Westport Fuel Systems Inc. Q1 FY2022 Earnings Call

Thank you for your patience. Welcome to the Westport Fuel Systems First Quarter 2022 Results Conference Call. Please note that all participants are in listen-only mode and the call is being recorded. After the presentation, there will be a chance for questions. I will now hand it over to Christian Tweedy, Westport's Investor Relations representative. Please proceed.

Good morning, everyone. Welcome to Westport Fuel Systems' first quarter 2022 conference call, which is being held following our press release yesterday of Westport Fuel Systems' financial results. On today's call, speaking on behalf of Westport Fuel Systems is Chief Executive Officer, David Johnson; and Chief Financial Officer, Richard Orazietti. This call is open to the public and the media, but questions will be restricted to the investment community. You are reminded that certain statements made in this conference call and our responses to various questions may constitute forward-looking statements within the meaning of the U.S. and applicable Canadian securities laws. As such, forward-looking statements are made based on our current expectations and involve certain risks and uncertainties. With that, David, I'll turn the call over to you.

Thanks, Christian. Good morning, everyone. Thanks for joining us to review Westport Fuel Systems' results for the first quarter 2022. In Q1, we generated revenues of $76 million, comparable to the same period of 2021. Excluding foreign exchange translation, our revenues increased by approximately 6% year-over-year. As you know, today's markets are anything but stable. That's true for the broader market as well as our specific automotive markets. Today's markets are volatile, unpredictable, and uncertain, and then Q1 volatility increased. Now, we have more inflation, and we have the Russian-Ukraine war on top of the existing well-known challenges of chip shortages and the still ongoing effects of COVID. There are myriad local market changes that matter, like the collapse of the Turkish lira and the actions governments are taking to manage their economies and help their citizens through these challenging times; fuel rebates, for example. So in light of this, matching our year-ago quarterly revenue in this most recent quarter looks to me like an accomplishment. And as noted, if we were to report in Euro, instead of U.S. dollars, we'd be up roughly 6% compared to last year because foreign exchange rates are also on the move. The reasons for this modestly robust quarterly result in these turbulent times are as follows. First, our core business is on the right path. Clean affordable transportation is in demand today and will be in demand tomorrow, and in fact, demand is increasing. Ultimately, high energy prices and challenging economic times tend to be tailwinds for our business. Transportation is not a discretionary purchase, and we make transportation products that are both low cost to acquire and low cost to operate. During times of financial constraints, our business can continue to grow. Second, Westport Fuel Systems has both product and market diversity. We serve 70 markets and we provide fuel components and systems for the full range of low carbon gaseous fuels: LPG, CNG, LNG, RNG, biomethane, and hydrogen. All our fuel systems are applied to a wide variety of engines and fuel cells in a broad spectrum of applications. We sell through diverse channels, both aftermarket and direct to OEMs, as well as to other Tier 1 suppliers. We have a diversity of customers around the world. Finally, and most importantly, at Westport Fuel Systems, we're on an important mission. Our 1,800 global team members and our partners around the world are each and all committed to delivering products and services that enable clean affordable transportation. We're determined and we're resilient. Looking into the quarter, I'm pleased to report that our OEM business continues to grow, up 21% over the year-ago quarter, including continued sales growth of our HPDI systems, which are up 16% to our lead European OEM customer. Why does our HPDI business continue to grow even in these challenging volatile times? Because HPDI is an excellent superior product and it's only available from Westport Fuel Systems. HPDI is surely familiar to you, and let me spend a little more time today reviewing the offer that HPDI makes in the marketplace. HPDI enables a diesel engine to maintain all the diesel performance and efficiency that fleets and drivers have come to expect but using clean natural gas and, importantly, biogas, otherwise known as RNG, biomethane, or bio-RNG. A recent article in a French trade magazine, France Routes, explains: 'Thanks to Westport Technologies, the compression ratio is that of a diesel engine.' I point to this quote that maybe only an engine geek like me could love because maintaining a high compression ratio and maintaining high boost pressure and maintaining high working pressure inside the engine are the key ingredients, enabling performance and efficiency. HPDI makes that possible with clean, low-carbon natural gas fuel. France Routes also documented a substantial efficiency difference: fuel consumption of the HPDI equipped trucks in their test was dramatically lower than that of competitive trucks using spark-ignited natural gas fueled engines. A 25% to 30% lower fuel consumption with HPDI. That's a huge difference for most any application, but especially in trucking, where competitive advantage and bragging rights are often measured in fractions of a percent. And I just have to pile on: the torque available using HPDI is 15% higher than those similarly sized engines without HPDI. HPDI is the right way, the best way to use clean gaseous fuels in internal combustion engines. So where do we go from here? First, we continue to grow to meet customer demand, respond to regulatory requirements, realize economies of scale in our manufacturing and supply chain, and improve our profitability. As we've reviewed before, the fleet average CO2 standards in Europe require a 15% reduction by 2025 and a 30% reduction by 2030. These requirements have not gone away due to COVID nor due to war. Europe is marking to make those requirements even more stringent. Natural gas fuel provides an inherent 20% reduction in carbon compared to diesel fuel. HPDI gets the most performance from natural gas. In combination, our product responds directly and powerfully to the regulations. An HPDI is fully compatible with biogas, which continues to grow strongly in markets around the world, including the U.S., where the Natural Gas Vehicle Association recently reported that RNG achieved a 