Clean Air Power - A Blue-Sky Case

http://www.cleanairpower.com/

Clean Air Power Logo

Over the past year, many companies that previously would have been analysed on value grounds have risen sharply to the extent that much of the small cap and mid cap markets are pretty fully valued, and finding any companies that fit value criteria is becoming extremely difficult. In many cases, investors are now paying for growth two years ahead, up front - for stocks that are not blue-sky cases, that is an unattractive proposition in my view. Clean Air Power (LSE:CAP) is however, a blue-sky case and potential investors into the company are potentially paying for profits, which are several years ahead. The difference is that companies such as Clean Air Power (abbreviated as CAP), are valued on growth potential, and with positive announcements in recent weeks, CAP could be set to re-capture bullish market sentiment. At the current 9.13p share price, CAP has 231 million shares in issue and is valued at £21m.


The technical position of CAP looks encouraging, but there are a few obstacles that need to be surpassed. The first is to form a higher high, and that requires a closing price above 9.75p. The second obstacle is the psychological 10p resistance and the third is the long-term overhead resistance that has now been formed. The shares have potentially formed a double bottom after rebounding swiftly from their latest visit to the 6p levels and that should be seen very positively. There is strong support around the upper 6p and lower 7p levels should the share price re-visit them. Overall, the technical position is currently at a point of equilibrium. If the share price can push a few percent higher, then I would expect a break to the upside. Given the recent bullish newsflow I would expect this path to be more likely than a downturn again.

The first thing to look at when analysing blue-sky stories, is to examine whether or not they have sufficient cash to fund the next 6-12 months. If they don't then it is often best to wait for the inevitable placing - blue-sky stories tend to attract large placing discounts because institutional investors argue that they lack the fundamental basis for a small discount. Blue-sky companies rarely raise debt either as many can't forecast profits with any real confidence. They are therefore high risk and setting a stop loss at around 7.50p should be encouraged.

In Clean Air Power's case, the financial position seems strong enough. As at the last financial reading (pre-placing), CAP had ~£2m in residual cash (although that is some time ago now). Moreover, the company completed a £5m placing back in August 2013, so assuming 95% of that is net cash, that should add a further £4.75m to the bank. Cash burn is not too bad at all, and that situation is forecast to continue to improve. On this basis, CAP meets the first important criterion. The terms of the placing is more important. It was completed at 9.625p, which represented a ~10% premium to the share price at the time. Attracting £5m of inward investment, in a large unproven business model (it is still loss making), at a premium, is a strong vote of confidence in the company. That is more so the case because that investment was through a company in which Russian oligarch Roman Abramovich is the beneficial owned. The wife of another super-rich Russian, Zara Shvidler, took part in the placing. Both Shvidler and Abramovich offered to subscribe to the full placing, but were scaled back. Unsurprisingly, the shares rallied by over 30% on the day, forming the spike on the graph that can be seen in H2 2013.

Despite the initial enthusiasm, the shares are now trading at a ~5% discount to the placing price. The new investors joined a list of institutions invested in CAP, who include Octopus Investments (over 10% holding) and Legal & General (over 7.5% holding). There are a raft of institutions with smaller stakes, including Hargreave Hale - these holdings all show that institutions are willing to back a company, which I say, is still largely unproven (although that is starting to change). Furthermore, directors subscribed to ~1.07m shares in September 2013 in a second director placing. The directors could not initially buy any shares as they were in a close period. Those shares were bought at 9.625p also, with CEO John Pettitt taking up circa £60,000 worth of shares. In total, the buys raised another £0.1m.

As the name suggests, Clean Air Power is a technology company - the classic blue-sky sector. The company's flagship technology is its patented Dual-Fuel system. Dual-Fuel enabled heavy duty goods vehicles with diesel engines to operate primarily on natural gas (either liquefied (LNG) or compressed (CNG), with the diesel fuel acting as the ignition source. As it stands, natural gas is the only commercially developed alternative to diesel for Heavy Goods Vehicles (HGVs) due to torque and power requirements.

CAP sells its Dual-Fuel technology through two routes. The first is through retrofitting existing vehicles with the Genesis-EDGE system (it can be installed without engine manager assistance). Through this method, the average diesel-natural gas substitution is 60%. The second is through partnerships with Original Equipment Manufacturers (OEMs) and is the Interfaced Dual-Fuel system. The OEMs are essentially the vehicle manufacturers who incorporate the technology during production. Interface has an improved average diesel-natural gas substitution rate of 75%-85%. CAP has a portfolio of well over 60 patents classified as held or pending that should provide good barriers to entry and help the company to continue to grow its first mover advantage.

