Quantum Fuel System's Business Expansion Is By Necessity, Not Choice

| About: Quantum Fuel (QTWW)


Margins are starting to shrink in Quantum's business of natural gas fuel tanks and systems.

Quantum was forced to lose its biggest customer, creating a huge hole in revenue forecast.

Quantum doesn't have the expertise or resources to successfully expand in the beginning, and possibly will never do well.

Shareholders can expect years of cash burn and share dilution ahead.

It's your friendly neighborhood short seller, Adam Gefvert, with another sweet short idea. I have done lots of due diligence and spoke with industry experts, and am confident with my long-term forecast of continual disappointment from Quantum Fuel Systems (NASDAQ:QTWW).

Quantum Fuel manufactures and sells natural gas tanks to be used with Class 8 trucks (big rigs). As of March, QTWW is expanding its business to selling the entire natural gas fuel system for Class 8 trucks.

I have a one year price target on QTWW of $1.93. This calculation is explained at the end of the article. QTWW deserves an EV/Sales multiple of around 0.5x sales because its most appropriate comp is FSYS, which has an EV/Sales of 0.27x. Circumstances have forced Quantum to change its business model. This will require a lot of time and capital and is uncertain to succeed. Quantum's existing business has consistently lost money, and this will continue as other competitors enter the market. Quantum faces challenges from many directions.

Because of inevitable share dilution to fund this ambitious business expansion, any bullish methodology that gets you to today's price still represents price downside. Dilution will push the share price down even if its market cap stays the same. An example of this happening to another alternative energy company is Capstone Turbine (NASDAQ:CPST), a stock I've written about before. CPST has never had a profitable quarter and has diluted its shareholders to death for years. Now it's a $1.40 stock with a market cap of $450M!

In response to Quantum's jump into natural gas fuel systems from only selling the NG tanks before, on May 6th, Quantum's biggest tank customer, Agility, announced a joint venture with Quantum's biggest NG tank competitor, Hexagon. Now Agility is Quantum's biggest NG fuel system competitor, and doesn't want to be its customer anymore. To illustrate the dynamics of what is happening, here is a story about a toymaker named Bob.

Bob The Toy Maker Analogy

Bob makes a popular action figure toy and sells it to different toy stores, and 45% of his sales are to his biggest customer, Toys R Us. Bob only has one major competitor, Jim, but Bob is still losing money every quarter, and he knows things are only going to get worse as more competitors enter the action figure market. To make matters worse, Toys R Us decides to partner with Jim to help make the action figures, that way it gets more of the profits. Bob realizes that his action figures don't have any edge over the competition, and his shareholders are going to think he's a loser when the results come out. Bob thinks:

"Hmmm, I'm in big trouble, the future doesn't look bright for my company. What will I do? Hey, why don't I just open a toy store of my own! Then I can talk a big game to my shareholders and they won't think I'm a loser!"

He then talks a big game to his shareholders about how great his store will be, how he can sell toys better and cheaper than Toys R Us can, and how rich everyone is going to be. Bob proceeds to invest a massive amount of shareholder money and opens up a toy store of his own, right next to Toys R Us. As a consequence, of course Toys R Us feels betrayed by Bob, and doesn't buy his toys anymore. Other toy stores follow suit and stop buying Bob's toys, because why would they want to support their competition?

Naturally, Bob doesn't have the funds, experience, connections, or reputation to compete against toy stores like Toys R Us. Toys R Us plays hardball against Bob and gives customers every advantage and incentive to buy from Toys R Us, and not from Bob. Bob can't get enough customers to make a profit, quickly runs out of money and shareholders refuse to give him any more.

In this story, Bob represents Quantum Fuel, Jim Represents Hexagon (OTC:HXGCF) and Toys R Us represents Agility Fuel Systems.

Quantum's Business Expansion Is By "Necessity, Not Choice"

Dougherty is an equity research firm that has been following Quantum, but has not engaged in investment banking services with them in the past 12 months. Therefore, it is a firm you can trust to give its honest opinion on QTWW. I respect research firms like Dougherty, who tell it like it is instead of kissing companies' asses trying to get investment banking dollars. Craig-Hallum, on the other hand, was the sole bookrunner for Quantum in their February offering, so naturally Craig-Hallum remains its cheerleader even after the negative earnings report and bleak future. Quantum badly missed both revenues and earnings last quarter.

After the earnings call yesterday, Dougherty wrote a new report and downgraded QTWW to neutral from buy. In the report, Dougherty states:

We thought the rationale for its path going forward was well articulated, however, we think the reality is that its strategy is born out of necessity rather than choice.

I agree with Dougherty's take. As of March Quantum changed its business strategy and made enemies with its largest customer, Agility Fuel Systems, who represented 45% of revenues. Companies that are successful with their current business don't do things like this.

If Quantum didn't do this out of desperation, then why didn't it ditch Agility and start selling the natural gas fuel system last year or the year before? From the earnings call yesterday, Brian Olson, Quantum's CEO said:

We have commercialized CNG vehicle and truck systems for OEM. We just have not been able to fully pursue the heavy duty market over the past two years due to certain non-compete restrictions Agility placed on Quantum.

