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Xuhua Zhou
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I am currently an individual investor with focus on event-driven trading and long-short opportunities. I graduated Emory University in 2009 and am also a finance Phd dropout from UCLA Anderson. I could be reached at zhouxuhua@gmail.com
  • Westport Innovations: A Failing Business With Undisclosed Material JV Stake Transfer 3 comments
    Jun 5, 2013 9:24 AM | about stocks: WPRT
    Clean-tech investing is filled with perils. Investors often fail to recognize the difference between companies that record current losses in order to invest in a brighter future and companies that record losses simply because they are inherently failing businesses. Westport Innovations (WPRT) was set up as a house of cards and has stayed a house of cards. Shareholders have been constantly given elusive hopes of imminent profitability yet the Company has repeatedly failed to deliver on such a promise. It is common practice at Westport to regularly put out positive press releases. However, when a material JV stake was transferred to another party which results in changed economics in the joint venture, Westport's management failed to promptly disclose to investors such information. Furthermore, Westport may face regulatory issues given its most recently filed 40F contain false statements. As recent as March 7th of 2013, the CEO made false statements when questioned about one of its joint ventures. The CEO stated that Weichai Power is excited about the joint venture with Westport when in fact Weichai Power has already exited its stake in Weichai Westport per relevant regulatory filings in Hong Kong. The CEO further hid gross margin impact from the JV agreement modification with Cummins on the February 20th 2012 conference call. CEO David Demers specifically stated that there will be no gross margin impact at CWI from the JV modification when questioned by a research analyst yet the gross margin of Cummins Westport collapsed by an astonishing 15% in the next few months. Additionally, the Company has a pattern of putting out lots of vague press releases with no follow through and the CEO making constant CNBC appearances to tout the stock. The bullish analyst community has constantly overestimated the financial performance of the Company. A failing and constantly loss-making business is somehow portrayed to the investment community as an innovative company with a bright future. The future, however, is much bleaker than what the investors can anticipate even if the market for natural gas engines does take off.

    While much buzz has been placed on the JV between Weichai Power and Westport Innovations, investors should focus on Westport's failure to disclose a significant structural change of Weichai Westport. Analysts have pegged a 10 dollar valuation on this JV or 33% of the current stock price. Many Westport bulls point to the substantial revenue growth in Weichai Westport and therefore conclude a bright future for Westport in China. An undisclosed stake transfer in the JV may serve as a wake-up call for such bulls. Given Westport management's prolific approach to issuing press releases, its failure to disclose such a material stake transfer by its partner only further validates the lack of credibility of the management. Potential future regulatory impact will likely add an additional layer of uncertainty for Westport investors if the 24 cents a share valuation of Weichai Westport is not alarming enough.

    Undisclosed Stake Transfer in Weichai Westport

    Management of Westport made material false statements in filings with the SEC as well as the Canadian Securities regulator with regards to a significant portion of its business. In the most recent 40F filed with the SEC on March 8th, 2013, the Company stated:

    "Weichai Westport Inc. ("WWI"), a joint venture between Westport (35% interest),Weichai Power Co. Ltd., ("Weichai") (40% interest) and Hong Kong Peterson (CNG) Equipment Ltd. ("Hong Kong Peterson") (25% interest) to focus on the Chinese market. WWI develops, manufactures and sells advanced, alternative fuel engines and parts that are widely used in city bus, coach and heavy-duty truck applications in China or exported to other regions globally. WWI's facility in China currently has an annual production capacity of 40,000 engines. Currently, WWI is integrating Westport HPDI technology to create the new 12-litre Weichai Westport HPDI Landking engine designed to deliver the same power, torque and performance as that of the original diesel engine. Expected to be launched in 2013, this engine will fill the gap in the natural gas engine market for heavy-duty trucks in China".

    In fact, Weichai Power Co. has already sold its 40% stake to its parent holding company for roughly 15 million USD in an arm-length transaction before the end of 2012.

    Per public securities filing with the HK Stock Exchange, Weichai Power announced on December 26th, 2012 the transaction to sell off its entire stake in "Weichai Wesport Inc.". The stake sale was completed on January 4th, 2013. Total consideration for the 40% stake was 94 million RMB or around 15 million USD. Following the release, there was a fair bit of media controversy surrounding the sale in China given Weichai Power's status as a publicly listed company in Hong Kong. Weichai Power maintained that the sale to its parent holding company was an arm-length transaction giving proper valuation to "Weichai Wesport Inc". The deal was properly appraised and subsequently signed off by all independent directors of Weichai Power. To further clarify the reasoning behind the asset sale, Secretary of the Chairman at Weichai Power gave an exclusive interview to a Chinese securities newspaper.

