Natural gas may or may not be the transportation fuel of the future, but regardless of the outcome of this debate, I see substantial downside to Clean Energy Fuels (CLNE) due to its egregious valuation and the commoditized nature of its offerings. Let’s start with valuation:

• Market Cap (basic shares): $2.1 billion
• Diluted Market Cap (after converts, warrants, and options): $2.7 billion
• EV at Diluted Market Cap: $2.5 billion
• Projected EV at End of 2012: $2.8 billion
• 2012 Consensus Sales: $377 million
• 2012 Consensus EBITDA: $13 million
• Diluted Forward EV / Forward Sales: 7.4x
• Diluted Forward EV / Forward EBITDA: 215x
• Pro Forma Book Value with Conversion: $740 million
• Price / Book Value: 3.8x

I think it’s undisputable that CLNE is expensive based on current metrics. The only way that fundamentals can justify the current valuation (much less any appreciation) will be for there to be massive growth in one or more parts of the business and for the company to have a big moat that keeps competitors out and allows it to earn high returns. Let’s examine the various business lines:

1)      The company offers vehicle conversion kits that allow owners of traditional vehicles to convert their vehicles to run on natural gas. This sounds like a great business with huge growth potential. Unfortunately, that’s not the case. There are two problems here. First, if natural gas engines ever really catch on then the OEMs are going to start offering natural gas engines as standard equipment. This will relegate this business to either the intervening period before natural gas engines are introduced by the OEMs or to conversions of older vehicles. The intervening period is, unfortunately for CLNE, likely to be brief because natural gas engines are widely available from major OEMs in other geographies. A breakdown of countries with lots of natural gas vehicles can be found here: http://en.wikipedia.org/wiki/Natural_gas_vehicle#Europe

As regards the potential for conversions of older vehicles, this is already a crowded market and it’s not clear that CLNE (which operates through the BAF Technologies brand) has the leading offering. In fact, it would appear that Landi Renzo, IMPCO technologies, and CNG Store (dba Auto gas Store) all have as many or more offerings based on the following: http://www.ngvamerica.org/pdfs/marketplace/MP.Analyses.NGVs-a.pdf

With many competitors, it’s hard for me to see how good returns are going to be made from this business.

2)      The company manufactures compressors for natural gas stations through its subsidiary IMW. These are needed to fuel CNG vehicles. Unfortunately, this is a commodity product since it can be made by pretty much any compressor company. The products tend to have relatively little differentiation and lots of competition, including:

1. Ingersoll Rand
2. Go CNG Pumps
3. http://www.ccf-compressor.com/cng-compressor/
4. http://www.bauergroup.com/en/produkte/erdgas_cng/bauer/index.php

3)      The company builds CNG and LNG gas stations. This is a commoditized business with law margins. In fact, the company remarked that its gross margins in Q4 were hurt by a shift in revenues towards this business. Some competitors include:

1. http://www.vocationalenergy.com/index_backup.htm
2. http://www.zeitenergy.com/
3. http://www.nexgenfueling.com/
4. http://www.southeastlng.com/

There are many more competitors that you can find with a simple google search for “CNG Gas Station construction”

4)      The company has a BOO (Build, Own, Operate) business for fleet owners. In this business, CLNE will build a CNG or LNG station at a customer’s premises and then sell the gas to the customer’s fleet under a long-term contract. In recent years, one of the major customer segments for this has been garbage trucks. This sounds like a neat business with recurring revenue and long-term contracts, but it’s also beset by competition and it’s hard to earn high returns here. Some of the competitors include:

1. http://www.pinnaclecng.com/
2. http://www.trilliumusa.com/
3. http://www.vocationalenergy.com/index_backup.htm
4. http://altlng.com/

5)      The company is building “America’s Natural Gas Highway” (ANGH), which will be a string of natural gas stations along the interstates at truck stops such that all of the major interstates will have enough refueling stations for long-haul trucking. This is an innovative idea where the company has (for now) relatively little competition and there’s clearly a big growth opportunity. The key to this being the future of the company is whether the company has a defensible moat (what the barriers to entry are). If the company has an opportunity to act with little or no competition in this market, it could be great. If a lot of competition can come in easily, I don’t see why CLNE should be able to earn good returns in what has otherwise been a mediocre business (gas stations). In fact, the CEO addressed this very question on the last conference call:

<Q - Steven M. Milunovich>: Okay. And could you talk about barriers to entry, I think the world's starting to believe this is going to happen, and that's likely to bring more folks into it. I think there's often a perception that the barriers are fairly low here. I assume you disagree with that to some degree. Could you numerate your reasons why not?

<A - Andrew J. Littlefair>: Well, we've talked – a lot of people on the call talked about this before. Can other people be in the fueling business? Sure. But I always like to start out by saying this is different than the passenger car market.