64% mix in transportation last year. Fantastic. Looking at Europe, a key market for our company, their transport sector generates 27% of the EU’s total CO2 emissions, and road transport alone generates almost 19%. Being able to rapidly reach climate neutrality in this sector will require the combined efforts of all stakeholders. Starting in 2025, OEMs in Europe will face substantial financial penalties associated with missing the fleet average CO2 requirements. Next, we move from low carbon natural gas to net zero carbon biogas to zero carbon hydrogen. As we announced last week, this week, we're unveiling our high-performance, high-efficiency hydrogen HPDI demonstration vehicle at the ACT Expo here in Long Beach, California. Our HPDI technology works brilliantly with hydrogen, as we've demonstrated in our laboratory, with more power, more torque, and more efficiency than the original diesel fuel engine and with near-zero carbon emissions. HPDI with hydrogen is just what the world needs for heavy-duty, long-haul trucking. It's economical, high-performance, and clean. Looking ahead, we're making progress with numerous hydrogen HPDI projects, including the announced work with Scania, AVL, 2P, and Cummins. We look forward to sharing more information at ACT Expo later this year, as we demonstrate our truck and develop the engines in our lab. Hydrogen HPDI is a big deal. This will make internal combustion engines with HPDI the best way to use green hydrogen for long-haul, heavy-duty transport applications. We have disruptive technology and we're pleased to show it off and offer it to our customers and the industry. Next, in off-road and high-horsepower applications, we see a clear opportunity to decarbonize this very hard-to-decarbonize sector using Westport Fuel Systems’ patented and proprietary HPDI fuel systems and by applying our deep expertise in managing gaseous fuel. Mining vehicles are a good example. Today's mining truck fleets are typically diesel-powered, and mining vehicle emissions represent about a third of miners’ greenhouse gas emissions. Our low-cost, affordable, and reliable solutions that are available now can play an important role in helping decarbonize mining while maintaining the reliability and dependability of their fleet, continuing to use the well-developed internal combustion engines but with HPDI fuel systems and clean low carbon gas fuels. The ongoing Russia-Ukraine conflict will continue to have an adverse impact on part of our business. As we highlighted during our Q4 call, about 10% to 15% of our light-duty OEM and aftermarket business has been sales to Russia, to OEMs and aftermarket customers. This Russian business has been growing and is an important market for gaseous fuel systems and components. Because of the continuing conflict, the future impact on our business of the commercial and economic consequences of the conflict are, of course, uncertain again. For example, with respect to commodities and component material pricing, 40% of Europe's natural gas and 25% of Europe's crude oil is provided by Russia today. Pricing pressure is expected on components globally as energy costs for reproduction and transport continue to rise as the conflict drags on. We'll continue to monitor these developments as the situation is changing rapidly. Despite these pressures, we remain confident that our products will continue to deliver and expand our market share in response to the persistent need for clean, affordable transportation. We saw this through COVID and we expect to keep seeing it through the current challenges. We are keeping our focus on the long-term, while we work to mitigate the near-term challenges as we have successfully done before. You might not believe what's happening in India, but having just been there, let me confirm that India is now the market with the highest penetration of natural gas fuel vehicles, with market shares growing towards 40% for passenger vehicles and commercial vehicles, and in India's unique three-wheeler segment. It's impressive and exciting, and Westport Fuel Systems is there supplying all the various components and systems required to enable the transition that's underway in India. Why? First, because regulations have driven a market change away from diesel and toward natural gas; because of product affordability; and third, because the Indian government has made clean natural gas for transportation a foundational element of their strategy, while also improving their quality. Natural gas fueling infrastructure continues to grow, now approaching 3,500 stations, up dramatically in just the past years. I'd like to quickly turn our attention to China and provide an update on our business. Lockdowns are back in effect across major metropolitan cities in China and key import-export areas, which is having a reverberating effect on the global supply chain. Meanwhile, natural gas prices there continue to be elevated, putting a damper on our JV’s existing spark-ignited natural gas engine business. Work continues to bring HPDI to the marketplace, but with high natural gas prices, the government is increasingly focused on the potential for hydrogen. China's hydrogen industry has undergone exponential growth in recent years, and local authorities and enterprises have shown strong enthusiasm for investing in the sector. A study released by the China Society for Finance and Banking projects that China will invest the equivalent of US$74 trillion in carbon neutrality financing over the next 30 years, representing five times its 2020 national output. Westport has the product to help China reach its stringent climate goals, and it's a reason why we have ongoing discussions with potential Chinese partners for the usage of hydrogen HPDI. Hydrogen HPDI can play a large role in transportation decarbonization efforts in a country that is embracing hydrogen and believes in its long-term growth potential and use case as a future fuel. We're excited about this opportunity ahead and look forward to updating the market on the development. Despite the pressures we and our industry are facing at this moment, the outlook for our company is favorable. The world needs clean, affordable transportation. Westport Fuel Systems has the solutions and will grow to respond to the increasing urgent needs of the market around the world. Hydrogen is an important growth factor for Westport Fuel Systems; HPDI enables the use of cleaner fuels in internal combustion engines for long-haul transportation. Growth will enable economies of scale that lead to profitability. We're well-positioned, ready, eager, and determined. With that, I'll hand it over to Richard to go over the financials.