    The wildly bullish analyst community has long maintained a lofty and unrealistic valuation target on Westport. Sum of the parts valuation on Westport has been one of the most popular methods used by analysts to justify their ridiculous price targets. In the most recent comparable transaction valuing WWI, 40% of Weichai Westport was worth roughly 15 million dollar and that puts Westport's stake in the JV at roughly 13 million dollar. With 55.3 million shares outstanding, Weichai Westport is worth roughly 24 cents a share. In the meantime, the bullish analyst community generally pegged at least a 10 dollar valuation for Weichai Westport, 40 times the amount that was fetched in the most recent stake sale that happened a few months ago.

    Furthermore, the management at Westport has been elusive to the investing public about the true status of Weichai Westport in China. Per relevant filings, WWI buys base engines from Weichai Power then sells products back to Weichai Power. In order to justify the arm-length transaction, officials at Weichai Power commented on the transaction. Mr. Dai at Weichai Power stated that they will start raising prices on the base engines to a fair market price. Mr.Dai further described Weichai Westport as a liability to Weichai Power due to the subsidies Weichai Power has to provide for WWI.

    On March 7th 2013, when CEO David Demers was asked questions about their Chinese partner's view on Weichai Westport, Demers stated

    "Weichai is running the show on how to sell natural gas engines, much as they are in diesel engines. And in China it is becoming incredibly competitive. The natural gas business is doing really well, and what the scale now, with these numbers, this has actually become a big business, and I think Weichai is very pleased with the opportunity."

    In fact, Weichai has already sold its stake in Weichai Westport because the discount it has to embed in the base engines that are being sold into the JV. The management also did not bother disclosing the potential gross margin implication of the JV stake transfer given base engines will now be sold into the JV at a fair market price. This will likely destroy the meager net income the JV has reported in the past. The most recent quarterly performance of Weichai Westport is a clear demonstration of such impact. I have translated an excerpt of the article dated January 14th, 2013, which sheds light on Weichai Power's attitude towards Weichai Westport.

    "To answer the controversy, Weichai Power's secretary of the board responded for the first time since the transaction. He explained to journalist at Golden Securities. "The reason we decided to sell the JV stake is that we feel strongly WWI stake is better owned by Weichai Holdings. Under Weichai Power, WWI is only a subsidiary. But at Weichai Holdings, WWI is more independent with more resources".

    In natural gas engines, the base engine and electric control systems account for 87.5% of the total cost. Especially the base engine part accounting for 50% of the total cost. The overall costs of those two parts largely decide the ultimate sale price and profits. For a long time, WWI purchased base engine directly from Weichai Power. Dai Lixin explained. "Because those are related party transactions, the price we sell WWI the base engines is also the price we sell at the market. This brings an issue for us because in order to support WWI, we priced our base engines too low. In other words, we are missing 100% of the profit for this 40% stake"

    Also, WWI currently has a capacity of 50k natural gas engines. With the help of Weichai's strategic advantages in the industry, it mainly sells to Shanxi and Futian heavy trucking as well as intra and inter-city buses. "In order for WWI to develop, it cannot only purchase base engine from Weichai Power. But the current situation is competitors are not willing to sell base engines to WWI. The reason is simple, wouldn't selling base engine be equivalent to aiding the competition? And once WWI is owned by the holding company, there's little direct competition hence WWI could purchase base engine from other vendors and maybe move into other fields".

    Dai further told the journalist from Golden Securities. "Over the course of these past few years, many major vehicle manufacturer and engine manufacturer such as Dongfeng, Shanghai Diesel engine and others are all working on natural gas engine. The field is getting very competitive. Plus, nature gas can count as alternative energy at most and it is not really new energy. It's unclear whether there'll be a bright future for the industry".

    When Westport announced the most recent quarterly results on May 2nd, 2013, in explaining the gross margin percentage decrease of Weichai Westport from 16.7% to 6.6%, Westport stated the following:

    "The decrease in gross margin percentage is related primarily to product mix and aggressive efforts to penetrate new markets and build market share in China"

    This directly contradicts statements made by officials at Westport's former JV partner Weichai Power. Mr. Dai of Weichai Power clearly stated in the interview that they would be selling base engines into the JV at market price following the sale of its stake in Weichai Westport and the increased price on base engines is most likely the real explanation for the 10 percentage points drop in gross margin. It is puzzling why Westport wants to attribute the dropped margin to product mix or aggressive efforts to penetrate new markets. Westport's management goes through great lengths to hide the fact Weichai Power has sold its stake and it further hide from investors the significant changes in the economics of WWI. While the Chinese natural gas engines market may grow, Westport is very unlikely to reap much benefits from such growth as evidenced by its $0.6 million share of profits in the most recent quarter from Weichai Westport.

