Description

Maxwell was written up on VIC a few years ago for entirely different theses. Since then the company has been drifting “betwixt and between” despite a change of management. The core businesses have encountered various headwinds on-and-off. Execution has been mediocre - although arguably most of the issues were outside of management control. Importantly, management has been allocating a significant amount of capital into an R&D project (dry electrode) that most investors deemed as a science experiment (a misconception furthered by the CEO’s PhD degree, inability to avoid technical jargons in earnings calls, and of course, a German accent). Adding injury to insult, the recent live sparring among world powers took a heavy toll on the company’s near term earnings - and Mr Market took notice. The stock came down 25% from its recent highs.

Just to be clear - many investors are looking for situations where they can express a directional view on US/China trade disputes. Although the company is experiencing a bad year partly because of those disputes, this is not the reason we own this investment. We own this investment because we believe the market vastly underestimates the company’s strategic value. We believe the “science experiment” is actually a real technology, and that the technology will be monetized in the next 12 - 18 months. Additionally, we expect mean reversion plus embedded earnings gains for the base business next year. We think the setup gives us multiple ways to win with a path to 100%+ upside.

Introduction

The company was founded in the 1960s as a Department of Defense contractor. It went public in the 1980s. Over the years, the company has developed various technologies, and bought/sold businesses that range from purification technologies and computer software. Historical financials are thus noisy.

Currently the company has an ultracapacitor business (~70% of revenues), a high voltage products business (~30% of revenues), and a dry electrode project that is burning cash but is yet to produce any revenues. Simplistically speaking, the common thread between ultracapacitor and high voltage is capacitor - a type of energy storage device that functions in a wide range of applications. Ultracapacitors can be viewed as high capacity capacitors. Those high voltage circuit breakers the company sells use high voltage capacitors. Therefore in a way (with typical cautions of oversimplification), the business can be viewed as different monetization efforts of different categories of high end capacitors - if that clears up some of the confusion around tech terminologies.

The portfolio is the result of the iterations by the current generation of management - led by CEO Franz Fink - that came onboard in 2014/2015. What they decided to do was to divest the microelectronics business (2016) and recycle the capital into their core businesses and R&D projects. They further consolidated the ultracapacitor market with the 2017 acquisition of Nesscap Energy, a subscale Canadian ultracapacitor maker. The acquisition gave them between $20MM and $25MM of annual revenues and important products in the automobile market. Nesscap also has a small/medium cell portfolio that complements Maxwell’s larger cell portfolio.

2018 marks the 4th year of this somewhat lengthy transition. Despite some external headwinds, arguably there have been no disastrous missteps by the current management so far. The only move that was poorly handled was the issuance of convertible bonds in late 2017 - as discussed below, it has not been adequately communicated to the street, especially with the concurrent fallout of a Chinese fund’s efforts to acquire a strategic share of the company. Otherwise, we think management has made sensible decisions.

The Pitch

The ultracapacitor business (~70% of revenues) is at an inflection point where previous design wins are finally coming online. We will not discuss technical features of ultracaps as they are widely available on the internet. We just want to give our simplified assessment upfront: at one point the technology was viewed as having great potential, but the development of lithium-ion batteries effectively eliminated its application as the primary energy storage for EVs. There is a small chance that it will regain some footing in the future, but it is not our base case. Currently the technology is limited to niche applications, but we believe these growing applications are sufficient to underwrite a solid investment thesis.

We do not have the most recent market share data, but we think the company likely has >25% worldwide market share and should be one of the world’s top two manufacturers of ultracapacitors, if not the largest. Other players include Panasonic, NEC-Tokin (part of KEMET), among others. The company does have brand value and is well-known among engineers.

Currently the company’s ultracapacitors are used in the following end markets: wind energy (onshore and offshore), which we estimate to be between 30% to 40% of ex-Nesscap ultracap revenues; automobile (primarily high end PHEVs), which we estimate to be 20% to 30% of ex-Nesscap ultracap revenues; others including heavy transportation (truck and rail), solid state drives, etc. We think three particular markets will likely outperform in the next 24 months: auto, rail, and wind (ranked in probability).

