A123: Investors Are Forgetting the Fundamentals

Yesterday A123 Systems (AONE) reached $28.20, implying a market cap of approximately $2.0 billion. This is more than double its IPO price, and triple the low end of the initial IPO offering range. Investors are clearly placing a lot of hope in A123’s technology, but are also clearly ignoring the company’s fundamentals and playing the stock for its momentum.

At the other end of the spectrum, other lithium ion battery plays such as China Digital Communications (CMTP) are also trading out of line with their fundamentals, but are undervalued rather than over valued.

In my last article on A123, I questioned the valuation of A123 when it was trading around $18 per share and I received massive amounts of feedback suggesting I didn’t understand the potential for A123’s lithium iron phosphate technology. I responded to many of these emails with a simple question: “What revenue and margin forecasts are required to justify the current valuation of A123 ?”. I received zero responses which actually answered the question, so I decided to construct an analysis of my own.

From the IPO prospectus, one can see that A123 has 2 business lines, battery products as well as R&D services. The majority of revenue and presumably the basis for growth expectations is derived from product sales, so I will confine my analysis to this part of the business.

Historical financials are as follows:

	2006		2007	2008		1H 2009
Product Revenues	$ 28,346		$ 35,504	$53,514		$36,638
Cost of Product Revenues	(28,960)		(38,320)	(70,474)		(39,186)
Gross profit	(614)		(2,816)	(16,960)		(2,548)
% of product revenues	-2.2%		-7.9%	-31.7%		-7.0%
Total operating expenses	16,517		30,884	67,348		39,493
% of product revenues	58%		87%	126%		108%

All numbers in US$ millions except %s

A few key things to note here. First, A123 has negative gross margins. Every time it sells another product, it loses a bit more money, although in 1H 2009 it did start coming close to being able to sell its products for above what they cost, coming only 7% short.

Second, even if A123 were selling its products at a profit, its operating expenses are still greater that 100% of revenues. Clearly numbers like this make it impossible to value A123 in a

traditional way and assumptions are necessary to make any kind of a forecast. To do this, I created a few very generous hypothetical scenarios and tried to answer my original question: “What revenue and margin forecasts are required to justify the current valuation of A123?”.

I assume a generous full year hypothetical 2009 and then compare it to a very generous hypothetical 2011, making assumptions for revenue growth and margin improvement. My analysis looks like this.

	Hypothetical 2009		Hypothetical 2011
Product Revenues	$100,000		$400,000
Cost of Product Revenues	(100,000)		(300,000)
Gross profit	0		100,000
% of product revenues	100%		25%
Total operating expenses	(80,000)		(80,000)
% of product revenues	80%		20%
Income tax expense	0		0
Net Income	(80,000)		20,000
Implied P/E multiple	N/M		100x

All numbers in US$ millions except %s

From the table above, it can be seen that in order to justify a P/E multiple of 100x, it will have to do the following things:

• quadruple revenues
• transform from negative gross margins to margins of 25%
• maintain operating expenses at current levels with no increase
• pay no income taxes due to tax loss carry forwards

If A123 does all of those things, net income should be around $20 million and the current valuation of $2.0 billion will represent a P/E ratio of 100x. With the exception of the tax losses, none of this seems particularly likely.

Compare this to a different lithium ion battery maker, China Digital Communications (CMTP). CMTP makes standard lithium ion batteries for portable devices and has a direct comparable company, Hong Kong High Tech Power Co (HPJ). CMTP is highly profitable, with gross margins in excess of 30% and net margins of over 20%. The company has no long term debt and the market cap consists of 30% cash. CMTP is in the same business as its Shenzhen neighbor HPJ, but while HPJ trades at a P/E of 21x ttm earnings, CMTP trades at only 5x earnings.

For CMTP, I can see two reasons why the stock trades at a discount its fundamentals and close peer. First, CMTP is not nasdaq listed. Second, CMTP has no research analyst coverage. To the extent that these factors change, CMTP is easy to benchmark against HPJ and should be trading at a price in the low $20’s, up from its current level of only $6-7. This would place it on a P/E similar to that of HPJ in the low 20s. It is notable that as recently as August, HPJ was an under-followed company as well and traded at $1.38 (a P/E of 9x) when coverage was initiated by Rodman & Renshaw. Less than 3 weeks later it traded as high as $3.89.

With A123 on the other hand, I can still see no reason to award a $2.0 billion valuation. But if anyone can better answer my question above, I would be eager to hear an informed opinion.

Disclosure: The author holds a long position in CMTP

Comments

[Ben B.:]

That was a hysterical article (not sure if it was intended to be).

