Westport Fuel Systems Inc. Q2 FY2022 Earnings Call

Thank you for your patience. This is the conference operator. Welcome to the Westport Fuel Systems Second Quarter 2022 Results Conference Call. Please note that all participants are in listen-only mode and the conference is being recorded. I will now hand the call over to Ashley Nuell, Senior Director of Investor Relations. Please proceed.

Good morning, everyone. Welcome to Westport Fuel Systems second quarter 2022 conference call, which is being held to coincide with the press release containing Westport Fuel Systems financial results that was distributed yesterday. On today's call, speaking on behalf of Westport Fuel Systems is Chief Executive Officer, David Johnson; and Chief Financial Officer, Richard Orazietti. Attendance on this call is open to the public, 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 US and applicable Canadian securities laws, and as such, forward-looking statements are made based on our current expectations and involve certain risks and uncertainties. With that I'll turn the call over to you, David.

Thanks, Ashley. Good morning, everyone. I'm pleased to be with you today to discuss our second quarter. Once again, our team delivered strong top line results as we continue to execute against our strategy in a very challenging macro environment. Today, I'll be walking through our HPDI growth story, including the regulatory environment and total custom ownership analysis, which demonstrates that HPDI is the most affordable way and the most available way to reduce CO2 and meet CO2 standards. I'll also discuss our LPG business to both our light-duty OEM and independent aftermarket channels, where we're seeing improvements because of the increased price advantage of LPG compared to petrol. Finally, I'll walk you through our Indian business, where we're seeing growth today and expect this growth to continue as CNG fuel station buildout continues towards 10,000 stations. Following that, I'll pass it over to Richard to cover the financials. Our business continues to deliver strong results quarter-over-quarter despite the ongoing challenges our industry is facing. In the second quarter, we delivered revenues slightly up compared to Q2 last year, an achievement considering the combined impact of adverse foreign exchange rates and sanctions stemming from the Russia-Ukraine conflict, which combined to negatively impact the quarter by $13 million. Excluding these impacts, revenue would have increased by 16%. This is truly a testament to the strong results driven by our business units, where we saw increasing sales. That is in India as well as in our hydrogen and electronics businesses plus the addition of the fuel storage business we acquired in late May 2021. Although not a second quarter item, I want to take a moment to highlight the significant new business we announced last month to supply LPG fuel systems to a leading OEM. This deal is forecast to generate €38 million in revenue through the end of 2025, with production expected to begin in Q4 next year. Cost competitive alternative fuel solutions such as LPG are a compelling option to reduce greenhouse gas emissions in markets like Europe, where refueling infrastructure is well-established. We're also developing fuel systems to respond to future regulations, including the proposed Euro 7 standards, and we look forward to updating the market on these developments. This new business highlights our industry position as a leading Tier 1 supplier of alternative fuel systems that respond to current and future emission standards and to customers' needs for affordable transportation. This new business we've secured is a key step in our plan to grow to profitability. In May, at the ACT Expo in Long Beach, California, we unveiled our hydrogen HPDI system for internal combustion engines for heavy-duty applications, and we did so in the form of a fully functioning heavy-duty demonstration vehicle. There was dramatic interest from all the different players in our ecosystem: OEMs, fleets, fuel providers, and more. Increasingly, hydrogen is viewed as the zero carbon fuel we need for our industry, and we're helping the industry to understand that ICE engines with HPDI will play a critical role in transforming from fossil fuels to clean and renewable fuels because HPDI is such an effective and affordable path to follow. Fundamentally, the outlook remains positive for our business as we continue to deliver solid results despite the various headwinds we and our industry are facing. In our heavy-duty OEM segment, despite a challenging LNG pricing environment, our European HPDI launch partner is continuing to gain market share over competitors that offer spark-ignited natural gas engines. We're seeing the market appreciating and valuing HPDI's superior performance and efficiency, and as a result, we continue to see order flow for HPDI systems, despite headwinds from higher LNG fuel prices relative to diesel. HPDI volumes will be a significant driver to bring Westport to profitability as increased volumes drive economies of scale. And we're in a good position now for HPDI growth with the 2025 European CO2 regulations driving OEMs to act to decarbonize. European OEMs need to meet regulations that require a 15% reduction in fleet average CO2 with products that don't adversely impact the performance and reliability of their customers' demand. HPDI is a solution. A key reason HPDI is gaining in the marketplace comes down to superior fuel efficiency. In a recently published road test, HPDI enabled fuel savings of more than 25% when compared to other natural gas engines. 25% is a massive number in this industry. In the lifetime of a typical truck, about $700,000 worth of fuel is consumed. So, a 25% savings means $175,000 in lifetime savings, a very positive business case and why HPDI is continuing to prove its economic and environmental business benefits every day on the road in thousands of vehicles in Europe. HPDI, especially when using biogas, will be an important part of the solution made even more compelling when the fuel price advantage of LNG versus diesel is reestablished. Looking to the wider policy climate, we continue to see a positive trend that supports our heavy-duty business outlook. The Ukraine crisis has spurred a commitment to reduce reliance on Russian gas, resulting in additional biogas production plans, which is a huge positive for our sector. We're already seeing examples of this. In June, Scandinavian Biogas announced a $269 million bio-LNG delivery agreement. And in Italy, Biomet announced receiving a $75 million investment to create Europe's largest plant for producing biomethane from waste. While it's unlikely that any single low-carbon energy source can replace Russian gas, especially as the EU seeks to reduce reliance on fossil fuels and imported energy, the wider adoption of biogas and more investments into net zero fuels creates further growth opportunities and new markets for our clean affordable products. To summarize, our heavy-duty business remains strong in the face of industry-wide headwinds. There is growing recognition and appeal of our HPDI systems because of its low cost, clear performance advantages over spark-ignited engines, and carbon reductions that fleet operators are looking for, and which OEMs require to respond to regulations. Hydrogen HPDI is going to play a pivotal role in the future of Westport, and we've demonstrated this through both analysis and engine testing and now with our demonstration vehicles that HPDI works great with hydrogen. Unsurprisingly, we saw considerable