Hexagon Composites - More Than 100% Upside As The NGV Industry Expands

Following my Hexagon Composites' 4Q earnings article I received messages from people who are finding it hard to analyze Hexagon Composites' (OTC:HXGCF) future potential due to limited earnings guidance from the company.

It is correct that Hexagon does not provide guidance in the traditional sense, but instead provides commentary during webcasts in connection with earnings. This commentary is not so easy to decipher if you are new to the company, and this article will hopefully make it easier to understand the future potential of the company.

Let us first take a look at the actual numbers for 2013, before I present my projections for Compressed Natural Gas (CNG) Type IV tank demand in North America and Hexagon's 2014 - 2016 earnings.

The table below shows earnings for Hexagon Lincoln and Hexagon Ragasco, Hexagon Composites' two divisions, from 2011 until the end of 2013. To keep the data easy to read I have broken out the quarterly data for 2013, but kept it on an annual basis for 2011 and 2012.

Source: Hexagon Composites

Hexagon Group revenue and EPS made a significant jump in 2013 due to:

• Strong revenue growth at Hexagon Lincoln


• Strong margin growth at Hexagon Lincoln


• Strong margin growth at Hexagon Ragasco, despite "flattish" revenue.

There is quite a bit of choppiness from quarter to quarter in Hexagon's earnings and Hexagon management recently stated that revenue growth will not be linear, as timing of large Hexagon Lincoln orders and seasonality at Hexagon Ragasco will continue to impact quarterly earnings. That said, the overall strong growth trend is expected to continue on an annual basis.

Market Potential for Hexagon's NGV-related Products

Before we delve into specific numbers for Hexagon, it is worth taking a "30,000 foot view" to examine the market potential for Type IV NGV tanks in North America. I emphasize that this table only looks at the market potential in North America and does not include tank demand from Europe (the CNG bus market in Europe is recovering and is likely to see rapid growth with the Euro 6 emissions standard now in place) or emerging demand from Russia or Asia. This is also a table that is highly relevant for those of you who are Quantum Fuel Systems (QTWW) shareholders, as both companies operate in the same NGV niches. First some specific comments to the table.

1. I have estimated the $ value for CNG tanks per NGV by using data from Frost & Sullivan, Hexagon Composites and various news articles and conference presentations.


2. The 8% estimate for Heavy Duty NGVs in 2015 has been based on 18,000+ ISX12 G engines being delivered in 2015. Reports suggest that more than 10,000 engines could be delivered in 2014, so the 18,000 is hopefully a prudent assumption.


3. As far as I know LNG is no longer used for new designs of transit buses, refuse and cement trucks. I have estimated the 70% CNG penetration number for heavy duty NGVs by using various sources of information, but the number could be higher or lower, greater visibility is expected later in 2014 as the market starts to mature.


4. I have not included heavy-duty vocational trucks, utility trucks, package delivery vans, medium-duty trucks, school buses, taxis, typical government vehicles or light duty passenger vehicles in my estimates. CNG conversions are being done in these market niches on a daily basis, and the overall CNG tank potential in these markets is undoubtedly vast and presents huge upside potential for Hexagon, but it is a fragmented market and therefore a very difficult market to analyze. Additional market data and feedback would be required before generating estimates.

(click to enlarge)

Source: Frost & Sullivan, Hexagon Composites, various articles and conference presentations.

Revenue Potential for Hexagon Composites

Production capacity at Hexagon Lincoln was fully utilized in 4Q 2013 and is also fully booked for 1Q 2014. Hexagon Lincoln's production capacity is currently being expanded through two phases. Phase one is expected to be available from the end of 1Q 2014 onwards and phase two one year later. Each phase will double Hexagon Lincoln's revenue generating capacity.

The revenue potential of Hexagon Ragasco is more difficult to analyze as strong seasonal effects and varying length of production series (with downtime to clean and reset machinery etc.) cloud the picture. If we use quarterly revenue from 1Q and 2Q 2013 and adjust these for apparently only running 4 out of 6 possible production shifts, then this would give us a maximum revenue potential of approx. NOK 160 million per quarter. However, this does not take into account the varying length of production series, so reducing the number from 160 million per quarter to 140 million during full production mode seems prudent.

Source: Hexagon Composites and author's estimates

Hexagon management stated during the recent earnings webcast that Hexagon Lincoln's production capacity is currently running at 100% utilization. The situation will be remedied in 2Q this year as the expanded capacity then becomes available, but the situation is expected to "tighten again towards the end of 2014 and early 2015" according to Hexagon management. This means that phase 2 of the capacity expansion should become available "just in time" in 2Q 2015.

For Hexagon Ragasco a gradual increase in production was mentioned by management. This should mean some improvement for 1Q and 2Q, but with the majority of improvement having to come in 3Q and 4Q; the traditional low points in Ragasco's production year. Below I have included a table that outlines my revenue and earnings expectations going forward.

Source: Author's estimates

Balance Sheet

Hexagon currently has a rock solid balance sheet with net interest bearing debt rapidly approaching zero following a NOK 115 million inflow of cash after the sale of the Devold division in January 2014. The company will use some of its cash pile to finance the second phase of Lincoln's capacity expansion which is expected to cost NOK 150 million, but its strong operational cash flow should almost make up for this expenditure as we move through 2014.

Dividends

Hexagon management confirmed at the 4Q earnings presentation that a dividend payment in April or May 2014 is highly likely. Covenants in the 2013/2018 bond agreement limit dividends to 50% of net profits for the previous financial year. For 2014 this means that no more than NOK 0.33/share can be distributed. In my view the strong operational cash flow can support a 50% dividend threshold for the coming years, unless Hexagon's rate of investment is increased substantially beyond what has already been communicated. But then again, if this does happen, I would be happy to forgo one or more dividends if it means making highly profitable investments in additional production capacity to meet even greater demand.

Valuation

Based on a 12 month forward-looking period and the current share price of approx. NOK 25, Hexagon is valued at approx. 19.8 times expected 2014 earnings. By applying this multiple to my expected 2014 - 2016 earnings for Hexagon, and of course assuming "Mr. Market's" current relative valuation view of Hexagon stays the same, I get the table below which shows a 120% upside potential within the next 24 months.

OK, so your future estimates seem upbeat, but what does the analyst community say? I am aware of 4 analysts that cover Hexagon and I have got access to reports from two of them. My estimates seem to be more or less in line with the average of these two analysts.

Summary

The global NGV market, and particularly the North American market, is booming. The roll-out of the ISX12 G engine is likely to fundamentally change the way heavy duty trucking is conducted, and as a private investor, being exposed to such a megatrend is the chance of a lifetime.

I am clearly biased as I am long Hexagon, but for a company that generates a pile of cash, is the undisputed market leader in its core market segments and is expected to grow EPS on average by more than 50% for the foreseeable future, I reckon it is moderately priced at its current share price.

Despite sitting on a large position, which has already yielded a phenomenal return, I will hold my position and continue to buy more shares in the months and years ahead. Given Hexagon's expected exponential growth, its shares could easily be trading north of 100 NOK 3-5 years from now, and I intend to come along for that ride.

Source: Hexagon Composites - More Than 100% Upside As The NGV Industry Expands

Disclosure: I am long HXGCF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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