    Given the value of WWI pegged by Weichai Power, the easiest valuation to derive for share price of WPRT is probably to simply replicate the analyst community's analysis in the Company. Three times the 24 cents valuation would reach a 72 cents price target for Westport. While this may sound harsh, further more detailed analysis on other business segments suggests 72 cents a share may not be as far-fetched from the reality as it sounds.

    CEO May Have Lied about Margin Impact of JV Modification

    Cummins Westport JV or CWI has seen its gross margin collapse following the modification of JV agreement in February of 2012. CWI has seen its cost of goods sold soar since Cummins started selling its base engines into the JV at a markup. Moreover, the modification gives Cummins the rights to compete in 2017 and the rights to buy out the JV at an attractive valuation. Both of thee provisions can end up leaving Westport shareholders with very little value in CWI. The gross margin percentage in the last three months of 2012 stands at 25.6%, down from 43.7% in the last three months of 2011. The most recently reported quarter showed a gross margin of 27.5% versus 37.2% in the same period in 2012. While Westport management is evasive in claiming that the margin impact primarily stems from product introduction and higher warranty accrual, it is clear that the margin impact came directly from the markup on the base engines given the cost structure of CWI's products and the sustained lower gross margin since the modification. Westport made a whopping 0.8 million dollar from its crown-jewel JV, down from 4.8 million in the same period of last year.

    For Westport investors, however, it is far more concerning the outright deception displayed by the management when they were questioned on a public conference call about the potential gross margin impact of the JV modification. The outright deception is on full-display when CEO David Demers answered questions about gross margin of CWI post JV modification on the February 21st conference call discussing the JV modification.

    "Rupert Merer - National Bank Financial - Analyst

    For modeling purposes, with the restated JV, should we expect consistent gross margin as well as the ASPs from CWI, relative to previous quarters? And will be gross margins to be similar on the 12L engine?

    David Demers - Westport Innovations Inc - CEO

    I think if you look at our past, Rupert, you've known us long enough to have seen this movie probably couple generations now. As you launch new product, there is always much lower gross margins, and as products mature and as warranty accruals are more mature, you see those gross margins rising. So we have been in a rising gross margin scenario with CWI the last few years, as the ISLG has become very successful. So it's inevitable that you're going to see lower gross margins on the 12G, and that is going to bring, depending on the product mix, it is going to bring margins down, and so we would think margins should be back to more of a historical norm. You will see this pattern as we see the product launch, but if you go back a few years and if you listen to what we've said for margin guidance going forward, margins for the last few quarters have been considerably above our median guidance on gross margin and profit. That said, I think most of the models we've looked at are pretty realistic going forward for contribution to both parents, and we think there is no reason to adjust models up or down, based on any particular quarter. But we expect the same pattern as we've always had. The ISX12 will get launched with a conservative warranty accrual. That is going to have relatively low gross margins at launch, probably for the first warranty period or two. So two or three years, you're going to see lower margins than at maturity.

    Rupert Merer - National Bank Financial - Analyst

    Okay.There's nothings materially different in the restated joint venture agreement that would impact the margins?

    David Demers - Westport Innovations Inc - CEO

    No.

    The CEO of Westport specifically guided the analyst community to model with flat-margin assumption going forward for CWI only to see the gross margin collapse by 1500 basis points a short few months afterwards.

    Core Business of Westport

    With WWI being priced at 24 cents a share and CWI currently generating little income and disappearing in the intermediate term, investors in Westport are really betting on a bright future of Westport's core business. At the current $1.6 billion valuation, investors may be placing way too much faith on a realistically negative NPV business. Given much of the future for Westport hinges on its presumed future dominance in the natural gas engine sector, the Applied Technologies Segment which reports roughly $10 million operating income can be viewed as a stable business. The focus really hinges on its On-Road Systems segment, or Westport HD.

    Westport HD, the wholly owned business segment of Westport Innovations, targets heavy duty trucks and has been a perennial loser for Westport shareholders. Westport attempts to compete with Cummins directly to gain shares from the predominantly diesel engine driven trucking industry. Unfortunately, Westport HD simply does not have much of a prospect in such a highly competitive sector without support from Cummins. As of 2012, the HD division has a total employee headcount of 79, compared with 44,000 employees at Cummins. Also, with limited plant and equipment, Westport simply is not in a remotely competitive position even if the gas engine market were to take off. Furthermore, the gross margin for the segment has stayed at single digit, laughable by any standards. To illustrate the ludicrous nature of the business, the entire segment shipped a grand total ofthree 15L engines in the most recent quarter.

