Natural Gas: The Future Fuel of Transportation – Not Without Help or Some Heroic Assumptions

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 19th, 2014

Natural Gas: The Future Fuel of Transportation – Not Without Help or Some Heroic Assumptions

  • The low relative price of natural gas in the US has prompted significant investment to use natural gas and NGLs as both a fuel and a feedstock. While there has been meaningful exploratory investment around using natural gas as a transportation fuel, our view is that the hurdles currently outweigh the perceived benefits and that adoption will be limited without substantial help.
  • High engine costs, even higher fuel tank costs and weight issues increase the cost of ownership and operation such that the payback period is long, even with current relative fuel prices. The lack of clarity on residual value is also a complication in assessing the economics.
  • The infrastructure costs associated with building filling stations is high and significant investment is needed to have the density necessary for this to be viable for many long-distance operators. Trial programs today tend to be local and focused on “return to hub” models.
  • Companies are talking a much more cautious game than they were two to three years ago. Levels of investment are falling and partnerships are more fragile or falling apart.
  • For this initiative to take off without Government help would probably require a natural gas/diesel differential of $2.00 per DGE; almost a third above current spreads.
  • If this is going to be a viable path going forward, Government help is needed now. Some significant medium term incentive structures need to be put in place to get the industry to critical mass, such that costs per vehicle fall and filling infrastructure is completed. Without such help our view is the industry will never reach its potential and could simply fade away.
  • Participants, such as Westport and Clean Energy are seeing lower share prices and negative revisions, and are at risk from cash burn rates that will require difficult capital raises. We would expect to see these share prices fall further unless there is immediate Government support or unless these companies are absorbed into larger entities through acquisition, but for that to happen potential acquirers would need to believe that the industry has legs.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Growth in the natural gas vehicle (NGV) market has not materialized nor is it likely to do so for several years, if at all, because of numerous factors. Operational costs savings are the primary motivator of those interested in making the switch. However, high relative upfront capital costs and questionable rewards have inhibited the adoption of natural gas (NG) as a transport fuel thus far and will continue to do so without significant government incentives. Some of the hurdles that must be overcome are as follows.

  • Costs of engines and fuel tanks must come down
    • Costs might not need to be at parity with diesel but low enough that ROI can be established in 36 months or less. This will happen slowly because of lower than anticipated adoption rates and the lack of competitors vying to create a better, more affordable product
  • Infrastructure must be built out. More stations and vehicles are needed for the market to become self-sustaining
    • Costs of building stations, extra capacity to process and distribute LNG are enormous. Even if considered over several years, there are not enough players such as Shell (which has signaled some commitment) to contribute the necessary billions in upfront costs.
  • A secondary vehicle market needs to develop in order to establish residual value
    • Large fleet operators are often unwilling to purchase vehicles that cannot be resold. Time must pass and adoption must increase to allow for a second generation of trucks to replace the first generation.
  • Credits, grants or other subsidies would help lower costs of developing tech and making purchases
    • These should apply to both the trucks and the infrastructure and will need to amount to billions of dollars. Reestablishment of old credits is not enough. State based incentives that exist today are also inadequate.
  • More powerful engines need to come to market (more R&D from more companies)
    • Cummins has stopped development of its 15L. Internationally there is a 13L (WWI model) but this will not appear in domestic markets. The displacement of Westport’s high pressure direct injection (HPDI) 2.0, due in late 2014 or early 2015, has been suggested at a range of values and there is little by the way of alternatives. It also would not be surprising to see delays after the multi-year delay of the ISX12 G. It may also be prohibitively expensive as Westport’s previous HPDI was.

Though it is listed 4th above, the ability of the government to influence the adoption of NG should not be underestimated. Unpredictable as Washington’s whims may be, legislation that supports the development of infrastructure could singlehandedly promulgate the transition that proponents have long dreamed of. While the costs and regulatory environment are discussed in greater detail below, it is important to remember that governmental aid is perhaps the single biggest potential game changer in the NGV and heavy duty natural gas vehicle (HDNGV) space. The industry would likely need to see the following credits for the next decade to truly benefit.

