Description
Valence is a terminal short that has a track record of: 1) about 20 years of consecutive quarterly losses totaling $536 million, 2) consistently burning significant amounts of cash, 3) diluting stockholders with significant increases to its share base, 4) never delivering on any of its promises and few if any of its goals, 5) huge turnover in the ranks of its highly paid senior management team, and 6) constantly changing its strategy and hyping the next “new thing” to reverse its fortunes. In addition, the competitive landscape for Valence has become more crowded as the company is trying to compete against some industry giants in the battery market with a product/technology that my research shows offers little competitive differentiation and few significant customers. While not a new name to many investors (given an already large short interest position), what makes this a timely call is the combination of: 1) the recent almost 4-fold surge in the share price since the beginning of the year, 2) some major questions emerging relative to the future growth from its two major customers, 3) an increase in capital expenditures and cash burn likely to occur in 2H of 2008, 4) the likelihood of a public offering by a very successful major competitor that will highlight significant holes/inconsistencies in the bull case for the stock, and 5) my belief that expectations will have to come down as early as next week when the company’s Q1 results are released. Noteworthy, the jump in the share price was tied to: the company being positioned by some investors as an alternate energy play, a very well hyped contract with UK based electric vehicle manufacturer Tanfield Group and the addition of the stock in the Russell 3000 index at the end of June. The stock currently has an EV of about $540 million which values it at a lofty 26x its TTM sales base of $21 million. Highlighting the absurdity of this valuation, by comparison a number of other larger, well established, growing and highly profitable (all the things Valence is not!) battery manufacturers sell at valuations of only 1.3x-2.1x sales. Thus, I am recommending Valence as a new short recommendation. Note, while the borrow has recently become more difficult and costly, it is not impossible to obtain. The following are some key points behind my recommendation:
Valence is a manufacturer of rechargeable batteries using a lithium phosphate technology. The company tries to differentiate its products/technology based on performance (energy density) relative to other chemistries (i.e. lead-acid and nickel-cobalt) and safety compared with traditional lithium-ion batteries (i.e. those used in notebook computers, cell phones and other portable devices). After unsuccessfully trying to market its products for use in mainstream consumer electronics devices as those listed above, the company has shifted its focus to alternate markets including: automotive, commercial, UPS, telecommunications, aviation and military markets. However, the real hype has been centered on use of the company’s batteries in the electric vehicle (EV) and plug-in-hybrid markets. This appears to follow a pattern in the past where the company has promoted heavily a number of trials/tests in certain vertical markets (i.e. consumer electronics, electric tools, electric wheelchairs, back up power for telco’s, etc.) that various new customers have been doing with the company’s products that appear to offer exceptional growth opportunities (leading to a rise in the stock price) but for one reason or another never pan out. As a result I believe Mr. Market has given investors an opportunity to take advantage of the situation to short the stock. To date, with the exception of Tanfield, none of these trials has translated into volume orders. In fact in one instance which directly counters the company’s claim of safety, one EV manufacturer (whose testing was hyped in a company issued press report) told me that in testing the Valence battery actually caught fire. Valence’s lack of signing new customers in this targeted market contrasts with the many announcements by the leading auto manufacturers about plans to roll out EV’s with either internally developed battery technology and/or with technology from various competitors. One of the reasons for this may be tied to the increasingly competitive landscape in the battery market, including suppliers of lithium phosphate products. Notable, in recent years a number of other domestic and Asian suppliers of lithium phosphate batteries have entered the market. For example A123 Systems (rumored to go public shortly), was founded in only 2001, but whose products have already gained wide acceptance with many customers in the same markets Valence is targeting and who (unlike Valence) I suspect has recorded significant growth in a short period of time. I believe a public offering and road show by A123 Systems will highlight the differences (i.e. superior: technology, management, financials, etc.) between each company and throw a lot of cold water on the bull case for Valence’s stock.
