Advanced Battery Technologies: Charging Up for the 2008 Olympics

| About: Advanced Battery (ABAT)

On Friday morning I decided to enter a small position in Advanced Battery Technologies, Inc. (OTCPK:ABAT) at $1.43. I sat down the night before and read all of the filings for the past year, and I felt that the company was significantly undervalued and provided solid earnings visibility. This is a venture that entails a bit more risk given the fact that the company is based in China, but I felt at the current valuation, the reward justifies the risk.

The stock is trading at 16 times trailing 4 quarters earnings, and the company is due to report on 4th quarter of 2006 any day now, which will take their 2006 P/E down to about 14. In addition, their recent contract to provide the batteries for 3000 electric sanitation trucks for the Beijing Olympics provides solid revenue visibility over the next year. The company is also bidding for a contract to provide electric buses for the Olympics, and the contract win on the sanitation trucks could be an indication of their competitiveness for this contract.

I’d like to dig in a bit further and explain why I decided to make the purchase, and to highlight the value that I see in ABAT at current prices.

Profile

ABAT designs, manufactures, and markets rechargeable polymer lithium ion batteries (PLI’s) that are used in consumer products such as laptops, PDA’s, and cell phones. Current customers for ABAT’s products include cell phone and laptop manufacturers, as well as a digital camera manufacturer. The company also provides one finished product–a miner’s lamp equipped with a rechargeable PLI. Finally, two years ago, the company decided to enter the vehicle battery space. They have designed a vehicle battery for commuter vehicles that has a traveling distance of 240 miles per charge and can be recharged in 3 to 4 hours.

They have also recently developed a battery for the use in buses and other large vehicles. This battery was designed to allow ABAT to compete for a contract to provide electric buses to Beijing in advance of the 2008 Olympics, and they have recently won a contract to provide electric sanitation trucks for Beijing 2008. The company is based in Harbin, China, and has strong links to the Harbin Institute of Technology. The company has 1260 employees, of whom some 160 are devoted to research and development. The company has a production capacity of approximately $40 million in revenues per year, depending on the product mix.

Review of past operating results (2005 and 2006)

After having largely shut down production in late 2004 in order to build out the capacity of their manufacturing plants, ABAT reported break-even results in 2005 despite the fact that production did not resume until late 2005. Revenues in 2005 were $4.2 million and gross margins were approximately 33 percent.

The company has yet to report full year 2006 results, but through the first three quarters, the company has reported revenues of $9.1 million and a net income of $1.9 million, or just under 5 cents per share. More importantly, the company has shown strong sequential increases in revenue and net income, with revenue increasing from $1.9 million in Q1 to $3.1 million in Q2 to $4 million in Q3. Gross margins have fluctuated within a range of 32.8% to 36.8% in the first three quarters (no doubt a result of product mix), but net margins have shown a steadily increasing trend, from 15.5% in Q1 to 18.9% in Q2 to 25.3% in Q3.

This is a very solid trend, although I would expect that there is not much further room for increasing net margins unless the company is able to grow gross margins in the coming quarters. The company should be reporting full year 2006 results sometime in the next month (last year the Annual Report was filed on April 14th).

Balance sheet

ABAT ended 2005 with a balance sheet that was less than satisfactory according to my standards. At the end of 2005, the company had cash of just under $2 million, and debt outstanding of approximately $4.1 million. This might not seem bad, but when dealing with microcaps, I prefer to see more cash on hand than debt because smaller companies usually have limited access to financing.

With that in mind, the company has used its strong operating results in 2006 to improve its balance sheet significantly. As of it’s Q3 2006 filing, the company had doubled its cash on hand to just under $4.1 million, and had payed down its debt to just under $3.9 million. The fact that cash now exceeds debt is a strongly positive sign, and I expect the balance sheet to continue improving over the coming quarters.