  • Credits for CNG of $0.50+ per DGE (dollar of gasoline equivalent) at the pump. LNG requires larger subsidies, closer to $0.75+ per DGE
  • Credits for heavy duty natural gas vehicles (HDNGVs) that could reduce additional costs to $40,000 or less
  • Builders/owners can receive up to 25% of new station cost through tax credits
  • If tax credits cannot be extended, subsidized loans must be made that can cover 50%+ of new station costs
  • Grants promoting the development of fuel storage systems and engines amounting to $250mm+

If credits are not extended, then adoption rates will persist at their current unsustainably low levels. Current fuel spreads are insufficient to compel truck operators to convert en masse. The costs of the technology need to come down or fuel price spreads, already at all-time highs, must become even larger. Currently, payback periods approaching 4 years are common. Payback must be accomplished in under three years, and preferably even faster, if adoption is to accelerate.
Government incentives are required to reduce the additional costs associated with NGVs. If incremental costs could be reduced to $40,000 and fuel price spreads widened to $1.50-$2.00 with the assistance of the federal government, the economics of the technology would be more feasible and investment/adoption rates should rise. This dynamic is illustrated below in Exhibit 2.

Exhibit 2

Source: Energy Information Administration, J.B. Hunt, SSR Analysis

In order to seeing adoption rates rise to the 20% estimated by the DOE to create a self-sustaining market, price spreads must widen and remain very large for several years. If diesel were roughly $2.50 more expensive than C/LNG on a DGE basis, then HDNGVs would likely enjoy a short enough payback period that, even with today’s high costs, operators would convert in large volumes. Today’s spreads and costs are such that ROI can potentially be generated after roughly 4 years but it is often still negative even 5 years after purchase of a new HDNGV.

To put this in context, spreads have recently been near record highs with CNG prices $1.57 lower than diesel prices on a DGE basis in April of 2014. Diesel-LNG spreads were much lower with different sources placing them between $0.75 and $1.05 per DGE. Though not the highest ever, these spreads are significantly above the 10 year average spread of $0.91 per CNG DGE. Problematically for NGVs, there are few obvious impetuses that will drive spreads well beyond their highest ever of $1.88 per CNG DGE towards the $2.00+ that is needed to expedite adoption.

A long position in WPRT, CLNE, FSYS or any of several other companies is a tacit affirmation of the belief that the adversities above can and will be overcome in the near future, with or without the assistance of the federal government. First and foremost, the financial benefit of adopting NG must be analyzed.

Financial Benefits – Can Converting to NG Add Value?

  • Financial or economic benefit is uncertain and contingent upon persistently low natural gas prices and incentives of some type.
  • High relative costs – engines and fuel tanks
  • High costs of converting maintenance facilities and training personnel
  • Realizing cost savings from fuel savings alone is difficult in any reasonable timeframe
  • Uncertain residual values make establishing positive ROI difficult
  • Credits, tax breaks and grants have a questionable future and many at the federal level have expired

If this business is to develop, fuel price spreads between NG and diesel and gasoline must remain sizeable. The graph below depicts fuel price spreads, currently at their highest levels ever. The spread has been significant for years and is higher than forward curves would suggest going forward – yet progress to use NG as a transport fuel is slowing.

Exhibit 3

Source: Alternative Fuels Data Center

Though estimating future NG prices may be the province of economists and government forecasters, it seems a bit shortsighted to suggest that prices will remain both stable and low into the foreseeable future. It is easier today to imagine scenarios that close the gap rather than open it.

However, there are several trends in place that could destabilize the spreads enabling cost savings from NG. These catalysts primarily include consumption by other industries including utilities and industrials, and a push to export material quantities of NG to capitalize on international price spreads.