Thank you, David. Revenue for the first quarter 2022 of $76.5 million was comparable to the prior year quarter, despite the challenging headwinds from volatile fuel prices, the impact of sanctions on our Russian sales volumes, and continued inflationary pressure and supply chain challenges plaguing the automotive industry. We continue to generate growth in our OEM revenues, primarily due to the addition of our fuel storage business, and saw modest growth in light-duty and heavy-duty OEM and electronics businesses. Offsetting the growth in OEM revenue, our independent aftermarket revenue was significantly lower year-over-year due to the lower volumes caused primarily by the impacts of sanctions resulting from the Russia-Ukraine conflict. Excluding foreign exchange translation, revenue increased by approximately 6% year-over-year, or an exchange that had a significant impact on revenues in U.S. dollar terms due to the 7% appreciation of the U.S. dollar relative to the Euro, which is the currency we conduct a substantial portion of our business. Net income was $7.7 million for the first quarter 2022, compared to a net loss of $3.1 million for the same prior year period. The increase in net income was due to the gain of $19.1 million recognized on the sale of our interest in the CWI joint venture and the monetization of the related intellectual property. This was partially offset by lower gross margin from our independent aftermarket business, inflationary pressure on cost of materials and manufacturing inputs, and the loss of equity income from CWI. Normalizing for the CWI gain, we generated negative $6.1 million in adjusted EBITDA for the quarter, as compared to $2.7 million for the three months ended March 31, 2021. Turning to our business segments, revenue for the first quarter 2022 for OEM was $51.8 million, up 21% compared to the prior year quarter. The operating loss from OEM was $6.5 million, which was the same for the prior year. The increase in revenue was driven by additional revenues of approximately $8 million from the acquisition of our fuel storage business in the second quarter last year. We also saw revenue growth in our light-duty OEM business due to rapid growth in sales volumes through OEMs in India, which was partially offset by a challenging market in Western Europe due to volatile CNG prices and the impacts of sanctions on our Russian sales volumes. Despite the headwind of elevated LNG prices at the pump, our heavy-duty OEM sales volume to our OEM launch partner increased 16% year-over-year. Revenue growth was partially offset by the annual contractual price reduction to our OEM launch partner. As a reminder, the first quarter of 2021 was the start of production challenges at our OEM launch partner from the shortage of semiconductor chips, which has improved since the fall of 2021. Higher relative LNG prices are causing a significant challenge to the demand for LNG trucks, which is expected to temper our expected sales volume goals to our OEM launch partner through 2022 until relative LNG prices return to a more favorable equilibrium. Gross margin was $5 million or 10% of revenues for the quarter compared to $4.9 million or 11% of revenues in the prior year. Gross margin increased by $1.3 million from our fuel storage business, which was offset by decreases in gross margin across all other OEM businesses due to the increased sales mix to emerging markets with lower gross margins and increases in material costs from the global supply chain shortage and inflation. Gross margin and gross margin percentage from our HPDI 2.0 fuel systems product will vary based on production and sales volume levels of development work, and successful implementation of initiatives to reduce the cost of input materials and foreign exchange rates. Margin pressure is expected to continue through 2022 as production costs and contracted price discounts with the existing OEM customers are only partially offset by cost reductions in materials until higher scale is exceeded. R&D expenses for the first quarter were $4.8 