- Capstone at $1.40 may be a decent entry for the long-term investor.
- There are still risks on a number of fronts.
- Cash burn continues.
A pair of recent articles on Capstone Turbine (NASDAQ:CPST) by contributor Peak Performance touts Capstone as "triple value bound" and a "tremendous" buy. The first article appeared on May 6th after the market closed when the shares ended the day at $1.45 and the second was published on Monday, May12th before the market opened, having closed the previous Friday at $1.33. On Monday the shares popped to $1.52, so kudos on the timing of the second article. Unfortunately the shares have since retreated back to $1.40.
Let me be clear. I am long Capstone, and have been since 2008 when a neighbor told me about the stock and the product. Normally I don't act on tips, but this person owned a successful cooling and heating business, was familiar with the product and knew of my interest in penny stocks. As a trading opportunity - I have been in and out of the stock nearly two dozen times - it has worked out very well. As an investment, it has been a dog. I bought my first shares on August 12 at $2.54 and sold them later that day at $2.73.
I continued to trade it for about a month, then kept a small speculative position opened at $2.44. Big mistake. I eventually resumed trading last August when I thought the company had finally turned the corner, and while that's not the point of this article, it may put things in perspective.
The pair of articles by Peak Performance have catchy titles, and in my view, grossly overstate the opportunity and strength of this company and understate the risks. The first one titled Capstone Part 3: Still Triple Value Bound certainly caught my attention. I wanted to know the thesis about why this stock was going from $1.45 to $4.35 and the time frame. Neither was there. Instead, we get a long quote by Cowen & Company Analyst Robert Stone from March 11th and the fact that he increased the price target from $1.70 to $2.90. This is the same Cowen & Company that acted as Co-Lead Book Running Manager on an equity offering priced at $1.70 per share while the shares were trading well above $2. (Am I the only one perceiving this as a conflict of interest on the part of Cowen?)
The Cowen $2.90 price target was established not too long after Capstone CEO Darren Jamison had re-iterated that the company expected to have a great fourth quarter at the end of the Q3 earnings conference call on February 10th, after the market had closed:
Obviously this is the best all around quarter [Q3] in the company history. We're very happy with the results; highest revenue, highest product revenue; gross margin in both dollars and percentage, record backlogs like we discussed, both in FPP and in product; a tremendous book-to-bill ratio of 1.4:1, average selling price is at the highest levels and strong cash, I mean our cash position is becoming more of a strength for us.
...So we still are maintaining our goals for Q4 -- as these are breakeven and a cash balance of $33 million to $36 million. So hopefully we can achieve those goals and have a great Q4 call.
That day the shares had closed at $1.64 and the following day it closed at $1.55. Capstone was about to take off, possibly dragged higher by other alternative power companies. On March 11th, before the market had opened, Cowen issued the upgrade to $2.90. On March 10th, the shares closed at $1.96, and by March 19th the shares had hit an intra-day high of $2.60 and Stone was looking like a genius. By May 1st we knew that Q4 was a disaster, and the brief charge to $2.60 was history. However, on May 6th Peak Performance wrote:
The company's financials are healthy and Robert Stone expects the company to be EBITDA positive in 2015. The offering statement indicated a cash balance of $27.9 million as of 3/31/2014 and adding the $29.8 million net sale proceeds yields a total cash balance of $57.7 million. With such cash and only $13 million in debt, CPST's balance sheet is strong.
I don't know whether Stone was feeling foolish, but Capstone's balance sheet was in shambles and the company's financials were anything but "healthy." Cash, instead of climbing to $33-$36 million had declined to $27.9 million. The reason the debt was "only $13 million" was because there was a debt cap imposed by its lender, Wells Fargo. In fact, the offering prospectus noted that as of March 31st, Capstone was in violation of the debt covenant and was required to obtain a waiver:
As of March 31, 2014, the outstanding balance on our $15.0 million line of credit with Wells Fargo Bank, National Association ("Wells Fargo") was $13.2 million. On April 25, 2014, we received from Wells Fargo a waiver of our noncompliance with the financial covenant in the credit facility agreements regarding our annual net income. If we had not received the waiver or if we fail to comply with the financial covenants contained in the credit facility agreements in the future, we would not be able to draw additional funds under the line of credit.