The same forces that compel the transportation sector to consider NG also put NG in the crosshairs of other industries. The trend towards higher consumption has been established in both utilities and industrials. From 2006 through 2013, consumption for electricity production increased 31% while industrial consumption increased 14%. These are by far the two largest domestic consumers of natural gas. Residential markets, the third largest domestic end use of NG, saw consumption rise 13% over the same period with NG now being consumed by residential users at volumes not seen since the 1970s. Overall consumption of NG increased by 20% during the period. The most recent consumption figures are shown in the chart below.

Exhibit 2


Source: Energy Information Administration

Not only is there a trend of higher consumption, there is also the fact that natural gas prices are notoriously volatile. Prices in the last 12 months have ranged from under $3.50 to over $8.00 with prices over the last decade ranging from under $2.00 to over $13.50.

Exhibit 3
Source: Energy Information Administration

It is perhaps a bit premature to suggest that spreads will remain large long enough for entire fleets to build or convert tens or hundreds of thousands of trucks. Even if they did, several other headwinds act against the adoption of NG as a transport fuel. This is a major contributor to the negative story – a fleet of natural gas powered trucks could look like a herd of white elephants, particularly if the fleet is established before the filing station infrastructure is complete. A change in relative fuel prices at that time could leave an operator with an expensive fleet of limited logistical value and with close to zero resale value.

Can Cost Savings Be Realized? A Look at Capital and Operating Expenditures

Should existing spreads prevail, or mechanisms be put in place to take away the commodity risk (through government guarantees, for example), there are still the numerous cost issues outlined above in the overview.

  • High relative upfront costs will continue to be one of the driving forces inhibiting the adoption of NG as a transport fuel

HDNGVs can cost 40-100% more upfront than their diesel counterparts. The graph below breaks down the upfront costs of engines, fuel tank storage systems and costs for the entire rig. The average diesel burning HD truck will cost between $100,000 and $150,000 but can cost up to $175,000.

Exhibit 4

Sources: JB Hunt, Westport Innovations, SSR Analysis

Engine and tank costs vary due to differences in specifications. For example, tanks can be engineered from metal or composites with varying strengths and weights leading to generally higher prices for lighter, stronger, less bulky tanks. They can also be made with different capacities. Higher capacity tanks allow for a greater range but at a greater upfront cost. Tanks for carrying LNG are also generally more expensive in that they are engineered to carry super-cooled fluid meaning that they must be insulated to maintain low fuel temperatures. Large LNG systems can cost up to $61,000 while more modest CNG systems may cost $20,000 or more or else be impractically heavy.

  • Significant upfront expenditure must also be realized on maintenance facilities.

Estimates place these costs at anywhere from $50,000-$200,000 with the high variance attributable to bay size and layout, configuration of bays and local code demands. Mandatory modification will include ventilation upgrades, adjustments to heating apparatuses, explosion proofing and ignition source reductions. Natural Gas is far less user friendly in a workshop than diesel.

Infrastructure – A Capital Intense Build Out is Needed

While trucks and repair shops are capital intensive, the fueling stations needed to support NGVs are even more so. The graph below illustrates the costs of different types of stations. Because there is not a single price paid to construct a station, a low and high estimate is given for CNG with time and fast fill capabilities, LNG and a conventional station for comparison purposes.
Exhibit 5

Sources: Alternative Fuels Data Center, America’s Natural Gas Alliance, Energy Information Administration

CNG stations can vary between $675,000 and $1,000,000 for time-fill stations and up to $2,000,000 for fast-fill. LNG stations are generally more expensive with costs ranging from $1 to $4 million.