Backlog

As of the Q3 filing, the company had a backlog of $6 million dollars. Since this filing, the company has received a contract to provide batteries for sanitation trucks for the Beijing Olympics worth $10 million. If we assume that the company will do approximately $4.5 million in fourth quarter and $5 million in the first quarter of 2007 (12% sequential revenue growth), the company would still have a backlog of at least $6.5 million at the end of the first quarter of 2007. This does not take into account smaller contracts which are not reported by the company, so it is very likely that the backlog will be a bit higher than my estimate above.

In addition, the company also still has a potential order worth $21 million from the Aiyingsi Company of Taiwan for vehicle batteries. This order, which was originally placed in 2004, has been continually delayed by Aiyingsi. Although the group tested and is satisfied with ABAT’s product, it remains unclear when or if shipments of vehicle batteries will occur. The market appears to be discounting the order based on the delay, and although I am not confident in the order either, it remains a potential area for upside surprise. As there is considerable uncertainty regarding the order, it is not included in the backlog.

2007 Outlook and beyond

Given that the backlog provides strong visibility of future revenues, I have confidence that the company will continue to report sequential growth in the fourth quarter of 2006 and the first two quarters of 2007. In addition, the company has some very interesting opportunities in 2007, especially in its vehicle battery segment. Their recent contract to provide electric batteries to sanitation trucks for the Beijing Olympics might hint that the company has a leg up in receiving a contract to provide electric buses for the Olympics, would should be worth $10 million or more. In addition, the company has substantial room to continue to grow its traditional line of business

Looking out further, ABAT has the opportunity to continue to grow its business by engaging regional and local governments in China looking to adopt cleaner technology. It is no secret that Chinese cities have some of the worst air pollution in the world, and that rapid changes are going to have to be made by the government over the next few years in order to reverse the environmental degradation that is being caused by rapid industrial development. The use of electric buses in Beijing, which is clearly being promoted for the Olympics in order to show China as being proactive about its environmental problems, could lead to the adoption of electric vehicles for public services throughout China. In this environment, the Chinese government may end up being a driving force for the adoption of electric vehicle technology in a way that could never happen in a market based system. If this technology is favored by the government, electric vehicles could have an interesting future in China (and perhaps elsewhere if China can make the technology cost effective).

In addition, I speculate that vehicle batteries would have higher gross margins than the more competitive area of cell phone and laptop batteries. I have no specific data to back this up at the moment, but it seems that increasing the share of vehicle batteries in the product mix should lead to margin expansion, providing for faster EPS growth in 2007.

Risks

Clearly, the company has a great opportunity going forward, but there are some significant risks, and, therefore, I have chosen to allocate only a small amount of my portfolio to ABAT. First, it is necessary to understand the risk of investing in Chinese companies, and especially small cap Chinese companies. Although they are required to file under the SEC, investors are not fully protected from unscrupulous practices by management. Because management resides in China, it would be very difficult to take legal action against the management in the case of misconduct, which is a significant risk of operating in China.

In addition, the other big risk is what happens after 2007. Given the backlog and the buildup to the Beijing Olympics, it is likely that 2007 will be a year of solid growth for ABAT. However, there is a significant possibility of the post-Olympic hangover in China, and that could mean a failure to sustain revenue growth past 2007. Personally, I don’t believe that China is just going to shut down after the Olympics, but for ABAT, sustaining growth will clearly require them to enter new geographic areas of China with their vehicle battery products, and that will likely entail significant investment in SG&A. It remains to be seen how growth will play out after 2007, but given the company’s recent win of the contract for sanitation trucks in Beijing, their technology appears to be competitive, and therefore, I expect that the company will be successful in winning future contracts in other cities in China.

Finally, the company does have competition, most notably from Nasdaq traded China BAK Battery (NASDAQ:CBAK). However, given the contract win for sanitation trucks in Beijing, as well as the short recharging time for its heavy vehicle batteries, it is my sense that the company has a very competitive product in the heavy vehicle market. Although competitive pressures are likely, especially on the lower-end products such as cell phone and laptop batteries, ABAT seems well suited to handle this competition.

