What is the “Locked-down Lithium Play?”

By Travis Johnson, Stock Gumshoe, November 4, 2009

If email volumes are any indication, investors are frantic about lithium as the next great growth “commodity” story — and a lot of my readers are really interested in learning more about the “locked-down lithium play” being teased by Alternative Energy Speculator. And hey, I like making money from electric cars as much as the next guy, so I thought I’d dig in a bit and see what’s on offer here.

The headline on the ad is promising, but it also probably tells most folks who follow the sector exactly which company is being teased:

“A Tiny $10 Chinese Battery Company is about to Become the World’s Largest Car Maker

“‘One of the most interesting small companies in the world.’ — Charlie Munger, Vice Chairman — Berkshire Hathaway

You’ve never heard of this amazing little company, or its pioneering founder.

Yet it’s already made one early investor $1 BILLION since September 2008… And it could deliver investors like you 550% gains by March 21st.”

So this one is not all that well disguised — it’s clearly BYD, the Chinese battery company that has become a significant electric car maker and a famous recipient of both Warren Buffett’s money and, more importantly, the gold stamp of approval for investors that comes with being a “Buffett investment.”

Instead of walking you through the ad and telling you the red hot secret at the end today, I thought I’d take a few minutes to look a little bit more closely at the BYD story, since it has gotten so much investor attention in the year since David Sokol’s MidAmerican Energy (that’s Berkshire Hathaway’s utility subsidiary) bought into the firm.

First of all, as you may have noticed, BYD is not listed on a US exchange — there is a stock with the ticker BYD, but it’s for Boyd Gaming, a much less popular but similarly priced stock. I only mention this because I’ve had a number of folks writing in to me who told me that they bought Boyd by mistake in their enthusiasm to pick up BYD shares. So if you do decide you want to buy BYD, note that they’re listed on the Hong Kong exchange at 1211, and they also trade on the pink sheets in the US at BYDDF.

Now that we’ve got the name of the company that’s being teased by the Alternative Energy Speculator folks (and to be fair, these guys, in at least one of their newsletters, have been teasing BYD for quite some time — I wrote about one for an affiliated letter back in January when BYDDF traded for a bit over $2, it’s now at about $9.40). And based on earnings, it looked pretty expensive to me back then at $2.

Here’s how they pitch the genius behind BYD and its battery technology:

“He’s known as the ‘Bootstrap Genius.’

“And his story is nothing short of sensational.

“By the age of six, he had been orphaned by his father, a peasant carpenter in rural China.

“No one could’ve known it at the time… but this boy would one day revolutionize the world.

“Ten years ago, inside a poorly-funded laboratory in a backwater Chinese outpost, he single-handedly invented a new kind of battery.

“It was the lightest, most powerful battery on the planet. And it simply blew away any other power source of its kind….

“At the age of 29 — fed up with party bureaucrats, red tape and poor funding — this man borrowed $300,000 and founded a small company to exploit the unique benefits of his battery technology.

“Success came quickly. As I mentioned, his technology suddenly found itself in 50% of the world’s cell phones!

“That’s when this genius inventor came up with an even bigger idea… the “Locked-down Lithium Strategy” to capitalize on the future of transportation.

“You see, the secret to making billions from the electric car industry isn’t in the car itself…

“It’s in the battery.

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“So he’s gone from building the world’s most successful battery company… and formed what will be the world’s most successful car company…

“In fact, his company has gone on record saying they will be bigger than Toyota by 2025!”

Now, as far as I can tell he didn’t really do all that much inventing — BYD was founded by the man who still runs it, Wang Chuan-Fu, and he essentially started out trying to build a cheaper battery inside China to serve the market that had previously been dominated by exports from Japan. He designed his batteries by reverse engineering those that were already on the market, which is certainly not an uncommon practice in China (or elsewhere), and tinkering with them a little bit (BYD has been sued several times for patent infringement, but I don’t know that they’ve ever lost one of those cases).