interest in our hydrogen HPDI solutions at the ACT Expo in May. And our work with Scania continues this summer with our newest 13-liter state-of-the-art engine in our test in Vancouver. Hydrogen HPDI is compelling with near-zero greenhouse gas emissions, lower vehicle costs, and low industrialization costs as compared to fuel cells or battery-electric vehicles, particularly for heavy-duty long-haul trucking applications. We've demonstrated that power, torque, and efficiency using hydrogen HPDI is significantly better than the same engine running on diesel fuel. These demonstrations are changing the conversation right now. To be clear, OEMs can now see that HPDI has a long and bright future because it's successful with natural gas and biogas today and is the most economic way to use hydrogen in the future. Driving our conversations with both current and future OEM customers regarding our hydrogen HPDI solution is the potential to bring the product to market sooner due to the straightforward application of existing HPDI componentry. The opportunity to continue using OEM's existing engine development capabilities and manufacturing communities, avoiding large investments required to develop and industrialize other technologies is very appealing. It makes good economic sense, good business sense, and is a real solution for the industry. Combining better economics with better performance is driving significant interest in our unique product offering. Hydrogen continues to gain significant traction and attention globally. The European Union has set a 2050 deadline to achieve its goal of becoming carbon neutral. And hydrogen fuel in the heavy-duty vehicle sector will play a substantial role in their decarbonization strategy. Following our success at the ACT Expo, we will introduce hydrogen HPDI technology for the first time in Europe at the IAA Transportation Conference in Hanover, Germany in mid-September. We're thrilled to continue to demonstrate to the global industry that our HPDI technology works brilliantly with zero carbon hydrogen and enables the most affordable way to use green hydrogen in long-haul heavy-duty transportation applications and other important high load applications. We're enabling HPDI used by OEMs and fleets for long-haul trucking with natural gas, biogas, and with a clear path to zero carbon hydrogen. HPDI is a solution of the future that OEMs can access today. Just last week, on August 4, we hit another milestone, the Westport Hydrogen HPDI truck pulling Raley's Ozark trailer fueled with hydrogen for the first time in America at the West Sacramento station, the first hydrogen station in the world. Turning our attention to China, in light of LNG pricing that continues to negatively impact the market in China, we're continuing to work with HPDI so that we’ll be poised to launch as market fundamentals return. Discussions continue with potential Chinese partners specifically around hydrogen HPDI. China is now ranked first in the world for the number of hydrogen refueling stations with more than 250, accounting for about 40% of the global total. The China Hydrogen Alliance forecasted demand for hydrogen will reach 35 million tonnes by 2030, with continued robust growth for decades to come. Light-duty vehicles fueled by LPG, our growing market trends that positively impact our business through both our aftermarket and OEM channels. High fuel costs create opportunities for our business as both industry operators and end customers look for lower cost options, lower cost to acquire, and lower cost to operate. Alternative fuels are part of the answer. What's happening currently with the price of LPG is a good example. For LPG, there's a clear price advantage that is a growing part of our story. Fuel prices change, and customers react. It's in these price advantage environments where we gain market share and ultimately drive profitability. In important markets like Turkey, Italy, and Poland, LPG is available and the price advantage of petrol has recently been increasing. In Italy, for example, historically, the price advantage of LPG was about $0.60, rising to over $0.80 more recently, comparing petrol price per liter with LPG price petrol liter equivalent. Drivers who use LPG are saving roughly €50 every time they refuel their car. I’ll say that again, drivers who use LPG are saving roughly €50 every time they refuel their car. In addition to the pricing advantage, LPG refueling infrastructure in Europe is widespread, supporting further growth in the market itself. Our business in India continues to grow, and it has become a case study for the type of market where we can be competitive, and as a result gain market share with our clean and affordable solutions. Our revenues in India continue to grow, up more than 50% to $10 million this quarter. The market in India is transforming from a diesel and petrol market to CNG, where we continue to see a price advantage. Natural gas-fueled vehicles are taking the place of diesel in a real way and now represent more than 11% of sales for passenger cars and about 29% of commercial vehicles. We're seeing strong demand for our products from three-wheelers and taxis as well as heavy-duty trucks. India aims to have natural gas make up 19% of their overall energy mix in the coming years, alongside plans to build 10,000 natural gas refueling stations, which are expected to be installed by 2028. India is poised to play a significant role in the growing hydrogen economy as well. In June, Adani New Industries, one of India's largest energy companies announced a $50 billion investment to develop a green hydrogen ecosystem, representing India's largest commitment to green hydrogen from an individual company to date. In summary, this industry represents a growth market for us, supported by strong fuel price advantage, a supportive policy backdrop, and a growing hydrogen economy. No question. We continue to face headwinds now, but we also have substantial tailwinds. Emissions regulations, government action, societal demand, economic and great products that respond to the call to action right now, we remain well-positioned as a company. We have the right products for today and for the future. China, the world's top LNG buyer last year, is in the midst of the largest sold-out period the industry has ever witnessed. 10 new LNG import terminals are slated to come online in 2023 alone, and capacity will roughly double in the five years through 2025. In Europe, we're just 2.5 years out from the 2025 regulation where penalties will be implemented, and I can tell you from discussions we've had with global OEMs around HPDI that life helps are going up as the cost significance and overall capability and reliability concerns of the newer technologies are being made there. The European Union has relaunched Repower EU in the face of its energy challenges. Repower EU's plans call for rapidly increased imports of LNG, replacing imported pipeline gas in Russia, and the utilization of the significant untapped biomethane resources in Europe and also green hydrogen production, all of which will require significant privatization and build-out infrastructure. There's also been a quadrupling of the hydrogen targets originally set out in the Fit for 55 legislation. The ambition was 5 million tons, and now with Repower EU Plan, we target 20 million tons by 2030. This represents a significant growth opportunity for our company. All of this indicates increased interest in hydrogen HPDI as a game-changer for heavy-duty transport. With that, I'd like to turn it over to Richard to go through our financials.

