A123 Systems appearance on the listed market came with full support by both its private investors (incl. Kleiner Perkins via its SC X Management LLC vehicle, North Bridge Venture Management IV) and many institutional investors (GE, Morgan Stanley, Gilden Gagnon Howe & C0., Janus Capital Management, Fidelity, and Invesco) who were happy to get their hands on the stock. But doubts about the firm’s current progress and medium-term outlook are appearing on the horizon.

Our insight
Morningstar put a note out which gives a factual summary of recent activities. The firms market cap is around $1bn (compared to Johnson Control’s $21bn) with a share price at approximately $9.70. Ahead of the analyst call tonight, the stock trades up +5%+ at $10.23. Q1/2010 Sales of $23m is a good sign.

Although the firm still faces major headwind, we continue to support the company’s vision. Nonetheless, we need more transparency from management on how (A) the technology development is progressing, (B) how production ramp-up capabilities are positioned, and (C) how they go about both securing a deeper bench of customers and how management deals with potential bad-debt (Th!nk City?).

Not much to ask for but competition is generally building. In particular we are keeping an eye on Saft Group/ Johnson Control’s JV. Equally, we are also monitoring most of the Asia player’s that are making good progress.

A123 Systems – The Past
AONE went public at $13.50 a share. Surely, Kleiner Perkins hype machine was in full swing to maximize their exit valuation. The stock rose to some $28 before coming down below $10 recently. The fact that this stock was scheduled to IPO at $8 or $9, but ended up at $28 a few weeks later is hurtful because it mismanaged the public’s expectations. So here we are eight months later and the stock goes back to reality- and some people think this is a sign of failure.

What has happened, what changed in the thesis? What changed with regards to customers and customer contracts? Any change in technology developments and/or did R&D plans go wrong? For now, A123 secured significant DOE funding and that gives the firm a cushion to move on with business.

We should not forget that A123 was never profitable and still is a quasi ‘start-up’ company. The company reports in the 12/31/2009 10-k filing that “We have had negative cash flow before financing activities of $56.1 million for 2007, $76.0 million for 2008, and $114.7 million for 2009. We anticipate that we will continue to have negative cash flow for the foreseeable future as we continue to make significant future capital expenditures to expand our manufacturing capacity.”

There is a potential risk in the firm’s limited client base also. We extracted their 10-k filing statement on Customer concentration risk: “During each of the years ended December 31, 2007 and 2008 and 2009, Black & Decker, together with its affiliates, represented 66%, 44%, and 14% of our revenue, respectively. We expect revenue from Black & Decker will continue to decline in 2010 and therefore represent a smaller percentage of our revenue in future periods. During the years ended December 31, 2008 and 2009, revenue from Mercedes-Benz High Performance Engines represented 12% and 8%, respectively, of our revenue, but we do not anticipate receiving any revenue from Mercedes-Benz High Performance Engines in 2010. For the year ended December 31, 2009, revenue from BAE Systems represented 35% of our revenue. For the year ended December 31, 2009, revenue from AES Energy accounted for 9% of our revenue.”

A123 Systems – The Now
The firm’s progress is supported by various government programs [$249.1m from ARRA (DOE) at 1:1 leverage, i.e. $1 from ARRA needs to be matched by $1 from A123’s cash and $233m of DOE ATVM money at 4:1 leverage] that amount to significant cash sums. However, our sources tell us that there is some doubt about the value-added its private investors are bringing to the table to ensure the firm can be retained as a going-concern.

We listened to the Q1/2010 analyst call. Here are the facts and our thoughts:

Management talked about market share growth. In particular, the customer relationship with major EV manufacturers appears to be going well. Specifically, four questions were addressed during the Q1/2010 update call:

(1) Adoption of electrification
(2) Progress with Customers
(3) EV battery prices are declining faster than anticipated
(4) A123 making progress to hit its long-term financial model

On (1) above, the CEO was excited to report on a recent purchase order one of the largest automotive OEM manufacturers. He believes that it speaks to its technology. But could it also mean that there is a lack of choice at that level of scale, in particular in the US market? They further have been selected by Eaton Corporation to help build a new truck- A123 is to deliver the battery system for a Ford F550 truck. This contract can be seen as an extension to their Navistar contract awarded the previous quarter.

