Seeking Alpha
Long/short equity, growth at reasonable price, small-cap
Profile| Send Message|
( followers)


  • Myth#1: FCEL "loses" their biggest customer by end of 2016.
  • Myth#2: POSCO Energy "steals" all of FCEL's technology and embarks solo.
  • Myth#3: 3% royalty is "insufficient" compensation.
  • Myth#4: There are no positive synergies from the POSCO Energy partnership.

During the month of August 2014 there have been negative media opinions about FuelCell Energy (NASDAQ:FCEL) along with an incredibly biased article that mirrored the true intentions of a disclosed short seller of their stock. I am generally fine with articles that contain bearish or negative sentiment, since it is wise for investors to view all angles that could translate into success or failure of their investments. However, this particular article really ruffled many people's feathers because it contained blatant inaccuracies and stressed negative points without providing a complete picture for balanced context. I will discuss some of the generally stereotypical "myths" that such media outlets keep repeating about the POSCO Energy partnership with FCEL and hopefully provide some balanced counterpoints to debunk such ignorance.

One of the concerns highlight the current order flow of fuel cell modules or kits totaling 122MW to POSCO Energy that is scheduled to end by fiscal 2016. An earlier agreement for 70MW was originally scheduled to run to October 2013 but was expanded and accelerated to conclude by April 2013 and was replaced by this subsequent larger order starting May 2013 that occurs within the framework of a revised partnership agreement. The issue pertains to a perceived substantial decline in revenue after this current sales contract runs out after 2016 and that FCEL shareholders should bail out and jump ship now before their revenues plummet by 80%-90%. We need to investigate further into the expanded partnership agreement with POSCO Energy to fully understand the implications and rationale for pursuing such a venture.

The current POSCO Energy agreement replaces and blends together two prior licensing agreements and essentially provides POSCO Energy the right to manufacture the entire FCEL Direct FuelCell (DFC) power plant. FCEL's partnership with POSCO Energy is their strategy for pursuing the Asian markets. Customer expectations for fulfillment and lower cost structure has lead to the identification of in-country manufacturing as the ideal solution. As a result, POSCO Energy assumes all financial and operational risk to build out a separate fuel cell manufacturing facility in South Korea which initially provides for 100MW of capacity that is scalable to 200MW if future demand and growth warrants it. FCEL has full manufacturing access to this South Korean plant along with a common integrated global supply chain platform shared by both parties. In addition, FCEL receives a one-time licensing fee (that amounted to $26M) that enables POSCO Energy to utilize FCEL technology in the manufacturing of complete power plants and also receive a 3% royalty for each plant sold. The expanded partnership agreement has an initial term of 15 years and also two optional extensions for up to an additional ten years upon mutual consent.

From my perspective, to actually believe that FCEL loses their current biggest customer after 2016 is quite asinine. If anything these two parties have progressed from a casual dating relationship to a more committed marriage.

It is important to realize that selling only fuel cell modules and kits are lower margin and trending more towards a commodity-type business at this time. If you review FCEL's Q1-2014 and Q2-2014 results for solely "product sales", you will find the gross margin is in the low single digits at 4%. Even though it might sound impressive to close a deal for over 100MW comprised only of parts, the reality is that there is not much value hammering out low margin deals even with expanded volume. So it is the vision of management and the nature of this present partnership to fully enable POSCO Energy to eventually manufacture their own fuel cell modules and build the entire stationary power plant once the South Korean facility is fully built and operational around mid-2015. POSCO Energy is not partnering up with FCEL to learn, acquire, and steal their technology in order to then dump FCEL onto the sidelines and embark on a solo profit driven quest afterwards. Once the new facility is operational FCEL receives a 3% royalty on the total sales price of each manufactured power plant for a minimum of fifteen years. This actually improves upon an earlier arrangement where FCEL only received royalties upon any extra value addition from POSCO Energy that excluded existing fuel cell components.

Now it is true that a mere 3% royalty on the sale of each manufactured plant is a relatively low amount, especially when it likely results in the discontinuation of future fuel cell module revenue from POSCO Energy. Even though a fully operational plant might be valued at a larger $10M, $20M, or $50M net dollar amount, a 3% royalty translates to just $300,000, $600,000, or $1.5 million respectively, and this might be tough to swallow as consolation for the loss of revenue from individual fuel cell modules or kits. Surely, an agreement with a higher royalty percentage in the 5%-10% range would have been more desirable and have more dramatic impact to the bottom line. But there are other important tangible benefits that FCEL will realize that likely resulted in a lower negotiated sales royalty of 3% in their partnership deal. Keep in mind that any type of sales royalty is essentially 100% gross margin because it involves no labour or manufacturing cost to FCEL. It would only require about $1.2 million in royalties to be equivalent to selling $30 million in a widget that nets you 4% in gross margin.