• Auto: Ultracaps are used in active suspension, backup power for ADAS, and start-stops. As far as we know, they are currently the only solution for e-active suspension. Indeed, the company has been benefiting from the secular electrification of the powertrain. It has design-ins with 15 vehicle platforms, most of which are expected to be online between 2018 and 2022. We know auto is a long cycle business - it typically takes more than five years from design win to revenues. But, as those vehicle models finally go into production, the auto business will see significant uplifts. For example, the most recent deal with Geely/Volvo is estimated to be $100MM revenue over multiple years (starting 2019). We think this deal alone will be 30c to 40c accretive to the stock over time. We do not know the magnitude of other deals (likely much smaller), but cumulatively these deals will likely be supportive of near term earnings. We want to point out that most of the design-ins are for high end PHEVs. There are two implications: 1) We do not know whether and when these features will trickle down to mainstream high volume models. We view any such trickling down as our upside case. 2) The growth of PHEVs is pedestrian compared with BEVs. It is a large market but not nearly as exciting as BEVs.
• Rail: The company has a contract with CRRC-SRI to localize production of ultracap modules in China. The factory is currently being built and is yet to contribute any meaningful revenues except for some paltry upfront payments. CRRC-SRI is a subsidiary of CRRC (Ticker: 1766 HK), one of the largest rolling stock manufacturers in the world with US$31BN of revenues and 176k employees. The behemoth is the result of a policy driven merger between two ginormous SOEs in China, China CNR and China CSR. We are not extrapolating that Maxwell will conquer China because they have the relationship, but we think they should have an advantage even against well connected local competitors. The company expects to see full volumes from this factory starting 4Q18.   
• Wind: Ultracapacitors are increasingly used for wind turbine pitch control and hybrid designs of distributed generation. This is the company’s largest end market exposure - but unfortunately it is an unpredictable market as most of the revenues are driven by wind capacity additions. There was ~540GW of global wind capacity as of 2017 (Source: Global Wind Energy Council). 2017 saw ~53GW of new installations and BNEF predicts ~58GW of new installations in 2018 and ~73GW in 2019. However, we do want to point out that ultracaps have a significantly higher market share in offshore wind installations due to the demand for lower maintenance of these facilities. There is ~18GW of existing cumulative offshore capacity as of the end of 2017, or +4.8GW year-over-year. BNEF predicts ~3.6GW new installation in 2018, ~6.3GW in 2019, and 6.7GW in 2020. Predicting wind capacity addition in any given year is beyond our competence, and historically Maxwell’s revenue from the wind segment in a given period has not been highly correlated with capacity additions during the same period (which is understandable due to supply chain delays and fluctuations). That said, we do think directionally Maxwell should see a moderate 2018 and stronger 2019/2020. Also, it is worthwhile to point out that there are currently ~10GW of wind capacity over 10 years old in the US alone. There is a significant need to retrofit these facilities, and often the new designs will come with ultracapacitors. If we simplistically assume 30% of the 10GW will be retrofitted with ultracaps and the retrofits will be evenly distributed across three years - that is ~1GW of retrofitted capacity annually with ultracap designs. It is not as significant as onshore/offshore additions but nonetheless a source of revenues for Maxwell. To sum up, we think the wind business will likely see growth in 2019/2020.

The high voltage business (~30% of revenues) is a gem that investors overlook, and is expected to revert to mean over the next 12 months. I am lumping two points here but they are closely related. The company makes CONDIS branded high voltage products mostly for utilities. The most important product family is circuit breakers that are typically sold to utilities around the world through power equipment giants like ABB. There are two types of circuit breakers - air insulated and gas insulated. Gas insulated switchgears are typically high end products. Maxwell dominates this niche market, particularly the high end gas insulated switchgears where they have a technological moat. These are very high margin products but the company does not break them out - we estimate gross margin could range between 40% to 60% (some products could have even higher margins). Investors typically dislike companies that serve the power market, but the high voltage business is actually a cash machine and good to own if someone has a long term view (the business is lumpy thus could see fluctuations in the short term). It historically generates between $40MM to $45MM of revenues, but 2018 year-to-date it has been running at only half of historical levels partly due to uncertainties around tariffs and confusions about the new tax code in the U.S. We expect mean reversion for the business in 2019. Importantly, there is a significant buildout of ultra high voltage transmissions around the world (800 kv and 1,100 kv) where high end circuit breakers are critical. Increased adoption of renewable energy including offshore wind also calls for these high voltage transmissions. The Economist had an article in 2017 that discussed these issues.  https://www.economist.com/science-and-technology/2017/01/14/electricity-now-flows-across-continents-courtesy-of-direct-current  

