John Petersen

John Petersen's articles on Seeking Alpha

Last month I wrote about a very smart plan the DOE developed for $4.5 billion in smart grid grants authorized by the American Recovery and Reinvestment Act of 2009 ("ARRA"). I was particularly impressed that the DOE's plan created a functional public-private partnership where grants would be available to companies that could raise matching funds from private sources, but would be denied to companies that could not attract substantial private sector funding.

While I hoped a similar plan would be adopted for $2 billion in ARRA battery manufacturing grants, my research was hindered by a broken link at www.grants.gov that wouldn't let me download the Funding Opportunity Announcement ("FOA"). Late last week, a reader sent me a copy of the FOA and I was delighted to learn that the same guiding principles will apply to ARRA battery manufacturing grants.

In the FOA for its "Electric Drive Vehicle Battery and Component Manufacturing Initiative" the DOE established goals for five classes of ARRA grant funding as follows:

The FOA also provided that grant recipients will generally be expected to provide 50% of the required funds from private sources. While the DOE has the power to approve grant requests with lower cost sharing ratios (subject to a floor of 25%) any reduction in the cost sharing ratio will count as a negative factor. Teaming among suppliers, manufacturers and end users is encouraged but not required. If the plan works like it's supposed to, $2 billion in DOE grants will be matched with $2 billion in private capital and used to build $4 billion in new manufacturing plants. It's a far more aggressive start than I could have hoped for when I first argued that America needs to rebuild its domestic battery manufacturing infrastructure.

To put the magnitude of the ARRA battery manufacturing grants in rough perspective, nine of the pure play energy storage companies I track account for about a third of the U.S. battery market and have a combined book value of $1.5 billion. If their ratios are typical, then the book value of the entire domestic battery industry is approximately $5 billion. By the time you add $4 billion in new factories and then add a like amount for associated inventories and accounts receivable, it's easy to forecast outstanding growth in the energy storage sector for several years. It's impossible to identify the likely winners of the grant selection process, but it's a pretty safe bet that every company that can apply will. I also believe that my nine pure play energy storage companies, as a group, are likely to receive a significant share of the awards.

Applications for the first round of ARRA battery manufacturing grants must be filed by May 19, 2009. The DOE plans to select the first round of grant recipients by the beginning of July and finalize the first round of grant awards by the end of September. While there will undoubtedly be a tremendous amount of posturing, positioning and PR over the next several weeks, I don't foresee any clearly investable events before the end of June.

None of the pure play energy storage companies I track has huge cash reserves that can be spent on new factories. This leads me to believe that every company selected for an ARRA battery manufacturing grant will have to go out into the market and find new financing for all or part of its matching funds. Once the new plants are built, a second round of financing will be required for associated inventories and accounts receivable. For most, the required financing will exceed their current capital by a wide margin. Since many of the likely recipients are smaller companies that cannot be classified as high quality credit risks, I expect them to rely heavily on the equity markets. One thing is certain; it will be a target rich environment for investors that are willing to make a long-term commitment to the energy storage sector.

Since it's impossible to talk about large stock offerings without having somebody worry about dilution, this is probably a good time to tackle that issue. I want to apologize in advance for the complexity of the following discussion, but these are critically important issues. So take your time, read it slowly and feel free to ask me about anything that's unclear.

Everybody above the age of five understands the concept of dilution. If you're sitting in a restaurant with a half-empty coffee cup and the server tops it off –

• With water, your beverage is diluted;
• With coffee, your beverage is unchanged; and
• With espresso, your beverage is fortified.

The same basic rules apply in corporate finance and substantially all sales of newly issued shares fortify the issuer's balance sheet. Nevertheless perception problems and other complexities frequently arise because every stock sale impacts three distinct groups who think dilution is important and approach the issue from different perspectives.

• New investors typically view dilution from a book value perspective and think they're being diluted if the purchase price they're being asked to pay exceeds book value per share;
• Insiders typically view dilution from a paid-in capital perspective and think they're being diluted if the purchase price of new shares is less than the average price paid for outstanding shares; and
• Public shareholders typically view dilution from a market price perspective and think they're being diluted if the purchase price of new shares is less than the prevailing market price.

All three perspectives are fundamentally valid, fundamentally flawed and irreconcilable. In most cases, the best a company can hope for is a modest discount from market.

Since the differences between book value, paid-in capital and market price per share can be immense, it's important for investors to understand the range of possible outcomes. The following table provides comparative book value, paid-in capital and market price data for each of the pure play energy storage companies that I would classify as likely applicants for ARRA grants. The data has been taken from the most recent SEC reports filed by the companies and gives pro-forma effect to the conversion of any non-redeemable preferred stock.

I regularly participate in pricing negotiations between investment bankers and emerging public companies that need to raise equity. In each case the first thing the bankers do is paraphrase Benjamin Graham and tell my clients that while the stock market is a voting machine, investment banking is a weighing machine. Next they explain that after completing their due diligence they plan to ignore the market price and base their negotiations on fundamental business, technological and product issues like the ones I've been discussing for the last nine months.

While it is generally easy to move the bankers up from a lowball initial offer by showing how historical expenses created enduring non-financial value for an emerging client, the banker's resolve typically stiffens to the consistency of granite as the negotiation approaches 80% of market price. The final negotiating rounds are always bare-knuckle affairs but when the table pounding and cursing is over, my clients invariably acknowledge the supremacy of the golden rule of capitalism (he who has the gold makes the rules) and accept the best price they can negotiate.

I have no experience with transactions like the ones that will be negotiated over the next few months. Potential investors will rightly argue that the ARRA grants effectively double the benefit of their investment for a grant recipient and its shareholders. The grant recipients will rightly argue that the ARRA grants effectively cut the new investors' dilution risk in half. While my right-brain tells me that the ARRA grants will simplify negotiations between companies and investors, my left-brain knows better. On The Mickey Mouse Club of my youth, Wednesday was "anything can happen day." For the next four months, energy storage investors need to remember that every day is Wednesday.

Disclosure: Author holds a large long position in Axion Power International (AXPW.OB) and small long positions in Exide (XIDE) and Enersys (ENS).