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.