The market under-appreciates the option value of their dry electrode technology - and the option value will likely be realized over the next 12 - 18 months. Since it is a complex topic, we will only provide a high level overview here - and fellow investors are encouraged to do their own background research. The company has a proprietary coating process (dry process) to manufacturer ultracapacitors. About a decade ago, it started researching using the dry process to manufacture lithium-ion batteries, and the efforts included several DOE funded projects. But back then the research had not been the company’s focus. When the current management came onboard in 2014/2015, they immediately decided that they should significantly increase investment in this project as “this will change the DNA of the company” (quoting the CEO). The real efforts started in 2016 when they recycled $21MM of capital from the divestiture of the microelectronics business. Since then, the company has completed a proof-of-concept for their potential partners. It is currently building a pilot production line that further proves the technology’s capability at scale. We believe an eventual monetization could be expected in the next 12 - 18 months.

Anyone who loosely follows the electric vehicle space would know that there is significant interest globally in increasing the energy density and reducing the capital intensity of batteries. Currently lithium-ion batteries are predominantly manufactured using the wet process. Dry process will provide three key advantages over the traditional wet process: 1) reduce manufacturing footprint by 75% and thus save significant capex. 2) eliminate the use of toxic chemicals that are prevalent in the wet process - and thus much more environmentally friendly. 3) Meaningfully increase energy density. Management claims the company has achieved energy density of 300 Wh/kg with existing chemistries and it is on a path to achieve 350 Wh/kg by 2020 (likely with new chemistries). In comparison, currently NCA based batteries (used by Tesla) provide energy density of 200 Wh/kg to 260 Wh/kg, and NMC111 based batteries provide energy density of 150 Wh/kg to 220 Wh/kg. The company is also working on eliminating first cycle loss which will further increase energy density.

Critically, the company stands at the cusp of massive new capacity additions and thus the potential adoption of dry process will not require battery manufacturers to rip out existing infrastructure. Indeed, as of 2018, there is ~113GW of lithium-ion battery manufacturing capacity globally. BNEF predicts the capacity could triple to ~350GW by 2022 driven by EV and stationary storage deployments. Also critically, the process works with existing chemicals and supply chains - and does not require any reconfiguration of the existing supply chain. It is compatible with major innovations in chemistry including the inevitable migration to NMC 811 (by 2021, 85% of cells globally is expected to be based on NMC, the number designates the share of Nickel, Manganese, and Cobalt in the mix) and solid state batteries in the longer term. Thus, adoption of the technology does not in itself require securing long term supply of new materials. We think the commercial risk is not as pronounced as what some people may think.

What gives us confidence that the technology is real? We have three proof points: 1) We have spoken with multiple engineers and industry experts. 2) China’s state sponsored fund SDIC was willing to pay a premium (at $6.32) to acquire a minority stake in the company. SDIC has deep expertise in the energy storage space and they had access to information that public investors do not. 3) In November 2017, the company’s CEO and another Board member each came in and bought over $1MM worth of stock in the open market.

To sum up - we think the technology is largely ready. It provides multiple economic benefits against incumbents. It faces massive greenfield opportunities and thus very little path dependency risk. It requires very limited change to existing supply chains and should be relatively easy to adopt. Thus we comfortably deviate from the consensus view that it is worth zero.

Lastly, we believe investors face a heads-I-win-tail-you-lose scenario here. If the company succeeds in monetization (which is our base case), investors will make a lot of money. On the contrary, if the company fails in monetization (our downside case), management will cut investment ($113MM of R&D invested over the past five years) and the company will start to generate real cash flow - or more likely, management will pursue a sale of the business. Importantly, investors usually give new management 3-5 years to execute a strategic plan. They rarely give them longer unless some rockstar management is hired. It is the fourth year of the strategic turnaround - and we believe investor patience is wearing thin. The involvement of an activist investor here also gives us an extra layer of comfort that management is well aware that the clock is ticking.

