Recommendation:
I believe Fuel Systems Solutions (FSYS) is likely to report disappointing second quarter earnings on August 8th and reduce its guidance, leading to a likely 10%-25% decline between now and after the earnings release.

FSYS’ closest competitor/comparable (a small-cap company trading on the Italian stock exchange) recently announced a significant cut to 2013 guidance, implying that 2013 EBITDA will be less than half of both 2012 levels and initial 2013 guidance.  Despite this news, FSYS’ stock price has been unaffected and remains near its 52-week high.

Unlike related stories like Westport Innovations and Clean Energy Fuels, the short interest for FSYS is not especially high (~6.7% of float sold short), and a borrow is available at reasonable costs.

Company Description/History:
FSYS is a designer and manufacturer of components that allow engines to run on alternative fuels like liquid propane gas (LPG) and compressed natural gas (CNG).  The Company operates in two segments.  The Industrial segment, which sells gaseous fuel systems to forklift and generator OEMs, represents 31% of LTM sales and 36% of LTM adjusted EBITDA (before corporate expenses).  The Automotive segment, which sells gaseous fuel systems to automobile OEMs, distributors, and aftermarket installers, represents the remaining 69% of LTM revenue and 64% of LTM adjusted EBITDA.  For the purposes of this write-up, I’m going to focus mostly on the Automotive segment, as that is where the bulk of the perceived value in FSYS lies (and for what it’s worth, the Industrial segment has seen declining profitability over the last couple years).

If you live in Italy, for instance, and want to buy a new car, for many models you have the option of purchasing a conventionally fueled version or a bi-fuel version.  The bi-fuel verson will likely cost anywhere from €2000 to €4000 extra, and you’ll lose some of your trunk space to the extra fuel tank, but your new car will have the ability to run on either gasoline or CNG (or LPG if you choose that version) at the flick of a switch.  Alternatively, you can have your existing car converted to have bi-fuel capabilities with the installation of an aftermarket kit.  Given the high cost of gasoline in Italy and the availability of CNG and LPG pumps at many Italian gas stations, the bi-fuel option is often compelling.  Whether you’re purchasing a new bi-fuel car or an aftermarket kit to convert your existing car, your bi-fuel car likely includes components made by one of the following three competitors (although there are a number of other small competitors that are more prevalent in less developed markets):

• FSYS
• Landi Renzo (ticker LR.MI): Landi is the most direct competitor and best comparable for FSYS.
• Westport Innovations (ticker WPRT): Better known for its focus on liquefied natural gas engines for trucks, WPRT’s Juniper and Emer Spa subsidiaries make components for bi-fuel cars. In addition, in June of 2013, WPRT bought two Clean Energy Fuel subsidiaries (BAF Technologies and ServoTech ) that also are in the bi-fuel components industry.

Given the stronger penetration of gaseous fueling infrastructure abroad as opposed to in the U.S., FSYS’ revenue primarily comes from overseas.  In 2012, 25% of FSYS revenue was from North America (I think most of this was in the Industrial segment), 19% was from Italy, 20% from the rest of Europe, 19% from Asia, and 17% from Latin America.

If you look at FSYS’ historical financials, you’ll see that in 2009, EPS reached almost $3 and EBITDA reached almost $100 million.  The stock touched the $50 level in late 2009 and early 2010.  You’ll also see that both earnings and the stock price have fallen considerably since then.  By 2012, EBITDA had fallen to $24 million and EPS (excluding an impairment charge) was $0.28.  Why have earnings fallen so considerably since 2009?

It turns out that FSYS’ 2009 results were buoyed by subsidies in the Italian auto market (there were also bi-fuel targeted subsidies in other European countries in 2009 as well).  First, in 2009 Italy enacted a cash-for-clunkers subsidy worth €1500 per new car purchased.  In addition, Italy also enacted an additional subsidy for the purchase of a new car with bi-fuel capabilities.  This additional subsidy was €1500 for LPG bi-fuel cars and €3000 for CNG bi-fuel cars.  Not surprisingly, this boosted both overall car sales in Italy and the penetration of bi-fuel cars.  In 2009, there were 2.2 million new cars sold in Italy, and by the end of the year, bi-fuel models represented over 30% of new car volume.  In 2012, only 1.4 million new cars were sold in Italy, and bi-fuel penetration was back down to 13%.

FSYS’ profitability declined dramatically when the Italian subsidies expired at the end of the first quarter of 2010, and the company’s profitability has drifted even lower since then:

The bull case for FSYS is that it is a play on the potential widespread adoption of bi-fuel cars in the U.S.  And indeed, GM, Ford, and Dodge all now offer bi-fuel pickup trucks in the U.S.  GM uses primarily FSYS as both the component supplier and installer for its bi-fuel offerings.  Ford uses primarily Westport as both the component supplier and installer for its bi-fuel offerings.  Dodge does the installation itself, and I believe they don’t use any components from FSYS, Westport, or Landi, but I’m not 100% sure of this.