Anybody that's been to a battery conference knows why opex runs so high for these guys: they spend a TON on getting their name out there. Certainly they've made good headway with vehicle OEMs, but a $2B valuation implies that (a) they're the 100 lb gorilla in the industry; and (b) that the industry won't ultimately convey auto parts (i.e., not good) margins. Neither is likely to be true.

I will say one thing - AONE did a good job at spreading out the underwriting pie to just about every investment bank out there, so you won't be hearing themes like this from the sell side any time soon.

Oct 06 08:29 AM

[fawnpass:]

China digital technologies (formerly CHID) has a rather sordid past, only recently rebranded with a new ticker and soon to be new name. Seemingly formerly solid company that has been torn apart by seemingly fraudulent management (shell businesses moving around). No, not a basher, but I did own the stock when all of a sudden they sold off the lithium division in a trade to gain a carved wood idol business. Now, somehow they have the lithium business back. That's the reason for the lagging price. Soon they will have a new name along with the new ticker symbol and their past may be forgotten. I advise new shareholders to do their DD. Perhaps the company has changed.

Oct 06 09:24 AM

[j baker:]

This is purely a momentum play. I played RST up to 32, this will go to 30. it may take a day, two or even a week, but my guess is we will see some action today into the midweek. Don't panic on this one. They have govt funding among other things.

Oct 06 12:50 PM

[Road Runner:]

A123 is a speculative play based on the idea that Li-ion battery sales are going to skyrocket over the next 5 years. Sales are supposed to go from 10s of millions to 10s of billion of dollars. That's like a 1000 fold increase in sales.

Currently, the battery market is relatively small which includes vehicles starting, portable electronics devices, flashlights, remote controls, etc. These are "sideshow" applications. But, in the future, batteries are going "mainstream" in all-electric and hybrid-electric vehicles, and power grid smoothing. Both of these applications are giant on their own, but together, “oh wow”.

I believe that A123 has one of the premier batteries for this coming energy revolution. It's battery is ultra-safe Lithium Iron Phosphate using a "bleeding edge" "nano" manufacturing process. I believe it will be one of the "gold standard" batteries.

Why do I think this? My investment approach is to do the standard research like in this article, and market analysis, and competitive analysis, etc. But, I also like to “try out the product” (see Circuit City comments below). Since I found it very difficult to try out A123 batteries, I did the next best thing. I looked for user stories on the web. I came across radio controlled (RC) user blogs. These guys were getting A123 batteries from Dewalt power tools and putting them in their RC planes. And, this is the big part, they were testing the limits, bordering on torturing of the A123 batteries. They were tracking the number of cycles, how much capacity was lost after hundreds of cycles, how reckless they could be in charging the batteries, how fast they could charge the batteries, how long they could fly at full power, etc. There was nothing but bragging on these blogs.

One interesting story was an RC flyer who had just put an A123 battery in his plane. He was so impressed by the results that he flew the whole session at full power which I understand is not advisable. After a while he saw blue smoke coming out of the plane. When he landed the plane, he realized that he burned up his motor. But, when he touched the battery, it was cool to the touch.

Extra. I believe that investors in Circuit City would have known their stock was in trouble if they visited both Circuit City and Best Buy stores. The Best Buy stores are alive with activity and light, and their sales force, with the Geek Squad, were very helpful and professional. I found the opposite with Circuit City stores, especially how dark and dreary the stores were.

Oct 06 02:22 PM

[Road Runner:]

I meant to say "burned up his motor controller" above.

Oct 06 02:27 PM

[TinyTim:]

RR
" The Best Buy stores are alive with activity and light, and their sales force, with the Geek Squad, were very helpful and professional. "

Not mine. The sales people are surely and lazy.

Oct 06 04:58 PM

[j baker:]

It seems to open with a good dollar and change run, I will look for it tomorrow.

Oct 06 07:42 PM

[Road Runner:]

TinyTim, Sorry. It's like any chain - there's always those badly managed stores no matter how well the chain is run. I'm in Dallas. The 5 or more BB stores I've visited here are well run. Though I've meet a few grumpy workers.

On Oct 06 04:58 PM TinyTim wrote:

> RR
> " The Best Buy stores are alive with activity and light, and their
> sales force, with the Geek Squad, were very helpful and professional.
> "
>
> Not mine. The sales people are surely and lazy.

Oct 07 03:38 PM

[j baker:]

well, it ran some today, I think it consolidated and will run more tomorrow (AONE)

Oct 07 11:26 PM