We believe the end game for the company is an acquisition by a strategic buyer. We think there are several interesting near term growth opportunities, but the company lacks the balance sheet to execute some of the real upside from here. An interim step would be a strategic joint venture partnership, but it ultimately belongs to somebody else. The current CEO Franz Fink has a history of doing the right thing for shareholders. His prior company Gennum was sold to Semtech for >100% premium in 2012. Potential buyers could include: traditional energy players who are investing in the energy storage space; auto OEMs and suppliers; lithium-ion battery manufacturers.

Why this Opportunity Exists

We have spoken with a range of analysts and investors and it is worthwhile to devote a section to discuss the undervaluation.

First, a checkered history with negative publicity. In the appendix below, we will highlight some of the historical events that earned the company a bad name.

Second, too complex a business for a microcap name. Despite its market cap, it is a global business with multiple, extraordinarily complex end markets. Arguably this earned it an orphan status without great comps.

Third, very few investors are willing to underwrite technology adoption risk. Very few went far enough to understand the real risk profile of dry electrode - and thus people typically fail to understand how close the company is towards monetization.

Fourth, poor topline/bottomline performance, partly masked by divestments of the microelectronics business and investments into dry electrode. The stock screens poorly based on financial metrics.

Fifth, lack of real sell-side coverage and lack of liquidity. The quality of sell-side research falls on a wide spectrum, but we think no sell-side analyst truly understands the technology - judging by the questions they asked on earnings calls. It is understandable as the stock trades at low volumes and those analysts are poorly incentivized to do in-depth work on the name.  

A Few Comments and Observations on Governance

We do not have a view about the quality of the Board, because we do not have enough data points that make our view skew one way or the other. However, we would like to point out a couple of relevant facts: 1) The company has a classified Board (negative). 2) One of the Board members used to serve on the six-person management board of BMW. BMW is heavily invested in electric vehicles and battery technologies and thus we view the relationship as a positive. 3) They brought in a young Russian venture capitalist as part of the Nesscap acquisition (neutral). 4) As part of the April 2017 settlement with activist VIEX Capital, the company nominated a VIEX representative to the Board. We generally view shareholder representation on the Board as positive.

We think management’s compensation plan should be revised with more focus on quantitative measures than qualitative assessments. For example, 30% of the annual bonus is tied to revenues and 20% tied to adjusted EBITDA, with the rest tied to achievement of “strategic objectives”. Since a significant portion of management’s time is spent on the dry electrode project which contributes no revenues and eats into EBITDA, we see some merit in this arrangement. Nonetheless, the plan is not as transparent as we would prefer.

Despite the low liquidity, the shareholder base is fairly scattered. Only three shareholders exceed 5% with the largest owning ~6%. In addition, this is not a hedge fund hotel - as hedge funds only own 11% of the company.

Appendix: Three Historical Events that Might Confuse Prospective Investors

Over the past 5 years, the company has been involved in several events that depressed investor interest.

The first event was the accounting fraud in 2013 - which is not related to the current regime. From December 2011 through January 2013, prior management prematurely recorded $19MM of future revenues. It was an outright fraud as the former head of sales colluded with customers and distributors to stuff the channel. It took several years to clean up the aftermath. Then in March 2018, the SEC charged the former CEO David Schramm and controller James DeWitt, and the company agreed to pay $2.8MM in fines. For any investor who prefers a more detailed look into the case, here is the link to the SEC document: https://www.sec.gov/litigation/admin/2018/33-10472.pdf  

The second event was the company’s windfall from the Chinese electric bus subsidy scandal, and the subsequent fallout from the bubble’s burst. The company’s ultracapacitors had design-ins with several large Chinese electric bus manufacturers. The Chinese government had been heavily subsidizing their electric bus industry. The lucrative subsidy created a huge boom cycle and the company made $75MM in revenues in the year when things peaked (~40% of revenues for the year). Then the Chinese government found out that many manufacturers, in their otherworldly wisdom, were essentially making big toy buses that could not even move - just to get the subsidy. Rightfully the government put a moratorium on subsidies, and the industry contracted violently. The company stopped disclosing segment exposures, but we estimate that revenues from the Chinese bus vertical almost halved in 2015 from the 2013 peak. To be fair, the company was not directly involved in the scandals - but as an industry participant its name among investors was nonetheless tainted.

