VC land a coup & A123 loses its CFO

Black Coral Capital, Flybridge Capital Partners, Stata Venture Partners landed a coup when they announced that A123 CFO Michael Rubino was going to join their venture backed firm Digital Lumens.

A123 – The consequence
This move may be a blow to A123 but a great opportunity for Digital Lumens. We wrote about ‘The Past, the now and the future of A123‘ earlier this year. With Michael Rubino leaving we feel that A123 has a lot to answer for. A123’s share price is down some 40% since IPO and the future path is somewhat in limbo. Losing a senior executive certainly adds to the uncertainty. Thus it is not surprising that Wunderlich Securities downgraded the stock. The new target price stands at $6! Now, for a company that was never profitable $6 may be considered good (remember those valuations?) but it certainly does reflect that the growth trajectory and EV/PHEV adoption curve is likely to be slower than anticipated. Arguably, we could see the stock trade lighter than current levels. However, at some point we would think that some large automotive players East (SAIC) or West (VW, Daimler – Smart) may have an interest in looking at the company.

The hard facts are bleak: A123 posted a loss of some $44m, with revenues at $26m. A turnaround seems still some quarters away.  A $6 share price doesn’t sound too bad when compared to our friends who may have had similiar costs but nowhere near as interesting revenues.

How does A123 business success relate to the EV sector? One of the interesting electric vehicles we have looked at is Th!nk, the Norwegian EV producer. (A HBR case study can be found here; paid content.) In May 2010, Think  presented an update on its business. It essentially announced that another $40m of equity was provided by the existing shareholder base. Moreover, the company projects that it will be cash-flow positive by 2011. A123, Enerdel (promo video) and Zebra will provide batteries ranging from 18 Kwh to 28 Kwh.

Think and Deutsche Bank provide a chart (see above) that summarized EV model releases over the next few years. So is A123 depending on the speed up model ramp up or are EV manufacturere depending on battery capacity? The interdependence is obvious and securing battery supply has long been a key battle ground.

Digital Lumens – Opportunity in the LED & SSL space
Digital Lumens operates in the energy efficiency segment which we consider is more attractive in the near term than betting on technology backed companies alone. Rather, the opportunity to replace existing stock with better materials seems obvious and makes both commercial and ‘green’ sense. LED lighting in particular appears to be attractive for its energy savings potential. The Department of Energy (DoE) has set up the Solid-State Lightening initiative (SSL) that proposes that it can cut US energy lighting usage by 25%. In March 2010, the DoE published a Muli-Year Program Plan for SSL. The report states that ‘[t]he global lighting fixtures market is expected to reach $94 billion by 2010, and SSL is expected to play a substantial role in the market by that time. Sales of high-brightness LEDs (HB–LEDs), the technology associated with LEDs for lighting applications, were $5.3 billion in 2009.” Siemens‘ Osram’s Sylvania program notably focuses on SSL.

Khosla Venture and General Catalyst have both been active in the LED space: both funded LumenZ, a Boston based University start-up. Checking on Khosla’s website, we fail to find it in their Portfolio section. However, in a presentation delivered in 2009, it is still in the portfolio. Highland Capital Partners made an investment in QD Vision. QD’s pitch is interesting ‘QD Vision is developing quantum dot solutions for efficiently backlighting mobile phones and other mobile displays, as well as LCDs for desktop and notebook computers and LCD television screens. These initial applications alone represent an addressable market exceeding $2 billion by 2014 for quantum dot-based components’. According to some news sources, QD Vision has raised a total of US$33m to date.

Overall, as costs of LED is coming down the adoption curve is likely to increase significantly. For now, technology hurdles, costs, and general consumer/ commercial acceptance are issues that need to be addressed.

Water – Where is the money?

Deutsche Bank’s piece on the Water sector (World Water Markets, pdf) presents an interesting read. Following on from our research Water Scarcity – An investment Opportunity, Deutsche Bank echoed some of our thoughts. In particular, two areas stand out.

First, the agriculture sector plays a vital part within the water value chain. We maintain our view that ‘water efficiency‘ remains the primary factor in extending the use of fresh water. Further, the challenge with respect to putting a price on water is discussed in the DB paper although no clear recommendations are being made how to overcome the conundrum.  We previously looked at tradeable water rights, Full Cost Recovery, and Polluter Pays Principle and suggested areas for thought how to establish a market mechanism.

