Shares of A123 Systems ( AONE have run out of juice and are down nearly one-third from their high of $28.20. It looks like the IPO hype has faded and the hot-money investors have moved on. Now it's up to the company to produce concrete results that meet investors' huge expectations. A much better way to play the lithium iron phosphate space is China Sun Group ( CSGH.OB. I haven't written about China Sun in a while because I wanted to wait for the company's customer test results to be released. They were released Tuesday and exceeded investors' already high expectations. Technical testing was completed by several customers and, as expected, China Sun's lithium iron phosphate product met the required technical specifications. More important, China Sun announced that it now has 21 customers undergoing technical testing of the product for their own use. Given that the product has already passed technical testing by leading battery producers Shandong Shengong and Beijing Zhongxinlian, I expect that this next wave of testing is just a necessary formality for the 21 new customers. The most significant part of China Sun's recent press release is that the company has signed a letter of intent with Beijing Zhongxinlian to jointly produce its new lithium iron phosphate-based batteries for use in electric vehicles under the registered brand name of "ShenKun." This news is tremendous. China Sun has effectively transformed itself into an end-to-end supplier in the lithium ion battery space, providing all parts of the supply chain from raw materials to finished product. Beijing Zhongxinlian is an existing customer of China Sun, has already completed its required testing and has been selected by China Sun to be their partner. As a result, I view this letter of intent as being much more substantial than a letter by otherwise unrelated parties. This feels more like a contract to me.
One line from the press release that is easy to overlook says: "The companies are now demonstrating a prototype battery to electric vehicle manufacturers to facilitate sales of finished lithium ion products." What this means is that there are already finished batteries in existence, presumably usable in electric test vehicles that are drivable right now. All China Sun and Beijing Zhongxinlian need to do is ramp up production of an already manufactured product. China Sun's stock recently came off a high of $2.10 and fell as low as $1.38 following the release of quarterly financials. This surprised me greatly, because I was very pleased with the company's financial results. Revenue was in line with the previous quarter, and gross margin and net income fell only slightly due to some pricing pressure. In my opinion, the sole reason for the drop in price was a single headline that read, "China Sun Earnings Drop on Lower Sales, Pricing," in the absence of other news flow. Investors who read more should have noted that despite a slight drop in earnings, the company's cash increased by 24% to over $11 million. There is clearly tremendous upside to this stock. The difficulty now is how to quantify that upside. China Sun's current valuation really only reflects its past business, not the new finished battery business. This makes for another interesting comparison to A123. At its current stock price, A123 has a market cap of $1.3 billion based on investors expectations that A123 will grow revenues tenfold in two years and radically transform the business from a money loser to a money maker. China Sun is already profitable based on its existing business and is now launching a new product in a way that should flow immediately to the bottom line. If A123 is successful in achieving its gargantuan tasks, investors will be correct in using the current valuation -- in other words they should make little or nothing on their current investment. If China Sun is successful in achieving its relatively simple task of commercializing its product, its shares should easily be trading in the $5-$10 range within two years.
I base my $5-$10 target on the following back-of-the envelope analysis: China Sun currently trades with a trailing 12-month price-to-earnings ratio of only 11, even though the company has gross margins of more than 30%. The new finished battery business is likely to have gross margins of 30%-50%, which will flow almost straight to the bottom line. If China Sun can double net income in one year, its P/E will be approximately 5.5. However, this is a business that clearly justifies a longer-term P/E of 25-35 -- if not more. Readers should feel free to use their own envelope to do their own analysis, but regardless of the specific inputs, the upside here is huge. The initial price range of A123's IPO had a low end of approximately $9, meaning that insiders were willing to part with their shares at that price. Yet in the aftermarket, the company's shares soared to more than $28.00 and are now sitting at $19.00, still a multiple above the original low end of the IPO price range. Meanwhile, A123 has a lot of work to do to meet the high expectations it has set. According to management targets, A123 would be estimated to achieve revenue of more than $1 billion in 2012, with gross margins of over 30% and operating margins of over 12%. This compares with less than $100 million in revenues right now and negative gross and operating margins. China Sun, on the other hand, has inside ownership of around 48% and no one is doing any selling at these prices. That makes me believe that buying and holding China Sun for two years makes much more sense than buying and holding A123.