar industry in general and has resulted in weakened liquidity of certain market participants, which has created significant uncertainty as to whether the remaining deposits will be received. The Company is in discussions with its customers regarding alternatives to these contractual commitments in the context of facilitating requests that may serve to maintain and enhance long-term customer relationships, including a renegotiation of certain terms and conditions. However, there is no assurance that the Company will be able to preserve the economic return to the Company while adjusting deposits, advances and timing of delivery to better reflect the current environment.
Any inability of the Company to address customer issues, whether regarding delivery volumes, quality or deposits, may delay or reduce deliveries of solar grade silicon, or result in termination of one or more of the long-term commercial contracts, including a repayment of deposits, any of which could also have a material adverse effect on the Company’s financial position, results of operations and liquidity, including in the case of termination of a long-term commercial contract, possible repayment on account of the remaining deposit.
The Company’s revenue recognition policy provides that revenue from long-term solar silicon contracts will be recorded net of an adjustment for estimated returns of scrap material. This estimate will fluctuate, with appropriate adjustments to the return provision, depending on changes in the Company’s experience with the return rate and other assumptions, including the prevailing market price for scrap material relative to the value of the credit customers would receive from the Company for returned material. A significant change in the return rate or other assumptions underlying the Company’s estimates could have a material adverse effect on the Company’s results of operations.
Solar Grade Silicon Production Costs
The Company anticipates that its variable cost of production for solar grade silicon will fluctuate in the short-term, as it continues to refine and optimize production processes at its new manufacturing facilities. The Company has established production cost targets for the purification of solar grade silicon based on long term production levels which it has not yet achieved principally because it is still in the production ramp-up stage.
The key factors that will influence the Company’s achievement of its target include:
- Quality of silicon metal feedstock – Lower impurity levels in the silicon metal that the Company uses as a feedstock for the purification process will provide higher yields of solar grade silicon per volume input into the process.
- In-house production of molten silicon metal feedstock – Cost reductions should be achieved once the current expansion project is complete and the Company is able to utilize molten silicon metal produced at its own facility as feedstock for the purification process as this is expected to enable the Company to eliminate one cycle of re-melting and purification.
- Scale – The Company expects to realize cost savings per kilogram when the current level of production of solar grade silicon is expanded to a planned level of 14,400 metric tons per year, based upon spreading overhead costs across a larger volume, and production efficiencies related to a more flexible plant configuration.
- Continuous process improvement – The Company expects to realize numerous small process improvements over time to enable it to lower production costs.
- Customer Requirements – The specific purity levels required by the Company’s current and future customers of solar grade silicon will impact the amount and nature of the processing that the Company would have to perform.
There is no assurance of the timing and extent to which the Company will be able to achieve its solar grade silicon production cost targets.
Expansion of Solar Grade Silicon Production Capacity
The Company has plans to eventually expand its production facilities in Bécancour to a nominal production capacity for solar grade silicon of 14,400 metric tons per year. This expansion will involve risks, including potential delays in construction of the new facilities and commissioning of equipment, and unanticipated costs and changes in design that may cause the Company’s capital budget for the project to be exceeded. There may also be delays in achieving the full production capacity while the Company is in the ramp-up stage in the new facilities. Failure to complete this expansion or to achieve the anticipated production capacity within the expected timeframe and on budget could have a material adverse effect on the Company’s financial position, results of operations and liquidity.
Protection of Intellectual Property Rights
The success of the Company’s solar grade silicon production and sales depends to a large degree on the protection and development of its intellectual property rights, including proprietary technology, information, processes and know-how. Such protection is based on trade secrets and patents, including two patents pending in respect of the Company’s manufacturing process for the production of solar grade silicon. The Company has received favourable preliminary reports from the international patent examiners in respect of two of its key patent applications. As well, the Company attempts to protect its trade secrets through physical security measures, as well as confidentiality agreements with customers, suppliers and key employees. The Company also enters into licensing arrangements in respect of third parties’ intellectual property rights, and collaborates with key equipment suppliers in the development of technologies that enhance the Company’s product offering. The Company could also be liable to third parties in respect of any infringements of their patents or other intellectual property rights. There is no assurance that the Company has adequately protected or will be able to adequately protect its valuable intellectual property rights, or will at all times have access to all intellectual property rights that are required to conduct its business or pursue its strategies, or that the Company will be able to adequately protect itself against any intellectual property infringement claims.
