Monster Rally Produces Pricey Valuation for Fuel Systems Solutions

I didn't expect to be writing about Fuel Systems Solutions (FSYS) again, especially the day after completing my previous piece. I anticipated that Thursday's news would propel shares nicely higher, but I was totally blindsided by the intensity of FSYS's  rally. I mentioned earlier not to even contemplate selling shares before the $50  mark was reached.

Who would have ever imagined that the share price would swell almost 29%, exceeding my target price in a single trading session?!  I suppose Friday's 300 point Dow rally didn't hurt matters either. What makes Friday's massive appreciation even more striking is the fact that it occurred despite FSYS issuing 2008 revenue guidance that was $4.9 million below analyst expectations of $354.9 million. Before, I was bullish, and now, I'm bearish. My flip flopping is simply a function of valuation, as the soaring share price has rendered this stock too expensive.

A wild ride:  Just last March, FSYS's market cap was a mere $160 million.  Friday's monster rally created more market cap in one day than FSYS's previous total market cap was just four months ago. An additional $190 million of market cap was created, enabling FSYS's market cap to swell to $838 million. Volume was extremely heavy at 3.3 million shares, and the shares ended up closing on the high of the day.  

It's interesting to note that when FSYS initially released results last Thursday, after the market close, the shares actually dropped 10% in after-hours trading before recovering to the unchanged mark. I guess some nervous investors hit the sell button in a panic, by interpreting the news release as "unfavorable".

Short covering:  I expect that much of the power attributed to Friday's rally evolved from shorts buying to cover. They surely experienced a classic "short squeeze" to say the least. A rally of this magnitude probably caused about 50-60% of the short positions to be closed, dropping the short interest from 1.3 million shares to nearer the 500,000 share mark. This decrease in short interest represents less potential buying power in the future.

Analyst action: Both Broadpoint Capital and Canacord Adams initiated upgrades on Friday. Broadpoint lifted its one year price target from $36 to $55.  The current share price is only $2 away from Broadpoint's new target price. Why would anyone be attracted to the shares at these levels, so close to their targets? There just seems to be more risk present than reward for those chasing the shares at these inflated prices.

Rich Valuation: Selling at 53 times 2008 earnings estimates of $1.01 and 42 times 2009 estimates of $1.26, the shares don't rate a bargain in my book, but it is probable that these earnings estimates will soon be ratcheted higher. The shares are selling at more than five times book value of $9.70, and that figure includes $46 million worth of goodwill and $18 million of intangible assets, making it somewhat over inflated.  The large goodwill entry creates prospects of further impairment charges.

As noted in my previous piece, the company's SG&A costs decreased as a percentage of revenues; however, they still increased 25% from $9.3 million to $11.6 million. The company's income tax rate also decreased 20.50 basis points, further benefiting second quarter earnings. There are many variables going forward into the third quarter that could adversely impact the bottom line.

Foreign Sales: Over 60% of the company's revenues are derived from international customers, and as a result, FSYS has been able to profit handsomely on the weakness of the US dollar during the currency conversion process. The US dollar has recently begun to rally, and if the rally continues, this currency benefit could soon become a liability, potentially hampering future earnings.

The law of larger numbers: Now that FSYS is delivering substantial earnings improvements, its comparables will be higher making it more difficult  to surpass those comps at the same accelerating growth rates.

The oil crisis: Much of FSYS's momentum has been caused by the oil crisis.  The oil crisis could be coming to an end, as crude has already dropped more than 20% from its highs.

The bottom line: I'll say it again. Shares have gone up too much in too short of a time. The stock is extremely overbought and susceptible to a sizeable correction. It's inevitable that shareholders will soon  begin to take profits. FSYS could fall as much as 10-20% in the near future. Don't get greedy on this one, place a "stop sell" order to protect your profits. It's a very ugly thing when your profits end up evaporating and in the process, turn into losses. For those looking for an "adrenaline rush", opening a short position, if the shares drop below $50 would be logical.  I would be inclined to "cover" in the $43-45 range.  This round turn could turn out to be a nice money maker.

Disclosure: Short FSYS.

Comments

[PA:]

Based on my calculation FSYS is ONLY trading at 8x next yr cashflow when it should be trading at 12x....I see another 50% upside from here...I dont believe there is any need to worry about FSYS doing a secondary due to the fact that they are generating alot of cash....It doesnt matter that oil prices are down...its more an enviromental factor and economics at this point....

2008 Aug 10 11:21 AM

[bt310:]

After being long FSYS, I too have shifted my thinking. With oil prices plunging, the cost benefit/per gallon has tightened, making the impulsive jump towards a life-changing decision less likely. People are stuck in their ways and paying $4000-10,000 for a conversion and another $2,000+ for a home "phill" hookup(regardless of tax credits) makes the possibility of change remote. In Southern California, there are several NG Stations, but most involve more waiting, driving out of the way and planning your day/trips regarding where the closest CNG stations are.
Hybrids don't involve such a drastic change, yet the percentage of people buying them(sans environmentalists) is small.
While I like their earnings, I too believe that this rate of growth should shrink. State restrictions emphasize buying new CNG Vehicles and conversion kits are highly regulated. You can't install one yourself. I think FSYS will continue to grow earnings/revenue, however, at this share price, it is overvalued. Momentum traders, IBD readers are taught to not chase stocks-especially when they're 25% above their buy-point or 50 day moving average. Anyone who bought below 40 will soon sell and those who bought above 50 will come to their senses when buying pressure wanes.

2008 Aug 10 09:05 PM

[Erin Young:]

I have this clown on the FSYS yahoo message board for a while now. He has several different screen names and pumps when he is long and bashes when he is short. He writes a Seeking Alpha note everytime he gets under-water in the share price and thinks he has the power to move the share price. This clown is a joke. If anyone here reads the message board on yahoo read what Hedgefund King says about this company. I have found his information and guidance to be far more credible than Mark Krieger's. Shorter beware.

2008 Aug 10 09:45 PM

[PA:]

FSYS gowth will not come from the consumer segment...There is ample growth to come from munincipal transport....transform... most govt vehicles to natural gas fuel will save them a lot of money considering that they will be paying the equivalent of $1.00/gal

2008 Aug 11 03:38 AM

[Square Circle:]

So.. let me get this straight: you are recommending taking a short position in a momentum stock where your potential upside is only 10-15%?

How can you justify this, especially risk-adjusted?

Correct me if I'm wrong, but this seems borderline irresponsible.

2008 Aug 12 08:20 PM

[John C. Lee:]

Technically, the stock may be starting to form a "bump-and-run" reversal, however, the trend is still up without any breakdown. I would want for a breakdown and a pullback to a resistance level before I short this one.

2008 Aug 15 11:49 PM