Furthermore, the 10k discusses some detail about the Wells debt as follows:
We maintain two Credit and Security Agreements, or the Agreements, with Wells Fargo Bank, National Association, ("Wells Fargo"), that provide us with a credit facility up to $15.0 million in the aggregate. At March 31, 2013, we had $13.5 million outstanding under this line of credit. Under this credit facility, we are required to satisfy specified financial and restrictive covenants. Failure to comply with these covenants could cause an event of default which, if not cured or waived, could require us to repay substantial indebtedness immediately or allow Wells Fargo to terminate the credit facility. In addition, we have pledged our accounts receivable, inventories, equipment, patents and other assets as collateral under the Agreements which would be subject to seizure by Wells Fargo if we were in default and unable to repay the indebtedness.
Several times since entering into the Agreements, we have not been in compliance with certain covenants under the Agreements. In connection with each event of noncompliance, Wells Fargo waived the event of default and, on several occasions, we amended the Agreements in response to the default. If we had not obtained the default waivers, or if we are ever again in noncompliance, we would not be able to draw additional funds under the credit facility.
With essentially ALL the assets of the company pledged to the Wells debt covenant, is it any wonder that the debt was "only" $13 million. Who else would lend money to Capstone? Or, if they did, what would be the interest rate on what would clearly be a junk bond offering? Capstone had put itself in a position where a significant revenue miss forced it to raise cash through a dilutive equity raise at a price that was significantly below where the stock was then trading.
I suppose, from a very narrow perspective, one could claim the balance sheet had become "strong." After all, it now had a lot of extra cash. But financially healthy? Not by a long shot. The company continued to rack up quarterly losses. By the end of Q3 it had lost nearly $13 million on revenue of $97 million. And after Q4 revenue was announced to be coming in at only $36 million, those losses were certain to have increased (subsequently the company reported a loss of another $2.2 million).
That strong balance sheet had already shown an accumulated deficit of more than $0.76 billion at the end of Q3. At least we know it won't be having cash tax payments any time soon. It should be crystal clear by now that Peak Performance was not presenting the whole picture. Nevertheless, Peak Performance wasn't done hyping the stock.
To make matters worse, a subsequent article decided to attack another Seeking Alpha contributor and defend the thesis in the first article. The title of the second article was Capstone: Extreme Sell-Off And Reliance Upon Misinformation Creates Tremendous Entry Point. Based on the misleading information in the first Peak Performance article, "misinformation" was a curious choice of words.
The target of Peak Performance's article was one by Adam Gefvert titled Capstone Turbine Shareholders Have More Pain Ahead published on SA on May 6th. While not nearly as negative on the stock as Gefvert, I had raised the same issues one day earlier. Both Gefvert and I were concerned about details in the 8K and Offering Prospectus, details that Peak Performance either was unaware of or chose to ignore.
Does $1.40 and below represent an attractive buying opportunity? I think so, but the stock and management both have a history of disappointing investors. Does Peak Performance have a right to blast another author for providing "misinformation"? Well, it's the pot calling the kettle black. Let's look at some of the claims in the second article.
Pending Bill HR 4428
Peak Performance begins the article by discussing the regulatory environment, citing Pending Bill HR 4428. Let's be clear. The bill is a proposal by a California Democrat in a Republican controlled House. In today's polarized political environment, I don't see how this even makes it out of committee. It has something both parties can hate. On the one side, there is the benefit of reducing carbon emissions, although a large portion of the Congress won't even acknowledge that there are any ties to carbon and global warming, or even acknowledge that global warming is an issue. Then, even those that want the possible green benefits, won't be in favor of offering investment tax credits to the oil and gas industry. And while cutting taxes would appeal to Republicans, cutting taxes somewhere else to be tax neutral would be likely to target Democratic social programs.