million, which were comparatively lower year-over-year, mainly due to foreign exchange benefit. Our R&D activities and OEM continue to focus on the development of next-generation HPDI fuel systems technology and demonstrations with potential OEM customers on our HPDI fuel systems, hydrogen, and natural gas applications. Now turning to independent aftermarket. The independent aftermarket business faced significant challenges in the first quarter from reduced sales volumes to our Russian customers caused by sanctions and fuel price volatility. Revenue for the first quarter of 2022 was $24.7 million, down 27% compared to the prior year period. Besides the impact of the Russian sanctions, we had lower comparative sales to our African customers, as the first quarter of 2021 included the recognition of a large one-time infrastructure project, and then there was the aforementioned foreign exchange impact of the U.S. dollar appreciation. Gross margin was $4.9 million or 20% of revenues for the quarter, down $3.2 million compared to the same prior year period. The decrease in gross margin and gross margin percentage was attributable to the lower sales volumes through Russia and Western Europe, increased sales to emerging markets with lower comparative gross margin, and to a lesser extent, higher manufacturing costs in the current quarter due to increased material costs. Consequently, we recognized a small operating loss of $300,000 compared to operating income of $1.6 million in 2021. On a positive note, the LPG price differential to gasoline has improved favorably during the first quarter, which is providing some support to increase sales demand with this positive tailwind, while other countermeasures mitigate the impact of inflation and improve productivity. We anticipate a return to profitability of our aftermarket business soon. Finally, I’d like to touch on liquidity. Our cash position increased by $2.7 million during the first three months of the year to $127.6 million from about $125 million at year-end. The increase was primarily from the $31.4 million in proceeds received from the sale of our interest in CWI and the monetization of the related intellectual property, offset by cash outflows in net working capital, investments in capital assets, and repayments of our short- and long-term debt. Our net cash flow used in operating activities was $16.9 million in the first quarter of 2022, an increase of $14.3 million of cash used compared to the same prior year period. The increase in cash used is primarily due to the net change in working capital from a buildup of inventory and decrease in gross margin. A net cash flow from investing activities of $29.2 million consisted primarily of cash acquired through the sale of our investment in CWI, partially offset by capital expenditures of $2.8 million. Net cash flow used in financing activities was $7.9 million for the first quarter of 2022, primarily due to a net repayment of debt as we began paying down our debt on a quarterly basis after a period of deferral from COVID-19 relief. As discussed, COVID-19, the impact of the Russia-Ukraine conflict, uncertainty, and volatility in our fuel prices, especially in Europe, had a negative impact on customer demand in the quarter. Further supply chain disruption and high inflation continue to challenge the automotive industry, with rising manufacturing costs pressuring gross margin in the near term, as we respond with pricing and productivity countermeasures to manage our profitability. As the conditions continue to persist, the duration and severity of the impact on future quarters are currently uncertain. Having said that, we do see positive signals in the growth of our OEM businesses and a path to profitability as sales volumes grow in our heavy-duty and light-duty OEM businesses. Our balance sheet and liquidity to fund the growth are currently in good shape, and we will remain prudent in our allocation of capital and resources and executing our strategic and operating plans. With that, I would like to turn it back to David.