It is estimated that the market for natural gas vehicles will not become self-sustaining until a 20 percent penetration rate has been reached. The Census Bureau estimated that there were just over 121,000 gas stations in the US at the start of 2014, suggesting that natural gas would have to displace some 24,200 stations. In order for this to be accomplished, total investments in refueling stations would amount to over $30 billion dollars. Additionally, tens of billions of dollars would need to be invested in liquefaction facilities with additional funds needed to produce and distribute the fuel. If dependence on foreign oil is to be reduced, 56% of vehicles will have to be NGVs with costs rising proportionally. With capital investments north of $100 billion for 20% of market share and a lack of funds, never mind certainty of ROI for such an ambitious endeavor, we cannot reasonably expect NG to take off as a fuel for transportation.

Operating Expenses – Costs of Operating and Maintaining HDNGVs

Several operating costs and considerations must be weighed when considering the switch to NG from diesel as the HDV fuel of choice. These include the following:

  • Fuel tanks not only cost more but are also heavier and occupy more space
  • Tank inspection and maintenance
  • Training or hiring third party mechanics with specialized knowledge of NG fuel systems and engines
  • Penalties to fuel efficiency and power are suffered with NG engines

Both CNG and LNG tanks suffer weight and space penalties compared to diesel, ultimately reducing payload. A 100 gallon diesel tank filled to capacity weighs about 850 pounds and occupies 14 cubic feet of space on frame rails. A comparable CNG fuel storage system would require roughly 4 tanks weighing 1,600 lbs. and occupying 64 cubic feet of chassis space. A single LNG tank carrying 100 DGE would weight about 1,300 lbs. and take up 30 cubic feet of chassis space. Both CNG and LNG tanks not only cost more but they also cause payload penalties.

Inspections must be performed every 36,000 miles or after a crash or fire. These inspections by themselves are relatively innocuous, amounting to several hundred dollars each. However, aggregating a fleet’s worth of inspections will amount to serious expenditures, especially when considering that the trucks gaining the most from the switch are those with high annual mileage counts. Other operational considerations are the costs of spark plugs and special engine oil, up to 3 cents per mile. Filters and other idiosyncratic costs of NG engines can cost 1 cent per mile but these will likely be offset by savings from not needing an exhaust after-treatment system.

As previously alluded to, problems also arise when trucks try to fill their CNG tanks quickly. Because of the pressure and heat created by quickly filling a CNG tank, filling in this manner will only utilize 80-90% of the tank’s total volume. This can limit range even with the largest tanks. It should also be noted that to achieve weight savings versus diesel, CNG tanks will likely need to be type IV composite based canisters which are lighter but more expensive than type I steel tanks.

Further uncertainty is introduced by the fact that there is a lack of mechanics qualified to work on NGVs. Without any large amount of these vehicles on the roads, there has not be a need for dealers or manufacturers to build out this capability. If critical mass is to be established, the shortage of skilled mechanics must be addressed, likely at no small expense.

Fuel efficiency penalties associated with NG engines are also problematic. Engines using spark plug ignition will suffer penalties of 10-15% compared to modern diesel engines. This can be offset with the use of a HPDI engine but, not surprisingly, these engines are more expensive and, for the time being at least, very limited in the domestic marketplace.

Given the large added upfront costs of engines and fuel tanks, maintenance and facilities upgrades, infrastructure investment requirements, penalties to power, range and payload and uncertainty about the residual value of HDNGVs, it is unlikely that the benefits of fuel savings will generate a positive return for the operator of these vehicles.

The NG “Green” Debate

Though NG may be cleaner burning than diesel or gasoline at present, when examined from extraction to end use, the fuel is hardly clean in absolute terms. This has ramifications for investors to the extent that the promotion of “clean” energy has been a hot topic in recent years with the government potentially assisting cleaner alternative and renewable energy sources. Production of natural gas is associated with two concerning phenomena: the release of fugitive emissions and the poorly understood impacts of hydraulic fracturing on the environment. Most concerns about fracking stem from its high water use, especially in high water stress geographies like Texas and Colorado, as well as its potential impact on drinking water. The EPA is expected to release a report detailing fracking’s water contamination potential later this year.