The latter method is CAP's long-term growth path, with the retrofitting seen as a shorter-term objective. The first real step for that was made back in July 2010 when CAP signed a 5-year supply agreement with Volvo trucks. Orders last year were slower than expected due to the introduction of Euro 6 emission standards and that caused constraints and lengthened lead times that eventually fed through into lower sales. In CAP's last trading update, they commented: "The increase in sales and forward orders in 2013 has been achieved despite constraints on expected production levels of methane-diesel vehicles by our European OEM partner ahead of the introduction of Euro 6 emissions standards in Europe in 2014. Demand for our products is expected to continue to increase in 2014 due to interest from several large UK fleet operators and the opening of a number of new natural gas refuelling stations. In addition, there will be an increased supply of vehicles available to retrofit as a result of the high level of late Euro 5 vehicle purchases made by operators ahead of the imminent change to Euro 6."

This gives customers of the Dual-Fuel system a number of advantages. The main two are:
- Lower operating costs: Natural gas is less expensive. Potential to reduce the fuel bill by as much as 20%
- An improved carbon footprint as carbon dioxide emissions are reduced.
Putting some figures behind the claims, the Genesis-EDGE system can generated cost savings per vehicle of £13,000/year versus an initial cost around double that. After five years, cost savings amount to ~£42,000. Of course, those figures are entirely plucked out of the air and are based on one specific scenario - a vehicle travelling 156,000 miles per year and assuming a 60% diesel-gas substitution rate. The real test for whether this system is worthwhile, is to see what purchasers of the kit have decided.

The Dual-Fuel technology can also operate on bio-methane or bio-diesel, potentially meaning it can be a carbon-neutral operation, so it fits in well with emission reduction objectives that many countries have. In that respect, CAP has received several significant grants to help develop its technology in recent years. When the natural gas runs out, the system switches so that the vehicle is back to running off diesel again, until the natural gas 'tank' is re-filled. Dual-Fuel customers are then supported through after-sales services - minimal routine maintenance is required, with the natural gas injectors easily accessible and able to be changed within an hour. The challenge with natural gas as fuel is that historically there hasn't been sufficient infrastructure in place to cope with a growing market. There haven't been many natural gas refuelling stations and the natural gas tends to be trucked, rather than through a more sophisticated system.

However, as both CNG and LNG are cheaper than diesel and gasoline, especially since the fracking boom, this has been changing. With natural gas for road vehicles becoming increasingly popular, particularly in the United States and Russia, more and more refuelling terminals are being constructed. Indeed, North America has a gas refuelling network that now spans from the West Coast to the East Coast. The Northern part of the USA remains fairly undeveloped. Similarly in Europe, plans are ongoing to improve natural gas refuelling infrastructure. Many new refuelling stations are being constructed as part of the EU's ongoing LNG Blue Corridor initiative that spans most of Western Europe. An increased number of stations in France, Germany and Italy (for example) are planned so to meet the EU's target for a maximum 400km distance between LNG fuelling stations, by 2020. As noted above, Russia holds significant potential for CAP as it already hosts 200 CNG stations and commitments to substantially increase their natural gas refuelling network. These underlying improvements provide a positive backdrop for CAP's technology, although as always, the impetus remains on the board to exploit that opportunity.

CAP derives its revenues from 2 commercial divisions. The first are the Dual-Fuel vehicle systems sales through OEMs or retrofitting. Revenues are earned from the initial hardware sales, and from engineering services. The second division is the components division - this division designs hydraulic valves, natural gas injectors and filters for natural gas systems. The 2012 results highlighted the growth phase of the company with the main points below:
- Group revenues up 73% to £7.94m
- Loss down 1% to £2.22m
- Number of system installations up to 300 from 70
Those figures were followed up by a set of interims in September, which showed a disappointing £4.1m in revenues and a £0.9m loss before tax. The disappointment came from the revenues figure, although if you strip out the exceptional contract (in the company's view) from the year before, that figure is higher Y.O.Y. Net payables stood at £0.73m although these were less than inventories which were £1.39m. Perhaps more importantly, 172 systems were delivered in H1 2013 compared to 116 in 2012. In sales terms, there is clear traction being gained, although admittedly it has been a little slow to start.