The big innovation from BYD was not in some radical redesign of the battery, as far as I can tell, but in using people instead of robots, taking advantage of what remains, at least for now, China’s largest resource: cheap labor. The big Japanese manufacturing robots were too expensive, so Wang figured out how to re-engineer the battery manufacturing process to use migrant workers instead of robots in order to cut costs, and became a major supplier to cellphone, laptop and other manufacturers. Your iPod or cell phone may well have BYD battery inside it right now.

What else does the teaser say about BYD?

“Our peasant-turned-billionaire inventor put the pieces together. He called up several Italian car designers and built an assembly plant to upscale his battery for cars. In true Chinese fashion, he borrowed what he could, procured the rest, and added a little pricing magic.

“Before you knew it, he was producing green battery- and gas-powered hybrid cars for the Chinese market.

“And he was doing it at half the price of a Toyota Prius and 1/4 the price of a Chevy Volt.

“In September 2008, the ramp-up was ready to begin. But as luck would have it, the global economy hit the worst recession in 80 years.

“The company’s stock would plummet to $2.50.

“Start-up investors got hit hard and the company found itself scrambling for cash.

“That’s when the world’s most famous investor, Warren Buffet, stepped up and bought 10% of the company, shelling out $230 million.

“Buffet’s financing funded it through the rough times. And his insight has made him an easy billion dollars in just eight months.

“But he’s not selling. That’s because the second ramp-up is just getting started…”

Of course, the other reason Buffett’s not selling is that he almost never sells. And that is probably a line that is worth repeating:

“And his insight has made him an easy billion dollars in just eight months.”

Why repeat it? Because pricing and timing is important, especially if you’re counting on making windfall gains, and we should — no matter what else — acknowledge the fact that Buffett investing in BYD at something like $2 a share was brilliant … but that it doesn’t necessarily follow that anyone else investing in BYD a year later at $10 a share is brilliant, too. The fact that Buffett isn’t selling at this price doesn’t mean that he would have made the deal for 10% of BYD at these prices (though he might have — even after he bought himself a railroad this week, Warren’s Berkshire Hathaway still has plenty of liquidity to buy whatever he wants, and he still talks about how much he loves BYD). Berkshire has continued to reiterate that they’re interested in buying more of the company if they can (they wanted to buy 25% originally and management wouldn’t sell more than 10%).

It may well be that BYD will become one of the top global carmakers, and even perhaps a dominant manufacturer of electric vehicles, as they hope — but the bull case is so strong from everyone touting the shares, and the halo that they receive from getting this investment from the world’s greatest investor is so impenetrable at times, that I thought I should focus on a few of the “negatives” for BYD for you, negatives that can really be summed up as, “it’s a tough business, and the shares are really expensive.”

First, the shares are extremely expensive compared to just about any carmaker or battery manufacturer I can think of. Then again, to be fair, I did also think BYD looked a little bit pricey back in January when it traded at a trailing PE of about 20. Today, BYD has about 2.25 billion shares outstanding (including the new shares that they sold to MidAmerican) at a current price of about $9.40 at today’s exchange rate, so that’s a market cap of about $21 billion, about the same market cap as Ford (though without the $100 billion in net debt that Ford also carries). In 2008 they earned about $187 million, and in the first six months of this year about the same as all of last year, $183 million. So right now, if we assume that 2009 ends up having earnings roughly double that of 2008, we get a current PE in the neighborhood of 50 or so.

That, to me, puts a lot of pressure on BYD to continue taking market share in cell phones and rechargeable batteries, which are an incredibly competitive business, and to do so without sacrificing their profit margins … and, of course, to build on their early success in the car business, which is also extremely competitive, especially in China.