Good morning, and thank you, David. Revenue for the second quarter of 2022 of $80 million was slightly up from the prior year quarter despite the challenging headwinds from volatile fuel prices, inflationary pressures, and production input costs, continued supply chain challenges plaguing the automotive industry, and the negative impact from the Russia-Ukraine conflict on our sales volumes to the Russian market. Further, the weakening of the euro against the US dollar during the quarter significantly impacted the translation of our financial results due to our large euro exposure. As David mentioned, the combined impact from the Russia-Ukraine conflict and the 13% decrease of the euro against the US dollar negatively impacted revenue this quarter by about $13 million. Despite what feels like a long list of headwinds, we are proud of the work that our team accomplished this quarter in our business units. Our OEM business continued to grow, primarily driven by the addition of our Fuel Storage business acquired in June 2021, but as well as modest growth in our hydrogen and electronics businesses and increased sales of our light-duty OEM products in the Indian market. Offsetting the growth in OEM revenue, our independent aftermarket revenue was lower year-over-year due to reduced sales volumes, primarily a result of the impact of sanctions from the Russia-Ukraine conflict. Net loss was $11.6 million for the second quarter of 2022 compared to a net income of $17.2 million for the same prior year period. As a reminder, the second quarter of 2021 included two significant one-time items that bolstered earnings, namely the recognition of a $5.9 million bargain purchase gain related to the acquisition of the Fuel Storage business, and an $8.9 million tax recovery recognized for a COVID-19 tax release ruling from the government of Italy. Besides these non-recurring items, the decrease in earnings was driven by lower year-over-year gross margins of $5.2 million and the loss of equity income from the termination and sale of the CWI joint venture. Adjusted EBITDA was negative $4.3 million compared to positive $6.2 million in the same prior year period. The $10.5 million decrease was mainly due to the loss of equity income from CWI and the lower gross margin, partially offset by decreased operating expenses. We are experiencing gross margin pressure due to higher material costs from the global supply chain shortage, general price inflation in our production input costs, lower sales volumes related to the Russia-Ukraine conflict, and also we are seeing pressure from volatile CNG and LNG prices, particularly in Western Europe on our sales volumes. Turning to our business segments. OEM revenue for the second quarter of 2022 was $54.3 million, up 15% compared to the prior year quarter. The operating loss from OEM was $5.6 million, up from a loss of $3.4 million for the prior year. The increase in revenue was primarily driven by the additional revenues of $5.1 million from our Fuel Storage business. We also saw increased light-duty OEM business sales volumes, specifically in India as well as increased sales volumes in our electronics and hydrogen businesses. This was partially offset due to lower sales volumes to our European OEM customers caused by higher CNG fuel prices. Our hydrogen components business continues to grow with Europe, China and North America being our primary market. Our existing GFI branded hydrogen business supplying components to Plug Power, Ballard, and others have seen average annual revenue growth of 50% over the last three years. In our electronics business, we are seeing volume growth from a key customer and supported by an overall demand increase across the business unit. Turning to heavy-duty OEM, our sales volume to our European OEM launch partner decreased slightly compared to the same prior year period, but remains in line with year-to-date volumes from last year. The decrease in the quarter was a direct result of the softness in demand caused by unfavorable fuel price differentials between LNG and diesel in many Western European markets. Higher LNG prices are causing a significant challenge to the demand for LNG trucks, which is expected to temper our expected volume growth through our OEM launch partner through 2022 and until relative LNG prices return to a more favorable equilibrium. Gross margin was $4.7 million or 9% of revenues for the quarter, compared to $7.2 million or 15% of revenues in the prior year. We saw a decrease in gross margin in our light-duty OEM business due to lower sales volumes to our European OEM customers caused by the higher CNG fuel prices, which was partially offset by higher sales growth to emerging markets with lower gross margins. Gross margin in our heavy-duty OEM business decreased year-over-year due to lower comparative sales volumes, a contracted annual price discount to our OEM launch partner in the first quarter of 2022 and higher material and warranty costs. Further, we continue to incur higher production input costs from supply chain challenges and inflation and logistics, utilities and other costs, which we have only partially been able to pass on to our OEM customers. Partially offsetting these pressures, gross margin increased by 1.1% from our fuel storage business. R&D expenses for the second quarter were $4.1 million, which were lower year-over-year due to foreign exchange. Our heavy-duty OEM R&D activities continue to focus on the development of next-generation HPDI fuel system technology and demonstrations with potential OEM customers on our HPDI fuel systems hydrogen and natural gas applications. Our light-duty OEM research and development is focused on the development of new LPG systems in line for installations for potential OEM customers. Now turning to independent aftermarket, our business continues to face significant challenges from reduced sales volumes in Eastern Europe due to the ongoing Russia-Ukraine conflict and volatile fuel prices. Revenue for the second quarter was $25.7 million, down 19% compared to the prior year period. Aside from the impact of Russian sanctions, sales volumes were lower to key markets of Turkey and Argentina, softness in the Argentine market specifically due to higher CNG prices, which have been a recent challenge for our CNG products due to the volatile fuel price. Further, the aforementioned foreign exchange impact of the weakening euro had a significant impact on the comparative performance. Gross margin was $5.8 million or 23% of revenues for the quarter, down $2.7 million, compared with the same prior year period. The decrease in gross margin and gross margin percentage was attributable to lower sales volumes and increased material costs from the global supply chain shortages and inflation. On a positive note, the LPG price differential to gasoline is improving, which is providing some support for increased sales demand, which we are seeing signals in some of our key markets like Argentina, Italy, Poland, and Turkey. With this positive tailwind and other countermeasures to mitigate the impact of inflation and improved productivity, we are taking the necessary steps now to improve profitability in our aftermarket business. Finally, I'd like to touch on liquidity; our cash position decreased by $29.4 million during the second quarter to $98.2 million. Our net cash flows used in operating activities were $16.5 million in the second quarter of 2022, an increase of $7.8 million compared to the same prior year period, primarily driven by an increase in operating working capital, specifically a buildup of accounts receivable and inventory. We've built up inventory to manage against supply chain risks along with shortages of raw materials and components. Further, our inventory levels increased due to lower-than-expected sales volumes from Russia and other markets. And our growing electronics business, for which we are taking actions to monetize the existing inventory and optimize our inventory levels. Our net cash used from investing activities in the quarter was $3.5 million, primarily driven by capital investments in HPDI. Net cash flows used in financing activities were $8.5 million for the second quarter of 2022, primarily due to a net repayment of debt as we begin paying down our debt on a quarterly basis after a period of deferral from COVID-19 relief. We remain focused on our allocation of capital and resources and executing our strategic and operating plans, and as such, are focused on improving profitability and liquidity. We have also seen continued pressure on gross margin, a trend we are working to reverse. Currently, we are working with our customers in both OEM and independent aftermarket businesses to implement price increases and also taking productivity countermeasures to manage our profitability going forward. As the negative macroeconomic and uncertain geopolitical conditions continue to persist, the duration and severity of the impact on future quarters is 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. We are also optimistic about our return to improved profitability of our independent aftermarket business from the current tailwind of favorable LPG prices. With that, I would like to turn it back to David.

