Westport Innovations is at the center of the natural gas conversion universe
The following is an example of our Gold Member Reports – This report is from summer 2012. The model portfolio successfully made over 33% on Westport Innovations during 2012. As of 12/31/2012 the model portfolio does not hold any Westport Innovations stock. Westport is currently on our watch list.
The phrase “linchpin” can be figuratively defined to mean; “something that holds various elements of a complicated structure together.”
The lynchpin that makes the conversion to natural gas powered transportation vehicles possible is Westport Innovations (WPRT). Westport is one of the companies that stand to benefit the most over the next several years from the migration to natural gas as a transportation fuel. They are a pure play on natural gas powered engines and current global leader in natural gas engine technology. The company controls technology that enables engines to run on alternative fuels without compromising performance, fuel economy, durability or reliability as compared to diesel engines. This fuel substitution, to natural gas, achieves a significant reduction in unwanted environmental pollution.
Macroeconomic factors influencing natural gas
This month’s review of WPRT continues my “Natural Gas Investment Thesis” laid out in detail in the summer 2012 newsletter (found at RulingTheMarkets.com). In that newsletter I discussed many factors influencing the natural gas market and I will not be repeating them here. So, register for the newsletter and be kept up to date.
First – some background information on natural gas as a fuel
Vehicles running on natural gas can be grouped into three main types.
- Bi-fuel vehicles have the ability to run on either compressed natural gas (CNG) or gasoline/bio-diesel. They typically retain their original gasoline/diesel tank and are retrofitted with an additional, smaller-capacity CNG tank.
- Dedicated CNG vehicles run solely on CNG and normally have a fuel capacity equal to or larger than the original gasoline or diesel tank. Up until recently the majority of light- and medium-duty CNG vehicles in operation around the U.S. were the result of a conversion process or retrofit performed by qualified installers. Today reliable natural gas engines are now being manufactured by the largest players in the industry.
- The third classification is liquefied natural gas (LNG). A vehicle running on LNG needs to be engineered specifically for handling LNG. This high degree of engineering allows for differentiation between competing products where a particular patent can give a competitive advantage over others. WPRT’s high pressure direct injection (HPDI) falls into this category.
The differences – CNG and LNG
CNG is made by compressing natural gas. It is stored and distributed in hard cylindrical containers at high pressure. CNG is used in traditional gasoline internal combustion engine cars and trucks. The up-front cost of conversion is a barrier for the low mileage driver and helps explain why high mileage public transportation vehicles have been the early adopters, as they can amortize more quickly the money invested in the cheaper fuel. The use of CNG has grown steadily in the U.S. as the natural gas / diesel spread has remained beneficial to adoption.
LNG is natural gas in a liquid form that is odorless, non-corrosive and non-toxic. LNG is produced when natural gas is cooled to minus 259 degrees Fahrenheit through a highly engineered process known as liquefaction. During this process, the natural gas is cooled, whereby impurities can be reduced and removed. The liquefaction process reduces natural gas volume by a factor of more than 600 – similar to reducing the volume of a beach ball to the volume of a Ping-Pong ball. This allows natural gas to be transported efficiently by sea or truck. Once it reaches its destination, LNG is unloaded, where it is stored as a liquid until it is warmed back to natural gas. The natural gas can then be sent through pipelines for distribution.
The positives and negatives of CNG and LNG
- LNG has fewer impurities as a result of liquefaction.
- Significant quantities are available within the U.S.
- Future growth likely due to pricing differential and enormous amounts of supply.
- LNG provides longer distance between fill ups – which Is ideal for long haul trucking.
- CNG and LNG cause less pollution and as compared to other fuels.
- LNG has a greater fuel density, requiring fewer tanks, less space and lower total weight, as compared to CNG.
- The lives of lubrication oils are extended, as CNG/LNG does not contaminate engine oils like diesel does.
- CNG has an unlimited hold times without fuel loss.
- Large scale LNG energy projects are very expensive and technically challenging.
- Development timelines for a large LNG plant can be many years.
- Since it is a compressed gas, rather than a liquid like gasoline, CNG takes up more space within the cargo area requiring additional tanks.