In any event, I’m skeptical that the U.S. market will be as lucrative for FSYS as the market believes.  Volumes are relatively low so far (FSYS will likely do 2000-3000 units for GM this year), competition is fierce (for instance, Ford has approved 6 different companies to install bi-fuel systems), and I’m not sure there’s much product differentiation here.  And of course there’s the problem of nearly non-existent CNG fueling infrastructure.  CNG is great fueling option for fleet customers who return to a centralized depot each day, but it’s much less attractive for a typical driver.  And lastly, if bi-fuel options do start to catch on, I think there’s a real risk that the OEMs will disintermediate companies like FSYS and develop their own bi-fuel systems (as I believe Dodge is already doing).  Writes FSYS in its most recent 10-K: “In the future, we may face competition from traditional automotive component suppliers, such as the Bosch Group, Delphi Corporation, Siemens VDO Automotive AG and Visteon Corporation, and from motor vehicle OEMs that develop fuel systems internally.”

Fuel Systems Solutions and Landi Renzo are in the same business:
Like FSYS, Landi Renzo makes components that allow engines to run on gaseous fuels.  The companies both list each other as chief competitors.  Landi claims that is the largest player in the space, with a 30% market share, followed by FSYS with a 27% share (from Landi March 2013 investor presentation).

The main difference between the two companies is that FSYS has an industrial segment (36% of LTM adjusted EBITDA before corporate expenses) focusing on things like forklifts and generators, while Landi focuses entirely on automotive customers.

The geographical breakdown is fairly similar.  In 2012, Italy was 28% of Landi’s sales, the rest of Europe was 31%, the Americas (both North and South) was 14%, and the rest of the world was 27%.  FSYS’ 2012 revenue breakdown was 19% Italy, 20% rest of Europe, 25% North America (mostly Industrial segment), 17% Latin America, and 19% rest of world.

The correlation with FSYS’ and Landi Renzo’s profitability has been high:
Below is a graph showing Landi Renzo quarterly EBITDA (I’ve converted Landi Renzo figures, originally reported in Euros, to dollars using average exchange rates for each quarter) and FSYS quarterly EBITDA over the last 5 years:

Not surprisingly, the initial 2013 guidance figures from Landi Renzo and FSYS were similar.  Landi Renzo’s initial guidance (released on March 14^th) called for 2013 revenue to exceed €280 million (at least a 1.7% increase) with EBITBA margins of “over 10%”, implying EBITDA of greater than €28 million (vs 2012 EBITDA of €28.3 million).  FSYS’ initial guidance (released on March 8^th) called for revenue of $400 - $420 million (a 2% to 7% increase), and operating margins to be 2% to 4% (vs 2.2% in 2012).  Based on notes from FSYS’ 10-K about 2013 D&A levels, this guidance implies a 2013 EBITDA range of approximately $22 - $31 million, as compared to $23.5 million in 2012.

Landi Renzo recently announced a substantial cut to guidance:
On July 10^th, Landi Renzo issued a press release pre-announcing 2Q13 revenues and revising 2013 guidance downward.  Landi Renzo’s 2Q13 revenue will come in around €59 million, down 25% YoY.  As for the full year, Landi now expects 2013 revenues of €210 to €240 million (a decline of 13% to 24%) and EBITDA margins of 3% to 6%.  This implies 2013 EBITDA of €6 million €14 million, down more than 50% from 2012 figures and initial 2013 guidance.  Management noted that “Several factors have impacted the market….Italy and some European areas have been affected by the economic crisis; extremely relevant geopolitical factors have produced adverse effects on the sector in question in some markets in Asia and South America.”

The drop in guidance is not entirely surprising, as Italian car sales were down 10.3% year-to-date through June, with car sales for the European Union in total being down 6.6%.  Moreover, in recent earnings releases, FSYS management has noted an increasingly competitive market:
FSYS mgmt, 3/8/13: “A stagnant global economy is resulting in increased competition, with some players now seeking lower prices.”
FSYS mgmt, 5/8/13: “Our marketplaces become increasingly competitive amid a tough global economy….some margin compression (is) expected from an increasingly competitive environment.”

Given the weak underlying trends in FSYS’ European end markets, the Company’s own observations about an increasingly competitive environment, and a drastic cut to 2013 guidance from its closest competitor and comparable, I think it’s likely that FSYS will fail to meet its own initially provided 2013 guidance.

It wouldn’t be the first time FSYS has overpromised and underdelivered on guidance:
Ever since the Italian bi-fuel subsidies expired on 3/31/10, FSYS has a consistent track record of missing its guidance.  In August of 2010 (a few months after the Italian subsidies expired), FSYS guided to 2010 operating profit of $59.5 - $72.0 million.  In December of 2010 they tweaked this guidance downward to a range of $58.8 - $68.8 million, and the stock fell 7% that day.  Operating profit for 2010 came in at $58.3 million.

In March of 2011, FSYS guided to 2011 operating profit of $18.8 - $28.0 million.  They later lowered this guidance in November of 2011 to $15.6 - $20.5 million, and the stock fell 17% that day.  They still missed even this lowered figure, posting 2011 operating profit of $11.8 million.