Second, Deutsche Bank raises the issue of how to find credible investments in the water sector. KPMG, also, put out a research report that looked at private investments in water infrastructure (2008, pdf). Although the primary investment focus in both reports is on water infrastructure, we are not comfortable with the likely returns that may be earned in this space. Specifically, the requirement for sewage plants may be interesting but the returns to be earned will likely mimic utility and/or project finance like returns. The high up-front capex is something we normally shy away from. Rather, we look at the technology side of the investment theme and focus on efficiency plays. Deutsche agrees: “A large range of technologies is needed. The demand for efficient irrigation technologies, seawater desalination and sewage treatment facilities, technical equipment (e.g. pumps, compressors and fittings), filter systems or disinfection processes (e.g. using ozone or ultraviolet light) and efficient sanitation facilities will probably pick up sharply.”

Another area that we explored a while back are the business and management issues for companies based in India and China that lack access to fresh and/or clean water. For investors who like to look at the state of the Chinese Water sector and how to potentially participate, we recommend KPMG’s report ‘The Water Business in China – Looking below the Surface.’ In a nutshell, the report explores ways to participate in the urbanization and how to invest in Joint Ventures at the Municipal level. JPMorgan explored business risks associated with water access in their report ‘Watching Water – A Guide to Evaluating Corporate Risks in a Thirsty World‘ which extends our thoughts from our Water Scarcity piece above. We mentioned a glass and pharmaceutical company which admitted that they were accessing ground water deeper and deeper under ground every year. At which point, does this become a clear cost and business risk issue?

We note that Fidelity Investment Managers has put a note out on the their take on the water sector; better late than never one might say. There isn’t anything new or jaw-dropping in the report, Fidelity lists the usual investment ideas such as Veolia, Hyflux, Doosan Heavy Industries, Jain Irrigation Systems, General Electric, HaloSource (recently IPO‘ed) and RusHydro as potential investment targets. We previously eluded to the fact that although GE only generates a single digit portion of their group revenues from water, in absolute terms these revenues ($2.5bn+) still rank them as a Top 10 water investor and supply chain player in the world.

Update: A list of some water ETFs can be found here.

Climate Equity Selection and Climate Opportunity

HSBC released a recent report on their Climate Equity Opportunity list (pdf), or short ‘CEO’-list. The list comprises 88 companies that derive 20% plus from their low carbon energy, energy efficiency and storage, or water and waste.

HSBC sees the fastest growth for Renewable Energy in Emerging Markets and proposes that Energy Efficiency makes up the largest opportunity, about 53%. Overall, HSBC estimates that the total market size could be around $2.2trn. Sizing the Climate Opportunity accompanies HSBC’s Climate Equity Opportunity research piece.

HSBC’s report ‘includes five key segments: transport efficiency (USD677bn, CAGR 18%), building efficiency (USD245bn, CAGR 10%), industrial efficiency (USD183bn, CAGR 6%), energy storage (including fuel cells) (USD66bn, CAGR 15%) and smart grid (USD23bn, CAGR 8%)’.

However one sector stands out. HSBC suggests that the electric vehicle market will grow more than 20x by 2020 to reach USD473bn. This based on the assumption that the grow will be back-loaded, i.e. the growth will be faster in the second half of the decade as input prices fall and the industry starts to see scale. Importantly, the report estimates that battery costs will come down from about USD1000/kWh to about USD350/kWh. Underlying the assumptions are global electric vehicles (EV) sales of 8.65m units and sales of 9.23m plug-in and hybrid electric vehicles (PHEV). The average prices for PHEV gasoline and diesel vehicles in 2020 will be 5-10% lower than average EV prices (USD27,500).

Source: HSBC, September 2010

Saft Groupe makes an interesting appearance in the HSBC report. According to the analysis, 75% of Saft’s sales comes from markets where it ranks sector leader. More importantly, sales are diversified across other industries including the military. We mentioned Saft Groupe back in February 2010 when we advocated that the automotive industry will change forever. But not without an improvement in the Energy Storage sector. We connected our argument to the Lithium-Ion market. Overall, we continue to rank Saft Groupe as a very interesting play on the interconnection between EVs and Energy Storage. However, HSBC prefers Energy Efficiency over Energy Storage. We cannot agree more, in the near-term anyway.