Purity of Solar Grade Silicon
The Company is currently able to produce solar grade silicon at a purity level of 99.999%, or “five nines”, with levels of phosphorus and boron that are contemplated under existing contracts. The Company has achieved a boron level of 0.5 parts per million and a phosphorus level of 1.5 parts per million, and is striving to consistently maintain these levels. Achieving and maintaining these levels could allow customers to increasingly utilize unblended versions of the Company’s solar grade silicon in their manufacturing activities, which could enhance the Company’s competitive advantage and may allow for increased selling prices and margins. However, achieving and maintaining these levels may also increase the Company’s production costs for solar grade silicon. The Company intends to invest certain resources to achieve improvements in purity levels of its solar grade silicon. However, there is no assurance that the Company will consistently achieve these or any higher purity levels for its solar grade silicon.
Solar Grade Silicon and Silicon Metal Selling Prices
Some of the long-term commercial contracts for solar grade silicon provide for renegotiations on pricing in certain circumstances. These pricing negotiations will be significantly influenced by the prevailing market price of solar grade silicon, and there is a risk that such prevailing market price will decline, whether as a result of any additional UMSi or polysilicon production capacity becoming available or due to declining demand. Such a price decline on incremental volumes could have a material adverse effect on the Company’s financial position, results of operations and liquidity.
The Company’s revenues, earnings and cash flows from the sale of silicon metal are sensitive to changes in market prices. In order to manage some of the price volatility related to these products, the Company enters into contractual arrangements to fix the selling prices for certain periods, generally a calendar year, where possible. However, the Company may not be able to reduce its exposure to such metal price risks.
Pricing and Availability of Raw Materials
Coal is a significant raw material in the production of silicon metal, and the market price of coal is an important factor influencing the Company’s cash flows and earnings. The price of coal has risen in the last few years, and more significantly since the beginning of this year, principally due to supply shortages. The Company has its own internal supply of quartz which is the source of the silicon. The Company has determined that alternate suppliers of quartz have superior quality for the production of solar grade silicon feedstock and accordingly has begun to procure more quartz from third party suppliers. The Company also buys silicon metal in the spot (or open) market to balance its production and thus is subject to fluctuations in market price, which has increased due to supply and demand forces. An increase in the pricing for, or limitations on the availability of, these raw materials could have a material adverse effect of the Company’s financial position, results of operations and liquidity.
Importance of Customer Capabilities in Producing Ingots
The next step in the solar value chain downstream from the Company is the transformation of solar grade silicon into ingots which are cut into “bricks”. The Company has discovered that there is a significant range of experience in its customer base with respect to this vital transformation. The quality of the resulting solar wafers can be quite different depending upon the process adopted for ingot making. To that end, the Company is collaborating with third parties and its affiliates to develop processes to optimize the quality of ingots and bricks made from its solar grade silicon. There is no assurance that such development efforts will be successful or that customers will adopt appropriate processes, and therefore there remains a risk that certain customers will not achieve the results they expected from solar grade silicon.
Limited History with Solar Grade Silicon
Although the Company has experience in producing silicon metal, it has relatively limited history and experience in producing solar grade silicon. As such, the Company’s historical financial results do not provide a meaningful basis for evaluating its future financial performance.
