Capstone Green Energy Corp (fka CGRNQ)

[CaptWhizbang]

Capstone Turbine: Risk Priced Into This Small Cap Stock Now Overdone
Nov. 19, 2014 11:57 AM ET
by Crunching Numbers

Disclosure: The author is long CPST. (More...)

Summary
•Shares down more than two thirds from 52-week high.
•Sell-off overdone despite risks.
•Cash position strong.

Capstone Turbine (NASDAQ:CPST) was founded in 1988 and it took ten years before it sold its first micro turbine. It is still a company that bleeds cash and has a host of problems. How serious are these problems? If one were to list the problems that would create a worst-case scenario that could affect growth and limit the company's ability to achieve positive cash flow, they would be hard pressed to match the list of all the barriers currently facing Capstone.

Strong US Dollar

More than half the company's revenue comes from sales outside the US. With a strong dollar, the cost of Capstone's products have been rising. It was a concern raised by an analyst on the recent conference call, and Jamison replied as follows:

“
We do sell in U.S. dollars. We are sensitive to the fact that the strengthening of the U.S. dollar is impacting some of our customers. We will look at it on a case-by-case basis. We are not going to do a wholesale price reduction. And we wouldn't do more than probably 3% to 5%. But we will look at that if there is a project that made economic sense six months ago and it doesn't today, if it is that borderline and we will look at it potentially doing a case by case basis.

In addition, four of the top ten economies in the world are in recession, with Japan being the latest to enter a technical recession with its second consecutive quarter of negative growth.

“
"Japan, Brazil, Russia and Italy are in a recession," [Lindsey Group managing director, Peter] Boockvar said. "Germany and France have been flat lining for the past two quarters. China is clearly slowing and the U.S. remains in the 2-2.25% range. The U.K. and India round out the top ten."

This would argue against the dollar weakening in the near term. Even worse for Capstone, one of the weakest currencies against the dollar is the Russian ruble, and Capstone's Russian distributor, BPC Engineering, was the company's largest customer in its most recent quarter. BPC accounted for 20% of revenue in the fiscal second quarter and 17% of the company's revenue for the first six months of the year (Capstone's fiscal year ends March 31st). BPC also represents a very high 36% of the company's Accounts Receivable of $23.2 million (up from 26% last quarter).

The ruble doesn't appear likely to strengthen any time soon. Not only have weak oil prices contributed to the weakness, but banking sanctions over Russia's intervention in Ukraine have continued to take their toll. Tensions in Ukraine, despite a recent ceasefire, do not seem to be easing. From a recent report:

“
Ukrainian president Petro Poroshenko says his country is "prepared for total war" as fighting continues around the pro-Russian rebel stronghold of Donetsk in eastern Ukraine.

...Before the latest reports of shelling, a Ukrainian military spokesman said the weekend had been calmer than in previous days, but warned again of a build-up in separatist forces.

"Compared with previous days, the number and intensity [of shelling] fell, but there are signs of rebels and Russian forces preparing for an offensive," Andriy Lysenko said in a briefing in Kiev.

The UN said it feared "a return to total war" in the area.

After a week in which Kiev said several unmarked armoured convoys of troops crossed the Russian border to reinforce rebels in the east, Mr Poroshenko toughened his rhetoric, telling the German daily Bild: "I am not afraid of a war with Russian troops."

Another report notes:

“
Green party politician Rebecca Harms, member of the Ukraine committee in the European Parliament, is promoting taking a balance of accounts: "You have to evaluate where you stand with trying to find a non-military solution to the deepening crisis that has been going on since the annexation of Crimea."

It has been clear from the beginning, Harms thinks, that economic sanctions need time to start showing results: "At the moment, the Russian economy is in decline, in free fall if you look at the ruble. That is not only because of the sanctions, but also because of the decrease in oil prices." Because of this, Russia has had to rely almost exclusively on energy exports.

What the Europeans do next should be twofold, according to the Green politician. "First, make it clear that sanctions will continue and that everyone is behind this, and secondly everyone should agree that no EU countries will do any big business with Russia."

While Harms's views do not represent all of the EU, there are indications that more pressure could be forthcoming. Following the latest G20 meeting, President Obama met with several EU leaders:

“
...to discuss the escalating conflict in Ukraine - a session that may prove critical to deciding whether a further round of sanctions are imposed on Russia due to the escalating conflict in Ukraine.

EU foreign ministers will meet on Monday to assess the situation on the ground, and determine whether Russia is abiding by the terms of the Minsk ceasefire agreement reached in September.

Herman van Rompuy, president of the EU Council, appealed to the Russians at a press conference to stop sending weapons into eastern Ukraine from its territory adding "we will use all diplomatic tools at our disposal including sanctions".