Thank you, Richard. Before we open the call for questions, I want to close on a few key points. Westport Fuel Systems delivers market-ready transportation solutions that reduce emissions and save money, lower costs to OEMs to bring to market and lower cost vehicles for fleet operators. We remain encouraged by the outlook for our business, and here are just three reasons why: our HPDI story; performance, efficiency, low cost, and even better with hydrogen; second, the growth of our LPG business; and third, the growth we're seeing and expect to see in our business in India. As a supplier of advanced fuel delivery components and systems for clean low-carbon fuels, I'm confident in our ability to capture the additional market opportunities we have in front of us. All these factors give us optimism in our ability to meet the needs of our customers and advance towards our financial objectives. And with that, I'll turn it over to the operator to open the call for questions.

Thank you. We will now begin the question-and-answer session. The first question is from Colin Rusch with Oppenheimer. Please go ahead.

Thanks so much, guys. Now could you talk about what you're seeing right now in terms of the ecosystem developing to support the ramp-up of hydrogen with HPDI? Certainly, there's a lot of action, particularly in the US, but certainly in Europe as well around some of the fueling and supply chain elements that going to be required to support that ramp?

Yes, good morning, Colin. Good question on hydrogen. It's, I would say, a very exciting time in the history and developments around the world, primarily driven by a combination of government and industry action; they are taking different approaches in differing details, of course, but fundamentally, what we see, and I think the Russia-Ukraine crisis has really crystallized is in Europe, is that there’s renewed energy or an increased energy around taking those actions and making those investments. So there are investments in building out the capability to produce and make available green hydrogen or incentives in the marketplace for all elements of the ecosystem. I think this is a really important development. What we saw at ACT Expo in May was that there’s a preponderance of or even a majority of the offerings out there are fuel cell-based, and ourselves and Cummins were at the show with internal combustion alternatives. And this, I think, is really what's new: the recognition by the existing and mature industry that hydrogen is coming as a fuel, that it's going to be the fuel of the future and it will have a place in the industry, and therefore, we need to get ready and now searching for what are those best ideas, best technologies, most practical and realistic to respond to the availability of hydrogen fuel in the future and the need to use that to decarbonize transportation. So I really see this kind of as a really formative time in our industry and actors like the Hydrogen Council, collaboration of industry and government, all the different players and ecosystem really having an important effect on capitalizing towards action of both generation of hydrogen, distribution of hydrogen, and use more hydrogen. And where we see HPDI playing is being very practical and an affordable way to use hydrogen very effectively for long-haul heavy-duty transportation. So in addition to showing our demonstration vehicle as we did at ACT Expo in Long Beach in May and then just last week in Sacramento, and then in September at the IAA and Hanover, we're demonstrating this capability in dyno cells with combustion engines. And there's, I would say, a tremendous amount of increasing momentum to accept and understand its potential to use the existing internal combustion engine infrastructure, existing plants, existing vehicles; all the existing infrastructure can be reused with HPDI and deliver a very effective product that uses green hydrogen in the future and therefore has a huge impact on decarbonization in a very affordable way. So we think this is really important for Westport Fuel Systems and really promising for our industry.

That's super helpful. And then just in a more practical way, given what we've seen in terms of raw material movement and some of those baskets and other elements recently, I'm just curious how quickly that might start flowing through some of your cost structure and what you're doing to kind of attend to that and start working down some of the component costs?

