As is often the case in high growth companies, valuation metrics seems to diverge significantly from the underlying business and market fundamentals. You don’t need to look beyond American Superconductor (NASDAQ: AMSC), Green Dot (NASDAQ: GDOT), OpenTable (NASDAQ: OPEN), and RealID (NYSE: RLD) as some examples of companies that have been brought back to earth after spending time ascending stratospheric levels. As is often the case, these companies enjoyed significant sponsorship from the sell-side and had highly promotional management teams that did not hesitate at any given instant to tom-tom the merits of their addressable opportunity.
We believe that Westport Innovations (“Westport” or the “Company”), a natural gas engine manufacturer represents one such company and is an extremely compelling short candidate at current levels. The frenzy in Westport Innovations (after all 11 out of the 17 sell-side analysts rate the company a “Buy”) stock has been driven by the Company doing a stellar job promoting itself across various media channels and the sell-side community positioning it as one of the best ways to play the natural gas “nirvana” for transportation engines.
This euphoria in Westport driven by historically low natural gas prices has translated into a share price that has almost tripled over the past three years. At a current market capitalization of $2.1B and an Enterprise Value of $1.9B, Westport enjoys an extremely rich valuation of 4.50x FY2012 Revenue consensus with market participants not discounting the very real and obvious risks to its business model detailed below.
The Company is EBITDA negative with analysts projecting Westport to generate $10.2M in EBITDA for FY2013. The Company completed a secondary offerings earlier this year exploiting the momentum in its share price and raising ~$270M. Since pricing at $43.25 per share, the Company has traded below the issue price. We believe that there is much more room for the stock to decline and provide our views on the same.
The Short Thesis
The Cummins Westport JV was amended in February this year with what we believe to be unfavorable long-term consequences for Westport. Suffice it to say, we believe that the economic profile of the CWI JV has peaked and we expect margins to decline going forward as Cummins captures the incremental margin from the mark-up which previously would have accrued to the JV. Also, there has been a sequential deceleration in the JV business this year which does not bode well for the Company as it happens to be the only profit making unit within the enterprise.
The key growth engine (“pun intended”) that provides the supposed justification for the overall valuation of the Company remains the Heavy Duty segment - upon which the sell-side analysts are counting on Westport to deliver strong results. However, this segment remains constrained by exogenous factors such as the build-out of adequate fueling infrastructure which will take a significant amount of time to materialize. For instance there are about 1,000 natural gas stations in the United States versus more than 160,000 gasoline stations. Till then, customer purchases will be sporadic at best as evidenced by the most recent quarter, where unit sales were down over 50% sequentially. Even if the infrastructure build-out starts gaining momentum and the move to purchase LNG enabled engines by Class 8 trucks becomes a reality, we find it highly unlikely that the existing incumbents will just watch the action unfold without making an aggressive push to develop a stronghold in the market.
We analyzed Morgan Stanley’s DCF model, in order to understand the assumptions baked into the current valuation. For the Company to be valued as per their “Bear” case (which we believe is still aggressive and translates into a $21 share price – ~45% downside from current levels), the Company will still need to grow EBITDA at a 70% CAGR over the FY2014-FY2019 period with FY2019 EBITDA of ~$270M. If we assume that CWI JV grows at a 20% CAGR over the 2011-2019 period, translates into ~$140M of EBITDA. Given the dynamics highlighted above that relates to the JV, we believe that this could be a tall order to accomplish given margin deterioration and increasing competition.
To summarize, Westport Innovation’s current valuation has diverged significantly from its intrinsic valuation based on both current and forward business fundamentals and metrics. With the market ascribing tremendous value to the Heavy Duty segment as if the growth in this segment and associated revenue capture by the Company was a “done deal”, the margin of safety is non-existent at current levels. With an increasing number of the established diesel engine manufacturers putting forward strategies for natural gas engines, the demise of Westport Innovations is not an “if” but “when” situation. In the meantime, the Company continues to burn approximately $100M in cash per year with a continued ramp in its opex indicating the lack of operating leverage in its business model. Note that timing of the short to play out is difficult to predict but we are certain that the underlying fundamentals of the business have begun to rapidly deteriorate as evidenced by their recently announced quarter. Given that ~38% of the float is sold short, we would encourage investors to size positions accordingly.