More certain are the negative impacts of fugitive emissions. Natural gas itself, generally methane, is a greenhouse gas that is 20-25 times more potent than CO2 in trapping heat on a weight equivalent basis. Though estimates vary, it can reasonably be said that more than 1% of natural gas produced in the United States is lost as a fugitive emissions, a statistic with serious emissions repercussions.

Perhaps the most highly touted feature of NG is how clean burning it is. When compared to diesel fuel, this may be true but in absolute terms, there are cleaner technologies. Estimates have placed total lifecycle GHG reductions from switching to NG from diesel at 11-16% for HDVs. When comparing the burning of the fuels itself, NG produces 117 pounds of CO2 per million BTU vs diesel’s 161.3 and gasoline’s 157.2. Natural gas also produces NOx which is associated with smog and respiratory ailments.

Though less so than diesel or gasoline, consuming significant quantities of NG would still contribute to warming global temperatures, ocean acidification, higher instance of acid rain and other negative impacts. The EPA also states that because of more stringent tailpipe emissions standards, the benefits of using NG are shrinking. Below is a graph depicting carbon intensity of alternative fuels. Conventional CNG and LNG are among the highest emitting.

Exhibit 6

Source: California’s Low Carbon Fuel Standard Final Regulation Order

If municipal fleets are concerned with greening, then hybrid diesel-electric vehicles represent a viable alternative to diesel burning vehicles. The frequent stops of refuse and municipal transport vehicles make them ideal candidates for hybrid electric technology which takes advantage of energy recapture technology to reduce waste created by braking. Arguments focusing on subsidies to cover high comparative costs could apply to this technology as well to the extent that these trucks and buses are also more expensive than their diesel counterparts.

The Regulatory Environment – Past, Present and Future

Various interests have attempted to legislate NGVs onto the road but to little success. This was seen in 2012 when a handful of individuals attempted to have the Senate pass legislation that would support infrastructure credit, mostly to the benefit of their companies. So far, there has been little to show for these efforts.

Perhaps more significant is the expiration of the Alternative Fuel Infrastructure Tax Credit and the Alternative Fuels Excise Tax Credit. The expiration of the latter of these two credits will likely lead to higher prices at the pump for both CNG and LNG. Prices paid at the pump may rise by $0.50 per gallon for both types of NG. This reduction in fuel price spread may be enough to almost single handedly eliminate the benefit of using an NG vehicle if fueling stations pass these costs on to their customers.

Due to the expiration of these credits, the most important existing credits are those extended by individual states. These credits might bring parity with diesel truck prices in limited quantities but their ability to cover the production or conversion of hundreds of thousands of vehicles across the country and into the future is questionable.

Without legislation at the federal level that commits billions of dollars to stations and truck engines and fuel tanks, the market penetration needed to sustain the industry will likely not materialize. Reinstatement of old credits will be insufficient to materially improve adoption rates. New laws must be passed, an inherently uncertain process that will not be easy or straightforward given the current political climate.

The most successful alternative fuels of the past have been the ones with the most government support, regardless of their independent economic viability. The two graphs below are illustrative of this. Biofuel tax credits played a large role in the rise of E85 as a vehicular fuel.

Exhibit 7
Source: Energy Information Administration

Exhibit 8
Source: Energy Information Administration

Actionable Investments Capitalizing on the Poor Outlook of NG as a Transport Fuel

As a result of the high costs associated with the technology, the lack of governmental assistance and the lengthy period of time required to earn a positive return on an HDNGV, several dynamics have developed. These dynamics are as follows:

  • Consensus adoption rates for NG among HDVs are between 3 and 5%. However, it appears more likely that adoption rates will have trouble topping 2%. Even a 3% adoption rate is problematic for WPRT, CLNE and the rest of the industry
  • Infrastructure to support a large amount of class 8 trucks (10,000s+ per year) does not exist nor are there plans in place for stations that will accommodate higher volumes of HDVs. While there are plans for stations, development continues at a pace too slow for higher adoption rates to be accommodated. We can reasonably expect 75-90 CNG & LNG stations to come online in 2014 with comparable volumes in 2015.
    • America’s Natural Gas Alliance estimates that for short term sustainability, 180 to 210 new CNG stations would need to be built annually
  • The chicken or egg problem is one of expected payback period for new infrastructure that is built without an anchor tenant or guaranteed contract. To generate positive ROI in 2 years or less on a $1.7mm-$2mm fast-fill CNG station, 210-250 trucks each driving at least 70,000 miles per year will have to fill up at the station. LNG stations can require even more volume if and when their costs rise past $2mm

Several companies that are key players in the HDNGV market will be adversely affected by these dynamics as well as their own idiosyncratic weaknesses. Westport Innovations Inc. (NASDAQ: WPRT), Clean Energy Fuels Corp (NASDAQ: CLNE), and Fuel Systems Solutions, Inc. (NASDAQ: FSYS) all stand to have their already weak performance weaken further if adoption rates do not rise as industry proponents have suggested they will.

Several qualitative and quantitative weaknesses detract from each company and they are expounded upon below.
Westport Innovations (WPRT)

We would avoid WPRT for the following reasons:

  • Cummins Westport (CWI) has guided towards 6000 units this year while Weichei Westport (WWI) may sell over 36,000 units in China. Despite these sales, Westport is not yet collecting profits from CWI and realizes very little in OI from WWI.
    • Note that all units will not necessarily go into on-road, HD applications. This virtually guarantees that adoption rates will be below the 3% lower bound estimate from Westport
  • WPRT depends upon strategic partners for much of its development, manufacturing and distribution capabilities
    • Cummins has shown reluctance towards expanding into NG engines by itself so it may be the case that it is unhappy with the business. If Cummins, Weichai, Delphi, etc. were to end their relationships with WPRT, perhaps due to continued poor performance, WPRT would lose a significant amount of sales.

Exhibit 9


Source: WPRT Q1 Earnings Call, SSR Analysis

  • Due to reliance on other companies, WPRT has a model that does not allow it to scale up efficiently
    • WPRT relies on the manufacturing and distribution capacities of Cummins and Weichai without which its capabilities would be severely limited
  • What poor margins the company already has are likely to be eroded if and when competition enters the space. Even if NG is adopted as the next transportation fuel, WPRT will enjoy less pricing power and fewer expansion opportunities with the arrival of competitors.

Several financial problems with WPRT are also visible:

  • We are concerned that WPRT will run out of cash in either 2Q or 4Q 2015 depending on how generous projections are. This acts as a catalyst to the downside in that the company will be forced to borrow at a high cost from either equity or debt markets or else face failure.
  • WPRT has a history of negative revisions and incorrect earnings forecasts

Exhibit 10


Sources: Capital IQ, SSR Analysis

  • Even as sales of engines at JVs have risen, gross margins have shrunk as has operating income. Higher adoption rates will not necessarily correct operating inefficiencies at JVs and in WPRT’s operations
    • 9.5% GM for 1Q2014 vs 20.7% for 2013 and 31% for 2012 at Cummins Westport
    • 5.6% for 1Q2014 vs. 8% in 2013 and 9.1% in 2012 at Weichai Westport
  • Goodwill/intangible impairments (WPRT assigned some $34mm in impairments because of a poor business environment in Europe and lower than anticipated adoption rates of NGVs)
  • OpEx rising faster than top line growth
    • 35.6% growth for OpEx from 2012 to 2013 vs 5.1% for total revenue
    • Note that total revenue is down (27.8%) from 2011 while OpEx is up 47.3% despite what is ostensibly the best operating environment ever for WPRT
  • Will not see dividends or share repurchases at any point in the foreseeable future though this is perhaps expected given negative cash flow and need for investment.

Clean Energy Fuels Corp (CLNE)

Like WPRT, there are several problems with CLNE, both qualitative and quantitative.