Yes. As a general premise in our industry right now, we are facing significant inflationary pressure globally. Therefore, our primary focus is to manage our pricing in real-time with the cost increases. This poses a considerable challenge. In our OEM business, for instance, our customers are somewhat reluctantly accepting price increases that reflect the inflationary cost pressures affecting both us and them. However, this process involves costs rising first, followed by our request for a price increase, which we manage to secure, but typically after the fact. This differs from our aftermarket business, where the price is directly passed on to consumers, who are generally willing to pay it if they can recoup costs through fuel savings. We are particularly pleased with the price advantage of LPG compared to gasoline and diesel, as this helps customers offset the cost of acquiring the necessary hardware for their vehicles and enables us to recover cost increases in our aftermarket products through higher pricing. The key element for us is to translate these cost increases to our customers. Furthermore, for our HPDI business, a crucial aspect is boosting our volume to access economies of scale, which would help lower costs and enhance our margins. We are on that path, but we have not yet reached the point where we can confidently say we have achieved the appropriate margins for that product, as it is still operating at relatively low volumes and requires further growth to reach profitability.

Okay. Thanks so much, guys.

Thank you, Colin.

The next question is from Eric Stine with Craig-Hallum Capital Markets. Please go ahead.

Hi, David. Hi, Richard.

Hey there.

So you just mentioned some of the market developments. As we think about hydrogen HPDI, I know we've got the introduction of the demo unit in Europe here in mid-September. But as you think about the next, I guess, for the remainder of 2022 and into 2023, without naming specifics, I know you can't do that, but just maybe some signposts that we should look for or expectations that you would have that say that you are on the right track here and in a timely fashion?

I believe there are various developments that could be announced in the future, Eric. While I can't predict or guarantee those outcomes, we have noticed that people are generally more willing to engage in discussions about hydrogen compared to our natural gas developments. We’re excited about our demonstration truck, as it allows us to hand over the keys to customers and government officials, helping them understand the potential of hydrogen HPDI. This truck can pull a load and drive like the trucks they are accustomed to. In my years in the industry, there's nothing quite like giving someone the keys to a vehicle and encouraging them to take it for a spin. We recently did this in Sacramento, which significantly shifts perceptions about this new technology. It shows that we can use hydrogen in an internal combustion engine to create not just a viable product, but an excellent one. We're proving that hydrogen HPDI offers more power, torque, and efficiency compared to the base diesel engine. It's an impressive offering, and we look forward to making more announcements that will provide the investor community with insights into the progress we are achieving.

Right. No, absolutely. Maybe a follow-up on that. Do you feel that, while this is the OEM world and it takes time, comparing it to LNG, the fact that you now have Volvo in Europe and trucks in the market, and the market recognizes HPDI, do you think that hydrogen could develop faster, or do you expect it to play out similarly to LNG?

Well, first of all, for sure, I expect that from our side as a fuel system provider, we can move faster with hydrogen than look at the history of HPDI with natural gas, just because we're taking existing components and system know-how and applying it to just basically connecting and using hydrogen as natural gas. So that development path looks quicker to us. It certainly looks quicker to us than the full industrialization of a fuel cell path, for example, where they've got to go build plants. The components we're using come off the existing lines as the componentry for our natural gas solutions. And so that seems faster. I would say also that fundamentally, the economics are in the favor of HPDI with respect to the efficiency of the engine delivers and the cost of the componentry versus the change that has to be made in the vehicle to adopt other technologies. So, I think, yes, that can move faster. But perhaps most importantly, this view that we're helping our OEM customers and customer prospects understand that HPDI is a long-term solution to achieving low-carbon long-haul heavy-duty transport that because hydrogen is a long-term solution with HPDI and you can use natural gas and biogas today, there is a path forward that says you can act today with natural gas and access the hundreds of stations in Europe, the thousands of stations in China, and almost 2,000 stations in the US; there's this ability to use HPDI today and have a path forward with hydrogen, and that adds to the potential for an accelerant of our business, pulled by hydrogen in the future, but grounded in natural gas and biogas today.

