Two interesting articles featuring Quantum Fuel Systems (QTWW) were published on 26 November. You can find the articles here and here. I was planning on writing an article about QTWW as the company was long overdue for some in-depth analysis here on Seeking Alpha, but the articles published on 26 November beat me to it and dealt with most of what I was planning on covering, so I will not rehash this here. As mentioned in my article about Hexagon Composites (OTC:HXGCF) I am currently reluctant to buying QTWW as I feel the company first needs to demonstrate a couple of things. I will touch upon these specific reservations below.
Before I do this, I want to highlight some additional information that has emerged since I published my article "LNG's Future As The Preferred Fuel For High-Mileage Heavy Duty Trucks Seems Doubtful."
This news report was published on 25 November and apart from being yet another article in the CNG vs. LNG debate, I find it particularly valuable as it refers to comments made by a player (Love's Travel Stops & Country Stores) that seems to have approached the CNG vs. LNG choice with a pretty open mind. The comments made in the article are refreshing as pros and cons are mentioned for both solutions. However, the biggest takeaway for me is the confidence by Love's' staff that CNG is about $1.0/DGE cheaper than LNG. This is a massive difference, and I remain convinced that price at the pump is going to be the decisive factor that will persuade a majority of heavy duty vehicles to go for CNG instead of LNG, as the installed cost of the fuel storage equipment on a truck is pretty much the same.
Now back to QTWW. As already mentioned, the 26 November articles discuss a lot of pertinent subjects and are good introductions to the company, but both articles are fairly light when dealing with the critical issue of how profitable QTWW's CNG tank manufacturing business might become once they have further expanded production capacity.
One of the authors incorrectly mentions that "QTWW is the industry's leader in the type-4 technology." There is no doubt that QTWW has great overall products, underlying technology and patents to protect certain innovative elements of their type IV CNG tanks. However, Hexagon Composites, 3M Company (MMM) and Luxfer Holdings PLC (LXFR) also claim they have equally unique products, and as far as I can ascertain, they have all sold out their respective production capacity and are busy investing in additional capacity.
In summary, to make money from a great product you also have to be able to run a production line efficiently and on such a scale that you can drive down your unit cost significantly. This is where my hesitation currently lies with QTWW. I see two specific challenges:
1) Executing successful capacity expansions
QTWW is currently ramping up CNG tank production capacity from 4,000 per annum at the start of 2013 to 25,000 by 1Q 2015, which means increasing capacity by more than 6 times in approx. 2 years. From a project execution perspective, this is no small challenge and one should not automatically assume that such a scale-up will run smoothly. Hexagon is a much larger entity with a broader knowledge base in running automated production lines for composite cylinders, and they have struggled with production capacity expansions in the past. It might indeed be the case that QTWW management are masters when it comes to project execution and plant commissioning, but so far this remains to be seen.
2) Running an efficient production line and achieving good margins
From the table above, we can see that Hexagon's reported total production capacity is at least 10 times greater than that of QTWW. Hexagon has a proven track record of running an efficient production line with good margins, and management have stated on several occasions that the capacity being rolled out over the next 18 months will be "state of the art" and unlike anything ever seen in the type IV CNG tank manufacturing industry.
What does this mean for QTWW? Well it means that they will be facing competition in the marketplace that most likely has significantly lower unit costs. I don't believe any of the products currently being offered by the type IV CNG tank manufacturers vary so much in performance that a price premium can be justified, which again means that cost of production, and thereby price of the product, is likely to become one of the decisive factors in the competitive landscape. Going forward it will be critical for QTWW to demonstrate that they can run an efficient production line with sufficient margins.
Both authors of the QTWW articles conclude that QTWW is a buy. One of the authors, Shaun Currie, is of the opinion that a price target of $10.75 per share (55% upside) can be justified. He arrives at this conclusion by valuing QTWW at 3x expected 2015 revenue.
I have included a table below that compares QTWW and Hexagon's upside to the current share price if we assume 3x expected 2015 revenue as a valuation criteria for both companies. I will use Shaun Currie's estimates for QTWW as his article has done a good job explaining and justifying them. I will use my own estimates for Hexagon's expected 2015 revenue. These estimates are more or less in line with analysts that cover Hexagon.
The table above indicates substantial upside for both companies going forward, but it does not give a correct picture in relation to the risk associated with investing in either company. The table below compares some of the key metrics I look at when assessing the risk of an investment, and this table leaves little doubt that QTWW is a far riskier investment than Hexagon.
QTWW is likely to be turning a corner and seems to have a bright future ahead, at least when compared to the dark place it has been stumbling around in for the past years. However, the share price has increased a lot lately and I currently feel QTWW trading in a $6-$7 range is a fair valuation until additional value generating events materialize, its balance sheet is further strengthened and the company can demonstrate solid margins from its CNG manufacturing operation.
In my opinion, Hexagon Composites is at this point in time an investment with a more attractive risk/reward profile when seeking exposure to the rapidly expanding CNG tank business.