- LNG must be maintained at very cold temperature and holding tanks are complex.
- Cryogenic parts have a high maintenance cost
Alternative fuel engine types – in general
Traditional spark ignited natural gas engines function much like gasoline engines. However, natural gas engines have a much leaner air / fuel mixture which makes the internal explosion less violent and therefore limits total horsepower and torque. When compared to diesel or gasoline only engines, this design produces tremendous emissions benefits and is best utilized in lighter hauling weight vehicles, such as refuse truck or city buses.
Technological advancements have allowed the traditional spark ignited engine to evolve into a “dual-fuel engine” that produces combustion at a much lower temperature and allows for the replacement of up to 95% of diesel fuel with cleaner burning, less expensive natural gas. This dual-fuel approach produces a horsepower and torque curve comparable to diesel-only engines which is extremely important in high-weight truck applications. Westport’s high-pressure direct-injection (HPDI) technology makes this happen. HPDI technology allows the engine’s power and torque to be 20% and 20-25% higher than that of the spark ignition natural gas engines respectively. Hence, HPDI solves the problem of large plateau power loss for gas engines. HPDI is all Westport’s technology – giving them a true competitive advantage in the market place.
More recently a third type of combustion engine called homogeneous-charge-compression-ignition (HCCI) is receiving renewed attention. Basically it is a combustion engine without a spark. As the engine’s piston reaches its highest point on the compression stroke, the air/fuel mixture auto-ignites (spontaneously without a spark plug) from compression heat, much like a diesel engine. The result is the best of both worlds: low fuel usage and low emissions.
So what exactly is Westport’s business?
Westport is a global leader in alternative fuel and low-emissions technologies, which allow combustion engines to have cleaner emissions through the reduction of greenhouse gases produced and lower levels of particulate matter. Their technologies allow engines to run on clean-burning fuels, such as compressed natural gas (CNG), liquefied natural gas (LNG) and biofuels (landfill gas).
WPRT leverages their proprietary technology by partnering with engine, truck and automotive equipment manufacturers (the OEMs) to develop manufacture and distribute their engines to a wide group of global vehicle manufactures. The partnerships provide them with access to manufacturing capacity, supply chain infrastructure and world-wide distribution networks without incurring the investment associated with them.
The markets they primarily focus on include; light-, medium- and heavy-duty engines. Recently the high-horsepower engines for large commercial applications have begun to garner attention. Westport addresses each market separately through the use of joint ventures or in-house development.
The light-duty market, or Westport LD, is focused on light-duty automotive systems and components. This area also includes industrial applications for smaller vehicles such as forklifts. Examples of LD vehicles are forklifts, passenger vehicles and small trucks.
The medium-duty (MD) and heavy-duty (HD) segments are currently dominated by the Cummins/Westport (CWI) and the Weichai/Westport joint ventures. They currently include a wide range of natural gas engine sizes depending on the JV. Examples of MD-HD vehicles are school buses, city buses, waste-haulers and delivery vans. Westport has developed a proprietary high-pressure direct-injection (HPDI) for the HD market segment.
The graph below is from Westport Innovations HD web page and details the horsepower and torque of the HPDI technology as compared to two other engines noted below. It is blatantly obvious that HPDI technology represents a significant improvement over current engine options.
Dark gray = Phoenix
Light gray = Cummins/Westport
Orange = Westport’s proprietary HPDI technology
The high horsepower market, or HHP, is focused on large commercial applications for marine, rail and mining environment. These engines all use millions of gallons of diesel fuel annually and although this is not a high-volume market opportunity, this area is certainly a high-margin opportunity. Anytime you can save a company millions of dollars in costs annually your pricing power should be unparalleled in the market. Just consider how much money shipping companies or railroads could save in diesel costs by adopting natural gas engine technologies.
Westport also earns technology license fee revenue from licensing fees earned over the duration of a contract. Additionally, the company generates parts and service revenue.