Yes, understood. Maybe last one for me, just on Weichai. Thanks for the update there in China. I know you've got the take-or-pay, but likely just given the macro, you're not going to hit those timing targets. Is that something that potentially could be renegotiated to, in some way, include hydrogen, a mix of hydrogen and LNG or how should we think about that?

Yes. As you've seen before, we struck the agreement with Weichai back in 2018, and then we had a renegotiation of the terms and the volumes just last year. So, everything is up for negotiation, I would say. Nonetheless, we do have some commitment, and it always should be an improvement on what we have today. But nonetheless, there are some practicalities, and today, we see this adverse price condition in China; we expect natural gas that is really weighing on the marketplace and specifically, the launch of our products at Weichai. So as that is remedied, as that is fixed in the marketplace through market mechanisms and perhaps government action, then we would look forward to some action, and that could include some change in our contract, but who knows that's all in the future.

Okay. Thank you.

Thank you, Eric.

The next question is from Rob Brown with Lake Street Capital Markets. Please go ahead.

Good morning. My first question is on the European HPDI product. I think it was a slight growth this year or this quarter. How do you see the order rates sort of in real time here? Are they continuing to slow down with the price spread or are they sustaining sort of flat or just sort of directionally, how is the order flow given the current price situation?

Yes, it's quite interesting. Historically, we've highlighted how our HPDI product and other case products can provide customers with an economic advantage due to the lower costs associated with natural gas and LPG compared to gasoline and diesel. Currently, in Europe and China, we are facing a situation where LNG is either on par or sometimes even more expensive than diesel at the pump. We anticipate that this situation will not last, but it is currently affecting our expected growth, leading to flatter volume trends regarding HPDI for now. Nevertheless, we're optimistic as CO2 standards are approaching, which will compel our OEM customers to meet new regulatory requirements starting in 2025, accompanied by significant penalties for non-compliance. This will be a major driving force in the market, as OEMs will need to reduce CO2 emissions, and our solution is one of the most effective means to achieve that. I previously mentioned a report indicating a 25% improvement in fuel economy when using HPDI compared to spark-ignited engines. This underscores the advantages of HPDI, especially when the goal is to transition to a lower carbon fuel. While higher LNG prices are creating a current economic challenge and contributing to slower growth, we do not foresee this trend continuing. As we approach 2025, we expect a notable increase in volume since HPDI provides a cost-effective response to new regulations.

Okay. And then on the LPG contract you announced with an OEM, is that a new contract or a new OEM or maybe just some color on what market it's in and is it an extension or a new contract?

Yes, sure. This is a really important step for us. It is a new business for us. So, we're really excited to have this new customer and have this new business. Obviously, it's a meaningful number for us in terms of our revenue outlook over the contract period of €38 million. So that's a big deal for us. And fundamentally, our path to profitability as the company is through growth. And so, we can really secure a business like this based on the technologies and the products that we offer and the services that Westport Fuel Systems offers to our OEM customers. It's a big deal, and we're really excited about it. And we hope to add more to that, of course, as we continue the growth trajectory. For us, as we look at LPG, the benefit of LPG is growing. The economic benefit, the environmental benefit, the huge installed infrastructure of refueling stations, and we're taking tens of thousands of stations across Europe; we're LPG. It's a very common fuel there, the most common in the world for transportation right now. And so that's a great development for us. We're excited about it and we think it really demonstrates that Westport Fuel Systems is the leading OEM for supplying these kinds of systems to the OEM industry in total.

Okay. Thank you. I’ll turn it over.

Thanks, Rob.

The next question is from Amit Dayal with H.C. Wainwright. Please go ahead.

Thank you. Good morning, everyone. Most of my questions have been asked, David. With respect to sort of the HPDI 2.0 sales environment, I know there are some near-term headwinds, etc. But have you seen any deals fall through, or are customers just slowing down adoption in this environment? Like how should we think about that product over the next few quarters, sales for that product?

Yes. I think it’s good to speak with you, Amit. I think in general, most of our activities are now with customers are now considering the opportunity that HPDI offers with both hydrogen and natural gas. And so this is really what's catalyzing our discussions with customers is the opportunity for HPDI to do both and to have that path to hydrogen in the future. And so that's making the opportunities for HPDI with natural gas and biogas more accessible, more interesting for our customers. And so that I would tell you is probably the main ingredient that's really driving discussions. And we see this around the world, right? So as an example, we've spent a lot of time talking about our business with Weichai and looking to get that launch with natural gas, but there is a tremendous amount of opportunity for HPDI with hydrogen in China. We're carrying on conversations with many OEMs there around that opportunity. They're building on hydrogen structure. So we talked about Europe, because it's very accessible to us. But in China, they're in the lead, like they are with natural gas in terms of refueling infrastructure. And so we see a big opportunity there. And that, to me, is really the catalyst for the discussions on HPDI in general across markets around the world is this move to hydrogen in the future, natural gas and biogas now.

