What's Under the Hood for IPO A123?
Hybrid car battery developer A123 is in line to go public Thursday, but we're not charged up on the company.
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Battery developer A123 is in line to go public tomorrow, and we are bearish on the company, valuing it at $8.50 per share. Already, A123 has raised its offer range once to $10-$11.50 per share, indicating strong investor interest in the offering. We think the A123's technology has some promise, and give the company credit for establishing research partnerships with several key auto manufacturers, including BMW and GM. At the same time, A123 faces brutal competition and uncertainty around its business. Morningstar equity analyst Anil Daka presents his thesis on A123 below:
"Hybrid cars powered by lithium ion (Li-ion) batteries promise to provide respite from pinching gas prices. A123 Systems' patented Nanophosphate technology makes Li-ion batteries cheaper, faster, and safer for high-energy-density commercial applications, including hybrid cars. While we think A123 has developed a technology that shows significant promise, there could be many a slip between the cup and the lip.
Though gas prices have retreated from historic highs, fuel efficiency remains an important criterion in car selection. Auto manufacturers are responding to consumer demand by investing millions in researching and introducing more fuel-efficient technologies. The primary thrust of this research is in Li-ion batteries that can improve fuel efficiency by as much as 100%. While cost and safety issues are preventing Li-ion adoption on a mass scale, A123's Nanophosphate technology helps overcome both these challenges. We believe mainstream Li-ion hybrids will be introduced by 2010 and almost every car type will see increasing levels of hybridization going forward.
We like that the firm has research agreements with multiple manufacturers. Today, A123 is developing Li-ion technology for BMW, Chrysler, SAIC, GM, Delphi, and Better Place. The firm is also the supplier for Daimler's DAI Orion Hybrid buses and for Think's City car. At this point, none of the major Li-ion battery manufacturers are ready with a deployable technology for auto applications, and A123 seems to have taken a lead.
We believe a key feature of this technology is its flexibility. Along with autos, Li-ion batteries currently find application in energy storage and power tools. The firm has supply agreements with AES and Black & Decker for the aforementioned applications. In coming years, consumer electronics may be another fertile market for these high-performance batteries. We think the flexibility of Li-ion technology will give the firm more options to change strategy, deploy capital, and invest in new assets across varied applications, thereby maximizing return on invested capital.
While A123 has inched ahead, major players such as Bosch-Samsung, Panasonic, NEC, LG Chemicals, and Johnson-Saft are pouring millions of dollars into developing their own Li-ion technology. Commercialization of Li-ion has a long way to go, and A123 will face intense competition from these players in the coming years. At its heart, A123 is still a research firm, and we expect the grind of manufacturing and distribution will be challenging."
As for the fair value estimate of A123, Anil considers several scenarios to get to his final valuation of $8.50 per share:
"The disruptive nature of the technology and lack of historical data creates significant uncertainty around our cash-flow forecast, and by extension, our fair value estimate. We use a probability-weighted scenario analysis to forecast the expected free cash flow of the firm. We assign probabilities for the three cases that A123's technology is superior (40% weight), comparable (40% weight), or inferior (20% weight) to other Li-ion technologies. We think the current research and supply agreements of the firm indicate it has a lead over competitors. Because the technology is disruptive and competition is intense, we extend this scenario analysis for four years to consider several different possible outcomes. We forecast explicit growth and margin rates for each case. In the case that A123 is better than competition, the firm could enjoy margins as high as 30%, while at the opposite end, margins could dip to 10%. We think A123 can also be an attractive acquisition target and can sell for around 12 times earnings before interest, taxes, depreciation, and amortization. We believe the probability of a sell-off will increase from 5% in 2008 to 50% in 2011. We adjust upward our estimate of equity value by $199.3 million to factor in an expected grant from U.S. Department of Energy. We discount our projected cash flows at our estimate of the firm's cost of financing of 14%. We model the number of common shares outstanding after the issue at 96.8 million before factoring in the dilutive effects of stock option exercise."