Power Supply
The production of silicon metal is energy intensive and the Company is dependent upon the continuous supply of electricity from third parties for its smelting and other operations in Bécancour. During the first quarter of 2007, the Company suffered an interruption in electricity service, and has since taken measures to mitigate the likelihood of such interruptions in the future. However, there is no assurance that the Company will not be subject to power interruptions in the future.
Risks Relating to the Magnesium Group
Closure of Facilities and Completion of Proposed Transactions with Winca
The Company intends to wind down production operations at its existing magnesium extrusion facility in Aurora, Colorado and close that facility later in 2009. The Company also intends to pursue the transactions contemplated by the non-binding letter of intent with Winca announced on February 18, 2009 that would involve the transition of certain aspects of the Company’s magnesium and specialty metals business and assets to a new merged business, to be known as Applied Magnesium International (“AMI”). The closure of the Aurora magnesium extrusion operations will result in severance payments and other cash closure costs of approximately $3 million, which will be incurred in 2009, and the Company expects to record charges in the first half of 2009 relating to these costs. The majority of the production assets of the Aurora facility were deemed to be impaired during 2006 and written down to fair market value at that time. To the extent that estimated proceeds of disposition, if any, are less than the carrying value of such assets, a charge will be taken in the first half of 2009. The Company expects to recover a significant portion of its investment in working capital as the Magnesium Group’s operations are wound down and the remaining business is transitioned to AMI. The Company expects to generate net cash proceeds from these announced plans during 2009. However, the actual closure costs may exceed the Company’s expectations, and the actual proceeds from disposition of working capital items may not meet the Company’s expectations. Moreover, the proposed transactions with Winca are subject to a number of conditions, including financing and execution of definitive agreements, and are expected to be completed in the second quarter 2009. A failure to complete such transactions on the expected timetables, if at all, could further increase the Company’s severance payments and other cash closure costs relating to the Magnesium Group, or further reduce the proceeds from disposition of working capital items. Any of these events could have a material adverse effect of the Company’s financial position, results of operations and liquidity.
Pricing and Availability of Magnesium Metal
The market price of magnesium metal has a significant impact on the Company’s cash flows and earnings. In the past few years, the price of magnesium metal has significantly increased. The Company purchases the majority of its magnesium metal and is subject to pricing cycles dictated by overall supply and demand for this raw material. Suppliers have demanded increased selling prices for magnesium metal, despite existing supply contracts, and, as a result, there is no assurance that such contracts will fully protect the Company against magnesium price risks. The Company also purchases magnesium in U.S. dollars, but is subject to pricing adjustments based on the exchange rate between the U.S. dollar and the Chinese Renminbi for a portion of its magnesium purchases. The Company attempts to pass on increased magnesium metal costs to its customers. However, existing customer contracts may limit the timing or amount of any adjustments and price increases reduce the competitiveness of the Company’s products.
The Company is currently dependent on the supply of magnesium metal from a number of third party suppliers in Russia and China, and has outsourced certain magnesium production functions to such suppliers as part of its ongoing manufacturing cost reduction initiatives. Financial difficulties or operational constraints affecting any such supplier may adversely affect its ability to continue to produce and supply a sufficient quantity of magnesium metal or to perform outsourced production functions. There is no assurance that any efforts the Company may take in response to or in anticipation of supply constraints will effectively mitigate the Company’s exposure to supply chain risk for its magnesium business.
Other Risks
Financing for Capital Expenditures
The Company’s growth plans will require capital expenditures. The Company is expanding its solar grade silicon production facilities in Bécancour, and may also require capital expenditures for acquisitions, mergers, business combinations, joint ventures, or strategic business alliances or partnerships in respect of its businesses or investments. The Company expects to fund its requirements for capital expenditures from common equity, term debt, credit facilities, operating cash flows and cash balances. However, these sources of financing may not be available to the Company when required in the amounts needed or on acceptable terms. The Company’s existing credit agreement also limits the Company’s financial flexibility in a number of ways, including restrictions on the Company’s ability to incur additional indebtedness, to sell assets, to create liens or other encumbrances, to incur guarantee obligations, to make certain payments, investments, loans or advances, and to make acquisitions or capital expenditures beyond certain levels.
