A123 Systems' Cell Family

A123 Systems warns of financial danger, and is selling more stock

The financial woes befalling A123 Systems led management to issue a "going concern" warning, to tighten up expenses, and sell more stock, as the company faces steep losses due to defective battery packs and slow ramp up of production at partners including Fisker Automotive.

Battery maker A123 Systems warned this week that its current financial status raises "substantial doubt on the Company’s ability to continue as a going concern," which lead some misguided theorizing that this is the "next Solyndra." This move is unsurprising given the recent history of A123 Systems, a company that has had a mixed bag of problems stemming not only from failures of the company, but slow production ramp-up in the company's partners. The company is taking steps to shore up its finances, and may well navigate its way to a safe shore.

The problems at A123 Systems center on three areas: First, the company's major partner, Fisker Automotive, was slow to get into production, which not only caused Fisker's Dept. of Energy loans to be frozen, but threw A123's business plan into disarray. Second, quality problems with the company's battery packs caused a recall affecting not only Fisker's Karma, but other vehicles using A123 packs. The ensuing "field campaign" is costing the company over $65 million, and perhaps loss of goodwill with its partner companies. Finally, the company has itself admitted in SEC filings a strategic mistake of overly depending on Fisker Automotive to provide revenue, and when Fisker didn't ramp up production as expected A123's revenue did not ramp up as expected.

In the company's latest quarterly SEC filing (10-Q), A123's management issued a "going concern" warning. This followed a declared loss of $125 million in the first quarter, $113.1 million in cash on hand at March 31, 2012, down from $186.9 million at December 31, 2011. A part of the loss is the $51 million "field campaign" to "replace battery modules and packs that may contain defective prismatic cells" produced at Livonia factory, and a writeoff of $15.2 million for inventory produced at that factory. In March, the company announced it had found one of the battery manufacturing machines at the Livonia factory was misconfigured and had been producing defective cells, necessitating the field campaign.

For the first quarter 2011, the company's top two customers represented 23% of its revenue, and in the first quarter 2012 the top two customers represented 28% of the company's revenue. This over-dependence on key customers is recognized by A123's management as a risk. For 2012 the company expects more of its automotive manufacturing customers to ramp up production, and additionally the company is growing its smart grid energy storage system business. Between those effects the company's revenue base is expected to diversify, but in the near term the company will continue to derive its revenue from a small set of customers. Stumbles by any of those customers, management warns, "could have a material adverse effect on our short-term revenue." Significantly, Fisker Automotive accounted for 2% of A123's revenue in 2010, and 26% of its revenue in 2011, talk about a high dependency on a single customer.

There was a significant falloff in revenue between the first quarters of 2011 ($18,097) and 2012 ($10,889), or a $7,208 decrease (-39.8%) in revenue. Management attributes this primarily to a decrease in demand, as well as "revenue recognition being precluded on shipments of prismatic packs that may be defective in relation to the field campaign launched in March 2012." The decrease in sales is attributed to "variations in demand from existing customers."

The cost of the field campaign to replace potentially defective battery packs shows up on the company's balance sheet as an increasing "cost of revenue." In the first quarter of 2011, the $18,097 million cost the company $33,574 million, for a loss of $ 15,477 million. In 2012 the $10,889 million in revenue cost the company $101,707 million, again because of costs due to replacing defective battery packs, for a loss of $90,818 million.

Clearly the company is facing an incredibly difficult period. The company is facing stiff losses due to defective battery packs, the loss of face due to those packs, a fall-off in orders, and a reliance on a couple major customers for a large chunk of the company's revenue. What is the company doing to fix these problems, and get the company back on a firmer footing?

In the company's history it has never had a cash-flow-positive quarter, and instead has always funded its operations on selling stock. Management intends to continue doing this for the forseeable future. On May 11, 2012 the company launched a private offering of $50 million worth of Senior Notes bearing a 6% interest rate, which will mature in July 2013. On January 25, 2012 the company sold, to a single institutional investor, $23.5 million worth of stock and stock warrants.

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In Feb 2012 the company started the process to close down its facility in Korea, to reduce operating expenses. This is expected to finish by the second quarter. Additionally the company is figuratively tightening its belt to reduce expenses.

On June 1, the company announced a special shareholders meeting to be held on June 29, 2012. On the agenda is approval of the private offering, as well as increasing the number of authorized shares of stock from 250,000,000 shares to 650,000,000 shares. This will allow management to continue funding the company through selling shares.

The company is also looking to increase sales revenue over the next few quarters.

Fisker Automotive recently released a business update claiming that, while the company isn't exactly sailing in smooth waters, it is seeing increased demand for the Fisker Karma, and is raising capital allowing it to replace the frozen Dept. of Energy loans. While increased sales of the Karma will give a positive benefit to A123, Fisker's plans to start production of the Atlantic were thrown into a tailspin by the frozen Dept of Energy loans. Fisker is apparently planning to delay Atlantic production until 2014, which will in turn hurt A123 Systems.

The Chevy Spark EV is still slated to go into limited production for the 2013 model year. Because it is a limited production vehicle, it may not result in significant revenue for A123.

The quarterly report refers to increasing sales in China, and a strategic plan to continue doing so. This carries a risk because of the complexity of doing business in China, and the need to work with joint partner ventures in China.

Battery pack quality issues has become an expensive mistake at A123 Systems, a mistake which may sink the company. The current field campaign is a one-time expense that has vaporized a big chunk of the company's cash, forcing management to issue more stock. With luck this will be the only significant warranty expense the company will face, and growing sales could turn around the company's finances. In the meantime the company's stock price is hovering around $1, down from the $5 vicinity last August, and down from the $2 vicinity in March.