CA - Westport Fuel Systems: Proposed JV With Volvo Is Positive But Risk Of Near-Term Dilution Remains

2023-07-19 21:10:35 ET

Summary

• Shares rallied to new multi-month highs after the company disclosed a letter of intent to contribute its HPDI fuel system technology to a new joint venture with key customer Volvo Group.
• With Volvo expected to acquire 45% of the proposed joint venture for approximately $28 million, the company's HPDI assets would be valued at $62.2 million.
• Depending on the performance of the joint venture, Volvo has committed to invest up to an additional $45 million.
• Reaching definitive agreements with Volvo will be crucial for the company as the current rate of cash usage would result in remaining liquidity being down to just $20 million by the end of this year.
• Even when considering the positive implications of the proposed joint venture with Volvo and market participants' vastly increased risk appetite, I would advise investors to remain on the sidelines due to the likelihood of additional, near-term dilution.

Note:

I have covered Westport Fuel Systems ( WPRT ) previously, so investors should view this as an update to my earlier articles on the company.

On Wednesday, shares of Westport Fuel Systems or "Westport" rallied to new multi-month highs after the company disclosed a non-binding letter of intent to contribute its HPDI ("High Pressure Direct Injection") fuel system technology to a new joint venture with key customer AB Volvo ( VLVLY , VOLAF , VOLVF ) or "Volvo" (emphasis added by author):

Westport's HPDI fuel system is a high-performance solution supporting significant carbon reductions in hard to abate sectors like heavy-duty and off-road mobility. HPDI enables the world's trucking and off-road equipment manufacturers to address the challenges of meeting the regulatory requirements of Euro 7 and the US EPA while offering end users affordable options that are powered by carbon neutral fuels like biogas, zero carbon fuels like green hydrogen and other renewable fuels.

While Volvo will be a key customer of the joint venture, the joint venture's mandate will be to enhance commercialization of HPDI through the addition of new trucking and equipment manufacturers as customers .

Westport will contribute current HPDI assets and activities including related fixed assets, intellectual property, and business into the joint venture. Volvo will acquire a 45% interest in the joint venture for the sum of approximately US$28 million ( approximately SEK 300 million ) plus up to an additional US$45 million (approximately SEK 500 million) depending on the performance of the joint venture.

(...)

Completion of the joint venture is conditional on the successful negotiations and execution of a definitive investment agreement, joint venture agreement, supply agreement and development agreement. The joint venture is expected to launch in the first half of 2024.

Remember, Westport's existing HPDI system contract with Volvo is scheduled to conclude early next year.

Just recently, the company entered into a settlement with Cartesian Capital Group ("Cartesian") to terminate an existing royalty agreement in exchange for $8.7 million in cash consideration, which included the release of a security interest in the Westport's HPDI 2.0 fuel system intellectual property.

Clearly, the release of Cartesian's security interest in the company's HPDI fuel system intellectual property was required to pave the way for the proposed joint venture with Volvo.

With Volvo expected to acquire 45% of the proposed joint venture for approximately $28 million, the company's HPDI assets would be valued at $62.2 million. Depending on the performance of the joint venture, Volvo has committed to invest up to an additional $45 million.

Should the joint venture indeed meet all performance requirements set forth in the yet-to-be-negotiated investment agreement, valuation of Westport's HDPI assets would increase to $162.2 million.

Reaching definitive agreements with Volvo will be crucial for the company as the current rate of cash usage would result in liquidity being down to approximately $20 million by the end of this year as compared to $72 million at the end of the first quarter .

That said, the press release does not provide details regarding the anticipated funding mechanism for the proposed joint venture but assuming both partners contributing their pro rata share, Westport's cash outflows related to HPDI would be almost cut in half.

Should Volvo buy its 45% stake directly from the new joint venture in exchange for an initial $28 million cash investment, there wouldn't be any near-term funding needs for Westport.

On the flip side, the company would not receive any cash proceeds this way.

At least in my opinion, the proposed transaction would be an important step for Westport Fuel Systems due to a number of reasons:

• contributing the HPDI assets to the joint venture would likely result in significantly lower cash usage going forward.
• the joint venture would elevate the relationship with key customer Volvo to a new level thus potentially resulting in higher sales going forward.
• Volvo's deeper pockets might help to accelerate the commercialization of HPDI.
• the company's controlling stake in the joint venture would allow for ongoing consolidation of the HPDI business.

Admittedly, the last bullet point is kind of a double-edged sword as for the first time, Westport would be required to break out the results of its HPDI operations which are likely to be underwhelming, at least when judging by recent disclosures made in the company's regulatory filings:

We continue to generate operating losses and negative cash flows from operating activities primarily due to the lack of scale in our heavy-duty OEM business. Despite customer interest in HPDI 2.0 fuel systems, sales of our HPDI 2.0 fuel systems to our OEM launch partner continue to be adversely affected by the impact of the continued volatility in natural gas prices and decreasing end-customer demand.

Last year, sales to Volvo amounted to $43.3 million or approximately 14% of overall revenue, down from $49.7 million in 2021.

While not explicitly mentioned in the press release, I would expect the company's large-scale supply agreement with its Chinese joint venture Weichai Westport Inc. ("WWI") to remain unaffected by the proposed transaction with Volvo.

Under the current terms of the supply agreement, Westport Fuel Systems will supply to WWI its proprietary components for " no less than 25,000 12-liter engines operating on the HPDI 2.0 fuel system by December 31, 2024 ".

That said, progress in China has been virtually non-existent in recent years with the eagerly-awaited commercial launch of HPDI system sales nowhere in sight.

Bottom Line

The proposed HPDI fuel system joint venture with Volvo Group would be an important step as the company won't be burdened with the costs associated with advancing and commercializing the technology anymore.

As a result, cash burn should decline significantly in the second half of next year.

In addition, Volvo's deeper pockets might help to accelerate the adoption of HPDI in the marketplace.

That said, the proposed joint venture won't have an impact on the company's near-term cash usage which will likely require a capital raise in the second half of the year in order to avoid going concern language in the 2023 annual report.

While management continues to explore options for securing additional debt, I wouldn't be surprised to see the company issue either convertible debt or outright equity in the not-too-distant future, particularly after the recent rally in the shares.

Even when considering the positive implications of the proposed joint venture with Volvo and market participants' vastly increased risk appetite, I would advise investors to remain on the sidelines due to the likelihood of additional, near-term dilution.

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