Recent Trends Overview
Fuel Tech, Inc. (NASDAQ:FTEK) engages in the worldwide development and application of technologies for air pollution control, process optimization, and advanced engineering services. It operates in two segments: Nitrogen Oxide (NOx) reduction technologies (Advanced Pollution Control or “APC”) and Fuel-Chem technologies, both of which improve the environmental status and/or efficiency of combustion units. The company provides its services to industrial companies and utility power-generation facilities worldwide.
As expected, the company’s business model is highly dependent on the continued enforcement of air-quality regulations, as well as the expectation that regulations will continue to tighten over time. The company has had strong success in the second half of 2011 given the expected implementation of the EPA’s Cross-State Pollution Rule. However, on December 30, the U.S. Court of Appeals delayed the implementation of the rule. We expect this action to delay, not eliminate, the necessary upgrades that utilities will have to make in order to become compliant. As a result, we expect that the companies that have already budgeted the upgrades and have signed contracts will go through with the upgrades, albeit at perhaps a slower pace. Additionally, we expect some slowdown in sales; however, it is likely that most of these sales will be pushed into later periods, potentially affecting realized revenue in the second half of 2012 and first half of 2013.
The company earned approximately 22 cents over the trailing 12 months; however, we do expect the company’s earnings to rise in the fourth quarter to 9 cents (from 6 cents in the prior year and down from 11 cents in Q3). For full-year 2012, we expect the company to earn 39 cents (compared with our estimated 27 cents for 2011). These gains are driven by modest sequential growth in all segments based on the contracts currently in the pipeline and the company’s operating leverage.
Both segments have been showing 3Q year-over-year top-line growth of 17-19%. The APC segment has been showing the most growth; however, it will also be the most adversely affected by the Court of Appeals ruling. As of the 9/30 10-Q (pdf), the company had a decent order backlog of $22.9MM (up 10% from prior year with $21.1MM in new orders announced in 3Q), but we expect this order backlog to decline due to the ruling, with a flattening to slight decline in revenue in the second half of 2012. Given that the APC segment exhibits significant operating leverage, we expect the gross margin from this segment to only modestly increase from an annualized $19.5MM through the first three quarters of 2011 to $20.6MM in 2012, before increasing at a fast rate in 2013. The Fuel-Chem segment is the company’s more stable segment, and given the strength it has been showing in new orders and recent quarterly sales growth, we expect 5% top-line growth for this segment in 2012. Overall, we expect the operating leverage to work in the company's favor in the next couple of years, which will lead to strong profit growth.
Additionally, there is room for the company to grow overseas, as the APC segment has reached a backlog of $8.6MM in orders from non-U.S. companies and announced $13MM in contracts in China in the first three quarters of 2011 per the 3Q earnings call. We expect this to be an increasingly significant source of income as China looks to improve its pollution profile.
Risk number 1: The EPA’s ruling (discussed above)
Risk number 2: The Company’s significant operating leverage makes for volatile earnings.
Given the EPA’s ruling, there is significant downside risk should power companies decide to stop their pollution abatement implementations; although the earnings potential should these implementations continue remains alluring for risk tolerant investors. Given that we expect that the ruling will delay not stop the pollution abatement process, we expect that the demand for Fuel Tech’s products will remain steady, with an anticipated forward P/E of 15x. As a result, we have decided to hold our position. At the current price, we think the stock is fairly valued given the risks and longer-term growth prospects, although it could easily bounce up to the $8-$10 range should a more positive growth trend emerge.