Understood. So just want to bridge that; it's almost like we have to come out with a new offering that can support both these capabilities or you have the hydrogen capability provided. What would be the timeline to introduce a product like this? Are you already sort of working on developing it at an accelerated pace? Like any color on sort of your thoughts strategically on how you have been tapping this opportunity?

Yes. So actually, to clarify that the fundamentals of our HPDI system from the injector and the system architecture and the componentry and so forth are very, very similar. So basically, today, in our demonstration vehicle we're using the same hardware. We do expect and are working on the various details of tuning that hardware and modifying it to make it fully validated and available for hydrogen. So I do expect in the long run that the actual hardware will be different, right? It will be exactly the same components for hydrogen and natural gas. Nonetheless, the fundamental technology and, for example, how it fits on the vehicle and how it fits in the engine is the same. And so this is what really opens the door for those developments that are future hydrogen natural gas now and biogas too. And so that is the path that we see and the path that we're working with our customers on many fronts for many markets like China, Europe, and North America.

Yes, I think I saw some of that at the expo, where you showed me some models. Regarding the LPG system, David, I believe you mentioned that production could start in the fourth quarter of next year. Did I get that right?

No, no, that's exactly correct. Fourth quarter of next year is the start of production for that project, and then over the two-year period that unfolds after that €38 million of revenue is our expectation.

Okay. Understood. So near-term margin outlook, should we assume similar levels for margins in the third and fourth quarters, even though the macro environment could be improving in your favor from a supply chain perspective?

So generally, I would expect in the near term that the main factors affecting margins are cost pressure from inflation, pricing actions we are taking, and the need for HPDI volume growth to achieve economies of scale. Consequently, I don’t foresee significant changes in margin in the near term as we work to pass on the costs we are experiencing to our customers through pricing. We are also looking for improvements in the economic conditions of LNG in the market to drive recovery and support growth in our HPDI volumes.

Okay, got it. Thank you. That's all I have for now. I'll take my other questions offline.

Thanks, Amit.

The next question is from Jeff Osborne with Cowen. Please go ahead.

This is Jeff Rossetti standing in for Jeff Osborne. Thank you for the opportunity to ask questions. I wanted to inquire about the OEM volume side and how to approach the challenges related to LNG for heavy-duty vehicles in contrast to the advantages you're observing for LPG in light-duty vehicles. I understand that due to LNG prices, there might be a slowdown with your HDPI 2.0 OEM launch partner?

Yeah. So our outlook right now is, I would say, for HPDI is flattish with some upside potential. And certainly, we've seen in global markets some moderation of the LNG prices. But the condition in Europe is really quite challenging with respect to trying to forecast fuel prices with the ongoing Russia-Ukraine war. I think someone who's got a crystal ball on that should be super valuable at this juncture. But fundamentally, in the long run, I do believe that the LNG flows around the world and natural gas availability will continue to grow. And certainly, with high LNG prices, we have more and more biogas coming online, and that will help. So fundamentally, until there is some kind of, let's say, reestablishment of an LNG price advantage versus diesel and then the implications associated with the CO2 standards in Europe, I would expect some flattish and modestly upward trends and some luck. And then when the price is reestablished and CO2 standards can in place, we expect a big change and a big growth potential as HPDI continues to demonstrate that it is the most cost-effective way for OEMs to respond to the regulations and for customers to access cleaner transportation.

Got it. Okay. And one that's very – another one that's probably difficult to sort of postulate on, but one large Tier 1 provider talked about potential gas supply disruptions in the back half of the year in Europe. And I was just thinking, if you had contemplated any scenarios around that or if you had any thoughts around that potential?

Yeah. No, I think as a general premise, we don't have an ore in the water with respect to controlling availability or pricing fuel. So we're – it's an external factor that we respond to. One of the things that I think is very positive for our company in this, let's say, dynamic market or volatile market or unknowable market in the future, is the fact that we do have a diversity of market, diversity of products, and a diversity of fuels that we support. So as an example, we're seeing growth in our hydrogen business right now in our markets in North America and in China. And we're seeing growth in our electronics business, our LPG business sees growth. And then we're working in markets around the world. So it's not all about Europe, LNG, and HPDI. There are other elements of our business, which are having those tailwinds supporting us. And so, that's where I think fundamentally looking at our results just this past quarter, coming off flat in the context of really constraining the business in Russia that was important to our P&L. Historically, and hopefully, in the future will be important again, but right now is super impacted by the conflict and then the foreign exchange. So the things that we would have been up more than 10% had we not had those factors; I think it's indicative of where the company is going in the long run.

Okay. Thanks. Just one last one, if I could. I think Richard talked about the working capital build. I just wanted to see if there was any thoughts on if there's going to be any kind of release near-term on the working capital side? Thanks.

We have indeed built up some inventories, particularly in our electronics division. The challenges faced globally in this sector were unavoidable. Our chip suppliers made it clear that in order to secure chips, it was essential to place orders promptly. Consequently, our options were limited, leading to the accumulation of those inventories. We anticipate that, over time, we will reduce these inventories as we utilize them, and hopefully, our suppliers' markets will stabilize to allow us to return to normal ordering practices instead of holding inventory to safeguard our sales.

