This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Can A123 go to 11?
Shareholders in electric car battery shop A123 Systems (Nasdaq: AONE  ) are smiling pretty widely this morning. Just days after one analyst short-circuited their stock with a downgrade, another banker, Morgan Stanley, has ridden to the company's rescue with an upgrade.

According to Morgan, there's no point selling A123 now that "near-term catalysts and revenue visibility offer favorable risk-reward." A123 says it has a contract in hand to produce batteries for "a major U.S. manufacturer for an all-electric vehicle." Additionally, "several" other customers are expected to "move to volume production" over the next few quarters. Capacity utilization is on the rise, and with it, profit margins. And according to Morgan, there's little risk the company will go bankrupt before it can reap these rewards; it's got "sufficient liquidity" to get it all the way through 2012.

But is Morgan Stanley right?

"Great" minds think alike
Perhaps. It's worth noting that none other than Goldman Sachs said much the same thing when upgrading A123 back in April. In addition to the factors Morgan cited, Goldman was also bullish on A123's chances to win a loan competition from the Department of Energy, and noted that A123 already vanquished one rival when it won away Fisker Automotive from Ener1 (NYSE: HEV  ) as a customer last year.

(Fisker, of course, is hardly what anyone would call a "major manufacturer." As for who A123's mystery client is, though, the odds are on Chrysler. After all, both General Motors (NYSE: GM  ) and Ford (NYSE: F  ) have already picked batteries from Korea's LG Chem. So unless we're defining "U.S. manufacturer" really broadly -- to include someone like Honda (NYSE: HMC  ) or Toyota (NYSE: TM  ) that's based abroad, but operates factories in the U.S. -- it seems Chrysler's the only hatchback still open.)

But getting back to A123 itself, let's play devil's advocate. Assume Goldman and Morgan are wrong about the positives. Even if every catalyst they name fails to materialize, it appears that even then, Morgan Stanley would like the stock because A123 "trades 28% below the value of the company's cash, hard assets and Department of Energy grant." If Warren Buffett likes buying dollar bills for $0.50, can you blame Morgan Stanley for wanting to scoop up A123 at $0.28 on the dollar?

Actually, yes
First, and foremost, you can blame Morgan for "creative" math. According to the analyst, A123's got enough cash to tide it over for the next 18 months, right? I presume that Morgan reaches that conclusion by taking the $137 million A123 had on hand at last report, adding the $254 million A123 just raised through a debt-and-stock issuance, and coming up with $391 million as the likely cash-on-hand number.

Well, first off, $37 million of that cash was already offset by debt at last report. The company incurred another $144 million worth of debt from its capital-raise. So net of debt, the company's only got about $210 million in the till. But even leaving that aside, A123's burning cash at the rate of more than $350 million a year. Unless something happens to drastically damp down that burn rate, A123's really only got enough cash to last about 11 months. At that point, the only thing left in the bank is a pile of IOUs.

And second, even if A123 does find a way to stay solvent through 2012 and beyond, I'm still not sure about the valuation here. Right now, viable, profitable battery makers like Johnson Controls (NYSE: JCI  ) and Exide fetch valuations of anywhere from 0.2 to 0.65 times sales. Meanwhile, the unprofitable and questionably viable A123's P/S ratio today stands at 6.3. Bump the stock up to Morgan's $9 target price, and the P/S would be 11.3!

Foolish takeaway
Yes, A123 bought itself some time with its capital-raise in April -- but probably not as much time as Morgan says it did. Yes, the stock could rise to $9, but in order to value it at a Johnson Controls level, that would require sales to rise 17-fold. At Exide's P/S ratio, A123 would have to multiply its current annual sales level 55 times.

Anybody out there think A123 will suddenly begin doing $5.1 billion in business within the year? I don't. Then again, I didn't just finish underwriting A123's stock and debt offerings. Want to guess who did?

That's right. Morgan Stanley.