Whether it's truck and engine company executives like those at Navistar (NYSE:NAV) and Caterpillar (NYSE:CAT), environmentalists, or energy policy pundits, it seems like there's a broad agreement that the U.S. needs to do more to make use of natural gas as a vehicle fuel. With high-quality partners like Volvo (OTC:VOLVY) and Cummins (NYSE:CMI), Westport Innovations (Nasdaq:WPRT) continues to look like a promising play on that trend. That said, while these shares could indeed have substantial upside from here, the LNG/CNG engine market is still in its infancy and there are no guarantees that customers will go in the direction of Westport's technology.
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Sluggish Third Quarter Results Don't Matter Too Much
Westport is arguably still at a point in its life cycle where quarter-to-quarter financial results are not the "end-all, be-all" for the stock. Nevertheless, these results do point to some of the ongoing challenges that the company faces.
Revenue declined 6% from last year (and 28% from the prior quarter), with product revenue down 10% from last year. While the reported revenue number missed the average analyst estimate by about 10%, the overall shipment numbers were broadly in-line. Revenue from the company's Cummins JV fell 8%, while light duty revenue was basically flat. Heavy-duty revenue was down 36%, but makes up a tiny part of revenue today. Although not consolidated, the company's venture with Weichai saw revenue nearly double.
Profitability was weaker than expected, but not alarmingly so. Gross margin fell about 300 basis points from last year, and more than 10 points from the prior quarter, largely on higher warranty costs. Margins improved into the 6%s within the company's light- and heavy-duty operations, while the gross margin at the Cummins JV fell more than seven points to 13.4%. Westport posted an operating loss, though the Cummins JV was profitable at the operating line.
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Shipments Progressing, with Big Launches on the Way
Westport has the unenviable task of trying to launch new technologies at a time when the commercial truck business is seeing tough times. Whether you look at OEMs like Navistar and Oshkosh (NYSE:OSK) or component players like Eaton (NYSE:ETN), nobody is saying too many good things about truck demand right now.
It's not altogether surprising to me, then, that shipments were down this quarter. In the Cummins JV, engine shipments were down 2% from last year and almost 20% from the second quarter. Heavy-duty shipments were down even more (32% from last year and about 20% sequentially), but at 58 it's definitely a small base.
I would think shipments should start accelerating next year. Volvo's new 13-liter engine should be available in 2013, and the Cummins JV should be launching its new 12-liter engine early in the year as well. What's more, Westport continues to make progress with off-highway customers like Caterpillar, as well as passenger vehicle manufacturers.
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Nothing's Certain, but the Economics Seem Compelling
Clearly there is plenty that can still go wrong with the Westport story. Although the company has a solid long-term relationship with Cummins in lighter-duty applications, there is still the risk that customers will prefer Cummins' own spark ignition (SI) engines or the dual-fuel approach previously favored by Navistar.
Likewise, while the difference between today's LNG prices and diesel offer quick payback for LNG engines (about three years) despite their higher cost, there are many industries building up on the back of cheap natural gas. Over time, that could shrink that fuel cost advantage and constrain or slow LNG/CNG engine adoption.
The Bottom Line
There's always an element of guesswork to any cash flow model or valuation analysis, but that's particularly true in the case of a company like Westport, where the model is explicitly predicated on big changes in the addressable market. Although I don't really argue with Westport bulls who believe Westport technology will be a share leader, I believe there's still many opportunities to debate just how large that market will be and how quickly it will develop.
Right now, I'm expecting the company to see a significant ramp up in revenue to about $1 billion in 2017, with double-digit growth for five years thereafter. At the end of that horizon, I see about $300 million in free cash flow, and that works out to a fair value in the high $20s. While I'm sure Westport bulls will argue that those numbers are appallingly conservative, I have always found it better to be careful with unproven stories, and even with that conservatism I think there's room to buy these shares today.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.