The past, the now and the future of A123 Systems

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
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 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.

Capturing the value in Efficiency

Reducing energy use through improved efficiency measures is often a better investment when compared to investing in cleaner energy generation sources as we have noted on this blog. While the returns to the consumer are documented well in our previous posts (3.0x-4.0x ROI)- how do investors capture these excellent returns?

Let’s first identify the business. A company seeks residential and/or commercial clients who need to retrofit an existing building. The firm may implement measures such as: improved insulation, replace lighting, replace roofing materials, install energy usage monitoring equipment and replace some appliances for more efficient versions. On some occasions these firms may offer to install solar panels or micro turbines.  For discussion’s sake- let’s focus on the efficiency side and ignore the generation component.

The question I pose to our readers is this: With such an excellent return profile for the clients, how can the firms delivering the value from efficiency also earn a good return?

Installing equipment is not very “value added” and does not differ much from any typical contractor who could also be installing a new pool or painting a house for example. The returns on these labor services are small and also very competitive in most markets. The value added, in my opinion, comes from the expertise of the efficiency firm in determining how to best maximize returns for the client when deciding where and how to invest the capital. The experts can best procure products and customize solutions for the individual needs of each building and house. Labor can be outsourced or done in house.

So, does a firm simply charge a fee to the client for their expertise? Again, margins on re-selling equipment and labor are not likely to be very productive. In this entire value chain, it seems like the biggest value is delivered to the end-client who will then save money once their return on investment is received. Perhaps efficiency firms could negotiate to capture a percentage of the energy savings until a target is met, using historical energy use and cost as a baseline model? It would be an ‘incentive’ payment of sorts- of course with many caveats.

What do you think? Your comments below are highly suggested.

PS. Check out two firms I’m currently reading about in the sector: OPower and GridPoint (who just bought Standard Renewable Energy)

Efficiency, the alternative Alternative

Earlier we wrote about the superior returns on investment efficiency plays offer when measuring reduced energy and emissions per dollar spent. Today we tackle the question- what does a region do that is renewable energy resource poor? What if there are no windy areas? When solar, biomass, geothermal and nuclear play a limited role- how do we lessen emissions, energy use and the need for additional power plants? The answer is not a surprise- reduce wasted energy.

A recent report by both Duke and Georgia Tech Universities gives further support to the argument that focusing efforts on efficiency can have a more dramatic effect than other methods, and can do so in areas where renewables are not competitive or available. The SouthEastern US is a perfect place to focus- an area that has virtually no wind resources.

Here are the highlights from the report:

  • In 2020, energy bills in the South would be reduced by $41 billion, electricity rate increases would be moderated, 380,000 new jobs would be created, and the region’s economy would grow by $1.23 billion. (regional GDP)
  • The cost/benefit ratios for the modeled policies range from 4.6 to 0.3, with only two showing costs greater than benefits. When the value of saved CO2 is included, only one policy is not cost effective
  • The initiatives would involve actions at multiple levels (state and local, national, utility, business, and personal). In the absence of such initiatives, energy consumption in these three sectors is forecast to grow by approximately 16% between 2010 and 2030.
  • The nine illustrative policies show the ability to retire almost 25 GW of older power plants and also avoid over the next twenty years the need to construct 49 GW of new plants to meet a growing electricity demand.
  • 8.6 billion gallons of freshwater could be conserved in 2020 (56% of projected growth in cooling water needs) and in 2030 this could grow to 20.1 billion gallons of conserved water (or 45% of projected growth).

Investments of $31.5B over the 20 years (to 2030) would generate a savings of $126B (4.0x ROI.) Clearly this is a net positive investment for any region and returns numbers that most renewables currently can not beat. The nine suggested policies include: increased appliance standards, weatherization of buildings, retrofit incentives, enhanced building codes and more (see page 15 of study.) Increasing appliance standards has the best ROI at 4.6x and all of the policies together have a 3.4x ROI.

Energy Use with & without efficiency (Duke/ Ga. Tech Report)

The South consumes 43% of the nation’s electric power, 40% of the energy consumed in residences, and 38% of the energy used in commercial buildings, says the study- thus a successful efficiency policy would have a major impact on both the US as well as any other renewable resource region in the world.