    Moreover, while infrastructure development is on the map, heavy duty gas engine market will most likely be very slow to develop given the current lack of infrastructure. A Reuters analysis in late March discussed in details the difficulties surrounding decisions to heavily invest in natural gas engines by the fleet operators. The actual realization of the diesel engine to natural gas engine transformation is likely many years away. Cummins most likely would have already bought back the Cummins-Westport JV at that time and it will likely leave Westport shareholders in the cold.

    Analyst Community

    Aside from the proven ridiculous valuation put out by the bullish analyst on Weichai Westport, analysts' projections of Westport's profitability have also been proven wrong repeatedly. To demonstrate, a Table is produced to show that analysts had repeatedly been wildly unreliable when it comes to analyzing the timing of Westport's bright future.

    Brokerage Firm

    Date of Initial View

    Initial Assessment

    Date of Subsequent Change

    Subsequent Assessment

    Piper Jaffray

    4/10/2012

    Profitable in 2013

    3/8/2012

    Profitable in 2015

    Morgan Stanley

    2/8/2011

    Profitable in 2014

    1/16/2013

    Profitable in 2015

    Macquarie

    3/20/2012

    Profitable in 2014

    1/17/2013

    Profitable in 2015

    Jefferies

    12/1/2011

    Profitable in 2014

    3/8/2013

    Losses in 2015

    Craig-Hallium

    5/19/2011

    Profitable in 2013

    3/20/2013

    Significant Losses in 2014

    The more downbeat analyst such as Stifel is predicting losses throughout 2018 and I am predicting losses till insolvency.

    The Strangest Compensation Plan Ever Existed

    While relatively unrelated to the investment thesis, Westport's old compensation plan is simply too amusing to pass up mentioning. Prior to 2012, the management's compensation was tied to the stock performance of a self-manufactured clean-tech index. Per the company's proxy in 2011.

    " The Corporation's main reference market for purpose of comparative analysis and benchmarking executive compensation includes publicly listed alternative power and energy technology companies of comparable size, complexity and market capitalization. The 'Comparator Group' includes: A123 Systems, American Superconductor Corp, Ballard Power Systems Inc., Capstone Turbine Inc., Clean Energy Fuels Corp., Energy Conversion Devices Inc., Fuel Systems Solution Inc., Fuel Tech Inc., Plug Power and Syntroleum, Inc, among others""Of the Units granted during the nine months ended December 31, 2011, 145,794 Units were subject to market and service conditions. The fair value of these Units was determined using a Monte-Carlo simulation using the following weighted average assumptions: expected dividend yield - nil%; expected stock price volatility - 59.98%; and risk free interest rate - 1.52%. The valuation model determined the grant date fair value based on assumptions about the likelihood of the Company achieving different payout factors as driven by the market conditions. Payout factors are determined based upon the absolute stock price two years after the grant date and the stock price relative to a Synthetic Clean Tech index of comparative companies two years after the grant date. One-half of these Units vest after two years and the remainder after three years from the date of the grant. The impact of market conditions, if any, on compensation expense for these units is determined at the time of the grant with no adjustment to the compensation expense for the actual results of the market condition."

    To dissect the group of "comparators"

    • A123 Systems (Pink Sheet: AONEQ) - Bankrupt
    • Gentherm ($560M mkt cap, NASDAQ:THRM) - fast growing, profitable manufacturer of heating, cooling, and ventilating devices for cars
    • Ballard Power ($100M mkt cap, TSE:BLD) - unprofitable manufacturer of fuel cell products
    • Capstone Turbine ($260M mkt cap, NASDAQ:CPST) - unprofitable manufacturer of microturbine technology
    • Clean Energy Fuels (NASDAQ:CLNE) - unprofitable and designs, operates, and maintains compressed natural gas (CNG) and liquefied natural gas (LNG) fueling stations
    • Fuel Systems Solutions ($310M, NasdaqGS:FSYS) - marginally profitable supplier of fuel components for natural gas engines
    • Fuel-Tech, Inc. ($80M, NasdaqGS:FTEK) - profitable designer of solutions for the optimization of combustion systems in industrial applications
    • Gentex Corp. ($3.5B mkt cap, Nasdaq:GNTX) - profitable auto-dimming rearview mirrors and camera-based lighting-assist manufacturer to the automotive industry worldwide.
    • PMFG, Inc. ($125M, Nasdaq: PMFG) - unprofitable manufacturer of custom-engineered systems for natural gas infrastructure.
    • American Superconductors ($140M, Nasdaq:AMSC) - Stock is down 90% since 2011

    Such compensation plan only goes to show the problematic incentive structure of Westport's management team. Instead of focusing on improving profitability and generating real value for the shareholders; Westport's management placed more attention on the actual stock price.