I have called CAP a blue-sky case in this article - I say that because the company is still loss-making, but that it has impressive technology, and the future growth trajectory can be altered by just one or two major orders. One very significant point that makes CAP less risky is that its technology is largely developed. Of course, there will be further developments to continue to improve it, but it has been created and is available for sale. That eliminates the initial development risk so the business strategy now is to ramp up sales. As a testament to CAP's product, the company completed its first coast-to-coast crossing of the US on a Dual-Fuel/LNG/Diesel tank during 2013. The trip, which covered 2720 miles, required one fuel refill in Dallas. CEO Pettitt commented, "The production of a Genesis-EDGE retrofit product for the US market is a key strategic goal for Clean Air Power that has the potential to generate significant revenue and further validate the technology to potential OEM partners."

Following on from the impressive August placing, the company announced a testing agreement with UPS (United Parcel Service) for 10 tractor units. These were retrofitted with the Genesis-EDGE technology. I'd imagine that the data provided by these trials will be more useful than any potential orders, not least because UPS announced a $70m deal with Daimler this week to buy 1,000 propane-fuelled trucks. Of course, that remains to be seen, but a trial period can only help. Taking a broader view, the UPS investment is a signal that the market is adopting the technology, and that is only likely to help CAP.

Further important news for investors started to flow through in September when CAP signed an agreement with Ricardo, Inc, a company that holds a global consultancy position for the development of vehicle and engine engineering. The agreement effectively meant that Ricardo promoted CAP as being the preferred supplier and developer of dual fuel systems. The benefits of this partnership were not immediately obvious, as all too often these co-operation agreements end up delivering very little for the company involved. However, that was not the case as CAP announced in February that they had entered a funded concept development agreement with a global truck manufacturer to develop an engine for the South East Asian market. That agreement was set up through Ricardo. Subject to a successful concept phase (expected to take 6 months), the agreement will enter a second phase whereby production for the technology will start. Whilst the end benefits of this are still not crystal clear, this gives CAP a foot through the door with this manufacturer and the opportunity to showcase its technology and this ultimately gives upside potential further down the line, at no material cost.

The disappointment that helped fuel the share price fall was released as a trading update in December. Despite confirming that 2013 system sales exceeded 400 (versus 300 in 2012), the level of unit sales was marginally behind market expectations (£11.1m in revenues). Furthermore, timescales for the release of Genesis-EDGE slipped to Q2 2014 from Q1. That knocked market confidence and was not helped by the Group Finance Director resigning in January. However, taking a step back, the news certainly was not as bad as the market made it out to be. Forecasting revenues for blue-sky stocks, where orders (thus revenues) are largely dependent on a few contracts is difficult. That is why these blue-sky companies rally strongly when they beat expectations - when they do, they tend to substantially beat expectations. In January, it was also said that the Finance Director was departing to pursue 'other business opportunities'. Unfortunately, that is an extremely opaque sentence that is commonly used when a director leaves a company, and it leaves investors in the dark. Given that there was an orderly handover and he participated in the director placing back in 2013 (albeit only to a small extent), I am not reading too much into it.

The real positivity was released in February through a number of very encouraging news releases that the market seems to have been fairly slow to react to. The first of three announcements came as CAP received an order for 19 units of the Genesis-EDGE system for a UK distribution company. That had an order value of £0.5m. Admittedly that is not a huge order, especially since 2014 revenue estimates are for north of £20m, but the key point is that it was a repeat order. The distribution company already had over 100 vehicles with CAP's technology so that is a vote of confidence in the product. I talked about this vote of confidence earlier. A few days later CAP received a $0.5m order in its component division for natural gas injectors.

This was followed up by the most significant of the three - a 50 unit order for Genesis-EDGE fuel systems from Sainsbury's. Not only is the deal with a major supermarket, but Sainsbury's are also a repeat customer as it already had around 50 trucks with Genesis-EDGE installed. That is a very significant endorsement for the technology and ultimately it shows customer satisfaction. This allowed the company to further re-affirm that it is confident of meeting FY2014 expectations, which is no easy feat given the expected revenue uplift. Importantly, these business wins all act as references to pitch for other companies, so reputation should build.