For investors who look for overvalued stocks that are burning lots of cash and have very little excess cash left on their balance sheet, Valence fits the bill. History shows that Valence is a huge cash incinerator. Noteworthy, over the last five years Valence has burned through $144 million. Currently the company has only $2.6 million left in excess cash and has been/is burning about $4-$5 million per quarter. The source of the company’s funding over the years has been from real estate magnate Carl Berg, a member of the Forbes 400 list with an estimated net worth of $1.2 billion, who currently owns 53.8% of the outstanding stock. Needless to say this funding has had a significant dilutive impact on existing shareholders. During the last five years the average share count has risen by about 60% as the company has added about 44 million new shares. While I can’t speak to the reasons for the support Mr. Berg has given the company or his future intentions, I can say that there has been a notable change relative to how he is funding the company in recent months. In previous years he has provided the company a promissory note capable funding the company for a prolonged period of time. However, more recently he has been funding the company for shorter periods while management tries to raise outside funds via a shelf registration with a broker. While some bulls don’t consider this important, it has not gone unnoticed by Valence’s auditors who for this reason for the last two years have issued the company’s financials a “going concern” warning. Importantly, there are indications that the company’s cash burn will likely increase in the near future. On the company’s last conference call they indicated that due to plans to expand capacity its capital expenditures would rise an undisclosed amount. This will likely translate into a more rapid destruction in existing shareholder value and another catalyst for a decline in the share price. Noteworthy, there has been another more recent change in Carl Berg’s funding to Valence. Instead of giving the company cash in exchange for stock as in the past, Mr. Berg’s most recent funding has taken the form of promissory notes that are due on September 15th of this year. This seems to suggest that Mr. Berg may not be too keen on where the stock price is today and may think he could get a more favorable exchange rate in mid September in return for his cash. I personally agree with him on this point.
Given the lack of acceptance of the company’s products and inability to sign on new significant customers, Valence has significant customer concentration risk. Personal transport vehicle manufacturer Segway accounted for 43% of revenues last quarter and UK based EV manufacturer Tanfield contributed 32% of revenues. Thus together two customers account for 75% of overall revenues. The problem that Valence faces is that there are indications that future orders from these two major customers may be negatively impacted, and below expectations, because of some issues/changes that both companies face. The issue at Segway is that they have been single sourcing their batteries from Valence by purchasing complete battery packs (batteries, electronics and packaging). However, apparently there have been significant problems with the batteries received from Valence. Noteworthy, a quick look at the message boards for Segway users indicates that this has been a major topic of discussion and dissatisfaction among users for quite some time now. My research indicates that Segway has made an internal decision to transition to manufacture their own packs and just purchase the batteries from Valence. This appears to be the first step by Segway to either move away from Valence entirely or take on an additional supplier(s) for the procurement of cells (more commodity in nature). Noteworthy, this move by Segway would directly contrast with the strategy of Valence to try to increase its value proposition by selling its products as complete packs or systems as opposed to just cells. In the very least, such a move would translate into lower revenues and margins from Valence’s largest customer and could also meaningfully impact future sales. Regarding Tanfield in early February Valence announced a highly touted supply agreement with the Smith Electric Vehicle division of this company that at the time was valued at “up to $70 million” in its first phase. Management has been touting the upside potential from this agreement with Tanfield very aggressively to investors and in the press. So much so that probably on the advice of its lawyers, the company took the unusual step of filing a 8-K report with the SEC to disavow the comments made by its CEO to a reporter, saying “the forecasts and estimates attributed to Mr. Kanode in the article do not represent the Company’s views”. However despite all this hype from management, recent indications suggest that the revenues that Valence will likely receive from Tanfield will likely be less than the $70 million previously expected this fiscal year. This is due to the July 1st announcement by Tanfield that stated that due to “a marked slowing” in demand the company “determined that its rapid growth strategy should be realigned”. As a result of this and some supply chain issues in its Smith Electric Vehicle division the company stated that its “forecast sales of electric vehicles are now lower than current market expectations” and it was postponing a move to a dedicated electric vehicle manufacturing site in the UK and revising its expansion plans in the USA. The significance of this announcement is underscored by the fact that Tanfield’s share price plummeted by about 85%-90% (yes that is correct!) from the mid $70 level to about $10 in response to the news. While Tanfield has not provided formal guidance on changes to its production targets for 2,500 EV’s in its fiscal year ending March 2009, it seems clear that it will be significantly fewer. This is important because as recently as April 17th Valence stated that “Smith's projection to build 2,500 Edison and Newton vehicles during the period ending March 31, 2009 will result in $70 million of revenue for Valence.” Thus, some significant revision to Valence’s $70 million forecast in revenues is certain, the only question is how severe will the cut be (and if management will share it with investors). Also, one has to view this against the company’s manufacturing capacity expansion plans to question the payback on those investments and the financial impact. Now here is the interesting part. You would think that Tanfield’s change in guidance and the huge drop in its share price would result in some selling pressure on Valence’s stock? If you believed that you would be wrong! After closing at a price of $3.31 before the Tanfield news broke, the share price has RISEN by about 20% since! Again, that highlights the absurdity of the valuation of the shares.
