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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 (OTC: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 (OTC:CMTP). CMTP makes standard lithium ion batteries for portable devices and has a direct comparable company, Hong Kong High Tech Power Co (NASDAQ: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

Source: A123: Investors Are Forgetting the Fundamentals