This Once-Hot Sector Has Cratered -- Time To Buy?

David Sterman's picture

Tuesday, May 20, 2014 - 3:30pm

by David Sterman

We've learned a clear lesson over the past 12 months: There is no sense in hopping into momentum stocks after they've doubled or tripled in value in a short time. 

That was the sobering lesson around 3-D printing stocks, popular IPOs and, more recently, fuel cell stocks. When I looked at fuel cell stocks a month ago, I asked whether they were in a bubble, and concluded that "this is a great group to put on your watch list, as any major pullback would provide excellent entry points."

Well, your ship has come in: Fuel cell stocks are dropping like a stone. They had already been pulling back when I looked at them last month -- and now they've now all lost roughly half their value since mid-March.

In retrospect, the group sell-off was inevitable. These stocks were pushed ever higher under the "greater fool theory," which states that a price can be justified by a rational buyer under the belief that someone else is willing to pay an even higher price. Of course, the moment that people believe that this circular logic has come to an end, everyone heads for the exits at once.

These stocks had become disconnected from the fundamentals (meaning their underlying financial factors), but with these pullbacks, they no longer look to be as ridiculously overvalued. Here's a quick snapshot of their projected revenue ramps and their enterprise value-to-sales ratios:

Just a few months ago, these stocks, as a group, were valued at about 5 times sales on an enterprise value basis -- which, as I wrote last month, was "not unreasonable in the context of solid sales growth -- as long as that sales base will eventually generate decent profit margins." And therein lies the lingering concern about these stocks. 

For example, Plug Power (Nasdaq: PLUG) has had the sharpest plunge in this group, in large part because management's promises of imminent profitability continue to get pushed out.

To be sure, Ballard Power (Nasdaq: BLDP) and Capstone Turbine (Nasdaq: CPST) have a reasonable path to eventual profitability, thanks to gross margins that now exceed 10% and are likely to rise. Plug Power needs to show steadily rising gross margins as sales volumes build, while FuelCell Energy appears destined to lose money on every sale it makes. 

I remain convinced that Ballard Power and Capstone Turbine have especially appealing business models, as I noted back in February. (After a surge and plunge, shares of Ballard are up 44% since then while Capstone is off 9%.) The case for Ballard Power has recently strengthened as Toyota (NYSE: TM) has recently thrown its future clean-energy plans behind fuel cells.

Yet in some respects, Plug Power remains the poster child for this group, in large part because it is witnessing the greatest sales growth right now. The company did investors no favors by delivering a string of boastful statements about its growth prospects -- statements that, in hindsight, appear to have been an effort to pump up the shares before a secondary offering. 

Then again, with a cash balance that now exceeds $150 million (thanks to that secondary offering), the company is now in a much financially stronger position -- a key consideration for any blue-chip customers that may be contemplating long-term contracts with Plug Power.

So what does the road ahead hold for Plug Power? The path for share price upside lies in the company's expected growth in sales and gross profits, which will be enough to satisfy growth investors who will be patient for net profits to arrive in 2016 and beyond.

However, if Plug Power doesn't hit consensus revenue forecasts for the remainder of this year, then the company's reputation will have been terminally tarnished with investors -- and as you can see, sales growth forecasts are extremely optimistic.

Risks to Consider: These companies are under the gun to show steady revenue gains. Any further hiccups in the road to growth may be test the patience of bulls, which is in short supply these days.

Action to Take --> In addition to near-term revenue growth prospects, it is also important to assess each of these companies' industry positioning. I still think Ballard Power has the right set of technologies and the right management strategy, but both Capstone Turbine and Plug Power could also deliver great upside from current levels. A small investment position in all three of these firms may be a smart strategy, which allows you to steadily enhance that position as these companies deliver on the high bar that they've established for investors.

P.S. If the potential of fuel cells has you excited, wait until you see what StreetAuthority's Andy Obermueller has been working on. Andy has identified five "game-changing" trends with the potential to revolutionize the way we live our lives -- and make early investors a killing. To learn more about these developing technologies -- and the companies behind them -- follow this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.