The valuable strategic and business alliances
First, I should mention that almost everyone who manufactures an engine is involved with or wants to be involved with Westport on one level or another. From tiny fork lift engines to the largest marine engines just about every manufacturer on the planet is either, talking with WPRT or has signed a more formalized agreement. The finalized contracts range from evaluation and feasibility projects to formal joint venture partnerships where parties are contractually bound together to perform. One thing is for sure – Westport is a first-mover in the area and everyone wants to be involved with the market leader.
The large joint ventures
Cummins Westport Inc.
Little more than 10 years ago Cummins Inc. and Westport formed a 50:50 JV called Cummins Westport Inc. (CWI). This partnership was created at a time when diesel prices were a better value in the market. That long ago and with no economic incentive to design, build and sell natural gas-powered products, Westport was probably not in a position to negotiate the best “terms” of a JV. They most likely would have been begging for a partner to help fund their losses and further their product development. At the time the primary driver was for environmental compliance due to regulations. Since the original agreement the price of natural gas has fallen substantially and has created a true economic demand for natural gas-powered vehicles.
In February 2012, the Cummins JV was clarified and extended for another 10 years and includes 5.9-liter to 12-liter engines. The updated JV serves to clarify (WPRT management’s word, not mine) the relationship between the parties. The new JV will focus future research and development on the North American market and has an “incremental bonus” calculation feature whereby WPRT will earn a 75% bonus on the income (as defined in the JV) above a base-line annual plan. WPRT management explained that within this new JV, Cummins was given the right to market engines outside North America in markets where they do not compete with CWI. Currently, WPRT is handling the final stages of the manufacturing process for the CWI engines. Cummins has agreed to take on all assembly once a unit volume (approximately 1500) threshold level has been reached. This is excellent news as it increases efficiency thereby lowering cost per unit and increasing margins
The natural gas engines from CWI are offered to OEMs for products such as transit buses, conventional trucks, tractors, refuse collection trucks and street sweepers. Cummins is responsible for most of the manufacturing and allows WPRT to utilize its supply chain, distribution and sale networks.
There is some “angst” in the market about their new JV relationship relative to the 15-liter market for long haul trucks. This “angst” needs to be worked out before WPRT can go to new highs on the chart. The better situation would have been for WPI to incorporate Westport’s HPDI technology into the JV. For some reason, however, the JV chose to differentiate at the 15-liter engine. Perhaps WPRT wanted a larger profit percentage for using their HPDI technology, or maybe Cummins thought they could do the 15-liter engine “in-house” cheaper by themselves. The real story will come out in time.
During a WPRT conference call about the new agreement, WPRT management used the phrase “adjusted economics” in terms of the new JV. This phrase implies to most people that some changes in the cost structure of the JV have occurred. Interestingly though, when asked whether the “financial models” Wall Street was working on needed to be changed, management specifically said “You shouldn’t see any changes.” Unfortunately, for competitive reasons, not all information can be disclosed all the time so we have to draw some intelligent assumptions. Why would management state specifically not to change the financial model? Having been in these situations in my professional career, I would suggest that management has found ways to make up for the “adjusted economics” of the new JV – perhaps though cost reductions or higher volumes which make the specific changes irrelevant. Just a guess, but a very logical one, though only time will tell if my assumption is correct.
Weichai Westport Inc. (WWI) was officially formed in July 2010 and is a JV between Weichai, Westport and Peterson Equipment. WPRT has a 35% interest in the JV. The JV focuses on the Chinese market and develops, manufactures and sells alternative fuel engines and parts for use in cars, buses, heavy-duty trucks, power generation and marine applications. WWI is utilizing WPRT proprietary “high-pressure direct-injection” technology (HPDI) which provides the environmental and cost benefits of a natural gas engine while delivering comparable benefits of diesel engines over the speed and torque operating range, along with exceptional reliability.
Here is why the “Cummins angst” may not matter – China
Recently the Chairman of Weichai said their goal for this year is 15,000 units. If achieved, this would represent a large increase over the 3,800 produced in 2010 and the 9,000 produced in 2011.