As alluded to earlier there will be tremendous synergies once the new manufacturing facility is operational and many unperceived benefits that the market and analysts are either ignorant about or discounting because no direct positive effects have trickled down to the bottom line yet during the present construction phase.

  1. The suppliers of raw material for both FCEL's Torrington plant and the new South Korean plant are the same and thus tremendous cost savings will be realized just from doubling your potential purchasing capacity. In addition, steel is one of the main components used in the fuel cell power plant and this metal was not previously purchased from the parent company POSCO and they are one of the leading global suppliers of steel.
  2. Having a second manufacturing facility provides another source of supply for fuel cell stacks. During periods of supply disruption or overcapacity this enables steady throughput and reassures concerns of certain customers or investors in specific power plant projects that require supply stability.
  3. The larger manufacturing facility once operational will likely be the catalyst that fuels a rapid increase in sales growth in the Asian markets that are presently underserved and limited by both the 100MW capacity and geographic location of FCEL's Torrington facility based in North America. And each fully operational power plant delivered and sold by POSCO Energy results in a 3% sales royalty that impacts FCEL's profitability at 100% gross margins.
  4. FCEL has potentially tripled their manufacturing capability at no additional cost to them but they reap the benefits by having access to this new facility. If they were to build such a plant on their own it would have resulted in either incurring significant debt or significant share dilution at unfavourable share prices before even seeing any benefit out of it.

The ultimate goal of FCEL is to pursue turnkey installation projects because they provide much higher profit margins in the double digits relative to selling commodity fuel cell components. They also provide for additional recurring long-term higher margin service agreements to monitor and maintain these stationary power plants. This is the corporate strategy and business model that FCEL is utilizing for the North American and European markets. The new POSCO Energy partnership will have a dramatic impact on the economics of its turnkey solutions that are not readily evident at first glance.

As an example, let's assume a $20M sale of a turnkey stationary DFC power plant that has a gross margin of 12.5%. That calculates to a gross profit of $2.5M and cost of goods sold of $17.5M. If the new POSCO Energy plant kicks in and doubles manufacturing capacity and lowers the purchasing cost of materials by say 5%, then one can calculate that such savings would result in a revised cost of goods sold of $16.625M ($17.5M - 0.875M) and an increased gross profit of $3.375M or now yielding nearly 17% in gross margin. This is an increase of +36% in profitability that will likely occur in the near term that many short sighted writers of negative hit pieces that focus on gloom and doom do not see at all.

And assume the optimistic scenario that Asian sales escalate rapidly now that capacity from a new plant in South Korea is able to accommodate more of that demand for cleaner energy as presently mandated by many nations, thus forcing POSCO Energy to scale up manufacturing capacity by doubling it to its designed rate of 200MW. Let us assume a revised savings amount that also mirrors the combined increased purchasing power that totals nearly 300MW (both Torrington and South Korea) that approaches 10% in reduction of cost of materials. Using the same example, the $20M power plant would then have cost of goods sold of $15.75M ($17.5M - 1.75M) and revised gross profit of $4.25M or gross margins now exceeding 21% or an increase of +70% in profitability.


These cost savings assumptions might be very conservative considering how the CFO of FCEL states that their fuel cell stationary power plants currently generate electricity on an unsubsidized basis in the range of $0.15 per kilowatt-hour and their intention is to drive down costs to approach unsubsidized grid level scale pricing in the $0.09-$0.11 per kilowatt-hour range. If we assume they can reach the higher end of the target at $0.11 per kilowatt-hour, then that implies cost savings that exceed 25% in cost of material. If that is more accurate then it could potentially open up more densely urban markets for FCEL to generate increased turnkey project sales. Such increased revenue could eventually dwarf the loss of low margin, commodity sales of fuel cell modules, because it provides flexibility to either compete with lower grid pricing while maintaining decent profit margins and touting the cleaner energy benefits of hydrogen fuel cells or allows for more modest growth but at substantially higher realized profit margin.

It has undoubtedly been a long and arduous road for shareholders to eventually realize the fruits of the partnership with POSCO Energy. Consider the timeline so far that has occurred. The initial preliminary framework for an expanded partnership was announced back in March 2012, only to take an unanticipated lengthy period of eight months of negotiation for an agreement to be officially signed in Nov 2012 due to its complex nature, and then an additional thirty month cycle involving design, planning, and construction of a new manufacturing facility assuming that the target deadline of mid-2015 is attained. Possibly such a lengthy period of time provides the easily spun story of financial ineptitude and lack of future visibility that many of the skeptics and naysayers use as ammunition in their slanted, biased articles that delve on negativity and pessimism.

Source: FuelCell Energy: Debunking The POSCO Energy Partnership Myths