Lack of cost savings initiatives and poor earnings guidance coupled with a deteriorating balance sheet also leads us to avoid CLNE.

The table below summarizes several of CLNE’s operational ailments.

Exhibit 11

Key CLNE Financials 2009* 2010* 2011* 2012 2013*
Revenue $115,968 $195,792 $274,828 $331,951 $307,036
Growth from Previous Year n/a 69% 40% 21% -8%
GGE Delivered 101 122.7 155.6 194.9 214.4
Growth from Previous Year n/a 21% 27% 25% 10%
SG&A Expense $47,509 $63,528 $86,850 $117,976 $138,024
Growth from Previous Year n/a 34% 37% 36% 17%
SG&A as % of Revenue 41% 32% 32% 36% 45%
OpEx $164,789 $217,356 $331,285 $404,530 $404,166
OpEx as % of Revenue 142% 111% 121% 122% 132%
Net Loss $ (48,784.00) $ (18,558.00) $ (65,522.00) $ (101,255.00) $ (112,407.00)
Net Loss Per Share $ (0.89) $ (0.30) $ (0.93) $ (1.16) $ (1.20)

Sources: CLNE Annual Report, SSR Analysis.
*VETC has been removed

  • Despite increasing volumes of NG delivered on a gallon of gasoline equivalent basis, the company has seen a widening loss after adjusting for fuel tax credits that the company will not earn going forward due to their expiration.
  • Clean Energy Fuels has poor cost controls and this does not appear slated to change. SG&A has risen to 45% of revenue in the most recent year after adjusting for VETC. Without a program of cost control, about which there has been no discussion thus far, it is reasonable to expect CLNE to continue operating poorly
  • CLNE also has a troubled balance sheet. After levering up significantly in 2013, the company has put itself on course to face a financing crossroads in 2016, with $147.8mm in convertible notes coming due
  • The margins CLNE enjoys on its fuel are unsustainable. The company has a $0.30 margin on each gallon sold. (compare to $0.08-$0.15 for most gasoline). Even if NG succeeds as a transport fuel, these margins will be eroded by competitors
  • Despite unsustainably high margins on fuel sold and 17 years of experience, the company has not turned a profit and operations burn $10-$20mm in cash each year. Add in ~$80mm in CapEx for 2014 and a similar amount for 2015 and it is reasonable to expect that CLNE will run out of cash just as liabilities come due in 2016

Fuel Systems Solutions (FSYS)

Our conclusion on FSYS is similar to that on WPRT and CLNE although less extreme. We would still avoid the stock.

The restructuring of FSYS’s business and corresponding reduction in earnings ability acts as a catalyst to the downside in the near term to the extent that it will compel the company to continue its downward revisions and eventually borrow as its poor operations eat into its balance sheet.

  • Lack of competitive advantages are likely to make a turnaround at FSYS difficult.
    • Despite FSYS listing several competitive advantages including a strong technological base, global distribution and OEM relationships, manufacturing experience and strong expertise and position for growth, the company has already begun restructuring its operations.
  • The company expects $340-$360mm in revenue in 2014 (at least a 10% decline) and not surprisingly did not give guidance on earnings, cash flow or capex.
    • This top line guidance is dubious at best given the company’s poor history of forecasting its ability to make money. Actual results may prove to be even worse if history is a guide.

Exhibit 12

Source: Capital IQ, SSR Analysis

  • Trouble has been driven by the FSS Automotive unit which is responsible for US automotive operations, infrastructure projects and aftermarket products. The unit represented 67% of 1Q2014 sales and has been responsible for most of the write downs and slowing growth.

