Zoltek Companies: Running out of Wind

Much like other sectors of the Alternative Energy space, Wind Energy stocks have been very strong in the first quarter. Coming off of strong 2005 and 2006 expansions, growth in the industry appears to be a sure thing. However, after a 40+% YTD move in the stocks of Gamesa and Vestas, one has to wonder if the space might be getting ahead of itself. Yes, the cumulative installed capacity grew 26% last year after growing 23% in 2005, and the expectation is that the cumulative capacity is expected to grow north of 20% for the next 5 years. However, what matters to equipment and materials suppliers is not the cumulative capacity but rather the amount of added capacity each year.

In 2005 the added capacity grew 40% to 11.4GW of equipment. In 2006, the Wind Energy industry grew 33% to 15.2GW of capacity. In 2007 and 2008 the growth rate is expected to be only 17% (roughly half the growth of 2006) according to Citigroup’s Mark Fielding. When stocks like Vestas and Gamesa rapidly appreciate, as they have over the past 3 months, the market is pricing in an expectation of growth. Unfortunately, there are industry dynamics that are going to limit growth. Specifically, shortages in gearboxes, bearings and casings (.pdf) are limiting the potential expansion for the next two years, regardless of demand.

Wind Turbines require very big blades (the largest blades are over 60 meters long) and account for 17-20% of the total turbine cost. There are a number of blade suppliers to the Wind Energy industry including all of the major turbine manufacturers (Vestas, GE (GE), Gamesa, Siemens (SI), Nordex, Enercon, Suzlon and Mitsubishi) and LM Glasfiber (who supplies to nearly all companies and accounts for approximately 28% of the blade market). All manufacturers use Glass Fiber for the shells of their blades and each has slightly differing composition of their spars. Only Vestas and Gamesa (~35% share of the blade market) use carbon fiber in any material amounts for their spars.

Suppliers in the carbon fiber industry are quick to point out the rapid increase in carbon usage for wind turbine blades over the past 3 years. The group also is quick to point out the advantages of carbon over glass fiber (stronger and lighter). However, what none of them seem willing to talk about is that the majority of the industry is not using carbon, and shows no signs of moving in that direction. Although carbon has the positive affects of reducing weight and improving energy transfer, it also introduces significantly higher costs (up to 10x the cost of glass fiber) and a higher potential for sheering (as Gamesa is experiencing in Pennsylvania). The issues cost and of bonding carbon to fiberglass or other materials are well known and have been an on going issue not only for the wind industry, but also the aerospace, yachting, and car racing industries as well.

Wind ≠ Zoltek (ZOLT)

The stock price of Zolt has run up (>65% YTD) in association with wind energy group, despite having less than 40% of its revenues come from sales to wind turbine producers. Zoltek is a supplier of low-grade commercial carbon fiber (called large-tow fiber). Zoltek supplies Vestas and Gamesa both directly and via composite suppliers like Hexcel (HXL). In the December quarter, Vestas accounted for 28% of Zoltek’s revenues and Gamesa wasn’t a 10% customer, although it has been often referred to as the Company’s other large customer for the wind industry. 29% of the December quarter's revenues were in technical fiber (used in brakes for airplanes). As much as Zoltek has convinced its investors that its future is tied to wind, its business is much more diverse and sanguine.

The TAM just isn’t that big and the SAM is even smaller. While a blade for a 2.5MW turbine might be 39 meters long and weigh as much as 19,200 lbs, the amount of carbon is only 810 lbs per blade (according to Signal Hill’s Mark Carboy). If one were to assume that the entire 17.8 GW of added capacity that is supposed to come on line in 2007 were using blades with carbon fiber, the ratio above would imply a 2007 TAM for carbon fiber of 17.3 million lbs (17.8 GW / 2.5MW = 7,120 Turbines x 3 blades x 810 lbs), which is less than the forecasted annual capacity of Zoltek hopes to have on line in the June quarter (Note: Zoltek is only one of several suppliers of large tow carbon fiber for the wind industry). Zoltek plans to add another 5 million lbs. of annual capacity in the September quarter. Note that while the TAM might be 17.3 million lbs., the Serviceable Addressable Market [SAM] is much smaller, as Vestas and Gamesa account for only ~35% of the total wind turbine market and neither use carbon in all of their blades—Implying that the 2007 annual SAM is less than 6 million pounds of carbon fiber.

