My IPO Recommendation is Up +74% — Here’s What You Need to Know Now…

I bought a pair of noise-canceling headphones from an airport vending machine.

When I put them on and turned the switch, the dim from the airport disappeared. After my flight took off, I put the headphones back on. The hum of the jet engines evaporated.

Every investor ought to own a pair, for one simple reason. There’s a ton of noise out there.

Turn on the financial channels. Turn on your computer. Look at the magazines and newspapers that cover the markets. Most of the coverage is meaningless clutter. The information might be immediate, but it isn’t that relevant or meaningful. It draws investors’ attention and keeps them from focusing on the truly important.

The danger arises when investment decisions are based on such noise. Investors see a piece of news or a price chart and they reflexively click the “buy” button before thinking things through. They rely on gut reaction, instinct — luck — instead of gathering critical information and objectively analyzing it.

It’s a great way to miss an opportunity. It’s not a very good way to make money.

Let me give you an example.

Last week A123 Systems (Nasdaq: AONE) debuted on Wall Street. The shares of this advanced auto-battery manufacturer were priced at $13.50 and, once they hit the market, immediately shot up. They surpassed the $20 mark and hit a high of $23.

All of that is good, factual information. But it’s noise.

You need something more substantial to decide whether A123 is a good stock to own.

That’s because what a company is selling for isn’t the primary concern of the focused investor. Day-to-day price fluctuations are noise, and smart investors choose to put on their noise-canceling headphones and focus on fundamentals. What really matters is not what the stock is selling for but what the business is worth, and, just as importantly, what it will be worth in the future. Certainly it’s where the focus should be with A123.

Some background:

The future of the automotive industry is the gradual adoption of the lithium-ion battery for plug-in cars. These vehicles are powered by electricity from batteries rather than gasoline from a tank. If the battery runs down, a gasoline-powered motor switches on to recharge it. Naysayers point out that charging up plug-in cars will cost too much, but that criticism is not borne out by the facts. Plug-in vehicles are cost-effective as long as the price of gasoline is above 75 cents a gallon, which is a pretty safe bet.

I’m not suggesting every car will be electric, but these vehicles will become extremely popular for urban commuters, most of whom make a daily round trip far less than the cars’ 40-mile range.

President Obama is an enthusiastic cheerleader for “green” cars like the Chevy Volt, which has yet to be released. Mr. Obama has allocated $2.4 billion to develop battery technology — $250 million of which went to A123 — and he has said he’d like to see a million plug-in vehicles on the road by 2015.

(That’s not a particularly ambitious goal: This nation typically sees 16 million new-car sales each year. Meeting Mr. Obama’s goal would mean that only 1 in 96 vehicles sold between 2010 and 2015 is a plug-in. One out of every 96 cars sold in this country is already a Toyota Prius.)

So the question an investor must ask is not whether A123 is worth $19 a share today but whether the company as a whole will be worth more than its current $1.34 billion market cap in the future.

Calculating A123’s Worth
First step: Put on our headphones and turn off the noise. Second step: Build a model.

For this we need to know the cost of the battery, the anticipated demand and a rough idea of the company’s profit margins.

Demand is the easiest: We’ll use the President’s figure of one million cars by 2015. That’s 166,666 cars a year.

As for cost, a recent Bloomberg article pegged the price of an A123 battery at between $5,000 and $10,000. We’ll err on the side of conservatism and use the lower figure, especially as high-tech costs tend to fall.

Lastly, we have to consider what the company can earn. For this we’ll borrow a net profit margin from a competing lithium-ion battery manufacturer: 3.8%.

Now we do the math.

166,666 vehicles times $5,000 equals $833 million in potential revenue.

3.8% of that — the net profit — is $31.7 million.

Next we must establish a valuation benchmark. That’s easy: A123 is worth $1.34 billion based on its current share price.

Price divided by earnings gives us the familiar metric known as the P/E ratio. And A123 is selling for roughly 42 times future potential earnings, assuming the company has a 100% share of the domestic lithium-ion battery market. (42 times $31.7 million is $1.34 billion.)

By this calculation, ignoring the noisy hype of the recent IPO, the stock looks pretty expensive. It takes a lot of profit growth to justify an earnings multiple that high.

It’s worth noting, however, that the competitor from which I drew the profit margin is trading at 112 times earnings. To meet that, A123 would only have to post 12-month earnings of $12 million, which is roughly the profit generated from about 63,200 batteries.

Now, one has to point out that this competitor is already producing the world’s leading batteries. It’s a profitable automaker in its own right, one that has grown its revue +317% in the past five years. And the company is positioned in China, one of the fastest-growing markets in the world, where A123 lacks even a toehold.

So the question remains: Is A123 a worthwhile stock to buy? Can an investor logically conclude that its future business will generate enough earnings to justify a stock price that would make buying the shares today worthwhile?

My answer: No.

I have four reasons.

The first is the model we built above.

Second, A123 has failed to secure major contracts. It’s not building the battery for the Chevy Volt, for instance. And recent tests with the Toyota Prius showed that A123’s technology — given its high cost — didn’t offer a significant increase in performance over the hybrid’s current battery.

Third, A123 faces serious competition, not only from foreign companies but also from domestic manufacturers. The Obama administration wants plug-in vehicles, but it’s not playing favorites with A123. It also made major awards to Ford (NYSE: F), General Motors, Chrysler and Johnson Controls (NYSE: JCI).

The fourth reason I think A123 isn’t a good buy is the global view. Scotiabank’s Global Auto Report forecasts worldwide demand for vehicles at 48.6 million in 2009, a level that’s clearly hampered by the recession. Assuming a modest worldwide growth projection of 3% a year, the world will see total vehicle sales of 58 million in 2015.

When electric-car technology catches on around the world — bolstered by consumers’ environmental concerns and direct government support — I think these vehicles will account for 3% to 5% of sales, or between 1.7 million and 2.9 million a year. Assuming A123 could capture a heady 25% market share, that would give it 2015 earning potential of $82.7 million, which, at 25 times earnings, implies a fair market value of $2.1 billion.

That amounts to an annualized +7.4% growth in market capitalization from 2010 to 2015, which could hardly be considered a successful growth-oriented investment.

When this IPO was announced, I recommended it. I saw potential. At the target price of $13.50 a share, I recommended investors try to lock in shares below $15 under the impression that they would, in time, rise to the $20 mark. I don’t think I undershot with this estimate. I think the market has overshot.

Far too many investors have bought A123 with rose-colored glasses on. What they really need is a pair of noise-canceling headphones.

If you bought A123 and made a nice gain, take your profits. If you want to trade the shares, good luck. But my prediction is that investors who buy these shares for the long term would be better served putting their money to work elsewhere.

P.S. The electric car sector is about to explode — and the best way to profit from it is with a stock that’s already up +415% this year. Warren Buffett’s loading up on this stock — so much, in fact, that the company’s CEO won’t let him buy any more. But you and I can — and right now is an ideal time to get in. Check out my latest newsflash for the details.