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Industrial Stocks

The Best Way to Play Natural Gas as a Transportation Fuel

By Elliott H. Gue, on Nov. 5, 2013

On Dec. 14, 2009, US energy giant ExxonMobil Corp (NYSE: XOM) stunned investors, announcing a $41 billion all-stock deal to acquire XTO Energy, one of the nation’s leading shale gas producers.

At the time, this mega-merger was seen by many observers as an affirmation of ExxonMobil’s belief in the long-term growth prospects for natural gas–a belief that persists despite the supply overhang in the US and Canadian markets for this commodity.

The integrated oil company’s annual energy outlook predicts that natural gas will be the fastest-growing major energy source through 2040, with US shale plays accounting for 80 percent of global supply in that year.

By virtue of its $400 billion market capitalization, ExxonMobil has the flexibility to take a longer-term view than smaller energy companies.

Investors have also taken a bullish stance on natural gas, through their focus is decidedly on the next three to five years. The investment thesis: US exports of liquefied natural gas and growing domestic demand will lead to higher price realizations for producers.

In particular, investors have enthused about the potential for growing domestic consumption of natural gas as a transportation fuel.

Although natural gas will gain share in this end-market over the coming decades, investors shouldn’t regard this development as a major demand driver for the commodity.

And you don’t have to take my word for it. Ask ExxonMobil, the energy giant that made a $41 billion bet on rising demand for natural gas. The company’s most recent energy outlook calls for natural gas to account for 4 percent of the global market for transportation fuels, up from 1 percent today.

In contrast, natural gas-fired power plants represent a much more important demand center for the commodity. ExxonMobil projects that electricity generation will account for 55 percent of the growth in global energy demand and expects natural gas to overtake coal as the world’s leading source of thermal power by 2040.

The Energy Information Administration likewise calls for transportation to consume about 1 percent of the nation’s natural-gas supply by 2025, up from 0.25 percent today.

Natural-gas powered taxis, garbage trucks, buses and other vehicle fleets can help to reduce emissions and decrease fuel costs. Nevertheless, gasoline and diesel will remain the dominant transportation fuels, though companies will seek to boost efficiency by shifting to rail or relying on engines and vehicles that operate more efficiently.

Growth Engine

Engine manufacturing accounts for about half of Cummins’ (NYSE: CMI) sales and profits. The firm produces engines of all sizes, from 48 horsepower to 3,500 horsepower and 2.8 liters to 9.1 liters of displacement, for a wide variety of vehicle classes.

The firm’s components business (about 20 percent of 2012 revenue) focuses on emissions solutions such as turbochargers, which enable smaller engines to produce more power and boost fuel efficiency. This segment also specializes in filtration systems for diesel engines, a product that removes particulate matter and harmful compounds such as nitrogen oxide from vehicles’ exhaust systems.

Cummins’ other two divisions (about 30 percent of 2012 revenue) produce diesel-powered electric generators and service the firm’s existing products.

The company generates about 60 percent of its sales in North America, where the firm controls 60 percent of the engine market for medium-duty trucks and 40 percent for heavy-duty vehicles. Moreover, Cummins is well-positioned in several key emerging markets, including the heavy- and medium-duty segment of the Indian market and the light-duty portion of the Russian market.

In terms of upside catalysts, Cummins’ engine business stands to benefit from stricter government standards for vehicle emissions, which will require operators to replace vehicles over time. These advanced engines also contain components that are more expensive than those in traditional engines; the company both installs these parts in its own engines and sells them to third-party manufacturers.

We also expect demand for turbochargers and similar solutions to increase, as consumers and fleet operators continue to demand better fuel efficiency.

Cummins is North America’s leading supplier of natural gas-powered engines for buses and similar vehicles, and the company remains our favorite way to play growing consumption of natural gas as a transportation fuel.

Investors interested in this trend often ask my opinion of Westport Innovations (TSX: WPRT, NSDQ: WPRT), a smaller-capitalization name that produces natural gas-powered engines.

Although Westport Innovations’ fuel systems represent an important technological development, the company is a chronic money loser. Meanwhile, Cummins and Westport Innovations in 2001 formed a 50-50 joint venture to design and manufacture 6- to 12-liter heavy-duty engines that run on natural gas.

In other words, an investment in Cummins gives you exposure to the future of natural gas-powered engines without the inherent volatility of Westport Innovations.

Third Quarter Disappoints

Cummins’ third-quarter results were weak by any standard.

The firm reported earnings per share of $1.94, compared to the Bloomberg consensus estimate of $2.10. Management also lowered its guidance for 2013, forecasting a 3 percent decline in revenue and reducing its outlook for midpoint operating margins by 75 basis points.

Revenue in the company’s engine business fell 1 percent from year-ago levels, reflecting weak demand in the mining and power-generation markets.

This news hardly comes as a surprise: Major mining companies slashing capital expenditures in response to weak demand for all manner of commodities. These trends explain why orders in Australian and Indonesia–leading commodity exporters to China–were particularly weak.

Cummins’ international revenue tumbled by 4 percent from the third quarter of 2012, but North America posted sales growth of 12 percent. With demand in Europe likely to improve as the Continent emerges from recession and China’s economy showing signs of improvement, this headwind should moderate in coming quarters.

And despite Cummins’ near term headwinds, we remain confident in management’s long-term guidance, which calls for earnings in the core engines business to grow at an average annual rate of 8 percent to 12 percent through 2018. This forecast assumes that global economic growth averages 3 percent to 4 percent over this period.

Management expects the introduction of higher-margin products to generate 200 basis points to 300 basis points of earnings growth, while gains in market share and acquisitions will each account for another 100 to 200 basis points.

Shares of Cummins pulled back sharply after the engine maker posted disappointing third-quarter results, giving investors with a longer time horizon an ideal buying opportunity. Cummins rates a buy up to $135.00 per share.

Elliott H. Gue is editor of Capitalist Times and Energy & Income Advisor.

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