As ever, the question remains: how do you value a growth company that is so speculative? The reality is that the market is willing to place lofty valuations with these sorts of companies, especially in the current market. Quadrise Fuels (LSE:QFI), Flowgroup (LSE:FLOW), Ilika (LSE:IKA) and Seeing Machines (LSE:SEE) are four examples of companies that are all forecast to make losses this year and who simply would not be valued on their current ratings if the market didn't factor in the growth. Others including Proxama (LSE:PROX), AFC Energy (LSE:AFC), ITM Power (LSE:ITM) and Monitise (LSE:MONI) are all further examples of the market paying staggering sums for growth, arguably, not where is it remotely justifiable. All of these companies are valued well in excess of £50m. Therefore, with CAP valued at a comparatively low £21m, there is certainly large upside potential if the board can continue to deliver on contract wins, and for completely speculative investments like CAP, that is the mindset that has to be taken. It's all about potential.

Given the lack of locatable value in the market, I therefore think that Clean Air Power offers investors a speculative, but potentially very rewarding choice. The recent series of contract wins bodes well, as it appears traction has been gained during early 2014. If the company does deliver on the £20m+ in revenues, that are expected, then the shares will probably re-rate higher over the course of the year (assuming no unforeseen placing). The cash position at the moment seems sound (for now) and the company appears to have passed the stage where it is 'cash hungry'. In any case, the placement late last year demonstrated that there was strong financial backing for the company should it be needed. With 'tangible progress' being spoken of, in relation to discussions with foreign OEMs and further product launches in the US and Russia over the course of 2014, CAP offers fairly attractive blue-sky upside. I have therefore put a Buy tag on Clean Air Power at 9.13p.

UPDATE (05/05/14) - I have moved Clean Air Power (LSE:CAP) from Buy to No Rating after economic conditions in Russia have worsened and the company has put out a corporate presentation noting that this should have an impact on sales potential for this year. Market expectations are now highly unlikely to be hit. On that basis, I have moved the company to No Rating at 7.88p for a circa 14% loss

9 comments:

  1. Nice choice el1te. Clean air is now recapitalised and has a strong product pffering as demonstrated by J Sainsbury's interest and placement of repeat orders.

    It is a growing sector and if they make £20m in turnover this year, I will be amazed plus th market will re-rate the stock up quite a lot. I totally agree that value has been lost in the markets now. Even companies like Photo-Me (PHTM) are trading on something like 25 times earnings! The best value is actually in large caps like Bae systems (BA) which is on 11 times earnings and boasts a near 5% dividend yield. The truth is that upside is unlikely to be stellar :/. Great article!

    CraigJ

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    1. You are completely right.

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  2. Thank you El1ite. Excellent research as usual.
    cmtcon.

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  3. Very interesting company this one. I shall take a closer look for the higher risk section of my portfolio

    Dave

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  4. Hi El1te. Any further thoughts? I know you changed your mind quite swiftly as you told me by email after the clean air power presentation, but is it worth a punt at 4p now? Very good move to cut your losses here it would seem. Someone has been selling for weeks. Abramovich? but no holdings rns?

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  5. Hi,

    I had to laugh at the unforseen placing caveat in your prose. I would love to here your thoughts on this and the chatter about a management takeovers. Is there any potential at all now?

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    1. Hi there,

      It is in many ways ironic that they have actually gone to the market to raise funds. It was entirely unexpected given that they supposedly still have a decent cash balance and you have to wonder what an extra £1m will actually achieve. For a blue-sky company it is not expensive, but the funding concerns have just arisen again simply because Abramovich has not backed CAP for as little as £1m. There's definitely potential, as demonstrated by the Sainsbury's contract win, but it's likely to be pushed back down the line.

      El1te

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  6. Thanks for your thoughts El1te. It's good of you to take the time. I've got a small holding here. Hopefully a slow back burner. Thanks once again. Jamie

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  7. I'm thinking EPA within the next week or two, possible UPS deal soon after, russia market slowly getting orders and potentail on a real big deal with a global truck manufacturer AKA i think Volvo (beating westport innovations HPDI technology- big deal) in April - keep your ears and eyes open... who knows maybe an acquisition by Ricardo... very cheap at the moment c£6m market cap.. will need funding arrangements after they get EPA, probably before xmas...............lots going on in the background...

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