Due to the added cost and bonding problems in producing carbon composite blades (described above), LM Glasfiber (the worlds largest blade manufacturer), as well as Enercon, GE, Siemens, and Suzlon use virtually no carbon in their blades today, and have no intention of moving away from their proven glass fiber processes and technologies (especially with the rising costs of carbon). John Vander Bosche, principal at Chinook Wind, says there are strong arguments that suggest the amount of carbon use in the future may decline, especially if energy costs continue to rise. Producing carbon fiber requires tremendous amounts of heat, i.e. natural gas power.

This year, Zoltek's stock price has climbed from $20 to nearly $36 and now has $1 Billion market cap, despite CY:06 revenues of only $109 million.

ZOLT 1-yr chart

This market cap is largely due to an expectation that the company is going to see massive expansion in wind-related revenues. To facilitate this growth, Zoltek has announced plans to add an additional 10 lines of capacity in Hungary in CY:07 taking total annual capacity up to 26.5 million lbs. With a CAPX cost of $7 million per line, this comes to $70 million. This expansion is expected to add 12.5 million lbs. of carbon fiber capacity, nearly doubling the Company’s current carbon fiber capacity. Unfortunately, Zoltek doesn’t have the financial resources to fund the expansion. Zoltek is being forced to take on $20 million in additional debt ($10 million from a revolver and $10 million from the CEO) to post bond for a breach of contract lawsuit that Zoltek lost against its spin out, Structural Polymer Group (ruling on April 12th set the bond at $23.5 million). On it’s December 2006 Balance Sheet, Zoltek had $39 million in cash and $49 million of Debt (prior to the aforementioned loans). While the first 4 lines of added capacity in Hungary might have been funded through cash on the books in the March quarter, the additional planned capacity is going to require substantial outside funding as it would leave the company with only $7.5 million in Cash and debt approaching $70 million.

It is important to note that the current forecasts for Zoltek’s revenues assume that: 1) all of the capacity will be added in the time frame communicated by management 2) the capacity will all be absorbed by the market and 3) that ASPs will continue to rise, despite the added capacity.

Without outside funding, Zoltek's expansion stalls and the revenue forecasts have to be adjusted. Without funding/expansion, the Company is already at max capacity running at an annualized revenue run rate of $120 million and generating $15 million in Cash Flow from Operations. The Enterprise Value of Zoltek is $1.1 Billion, which is 73x the annualized Operational Cash Flow of the business (including capital expenditures and financing costs only makes the valuation that much more questionable) and 9.2x annualized Sales. Clearly, without additional funding/expansion the expectations and valuation would have to be reset lower.

With funding, the expansion occurs and the Company exits 2007 with more than 4x the capacity the entire wind industry needs. If Zoltek adds 12 million pounds of capacity this year, it is improbable that the wind industy (and other commodity carbon fiber markets) could absorb the production. Moreover, it is nearly impossible to believe the market wouldn't demand price reductions, especially since Zoltek's competitors are also adding capacity. With lower ASPs and less than 100% capacity absorbtion, the current forecasts will need to be revised lower, and the valuation will be reconsidered.

Because of the recent lawsuits and the Company's desire to capture additional market share, it is not a question of if Zolt is going raise capital and dilute shareholders, but rather through which means (convertible debt or equity) and by how much. This near term dilution, combined with the fundamental mediocrity of the commodity carbon fiber markets makes Zoltek’s current valuation seem more than a bit rich (73x Cash Flow From Operations and 10x trailing Sales).

Disclosure: Author has a short position in ZOLT

Comments

[User 73518]

The article was well written and appeared to have some good points but may not have been terribly accurate.