In light of rising demand, management is ramping up a further 200MWh of capacity. Once completed this translates into firm-wide capacity of 760MWh (an increase of 350% of end of 2009). Ceteris paribus, this could translate into a total annual revenue line of +/-$500m once completed. In the same breath, the CEO management a generous offer for a $5m forgivable loan from the State of Massachusetts. Proceeds are used to build out HQ, among other things.

As regards to (2) Project activity: the firms pipeline keeps growing and momentum continues to build. Transportation projects doubled since IPO (September 2009) from 18 to 36. 50% are passenger car applications of which 80% PHEV/ EV vehicles. Furthermore, half of the contracts are sourced from a global customer base.

The CEO briefly addressed their Grid/ Consumer business: to sum it up, management did not come across very confident but still put the message out that they can win business.
To that end, management is ramping up its Sales force and enhancing spending over 2009 to grab further market share. AES bought some $5m worth of grid system technology in Q1/2010. We do challenge the view whether, in the medium term, it is viable to focus on all segments in the battery space or whether it would make more sense to concentrate all efforts to become the #1 by volume, number of customers and market share in the automotive sector. As far as cost competitiveness is concerned this may further enhance the time to bring the costs down to make PHEV etc economically viable. Just a thought.

As far as future growth is concerned, management highlighted two areas:

(1) Product Innovation
(2) Cost of Manufacturing

As to product innovation, the firm had filed for 250 patents worldwide prior to the IPO. Since the IPO, the company added 89 patent filings. On a cost-down plan (2012-2013 time frame), internal matrices are in place and engineers are responsible to deliver.

Management felt obliged to comment on Battery system pricing which was reported to be in $350/kWh range. From A123’s standpoint, it is important to look at the ‘usable energy’ not ‘nameplate energy’ alone. Management simply used this headline story to inform us that their system delivers better output than its competitors (i.e. their 20kWh system delivers as much usable energy as their peers 24kWh systems = 20% difference). Secondly, warranty issues and what is covered were addressed. A123 is a diversified business, longer term margins will be most aggressive on automotive systems. In return, grid and more complex system will cushion an overall erosion of margins. Further, the company believes that hosting the technology, sourcing of raw material, keeping production in-house and vertically integrating the value chain is the most viable path going forward. We believe that this may be true in the short term but longer term ‘specialists’ are likely to emerge similar to today’s OEMs. Disagree with us? Comment below!

Overall, it appears that investors need to sit tight before they will see a positive EPS. In particular, as demand for battery systems and electromobility ramps up, A123 is keen to scale alongside the demand. The comment that they are ramping up another 200MWh certainly demonstrates that. In essence we are supportive. In our view however, and we do believe in the EV segments as demonstrated throughout this blog, A123 needs to ensure that it not over-trades. Simply put, without government grants the companies cash position and Working Capital respectively need to be aligned with actual demand rather than ‘potential’ demand alone. In the end, it may take longer for consumer demand to buy into the EV story. (see Th!nk City which was near collapse last year despite several thousand customer pre-orders.)

A123 Systems – the Future
Looking ahead, execution of the business plans remains important. Increasing global share both by number of customers but also by volume must be a key exercise for management. Any announcement to that end should be a positive for the firm. On the technology front, it would be good to get some positive news from the company or from customers confirming that they are on track and happy with the performance, customer servicing, and a ‘felt’ partnership-level relationship. Their technology ultimately is a key factor for success in the long run and very few people mention this. Auto OEMs usually take a long time to test and evaluate- for good reasons. If A123 has a superior battery they will ultimately succeed in spite of potential risks in other areas (to some degree.)

It is important that we focus only on A123 fundamentals such as cash flows, technology and client contracts. Ignoring hype, stock volatility and speculation is key to a more accurate analysis.

We will continue to monitor A123: we would like to see the firm managing their growth adequately and not excessively. We still look back at some of the consumer stories back in the dot.com days as a comparison. No doubt, A123 has a ‘real’ product and its strong governmental support and key relationships with EV manufacturers will see this company go far. Let the share price reflect this, please.

UPDATE: see this article that mentions General Electric (GE) as a potential bidder for A123.