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The race to commercialize products using hydrogen for fuel has been running for several years now, with products ranging from generators for recreation vehicles to power plants for electric cars and buses to backup power for buildings.

From an investment point of view, the choices are limited, and profitability has been elusive. For most companies, the path to profitability has been slow and difficult. In some cases, the companies rely on the subsidization of governments, looking to use hydrogen fuel as a way to achieve environmental goals such as greenhouse gas reductions.

One company, Plug Power (NASDAQ:PLUG), is in the small group of companies that show the potential to reach profitability without government handouts, purely on the commercial viability of their products. They build a set of power modules which are used to replace the traditional battery pack used in fork lift trucks. On June 4th, Plug received the Canadian Hydrogen and Fuel Cell Association (CHFCA) commercialization award at the 2012 World Hydrogen Energy Conference.

The company's products replace the traditional battery pack used in fork lift trucks. Significantly, the buyers of these products are not governments, but major companies such as Wal-Mart (NYSE:WMT), Sysco (NYSE:SYY), P&G (NYSE:PG) and Coca-Cola (NYSE:KO). These companies often have 100 or more lift trucks in a major distribution center.

By replacing battery packs with hydrogen power modules, these companies expect to save money, and to reduce greenhouse gas emissions at the same time.

It is still early days, but some of these users have been through the learning experience of using hydrogen in one center, and are placing orders and rolling out additional centers with hydrogen powered lift trucks. As of June, the company had shipped over 2,200 fuel cell power modules.

Reaching for Profitability

Although orders and shipments have continued to grow, profitability is still an issue. PLUG took major steps to reduce its expense run rate. Still, product gross margin has remained negative. Power modules have been priced to be cost competitive against the battery pack alternative, however costs to manufacture the product are still high.

Partly it is a volume thing. The fixed costs of the manufacturing process had to be allocated over a small number of shipments in the early years. Gradually however this issue is being addressed as more units share the fixed manufacturing costs and shipments in 2011 were up 57% over the previous year.

Gross margins have already been improving and a major R&D focus of the company is further cost reduction. For example, they have been working on using an air cooled fuel cell stack (sourced from their development partner, Ballard Power Systems (NASDAQ:BLDP), to replace the more expensive liquid cooled stack. Component costs can be reduced, and fewer components are needed. Labor costs should be lower as should be warranty/support costs.

It takes time to move the lower cost designs into their shipping units but the results are now becoming apparent. In 2010, the cost of sales of products was about 147% of revenue. In 2011 the cost of sales were about 132% of revenue. In Q4 of 2011 when shipping volumes hit a peak, and the lower cost designs were starting to ship, the cost of sales were just over 100% of revenue.

The company expects that it can reduce product costs by 15-20% per year. This year (2012) we should see positive gross margins for the first time. It is quite likely that we will see gross margins in excess of 10% by the end of 2012.

After a solid Q4 in which the company took record orders, and shipped record numbers of units, the Q1 period was disappointing. Shipments fell back to 299 units. With a backlog of over 2,000 units going in the quarter, investors may have been looking for more shipments.

However some shipments could not be recognized as revenue due to accounting rules, and customers continued to need a lot of time to implement these systems. It typically takes six months to a year from the time of order until the customers are ready to take shipment. This lengthy time delay should improve as the customers and the hydrogen gas suppliers get more experience with the equipment.

Also in Q1 the company raised more cash through a $15 million dollar institutional stock offering priced at $1.15. This offering was followed by an immediate drop in the stock price. From February to April the stock price dropped from the $2.40 range to the $1.20 range and has not recovered.

Investors may be concerned about the cash and that the company is still burning cash for operations. They had about $20 million cash on hand on March 31st, and had used about $3.5 million in the first quarter. It is quite likely that they will need to raise additional capital before reaching cash flow positive territory.

The Market

The market for fork lift trucks is huge, PLUG has seen very little competition to date, and PLUG is only tapping a tiny percentage of the market so far. Their joint venture with Air Liquide appears to be gaining momentum as a way to tackle the large European market. PLUG products compatible with European standards are already being built, with more coming to market in the next 12 months.

Profitability

Plug will likely need to reach revenues in the area of $80 million per year to be profitable. At current growth rates and gross margin projections profitability is a couple of years away.

Setting New Expectations

The majority of 2012 sales are already in the order backlog. For the full 2011 year, Plug Power received orders for $46.1 million from material handling customers; $18.1 million worth of those orders were received during the fourth quarter. Full year 2012 revenue of about $40 million seems likely, compared to $28 million in 2011.

Valuation

Plug is a speculative investment. We view the stock as a hold at current $1.15-$1.20 stock levels. Although Q1 sales and bookings were short of our expectations, one quarter is a short period of time. We were disappointed that PLUG had to issue new stock at the $1.20 "ish" level, as this apparently had a big dilutive effect.

We will look to see what progress the company can make in bookings, and in particular in reducing product costs over the next two quarters before recommending a new target price. We are looking for confirmation of booking rates in the $50 to $60 million range and gross margins approaching 10% in 2012.

Source: Plug Power: Driving To Be A Profitable Fuel Cell Company