I have a confession to make. I'm a sucker for story stocks, especially those in the energy space. There is just something about companies looking to change the way we use or produce energy that gives me the warm and fuzzies as an investor. This affinity for a great company narrative has burned me more than once, and because of that I find myself resisting the temptation to jump into "the next big things" in energy. Part of me wants get behind new trends, but it always feels like a crazy girlfriend coming back in the middle of the night and saying, "I promise, this time it's different." Deep down, I want to believe it, but history tells me to be skeptical.
The one company that exemplifies my resistance to optimism more than any other is Capstone Turbine (NASDAQ: CPST ) . For over a year I have wrung my hands as to whether I should buy shares. I believe this company has the potential to completely disrupt the way we think about energy generation, but aspects of the business have me worried that it could never realize that potential. I get the feeling that I'm missing something when it comes to picking this company apart.
Ultimately, my optimism won over and I recently acquired shares in this company. So I want to walk you though why I like Capstone and what convinced me to buy, what parts of the business still worry me, and what goals I'm looking for over the next couple of years that will keep me invested in this company.
What's this company's deal?
For those of you who may not be familiar with Capstone -- which is likely, considering it's only a $400 million company -- it can be most simply described as a manufacturer of gas turbine engines. I know, it sounds pretty boring. But what makes this particular turbine unique is in the guts of the engine. Without getting too deep into the technological details, this turbine is unique because it is more efficient, more reliable, and can run on a plethora of fuels. It is able to do this because of three main design components:
- It only has one moving part that acts as the air intake compressor, the turbine, and the generator all in one. Fewer moving parts means less friction and less energy loss.
- It features a unique bearing system that uses air instead of oil, which reduces drag
- Advances in insulation enable the engine to run at higher temperatures and pressures, which means it has more complete combustion (cleaner emissions) and can run on almost any combustible material.
Engine efficiency refers to the potential energy within the fuel that can be captured by the engine, and a general rule of thumb is that a larger engine is more efficient. However, Capstone's turbines can achieve higher efficiency at even smaller sizes. For example, the size and type of engine found in your car today has an average efficiency of 15%. By comparison, a turbine of similar size from Capstone has an efficiency rating of 25%. When scaled up to larger engines, Capstone's system can achieve as much as 33% efficiency.
Also, since there is only one moving part with no fluid lubrication that needs to be replaced occasionally as in traditional engines, maintenance is reduced significantly. According to NASA, which has worked on air bearings in conjunction with Capstone, not using fluids for lubrication eliminates half of the maintenance costs on an engine. Finally, thanks to the high temperatures and pressures that can be achieved, the engine can run on just about any type of combustible fuel: pure natural gas, biogas from decomposing waste, or even liquid fuels such as diesel and propane.
Why Capstone gives me the warm and fuzzies
A more efficient natural gas engine doesn't really sound that special on its own, but it is when you consider the potential to disrupt the way we power everyday things from our house to our vehicles that you can see the company's potential. I think that the benefits of Capstone's turbine can have a profound impact on three major markets.
Distributed electricity generation and combined heat and power:
The conceptual design of our electricity infrastructure was created over 100 years ago: generate power at massive facilities away from commercial and residential areas and transmit via miles of wires. At the time, it was the most efficient means of generating power; small-scale generation from the technology of the time -- coal-fired steam plants -- was less efficient despite the losses incurred from transmitting power over long distances.
However, Capstone's turbines are small enough and efficient enough to reconsider this dynamic. Localized or distributed generation allow for combined heat and power systems that use engine exhaust for building heating, hot water, and other purposes. These systems can effectively use 80% of the energy released by combustion of fuel. This type of system would be extremely attractive for distributed generation by itself or as a high-efficency supplement to alternative energy installations.
Aside from bragging to your friends that your car has a jet turbine for an engine, Capstone's turbines have the potential to tap two major trends in the transportation space: It gets to piggy-back on the efforts of companies like Westport Innovations (NASDAQ: WPRT ) and Clean Energy Fuels to convert a large chunk of vehicles to run on natural gas, as well as the increased use of fuel-electric hybrids. A Capstone turbine by itself wouldn't be great for a vehicle because it operates best at a more constant workload instead of the stop and go nature of driving. When combined with batteries and an electric engine, though, it's a very powerful creation that can do lots of things traditional engines can't. That is why Capstone is teaming up with Wal-Mart and Peterbilt for this:
This concept long-haul carrier is a potential game changer because it's incredibly efficient -- the aerodynamic profile alone reduces fuel consumption by 10% -- and it can run on natural gas, traditional diesel, or potentially alternative fuels. This would give companies the ability to select which fuel is the least expensive or most readily available. Also, these benefits could also be translated to other methods of transportation, such as rail and marine.
So far, Capstone management doesn't quite see long-haul trucking as a major market for the company, but it does see this system being very effective in buses and other fleet-style vehicles. However, if this proof-of-concept vehicle can be manufactured economically, then it may want to reconsider this as a major market for Capstone's future.
