Description

I believe Westport Innovations is a compelling and timely short.  Earlier this year, a sharp drop in natural gas prices sparked a frenzy in Westport’s stock with the market capitalization at one point reaching a stunning $3 billion.  Many investors and analysts deem Westport an exciting way to play a potential surge in demand for natural gas engines and one analyst even explicitly applies a premium valuation due to “investment scarcity” in the space.  The company is extremely promotional with a steady flow of bullish press releases and regular CEO appearances on CNBC, which I believe has attracted a huge retail following.  Ironically, I believe the drop in natural gas prices has actually set off a series of events that likely will seal Westport’s fate as a worthless or near worthless stock. 

Westport’s main business is conducted through a 50% stake in a joint venture with Cummins, a large manufacturer of diesel truck engines.  Roughly a decade ago, Cummins entered into the joint venture with Westport to develop Cummins’ natural gas engine technology for medium-duty engines that target fairly short distance vehicles such as buses and garbage trucks.  When the joint venture was formed, this effort was not much of a focus for Cummins so splitting the cost and management efforts with a third party likely seemed compelling at the time. Westport’s share of the joint venture currently generates around $15 million of net income, a tiny number in relation to the company’s current market capitalization of around $1.8 billion.  While volumes in this business should grow nicely for the next few years, the overall addressable market is rather limited and I believe the ultimate potential of this business is likely not much more than two times its current size, which still wouldn’t come close to justifying Westport’s current market value.

The bulk of the excitement around Westport has come from its aspiration to sell engines into the much bigger heavy-duty market for large, long-haul trucks.  Many analysts project this business eventually outstripping the size of the Cummins joint venture and given that Westport does not share profits with Cummins in this segment, the bulls point to an enormous profit opportunity for Westport. Westport is not permitted to use the technology from the joint venture as it belongs to Cummins so Westport has been attempting to develop its own technology.  This division currently loses a significant amount of money and is not even profitable at the gross margin level (in fact they need to buy the base engine from Cummins as Westport does not have any meaningful manufacturing capabilities). 

The heavy-duty market will be very slow to develop (if it even happens at all) due to the lack of natural gas fueling infrastructure needed for longer range hauls, but in any event, my belief has been that Westport has a slim chance of competing successfully with vastly larger, entrenched players.  If natural gas engines were ever a material part of the truck engine market, my view has been that the existing diesel engine manufacturers could easily shift their focus and their significant advantage in scale, manufacturing, service and dealer locations would render Westport irrelevant.  To give you a sense of what I am talking about, consider the following figures. Westport’s heavy-duty division has 79 employees.  Cummins has 44 thousand employees.  I estimate Westport has no more than $15 million of plants and equipment in its heavy-duty division.  Cummins has $2.3 billion of plants and equipment.

Perhaps unsurprisingly, as the debate around natural gas engines has been propelled to the forefront in recent months, the existing diesel players have already responded.  In early February, large truck and engine maker Navistar introduced a new natural gas engine technology.  Then, in late February, Cummins and Westport announced changes to their joint venture agreement. Westport quickly positioned the changes as a positive development, highlighting a renewed partnership with Cummins and the inclusion of a potential “performance bonus” for Westport.  The mechanism for this bonus was not disclosed for “commercial reasons” according to Westport. Why such a number is considered secretive and commercially sensitive is a mystery to me and the lack of disclosure raises serious doubts as to whether this bonus is even remotely achievable or material. 

From my perspective, the agreement is a potential disaster for Westport.  I suspect the changes were instigated by Cummins as they now seem to be focused on this part of its business.  First, the joint venture now excludes any activities outside North America as Cummins will be targeting those markets without Westport’s involvement.  Second, Cummins will sell the base engines into the joint venture at a mark-up versus the prior practice of contributing them at cost (the joint venture pays Cummins for the engines and retrofits them with natural gas capabilities and in turn sells the finished product for a profit).  This change in the economics shifts profits out of the joint venture to Cummins alone.  On a conference call discussing the agreement, Westport’s CEO failed to highlight these new terms, and in response to a question, he asserted the new arrangement would have no impact on margins.  That strikes me as impossible and I look forward to seeing future quarterly results as I can’t imagine how there will not be a meaningful degradation in the profit margin.  Finally, there is a clause in the joint venture agreement that I haven’t heard any analyst or the company address that allows Cummins to compete with the joint venture in five years as long as “such engine model is based on an entirely new Cummins heavy-duty platform” (the agreement is publicly available with the Canadian Securities Administrators and it appears few, if any, analysts have actually read it).  I didn’t think too much of this clause at the time, but several weeks later, Cummins announced its own new heavy-duty platform based on the technology currently used by the joint venture (recall Westport is not entitled to this technology and is using its own distinct technology for heavy-duty engines).  So in one fell swoop, Cummins has become a competitor with Westport on heavy-duty engines and the door is now open for Cummins to sell medium-duty engines outside of the joint venture.  Simply put, I don’t see how Westport has any meaningful future given these developments.

I suspect Westport might share some of our concerns.  On January 23, 2012 before the joint venture agreement was changed, CEO David Demers appeared on CNBC promoting the company’s story (as he has done incessantly over the past year).  When asked if the company would need to raise equity, he responded by comparing Westport to “the early stages of a gold rush” but stressed they “won’t be doing an equity offering any time soon unless there is a major opportunity.”  He continued, “We don’t need any more money to do what we said we are going to do on the trucking side.”  Not even one month later (after the joint venture changes but preceding the Cummins new heavy-duty platform announcement), Westport sold $270 million worth of newly issued stock in a public offering (with no apparent “major opportunity”) – an amount exceeding the company’s entire market value just two years ago. 

Catalyst