Fuel Cell Energy - Forget About The Recent Carbon Capture Hype And Instead Focus On The Company's Business Fundamentals

| About: FuelCell Energy, (FCEL)

Summary

A recently announced partnership with Exxon Mobil to "pursue a novel technology in carbon capture" has very little near-term implications for the company's business.

Still the shares went up by more than 50% after the announcement before being brought back to reality by just another set of dismal quarterly results last week.

Investors should instead focus on potential near term catalysts like the much anticipated award of the large Beacon Falls Energy Park project later this year.

Just like other players in the space, the company badly needs an extension of the fuel cell investment tax credit currently scheduled to expire at the end of 2016.

Six weeks ago Fuel Cell Energy (NASDAQ:FCEL) published a press release titled "Exxon Mobil and Fuel Cell Energy, Inc. Pursue Novel Technology in Carbon Capture". The agreement initially generated some major investor excitement, causing the stock to jump more than 20% in the trading session following the release before coming back in to settle at a more moderate 5% gain.

Since then, the agreement has been discussed enthusiastically in three articles so far on Seeking Alpha. They can be accessed here, here and here.

For example, fellow contributor Mike Siefferman concluded:

The addition of fuel cells to existing power plants throughout the world would provide enough additional hydrogen as a byproduct of carbon capture to offset the need for new steam reforming hydrogen production facilities. This would save the cost of construction, the methane fuel source and the power required to produce hydrogen. It would also propel the adoption of this model to worldwide implementation of FuelCell Energy's fuel cell carbon capture application.

I believe FuelCell Energy will see the greatest year-over-year revenue growth with expanding margins from this and many other applications. Its current market cap is barely above its cash value, if at all. Once it begins to show a consistent recurring profit, the company's share price should represent the expected significant revenue growth. However, Exxon Mobil is also a major consumer of hydrogen and the associated byproducts. Conceivably, this should have a significant impact to its revenue and bottom line. The details of the contractual arrangement between Exxon Mobil and FuelCell Energy are not public yet, but it seems clear that they both stand to benefit greatly from this recent innovation.

Ultimately, this is a win-win for the environment.

Unfortunately Siefferman's conclusions are to some extent based on a couple of factual errors:

  1. The company's market capitalization at the time the article was published wasn't "barely above its cash value". Looking at the company's balance sheet for the quarter ended January, 31 we see unrestricted cash of $77 mln and restricted cash of $37 mln for a combined gross cash balance of $114 mln. After deducting $32 mln in short- and long-term debt obligations we arrive at a net cash balance of $82 mln. In contrast the company's market cap at the end of May was still close to $200 mln.

    Since then the balance sheet has continued to deteriorate as the company's net cash balance for the quarter ended April, 30 was down to just $60 mln mostly due to a significant increase in short- and long-term debt. While the abysmal Q2/FY16 earnings report last week meanwhile also caused a significant drop in the market capitalization, there's still a roughly $100 mln gap between the company's net cash balance and its market cap.

  2. There haven't been any expectations for the company to show neither a "consistent recurring profit" nor "significant revenue growth" anytime soon. Even worse, management last week issued a material downward revision to its original 2016 revenue expectations, that are now forecasted to come in significantly below FY15 levels.
    While 2017 consensus estimates are indeed calling for a whopping 55% growth in revenues, this is to a large extent a function of the recent major guidance reduction. Moreover analysts are still looking for material losses on the bottom line next fiscal year. The 2017 estimates actually include the anticipated Beacon Falls Energy Park project win, which is still in limbo as of today. Should the project not be awarded, revenues might very well remain in the current ballpark going forward. Furthermore analysts' estimates are based on an extension of the fuel cell investment tax credit (FTC) which is currently set to expire at the end of 2016.
  3. Contrary to Siefferman's statement, some details of the new Exxon partnership were actually available in the press release:

    "The scope of the agreement between Exxon Mobil (NYSE:XOM) and FuelCell Energy will initially focus for about one to two years on how to further increase efficiency in separating and concentrating carbon dioxide from the exhaust of natural gas-fueled power turbines. Depending on reaching several milestones, the second phase will more comprehensively test the technology for another one to two years in a small-scale pilot project prior to integration at a larger-scale pilot facility."

    So it will take another one to two years to further improve the technology in order to potentially move to a small-scale pilot project. But this step will already depend on "reaching several milestones". Even if successful, it would take another one to two years before the technology might ultimately be integrated into a "larger-scale pilot facility" with no expected time frame given for this last project phase but clearly it would take several more years to successfully prove the technology at large scale.

    Any potential commercialization of the technology might be more than a decade away at this time and given the previous very limited success in developing economically viable carbon capture technologies worldwide, there's actually a great chance that the project might not even reach its second phase (small-scale pilot testing).

So betting on the new carbon capture partnership with Exxon Mobil at this time looks pretty much premature to say the very least.

Despite these obvious issues, the stock managed to stage a more than 50% rise in the weeks following the press release before the abysmal Q2/FY16 results finally brought the share price back to reality.

Investors would in fact be better served to focus their attention on the company's core business with a potential major catalyst expected to kick in over the next few months, the long anticipated award of the Beacon Falls Energy Park project:

As announced previously, the 63 MW Beacon Falls Energy Park was bid for the tri-state RFP in January of 2016. We feel this clean energy project is very competitively priced and brings benefits to the tri-state region as competing bids do not.

It provides ratepayers with affordable and ultra-clean power generation in the region, enhancing the resiliency of supply. This project also drives and pays for desirable natural gas, electrical and water infrastructure for the state and region that will help with adjacent economic development and directly benefits ratepayers.

