Who’s the Real Winner if Natural Gas is our Next Transportation Fuel?

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

You are one of the lucky ones.  You can see into the future and that insight can make you a lot of money.  The future you see is fueled by natural gas.  It’s clean and cheap and produced right here in the good ole US of A.  Unfortunately you can’t see everything (it’s OK, nobody’s perfect) and you don’t know which way to invest to ensure your share of these future riches. 

While you already know that natural gas is our future, your just not quite sure if Clean Energy Fuels (NASDAQ: CLNE) is the best way to invest in that thesis.  Do they have what it takes to deliver wealth building returns?  If you want the answer to that question you must first answer these three questions.

What’s Their Addressable Market?

To quote a TV commercial I hear all the time, “big is too small a word for it.”  There are more than 150,000 gas stations in the US that could be replaced or converted to natural gas refueling stations like the ones that Clean Energy Fuels builds and operates.  Only about 1,000 natural gas fueling stations currently exist in the US and to date Clean energy has built 150 of those stations.  The big news is their build out of an ambitious plan called America’s Natural Gas Highway.  This network of stations will connect major metropolitan areas from coast-to-coast and border-to-border to serve our nation’s trucking industry. 

The reason why their addressable market encompasses every gas station in the union is because the product that flows through their pumps is a game changer.  Take a look at the cost differential between natural gas and gasoline and diesel just looking at California:

<table> <tbody> <tr> <td>Average California Retail Prices</td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>(per gasoline gallon equivalent)(1)</td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Year Ended December 31,</td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td>2009</td> <td>2010</td> <td>2011</td> </tr> <tr> <td>California retail gasoline(2)</td> <td> $ 2.68</td> <td> $ 3.09</td> <td> $ 3.82</td> </tr> <tr> <td>California retail diesel(2)(3)</td> <td> $ 2.34</td> <td> $ 2.84</td> <td> $ 3.67</td> </tr> <tr> <td>California CNG—Clean Energy </td> <td> $ 2.14</td> <td> $ 2.51</td> <td> $ 2.70</td> </tr> <tr> <td>CNG discount to gasoline </td> <td> $(0.54)</td> <td> $(0.58)</td> <td> $(1.12)</td> </tr> <tr> <td>CNG discount to diesel </td> <td> $(0.20)</td> <td> $(0.33)</td> <td> $(0.97)</td> </tr> <tr> <td>California LNG—Clean Energy </td> <td> $ 1.93</td> <td> $ 2.03</td> <td> $ 2.33</td> </tr> <tr> <td>LNG discount to diesel</td> <td> $(0.41)</td> <td> $(0.81)</td> <td> $(1.34)</td> </tr> </tbody> </table>

The problem for Clean Energy is having enough capital to keep building stations to address this opportunity.  They’ve had to go out and raise capital from outside investors on more than one occasion.  Last year they raised $160 million from Chesapeake Energy (NYSE: CHK) who led the investment round which attracted another $90 million from other investors.  Chesapeake wants to see demand rise for the gas that they produce in hopes that prices will rise in lockstep.  That quarter billion dollars will just put a dent into their total addressable market and they’ll have much more capital to keep building.

Are They Differentiated?

That question can also be broadened to ask if they have a better product than what’s currently on the market or have they developed a disruptive technology?  Here’s where I am a bit lukewarm on Clean Energy’s prospects.  Natural gas certainly can be a disruptive force, but is it really differentiated by flowing through a Clean Energy pump?

Not much sets apart a Clean Energy station.  They specifically call this threat out in their annual report by saying that a real threat is, “the potential for oil companies, natural gas utilities and others to enter the natural gas fuel market.” It costs an extra half a million dollars to build the compressor and storage tanks necessary to build a natural gas station so the only thing stopping a mom and pop gas station owner from adding natural gas fueling to their station is capital.  If there is money to be made you can bet gas station owners will build a station and if they’re all selling the same commodity then margins will be compressed.

