A123 IPO - Risky but interesting

I have been trying to decide how much I am willing to pay for shares of A123 which is scheduled to issue shares for the first time (IPO) after market close tomorrow. As I noted in my last post, I am pretty excited about the whole battery sector and this has the potential to draw a lot more attention to the sector. Having said that, this is a risky investment case.

First, A123 is a battery company that makes Lithium phosphate batteries for use in consumer products (ex. cordless drills), vehicles (such as the Chevy Volt which they lost) and maybe the electricity grid. I am not a chemist, but my understanding is that Lithium phosphate chemistry has a better safety profile than Lithium Ion, but doesn't pack quite as much punch either.

Let me start with the risks, because they are more significant than I originally thought. First, if you buy this stock, you are expecting that Lithium phosphate chemistry will participate in the industry growth. Early indications were very good, but GM recently picked LG Chem over A123 to provide the batteries for the Chevy Volt car. Granted, this was just one car, but a company that was able to do much better analysis than I can do determined that A123 was not the best choice. I have heard that A123 may not have had the capacity in place to produce enough batteries and that was a big determinant of the outcome. I don't know if that is true. It could be more substantive issues.

Another big risk is that A123 is involved in a couple legal disputes over patents. A123 has an exclusive license from MIT for some nanotechnology used to make the lithium phosphate batteries. Evidently, there are some other patents that are in dispute. It is possible that A123 could be required to license additional patents which would be detrimental to their ability to turn a profit.

The last big risk really incorporates the others as well. A123 is not profitable right now. How much I am willing to pay for this stock depends a great deal on how soon they can break even, and how big future profits will be. These are difficult projections to make. I did end up buying shares of ENS which has an existing business that is profitable and offers some downside protection. A123 does not have that downside protection.

I hope you are reasonably nervous now. Despite those risks, this is also a company that has tremendous upside if it works. It is part of an industry that I think has huge growth ahead of it. To cut to the chase, I am going to try to buy some shares if I can get it under $9.00 per share.

To get that number I have to make some aggressive assumptions so hold on to your hats. First I think revenues will be $100m this year, then $175m in 2010, $350m in 2011, $525m in 2012 and continued high growth thereafter than gradually slows to 10% in ten years. More importantly, I am projecting an operating margin of -93% in 2009, -30% in 2010, break even in 2011, 5% in 2012, and 10% thereafter. I am expecting battery prices to fall by 8% per year.

If those revenue assumption seem crazy, consider this scenario. There are about 70m vehicles with internal combustion engines sold globally every year. If 5% of those have an advanced battery in 2012, A123 has a 2% market share, and they sell the battery for about $8400 each, that would represent revenue of $588 million in 2012. Of course we have almost no way of knowing whether they will miss or exceed those assumptions, but I don't think they are crazy. This does not include any revenue from the power grid or consumer products.

Under those assumptions, I think the company is worth $9.94 per share, assuming a share count of 111 million after the IPO. I think it is likely that there will be a sentiment multiplier on this stock of maybe 1.2 (people will get excited about this stuff). So this stock could easily trade to $12 per share under that scenario. Given the risks, I am not willing to pay a sentiment multiplier and would like to get it at a discount to my estimated intrinsic value. As such I will probably buy a below average position if I can get it below $9, or buy an average size position if I can buy it closer to $8. My guess is that this will be a very successful IPO however, so there is a pretty good chance I won't get a shot below $9. If you buy some, please remember that this is a stock that can go to zero easier than most, so control your risk with position size and be disciplined on what you pay.

Market Update and Batteries

I apologize for the delay making a post. I have been working through several ideas as well as continuing my job search. But maybe most important for me, I have been refining a valuation methodology that I came up with in grad school, but never really fleshed out. As I have been using it over the last few weeks, I have become increasingly convinced that the overall market is fairly valued between 1000 and 1050 on the S&P500. This is consistent with my prior view that the S&P would be up about 10% this year and another 20% next year. The S&P 500 is currently up about 15% ytd, so a little ahead of what I was expecting. Given that performance and my valuation work, I think the market is most likely to tread water for a quarter or two. The next leg up will need to be driven by real economic data which probably won't happen until well into 2010.

