Westport Innovations - Lighting a Single Candle

Here at Marketdepth, we are not in the business of selling equities to the public.  In fact, our focus is often on the somewhat less glamorous activity of preserving capital.   However, being of a generally curious disposition, from time to time we do a bit of digging on one of the local companies of our acquaintance.  Small cap management in town is generally rather approachable and we enjoy hearing them out.  When the time to buy advantageously comes along we know how to hit a bid.  But every company knows a lot of other times.  

 

It is in this spirit that I review Vancouver-based engine technology business, Westport Innovations Inc. (TSX:WPT).   Recession notwithstanding, the company still grew sales by 9% and its gross margin dollar line expanded by 28% in calendar year 2009.  While not cheap on a ratio basis, I consider Westport one of the more promising looking “acorns” in its class and worthy of longer-term consideration.  Better to light this single candle of background research than curse the prevailing darkness of overvaluation.

 

Figure 1:  Better to Light a Single Candle…

 

 

 

 

Background

 

Westport began operations in 1995 with the intent of commercializing a natural-gas fuel injection technology that resulted from research led by UBC engineering professor, Phil Hill.  Under the direction of CEO David Demers, Westport has since become the world’s leading technological solutions provider to developers of heavy duty engines that run on natural gas.

 

The principal current installations of these engines are municipal service vehicles like buses and garbage trucks.  However, there is clearly potential to expand the penetration of Westport’s technology into commercial trucks and, ultimately, into any type of engine that currently runs on diesel or gasoline.

 

Westport’s business model more closely resembles that of an outsourced R&D group rather than a fully-fledged manufacturing business.  In fact the company has largely gone to market through product-specific joint venture arrangements with established engine makers.  The most significant of these relationships at the moment is Cummins-Westport Inc., a 50-50 joint venture that accounted for the lion’s share of Westport’s revenues in 2009.  Recent deals with several international partners including Volvo and China-based Weichi Power Co. may establish a path towards a broader product mix and a more diversified customer base over the next three to five years.

 

Investment drivers

 

From an investment standpoint, it is useful to consider two important, and separate, underlying drivers of demand for Westport’s engine technology.  The first driver is the global demand for heavy engines.  Heavy engine demand has taken a hit over the past year or so due to weak economies.  I have no special insight into when that demand might recover, but flag here that Westport’s success is dependent on this variable.

 

The second key driver of demand for Westport’s product relates to penetration of the transportation energy market that can be achieved by natural gas engines.  And the critical factor here is the long-term development of the ratio between natural gas and oil prices.

 

Figure 2:  Oil to Gas Ratio

 

 

 

 

On a pure energy equivalent basis, the ratio between the value of a barrel of oil and a thousand cubic feet of gas (mcf) should be 6 to 1.  However, with current market prices of about $80/barrel of oil and $4/mcf for gas the actual price ratio is 20 to 1.  In other words, the market is paying more than three times the price it “should” pay for petroleum products relative to the price of gas or liquefied natural gas (LNG).  Why the discrepancy?  Clearly gas is in a glut situation, driven by large new discoveries and improved extraction techniques.  On the other hand oil markets are facing dwindling conventional production combined with a growing base of transportation equipment designed to run on petroleum-based fuels. 

 

The other factor weighing against gas at the moment is that the market lacks the necessary infrastructure (pipelines, distribution networks, marketing organizations etc.) which are required to realize the pure chemical arbitrage.  However, I believe it reasonable to expect that the long-run oil-to-gas price relationship will converge towards the energy equivalence ratio of 6 to 1.  And, given that prospective trend, underlying demand fundamentals appear generally supportive of Westport’s product offering. 

 

Entry Point

 

With a recent enterprise value of about $450 million, Westport Innovations is somewhat bigger than your typical acorn.  And trading at 4X consolidated sales, it is difficult to construct a classic value case here.  Simply put, this company needs to grow rapidly in order to justify its valuation.

 

I tend to agree with management that the prospects for Westport are good in the long-run, but also flinch a little at the current sticker price.  However, 2010 could easily deliver bad news on the global truck market or a see a temporary collapse in the oil-to-gas price ratio.  Ideally, we might get both situations going wrong at once.  At such time, no doubt the chorus of boosters for Westport may be somewhat thinned out.  But that would be a wonderful entry point on Westport Innovations, a business with a fundamentally strong story with great potential for future growth.

Comments

[J Offord]

There technology is old and very very unreliable!do the research and not as clean as they say with out after treatment.
this company day has come and gone.