One would expect resistance for any political measures that mandate clean energy requirements from areas that are not fortunate enough to have the natural resources to comply. Accounting for improved efficiency standards in commercial and residential homes is a worthy compromise that achieves the same goals as clean energy and does so, at times, at a more economical rate. Because the numbers speak for themselves, it likely is a good idea for the capital and policies to follow.

Path to Greener Flight – Part 2

If we are to consider other forms of energy storage we should also explore how it could be put to use. Developments with superconductors are laying the way for very high power to weight electric motors that could be used for aviation with the potential to be lighter than a turbofan based propulsion system, allowing the use of an energy store that does not need to be ejected to create thrust. With the potential development of room-temperature superconductors (currently at 254K or -19 degrees C), this becomes even more appealing by making refrigeration of the motors redundant (another sizeable weight saving).

The turbofan propulsion system used in a Boeing 747 is powered on jet fuel (Kerosene) with an energy density of about 45MJ/kg. Currently only being able to hypothesise on energy conversion efficiencies and weight reductions obtainable above, it would only be realistic to power an aircraft with an energy store with a comparable energy density. EEstor is a battery company claiming to have a device (a form of an ultracapacitor) capable of 1.47 MJ/kg. This claim is not without its sceptics, after all this is three times the energy density of today’s lithium-ion batteries (0.58 MJ/kg). While well suited to automotive applications, this is currently far too low to be used for aviation but progress is progress. Lithium-air batteries offer hope with theoretical energy densities in excess of 5,000 Wh/kg (18 MJ/kg). While battery energy densities may not reach the required levels to allow for all-electric propulsion (or no hydrocarbon fuels), a hybrid generator powering superconductor engines could be the path of the future.

A Boeing 747 has an average power consumption of 140MW. Power delivery is as crucial as energy density for an aircraft. Numbers of this scale are normally associated with power stations. If we look far enough into the future it may be reasonable to put a power station on an aircraft, after all we do have nuclear submarines. Granted, there is no shortage of obstacles when it comes to considering a flying nuclear power station. However, there is a lot of progress being made on nuclear fusion. There is a program being funded by DARPA for naval power generation with the aim of developing a 100MW-1GW fusion reactor for ship propulsion.
IEC Fusion, if successful, would be able to provide a source of nuclear energy generation within a relatively tiny space, producing no nuclear waste and no risk of a runaway nuclear reaction via a proton-Boron fuel (PB11). Updates available on their blog. The ignition and waste products of this reaction are not radioactive, in fact far safer than current aviation fuel. On the other hand, if nuclear fusion would be able to be harnessed on a commercial aircraft I think we would have found a solution to a much larger problem. The final alternative to flight dependent energy storage is none (well, excluding reserve systems and batteries at least). Strictly speaking I am referring to remote energy generation and transmission.

The electrical genius Nikola Tesla had a vision of global wireless power at the turn of the 20th century. This has eventually led to technologies such as electromagnetic resonance and microwave transmission.Witricity is focusing on using short-range energy transmission at home, providing a means to charge devices without wires within several meters. While electromagnetic induction is well suited for domestic applications, microwave appears the only current feasible contender for wireless energy transmission to aircraft. Whilst microwave power transmission has been proved to be very efficient obstacles remain with distance (currently effective up to 1km) and public image. No one wants to be boiled from the inside out on their way to a summer retreat.

Air travel may be seen as indispensable in modern times; however there are possibilities of replacing long-haul flights with a greener alternative. Why do we fly? – To get across vast distances on earth in short periods of time. For shorter distances a dedicated maglev train with speeds reaching over 350 mph would be a possible substitute. If green air travel can be achieved, it will start with shorter distances. The real issue is transatlantic / long-haul flights. A variation of the maglev offers an alternative with an exceptional engineering challenge. The Discovery Channel recently aired an episode of Extreme Engineering called Transatlantic Tunnel which explored this option. Known as a Vactrain, it is merely a maglev train placed within a vacuum tube. The reduced drag from wind resistance and friction offers speeds in excess of 4,000 mph, shortening a trip from London to New York to around one hour. The costs of submerging a transatlantic vacuum-pumped tunnel 300m below sea level for nearly 3,500 miles are staggering (estimated at $1trillion). Of course this would require a clean energy source to be considered green. The good news is that it wouldn’t have to be airborne.

Path to Greener Flight – Part 1