Obama is likely to be urging the EU to go further, and will have the support of David Cameron, but probably face greater reluctance from the German chancellor Angela Merkel.

Even if Obama is unable to convince the EU to impose additional sanctions, there is the possibility that he will still propose that the US take actions, actions that could further weaken the ruble and also impose additional trade restrictions.

Trade Restrictions

To date, Capstone has released statements that the trade sanctions have not yet impacted BPC. The recent 10-Q states:

“
While we believe that the executive orders currently do not preclude us from conducting business with our current customers in Russia, the sanctions imposed by the U.S. government could be expanded in the future to restrict us from engaging with them.

During the Q2 earnings conference call, Capstone's CEO Darren Jamison reiterated this concern while discussing growth opportunities, noting:

“
We are excited to see BPC continue to grow its business not only in oil and gas but also in the manufacturing sector as these two great projects showcase.

At this time there is nothing that would restrict micro turbine sales to Russia or BPC. However the sanctions with Russia are certainly a concern and [we'll] continue to monitor the situation closely.

When discussing risks, it is not unusual for the official reports and statements to emphasize their potential downside. Nevertheless, the potential for expansion of the sanctions has probably contributed to the market concerns for companies like Capstone and placed additional pressure on the current share price.

Low Oil Prices

When oil prices are high, not only does exploration drilling increase, but companies also find it profitable to focus on more expensive and/or lower producing opportunities. Capstone's sales into the natural resources segment are very important to the company's business. How important? On the Q2 call, Jamison stated:

“
For our vertical markets by product shipment for the second quarter, 57% of our shipments were for the use in natural resource applications, including oil and gas;

Later, while discussing significant recent orders, he added:

“
Elsewhere in the natural resources market Infinity received a follow-on order for additional six C600s totaling 3.6 megawatts for an independent oil and gas producer. That producer has operations in both in Marcellus and Utica shale.

From a consumer perspective, low oil prices are great. We save money every time we fill up at the pump. As the temperature falls, we spend less on fuel to heat our homes. To a lesser extent, electric bills drop.

For businesses outside the energy industry, the impact varies. Industries that are heavy users of energy for transportation or power find their costs come down and profits expand. From Capstone's perspective, there are different issues.

Recent articles have discussed many potential concerns resulting from prolonged low oil prices. The Telegraph goes so far as to suggest "Falling oil prices and and [sic] US shale drillers drowning in a sea of debt could be the spark for a new credit crunch," explaining:

“
Five years ago at the beginning of what has become known as the US shale oil revolution, drillers started to load up on debt to fund their operations and acquire new acreage as vast areas of North America started to open up for exploration.

...The problem is that much of America's shale oil is expensive to produce and the industry is comprised of numerous small companies who were forced to leverage their operations with debt to fund the high cost of drilling wells through a process known as hydraulic fracturing, or fracking. Should oil prices fall for a prolonged period of time many who have been forced to borrow at a higher rate could be forced out of business and ultimately default.

Ignoring the overall impact of a credit crunch, low current prices could slow expansion of shale E&P operations in places such as North Dakota, which according to Capstone, became the second largest oil producing state in the US in 2013, behind only Texas. If there is a significant slowdown, Capstone's current and future revenue expectations could be reduced.

And it doesn't stop there. Should energy prices come down, the payback on Capstone applications addressing CCHP (combined cooling, heating and power) and CHP applications in commercial buildings could lengthen.

Collecting From Distributors

As noted earlier, BPC makes up a major portion of Capstone's Accounts Receivable, but it doesn't stop there. There have been times in the recent past when Capstone had to hold back shipments to certain distributors over credit concerns and receivable balances. At the end of the first quarter of FY 2014, Capstone held back about $8 million of shipments due to credit concerns with some of their distributors. The expectation was that product would be shipped in the next quarter and the company would meet its soft guidance for the year. It never made up for that shortfall and badly missed top-line guidance.

This past quarter Capstone announced that it took a $2.9 million charge to bad debt expense, although during the conference call it noted that it expects to reverse the charge by the end of the fiscal year. This was explained by CFO Edward Reich:

“
The year-over-year increase [in G&A expense] is primarily due to a $2.9 million increase in bad debt expense related to an accounts receivable allowance for a single distributor. This distributor has been in business for over 20 years and has serviced North Africa and Middle East for us since 2012. The allowance relates to a single end use customer order and we are working with our distributor and expect the situation to be resolved by the end of this fiscal year.

In response to an analyst's questions, Jamison later added:

“
...obviously we sell to distribution. If the distributor doesn't get paid on a project or is paid late by contract that should not impact us. But the reality of the situation is it often does. This distributor is one we think very highly of. They took some other product recently. This actual order we believe will proceed in probably December-January time frame. So we fully expect to collect that money. In fact they are looking at doubling the size of order from three megawatts to six megawatts.

