A Lithium-Ion Battery Play From China

Editor's note: This is the first column from Rick Pearson, a Beijing-based private investor focusing on U.S.-listed China small-cap stocks.

BEIJING ( TheStreet) -- Judging from its latest earnings announcement and conference call, Advanced Battery Technologies ( ABAT) is pursuing a new and less-profitable direction.

ABAT essentially is following a business model that will place it squarely in the highly competitive electric-vehicle space rather than in the highly profitable Li-ion battery space. The markets immediately recognized this, driving ABAT down by more than 10% to $3.90 Thursday, and down from a recent high of $5.04 on Aug. 6, a decline of 23%.

Over the past year, ABAT has twice diluted shareholders by raising equity/equity-linked financing and intends to use the new funds to expand in a less profitable but more visible and rapidly growing business area, namely electric vehicles via wholly owned subsidiary Wuxi Zhongqiang Autocycle.

While ABAT did its best to post nice-looking numbers, the underlying deterioration of its business model is clear. Revenue rose 29% to $13.8 million from last quarter, primarily on increased sales of its wholly owned subsidiary, Wuxi ZQ. As a result, even with Wuxi ZQ sales accounting for only 26% of revenue, total gross margin fell from 50.8% to 45.8%.

Sales via Wuxi ZQ are expected to comprise an ever growing-portion of ABAT sales, resulting in increasing pressure on its gross margins.

Moreover, while profit increased a seemingly impressive 122% to $8 million quarter over quarter, the increase was due to a one-time gain of $9.9 million on the purchase of Wuxi ZQ. It's unclear how that gain was calculated.

Excluding the one-time gains, net profit would have been $1.3 million, a decrease of 50% quarter over quarter, representing a net margin of only 10%.

I originally entered my position in ABAT when ABAT was still an OTC BB-traded company focused on providing profitable Li-ion battery units to end-battery users. Two things have changed since then that caused me to exit my position in ABAT.

First, ABAT has raised over $40 million of highly dilutive financing to pursue the electric-vehicle market, which is already highly competitive and becoming more so every day. Margins will unquestionably come under greater and greater pressure.

Second, the entry into the end-use Li-ion battery market by Cnooc ( CEO) through its $720 million investment in privately held Tianjin Lishen to set up 20 new Li-ion battery production lines will also add pressure on margins of end-use battery makers. This new entry is just the beginning of the next wave of entry into the end-use Li-ion battery manufacturing space.

My new pick for playing the profitable Li-ion space is another still-as-of-yet OTC BB-traded company, China Sun Group ( CSGH.OB). CSGH is poised to benefit strongly from increased investment in the end-use battery manufacturing space because it is a supplier of cobalt-based and lithium iron phosphate products to the end-use battery makers.

The valuation of CSGH is worth noting. China Sun Group, the second-largest cobalt series production in China, is due to report earnings within the next three weeks and is expected in coming weeks to report test results from customers testing its new Lithium-ion phosphate product.

For the nine months ended Feb 28, CSGH already has achieved revenue of $27.4 million, an 8.3% increase over full-year 2008 results. Assuming a broad range of $5 million to $10 million for the fourth quarter, CSGH will show year-to-year revenue growth of 28% to 49%.

For the first three quarters, gross margin has been maintained at 37%, while net margin has held at 22% to 23%. Again, assuming the company posts $5 million to $10 million in revenue for the fourth quarter, it would result in full-year earnings growth of 9.5% to 26.6% year over year. This would imply a current P/E vs. full-year 2009 of approximately 4.9.

The company is cash flow positive, has no debt and has cash on its books in excess of $12 million.

China Sun's position as a supplier to battery makers, as opposed to being a battery maker itself, is a favorable investment consideration, yet it continues to trade at a significant discount to battery makers such as ABAT and China Bak Battery ( CBAK).

Following its convertible financing in June, and based on a fully diluted share count, ABAT trades on a P/E of about 17 times trailing 12 months. CBAK's current share price implies a $190 million market cap despite the fact that over the past five quarters it has had only one profitable quarter, when it posted $480,000 in pre-tax income.

While CBAK continues to note progress in securing automotive contracts, its low gross margin of only 11% means that it will need to achieve significant volume in order to justify its current valuation. CBAK will also face inevitable pressure from new entrants such as Tianjin Lishen.

I continue to believe that the smart way to play the lithium-ion battery space is not in buying battery makers, but in buying the suppliers to the battery makers, particularly given the sustainability of margins.

Over the past three months, CSGH issued two press releases noting that production of lithium ion phosphate has already begun at its Dalian facility and is currently undergoing natural decay testing by six potential customers.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider ABAT, CBAK and CSGH to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Pearson was long China Sun Group. Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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