A123 Systems: A Growth Story in the Making

| About: A123 Systems, (AONEQ)

By now everyone has heard plenty of news about the electric vehicle revolution. With gas prices hovering around $4 per gallon, consumers have already began opting for more fuel efficient vehicles versus gas guzzling trucks and SUVs. In Europe, where gas costs as much as $10 per gallon, fuel efficiency is even more important. Whereas it took years for automakers to adopt hybrid technology, there is no shortage of new electric vehicles hitting the market over the next couple of years. The number of electric car offerings are expected to grow from just a few models (e.g., Nissan Leaf, Chevy Volt, etc.) to several makes and models ranging from economy cars all the way up to Audis, BMWs, Porsches, and possibly even Rolls Royces.

Despite all this fanfare, shares of one of the only pure play stocks with exposure to this rapidly growing market, A123 (AONE), are stuck near their all-time lows. After its IPO in Fall 2009, A123's stock jumped from $13.50 into the $20s before retreating to around $10 at the end of last year. Since the start of the year, shares have been stuck in a downhill pattern and are currently below $6. Even after a small bounce after an upgrade from Goldman on April 18, stocks have headed lower again. Goldman suggested that at $6 per share, the stock provided a 2:1 risk reward ratio, protected by the company's book value on the downside.

It's not surprising that investor interest waned over the past 18 months as the company experienced one delay after another, lowering its long-term outlook upon realization that profitability may be farther off than it previously expected. On top of that, heavy competition from well-financed Asian conglomerates such as LG Chem, Panasonic (PC) and Samsung (OTC:SSNLF) have forced the company to compete on price, rather than resting on the technological laurels. A123 found that it needed additional funding to be able to draw the remainder of its government grants and to fund an aggressive capex buildout to better position the company versus much larger competitors.
2010 is a year that A123 is probably happy to bid adieu. The company reported revenue of only $97 million, representing 7% y/y growth and loss per share of $1.46, about a dime behind estimates. Though A123 signed a number of contracts during the year, it generated little to no revenue from its all-important passenger car segment. Fisker-- the company's highest profile customer-- experienced delays, pushing the launch of the Karma luxury sedan out to Spring 2011 and BMW forced the company to build a factory in China in order to secure the partnership, but the factory remains idle until production begins in the second half of 2011. The company's contract with SAIC to produce cars for the Chinese market is not expected to go into production until around the same time. A123 has at least five other passenger car contracts, including one widely assumed to be with GM, but none of them are ready to start rolling yet. Over the course of the year, investors got tired of investing in a story and wanted to see proof of some traction.

If you have a long-term horizon, now is the time to invest in A123. The company is about to gain traction, reaching an inflection point that will propel sales growth exponentially. The pieces of the puzzle are in place for the trajectory to take off. Fisker's Karma will start shipping this month, meaning the company will start recognizing revenue from Fisker starting this quarter. Whereas Fisker initially expected sales of 15k Karmas, a recent Bloomberg article cited that the company expects at least 7k Karmas to ship in 2011. Keep in mind that reviews for the head turning luxury sports sedan have been great, and that 3-5k buyers have already placed $5,000 deposits for the car. With a market size of about 200k luxury sedans, Fisker could easily grab 5% of the market by next year. Most analysts are modeling Fisker Karma sales at about 5k, which implies ~$75 million of revenue for A123, assuming battery pricing of $15k per battery pack based on ~$800 kWh and 20KWh per Karma battery. This represents about one-third of the management's revenue forecast for 2011. If Fisker is able to sell 7k Karmas this year, A123 should generate over $100 million of revenue from Fisker alone, nearly 50% of management's revenue estimate and more than all the revenue generated in 2010.
Fisker should launch the mid-priced Nina sedan by 2013, which could easily sell 20k units given its sub $50k pricing. Sales of 10k Karmas and 20k Ninas at an average price of $10k per battery would generate $300 million of revenue from Fisker alone, in two years. However, analysts are not even including Nina sales given the fact that Fisker is still an unproven start-up automaker.
While Fisker is the biggest customer this year and likely in 2012 as well, A123 has at least eight other contracts that can each generate over $100 million per year once ramped up. BMW and SAIC should begin selling in Q4 of this year at the latest, and others should come online sometime next year. The company was initially expecting to reach $1.5 billion in revenue by 2013, but given the delays,its longer-term outlook has been lowered to $1 billion in 2013. Most analysts are discounting that figure, expecting the company to generate $650-750 million in 2013. Even based on those hugely discounted figures, revenues are expected to double on average each year between 2010 and 2013. Even if half of the customers fizzle out, the passenger car segment could easily generate over $400 million in revenue by 2013.

