The Perfect Trade for the Natural Gas Vehicle Boom
That car in your garage should be running on natural gas. With oil prices around $100 and unlikely to fall much lower in coming years, and natural gas selling for less than $3 per thousand cubic feet (MCF), the cost differential is far too big to ignore.
Consider this: $3 of natural gas gets you about one million BTUs (British thermal heating units) of energy. It takes about eight gallons of gasoline (or about $25 to $30 worth at current prices) to get the same amount of energy. The gas price is wholesale while the gasoline price is retail, but even on an apples-to-apples basis, gasoline is at least five to six times more expensive.
So why is Honda (NYSE: HMC) the only major auto maker selling a factory-built natural gas-powered car? Because Honda also arranges for consumers to fill up their tanks in their own garage through expensive, specialized devices. Simply put, if you buy one of these cars, you won’t find a natural gas filling station nearby.
In his recent State of the Union address, President Obama appeared to tacitly support a move to natural gas as a transportation source.
But as we know with Washington, even the most practical legislation is nearly impossible to achieve these days. Indeed, there are an array of natural gas users, most notably in the industrial sector, that want natural gas to stay cheap and abundant, so they’ve blocked legislation that would boost demand for natural gas at every turn.
Yet hope springs eternal. Shares of Westport Innovations (Nasdaq: WPRT), which retrofits truck engines to run on natural gas, have been on a tear, surging from $14 to $38 in the past year. The company would be a clear beneficiary if Washington ever took action. But it’s unclear if that will ever happen, and investors may be overestimating this company’s potential success, considering it is expected to be barely profitable in fiscal (March) 2013.
Meanwhile, a key rival has completely missed the rally. Fuel Systems Solutions (Nasdaq: FSYS), which is similarly exposed to any upside that legislation may bring, has fallen from $50 in late 2009 to $40 in late 2010 to $30 last spring to a recent $20. As a result, Fuel Systems is quite undervalued compared to Westport Innovations, by a variety of measures.
This means Fuel Systems has firmer downside support if natural gas bulls see their hopes dashed if Congress again fails to pass the NAT GAS Act. (Two pieces of legislation were proposed in Congress last year, though neither made it to a floor vote. You can read about them here.)
It also means that if Washington finally takes action, then Fuel Systems may have significantly more upside.
Trucks, then cars
There’s a reason investors are buzzing about Westport Innovations while seemingly ignoring Fuel Systems Solutions. Wesport focuses on trucks, while Fuel systems focuses on cars. President Obama’s plans appear to focus squarely on subsidies for truck makers and efforts to build a network of natural gas-powered fueling stations along interstate highways.
Yet if that happens, then the viability for natural-gas powered cars sharply improves. It would no longer be about automakers like Honda providing refueling pumps right in garages. Instead, it would enable consumers to fuel-up in-town, assuming they live somewhere near an interstate highway.
A number of automakers such as Fiat, Volkswagen, Ford (NYSE: F) and GM (NYSE: GM) have said they’re ready to supply the market with natural-gas powered cars when the infrastructure is in place. Notably, Ford and GM have long-term contracts with Fuel Systems Solutions to make that happen.
Yet as noted earlier, these two stocks are valued quite differently. Westport Innovations has an enterprise value of about $1.6 billion, which equates to about seven times projected fiscal (March) 2012 sales. Fuel Systems Solutions has an enterprise value of about $300 million, which equates to less than one times trailing 2011and projected 2012 sales.
Both companies have gross margins in the 30% to 40% range, so it’s unclear why a dollar of sales for Westport should be valued so much more than a dollar of sales for Fuel Systems.
It’s worth noting that Westport is expected to boost sales nearly 50% (to around $350 million in the coming fiscal year, while Fuel Systems is expected to see sales rise just 10% to around $450 million. (Fuel Systems has operations across the globe, not just in North America, hence the higher sales base.) Yet roughly half of Westport’s projected growth is coming from a pair of acquisitions in Italy and Sweden.
To be sure, Westport is the company with momentum in the United States, where natural gas is especially cheap compared with gasoline. Yet with the enterprise value/sales ratios at a 7-to-1 gap, investors have clearly gotten carried away.
Risks to Consider: Fuel Systems’ sales mix is more heavily dependent on Europe. Further economic weakness on the continent would likely restrain the company’s sales growth to an extent, even if the U.S. market took off.
Action to Take –> If legislation passes, then both of these stocks would rally, although investors have already bid up Westport to astronomical heights, while Fuel Systems has a huge valuation gap to close. If legislation doesn’t move forward, then Fuel Systems is likely dead money, while Westport could be ripe for a huge pullback.
That sets up a perfect paired trade. You could go long Fuel Systems and short Westport, essentially (and theoretically) negating the effect of legislation and focusing on these two stocks from purely a valuation standpoint. Or, after further research, you could easily take one side of this trade or the other, provided you have the risk tolerance for such a move.
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