Generating energy at remote and nontraditional locations that have historically flared natural gas
Between oil wells, landfills, wastewater treatment facilities, and agricultural waste, the United States flares off approximately 1.66 billion cubic feet per day of natural gas. This is roughly equivalent to 2.5% of domestic consumption simply vanishing into thin air. A large reason for this is because either the amount flared at an individual site isn't significant enough for a capture system, or it would require significant amounts of processing to make it usable. However, Capstone's systems are efficient enough on a small scale that several of these sources are economical. Furthermore, the high temperature, high pressure system means that gas from biological sources needs minimal processing before consumption; it also reduces the up-front costs of a localized system.
Those benefits make this market the most attainable for the company. Remote generation and biological gas systems represent almost half of all the markets Capstone's management believes it can capture.
The diversity of all these markets gives the company a wide footprint to work from, and management believes the total potential market capture for Capstone's systems is $1.5 billion in annual sales. This company now only generates about $130 million in sales per year, so we're talking about a market almost 12 times what it is today.
A company like Capstone that has a new, revolutionary technology, needs to be able to protect that position. The one thing that Capstone has in its favor in this regard is its patent portfolio. With over 100 patents on its designs and technology, Capstone will have some firepower to prevent major turbine and engine manufacturers such as General Electric and Caterpillar, which have major advantages such as manufacturing capability and economy of scale, from encroaching on its business.
Several of the business segments mentioned above are very long-tail ideas that may take years to produce tangible results. However, Capstone's turbines have already developed a strong foothold in the oil and gas industry. Microturbines have proven to be a very attractive diesel generator alternative for exploration and production companies that need power at remote drilling locations. Not only are the systems highly efficient, but they can use the natural gas produced at the well head without processing. As of the company's most recent quarter, more than 59% of Capstone's sales have come from the oil, gas, and other natural resources segment.
Long term, Capstone is targeting oil and gas for only about 20% of total revenue. However, until those other markets come into the fold, sales to the oil and gas industry will provide a nice boost to the income statement and hopefully fuel growth and development elsewhere.
Success in the markets it has penetrated thus far offer trends that suggest a bright future for Capstone's product: robust sales growth, improving gross margins, and an increasing backlog of orders. When compared to other upstart companies in the energy technology space -- natural gas engine manufacturer Westport Innovations, and fuel cell manufacturers FuelCell Energy (NASDAQ: FCEL ) and Ballard Power Systems (NASDAQ: BLDP ) -- Capstone may not have the best or fastest growing gross margins. However, its sales and backlog growth have been the best of the group, and margin improvement has grown enough that it isn't at a major disadvantage to its competitors. With annual sales at $133 million, a backlog of $171 million already in place, and a book-to-bill ratio of 1.4, the foundation to grow sales into that $1.5 billion figure is starting to take shape.
|Company||Gross Margin (2007)||Gross Margin (Most recent quarter)||Order Backlog growth (2007-last quarter)|
|Westport Innovations||34.3%||29.3%||Data not given|
|Ballard Power Systems||6.6%||25%||Data not given|
Tying it all together, Capstone has the capacity to completely disrupt the way we use energy across multiple sectors; it has the patents in place to protect itself from any rival looking to encroach on its turf; it has at least one sector in which sales are strong that shows the technology is effective; and it has the five-year sales history to suggest that better times are ahead. These are what has made Capstone such a tempting stock.
Why Capstone still gives me the crazy-girlfriend vibe
As excited as I am about the promise of Capstone's turbines powering the way we do things in the future, this story still has me slightly concerned that I'm chasing a hope and a dream. This company has been around since 1988, but it hasn't generated a dollar in profit yet. Heck, the company hasn't even achieved EBITDA breakeven. But my concerns go beyond its lack of profitability and the fact that it's looking to break through in an industry dominated by the likes of GE and Caterpillar. Here are the four things that really have me worried about Capstone's future.
The Royal Rumble for energy domination has begun: For those who aren't fans of wrestling, one of World Wrestling Entertainment's biggest events of the year is the Royal Rumble. It's a superchaotic match in which 30 men enter the ring at various time intervals and all try to throw each other out of the ring until only one wrestler remains. When I look at the energy space today, for some reason this image comes to mind.
That is because we are in quite possibly the most competitive the energy market ever. You have the reigning belt holders such as GE that hold a dominant position in the market, but then there are a slew of young companies building new technologies that are becoming more cost competitive. Not only are they looking to knock each other out, but they want to take a shot at the champs as well. In one corner we have alternative energy generation options such as solar and wind. Costs for those energy sources have dropped significantly over the past several years, to the point that in certain situations they are at price parity even before tax credits. In the other corner, cheap domestic natural gas supplies are making a run as a major player in both power generation and transportation thanks to the likes of Capstone and Westport. On top of that, other options such as fuel cells are seeing cost reductions that could make them a viable option in the coming years. Combine these things and you have a level of competition that was almost nonexistent less than five years ago.
