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Why This Natural Gas Game-Changer Has 40% Upside

Joseph Hogue

From my apartment here in Medellin, Colombia, I can see the sign to a local gas station. The price of gasoline has climbed to $5.20 a gallon -- but there's another price listed just under that... 

For $2.68 per gallon equivalent. 

That's the price for natural gas, and people down here love it. 

The boom in natural gas production in the United States pushed prices to historic lows, and many were predicting massive conversions of cars away from gasoline to natural gas. The transformation would have driven a huge shift in the auto industry, and one company has a virtual lock on natural gas engine technology.

Sentiment jumped in this game-changer, and this company's shares surged more than threefold over the two years to early 2012. It seems the market was ahead of the curve, and the conversion cycle has not come just yet.

But that doesn't mean it's not coming -- only that the game isn't changing as quickly as investors had hoped.

According to the Natural Gas Coalition, there are 130,000 natural gas vehicles (NGVs) in the United States and more than 2.5 million in the world. Considering there are roughly 143 million cars on the road, that puts the percentage of NGVs at just 0.09% in the United States. 

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While the conversion cycle might not have caught on yet in the States, it certainly has in other parts of the world. Of the 7.2 million vehicles on Colombia's roads, 300,000 are natural gas vehicles, accounting for more than 4% of all vehicles. More than 1.5% of Italy's 52.6 million vehicles run on natural gas.

Even coming off decade lows, the price of natural gas in the U.S. is still up to five times cheaper than it is in other parts of the world. The cleaner combustion of natural gas also means lower maintenance costs over the life of the vehicle.

One of the biggest long-term drivers for natural gas conversion is the environmental impact. Compared with gasoline-powered vehicles, natural gas vehicles can reduce carbon monoxide emissions by over 90% and reactive hydrocarbons by half. 

While most of the U.S. still enjoys relatively clean air, take a trip to the largest cities in the world, and you'll see a different picture. Population and economic growth around the world are going to be big drivers for pollution control over the next decade.

While the conversion cycle has not taken off yet, it could be on the verge. The average age of the heavy-duty Class 8 fleet in the United States has jumped to 11 years on slower capital investment and sluggish manufacturing growth. The average age of U.S. cars and light trucks increased to a record 11.4 years at the end of last year. Improving Institute of Supply Manager data for manufacturing points to a turnaround in production and possibly positive sentiment at carriers to upgrade their fleets. 

More than 40 different manufacturers now make natural gas vehicles, including Ford (NYSE: F), General Motors (NYSE: GM), Toyota (NYSE: TM) and Volvo.

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But only one company is the runaway leader in natural gas engines.

Westport Innovations (Nasdaq: WPRT) owns more than 300 patents for natural gas and fuel system technologies on an aggressive R&D program spanning the past 15 years. The company has partnership agreements with some of the largest companies in the transportation space, including Volvo, Ford, Cummins (NYSE: CMI) and Caterpillar (NYSE: CAT)

Westport beat earnings estimates in its most recent quarter by 30%, which could signal an end to its trend of revenue and earnings misses. After a drop of more than 70% off their 2012 high, shares trade at an enterprise value-to-sales ratio of just 3.7 times expected 2014 sales of $180 million. That is incredibly cheap for a company experiencing double-digit sales growth in an industry that is just getting started. 

Cash on hand more than doubled last quarter to $211 million, equal to nearly a quarter of Westport's market cap, which should be enough to meet its capital needs this year and next. Westport also paid down most of its debt last quarter. 

Its strong cash position and positive cash flow from operations in a young and growing industry could make Westport a takeover target. Problems with Westport's execution at the management level may attract private equity buyers on a turnaround, while its growth and valuation could attract strategic buyers from other transportation companies.

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Short sellers have a $163 million bet against Westport, with 12.7 million shares borrowed to sell. On current average volume, those short positions would take more than 10 days to cover. If sentiment and the share price are close to a bottom -- and I think they are -- then these borrowed shares will provide strong support to demand and higher prices, and could even lead to a short squeeze.

Westport is due to report its first-quarter results in early May, and any positive guidance by management could be a huge boost to sentiment. Even on subdued growth expectations, investors can feel comfortable that shares should rise significantly over the long term.

I have a one-year target price of $17.85 per share on a forward enterprise value-to-sales ratio of 3.5 and expectations for 2015 sales of $260 million, after adjusting for $35 million in cash burn this year. This represents nearly 40% upside, but it's still an extremely cheap valuation multiple on a growing industry. 

Risks to Consider: The adoption of natural gas for U.S. vehicles has disappointed the market, and expectations for growth may still come down further. 

Action to Take --> The price differential for natural gas compared to gasoline is enough to make widespread usage in vehicles a reality in the United States. The hot money has been shaken out of Westport Innovations, and the shares are trading at a steep discount to future growth. I would buy at anywhere under $15 a share.

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