According to Weichai Power’s most recent Annual Report, Weichai holds approximately 40 percent of the heavy duty truck engine market for trucks over 14 tons (HD category). According to Weichai’s August 2011 Interim Report, they sold over 200,000 heavy-duty engines for the six months ending June 30, 2011. In 2010, heavy-duty truck sales in China exceeded 1 million units.
Please keep in mind a couple of things; one, this only represents the truck market over 14 tons, and secondly, the pricing differential of natural gas to diesel is not as favorable in China. The decision to move to alternative fuel is based more on the political policies surrounding environmental goals. However, recent articles have suggested the possibility of enormous, shale-based, natural gas supplies in China that are yet to be fully developed. So it is plausible that someday a truly economic reason may exist.
This WWI is currently utilizing HPDI technology in their 12-liter engine.
WPRT has many other relationships with global brands. Some relationships are more formalized than others but they include such companies as; Volvo, Delphi, Freightliner, Paccar, Kenworth, Daimler Group, Beijing Auto, Tata, Weichai, Caterpillar, EDM, Rolls-Royce, Komatsu and Peterbilt to name a few. The point I am trying to make is that Westport is involved all over the world with all the major players. The partners are all leveraging WPRT technology and allowing WPRT to use their fixed cost base. This is called a capital-efficient business model and Wall Street LOVES capital-efficient business.
Westport Innovations – Capital efficient business model
Capital efficiency / leverage can be defined as:
- The ratio of output in comparison to the amount of capital expenditure involved in maintaining the operation of a business or a product line. Stated another way – as sales and profits increase, capital investments do not.
WPRT has designed a business model that is high on intellectual property and low on fixed costs. They are using Joint-Ventures (JVs) with major engine manufactures to leverage their partners’ fixed-cost base and manufacturing expertise while WPRT contributes their intellectual property. This is a capital-efficient business model.
So why is that important?
It all has to do with “valuation modeling”. Wall Street loves companies running “capital-efficient” models because they are structured with low fixed costs and have the potential (if successful) for significant profits (and cash flows) as a percentage of their low-cost base.
This is a very simplified example for illustrative purposes:
Think of capital efficiency like this – in general terms – from WPRT’s perspective:
- Intellectual property development costs for product = $100
- Allocated portion of engine profit from JV = $500
- Ratio = 5:1
Now assume sales and profits increase:
- Intellectual property development costs for product = $100
- Allocated portion of engine profit from JV as a result of increased sales = $1000
- Ratio = 10:1
The example could go on and on until the IP is no longer valid or new costs are incurred to develop additional IP. You can see how WPRT incurred $0in additional cost to earn $500 more in profits. In comparison, the JV partner most likely had to expand its plant (fixed cost increase) hire supervisors (more fixed costs) etc. – all to earn the same allocated profit percentage. Admittedly, the terms of the JV are all up for negotiation.
Capital-efficient business models are set up to generate high returns on capital, producing large cash flows. Both of these factors significantly impact Wall Street’s fair-value calculations where a high price-to-earnings ratio can be “justified” as a result of the strong cash flows generated by a capital-efficient model. Additionally, the expected high cash flows are then modeled using a discounted-cash-flow analysis, which in turn further supports the public valuation of a company.
One reason Wall Street loves Apple Computer is their capital efficient business model. Apple controls their design and intellectual property while the actual manufacturing is sourced out, thereby keeping fixed costs low.
Oh, one other thing to note – ever heard of Warren Buffet? He believes strongly in capital-efficient business models.
Westport Innovations – Intellectual Property
WPRT has an industry leading intellectual property position. This IP position gives them a competitive technological advantage over industry participants. The data below is from Westport Innovations (April 2012) and is graphically presented by RulingTheMarkets.com.
The company’s research and development efforts have resulted in a substantial patent portfolio that serves as a technological differentiator and a foundation for what WPRT describes as its competitive advantage within the market place.
When I had the opportunity to discuss Westport’s patent portfolio with company officials, I learned that the above information detailing 294 owned patents does not include the patents jointly held within any of their joint venture arrangements. This means Westport’s “patent leadership role” is more significant than the above chart illustrates. It was also explained to me that Westport has the right to utilized patents held within the JV’s, as do their partners.
