Energy Conversion Devices: An Amorphous Gem

| About: Energy Conversion (ENER)

Probably the most intriguing and fascinating company in the world is Energy Conversion Devices (NASDAQ:ENER), also known as ECD, also known as Ovonics. It has been a public company for more than forty years, yet few people know of its existence. Products using the technology developed by this company include the MIR space station, solar powered airplanes, and the batteries that enabled the development of the EV1 (electric car) and the Prius hybrid, all of which are based on the science of amorphous materials, which some decades ago many scientists dismissed as an uninteresting and almost useless area of science. The man that proved the value of these materials and science is the founder of the company, Stan Ovshinsky, who didn't attend college and is an autodidact. Stan and Dr. Iris Ovshinsky, together with many brilliant scientists and engineers (like Jeffrey Yang and S. Guha), have developed over the years one of the most valuable patent portfolios in the world (e.g. the company is included in the Ocean Tomo 300™ index). Yet, despite these amazing inventions, the company has yet to show an operating profit.

Why should someone invest in a company that has been unable to make an operating profit for more than forty years? Because many things have changed making the future look very bright for the company, and it looks like it will finally be able to construct the business after spending so many decades working on the R&D foundations.

Arguably, the most valuable division is Unisolar, which is the only large solar company offering flexible & lightweight thin-film solar panels. These panels have an important competitive advantage in that they are ideally suited for BIPV applications (building integrated PV). In other words, they not only produce energy, but serve as the roof too. Being lightweight and flexible reduces installation costs, and in some cases they are the only solar option some buildings can choose without having to reinforce the building structure (it is calculated that approximately 30% of buildings fall in this category). Unlike CdTe solar panels from First Solar that use toxic and scarce materials, Unisolar's solar panels use abundant materials that are environmentally benign. The company is currently producing approximately 58 MW per year, and is on track to increase production to almost 180 MW next year (the goal is 300 MW in 2010). Something that investors should be realizing (which judging from the pps is not the case) is that more than 50% of sales are exports (therefore the company benefits from a weak dollar), and margins are expected to increase significantly.

There are several forces driving margin expansion:

1) economies of scale

2) higher production yields

3) higher product efficiency

4) higher throughput per machine.

The company is targeting 25%+ gross margins (which seems to be conservative and considers ASP reductions). If ASPs fall to $2/watt by 2011, assuming 15% net profit margin and 300 MW production, the company would be looking to make 90 million dollars in 2011. A 30 p/e ratio would produce a 2.7 billion market cap, discounting to the present at a 15% rate would yield a net present value of almost 1.6 billion dollars. The company has enough cash to build capacity to at least 180 MW, and might be able to attain 300 MW using cash flows.

But that is not the end of the story. The company owns, on a fully diluted basis, about 1/3 of a little company called Ovonyx. This company has licensed its memory technology to semiconductor giants like Intel (which is a partner in Ovonyx), Samsung, Elpida, Hynix, Qimonda, and ST Microelectronics. The memory technology is based on chalcogenide materials,and is called PRAM, OUM, PCM, CRAM, and phase change memory. It is expected to replace NOR flash memory, and could also eventually replace DRAM and NAND flash. Samsung has announced production of a 512Mbit part in 2008, and Intel a 128Mbit part that could arrive as soon as the end of this year or early 2008 (Intel's part codename is Alverstone).

What's interesting for investors is that phase change memory could become a 40 billion+ market in a few years. The royalty rate is not known, but they usually tend to be around 25% of gross profits. Assuming 12% gross profits for semiconductor companies, the royalty rate should be around 3% (about 1% for ENER). To try to give a valuation to this part of the company I am going to assume a 40 billion phase change memory market in 2017, .7% royalty received by ENER (assuming a conservative 2.1% royalty rate), 25 p/e ratio, and will use a 20% discount rate. That results in a net present value of approximately 1.1 billion dollars (ENER has significant tax loss carry forwards).

The company also owns 50% of a JV called Cobasys that is the only North American manufacturer of NiMH batteries for hybrid vehicles. There is too much confidentiality and ambiguity around this JV, but hopefully it is worth something, especially with oil close to $100.

If these valuations are approximately correct, the company is selling today at less than half of its intrinsic value (a good margin of safety), and its wonderful technology promises to give the company a wide moat in the future, allowing it to obtain high returns on invested capital (therefore becoming more and more valuable as time goes by). The new CEO Mark Morelli seems to be very smart and very hard working; he comes for the Carrier division of United Technologies. There was some insider buying recently, and approximately 30% of the shares are shorted. With so much pessimism and such a bright outlook, don't be surprised if ENER becomes the stock of the century.

Disclosure: Author holds a long position in ENER

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