Exhibit 13

Source: FSYS Annual Report, Q1 Earnings Call, SSR Analysis

  • With regard to cash flow, FSYS has actually had decent performance in years past but has been losing ground to competition more recently.
    • Its cash flow from operations is positive, though modest. These cash flows were enough to cover capex in 2013 but were shy in 2012 ($13mm in CFO vs $14mm in capex) and 2011 ($10mm in CFO vs $12mm in capex). Capex was modestly larger than CFO in the first quarter of the year ($3.32 in CFO vs $3.65 in capex.)
  • The company has shied away seeking external financing recently. This trend appears primed to end in the near future as restructuring costs mount and sales decline leading to cash burn
  • Related party dealings make it easy to question the motivation of management.
    • FSYS transacts with over 10 companies that are owned, in part or whole, by the CEO and his family. Whether or not conducting business with these companies is in the best interest of shareholders is debatable but it certainly contributes to an appearance of impropriety

The company is presently valued based on the expectation that it will return to historic profitability but we remain much more skeptical that this will occur.

It is also not coincidence that numerous companies previously associated with the technology have stepped back from it or are slowing the pace of their investments substantially. These include:

  • Chesapeake who disposed of its NGV team
  • Cummins who has indefinitely delayed its 15L engine
  • Blu LNG who fired 20% of its staff and slowed the pace of its infrastructure building in 2014
  • AT&T who has stepped back from its fleet conversion to re-evaluate the situation
  • PACCAR who still only builds diesel engines, though its subsidiaries do build trucks that support NG engines
  • Shell who has shuttered plans for a Canadian liquefaction plan and is now looking towards a partner to shoulder some of the risks in operating new LNG stations
  • JB Hunt who has a single digit NG truck count as of February 2014
  • Navistar who has devoted only a few million dollars of its R&D budget to NG technologies out of an expected $350 million in expenditures, stating that they prefer to follow others if NG becomes more popular

This begs the question…

If the story changes, what companies make compelling buys?

There are three types of companies that would benefit from high penetration of this technology: OEMs (the makers of the engines and tanks), Infrastructure Companies (companies building fueling stations, NG compressors and production/distribution capabilities) and Fleet Operators (companies that would presumably be saving money as they convert their fleets).

OEMs

WPRT is perhaps the most compelling OEM to the extent that all of its products and services are based on NG engines, storage and fuel delivery systems and servicing these goods. It is a pure play on NG engines and rising adoption rates. The company is also looking into LNG locomotives and NG engines for marine applications.

Several other companies have exposure to this business but NG engines have thus far made very small contributions to their earnings. These include Cummins, Caterpillar and General Electric. Navistar and PACCAR could also jump on the bandwagon. Even if NG engines were to gain in popularity, their contributions to each of these companies would be negligible compared to their other businesses.

Outside of engines, there are companies that provide fuel storage tanks, fuel delivery systems and vehicle conversion kits. Quantum Fuel Systems represents the best of these companies. FSYS is another one of these companies but it has a long road ahead. Internationally, Hexagon Composites represents an opportunity with its wide array of storage tanks. WPRT also has exposure to this business. There are also several private players such as Agility Fuel Systems and FYDA Energy Solutions.

WPRT has the most to gain from rising adoption rates of NGVs.

Infrastructure Companies

In the infrastructure space, there are several companies that could represent actionable investments.

CLNE has thus far led the effort to construct CNG and LNG stations and maintains the highest station count of any existing company. If adoption rates rise, other companies to consider will be Questar and Wisconsin Energy Corp. Larger names exploring the space include Royal Dutch Shell and Encana as well as the Chinese company ENN group through its subsidiary Blu LNG. Much like in the OEM space, the largest of these companies may not have enough exposure to NG stations to realize material upside.

Fleet Operators

Though none of these companies stand to gain directly from rising NG adoption rates, they will see reductions to their costs if industry proponents prove correct.

Trucking companies presently operate on razor thin margins and would stand to gain the most from reduced fuel costs. These include J.B. Hunt, Con-Way, Old Dominion, Swift, Werner and ArcBest.

Several other companies also operate large fleets and could potentially enjoy large savings including UPS, AT&T, PepsiCo, Walmart, Procter & Gamble and FedEx to name a few.

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