Thank you.

Thanks, Jeff.

The next question is from Mac Whale of Cormark Securities. Please go ahead.

Good morning. In terms of, when there's a truck sales downturn, we usually see fleets drive their vehicles longer, and that builds up some pent-up demand. So when you finally do launch or when your partner is actually ramping up, do you have any insight from, say, new OEM projections about whether that will play a role in the ramp-up phase?

Yes. Good morning, Mac. So the view I have in this regard is that our business right now is still sub-5% of the marketplace, right? It's a very small fraction of the total market. So if the market declined by 10%, 15%, 20%, the reality is that I expect, and we've seen historically, that the markets moved around, and we've been growing through the years after the launch in 2018 despite the ups and downs in the marketplace because we're a small percentage. The focus of our customers, the OEMs and their customers, the fleet is in accessing lower carbon fuels for their trucks and being able to offer lower carbon solutions to the marketplace. So I don't think that affects us so much. Of course, it can't be viewed as positive that the volume goes down and can be viewed as positive that the volume of the market was up in total, but I would say the impact is not nearly as important as the impact of the growth of market share of our product. So historically, just a couple of years ago, gas-fueled products in the European truck market were sub-1% and now they're on the order of 3%; so it’s triple, right? So we've seen that our volume, which has gone up dramatically this time, but still it's still relatively low buying even though the growth has been good. So yes, overall, I don't see the market volume in total having such a big impact, but rather the growth trajectory of our product, and that's driven by the economics that we talked about and the regulation that we talked about.

I want to clarify my understanding. You have market share and the market is rebounding due to pent-up demand. Are you suggesting that the adoption of natural gas will continue regardless, and thus your market share growth may slow because it's mainly focused on a niche? Or are you indicating that the market will expand and benefit all sectors, including alternative fuels, leading to a faster growth rate for you? I’m trying to grasp your response fully.

Yes. I think there are two key percentages to consider. First, we need to look at the percentage growth of the marketplace. For instance, in Europe, are we seeing a rise from 300,000 trucks per year to 400,000 trucks, or a drop from 350,000 to 250,000? Then, we must consider our product's market share, which I believe is the more crucial growth factor. Our main focus is on the movement of our market share. Currently, diesel fuels hold about 97% to 98% of the market. If the market declines by 10%, diesel volumes also decrease by 10%. However, in our situation, that doesn't apply since our market share is expected to grow significantly. Therefore, that is the more critical impact.

Okay. Okay. I have a bunch of other questions, but we will take it offline this afternoon. I have a call at 11. I have to jump on. So sorry, I was late in the queue, but hope we’ll talk later. Thanks.

Okay. Thanks, Mac. Thanks so much.

The next question is from Bill Peterson with JPMorgan. Please go ahead.

Thanks for taking my questions. I wanted to come back to hydrogen. I know you've done some work with TUPY AVL. I believe Cummins was supposed to happen this year. I just want to get an update on that one in particular. Do you still expect that? And I believe you talked about the potential fourth partner. Just trying to understand how the interest in hydrogen should play out with these specific partners?

Yeah. Good morning, Bill, thanks for your question. So it's right. We have these projects. We have a project with Scania that we mentioned earlier in this call. We have a project with AVL and TUPY also working. That activity is actually taking place at AVL in Graz, Austria. We have work going on with Cummins that was announced as part of our announcement earlier this year on the share sale that we did. So these projects are all running, and we'll look forward to sharing some information about them when our partners agree that's okay to do when we hit certain milestones and so forth. We do expect to have new customers added to the queue as we work with customers around the world, including China, Europe, and North America to demonstrate as we are doing with our demo vehicle. So all those are progressing, and we look forward to sharing updates when they're available and approved by our customers.

Thank you for that. Regarding operating expenses, how should we view the trajectory for the rest of the year? It seems likely to increase, but there are uncertainties around exchange rates. Please help us understand your approach to managing costs.

I think we can expect our performance to be comparable as we approach the end of the year. In terms of operating expenses, our R&D program is anticipated to spend around $30 million this year, while general and administrative costs may be slightly lower. We are definitely investing more in business development. Sales and marketing efforts are ramping up as we launch the hydrogen truck and intensify our activities in North America, although these amounts are relatively modest. The main concern lies within our gross margins, where we are experiencing a shift in our mix. We will discuss this further in our call, but we anticipate improvements in our independent aftermarket margins. Our OEM business is facing challenges from elevated CNG prices, leading to a mix change; however, we are experiencing significant growth in India, which presents a lower margin but holds promise. Regarding our heavy-duty business, we expect year-over-year growth to be flat at this stage. Therefore, margins should generally reflect what we saw in the second quarter. They may improve slightly, accounting for additional warranty costs that were higher than usual, but these will be managed by our engineering department.

Good. Thank you. Good luck.

You're welcome.

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

Yeah. Thanks, everyone, for your time and attention this morning. In the grand scheme of things, I appreciate the chance to review our results with you. I feel guardedly optimistic in this really challenging time that we continue to deliver the product that the marketplace needs to both economically and environmentally improve transportation. There’s work to be done ahead, and we look forward to reviewing with you in upcoming investor conferences. Thanks again for your time.

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