So, let's for at least for the moment take that integrated play, the majors out of this, because they are not really in this market. They are not fueling trucks, and they are not fueling trash trucks, and they are not – that's not their market.

So if we thought that every passenger car in the United States was going to go to natural gas, I think I'd have a harder story on that. I'm not going to get wiped out by somebody that has 5,000 or 10,000 fueling stations.

When you look at the truck market, it's a little bit different story. The more I've gotten to know our partners at Pilot

Flying J, the more impressed I'm with what an operation they run. But think with me that they have 450 truck stops

Pilot Flying J truck stops in the United States that sell somewhere around – I don't know, 8 billion gallons of diesel. Do a million transactions a day. And so – and they are my partner. So, when – Steve, when you asked about the market size the 3.2 million Class 8 trucks, those Class 8 trucks use about 24 billion to 25 billion gallons of diesel. So, they got a pretty big piece of the market. And they are our partner, and that's why we are rolling out there.

So I think that was a key strategic move to partner with the Pilot Flying J, and we've announced some others, they don't get quite the cachet. But we've signed up the Quarles Petroleum people in the Mid-Atlantic that have 180 locations. And we have several others that will be announced soon. We think this is a very key piece of this business, which is to have locations under contract, under long-term exclusive arrangement so that we can put LNG truck stops in where America's trucking fleets go.

So I think in one way that's probably the most important – and I don't like barriers to entry, I think that's one of the most strategic advantages we have. Now, the other thing is we have a compressor company, other people can get those I know that. We have one of two LNG fabrication and construction companies that we have, and we have a nationwide network of construction people building these, and we operate now, we have contracts from 650 of the nation's largest fleets. So, we're already doing business with a lot of these. That doesn't mean we couldn't be displaced, but we think that's an advantage.

We have LNG plants. We understand LNG supply. We have an LNG cryogenic tanker fleet. And so Steve, what I think– and we've been in the business – and after all, we've spent I don't know, $600 million, $700 million, $800 million, it's not like we've just been casual about this. And we are building out – we are way ahead. I mean, nobody else is really building. There's been a handful of LNG fueling stations, nobody else has done what we have done. So, I think when you put all that together, we are pretty far out in front of the crowd. Now, I think we will have competition, and we are starting to see little pieces of it pop up. And I think, that's just – I think that's, frankly, is good news. I think that validates the fact that we got a real business.

Wow! That was a mouthful. Let me see if I can summarize it in a few bullet points:

• CEO says: We are fueling trucks / not cars. My response: This is not a barrier to entry. This is just a market segment.
• CEO says: We have Pilot Flying J as a partner. They have lots of stations. My response: Pilot Flying J has only 4-5% of the total truck stops in America. Pilot Flying J doesn’t make great returns selling gasoline, so why should someone collocated with them and also selling a commodity make great returns? They shouldn’t.
• CEO says: We have other partners we are signing up. My response: So you have another 2-4% of the market. So what?
• CEO says: We have a compressor company but other people can also get them. My response: thank you for admitting this is not a barrier to entry
• CEO says: We have LNG construction and fabrication companies. My response: so do lots of other people
• CEO says: We have contracts from 650 of the nation's largest fleets. My response: you don’t make money from them now and your BOO business does not necessarily translate into highway customers, especially if you’re going to charge higher prices than the competition
• CEO says: We have LNG plants. We understand LNG supply. We have an LNG cryogenic tanker fleet – and after all, we've spent I don't know, $600 million, $700 million, $800 million, it's not like we've just been casual about this. My response: $600-800 million of capital spent is not a barrier to entry. CLNE is also measuring this against the wrong number. The right question is how much would it cost other truck stops to install CNG. This is only a couple million dollars.
• CEO says: We are way ahead. I mean, nobody else is really building. There's been a handful of LNG fueling stations, nobody else has done what we have done. My response: This is not a barrier to entry. You’re just admitting that you’ve built stuff and there’s not much demand (yet).

So what’s my conclusion here? CLNE represents a vision that the United States will see a massive move in its transportation infrastructure from gasoline to natural gas. None of the businesses, with the exception of America’s Natural Gas Highway (ANGH), address a market that’s even remotely likely to be large enough to justify the company’s market cap. As regards ANGH, it’s unfortunately targeting a market that may be large but is without any long-term competitive differentiation or barriers to entry. We know this because diesel replaced gasoline as the primary fuel for trucks in the 1960s and 1970s and none of the companies that built diesel stations created lasting franchises with superior returns. At best, these markets tend to earn their cost of capital. I recommend shorting CLNE with a target of 0.5x book value ($3/share) which represents a 50% chance that ANGH never takes off and the company collapses under its existing debt and cash burn and a 50% chance that ANGH succeeds in earning its cost of capital and CLNE trades to book value. If anything, I see these probabilities as being generous to CLNE.