In comparison, many competing bids will require the construction of transmission lines, to connect the region to distant power generation sources. Beacon Falls is the only fuel cell project bid into this RFP, illustrating our focus on utility scale applications.

The Beacon Falls Energy Park also presents a superior economic development profile versus competing submissions. Because of the unique operating characteristics, fuel cell projects like these can be installed in densely populated environments where they provide significant benefits for regional economics.

This project will generate property and sales tax. And because it is located in a region and utilizes locally manufactured equipment, it provides income and payroll tax benefits as well. Competing technologies manufactured overseas and installed outside the region cannot begin to provide this level of regional economic impact.

If awarded, the Beacon Falls Energy Park will generate an estimated $90 million in tax revenue at local and state level for the life of the project, about three times the tax revenues that will be generated by competing solar projects of similar size. It will also generate approximately five times the amount of renewable energy credits or RECs as a similar sized solar array due to low availability for solar in the region. RECs assists states in reaching its renewable energy portfolio standards and represents significant monetary value for a project.

The potential revenue value of the Beacon Falls project to FuelCell Energy is more than $500 million, including both equipment and services revenue. According to the wording of the tri-state RFP, the valuation phase of the process will be complete by the end of July, bidder notification and contract awards are scheduled to occur subsequent to the evaluation phase, likely in late summer or the fall of 2016. If awarded, we expect the project will be executed multiple phases, beginning in 2016. Project financing discussions are in progress.

Now that's what I call a potential short term catalyst. Investors should be cautioned that Fuel Cell Energy is widely expected to win this award, so a loss would clearly send the shares to new all time lows. Hopefully management's statements on the recent earnings conference call about the project proposal being "very competitively priced" does not translate into even more margin and cash flow pressures for the company going forward.

Including the Beacon Falls project, the company currently has a pipeline of 125 MW in outstanding project bids. Unfortunately, projects so far have not been awarded at the anticipated pace which actually lead to the recent material guidance reduction.

Secondly, the company badly needs an extension of the FTC beyond the current 2016 deadline in order to attract affordable capital for its projects. Without the FTC, large parts of the company's current US project pipeline might become uneconomical or will simply fail to attract financing. Given that large parts of the company's future revenue potential is expected to be initially derived from the US, the extension of the FTC will be crucial for the company's business going forward.

I have extensively covered Plug Power (NASDAQ:PLUG) in the past, another fuel cell company currently challenged by pretty similar issues, particularly with regard to the much needed FTC extension. Just like PLUG recently, Fuel Cell Energy has switched from outright selling their products to a more project based approach. Frankly speaking, both companies were more or less forced into the new model - in case of PLUG, the company's largest customer is demanding Plug Power to provide operating leases at highly favorable conditions and in case of FCEL the previous main revenue driver, a multi-year agreement to sell fuel cell kits to South Korean independent power producer POSCO Energy, is slated to expire later this year.

Particularly in case of FCEL, the new approach might lead to some much needed margin appreciation, but on the flipside large amounts of affordable capital are required to run the business this way.

With the FTC extension still in limbo, neither PLUG nor FCEL currently have sufficient access to cheap capital as evidenced by the elevated interest rates attached to their latest financing agreements. Admittedly FCEL still looks to be in the much better position, given the 9.5% interest rate reported for the recent $25 mln Hercules Capital loan facility compared to PLUG's recent $30 mln term loan provided by Generate Capital with a 12% reported interest rate (which later turned out to be effectively 16.4%), but looking at the reported margins of both companies, the current cost of capital appears way too high to support the business in an economical fashion.

Moreover the elevated capital needs have already led to a massive deterioration in both companies' balance sheet, which will only get worse over time. FCEL as well as PLUG have a long history of debt free operations, but are now accumulating debt at a rather fast pace. Debt in most cases carries some sort of restrictive covenants, as recently evidenced by Plug Power's recent loan facility. Without an extension of the FTC, both companies might be at risk of potentially breaching their credit covenants.

Bottom line:

Investors should not base their investment decision on the recently announced carbon capture partnership with Exxon Mobil given that even in case of success a potential commercialization of the technology might still be more than a decade away.

Instead the focus should be on the company's core business and potential short-term catalysts ahead like the widely anticipated award of the Beacon Falls Energy Park project later this year.

In addition, investors should look towards Washington for a potential near term extension of the FTC currently scheduled to expire at the end of this year. An expiration would be a devastating blow for companies trying to successfully commercialize fuel cell based technology like Fuel Cell Energy or Plug Power.

An extension on the other hand would potentially clear the way for tax equity investors to provide much needed cheap capital for projects incorporating fuel cell technology.

In case the Beacon Falls project gets indeed awarded to FCEL, I would urge investors to take profits into the expected major share price appreciation during that session given that the award has already been widely anticipated for a long time now.

But the real catalyst for the shares would be a rather quick extension of the FTC. While most market participants are still expecting an extension to happen, the time frame looks pretty unclear at this point and in light of the upcoming presidential elections the issue might very well have to take the backseat for the time being.

Even when looking at these potential short-term catalysts, I am actually not optimistic for the company's business going forward. In almost 25 years as a public company, Fuel Cell Energy has never managed to even come close to sustainable profits and still lacks a viable business model as of today. In fact, the company has amassed more than $720 mln in tax carryforward losses over time and is expected to record further material losses going forward.

Management's execution history also looks less than impressive as once more evidenced by the material guidance reduction last week.

So forget about carbon capture for the time being and instead focus on anticipated near-term business developments which have both the potential for either great rewards or even steeper losses than already suffered by many FCEL shareholders so far.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.