Valuation

I would caution investors against using the P/E found on Yahoo Finance or Marketwatch, as it is not very instructive due to some one time charges from the fourth quarter of 2005. Because we have good earnings visibility for the fourth quarter of 2006, we can create a reasonable valuation estimate.

If we project fourth quarter 2006 numbers at $4.5 million in revenue (12% sequential growth) and steady net margins at 25%, this would yield net income of about $1.13 million, or about 2 cents per share (assuming the share count comes in at just over 50 million). This would give full year 2006 earnings of around 7 cents per share, which means that ABAT is trading at 20 times its 2006 earnings. I would also add that given the trend of revenue growth in previous quarters, 12% sequential growth is rather conservative.

Given the backlog at year end of 2006 was likely around $11 million, we have strong visibility for 2007 revenues as well. Given that we are still early in the year, I think it would be safe to assume that the company will be able to deliver at least $18 million in revenues, which would represent 32 percent growth. This seems to me to be a very conservative estimate, with a more likely range being in the $20-$25 million range. However, even at this conservative estimate, if we assume that net margins will expand to 28 percent (representing higher margin vehicle battery product increases, as well as declining operating expenses as a percent of revenue), the company will earn about 9.5 cents per share in 2007 (assuming 55 million shares out, an increase of 10% over 2006). This would give the stock a forward P/E of just 15, which appears to be quite cheap given the revenue and EPS growth the company has managed to deliver in the past.

If we take a slightly more aggressive (but still very achievable) estimate of revenues of $22 million, then EPS would come out at just over 11 cents per share for 2007, and the forward P/E drops to 13. For a company that has been delivering 100+ percent revenue and EPS growth in its most recent quarters, this appears to be a very cheap valuation indeed. If the company is able continue to increase its backlog in the coming quarters, I would expect the forward P/E to rise to at least 20, representing the strong visibility for 2007 earnings. This should drive the stock above $2, and depending on the size of contracts, it is possible that the stock could be valued at close to $3 as the year plays out.

Summary

ABAT is clearly a higher risk, higher reward venture. The fact that it is operating in China, as well as worries about the post-Olympic hangover, make ABAT a more risky investment than my core holdings.

However, the fact that the balance sheet has shown steady improvement, and that the company’s backlog gives strong earnings visibility over the next few quarters, serves to mitigate some of the risk of investing in a fast growing Chinese company. In addition, the valuation appears to be quite reasonable when taken in the context of historical and expected future earnings. At 20 times 2006 earnings, the company appears quite reasonably priced.

These facts allow an investor to have confidence that the business will remain sound over the next few quarters, which allows him the flexibility of waiting for further catalysts to drive the stock price higher. The potential for a large contract for electric buses for the Beijing Olympics is a potential catalyst, and seems to have a reasonable likelihood given the recent contract for sanitation trucks. In addition, the potential for future orders of the company’s mining lamps, cell phone batteries, laptop batteries, etc, could potentially drive the stock price higher. Finally, the delayed contract with Aiyingsi, which is valued at $21 million dollars, would definitely drive the price higher if it is finally confirmed. Given that the company already has a capacity to produce $40 million worth of product, the company is well set up to handle an increase in orders, and should be able to capitalize very quickly on any opportunity to expand.

Overall, the company appears to have significant upside potential, and the backlog provides downside protection over the next few quarters. Given the already cheap valuation and improving balance sheet, ABAT is providing investors with an opportunity to participate in potentially rapid growth with a limited downside to the BUSINESS (the stock price will, as always, be subject to volatility) over the near term. The potential reward justifies the risk of investing in ABAT, and therefore, I have allocated a small piece of my portfolio to the company.

Full disclosure: The author is long ABAT.OB

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