If a strong, stable and well experienced management team with a track record of execution is a hallmark of any potential investment, Valence highlights just the opposite. Senior management at Valence has been a revolving door relative to the amount of change throughout the entire ranks. For example, consider the following. Since 2001 Valence has had three CEO’s. Over the same time the company has had three different CFO’s, with the last one lasting only five months before departing in July (how many times has that been a good sign!). Also, since 2000, Valence has had two people head sales/marketing and since 2005, four different individuals head Asia/Pacific operations. Additionally, I have done some research on the background of the company’s new President & CEO, Robert Kanode. Noteworthy, his tenure at Evercell was somehow not included in his glowing bio in the press release announcing his appointment at Valence. What I find very interesting is that some of the things which are highlighted below (positioning its batteries as having unique technology, touting the potential from large contracts, plans to expand production, needing to raise money to fund its growth, unprofitable/burning cash, etc) are very similar to what has taken place at Valence since his arrival. I have a feeling that things will end at Valence similar to Evercell with shareholders being the big losers. Highlights from Robert Kanode’s tenure as President & CEO of Evercell are as follows:
• Evercell (EVRC) spun out from FuelCell in tax free distribution to existing shareholders in February 1999.
• Robert Kanode joins Evercell as President and CEO on July 5th, 1999.
• The company touted its new nickel-zinc rechargeable batteries as breakthrough technology and targeted the large opportunities in two markets: 1) the scooter and bicycle markets in Europe & Asia 2) the electric trolling motor market for sport fishing in North America. In addition the company spoke of opportunities in a number of other markets, including: electric vehicles and uninterruptible power supplies (including back-up power for computers and tools).
• The shares of EVRC rose from about $3 to $30 after Kanode becomes President & CEO in the late 1999/early 2000 time period on the hype associated with its JV relationship (Xiamen Three Circles Co. Ltd.) in the PRC, its licensing agreement with Nan Ya and orders from: Taiwan EVT Technology, Flying Electric Motor Co. of Taiwan, and Oxygen S.p.A. (also spoken of as a potential customer of VLNC).
• During Kanode’s tenure the company raises about $60 million in equity and debt to fund its projected strong growth plans. This includes two equity offerings in May 2000 (at $12.50 per share) and February 2001 (at $9.00 per share) which raised $41 million and issued 4.391 million shares.
• In July 2000 the company opens up a new 97,600 square foot manufacturing facility in Newport News, Virginia under a 20 year lease to manufacture electric trolling motors for the North American market.
• However, in April 2001 (just a short time after their February 2001 stock offering) the financial outlook of Evercell significantly deteriorates. On April 11th, 2001 the stock drops 26% to $3.71 per share after the company warned that Q1 results would miss prior expectations and that the outlook for the rest of the year is uncertain.
• With the stock now in the $2-3 per share range Kanode resigns from the company on July 18th, 2001 and the company closes its new Virginia manufacturing facility in September 2001.
• The financial results during Kanode’s tenure show a very dismal picture:
|
|
FY 1999 |
FY 2000 |
FY 2001 |
|
Revenues |
$196,000 |
$200,000 |
$730,000 |
|
Net Profit (Loss) |
($4,961) |
($11,530) |
($28,128) |
|
EPS |
($1.11) |
($1.80) |
($2.82) |
|
Shs. Outstanding |
4,457,000 |
6,679,000 |
10,126,000 |
• However, all is not bad for Kanode as he collects total compensation of $925,629 and 200,000 shares for his 27 month tenure at Evercell. Note his replacement collected a yearly salary of only $69,231.
• However, the same cannot be said for most stockholders who purchased stock in one of the company’s public offerings or in the public market during his tenure in the 1999-2001 period as illustrated in the following chart:
http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=evrc&sid=0&o_symb=evrc&freq=2&time=13
Disclosure: The comments on this stock, and any other I discuss with VIC members on this site, represent my own opinion on the stock which are based on my own analysis and independent research from multiple sources that I believe are reliable. In keeping with the spirit of the club, I suggest others should do their own research before making any investment decisions and welcome any feedback or opinions from other VIC members. Consistent with my investment opinion, my firm has had and may continue to have a short position in the shares of Valence.
Catalyst
1) Some major questions emerging relative to future growth from its two major customers that comprise 75% of revenues.
2) An increase in the cash burn and dilution in 2H of 2008.
3) The likelihood of a public offering by a very successful major competitor that will highlight significant holes in the bull case for the stock.
4) My belief that expectations will have to come down as early as this week when the company’s Q1 results are released.