Agility Now Hates Quantum

I spoke with two industry insiders who went to the Alternative Clean Transportation (ACT) Expo earlier this month (unfortunately, both wish to remain anonymous). One of these insiders knows Quantum the natural gas fuel industry inside and out. He told me that he has spoken with people from Agility, including the CEO, and found they are angry at Quantum for turning around and now becoming a competitor, after having a close business partnership for a long time. They feel back stabbed. It's more than just a business situation, it's emotional as well.

Quantum has been selling its natural gas tanks to Agility, who then incorporates them into a whole natural gas fuel system, adding parts like the pumps, valves, the control system, the charging system, the refueling system, indicators, etc. Then it sells the whole product to the truck fleet companies. Now all of a sudden Quantum wants to be more than a tank company, and wants to manufacture and sell the whole fuel system.

In the past, Agility bought natural gas tanks from both Hexagon and Quantum. As soon as contractually possible, it will get all its tanks from Hexagon. In June, 2013, Hexagon invested to double its manufacturing capacity. Now it has enough capacity to be able to completely satisfy Agility's tank needs.

Quantum Is Essentially Abandoning One Business For Another

In the conference call, Mr. Olson claimed that Agility will still buy tanks from Quantum throughout 2014. However, an insider I spoke to said that he spoke with Agility representatives who said they will stop buying from Quantum as soon as it's contractually possible. Also, Mr. Olson assumes that Quantum will continue to be able to sell to other system companies now that Quantum is a competitor. Those system companies, like Agility, will likely just want to buy from companies who only make tanks to avoid supporting their competition.

Natural gas tanks is a commoditized business. One tank isn't that much different than others. It isn't that hard for other players to enter the game. The industry insiders that I spoke with saw some Korean companies at the ACT expo who are going to start making natural gas tanks for the North American market. Also, 3M was at the ACT Expo and is showcasing its NG tanks as shown here. It's 26" x 80" tanks are the big ones for the Class 8 trucks. These additional competitors haven't entered the market yet but intend to later this year and take market share from Quantum and Hexagon.

Quantum Is Late To The Natural Gas System Party

Fuel systems is an integration business. It's heavy on people, consulting, and design. There are many moving parts, expenses, and it's a long sales cycle. Many other companies have already established their natural gas system business and have relationships with truck fleets.

By far, Agility is the natural gas fuel system leader, with about an 80% market share in 2013. But there are other players that have a strong foothold. D-Hybrid, Trilogy and Mainstay are the three other major players in the Class 8 truck NG fuel systems game, and have been doing it for years.

As time goes on, the natural gas fuel system business will continue to have its margins get squeezed as more competitors enter the market, and truck line OEMs end up doing it in house. Fuel Systems Solutions (NASDAQ:FSYS) has gone on a similar path as Quantum is now taking and is a good comparison. FSYS started making natural gas products and fuel injectors for light duty trucks like vans and pickups. Then they expanded over time to build integration and after-market systems. They started selling these systems in 2009 and had success for a few years, but then the market stopped being the cash cow it once was. Around the beginning of 2012, the fat margins started declining because more competitors stepped in, and now it's a low margin business. Now FSYS fuel system is a much more commoditized piece of equipment and are often being made in house by the fleet owners. The stock chart of FSYS tells the story:

Natural gas fuel systems for Class 8 trucks is a newer industry and faster growing than that for light duty trucks. However, in a couple years the industry for Class 8 trucks will be just like it is today for light duty trucks. That's about the time Quantum will have started getting in a good sales rhythm, that's assuming that it will be successful. Quantum will miss the boat of juicy margins, and in the meantime it will have burned 10s of millions of dollars of shareholder money.

The Monstrous 2014 Costs Of Quantum's Expansion

The following are huge investments that Quantum will take on in 2014:

1. Improvements on its natural gas tanks and capacity increase.

2. The creation of an entire natural gas system sales and support infrastructure.

The extent of these projects will cost multiples of the cash balance that Quantum currently has. Especially number 2. I don't think most shareholders fully understand everything that is required.

Analyzing both in detail:

1. Improvements on its natural gas tanks and capacity increase.

In the conference call, Mr. Olsen said:

Yeah. Our guidance was to get to the 20,000 (capacity) tanks by, I think September.

This is going to cost Quantum $7 million this year to increase its capacity. To me, this is an unnecessary spending of much needed capital. Quantum lost Agility which had purchased 62% of its tanks last year. I believe it will also lose some of its other customers. So why would it be spending precious capital increasing capacity, when it will only sell about a third of its tanks than it would've been able to sell before?

Neck mounted vs. strap mounted tanks. Quantum sells a strap-mounted tank, Hexagon sells a neck-mounted tank. Both of the insiders I spoke with agree that the market thinks neck-mounted tanks are superior to strap-mounted tanks. Neck mounted designs are safer, easier to service and inspect, and better accommodate the expansion/contraction of the tank. One insider said even a Quantum salesperson acknowledged that they need to have a neck-mounted tank because that's what the market is asking for. Quantum will have a neck-mounted tank out in the fall of this year. But in the near term, not having a neck-mounted tank will hurt sales as those fleets who want a neck mounted tank will buy from Hexagon instead.

