Why A123 Systems Still Not Worth It

A123 Systems ( AONE) shares reached $28.20 today, implying a market cap of approximately $2 billion. This is more than double its IPO price, and triple the low end of the initial IPO offering range.

Investors are clearly placing a lot of hope in A123's technology, but are also ignoring the company's fundamentals and playing the stock for its momentum.

At the other end of the spectrum, other lithium-ion battery plays such as China Digital Communications ( CMTP) are also trading out of line with their fundamentals, but are undervalued rather than overvalued.

In my last article on A123+, I questioned its valuation when it was trading around $18 per share; I received massive amounts of feedback suggesting I didn't understand the potential for A123's lithium iron phosphate technology. I responded to many of these emails with a simple question: "What revenue and margin forecasts are required to justify the current valuation of A123?" I received zero responses that actually answered the question, so I decided to construct an analysis of my own.

From the IPO prospectus, one can see that A123 has two business lines, battery products as well as R&D services. The majority of revenue and presumably the basis for growth expectations is derived from product sales, so I will confine my analysis to this part of the business.

Historical Financials of A123
2006
2007
2008
1H 2009
Product Revenues
$ 28,346
$ 35,504
$53,514
$36,638
Cost of Product Revenues
(28,960)
(38,320)
(70,474)
(39,186)
Gross profit
(614)
(2,816)
(16,960)
(2,548)
% of product revenues
-2.2%
-7.9%
-31.7%
-7.0%
Total operating expenses
16,517
30,884
67,348
39,493
% of product revenues
58%
87%
126%
108%
*All numbers in US$ millions except percentages.

A few key things to note here. First, A123 has negative gross margins. Every time it sells another product, it loses a bit more money, although in the first half of 2009 it did start coming close to being able to sell its products for above what they cost, coming only 7% short. Second, even if A123 were selling its products at a profit, its operating expenses are still greater that 100% of revenue.

Clearly, numbers like this make it impossible to value A123 in a traditional way, and assumptions are necessary to make any kind of a forecast. To do this, I created a few very generous hypothetical scenarios and tried to answer my original question: "What revenue and margin forecasts are required to justify the current valuation of A123?" I assume a generous, full-year hypothetical 2009 and then compare it to a very generous hypothetical 2011, making assumptions for revenue growth and margin improvement. My analysis looks like this.

How A123 Could Justify Its Multiple
Hypothetical
Hypothetical
2009
2011
Product Revenues
$100,000
$400,000
Cost of Product Revenues
(100,000)
(300,000)
Gross profit
0
100,000
% of product revenues
100%
25%
Total operating expenses
(80,000)
(80,000)
% of product revenues
80%
20%
Income tax expense
0
0
Net Income
(80,000)
20,000
Implied P/E multiple
N/M
100x
*All numbers in US$ millions except percentages.

From the table above, it can be seen that in order to justify a P/E multiple of 100, it will have to do the following things:
  • quadruple revenue.
  • transform from negative gross margins to margins of 25%.
  • maintain operating expenses at current levels with no increase.
  • pay no income taxes due to tax-loss carry forwards.

If A123 does all of those things, net income should be around $20 million, and the current valuation of $2 billion will represent a P/E ratio of 100. With the exception of the tax losses, none of this seems particularly likely.

Compare this with a different lithium-ion battery maker, China Digital Communications. CMTP makes standard lithium-ion batteries for portable devices and has a direct comparable company, Hong Kong High Tech Power ( HPJ). CMTP is highly profitable, with gross margins in excess of 30% and net margins of over 20%. The company has no long-term debt, and the market cap consists of 30% cash. CMTP is in the same business as its Shenzhen neighbor HPJ, but while HPJ trades at a P/E of 21 times trailing 12 months' earnings, CMTP trades at only five times earnings.

For CMTP, I can see two reasons why the stock trades at a discount: its fundamentals and close peer. First, CMTP is not Nasdaq-listed. Second, CMTP has no research analyst coverage. To the extent that these factors change, CMTP is easy to benchmark against HPJ and should be trading at a price in the low $20s, up from its current level of only $6-$7. This would place it on a P/E similar to that of HPJ in the low 20s. It is notable that as recently as August, HPJ was an underfollowed company as well and traded at $1.38 (a P/E of 9) when coverage was initiated by Rodman & Renshaw. Less than three weeks later, it traded as high as $3.89.

With A123, on the other hand, I still see no reason to award it a $2 billion valuation. But if anyone can better answer my question above, I would be eager to hear an informed opinion.

The author can be reached at comments@pearsoninvestment.com.

At the time of publication, Pearason was long CMTP.

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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