Foreign Exchange
The majority of the Company’s products are priced in U.S. dollars and Euros. The Company reports its results in Canadian dollars, and a substantial portion of the operating costs of the silicon business is in Canadian dollars. Consequently, the Company’s earnings and cash flows are sensitive to changes in exchange rates. The Company enters into foreign exchange contracts from time to time to mitigate its foreign currency risk relating to certain cash flow exposures. However, there is no assurance that such foreign exchange contracts will fully protect the Company against foreign exchange risks.
Customer Concentration
The Company has traditionally had several large customers, the loss of any of which could have a material adverse effect on the financial position, results of operations and liquidity of the Company. At December 31, 2008, one customer accounted for 14% of total sales (for the year ended December 31, 2007 three customers accounted for 39% of total sales). Not all of the Company’s key customers are subject to long-term contracts. Some of the existing long-term customer contracts for the Magnesium Group are currently under renegotiation, and the Company is experiencing significant pricing pressure as a result of increased competition.
Environmental Liabilities
The Company is, and historically has been, involved in businesses that may be deemed to be hazardous to the environment and subject to extensive and changing laws and regulations governing, among other things, emissions to air, discharges and releases to land and water, the generation, handling, storage, transportation, treatment and disposal of wastes and other materials, and the remediation of contamination caused by discharges of waste and other material. The Company has accrued $5.8 million as at December 31, 2008 for future costs relating to site restoration and closure of certain of its former facilities and operations. The actual cost for such site restoration and closure in the future could be higher than the amounts estimated. The Company’s estimate for this future liability is also subject to change based on amendments to applicable laws, the nature of ongoing operations, the timing of future closures and technological innovations. In addition, a violation of environmental or health and safety laws could lead to, among other things, a temporary shutdown of the Company’s facilities or the imposition of fines, penalties or additional costly compliance or remediation procedures.
Interest Rate Risk
The Company is exposed to interest rate risk to the extent that cash and short term investments, bank indebtedness, convertible notes receivable and amounts due to an affiliated company are at floating rates of interest. The Company’s maximum exposure to interest rate risk is based on the effective interest rate and the current carrying value of these assets and liabilities. The Company monitors the interest rate markets to ensure that appropriate steps can be taken if interest rate volatility compromises the Company’s cash flows. However, the Company may not be able to reduce its exposure to all such interest rate risks.
Credit Risk
Accounts receivable, convertible notes and long term receivables are subject to credit risk exposure and the carrying values reflect management’s assessment of the associated maximum exposure to such credit risk. Substantially all of the Company’s accounts receivable are due from customers in a variety of different industries and, as such, are subject to normal credit risks in their respective industries. The Company regularly monitors customers for changes in credit risk. Where available, the Company has insured its accounts receivable under credit insurance policies to offset the increased credit risk environment. However, since all customers may not qualify for credit insurance the Company may not be able to reduce its exposure to all such credit risks.
Liquidity Risk
Liquidity risk arises through excess financial obligations over available financial assets due at any point in time. The Company’s objective in managing liquidity risk is to maintain sufficient readily available sources of funding in order to meet its liquidity requirements at any point in time. The Company attempts to achieve this by maintaining cash positive operations and through the availability of funding from committed credit facilities. As at December 31, 2008, the Company was holding cash and cash equivalents of $4.5 million and had undrawn lines of credit available of US$6.2 million. On October 21, 2008, the Credit Agreement was amended to increase the total maximum credit lines to US$50.0 million. Subsequent to the year end the Company raised $24.2 million in a common equity private placement to further strengthen its overall liquidity. If sufficient sources of funding are not available in the future, the Company may not be able to fully implement its growth plans or strategic objectives, which could have a material adverse effect on the Company’s business or investments.