Even if HR 4428 makes it out of committee and miraculously gets passed, I was amused by the following statement from the bill: "By advancing smart tax policy and regulations to help businesses expand and grow, H.R. 4428 would enable American microturbine producers to triple their domestic manufacturing." "Smart tax policy and regulations" is an oxymoron. Tax policy rarely has the desired results as lawyers and accountants find ways to avoid taxes and ignore regulations. And, like the Peak Performance claim of triple value bound, there is no timeframe for the alleged tripling of domestic production. Peak Performance also states:
The bill is currently with the House Ways and Means Committee, of which Congresswoman Sanchez is a ranking member - thus increasing the likelihood of the bill moving to the floor of the House for a vote.
According to the Committee on Ways and Means government web site, Sanchez is NOT the ranking member. It lists Sander Levin of Michigan in that position. She is the ranking member of the House Ethics Committee and has a variety of other influential positions, but as to Ways and Means, according to her web site.:
Congresswoman Sánchez also serves on the powerful and prestigious House Committee on Ways and Means. The House Committee on Ways and Means is the chief tax-writing committee in Congress and also plays a critical role in federal legislation on trade, Social Security, and Medicare.
On the House Committee on Ways and Means, Congresswoman Sánchez serves on two crucial Subcommittees -the Subcommittee on Select Revenue Measures and the Subcommittee on Oversight. The Subcommittee on Select Revenue Measures has jurisdiction over federal tax policy. The Subcommittee on Oversight oversees all programs within the jurisdiction of the full Ways and Means Committee, which includes oversight of the Internal Revenue Service (IRS) and the Treasury Department.
Congresswoman Sánchez also serves as the Ranking Member of the House Committee on Ways and Means Manufacturing Tax Reform Working Group, which reviews current tax law regarding the manufacturing sector.
And, being the ranking member of the minority party does not wield a lot of influence.
In an unwarranted attack, Peak Performance writes:
Mr. Gefvert published an article on May 6, 2014, expressing concern that "Russian sanctions targeting the energy sector will affect its [CPST's] Russian distributor which represents over 10% of sales." Message board chatter following this article indicates that many investors sold the stock based on this misinformation.
In fact, Capstone subsequently addressed this concern on May 8th , stating, "…the sanctions have had no impact on Capstone's Russian distributor or the company. The current EU and US sanctions are directed at particular Russian citizens. Additional sanctions are directed at dual use items and have not directly affected Capstone, as microturbines are not dual use items (meaning an item that could also be used for defense purposes)." (Emphasis added)
The quote makes it appear that Gefvert was stating that the sanctions will affect Capstone's Russian distributor, while in fact he was quoting a third party and mostly stated that it was a risk, and not some foregone conclusion. Sanctions are a risk that I also raised on May 5th because of the statement in the 8K:
The current geopolitical instability in Russia and Ukraine and related sanctions by the U.S. government against certain companies and individuals may hinder our ability to conduct business with potential or existing customers and vendors in these countries.
We derived approximately 15% and 11% of our revenue from Russia in the nine months ended December 31, 2013 and the 12 months ended March 31, 2013, respectively. The continuation or escalation of the current geopolitical instability in Russia and Ukraine could negatively impact our operations, sales, and future growth prospects in that region. Recently, the U.S. government imposed sanctions through several executive orders restricting U.S. companies from conducting business with specified Russian and Ukrainian individuals and companies. While we believe that the executive orders currently do not preclude us from conducting business with our current customers in Russia, the sanctions imposed by the U.S. government may be expanded in the future to restrict us from engaging with them. If we are unable to conduct business with new or existing customers or pursue opportunities in Russia or Ukraine, our business, including revenue, profitability and cash flows, could be materially adversely affected. In addition, we are currently evaluating the impact of the executive orders on our relationships with vendors. If we are unable to conduct business with certain vendors, our operations in Russia and the Ukraine could be materially adversely affected.
The sentence quoted by Peak Performance in rebutting the risk began "To date" and the full sentence reads as follows:
To date the sanctions have had no impact on Capstone's Russian distributor or the company.
In other words, Peak Performance has deliberately dropped two critical words at the start of the sentence. That statement only addresses the current state and ignores the future risk. It is my view that Peak Performance is deliberately misinforming readers of the potential risks. The market hates unknowns, and if the risks do not materialize, the risks may have presented a buying opportunity. But, even if these risks do not materialize, the stock will likely be under pressure until the some of the uncertainty is removed and the geopolitical situation becomes clearer.
