Alternative Fuels Make a Good Alternative Investment

by: Aaron Foster, CFA


Commercial grade lithium-ion batteries are poised to take advantage of a rapidly evolving automobile industry. Through advanced chemistries and efficient manufacturing techniques, battery powered cars could represent a majority of future solutions for automobile manufacturers as they attempt to tackle issues related to increasing fuel efficiency standards and consumers' growing distaste for expensive oil based fuel.

If vehicles powered by battery are truly the future of the automobile industry, it's appropriate to understand who will be profiting from the production of these battery powered lithium-ion "engines." While mass production at lithium-ion battery manufacturers is yet to begin, several large auto companies have established relationships and inked deals for future vehicle models. However, there is currently a dilemma to be resolved before any mass production takes place. The auto makers are telling the battery companies they need to ramp production capabilities before receiving a supply contract, while battery companies are waiting for the supply contracts before commencing mass production.

It is completely plausible that perhaps many of the finer details of today truly matter. Considering the battery market currently has just $10 billion of capacity available, and the battery market is projected by some analysts to reach $20 billion by 2015, automobile manufacturers may end up purchasing lithium-ion battery engines from anyone that can produce them. Furthermore, the market for automotive-grade batteries could grow to over $150 billion by 2030, according to Alliance Bernstein.

One of the best pieces of evidence supporting why battery powered automobiles will be a major piece of the solution comes from venture capitalist James Woolsey. He brings attention to the fact that off-peak charging of vehicles at night would use unutilized capacity. The DOE's Pacific Northwest National Lab estimates that electric cars could constitute 80% of the nation's 220 million passenger vehicles before new baseload electricity plants would be needed, assuming cars are charged at night.

As energy independence, climate change, and a dying auto industry continue to become larger issues in the United States, battery powered vehicles become much closer to reality. President Obama proposed a plan to have one million electric cars on the road by 2015. However, the prospect of consumer adoption in the U.S. is uncertain considering current electric powered vehicles and models only allow a drive of 200 miles before a re-charge is necessary. Although most Americans rarely drive further than 200 miles at one time, the mental block could be enough to slow mass adoption.

Although many battery companies have received federal grants and low cost loans to further ramp production, and many companies have already established relationships with both small and large automobile manufacturers, the future is still very uncertain. The main risks to investing in a battery producing company include: 1) declining oil prices, 2) lack of popularity among consumers, 3) reliance upon China for lithium supplies and 4) inability to differentiate the potential industry winner.


Oil Price Decline

The rapid increase in the price of oil in 2008 is one of the key reasons electric vehicles and other alternative fuel strategies have come into focus. When oil prices reached all time highs in the $140 and above range during the summer of 2008, the United States and many investors in other parts of the world quickly began developing ideas and allocating both private and government money towards alternative energy projects. While these projects have certainly not been abandoned and money continues to flow towards these investments, it is worth noting that the price of oil has since fallen below $100 per barrel until just recently. While many analysts believe this price is still plenty high enough to warrant shifting away from oil dependence, if the price starts to decline again, and then translates to lower gas prices at the pump, battery powered vehicles may not be entirely necessary in the minds of most consumers. Saving on fuel costs will be the primary pitch to consumers, along with climate change. Considering a battery powered engine costs approximately $20,000, and isn't necessarily guaranteed to last as long as a gas powered engine, the costs for electric vehicles will initially be more expensive than comparable gas powered vehicles.

Consumer Adoption

The number of factors that will determine whether or not battery powered vehicles are successful seem to be countless, but perhaps the most important aspect of the situation is whether or not consumers feel comfortable purchasing the vehicles. At the end of the day, the mass public will need to embrace the battery powered engines and prefer them over gas engines, all else equal. The jury is still out on whether or not cost savings will attract a large number of converts primarily because the dollar amount of savings is difficult to predict with a high degree of certainty. Americans have long had a love affair with the internal combustion engine. Muscle car aficionados and truck lovers will probably find it very difficult to replace the power and feel of a gas engine. However, it's important to note that not every car has to become battery operated in order for a battery production company to be considered a profitable investment. Considering there are 220 million passenger vehicles on the road in America, Obama's 1 million car goal suddenly doesn't seem very intimidating. Hybrid electric vehicles sold by Honda and Toyota have witnessed solid demand, and the Toyota Prius has already cracked the top 10 in overall U.S. sales.

Tesla Motors (NASDAQ:TSLA), based out of Silicon Valley, has also already started selling their Roadster model, which caters to drivers who have a taste for fast and sleek sports cars. Tesla will also soon offer a sedan version of their vehicle. While none of these factors ensure there will be widespread adoption in the U.S., it has at least started the movement and brought attention to the concept. However, while consumer acceptance remains a question abroad, it's interesting to note that Europe and Asia have been much quicker in embracing electric powered vehicles.

China Supplies

As mentioned, the rapid deployment of capital towards alternative energy projects was for the most part spurred by the rapid increase in oil prices in 2008. Climate control has also played a large factor, however it's likely that high gasoline prices provided the initial spark of urgency behind finding alternative sources of power. Interestingly, most of the world's resources for the inputs into lithium-Ion batteries come from China. Therefore, it's entirely possible that battery powered vehicles won't solve any energy dependence issues whatsoever. Instead, the U.S. would simply be shifting their reliance to another country.

Which Company?

While it's established that if electric vehicle demand takes off, all of today's current companies could work at full production capacity and still fall short of many analysts' expectations for orders. If these expectations come to fruition, most any company that stays in business should profit handsomely. However, there are reasons to believe that no U.S. based company will be able to compete with China's battery production capabilities given their significantly cheaper sources of labor and ownership of raw supplies. American companies such as A123 Systems (AONE) and Ener1 Inc. (OTC:ENON) can probably be considered "all or nothing" bets, meaning they will either provide huge gains for investors or result in a complete bust. While A123 has established relationships with some major auto companies, Ener1 is relying more on smaller auto manufacturers. Whatever the case, it will prove to be very difficult to compete with China's BYD Company (OTCPK:BYDIF) and other foreign corporations with access to inexpensive labor and abundant national resources.

It's important to note that none of the independent "pure play" battery companies are profitable at this point in time. Valuation is very much dependent on future years' expected profits and production expectations. Funding needs for companies in this industry could involve raising capital via stock issuance, diluting existing shareholder equity, or through debt issuance, which would be a drag on future EPS earnings. Considering a majority of the potential equity value is derived from projections several years into the future, the market has created a quasi-speculative investing environment.

Nevertheless, the upside potential of any of the publicly traded companies involved in this industry is immense and worth the risks involved for an investor who wishes to allocate assets to relatively higher risk/return ideas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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