Following the subsidy change, the China bus vertical never recovered. Local ultracapacitor makers (often in the low end) became very aggressive on pricing and gross margin was compressed to such an uneconomic level that in late 2016 Maxwell decided to pull out of the market entirely. Does it mean there is a structural change that will proliferate into other verticals? No, in our view, as the Chinese ultracapacitors do not have the quality to compete in most verticals.

But even before the company’s decision to pull out of the China bus market, the Chinese government established a local sourcing requirement for components and Maxwell - not having a local factory back then - was effectively banned from the market. Revenues from the China bus market trickled to high single digits in 2016 (our estimate), and went to zero in 2017. That was perhaps one of the biggest reasons that on paper the company went nowhere over the past few years - a $75MM vertical went to zero.

The third event was SDIC’s strategic investment in early 2017, and the subsequent fallout in September 2017. As discussed earlier, SDIC is a Chinese state sponsored fund. They planned to buy 7.4MM newly issued shares (~19.9% of shares outstanding) at $6.32/share, a premium to the ~$5.45/share one day before the announcement. However, the stock traded poorly - as investors became skeptical whether CFIUS would approve any Chinese cross border deal. In September, shortly after a second attempt to address CFIUS concerns, the company decided to pull out of the deal. Concurrent with the fallout, the company did a $40MM 5.50% convertible financing (due 2022). The convertible financing effectively magnified the shock to the market. We understand the strategic rationale to shore up the balance sheet, but we think the financing could have been handled much better.

Risks

We hold a long term view about the stock - but there are several short term risks that people who live by quarter-to-quarter numbers should be aware of.

They will likely miss quarterly consensus numbers (revenue and profitability). Although consensus does not mean much as only five small brokers cover the stock, it is nonetheless a risk. The contraction in high voltage revenues will significantly curtail overall gross margins - and current consensus estimates have not sufficiently adjusted for the risk. That being said, arguably the market has priced in most of the near term risks. Any further price reactions would be a good purchase opportunity.

If recovery of the high voltage business continues to get pushed out, the company could eventually need external financing again. As discussed above, the high voltage business enjoys 2x to 3x the gross profit of every revenue dollar the ultracap business produces. If 2018E’s high voltage revenue turns out to be only half of 2017’s level, we think there could be a $10MM to $15MM additional cash burn and the company may be forced to shore up its balance sheet again. They have no more businesses to jettison, so external financing could be needed.

Although it is not a capital equipment business, it has some capital equipment type of exposures including lack of quarter-to-quarter visibility. This is a function of project based revenues especially on the high voltage side and in the wind vertical. However, historical reactions to negative earnings tend to be relatively muted (compared with real capital equipment stocks). The lack of hedge fund ownership likely helps.  

Overall Maxwell is a mediocre business. One important factor that we look at is the occurrence of unexpected external shocks over a medium term - and Maxwell has had several of these over the years - the Chinese subsidy cut, localization requirement, moratorium on new wind builds, tariff concerns...to name a few. That is why we look for multiple ways to win - the assumption that “everything goes according to plan” does not hold here. Also, overall the company’s gross margin profile is not highly attractive and there is not enough recurring cash flow to get us excited. But, we do think the valuation here is attractive enough that we are willing to give up some business quality.

Ultracapacitors are subject to tech deflation. We estimate there is ~10% annual price deflation. This will be partly mitigated by cost deflation and migration to newer, higher end products.

Management can be more transparent - but we sympathize with their decisions. Current management has retreated from disclosing end market exposures to the street due to concerns about competition (they are either #1 or #2 in their markets, and their competitors have very little in the public domain). They have also refrained from technical disclosures about dry electrode - which is again understandable. We have spent a significant amount of time understanding the technology and obtained separate data points that give us comfort.

Both the renewable energy industry and EV industry have been beneficiaries of favorable government policies including subsidies – which adds some “stroke of pen” risk to the end markets. Additionally, China will likely sunset wind subsidies by 2022 and market participants are already cautious about 2020 and beyond capacity additions there. Part of the reason for the subsidy reduction is that the Chinese renewable energy fund is running a significant deficit. That said, we think other parts of the world will eventually catch up. The risk is also somewhat mitigated by the fact that the company is marching towards an earnings trough because of those very policy concerns.

Catalyst

• Announce a deal to monetize the dry electrode technology.
• Potential sale of the business to a strategic.
• The US - China dispute gets resolved and Trump proves his art of the deal.