Commentary on Financials and Related Concerns
Peak Performance made the following statements about the financials:
- "Investors reacted to slightly lower-than-expected revenues along with the need for a capital raise." Investors certainly reacted, and perhaps over-reacted, but the fact remains that the capital raise was well below market value. And the "slightly lower" revenue was a miss of $16 million on the company's soft guidance of $149 million. You be the judge as to whether an annual miss of more than 10% is slight.
- Peak Performance includes a long quote by CEO Darren Jamison about the year-end FY 2014 backlog of $171.6 million. Perhaps the author should have gone into much more depth and critically assessed the statements. Investors should be aware that Jamison once again stated that the backlog is "is a leading indicator of future revenue growth." He made the same statement regarding the backlog last year when the figure was $148.9 million at FYE 2013. By now we know that was a big miss. Now, consider that if the company had actually shipped product totaling $148.9 million rather than $133 million, there would be $16 million less in backlog. The "$22.7 million, or 15%" backlog growth cited by Jamison would have been under $7 million and closer to 5%. Maybe Jamison will be correct for next year, but the author had the obligation to inform readers of the poor track record of Jamison.
- Jamison concluded "Capstone's crossover to positive EBITDA and cash flow is forthcoming." This has been an elusive goal for quite some time. Is 2015 the year? Q4 2014 was supposed to be breakeven, and that clearly did not happen.
- Peak Performance once again claims that Capstone "clearly has a strong balance sheet both in absolute and relative terms." I certainly don't think so. The company was forced to go to the market twice this past year to raise capital, required waivers on its debt covenants and burned through an inordinate amount of cash. A cash balance of $38.9 million at the start of the FY was down by $11 million by year end, and that large decline came despite a $6 million capital infusion from the exercise of warrants.
Peak Performance concluded:
In the past 10 trading days, in response to lower-than-expected revenues, a capital raise and unfounded fears of impact from Russian Sanctions, CPST's stock price has dropped nearly 40% - falling from $2.20 on April 25th to a close of $1.33 on May 9th. In reality, the capital raise should serve to increase near-term revenue growth and the Russian Sanctions are irrelevant to Capstone.
As of April 15, 2014, a tremendous 15.4% of the float was short and that figure is likely much higher today. A major short-squeeze could be triggered by news of further positive developments such as additional orders for CPST's products and advances on the regulatory front. Such likely events could cause a dramatic surge in CPST's stock price.
I have provided investors with additional information that may provide some balance. I will let investors decide if a pending bill that is still in committee ever gets passed. I will let other investors decide whether the Russian sanctions are irrelevant or if the potential and uncertainty will weigh on the share price. I will let investors decide if the revenue miss is small. I will let investors decide whether the capital raise that diluted their equity and was priced at a steep discount to the market is a cause for concern. I will let the investors decide about whether to trust management forecasts based on backlog.
Peak Performance may be right that the capital raise may increase near-term revenue growth if Capstone uses the funds to grant more credit to its distributors. But they should be aware that it comes with its own set of problems. Capstone's DSO had already increased to 54 days at the end of Q3, so investors should also consider the risks inherent with a concentrated distributor-customer base.
Perhaps the most interesting statement by Peak Performance was about the short interest and the potential short squeeze. The "tremendous 15.4%" of the float has been consistent for six months. I'm not sure why that figure is "likely much higher today." Maybe it is, but it should be clear to everyone that those that were short the shares as of April 30th when the shares closed at $2.06 had a tremendous opportunity to cover the past several trading sessions.
I think the current price represents a buying opportunity, and I hope the additional information provided will allow investors to make sound and informed decisions. Could there be a squeeze? I won't even speculate, but that would be a foolish reason for a long-term investor to buy any stock.
But the trader or speculator looking for a short-term bounce? That's an article for another day.
Additional disclosure: Although I am currently long, and have held a long position (nearly uninterrupted) since 2008, I will also actively trade in and out of Capstone and can be expected to buy and sell shares at any time.