Is A123 Facing A Major Inventory Write-Down?

Mar.28.12 | About: A123 Systems, (AONEQ)

On Monday morning investors in A123 Systems (AONE) were shocked to learn that the company was launching a $55 million field campaign to replace defective cell modules and battery packs that were shipped to customers from its Livonia plant.

Tuesday morning I listened to A123's conference call where management explained the problems in greater detail. The defects were apparently caused by a misalignment in one of four automated tab welding machines in the plant. The misalignment was small enough that the defects were not detected by visual inspection and other quality control protocols before the cells were built into modules and the modules were built into packs.

During the call, management explained that while the number of defective cells was a small percentage of total cell production, due to the multi-cell nature of cell modules and the multi-module nature of battery packs, the probability that a cell module would contain a defect was high and the probability that a battery pack would contain a defect was higher still.

While warranty issues are not uncommon with new products made in new factories, I was troubled by management's inability to assess the impact of defective cells on A123's inventories, which included $5 million of finished goods and another $54 million of work-in-process at December 31st.

If the battery packs shipped to customers from Livonia have defects that require a complete pack replacement, then the only reasonable assumption at this point is that all assembled battery packs in Livonia have similar problems.

A more complicated but equally troublesome dynamic exists in the case of work-in-process inventory, which presumably includes cells that haven't been assembled into modules and modules that haven't been assembled into complete battery packs.

If cells that were processed on the misaligned welding machine can be reliably identified and culled from the work-in-process inventory, a portion of the work-in process inventory should be salvageable. If cells can't be traced back to the misaligned welding machine or reliably identified by alternative inspection procedures, the entire work-in-process inventory at Livonia may be in jeopardy.

A123's financial statements don't segregate its $59 million of work-in-process and finished goods inventories on a plant by plant basis, so there's no reasonable way for me to estimate the magnitude of the potential inventory write-down. Under the circumstances, however, I have to believe the substantial bulk of the work-in-process and finished goods inventory in the Livonia plant is suspect.

Until the magnitude of the inevitable inventory write-down is more clearly defined, I'd be cautious about assuming that the announced loss will be the only loss.

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