Will Plug Power's New Fuel Cells Change Ballard Power Systems' Future Growth?

Source: FuelCell Energy.

We're about to enter a new period for fuel cell manufacturer Ballard Power Systems (BLDP -2.68%), both for good and bad. The good thing is that the comapny expects to break even on an EBITDA basis this year for the first time ever. The bad news is that one of its largest clients, Plug Power (PLUG -6.95%), will start to manufacture its own fuel cells. With so much news surrounding this industry lately, it can be difficult to get a feel for how to value these companies over the long term. So let's do a little sales growth forecasting to determine what we can expect from Ballard over the next several years to come. 

Who are we talking about here?
For the past several years, Plug Power and Ballard have been tied at the hip. All of Plug Power's fuel cell systems built to replace traditional batteries in equipment such as forklifts have used Ballard's fuel cell stacks as part of an exclusive supplier agreement. This symbiotic relationship will not be as great as it was before, though, because Plug Power just purchased fuel cell stack manufacturer ReliOn for $4 million in stock. At the end of 2014, Plug and Ballard's exclusivity agreement will come to an end, and it's likely that Plug will start to use RleiOn's fuel cell stacks in its fuel cell systems.

Source: Ballard Power Systems investor presentation.

But Ballard's business goes beyond just its deal with Plug Power -- it is diversifying into several other possible uses for fuel cells as well. The company has already made some modest inroads with the Telecom industry as a power supplier for emergency backup power for cellular towers. In 2013, the company's product sales in this part of the business grew by 74% to over $20 million annually. Also, Ballard signed a four-year service contract with Volkswagen in 2013 estimated at $55 million-$90 million. Both Ballard and Volkswagen are looking to develop fuel cell technology into vehicles. With Toyota looking to ship its first fuel cell vehicles to the Los Angeles market in 2015, the possibility of using hydrogen fuel cells in vehicles are looking more possible by the day, even though there are still several hurdles it will face along the way. 

What kind of value is in this company's stock?
Ballard has been around for a while, but up until recently fuel cells were so costly to manufacture it hardly seemed worth it to purchase one despite the competitive advantages they provided. Ballard has yet to generate a profit from the sale of its fuel cells, and it even registers losses on EBITDA to this day because of expensive manufacturing costs. The company does anticipate that it will break even on an EBITDA basis for the year through both an increase in sales as well as improving gross margins across all of its product lines.

Still, without much to work with regarding profitability, one crude way we can get an idea of what to expect from this company in the future is to look at its price-to-trailing-12-month-sales ratio, which today stands at 7.7. After its 150% gain the past few months, it shouldn't come as a surprise to anyone that this is a very strong premium to the S&P average price to sales of 1.7. Aside from Plug Power, though, Ballard's shares are valued at a pretty high premium in comparison to many of its high-flying energy technology peers. 

Source: S&P Capital IQ.

Ballard is a growth-oriented company, so it probably should carry some premium to the S&P average, but to be valued at more than four times the overall market based on this metric, it would need to post some pretty impressive sales numbers. According to S&P Capital IQ, we should expect to see healthy growth and just about double current sales by 2016. 

Source: Capital IQ, author's calculations Note: Revenue from its former contract manufacturing business prior to 2011 was omitted from this chart to better reflect the growth it can from sales and service of its fuel cells.

Ballard has not yet achieved the type of sales growth that S&P is estimating over the next couple of years and analysts estimate that fuel cell sales are only expected to grow by 18.9% annually. Also, Plug Power's ReliOn deal will likely mean that sales to Plug will decline over time. However, this does not mean that Ballard will no longer be selling fuel cell stacks to Plug Power. If Plug Power can meet its lofty sales growth goals, then it will most likely need to purchase stacks from Ballard at a pretty high rate. Also, if Ballard can continue to grow sales in its emergency backup power units at the same rate it did over the past year, it isn't completely out of the realm of possibility to see Ballard grow sales well above the industry average. 

Company growth versus investor expectations
No matter how much potential Ballard has, it's highly unlikely that shares will trade at such a lofty price-to-sales premium for long. For that metric to fall in line with its peers, either the company will need to grow sales at an incredible pace or the price of those shares could decline to bring it back to a more modest valuation. 

For investors, we don't want to buy shares in a company simply for the price to stay the same while sales catch up to a high valuation. We want the price of those shares to appreciate. So let's draw out some potential scenarios for the company. The following tables give a breakdown of what kind of sales growth Ballard needs to achieve over the next several years to bring its price-to-sales ratio in line with its peers as well as the S&P average. It also give the sales it will need to achieve over those same time periods to achieve compounded annual returns of 8%,10%, 12%, and 15% on shares at those price-to-sales ratios.

These calculations are not to show you exactly what will happen with shares over the next several years, but rather they lay out various scenarios to help show what it will take to get to a certain point in the future. As long as Ballard continues to grow sales at an impressive rate, we can assume that it will be priced at a premium to the S&P average, but probably not as high as it is today. Based on that assumption, it will be extremely difficult for the company's shares to grow much more over the next couple years. Further down the road, though, the chances of meeting pretty high rates of return become that much greater. If the company could maintain a sales growth at a compounded annual rate of 22.2% for the next 10 years -- ambitious but certainly attainable -- then the company's price-to-sales ratio could fall to a much more modest 2.6 times and you could still expect an annualized return of 15%, which would put shares of Ballard at $16 from current prices.

What a Fool believes
Ballard may lose its exclusivity contract with Plug Power, but that doesn't mean the end of this company. Investors should probably be ready for shares to take a big hit over the next year or so as fear of Plug Power going off on its own and the price-to-sales ratio falling more in line with its peers in the space. Over the long term, though, there is room to grow even at today's prices, but lots of things need to go right to make it happen. You know, those little things like actually make a profit.

If you do buy shares in Ballard, though, be sure that you are investing over a long-term time horizon -- more than five years -- and you have the temperament to weather a major sell-off or two over the next couple years.