Some of these technologies complement each other and others are in direct competition. It is hard to foresee which ones will tag team to throw the rest of the competition over the top rope.
Don't let low debt figures fool you: At first glance Capstone's balance sheet looks great: The company has only $200,000 in long-term debt and a $15 million-20 million revolving credit facility that has some extra borrowing room at any given moment. For a company with a market cap greater than $400 million, that sounds great. Capstone should be able to take on some debt to grow its manufacturing capacity and distribution network to juice those sales figures.
Not so fast.
Since Capstone is not yet a profitable company, that revolving credit facility is tied to a bunch of financial covenants, and it has failed to meet those covenants on multiple occasions. This means Capstone is not allowed to take on new debt or make an acquisition or sale of the business, and its capital expenditures and net losses are capped. In the short term, this limits Capstone's ability to grow. This stinks as an investor, but I can live with it. The greater concern is that if Capstone can't meet the obligations of a $20 million credit facility, will the company be capable of handling a greater debt load?
I'm sharing the potential profits with 325 million of my friends, and that circle of friends keeps growing: Without the ability to issue any additional debt, Capstone has repeatedly gone back to the equity market to raise capital, and that increased level of shares keeps diluting any future profits the company may see. Using the 2007 to today time frame from above, Capstone has more than doubled its share count.
Management doesn't have a lot of skin in the game: For me, all of these issues would seem a lot less significant if Capstone were either led by its founder or if the company's management had a significant stake in the company through insider ownership. Unfortunately, this isn't the case. Only 0.6% of the company's shares are held by members of the board and executive management. Also, many of those board members and officers have been selling shares over the past year.
Of all the issues I noted, this concern can be most easily remedied by management. I'm not going to point fingers at them for selling shares, because someone could sell shares for a multitude of reasons. However -- and perhaps this is a plea to management more than anything else -- a greater level of insider ownership would certainly instill a level of confidence in investors like me who plan on holding shares for several years.
Despite all of the issues listed above, I still decided to buy shares, but you can see why I held off for so long before making my purchase.
The "prove it" checklist
I have no delusions that shares of Capstone are going to do something ridiculous like double within a year. Buying one of Capstone's turbines isn't like getting a new iPhone. Institutions or companies making an investment in a combined heat and power system can pay seven figures or more, and automotive companies can spend decades designing and developing new models before they hit the roads. This is why I have continued to hold shares of Westport Innovations despite its lackluster performance, and why I'm willing to be very patient with my investment in Capstone Turbine. However, there are a couple things that I personally would like to see as an owner of this stock.
Compound annual sales growth at least in the double digits for the next five years: Maintaining a 30% compound annual sales growth, as the company has for the past several years, seems unrealistic from here. After all, that involved increasing sales from a paltry $21 million to the last 12-month figure of $133 million. Maintaining that pace means sales would need to be more than $480 million in five years. However, if the company cannot maintain an annual sales growth pace of 10%, then I may need to seriously reconsider this investment.
Maintain gross margin growth: Capstone's management says it believes it can achieve a gross margin of 35% on its products, more than double the current 16%. It hopes to get there mostly by reducing costs and raising higher prices. As long as it can maintain a steady pace of margin improvement on an annualized basis -- last quarter's margins improved 3% year over year, which seems like a reasonable rate -- then I'm OK. But a margin that stalls well below that 35% target would be really concerning for shareholders such as myself.
Neutral operational cash flow in two years and no additional share issuance afterward: Over the past fiscal year, the company burned through $15 million in cash it couldn't generate from operations. Following its most recent equity issuance it has $28 million in cash and short-term investments on the books. Management says it can reach a neutral operational cash flow position at annualized sales of $169 million. It will need to grow sales at an annualized clip of 14% over the next two years to reach that point before its cash reserves run dry again and Capstone needs to issue more shares. If it still requires a boost from equity after that, then the company's prospects may not be as good as I originally had thought.
What a Fool believes
I cannot say that my investment thesis or style fits everyone. I will not need to rely on my investments as an income supplement for quite some time, and I have the luxury of taking a flier on a few investments that have huge potential but could eventually flame out. Despite the clear reservations I have about Capstone, they weren't quite enough to sway me from its siren call as a potential disrupter of the energy generation space.
At current prices, shares of Capstone are selling at a little better than three times sales, which is a premium to the S&P 500's average 1.76 but considerably lower many of the other young energy players mentioned above. Hopefully that premium will be justified by growing sales and Capstone's emergence as a profitable company in the foreseeable future.
Shares of Capstone have been all over the place over the past couple years, so I wouldn't be shocked if shares were to skyrocket or plummet from where they are today. But I'll be happy as long as the company meets or exceeds my stipulations above. If shares drop further from where they are today, then I'm much more likely to add to my position than sell.
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