With that view, I think it continues to make sense to be invested in equities since the rally could start sooner than I think, but I think good stock selection or thematic ideas will be key to positive performance over the next few quarters (as opposed to just being in the market).

The theme I have been doing a lot of work on recently is batteries. Not the AA kind, but industrial batteries. There are two trends that are already in play that I think will have a long duration. First, I expect the percentage of vehicles sold around the world that have some level of hybrid capacity will skyrocket. It would not surprise me if hybrid/electric cars represent over 50% of the market within five years. Whether these cars are micro hybrid (use a battery to run functions when car is stopped), mild hybrid (that use a battery to assist the conventional engine), full hybrid (that occasionally use only a battery power to move), or Electric Vehicles (that don't have an internal combustion engine); I think the demand for advanced batteries for vehicles is likely to boom over almost a full decade. The second trend is toward using batteries to stabilize the electricity grid and to integrate alternative power sources into the grid. The existing grid is not good at storing power for peak periods of consumption. Furthermore, my understanding is that peak electricity demand is at about 7pm, but solar output is highest in the early afternoon and wind power is usually highest overnight. Large arrays of industrial batteries are a way to store power during off-peak periods and use it during peak periods. These batteries could be installed at the point of generation (for example, at a wind farm), or potentially in homes across the country (the batteries charge in your basement overnight and then run your AC in the afternoon).

There are a lot of competing technologies as you might expect. Lead acid has been around a long time and is what you use in your car. It is relatively cheap, but the batteries are heavy. There has been a new wave of R&D in this space to see if there can be improvements. If nothing else, it is a proven technology with well established recycling capacity for the lead. Some of that R&D has been toward Lead Carbon batteries, which replace the negative electrode with a carbon based material. This increases the life-cycle of the batteries, reduces their weight, and in some cases improves the speed at which they can be charged. Nickel based batteries are currently the most common in hybrid vehicles. They work pretty well, but there are concerns about the availability of nickel as an input commodity. Finally, lithium ion batteries are the coolest kid on the block. They are much lighter, have higher energy density, but cost a lot more. In addition, there are flow batteries, compressed air batteries, flywheel technology, sodium batteries, all of which are vying for acceptance.

At first, I was trying to determine which technology was likely to be the winner, but I decided that I don't need to. My best guess is that this trend is big enough to accommodate multiple technologies for various applications. The highest performance electric vehicles will probably end up using lithium ion, but mild hybrids can probably use lead carbon as a more economical solution. The power grid probably won't use lithium ion because it will be focused on economics and the cheaper, more established, solutions are more likely to win.

There are three stocks I have decided I like for now. SAFT is a french company (which makes it hard to buy in my brokerage account but maybe not yours) that has a very well established industrial and defense battery business. This offers good downside protection since that business probably won't go away even if my growth thesis doesn't play out. The interesting part is that they have a JV with Johnson Controls to build lithium ion batteries for the auto market. This is not generating a profit yet, but I think the potential is massive. I like this stock under 33 euros. I think SAFT has a great balance of downside protection and a great chance of capitalizing on the lithium ion wave, but I probably won't be buying it unless I switch brokers.

Enersys (ticker ENS) is another established industrial battery company based in the US that is also doing work on lithium ion batteries. Again, their established business provides some downside protection and I think they are especially well positioned to win business from the electricity grid thesis. I like this stock under $25. I currently have a limit order in trying to buy it at $20.10. This is my favorite idea given the low growth assumptions needed to make $25 look attractive.

Finally, Axion Power (ticker AXPW) is a micro cap company that has a lead carbon technology. This one is much more risky because they do not have an established business so you are completely dependent on dramatic growth for their new technology. They lost money in the most recently reported quarter, but they also recently signed some contracts with Exide to provide the carbon electrodes. I just listened to a conference webcast today and it sounded to me that their biggest obstacle is increasing their capacity. Having said that, this one is tricky to value because the range of outcomes is simply massive. I am hoping to buy it closer to $2 per share. For now, I'm watching it and continuing to do more work on it.