BYD has been built on cost-cutting and has an extremely cost-conscious culture — I haven’t seen any commentary that indicates that BYD makes the best “must have” vehicles or has the strongest products, they’ve built their business and reputation largely by being cheap and effective and fine-tuning technology to manufacture more efficiently, which means they need to grow like crazy on the top line if they’re going to bring continued dramatic profit growth in the years ahead. Their battery supply business is very competitive and they have to compete against lots of other battery makers in China these days, but that’s nothing compared to the car business — in the auto business they’re effectively entering a direct-to-consumer business serving some of the most competitive and price conscious shoppers in the world. Margins are very good already, overall profit margin of almost 8%, operating margin of close to 20%, so they have room to be very competitive on price but it’s hard for me to see them expanding those margins very much.

It is no secret to any carmaker in the world that China will be the biggest car buyer for the decades to come, with annual unit sales already on par with the United States, and neither is it a secret that electric cars are likely to be an important segment of the market. BYD is not really an electric car company yet, they’re a company that makes cellphone components and rechargeable batteries and inexpensive cars for China and emerging market customers, and a few of those cars are electric — that’s not worthy of a PE of 50 to my mind, not even for a Warren Buffett choice (remember, the PE ratio when he bought his shares was probably in the range of 10-15). If you’re going to carry that kind of valuation you need to lead the electric car revolution. They might eventually, but for how long, and for what profit? There was a great article in Spiegel a couple weeks ago cautioning against betting too much on the future in electric cars, including some cautionary comments about BYD.

Second, making lithium-ion battery-powered cars is expensive and uncertain in China, too — the company’s sales were tepid for the electric vehicles recently, though sales for Chinese autos in general have been through the roof. Those tepid sales seem to be largely due to the fact that they haven’t figured out the government incentive for green vehicles yet. So yes, even in China they need cash incentives to sell green vehicles — costs are lower, but there’s nothing magic about lower costs in a country that also has significantly lower per capita income, there still aren’t that many folks who can afford to pay much higher prices just to get an electric car. There was a note about this in the Wall Street Journal just last week, including a comment from one auto insider that their electric car is “half-baked.” So far, in the US and Europe, which remain target markets for BYD, electric and hybrid cars have been a high-end product — small, but generally bought by folks who could afford larger and more opulent cars, so expectations of quality and fit and finish are very high. I expect it will be a while before that changes in the developed world, the folks who will buy early generation electric cars in any volume are the same folks who expect the cars to be built to Toyota standards (or Ford, or Honda, or whoever), which doesn’t seem to be where BYD is just yet.

Wang Chuan-Fu has built a remarkable business, and legitimately caught the eye of Charlie Munger and Warren Buffett by doing things better and cheaper, building to a large scale very quickly and effectively, and taking full advantage of the resources at his disposal. He’s also apparently a great marketer, and there is no greater way to market a stock than to sell some of it to Warren Buffett. BYD really took off when it reached the eyes of global investors and became a big part of the global electric car conversation, which happened gradually over the year since Berkshire Hathaway bought in, but really took a big leap in the months following the profile of Buffett’s buy of BYD shares in Fortune Magazine. The share price just about doubled in the month following that article’s release, and it has never really looked back.

I don’t share all of the above in an effort to scare you away from BYD shares — it may well go up another 500% if they can keep the torrid growth going, I just want to note that at these prices it appears to me that you’re paying quite a bit for that growth. I wouldn’t question Charlie Munger, David Sokol and Warren Buffett’s analysis of the character of Wang Chuan-Fu or the potential of BYD, and I will kick myself for not buying shares last Fall when I first wrote tangentially about BYD for an article on another battery company. I will also happily say that I’d rather buy the shares at $2 than $10. I know a lot of Gumshoe readers are or have been BYD shareholders, too, so feel free to share your thoughts if you’ve something to note about the promise or perils of BYD and their batteries.

If you’re curious and want to read more, electric car and lithium teasers have been popping up quite a bit lately — I wrote about a big lithium producer based on a Money Map teaser back in early October, and about another Chinese battery maker around the same time.

Full disclosure: I own shares of Berkshire Hathaway but not of any other company mentioned above. I will not trade in any stock noted in this article for at least three days


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