2. The creation of an entire natural gas system sales and support infrastructure.

When Quantum was making tanks, they only needed to sell to fuel system companies. This didn't require an extensive sales force because all it did was sell to the natural gas fuel system manufacturers, who in turn did all the distributing and sales to the truck fleets.

Now, Quantum will have to do the sales and distributing to the truck fleets itself. The sales process for natural gas systems is very complex. Quantum will need to open offices around the country. It will need to hire sales people, engineers, field inspectors, and administrators. It will need to file numerous applications and get its systems factory certified. Part of the reason that Quantum missed earnings and revenues last quarter is because they encountered issues moving the test and validation facility. If they can't efficiently move a facility between two buildings in Southern California, I'm skeptical that they will be able to execute their fuel system business effectively.

Fuel systems sales is a long, labor-intensive sales cycle. While there is only a handful of truck lines like Freightliner, Volvo (OTC:VOLAF), Mac, and Peterbilt, there are tons of individual fleets out there. Quantum will not only have to win over the truck line and become factory certified, and hopefully be on their list of fuel systems they view as acceptable, but it also has to identify the individual fleets that are using natural gas, sell to the fleet manager, and then tailor a specific system to each specific truck's route characteristics.

The north American truck market is more complex than that of Europe. Different fleets in the same company have different kinds of Class 8 trucks. For diesel it's easy, they just put on a typical tank configuration for a Class 8 truck. But with a natural gas fuel system it is more expensive and weighs more than the typical diesel system, so the fleet owner makes a specific decision to craft a fuel system that meets the route characteristics of the truck. For example, they don't want to put on a system that drives 750 miles a day when the route only demands 500 miles a day because it's heavier and it will lose fuel costs. Trucking companies are super cheap, every penny counts.

Quantum isn't yet a factory certified supplier of fuel systems. Being factory certified enables the fuel system company to install the system at the truck line's facility. If the fuel system company isn't factory certified, the truck must get shipped to the fuel system company's facility to have the fuel system installed, and then it's shipped to the end customer. So for example, if the truckline OEM is in Arkansas, and it wants to purchase Quantum's NG fuel system, it has to ship the truck all the way to California and back. If Quantum's system was factory certified, then the OEM could just install the system in Arkansas. Allowing the fuel system installed at the facility saves a lot in shipping costs. However, getting factory certified costs a lot of money, over $1 million per program.

Quantum's Conference Call Makes It Clear The CEO Has No Clue What 2015 Revenues Will Be

In the conference call, it's clear to me that a lot of numbers were taken out of thin air and management is overly optimistic. Quantum's CEO Mr. Olson said:

Let's focus on 2015. We believe we can do a conservative basis around 2,500 heavy-duty OEM level systems in 2015. Ryder could be half this number

So here Mr. Olson is suggesting Ryder will purchase 1250 systems in 2015.

Then, later in the call, was this exchange:

Andrew Brown - Dougherty & Company LLC

Just one clarifying piece. The numbers that you gave for Ryder in terms of potential annual revenue of $20 million to $30 million, you could see that coming to fruition as soon as 2015?

W. Brian Olson

Yeah, units in 2014.

$20-$30 million is only selling 666-1000 units at the $30K system ASP referenced on the call. That's much less than the 1250 units Mr. Olson mentioned earlier. So clearly he's just pulling up big numbers out of the blue, and has no solid read on how many units Ryder, its first and only NG fuel system customer, will purchase in 2015.

From the Dougherty follow-up report:

At a $30K ASP, QTWW's guidance implies Ryder will purchase between 670-1000 systems annually. Ryder has recently stated its natural gas fleet is 500 vehicles and it plans to add up to 500 more in 2014. QTWW clearly has much greater insight into Ryder's plans than we do, but we note the achievement of such revenues will require significant acceleration in Ryder volumes.

Valuing QTWW Similar To FSYS

Quantum predicts it will make $75 million in revenues in 2015. I think that is an overly optimistic number, and wouldn't expect them to make more than $45M. I'm going to use the middle between the two numbers, and assume the revenues will be $60M for 2015.

Fuel Systems has an analogous product to Quantum. Its forward EV/S is trading at under 0.27x. I think 0.5x of 2015 revenues is an appropriate EV/S multiple for Quantum. That puts its EV at $30M. Its net cash as of March 31st is $9M. Add that to $30M, and we come to a $39M market cap. Divide that by the 20.14M shares outstanding, and we come to a share price of $1.93.

Some might say that FSYS isn't a fair comp to QTWW because its revenues are stagnant or shrinking, and QTWW is growing revenues. However, I think it is a fair comp because FSYS is cash flow positive, and QTWW will be losing money for the next few years to come. By the time QTWW becomes cash flow positive in a few years, its market will have matured and likely become the same as that of FSYS, with low margins.

Disclosure: I am short QTWW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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