Thanks, Richard. While current global factors are causing headwinds, the market fundamentals, regulatory environment, and the overall global trends remain in our favor. The world needs clean, affordable transportation. We’re excited to bring our hydrogen HPDI fuel system technology to the forefront, and we’ll be sharing more of our technical and commercial results with you through the year. Our team will continue to work hard to meet the needs of our customers and the industry with a focus on executing our long-term strategy, growth in new markets, new product development, and a commitment to quality and reliability. Westport Fuel Systems is driving the affordable decarbonization of transportation globally. Thanks for your time today. Looking forward to your questions.

Thank you. We will now begin the question-and-answer session. Our first question comes from Eric Stine of Craig-Hallum. Please go ahead.

Hi, David. Hi, Richard.

Good morning.

Good morning, Eric.

So maybe just to start with your heavy-duty OEM with Volvo in Europe, and maybe this is tough to answer, but for obvious reasons, kind of a tempered outlook for the end of 2022. I’m just curious if there's anything you can share relative to maybe the shortfall versus your expectations, potentially versus Volvo’s expectations. Just anything to add some details and then also would just love your thoughts on kind of the linearity of revenues throughout 2022, at least how things stand today.

Yes. So glad to talk a little bit about the business in Europe with HPDI with our launch partner. Fundamentally, a key ingredient in that is the fuel price, and fuel prices are a bit elevated these days, given the LNG price relative to diesel. So that is for sure a headwind. Nonetheless, looking at our results in Q1 and what we shipped to our customer, fundamentally, we’re up 16% year-over-year. I would also point to, in general, our Q1s have been kind of the soft quarters and then Q4 tends to be a stronger quarter. So we’re hopeful for a repeat of that and increase through the year as we go forward. Nonetheless, we do have this headwind of the fuel prices, but we still have the amount tax abatement of about €10,000 per truck and other purchase incentives. So the market has many factors, and I think one of the things we can have significant confidence in is the fact that it is the superior product in the marketplace. Our customer is taking share from other natural gas and other alternatives in the marketplace. So we feel good about the business in the long run. We see this up quarter and forecast that we will have a relatively good year, although these fuel prices are a challenge when they’re elevated right now.

Right. Got it. Well, then maybe turn into China. You mentioned that with elevated fuel prices and COVID lockdowns, everything going on there that the government is starting to change or look more at hydrogen. Just curious – so you’ve got the take-or-pay with Weichai. I mean, is there a mechanism in there where that can be shifted or a portion of that can shift to hydrogen? Or when you’re talking about elevated interest, are you talking about potentially other parties as well?

Yes, I think it’s both. So basically, what we see in China today relative to hydrogen is a lot of push from the government, a lot of funding available, and basically all the OEMs have varying degrees of interest in how to approach the market with hydrogen. Frankly, we have work to do to make sure they understand, like we do globally, and like we’re doing this week at the Expo. We help the world understand what’s possible with hydrogen and HPDI, because this really is quite novel compared to the other alternative of spark-ignited hydrogen engines. This is our work to help them understand the potential of HPDI with hydrogen. But fundamentally, going back to the contract, anything is possible, but at this point in time, we have a contract in place and we have a customer; they continue to work to bring HPDI to the marketplace and pivot to either add or move towards hydrogen. I would say this would be beyond the timeframe of the contract we’re talking about with Weichai.

Got it. Okay, thanks for that. And then just maybe one quick one, bookkeeping here for Richard. Just on the debt repayment, can you just maybe give some color into debt repayment expected for the remainder of the year? And then, I guess, maybe in 2023 as well as you start paying things that were deferred.

Yes, it's outlined in the notes of the financial statements. You can see it’s going to be roughly about $12 million on our debt, and then there’s usually a $5 million bullet for the Cartesian royalty.

Got it. Thanks a lot.

You’re welcome.

Thank you, Eric.

Our next question comes from Rob Brown of Lake Street Capital Markets. Please go ahead.

Hi. Good morning. Thanks for taking my call. Just wanted to follow up on the China comments. Are you implying that maybe the HPDI product is not launching into the market right now in terms of the natural gas side? Or is that still moving forward? And I guess, just relative to your comments on hydrogen, what does that mean for the natural gas product at the moment?

Yes. So first of all, the project with respect to natural gas HPDI with our partner and with their customers, the truck OEMs, continues to move. The comment I made was in the context that every OEM looks for the best time to go to the marketplace and launch a product. This is on the truck OEM side. With elevated LNG prices right now, it’s easy to say it’s maybe not the best time. We’re hopeful for a realignment in the marketplace, which creates a window for properly launching the product commercially. But we wait for our customers to make those decisions. With respect to hydrogen, I think we have the same dynamic with hydrogen HPDI in China that we do with hydrogen HPDI in Europe and North America. Our HPDI technology is being demonstrated now with our vehicle at the ACT Expo. The increasing power, torque, and efficiency using hydrogen HPDI, gives all OEMs considering how to respond to the marketplace and demands for lower CO2 and clean transportation a basic vision and potential that they can adopt HPDI today with natural gas, use it today with biogas, and use it in the future with hydrogen as hydrogen becomes increasingly available in the marketplace. This provides longevity of technology, a roadmap for decades to come, making the decision to adopt HPDI sooner more tenable and interesting for our OEM customers. And that is the key dynamic we see in all markets around the world, including China.