For example, the writer suggests that most wind mill blade manufacturers, less Vestas and Gamesa, do not use carbon fiber in their blades. He points out that LM Glasfiber (who is the world’s largest BLADE manufacturer) uses “virtually no carbon fiber in their blades today”. LM Glasfiber did say that in their 2005 annual report, but now that they are building longer blades they ARE using carbon fiber. From the LM Glasfiber web page:

FutureBlade is LM Glasfiber’s answer
to the technological challenges that the
new multi-MW blades present.
The FutureBlade technology plays an
important role in the design process
when we manufacture large blades using
a combination of glass fibre and carbon
fibre. Carbon fibre is stiffer and stronger
than glass fibre but more expensive. The
FutureBlade technology allows us to
design blades with the best possible
blend of carbon and glass fibre.

AND:
With production of the LM 61.5 P, we were able to customise the material we use for the core of the blade’s sandwich construction still further. In certain specific areas, we also used carbon fibre in the main laminate.
And the fibre technology development work we have done as part of the Future Blade concept has proved exceptionally positive all round.

The writer also devotes an entire page to the premise that Zoltek is over priced on a value basis. There is some merit to that argument given that at a $33 price, the Company is selling at 49x the 2007 projected EPS. But I did a PE exercise using the current analysts expectations If those projections are realized, the trailing PE ratios on future ZOLT earnings will come in as follows:
For FY 2007 Ending Sep, 49x (33/.67)
Q1 Dec 2007, 35x (33/.94)
Q2 Mar 2008, 29x (33/1.15)
Q3 Jun 2008, 24x (33/1.36)
For FY 2008, 22x, (33/1.49)
For FY 2009, 13x, (33/2.46)
Some of you might say that June of 2008 (for example) is far away. But we are in April of 2007 which is not far from June of 2008 given that the stock market is an anticipatory animal. The stock price will reflect the increasing earnings long before those earnings are actually realized. That is precisely why we are seeing a high price, relative to earnings, right now.
Also, if the earnings estimates are achieved, the quarterly EPS growth, Q to previous year Q, will be 36% for ZOLTs Q2, 2007; 83% for Q3, 2007; 1200% for Q4, 2007; 343% for Q1,2008; 140% for Q2, 2008; 95% for Q3 2008; and 69% for Q4 of 2008.
Full FY EPS growth rate will be 294% for 2007 (ending Sep) and 122% for 2008.
Estimates can often be wrong, but I would have a hard time shorting into those kinds of projections

[User 73518]

The writer suggests that Zoltek might not perform up to expectations. That is always the case with any company. But we each have to look at what we think the future will bring and then make the investment call.

The writer suggests a possible dilution from a future security offering. Hopefully the analysts have already factored that into projections. In a recent RBC report, they say they expect a financing mix of equity and debt in the first half of 2007.

So what are we looking at immediately ahead? The next revenue and earnings numbers should be available during the week of May 7th. Those numbers will hopefully confirm that we are on track for the growth we are all looking for. But to me, a more important event will be the release of the revised contract terms with Vestas. The existing contract matures at the end of this year. Stuart Bush at RBC says he believes the revised contract could be 2.5 to 3 times the size of the prior yearly levels. If the contract comes in at those levels, that could add 10 to20 cents to his 2008 estimates and further 2009 growth. This kind of a contract revision would most likely be considered a material event requiring immediate disclosure, creating a catalyst for this stock. Vestas is the largest wind turbine manufacturer in the world. Such a contract would not only accelerate revenue and earnings, but it would remind the world once again, that Zoltek, the manufacturer of the lowest priced carbon fiber with its near monopoly position, is also a key player in one of the most exciting new industries to emerge in a long time, namely alternative energy.

One other point. The other day the judge ruled on the SP Systems suit. You have all seen that ruling. After the ruling, RBC reminded us that after the initial suit, SP ordered 3.2 M pounds of carbon fiber making them one of the largest Zoltek customers behind Vestas. The SP contract ends in 2010. Any settlement with SP in exchange for a contract extension would certainly be an upside for Zoltek and perhaps a positive turn for SP Systems.

Anyway, I thought I would post an opposing position to the “short” poster and it is just one opinion. I have no idea how all this will play out. But that is what makes this investing game so much fun and never boring.
Jan