Are Westport’s’ patents truly more valuable than others? Do they represent a long-term defendable intellectual property position that can benefit shareholders for years to come?
These are tough questions to answer. As time passes a clear winner will emerge. Perhaps a relevant parallel can be drawn with Google and Yahoo. In the beginning both were respected start-up companies but Google was able to differentiate itself through its patent portfolio and an ingenious way to rank web pages. As time has passed Google is without a doubt the clear winner. Yet the original technologies were very similar and hard to differentiate. Perhaps the 15-liter competition between Westport and Cummins will play out similarly – only time will tell.
Westport has first-mover advantage in a category that could reshape how we use fossil fuels. A firm can gain first mover advantage when it has some sort of breakthrough in its research and development, resulting in a direct breakthrough in technology. A learning curve can provide a sustainable cost advantage for the early entrant if the learning can be kept proprietary (HPDI is owned by WPRT) and the firm can maintain leadership in market share. This advantage results from the fact that the first entrant can gain control over resources (patents) that followers may not be able to match. Sometimes first-movers are rewarded with huge profit margins and a monopoly-like status.
All of this is hard to quantify now to answer the question – Is the technology worth a few million or a few billion? A clear answer to this question is difficult to come up with, but Westport has the “structure” in place to have a significant impact on an enormous market segment, a defendable patent portfolio and key relationships with all the major players in the industry. In other words, the odds appear to be in Westport’s favor, but only time will tell.
WPRT owners will need to watch the Cummins 15-liter developments closely and the competitive landscape within the industry.
But why invest in WPRT now?
We have discussed previously how macroeconomic factors, strategic alliances, capital efficiency and their patent portfolio all represent positive influences on our investment case. So now it is time to update my technical analysis of WPRT stock and evaluate our timing.
Technical review of stock action
On April 5th I detailed a technical review of WPRT and concluded the market timing was not appropriate to initiate a long position (Posted at RulingTheMarkets.com – under the free stuff tab). Since then WPRT has gone from around $38 to $31 and is now at prior support in the area of the 200-week moving average. So next I will update our technical view using my three-step process:
- Review macro factors driving an industry (big-picture analysis).
- Review the specific company fundamentals.
- Consider the timing of investments.
Step 1 – Market Health (at the date of publication)
By most measures, the S&P is pausing and has consolidated through time. The basing near the high for the last six weeks has allowed the 50-day moving average to “catch up” so the market is no longer extended – but – the higher-volume days in the market represent bearish days, not bullish. This makes reading the market a bit fuzzy. We need to keep watching the S&P for further information.
Step 2 – Company Review
This has been covered extensively in this document.
Step 3 – Timing (weekly charts, then daily charts)
Long Term Weekly Chart – buy point #2 – The 19-month long support
Current market capitalization is about $1.7 billion.
I think this weekly pull back to the 200-week moving average is attractive. However, I am mindful of the sell-off occurring on high volume. Volume = conviction in this market. Additionally, the general market appears ready for a pull back. All of that having been said, there has been a fair amount of “uninformed opinions” being offered to scare weak shareholders into selling and locking in their gains to date. I believe the macroeconomic influences are still extremely positive and this pull back to the 200-week moving average and daily support range, provides us with an opportunity to have a tight stop on a stock that could potentially re-write the alternative fuel market.
RulingTheMarkets.com is where our trade entries, exits and management are posted. They can be seen within the Trading Blog which can accessed from the navigation bar on each web page.
If this trade stops out – I will look for a re-entry at the 19-month long-term weekly support around the $20-$24 area.
In the market you can always find stocks, bonds and options you can “trade” on various time-frames – trading or fast money is more Wall Street’s style now-a-days than it ever was in the past. Rarely, are you presented with an “investment” opportunity that allows you to earn compounded returns over many years (sometimes decades) no matter what the economic situation and potentially change your financial outlook for the rest of your life. If the natural gas / diesel fuel pricing differential holds – Westport Innovations might just be a stock for the next decade.
The center of the natural gas conversion universe is Westport Innovations. Originally published April / May of 2012.
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