Another major segment for A123 is the heavy-duty transportation sector, where the company is finding higher margins and much less competition. A123 already has five contracts in place with Daimler (OTCPK:DDAIF), Volvo/Magna, Navistar (NYSE:NAV), BAE and Eaton (NYSE:ETN) that should each generate $20-50 million of revenue when fully ramped. With more sophisticated software required and higher emphasis placed on technology, A123 has quickly secured a top spot among heavy-duty battery suppliers. This business could produce over $200 million of revenue by 2013. The company's third major segment is grid storage, a segment that enjoyed considerable success last year with a huge win with AES. The AES contract includes a number of different projects. Based on the company's estimate of grid storage representing 30-40% of its total revenue long-term, this business could also generate $300 million by 2013.

Though the company would like to acheive double digit EBIT margins within 3-4 years, analysts suspect profitability is much farther off. In fact, no analyst predicts the company to break-even in that time frame, let alone produce double digit EBIT margins. The key to success will be capacity utilization. Last year, given the idle plant in China and the delays with Fisker, capacity utilization was in the 20% range. Since BMW and SAIC will not come online until late this year, capacity utilization is likely to improve to the 30% range this year. However, as the other partners begin rolling production of their electric vehicles, utilization rates should improve to over 50% next year, and possibly approach a more normal level of 80% in 2013.
The company needs to achieve capacity utilization at a more normalized level before it can approach break-even, and eventually profitability. The big key to this path was how the company was going to fund operations and growth to be able to get to 2013. The recent equity financing should have answered those questions. A123 raised $254 million ($116 million of equity and $138 million in the form of convertible debt). This better positions the company to be able to draw the remaining $171 million of government grants (which requires 50/50 equity matching) and the $233 million DOE loan. Together, these funds will bring total sources of cash to nearly $900 million, versus the cash balance of about $250 million prior to the equity financing.
With $900 million of cash on the balance sheet, the company can double its projected year-end capacity of 760 MWh and fund operations for the next 3+ years. Capital expenditures are estimated to be $140-150 million this year. Building out another 760 MWh should not exceed $400 million over the next couple years, and operating expenses for the next 3 years should be less than $300 million (note, I've built in an extra cushion of $100 million in aggregate between these numbers and there is still $50 million of excess cash). With 1500 MWh of capacity, and a cost per KWh of $650 in 2013, the company could generate $800 million of revenue assuming 80% utilization rates. Add in the grid storage business, and you can see why management thinks it can achieve over $1 billion of revenue in 2013, a huge jump from less than $100 million last year.

A123 is still a growth story in the making, but is finally at the point that it can prove its value. Goldman Sachs believes the stock can get back to $9 if it starts producing revenue in line with management expectations, and that the stock can potentially go higher if management can demonstrate a road map to profitability. With a book value between $4 and $5, the stock has downside potential of about 20%, even in a distressed sales situation, and upside potential of over 50%.
If you are convinced in the merits of the electric vehicle market, but are worried that the company will have difficulty maintaining and gaining share vis-a-vis much larger, better capitalized competitors, a safer way to play the stock is through the recently issued convertible bonds. With an annual interest rate of 3.75% (paid semi-annually) and a conversion price of $7.20, there is really no downside in the bond, while you still maintain plenty of upside if the stock jumps above $7.20. Also, the bonds can be converted at any time, but the company does not have the right to pre-purchase the bonds prior to maturity. Given the large offering at $6 last month, shares should find a floor around current levels, but now it’s up to the company to demonstrate it is worth more!

Disclosure: I am long AONE.