    Conclusion

    The management hid from investors a significant JV stake transfer. The stake transfer not only marks a significant mistaken valuation by the market but also implies a complete structural change on the operation of the JV, WWI. The CEO stated, publicly and incorrectly, on a prior conference call discussing the gross margin structure of another important JV, CWI. Lastly, shipping three engines a quarter is an embarrassing report from a $50 million dollar company, much less a $1.6 billion dollar company. While on the surface, Westport's management portrayed a promising and innovative clean-tech business that will transform the entire transportation sector. In reality, the entire business is really a stack of cards that is waiting to collapse. With Weichai Westport being priced at 24 cents a share, Cummins Westport reporting meager profits and disappearing in a few years and the troublesome performance of its core business division, Westport will only continue to burn cash and destroy shareholder values. When the market stops financing Westport, the shareholders will likely be left with little to no value.

    Disclosure: I am short WPRT. 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.

    Disclosure: I am short WPRT.

    Stocks: WPRT
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Comments (3)
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  • I would not placed such an emphasis on the arm-length transaction within Weichai. It is not unusual for Chinese listco to sell a promising subsidiary at a "super-cheap" valuation in early-stage to an entity controlled by the owner and screw public shareholders over.

     

    If one examines Weichai's annual/interim reports and Weichai's analyst coverages, Weichai Westport (WWI) was really under the hood since WWI was insignificant to Weichai's top and bottom line (I want to go as far as WWI was never mentioned, but I of course did not read every single one). I don't blame anyone (or even analysts) to miss WWI when scrutinizing Weichai if they solely look at the Hong Kong/China market. Heck, Weichai owns like a hundred subsidiaries and JVs, and $WPRT is relatively unknown to Chinese investors.

     

    Anyhow, I would illustrate an example: NetDragon (777.HK) and 91Wireless (the largest Android app store got brought by $BIDU for USD1.9Bn).

     

    NetDragon found 91Wireless as subsidiary in Jan 2011. While NetDragon was holding RMB 1Bn net-cash, it did a series of share awards, preferred share and convertible bond subscriptions for "working capital" purposes to connected parties at the 91Wireless level throughout 2011-12, resulted in diluting NetDragon's stake down to 59%.

     

    In terms of valuation, 91Wireless's convertible note issued on Sept 2011, USD5M principal was converted into 4M shares (out of 120M total shares along with 8% interest rate), in which translated to USD 150M valuation. The one in May 2011 was even more ridiculous, 18% of 91Wireless was sold for USD 5.5M. These shares and notes were sold to IDG, indirectly held by NetDragon's founders and managers.

     

    In July 2013, Baidu brought 91Wireless at a USD1.9Bn valuation, and NetDragon shareholders got screwed for USD700M.

     

    NetDragon's case can drew some similarities since the "China's app store" concept is relatively unknown to investors back in 2011 when examining NetDragon as a game-maker. Right now, you got a fast growing CNG/LNG engine subsidiary that is relatively unknown when examining the company as a diesel engine maker.
    24 Sep 2013, 05:53 AM Reply Like
  • With all these words, I view this arm-length transaction a big positive to WWI, but instead of questioning the valuation, I am second-guessing $WPRT became yet-another victim of Chinese accounting gimmicks that marginalized foreign investor profits.

     

    25% of WWI is owned by a Hong Kong company, but not that many people know that the owner of this Hong Kong company is also on the board of Weichai Power.
    24 Sep 2013, 06:19 AM Reply Like
  • Zhou,

     

    I enjoyed reading your view of how WPRT is participating in the rough and tumble world of Chinese capitalism.

     

    I agree with the two comments above about the incomplete analysis you have presented. It's plain to see that the "arms length" transaction you use as a basis for $.24/share value of WWI is completely without merit.

     

    Your analysis should have at least included the fact that the "arms length" transfer was from one Weichai ownership entity to another, it could be likened to a transfer from one corporate division to another. Such a transfer should in no way be considered a basis for valuation.

     

    However, I do appreciate the fact that you have disclosed that you were a short seller of WPRT back in June 2013. You're an intelligent investor, as such, I presume you have used WPRT's recent low as an opportunity to cover your shorts.
    14 Nov 2013, 06:23 PM Reply Like
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