This is why we not only see Chesapeake investing millions directly into Clean Energy, we also read where they’re looking to partner with companies like Valero to build stations.  Valero has 6,800 retail stations in the US and has stated that they’ll add natural gas pumps “if there is demand.”  Chesapeake is in talks to form joint ventures with other smaller gas station owners, apparently not content to be committing to just one player in this race to build out our nation’s natural gas refueling infrastructure. 

Do They Have a Sustainable Competitive Advantage?

If I’m lukewarm on Clean Energy’s ability to differentiate their business I’m even more tepid on their ability to produce a sustainable competitive advantage.   For that future fueled by natural gas there are three necessary components in the ecosystem: cheap fuel, available refueling infrastructure and vehicles to refuel.  We already have the cheap fuel; we’re just lacking the infrastructure and vehicles.  Fuel and fuel stations are more of a commoditized business which doesn’t yield many competitive advantages.

On the vehicle side of the equation, Westport Innovations (NASDAQ: WPRT) has filed 400 patent applications with 290 patents issued worldwide.  Their extensive intellectual property portfolio is nearly triple the size of their competitors.  They also have an impressive list of partners who’ve decided it’s better to join them than compete against them.  That IP portfolio is a big advantage for Westport.

It makes a lot of sense and saves a lot of cents by going with an engine designed by Westport.  One real world example is turning more trash into treasure for Waste Management (NYSE: WM).  They are planning to have 80% of their trash truck purchases over the next five years be those fueled by natural gas.  Those trucks cost about $30,000 more than traditional diesel trucks but they save $27,000 per year or more in fuel costs. The proof is in the profits for Westport as you can see by this chart:

<table> <tbody> <tr> <td>Units</td> <td> Revenue </td> <td> Gross Margin </td> <td> R&D Margin </td> <td> Adjusted EBITDA </td> </tr> <tr> <td>7551</td> <td> $   217,000,000.00</td> <td> $83,000,000.00</td> <td> $9,000,000.00</td> <td> $   42,000,000.00</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Per Unit</td> <td> $           28,737.92</td> <td> $       10,991.92</td> <td> $       1,191.90</td> <td> $           5,562.18</td> </tr> </tbody> </table>

Westport splits the profits with their joint venture partner Cummins (NYSE: CMI) but for every $30,000 engine the entity sells to Waste Management and others their gross margin is 38% and their adjusted EBITDA margin is nearly 20%.  Their growing patent portfolio will yield higher margins over time as their scale kicks in and more profit falls to the bottom line. 

Whereas 20% of every engine from the Cummins-Westport joint venture has the potential to pad their bottom line, the margins at a typical gas station are much lower.  This year the distribution and marketing percentage of the cost of gasoline fluctuated between 5.2% and 14.4% of the price of each gallon.  That included all costs and profits of the stations and as well as getting the gas from the refinery.  Clean Energy operates in both the marketing and distribution segments as well in vehicle conversion, compression systems and vehicle acquisition and finance.  However, a bulk of their business is and will continue to be in their marking and distribution segments.  Those margins will never be as high as those enjoyed by Westport Cummins, especially as more competition enters the field. 

Clean Energy’s specifically pointed out Chesapeake as a competitor they their main concern is to see the demand for natural gas rise.  Sure, they want their $160 million dollar investment in Clean Energy to be profitable, but that’s a tiny slice of their multi-billion dollar annual capital budget.  They’ll make more money on the gas that ends up being used as a transportation fuel than on profits flowing through Clean Energy’s stations. 

While I’m intrigued enough to keep watching the company, I’m not ready to commit any capital just yet.  I’m just not sold on Clean Energy’s ability to generate above average profits and they still need to raise a lot more capital which could keep a lid on future returns. Would you answer the three questions I posed of Clean Energy any differently?

latimerburned owns shares of Westport Innovations. The Motley Fool owns shares of Clean Energy Fuels, Cummins, Waste Management, and Westport Innovations and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Motley Fool newsletter services recommend 3M Company, Clean Energy Fuels, Cummins, Waste Management, and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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