Okay, great. Thank you. That’s helpful. And within the pricing environment, maybe between OEM and independent aftermarket, how much pricing kind of ability do you have in each of those markets, and how quickly can you change prices as your cost structure changes?

Yes. Great question. I think it’s a different time in the marketplace than we’ve seen for some decades, frankly, with respect to inflation being relatively low and stable for many, many years. Now we have this high and unstable inflation growing in many markets around the world. You’re right, our aftermarket business and the ability to price in that is different than our OEM business. Typically OEM business is characterized by long-term supply agreements that have some clauses allowing you to go back and renegotiate and pass on costs. Each one of those contracts with OEMs is different and requires going back and discussing the passing on of those costs. This takes time and work. We’ve had numerous successes, but there’s more to be done because of course, metro costs keep going up. On the aftermarket side, we can raise prices more easily. Customers are buying those products to save money on fuel. The key ingredient is to pay attention to the fuel price differentials in the various markets and the cost of the product. While we can price, if the truck cost goes up, it makes the attractiveness of the product less. So that’s our challenge. Higher fuel prices also make people more sensitive, looking for ways to save money on fuel. LPG kits are becoming increasingly favored in this moment. Higher fuel prices, and rising fuel price differentials give us room to price, but we still need to manage it market by market, and as we talk about, we have 70 markets around the world, and not all of them are LPG markets.

Okay, great. Thanks for the color. I’ll turn it over.

Thanks, Rob.

Our next question comes from Colin Rusch of Oppenheimer. Please go ahead.

Thanks so much, guys. You’ve got a certain amount of engineering work that you have to do to get the HPDI 2.0 for hydrogen to market. Can you just give us an update on where some of the balance system engineering and preparation is at this point?

Yes. Thanks for asking, Colin. Good to speak with you this morning. Fundamentally, the applications that we’ve done so far of our HPDI system to existing engines have been to apply the product that we use today for natural gas, with no modifications. We expect there will be some modifications as we develop and optimize the system for production, but we’re fundamentally in this phase, basically demonstrating the capability, which has been really exciting for us and for our customers to see the potential to apply our fuel system off the shelf, if you will. We have already achieved a 15% to 20% improvement in power and torque compared to diesel or natural gas. With hydrogen HPDI, we can actually increase 15% to 20% similarly, with efficiency. We see about a 4% to 5% improvement in brake thermal efficiency, translating to about a 10% improvement in vehicle-type efficiency. These are really big benefits that we’re demonstrating in the lab. We’re looking forward to demonstrating them on the road. However, no OEM is going to take the HPDI system bolted onto their engine and start feeding in hydrogen without the validation steps. These are programs that are multiyear programs to bring hydrogen to market, but that’ll be plenty fast enough relative to the infrastructure developing the availability of affordable hydrogen.

That’s super helpful. And then could you just give a sense of where things stand from a labor perspective on your manufacturing side? Certainly, labor’s been an issue all over many geographies, but just wanted to see where you guys are at in terms of labor inefficiency or concerns as you navigate through some of these ups and downs of the market?

Yes. I would say that in general, we don’t see ourselves having, let’s say, a labor problem of any kind. We’re able to access the quantity we need. Of course, there is inflationary pressure, as people want to raise their salaries in response to the costs they’re seeing in the marketplace. We have to manage that. But it’s just another element of our cost structure. In terms of labor in total, we don’t have an access to labor problem or a quantity of labor problem. I would say one thing we’re seeing is still some trailing effects of absenteeism due to people getting sick, whether with COVID or something else. It is a challenge for us. However, we’ve been managing this for two years, and it’s not affecting our operations significantly. It’s just something we manage.

Perfect. Thanks so much.

Our next question comes from Amit Dayal of H.C. Wainwright. Please go ahead.

Thank you. Good morning, David, good morning, Richard. Just on the pricing question earlier, have you started implementing some of these price increases? And by the time, maybe you get through some of it, is it like a 2022 time frame where you can achieve most of these price increases, and any color on how that is being executed would be helpful? Thank you.

