Valuation Metrics for Alternative Energy Storage Stocks
Over the last six months I’ve written thirty-two Seeking Alpha articles on energy storage, an industrial sector that is developing basic enabling technologies for cleantech, the sixth industrial revolution. My initial plan was to evaluate the relative long-term investment potential of a short list of pure-play energy storage companies by focusing on the performance, costs and benefits of their technologies. While I expected to run out of ideas within a couple of months, readers kept asking incisive and probing questions that deserved detailed answers, so I continued the series and delved deeper into the relative values of the energy storage companies on my list. My core philosophy comes from the work of value investor Benjamin Graham who said, “In the short run, the market acts like a voting machine, but in the long run it acts like a weighing machine.”
Recently, several readers have asked me for a more detailed explanation of the analytical framework and valuation metrics I use to compare companies. Since I’ve previously written at length about the strengths and weaknesses of the principal storage technologies, I won’t revisit those topics today. Instead, I’ll try to focus on how the market’s voting machine is likely to respond to the real world’s economic weighing machine of over time. The following is no more than one man’s considered opinion based on personal experience; but I hope my comments and observations will help readers make better investment decisions.
As many readers know, I’m a lawyer who’s spent the last 30 years guiding entrepreneurial companies through the corporate finance process. Over the years I’ve had countless opportunities to help current and former clients develop their plans and pursue their businesses. In the process I’ve learned that all growing companies face similar problems, challenges and difficulties at similar stages of development. I’ve also developed a pretty good sense of what works and what doesn’t work when the predictable business development issues arise.
Analytically, I divide companies into two classes, speculative investments and everything else. Due to the nature of my practice, the bulk of my experience comes from working with early stage companies and the visionaries who manage them. My experience beyond the speculative investment stage is limited to the occasional special project because as clients grow they invariably require more comprehensive services than my firm can offer. While most financial analysts use far more stringent standards, I classify a company as a speculative investment if:
- The company’s net loss in the most recent year equals or exceeds its total revenue for the year, or
- The company’s net loss in the most recent year equals or exceeds its net worth at year-end.
As soon as a company falls into either of these categories, I eliminate all goodwill and intangible assets from its balance sheet to calculate a “net tangible book value,” which I then deduct from market capitalization to arrive at an “intangible premium” that represents the proportion of the market capitalization attributable to non-financial assets, business expectations and voting machine factors. As a final step, I try to identify the specific business, technical and economic factors that either justify the intangible premium or lead me to believe that the intangible premium is excessive. Since it’s a highly subjective process, I strongly encourage each reader to make his own judgments.
The following table identifies six pure play energy storage companies that I would classify as speculative. For each company, I’ve taken the raw financial data from third quarter SEC reports, folded in reported fourth quarter changes for acquisition and financing transactions and then annualized their nine-month revenue and earnings in an effort to estimate their financial condition at December 31st. I did not try to estimate fourth quarter changes arising from sales or other operating factors. My numbers will undoubtedly be off, but they shouldn’t be off by much.
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If you focus on the intangible premiums, you’ll see a huge variation among the six companies. At the low end of the spectrum ZBB Energy’s (ZBB) market capitalization is only $3.9 million greater than its tangible net worth. In my experience that’s a low intangible premium for a speculative stock. At the other end of the spectrum, Valence Technologies (VLNC) and Ener1 (NASDAQ:HEV) have intangible premiums of $264 million and $464 million, respectively. In my experience, both of those intangible premium are unsustainably high. The three remaining companies are clustered in the $15 to $45 million range, which is low compared to historical norms, but probably not unreasonable under current economic conditions.
Over the years, I have developed a set of touchstone principles that I adhere to when advising speculative clients. Most of them are little more than sound business practice, but in the heady atmosphere of a speculative company, sound business practice is often the last thing people consider because the dreams are more fun. I think they can also be useful for investors who want to evaluate speculative companies:
- Like children in developing countries, small companies rarely starve but frequently die of dysentery.
