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I have discussed Westport Innovations (NASDAQ:WPRT) at length in my article "Bullish Case For Westport Innovations" and the macroeconomics behind natural gas as a primary fuel source within "The Case for Natural Gas Related Stocks".

Based on the number of times those articles have been read - there is quite a bit of interest relative to WPRT within the Seeking Alpha community.

So, I took it upon myself to dive a bit further into three important areas within WPRT's business model in a three part series. Part one detailed their "Strategic and Business Alliances", part two, is below, and discusses their "Capital Efficient Business Model" and part three next week, will be about "Intellectual Property".

Part 2 - "Capital Efficient Business Model"

Capital efficiency / leverage can be defined as:

  • The ratio of output in comparison to the amount of capital expenditure involved in maintaining the operation of a business or a product line. Stated another way - as sales and profits increase, capital investments do not.

WPRT has designed a business model that is high on intellectual property and low on fixed costs. They are using Joint-Ventures (JVs) with major engine manufactures to leverage their partners' fixed-cost base and manufacturing expertise while WPRT contributes their intellectual property. This is a capital-efficient business model.

So why is that important?

It all has to do with "valuation modeling". Wall Street loves companies running "capital-efficient" models because they are structured with low fixed costs and have the potential (if successful) for significant profits (and cash flows) as a percentage of their low-cost base.

This is a very simplified example for illustrative purposes:

Think of capital efficiency like this - in general terms - from WPRT's perspective:

  • Intellectual property development costs for product = $100
  • Allocated portion of engine profit from JV = $500
  • Ratio = 5:1

Now assume sales and profits increase:

  • Intellectual property development costs for product = $100
  • Allocated portion of engine profit from JV as a result of increased sales = $1000
  • Ratio = 10:1

The example could go on and on until the IP is no longer valid or new costs are incurred to develop additional IP. You can see how WPRT incurred $0 in additional cost to earn $500 more in profits. In comparison, the JV partner most likely had to expand its plant (fixed cost increase) hire supervisors (more fixed costs) etc. - all to earn the same allocated profit percentage. Admittedly, the terms of the JV are all up for negotiation.

Capital-efficient business models are set up to generate high returns on capital, producing large cash flows. Both of these factors significantly impact Wall Street's fair-value calculations where a high price-to-earnings ratio can be "justified" as a result of the strong cash flows generated by a capital-efficient model. Additionally, the expected high cash flows are then modeled using a discounted-cash-flow analysis, which in turn further supports the public valuation of a company.

One reason Wall Street loves Apple Computer (NASDAQ:AAPL) is their capital efficient business model. Apple controls their design and intellectual property while the actual manufacturing is sourced out, thereby keeping fixed costs low.

Oh, one other thing to note - ever heard of Warren Buffet? He believes strongly in capital-efficient business models like Coca-Cola (NYSE:KO).

Next week -

Part 3 - Intellectual Property

Disclaimer: This work is based on public filings, public events, interviews, corporate press releases, and what I have learned as financial journalists. It may contain errors and you shouldn't make any investment decision based solely on what you read here. It's your money and your responsibility.

Continue to Part 3 >>

Source: Westport Innovations: The Capital Efficient Business Model, Part 2