...I think if you look at the time I have been with the company we've done almost $650 million of revenue and besides Green Environment which went bankrupt on us we had very little incidents like this. So we think it is a speed bump and we think it will reverse itself in either Q3 or Q4 and we will go on with our business.

...it will be paid. So it is a reserve today, we did not write it off. It's a reserve for the product and when the product ships to the customer they will obviously collect and pay their bill. ...We will just see it reverse from a bad debt perspective. In today's accounting world because the receivable is older and we didn't have clear path to payment on it and we had to make a reverse [sic] to be conservative.

There will always be a balance between granting credit and requiring payment in advance, especially where the turbine is typically part of a larger project being sold by the distributor.

Guidance

Capstone does not give "official" guidance figures. Instead, it tells investors and analysts that the product backlog entering the year is a good indication of that year's revenue. It has also given estimates about when it will reach EBITDA breakeven and stop burning through cash. Capstone management has failed badly on these measures.

Last year, the company entered the year with a backlog of $148.9 million. After that poor first quarter where $8 million of product failed to ship, and revenue came in at $24.4 million, backlog rose to $155.8 million, and Jamison reiterated the guidance:

“
As I said in the prepared remarks, we're not changing the guidance we gave you last quarter. So the backlog that we entered the year with is a good indicator of what we think we'll do for the year. We don't give specific guidance on a quarterly basis just for this very reason. As you know, we can be lumpy quarter-to-quarter.

The company never recovered from the poor Q1 and finished the year with revenue of just $133.1 million, well below the $148.9 million of product backlog that Capstone had entering the year.

The FY '14 revenue shortfall resulted in the need to raise additional cash, and Capstone issued 18,825,000 at a price of $1.70 per share, although it would only realize $30.2 million from the sale after fees and discounts.

One very small consolation. Backlog entering FY '15 had grown to $171.6 million, up $22.7 million (or 15%), from the prior year. If Capstone had been able to meet guidance and sell the additional $15.8 million of product, backlog would only have increased by $6.9 million, or less than 5%.

This year appears to be a repeat of last year, and is a key reason shares can be bought for less than $1. Q1 came in at a disappointing $23.1 million, as delayed shipments were once again the culprit. On this year's Q1 conference call Jamison said:

“
The lower-than-expected revenue for the first quarter was due to delayed shipment requests for the delivery and installation of equipment on project sites. And this resulted in excess finished goods at the end of the quarter. The timing fluctuations are not the result of an any ongoing pattern of project cancellations or postponements by customers that we're seeing, but instead demonstrate the lumpiness of our business on a quarter-to-quarter basis.

Reich repeated the same assurances about the revenue shortfall in Q1 in his prepared remarks:

“
As our customers work out their project completion schedules over the course of the year, we expect to make up for the lower revenue.

Considering the weak revenue and product shipments in Q1, backlog growth of $3.6 million from $171.6 to $175.2 million was disappointing.

I wasn't the only one concerned about the guidance. The very first question(s) on the conference call began:

“
Just real quick regarding the delayed shipments, and Ed, you've touched on this briefly in your prepared remarks. You expect to make that up throughout the remainder of the year. Just wondering what kind of visibility you have? Are there any orders that you guys have booked or shipped already here in Q2? Does that mean that we're going to see a [bonus] of business come through in Q2, or just what kind of cadence do you guys expect just with regard to those delayed shipments?

Jamison, rather than Reich, answered:

“
We're expecting a strong bounce-back in Q2. I don't think all of the Q1 orders will ship in Q2, but I think at least half of them, if not more, will -- so we'll clean up a lot of that finished goods. We also had an imbalance. We had too few [C65s] slotted for the quarter and too many C1000s for the quarter, so really, a combination of project delays and a mix change that we didn't anticipate. So we're increasing our C65 production over the next couple of quarters to handle that increased order flow. Then obviously, the C1000s we believe will ship either Q2 or Q3. So from a cadence standpoint, I would expect a strong bounce-back in Q2. Q3 is typically our best quarter of the year. I don't see any reason why that won't be the same this year, then finish hopefully strong in Q4.

The questioning continued from another analyst:

“
I'm sorry to kind of beat a dead horse here. Talk about the nature of the delays that you're seeing with these projects. Having projects push out more than a quarter is actually a fairly long timetable. .... But I think we're going to get a lot of concern around visibility and then how trustworthy that visibility is. So if you could just give us a bit more detail around that, that would be very, very helpful.

