NLLSY - Nel ASA: Vulnerable To Commoditization And Highly Overvalued

2023-08-09 10:11:50 ET

Summary

• The hydrogen industry is expected to play a key role in global decarbonization efforts, particularly in hard-to-abate sectors, and a major capacity increase is expected.
• The market for electrolyzers is highly competitive with few barriers to entry, and there is a risk of overcapacity and competition from cheaper Asian manufacturers, similar to solar panels.
• We rate Nel ASA as a Sell due to its stretched valuation implying overly optimistic expectations.

We present our note on Nel (NLLSF), a pure-play hydrogen company. We issue a Sell rating as a result of Nel's stretched valuation, substantial capital requirements, operational transformation challenges, and commoditization. We see Nel's stock as overhyped, and we are cautious about long-term performance. We will provide a brief overview of the company and the nascent hydrogen industry and lay out our investment case and valuation.

Introduction To Nel

Nel is a pure-play hydrogen technology company. It manufactures electrolyzers that are used to separate water molecules into hydrogen and oxygen using electricity. Nel provides both Alkaline and PEM (proton exchange membrane) electrolyzers and has delivered more than 3500 electrolyzer units to 80+ countries since 1927. In addition, Nel builds hydrogen fueling stations for hydrogen vehicles. It has delivered or is working on more than 120 stations in 14 countries. Nel is listed on the Oslo Stock Exchange since 2014 and has a market capitalization of ca. NOK21.6 billion or $2.1 billion.

Hydrogen - A Nascent Market

Hydrogen will be a key technology in the global decarbonization drive, as CO2 emitters find alternative sources of energy. Multiple industries including steel, cement, petrochemicals, transportation, etc. are categorized as hard-to-abate, meaning emissions are prohibitively costly to reduce, or impossible to reduce with current technologies. The energy sources for these sectors are likely to be split between carbon capture and storage , batteries , and hydrogen, with the latter being mostly used in transportation (e.g., trucking) and as feedstock in industry (e.g., steel) and chemicals (e.g., fertilizers).

As per the International Energy Agency, global hydrogen demand stood at 95 million tons in 2022, predominantly made through SMR (steam methane reforming), and coal gasification, both carbon-intensive processes. Meanwhile, green hydrogen is produced using electricity from renewable energy sources to split water molecules. The European Union has called for 100 GW of green hydrogen capacity by 2030, with 40% made using European electrolyzers. Moreover, IRENA expects globally up to 5000 GW of electrolyzers by 2050.

We are certainly optimistic about the long-term outlook for green hydrogen and acknowledge its importance in reaching global net zero targets backed by a strong political and business momentum. However, we would like to note that electrolysis is a process that has been in practice since the early 20th century and several industrial conglomerates (Linde, ThyssenKrupp, Siemens Energy) and new smaller players (ITM, McPhy, Nel, etc.) participate in the market. We judge the market as highly competitive with few barriers to entry. The investment required to build 1 GW of capacity is in the range of a few hundred million euros, hence scale is not remarkably prohibitive. We would not be surprised to see a flood of capacity entering the market. In fact, Wood Mackenzie points out that electrolyzer manufacturing capacity is on track to be twice as high as demand by the year 2025. There could be a significant risk of idle plants, rather than a price crash, if manufacturers ramp up as quickly as announcements suggest.

Moreover, the production of electrolyzers is akin to that of solar panels, i.e., commoditized and bound to face the same competitive pressures as the latter in the long run. BloombergNEF estimates Chinese electrolyzers are a quarter of the price of equipment made in the US or Europe. According to a Chinese consultant firm , China's government alone is investing annually in excess of $10 billion in hydrogen projects, more than 10x the size of the EU's Innovation Fund commitment . At the moment the industry is insulated from Chinese competition through protectionist measures, but we see this as a revealing data point indicating potential future trends.

We remain skeptical about the equity returns of a highly competitive and commoditized industry with no major barriers to entry and a threat of overcapacity, despite a triple-digit fold growth of the underlying market.

Thesis And Valuation

In addition to our concerns about the electrolyzer business, we also do not see a strategic rationale for the hydrogen fueling division given it is subscale and significantly loss-making (-80% EBITDA margin) and lacks a competitive advantage. We would rather prefer an alternative solution such as a strategic partnership / joint venture or asset sale.

Nel's current market capitalization of $2.1 billion reflects 5x consensus sales in 2025, vs 2.5x for peer McPhy (MPHYF), 2.6x for Plug Power (PLUG), <1x for Fusion Fuel Green (HTOO), and >7x for ITM Power (ITMPF). While we acknowledge the multiple-fold upcoming growth, we find this valuation remarkably expensive, especially given the lack of a competitive advantage both in electrolyzers and fueling. Consensus foresees ca. negative $3 million of EBITDA in 2025, hence an EV/EBITDA multiple analysis is not applicable for FY 2025. However, for the purpose of this exercise let's assume a 15% target EBITDA margin, which may be optimistic given the nature of the industry as discussed above. This target margin would imply ca. $38 million of EBITDA in FY 2025, or an EV/EBITDA multiple of 55x.

Alternatively, assuming a 10% equity IRR, we arrive at a target market capitalization of $4 billion in 2030. A mature industrial enterprise should realistically trade at ca. 10x earnings, implying around $400 million by 2030. At 10% net margin, that would be $4 billion of sales per year. At $300k/MW, we could arrive at implied sales of 13 GW+ per year while the EU aims to add around 6 GW per year. That is excessively optimistic. Moreover, the current market capitalization does not discount the significant investment required to reach that scale.

While our valuation exercise entails many assumptions, it is evident to us that Nel's shares are significantly overvalued and reflect excessively optimistic or impossible to achieve financial targets while failing to discount the required capex. We see Nel as an example of the hydrogen bubble and note it is one of the most expensive names in the space. With generous assumptions regarding 2030 capacity, sales, and margins we see at least 50% downside from here. We would have recommended a short position but we do not see a near-term catalyst that could crystallize the short, and short-sellers would have to stomach significant volatility in the meantime.

Risks

Risks to our thesis: i.e., upside risks include higher than expected penetration of hydrogen vs CCS and batteries, higher than expected political support for hydrogen including further substantial incentives and subsidies, tougher than expected protectionist measures insulating European players from global competition, the company becoming an acquisition target for a major industrial player, integration in big scale renewable energy projects, the company gaining technological superiority vs. competitors, etc.

Conclusion

Despite the high growth of the hydrogen sector, given the overvaluation of the stock driven by overly optimistic expectations, and the significant competition, we rate Nel as Sell and see more than 50% downside.

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