- Debt is always toxic because nobody wants to invest money that will be used to pay for past mistakes.
- Whenever equity financing is available, take it because you will need it.
- Unless you plan to sell equity at a discount to net tangible book value, any talk of dilution is meaningless.
- If you’re lucky, it will take twice as long and cost twice as much to accomplish any goal.
- Talk about milestones when you pass them, not when you establish them.
- Be cautious with forward-looking statements because broken promises are disastrous.
- Successful manufacturing is far more difficult and expensive than successful science.
- Product testing and marketing cycles are directly proportional to product life cycles.
- Since you don’t want all your eggs in one basket, a product that has several uses is far less risky than a specialty product for a niche market, even if it’s a huge niche.
- Grow your revenues gradually, but make sure the growth is sustained and consistent.
- You need to go with the flow instead of fighting momentum.
- In a competitive market, the cheapest product that can do the work will always take the lions’ share.
Based on the financial data in the summary table, I believe all six of the speculative companies will need additional capital in 2009. Since they follow sound business principles, their capital needs are modest and their intangible value premiums are relatively low, I think ZBB and Axion Power (NASDAQ:AXPW) should be able to attract the capital they need at attractive prices. I am less confident when it comes to Beacon Power (BCON) because it will be years before Beacon’s planned frequency regulation projects make a substantial contribution to overhead. I’m a cynic when it comes to Altair Nanotechnologies (NASDAQ:ALTI) , Valence and Ener1 because they routinely violate sound business principles; their cash needs are far greater than their peers and their intangible value premiums range from moderate in the case of Altair to outrageous in the case of Valence and Ener1. Since new investors always bring a scale and conduct detailed peer group comparisons when they conduct due diligence, I think all three of these companies are in for a very tough time.
While it may be a bit simplistic, I’ve found that my methodology can be useful for comparisons between established companies that are not operating close to the edge. The following table identifies eight pure play energy storage companies that I would classify as established. Once again, I’ve taken the raw financial data from third quarter SEC reports, folded in reported fourth quarter changes for acquisition and financing transactions and then annualized their nine-month revenue and earnings in an effort to estimate their financial condition at December 31st. I did not try to estimate fourth quarter changes arising from sales or other operating factors. My numbers will undoubtedly be off, but they shouldn’t be off by much.
The biggest problems I have with using a table like this to compare established companies arises from immense differences in relative size and the fact that the first four companies on the list are based in China and operate in a business, regulatory and cultural environment that I don’t fully understand. Those problems are compounded by the fact that well-established companies frequently have property, plant and equipment accounts that do not fairly reflect the true value of their underlying assets. Despite the difficulties, I have no problem concluding that China BAK (NASDAQ:CBAK), the largest of the Chinese battery companies, should not be valued at a 30% discount to Advanced Battery, the smallest of the Chinese battery companies. Likewise I have no problem concluding that Enersys (NYSE:ENS) and Exide (XIDE) are undervalued when you compare their market capitalizations with everybody else in the industry.
I used the financial data in the tables, my touchstone principles for speculative companies and a little bit of common sense in connection with the preparation of my recent review and outlook article on energy storage stocks. Since nothing much has changed over the last four weeks, I won’t bore readers by restating my conclusions here. I would, however, encourage new readers who want to better understand the energy storage sector to read as many of my past articles as they can stomach.
Currently, the markets are operating in voting machine mode and because of the economic turmoil nobody really seems to understand what their votes mean. As stability returns over the next year and the nation comes to grips with the massive energy storage issues that confront it, I expect a weighing machine mentality to become more prevalent. When that happens, I expect the market capitalizations of the high premium companies to plummet while the market capitalizations of the low premium companies surge.
Disclosure: Author holds a large long position in Axion Power International, a leading U.S. developer of lead-carbon batteries. He also holds small long positions in Exide and Enersys and plans to buy a small long position in ZBB Energy.