Yes, great question. I think as mentioned earlier, we’re in a new regime in this inflationary environment. We did a bit of this last year specifically related to the chip shortage and the extra cost we were incurring to find and access the materials needed. We made pricing changes during 2021 on some of our aftermarket products to mitigate those added costs, and we’re doing that now, as costs continue to rise across all sorts of commodities and raw materials. Energy costs have almost doubled because of the Russia-Ukraine war, causing a structural cost change on our OpEx side. We’re able to pass these cost increases onto our customers, but with the OEM business, it takes more time; we can’t be as quick to implement because it means going back to discuss passing on those costs. Most contracts require negotiations. Everyone’s very understanding of our situation. No one wants a price increase, but we can justify them. There’s a lag, between costs going up and prices going up, which does put pressure on margins in the near term. We hope that when prices stabilize, we can get some benefits back to our margins.

Understood. Thanks for that, David. And then with respect to the independent aftermarket business, is the pressure primarily coming from Russia? I mean, what are the other drivers that could help you recover in this segment?

The direct impact of the sanctions has led to reductions in our Russian business in the aftermarket, which is typically a profitable business for us. As far as we can tell, this situation looks like it’s going to persist, and we don’t know when it might end. So that’s just a special case. With respect to other markets, the operating characteristics really are fuel price differentials. For instance, we had a depressed market in Italy, where our aftermarket business historically has been strongest. During the COVID lockdowns, we struggled to determine how much was due to COVID versus market dynamics in alternative fuels. In March, we saw a steep uptick in our business, coinciding with the outbreak of the Russia-Ukraine war as fuel prices spiked significantly. When the government intervened in Italy in April, providing incentives to ease the pain at the pump, it had a differential effect favoring petrol prices over LPG, resulting in a tapering off of demand we saw in March. This is just an example, and it really depends on the market dynamics around the world. We’re managing all those and doing the best we can in these turbulent times.

Understandable, David. With respect to China, could you give us any sense of what your overheads are in terms of just maintaining the status quo at this point for that effort?

Yes, this isn’t a lot of effort on our part. We basically support our customer through regular dialogue, answering technical questions as they come up. It’s not a heavy lift on our part. We’re not spending a lot of money on it. The biggest impact to our business is the absence of the volume that we planned on, right? We expected volume from our business in China now. The absence of this volume means we’re unable to access the economies and scale we targeted. Therefore, our profitability is still challenged. This is the significant effect of our business in China being in this state right now, but in terms of actual day-to-day work and spending, there’s very little.

Okay. Okay. All right. That’s all I have, David. My other questions were already discussed. Thank you so much.

Perfect. Thanks, Amit.

Our next question comes from Mac Whale of Cormark Securities. Please go ahead.

Hi, David. I think I just missed the answer to one of the earlier questions about expectations for volume sales in OEM heavy-duty, HPDI with Volvo in Europe. Did you say 16% was the year-over-year increase in volume?

Yes. It was 16% in Q1 of 2022 versus Q1 2021.

And what would've been like entering into the quarter, what was sort of the expectation of growth?

What we've seen over a long period of time since we launched in 2018 is nearly a doubling kind of year-over-year of the volume. So it's been in some cases larger than that, in some cases smaller than that, but kind of year-over-year, over a long period of time, it's been a doubling. Our expectations are yes, we have big expectations for the product in Europe. We think it's really important in the marketplace. We think it's very well received. We can see the testimonials from customers, and frankly, it's hard to understand how the higher LNG prices in this moment are affecting sales because sometimes sales are booked and then the trucks come later. It’s tough to tell in this moment what the rest of the year will be. If LNG prices decline or diesel keeps going up and the price differential gets reestablished in a favorable way, that’ll propel sales, and there are CO2 regulations that come into play in 2025 that OEMs need to meet. There’s really a lot going on, and it’s hard to even for us and our customer on the inside to figure out all the factors and forecasts where it's going to go, so hence no forecasts for the market. Sorry for that.

So if the... let's suppose the various regulations don’t move. Is there... as the shipments are low, how do you expect the next few years to play out in terms of catching up to where they need to be? Like can you... is there enough slot capacity where you would see much greater than doubling in order to catch up by mid-decade? How would it play out do you think?

Yes. The way I view it is that we have a really good future in Europe specifically with our launch partner. We expect other companies and customers to come along and join us because the CO2 standards have not moved through all of COVID, through chip supplies, through now the war. None of these things are deterring the European Union from their goals concerning reducing CO2 emissions in transportation. We see our product in the marketplace proving effective at decarbonizing and providing all of the fundamental transportation capability that a fleet or a truck driver expects from their truck. In terms of scale and where it could go, we have the capacity installed, and we're ready to scale up significantly, and so does our customer, because basically all it means is instead of grabbing a diesel tank and putting it on the truck; they grab an LNG tank and put it on the truck. The same is true for the injectors; instead of grabbing six diesel injectors, they grab a set of six HPDI injectors. For them, this is normal production, and they have their full production capacity available. There might be constraints along the way as they break bottlenecks to change the mix, but these are relatively easy for them to overcome. The capacity is there, and the requirement fundamentally doesn’t come into play until 2025. That's when OEMs will have to start paying penalties if they don't meet the 15% reduction requirement.