Again, Jamison responded:

“
Projects move in 3 or 4 months. To the right is not anything significant. We don't see it a problem from an annual basis. And if you think, last year, this is very similar numbers we had last year. We came off a good Q4, had a slow Q1, rebounded nicely in Q2 and Q3. So we're expecting something similar. Again, I know folks that are familiar with project-based businesses and doing this type of building retrofits and new construction may be concerned about it. But, again, we've always said quarterly forecasting is always challenging for us. And something [slips] even 30 days, it moves outside the quarter for us. So hopefully...

I too feel like I am beating a dead horse. The problem this year is similar to the one from last year. After a poor Q1, Q2 had a rebound, but that rebound was much less than was anticipated, and this year is progressing worse than last year. Q2 '15 revenue was $32.2 million, compared to $35.3 million for the same period last year. That brought the year to date revenue to just $55.5 million compared to $59.7 million a year ago, a decline of $4.2 million.

Equally important, the backlog has declined from $175.2 million at the end of Q1 to $172.3 million at the end of Q2, barely above the $171.6 million entering the year. What lies ahead for the second half of the year? Certainly not enough revenue to make up for the shortfall. We know this because Reich also said:

“
As our customers work through their project completion schedules we expect to realize year-over-year revenue growth in the mid-single digits for the second half of our fiscal year.

As a reminder, the revenue in the second half of last year was $73.4 million ($133.1 million for the full year less the $59.7 million in the first half). If revenue growth is to only come in at "mid-single digits" over $73.4 million, then a 6% growth figure puts the second half revenue around $77.8 million. Even using 7% only brings the figure up to a maximum of $78.5 million for the second half of 2015. $78.5 million added to the $55.5 million from the first half of the year puts guidance at only $134 million for 2015, just barely ahead of last year's $133.1 million! This is would be well below the initial soft guidance of $171.6 million.

Too Conservative?

Has Capstone management become too conservative? Are the issues surrounding a strong dollar, current banking sanctions potential trade sanctions, weak oil prices and weak economies taking their toll on Capstone? Even with these issues, there are reasons that Capstone should be expected to generate stronger revenue growth than "mid-single digits" over the second half of the year.

Last year, Q3 set a record of $37 million and Q4 was slightly below at $36.4 million. As noted earlier, product backlog going into 2014 was $148.9 million vs. $171.6 million entering the current year. However, with that 15% larger backlog, and especially with revenue this year already $4.2 million behind 2014, the company would seem well positioned to exceed its very modest growth forecast for the second half of the year.

The Share Price

The share price has taken a beating and is currently below ninety cents. At that price, it seems as though all of the negatives have been priced in, and then a penalty added on because there is, as one analyst noted, "a lot of concern around visibility and then how trustworthy that visibility is."

The shares traded as high as $2.60 eight months ago. Then, six months ago, the company was forced to issue more shares and dilute current shareholders. As noted earlier, those 18.8 million shares were sold at $1.70. The shares "were allocated to a single institutional investor"; an institutional investor that apparently thought the shares were worth far more than ninety cents. That cash infusion has strengthened the company's balance sheet and cash is currently at more than $40 million. (It should be remembered that there is an additional $2.9 million of cash that the company expects to receive from the previously mentioned bad debt expense.)

Regardless of the amount of cash, when shares are priced so low, there is the potential loss of distributors and/or customers. They look at the share price and question the viability of the company. They might not be willing to take a risk that the company won't be around to maintain and support their investment. As yet, this does not appear to have been a significant issue.

Conclusion

Capstone certainly carries a risk and should be considered a speculative holding. It is also a holding that has an excellent chance to double in price over the next twelve months, and perhaps much sooner. Part of this is based on the backlog and the likelihood of a $40 million quarter, or better yet two consecutive $40 million quarters, and the market's reaction to those types of numbers.

Those levels of revenue would allow Capstone to improve gross margins and approach its elusive goal of EBITDA breakeven. Jamison had concluded his prepared remarks as follows:

“
All indicators point to a much stronger second half of the year as we advance through EBITDA stock comp breakeven and modestly higher revenue compared to last year.

We have worked extremely hard over the past year to improve our margin profile and today we are very pleased to see the benefits of lower manufacturing costs related to margins. As revenue expands in the future this will drive our crossover into profitability. The fiscal third and fourth quarters are typically and historically are strongest quarters of the year for revenues and shipments. Our pipeline is solid and we are excited about the future growth opportunity in the second half of fiscal 2015.

Jamison later discussed various markets showing areas of strength, and added:

“
So Q3 is typically the strongest quarter and has been over the last several years. We are expecting another strong Q3 and following into Q4.

The market reaction and current price indicates that it is not expecting another strong Q3 or nearly as excited about the future growth opportunity as Jamison. And that presents a buying opportunity.

http://seekingalpha.com/article/2695455-capstone-turbine-risk-priced-into-this-small-cap-stock-now-overdone?uprof=44