In March of 2012, FSYS guided to 2012 operating profit of $12.6 - $22.0 million.  Guidance was withdrawn in May of 2012, and the stock fell 19% that day.  Guidance was reintroduced at a slightly lower level in August of 2012 (operating profit of $12.2 - $21.0 million), and the stock fell 12% that day.  They lowered this guidance again, in November of 2012, to $3.8 - $11.9 million; the stock fell 13% that day.  They ended up posting 2012 operating profit, excluding impairment charges, of $8.8 million.

In March of 2013, FSYS guided to 2013 operating profit of $8.0 - $16.8 million.  They reaffirmed guidance in May in conjunction with an earnings release that missed Street forecasts.  Since then, auto sales have continued to weaken in Europe, and Landi Renzo has slashed EBITDA guidance by more than 50%.  In the meantime, FSYS stock is up more than 20% since the initial 2013 guidance was provided.

FSYS is expensive on any cash flow metric:
At its current $19.03 share price, FSYS trades at:

• 63x LTM EPS of $0.30
  • Note that LTM EPS of $0.30 excludes impairment charges
• 66x the midpoint of its implied 2013 EPS guidance
  • I estimate the Company's 2013 guidance (operating profit of $8.0 to $16.8 million and a 54% tax rate) translates to an EPS range of $0.19 to $0.39
• 24x EV to LTM operating income of $12.6 million
  • Note that in calculating operating income, I’ve excluded amortization of intangibles ($4.7 million in the LTM period), as well as impairment charges, gains/losses on asset disposals, and changes in contingent consideration related to prior acquisition
• 20x EV to the midpoint of its 2013 adjusted operating income guidance
  • Stated guidance for operating income is a range of $8.0 - $16.8 million; if we exclude amortization of intangibles of $2.9 million in 2013, then the range increase to $10.9 - $19.7 million
• 11x EV to the midpoint of implied 2013 EBITDA guidance
  • If we add my estimate of 2013 D&A of $14 million to the Company’s operating income guidance, that implies EBITDA of $22 - $31 million

My recommendation on FSYS is more based on my view of upcoming earnings and guidance than it is on valuation, but it doesn’t hurt the cause that the Company’s valuations are where they are.

Risks:
I’d argue that the biggest risk in shorting FSYS is the potential that it is bought out by a strategic player.  In June of 2013, Westport Innovations bought the BAF Technologies and ServoTech subsidiaries (both involved in the same business as FSYS and Landi) from Clean Energy Fuels.  Westport paid $25 million (all of it paid in Westport stock) for the deal.  Reported LTM sales for the BAF and ServoTech as of 4/30/13 was $20.9 million, so the EV/sales multiple was 1.2x.  If Westport or someone else were to pay 1.2x sales for FSYS, that would imply a ~$27.50 stock price for FSYS.

That said, acquiring FSYS, with a current enterprise value of ~$300 million, would be a much bigger bite than buying the BAF and ServoTech subsidiaries from Clean Energy.  Moreover, if you want to build your company’s exposure to the automotive gaseous fuels component market, I’d argue that Landi Renzo might be a more attractive target.  Despite having a larger market share in the automotive gaseous fuels component market than FSYS, Landi currently sports a lower enterprise value (~$240 million for Landi vs. ~$300 million for FSYS).  With Landi, you’d be buying a pure play company, whereas with FSYS, you also have to pay for the Industrial segment.  For these reasons, I’m willing to stomach the buyout risk.

Another risk is the potential for a resurrection of the NAT GAS Act or something similar.  The NAT GAS Act was last on the congressional agenda in March of 2012.  The version that was voted on in the Senate would have granted tax credits to purchasers of natural gas powered vehicles ($7500 per vehicle for light trucks all the way up to $65000 per vehicle for 18 wheelers) and would have extended through 2016 the $0.50 per gallon-equivalent tax credit that sellers of natural gas fuels for automotive use can claim (the $0.50 per gallon-equivalent credit was set to expire at the end of 2011 but has been reinstated twice and is now set to expire at the end of 2013).  FSYS stock surged in early 2012 to nearly $30 per share when the NAT GAS Act was being considered, although it gave up these gains after the act failed to muster the required 60 Senate votes to be added as an amendment to the Transportation Bill.  45 out of 52 Democrats present voted for the NAT GAS Act, while 39 of 45 Republicans voted against the act.  The NAT GAS Act lost lots of support in the lead-up to the vote when several conservative groups (Heritage Foundation, Club for Growth, Americans for Prosperity) lobbied strongly against it.  Given the current makeup of Congress and the lack of an appetite for new energy subsidies that would add to the deficit, I think it’s unlikely the NAT GAS Act gets resurrected anytime soon, but it is a risk worth mentioning.

I’ll also point out that my recommendation here is short-term focused (I’m arguing that FSYS will likely have to cut guidance when they release second quarter earnings).  Even if I’m right about FSYS missing its current 2013 guidance targets, FSYS may wait until later in the year to adjust guidance downward, thereby delaying a potential stock price correction.

• Report of 2Q13 earnings (and potential guidance update) on August 8^th
• Report of 3Q13 earnings (and potential guidance update) in early November