Well, given that the customers are so focused on total cost of ownership and not the pricing for the fuel is volatile, and you have this additional cost coming from regulation, is there any exploration of different pricing regimes? For instance, capturing some of the potential, given your technology is helping them ensure efficiency with lowering carbon? Would you be able to implement new pricing models where you might share the savings?

I think – no, I don't think it's impossible, but I do think it's challenging. I would say especially for us, perhaps it would be easier for OEMs to make this type of transaction with their customers. If you look at what Nicola’s proposing to do with their trucks, they’re saying, 'Hey, we're going to put the fueling infrastructure in place for you, and here are these trucks. We can share the fuel efficiency benefits or some savings.' I think a similar arrangement could be made on the OEM side for HPDI trucks, but that’s on the OEM side. it's not something that Westport Fuel Systems is doing directly with fleets. We sell our product to OEMs, who then sell trucks to fleets. The basic idea you raised is very interesting.

Okay. That's all my questions. Thanks, guys.

Thanks, Matt.

Our next question comes from Jeff Osborne of Cowen & Co. Please go ahead.

Yes, good morning. Quite a bit's been discussed already, but a couple of housekeeping questions and clarifications. One Richard, I was wondering if you could just summarize all of last year what percent of revenue is Euro denominated, just as we think about FX changes and the impact to you folks?

I want to say it’s close to like 85%. It’s a significant portion.

Okay. Got it. That's helpful. And then I wanted to dig into the LPG comments. You talked a lot about in the Q&A on the LNG side, but I thought you had said that the differential between gasoline and LPG is improving in some markets. So I just wanted to clarify A, if that's right and then B, if you can talk about which countries that is, and then maybe as a second derivative, what the impact of those differentials are to your tank business, which was about 10% of revenue this quarter.

Yes, thanks for the question, Jeff. It is different market by market. I don't have a long list in front of me, but as an example, in Italy, we saw these price differentials moving favorably. In the Netherlands, Germany, Poland, Turkey; these are typical markets in Europe where we saw it moving in the right direction. Gasoline and diesel prices went up significantly, and LPG prices didn't move up as much. They did go up, but not nearly to the same degree. So this is where we've seen this benefit. It’s modest but heading in the right direction. However, it doesn't overcome some challenges we see with respect to CNG, for example, where CNG prices are currently among the highest fuel prices in Europe, leading to a pullback in our CNG business in various markets.

Got it. That's helpful, David. And then maybe just the last one for me is you touched on the demand side in China and the potential shift to hydrogen. I was curious on the supply side; are you having any issues with your manufacturing partners on the availability of fuel injector technology or any other adjacent equipment you need or produce yourselves or through third parties?

No, I would say no specific issues. We’re continuing to monitor the situation. There’s big anxiety about how the COVID lockdown in Shanghai and Beijing will affect us moving forward. We’re doing what we can, working with suppliers to keep our supply chain moving. We don’t have a specific issue to highlight that hurt us in Q1 or that is about to hurt us in Q2.

Got it. That's helpful. That's all I had. I look forward to seeing you later this week at the ACT show.

Sounds great. Thanks, Jeff.

This concludes the question-and-answer session. I would like to turn the conference back over to Mr. Johnson for any closing remarks.

Yes. Thanks, everyone. Thanks for your time today. I appreciate your questions and tuning in for the call. It’s a challenging time for sure in the marketplace, but I think fundamentally we have great products. We have a great presence around the world. I think the diversity of our markets that we serve is crucial. So while CNG markets are down, LPG markets are up; while hopefully Russia is down, perhaps we could move up in other markets. Fundamentally, the key ingredient is that we continue to build HPDI, and I can't emphasize enough how we see the HPDI hydrogen opportunity affecting our business mid-to-long-term as we unveil this technology and demonstrate it around North America and later this year in Europe. That’s an exciting part of our business, and we look forward to the chance to speak with you more about that in the coming days. We have some Investor Conferences coming up, the RBC Auto Conference in Toronto and H.C. Wainwright’s Conference in Miami, and looking forward to seeing you there and speaking more about the business. Thanks for your time and have a good day.

This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.