Westport Fuel Systems Inc. Q3 FY2022 Earnings Call

Thank you for standing by. This is the conference operator. Welcome to the Westport Fuel Systems Third Quarter 2022 Results Conference Call. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. I would now like to turn the conference over to Ashley Nuell, Senior Director of Investor Relations. Please go ahead.

Good morning, everyone. Welcome to Westport Fuel Systems Third 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 is Chief Executive Officer, David Johnson, and Chief Financial Officer, Richard Orazietti. Not speaking today, but joining us on our call is Bill Larkin our incoming CFO, who will assume the role following Richard’s departure on November 30th. 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.

Thank you, Ashley, and good morning, everyone. I'm pleased to be with you today to discuss our third quarter. Once again, our team delivered solid results as we continue to execute our strategy and showcase our pioneering hydrogen HPDI technology, to a wide audience amid the ongoing challenging macro environment. We continue to work through the industry felt headwinds, and feel both prepared and poised to grow into the future. We believe that strong LPG price advantages, continued expansion in the new markets, supported by global emissions reduction requirements, and further OEM conversations about hydrogen HPDI will drive growth and profitability. We remain committed to our announced $1 billion of revenue and profitability goals, but also recognize that, due to the headwinds we faced so far this decade, which continue to persist at least in the near-term future, the time to achieve these goals will be later this decade. The environmental, economic, and regulatory requirements will not stop or wait, and Westport is well positioned to respond. Today, I'll be walking you through an update from our hydrogen HPDI roadshow, where we've been promoting our technology at important industry and government events. I'll also dive into our recently announced Scania test results to clarify the significance of what we've achieved. I'll discuss the rise of liquid biomethane, highlighting its growth, particularly in Europe and its increasing usage in heavy-duty transport, and why Westport stands to benefit. Finally, I'll walk you through our independent aftermarket business where we see recovery through this year, which is being bolstered by the continued price advantage of LPG in many markets. In Q3, we delivered revenues of US$71 million, slightly lower than Q3 last year. As indicated in prior quarters, the Russian market has been historically important for Westport through both our aftermarket and OEM channels. Now, with the war in Ukraine, and sanctions on Russia, combined with the weakening euro and high natural gas prices in Europe, we've been heavily impacted. If we were able to set these aside, our business would have grown by 15% in the third quarter. Absent changes in foreign exchange, our revenues grew by 10%. We also continue to experience the impacts of rising inflation, supply chain constraints, higher utility costs, and fuel price volatility that have weighed heavily on our industry. As many of you know, we are the only company with a technology that enables diesel cycle combustion using LNG and biomethane, and there are thousands of trucks on the road today utilizing our technology. Taking this a step further, our fuel system technology paves the path from natural gas and biomethane today to green hydrogen tomorrow. We were excited to continue to inform both industry participants and policymakers about our unique capabilities and the advantages of hydrogen HPDI with our Class 8 demonstrator vehicle at multiple industry events in Europe and North America. It is no surprise that as populations grow and economic development continues, we will need to move more freight. Both industry participants and policymakers agree that the number of trucks on the road will grow and the performance and cost-effectiveness of lower carbon solutions will become increasingly critical. We truly believe that HPDI is the solution today and for the future. Speaking more broadly about our business, fundamentally, the outlook remains strong. The demand trends for affordable mobility options that reduce emissions are encouraging. We're seeing regulatory and policy support for options that utilize zero carbon fuels like hydrogen and biomethane. We're capitalizing on this now with the advancements we've made with hydrogen HPDI and the further recognition of what HPDI technology can achieve today with natural gas and liquid biomethane. In addition to the work we're doing developing fuel systems to respond to future regulations, including the pending Euro 7 standard. I wanted to take a moment to reiterate our three-pronged go-forward strategy as a company, and how we are positioning ourselves for the future. First, we will drive sustainable growth in our existing markets through a diversified portfolio of technologies, products, and services. This will be evident across all our business units. Second, we aim to unlock new and emerging markets through the delivery of cleaner, affordable transportation solutions. Third, we will continue, as we've done in the past, to drive operational excellence and maintain our reputation as a Tier 1 supplier with enhanced quality and reliability. Historically, when the term hydrogen has been used in relation to on-road transportation, only fuel cells come to mind. We are challenging this narrative. The future requires many options, including solutions best suited for certain applications based on factors like distance, payload, durability, and affordability. Our technology is a solution for using zero carbon hydrogen effectively in many applications with the required performance at an affordable price. We're engaging in these conversations now, including unveiling our hydrogen HPDI fuel system-equipped Class 8 demonstrator vehicle at IAA Transportation 2022 in Hanover, Germany, one of the largest commercial vehicle conferences in the world. Further distinguishing hydrogen HPDI from other technologies is the ability to utilize existing manufacturing infrastructure, a key factor in the near-term adoption of sustainability solutions and a discussion point with all OEMs at the Hanover show. Minimizing investment, both public and private, on the path to decarbonization is a key component of our ability to achieve real change quickly. OEMs are taking notice. We've demonstrated that our technology achieved better performance than diesel engines with near-zero CO2 emissions, all while utilizing existing manufacturing infrastructure that has already been paid for. The interest in our solution continues to grow, and IAA was a significant milestone in highlighting our technology to leading industry participants. Recognition and momentum around the product are building, and so like many others, our excitement is growing. In our discussions with global OEMs at IAA, it was clear they are beginning to understand that Westport's hydrogen HPDI fuel system solution addresses the sector not addressed by electrification, and it does so in a more affordable way than a fuel cell. OEMs recognize that full electrification of all applications is not feasible, and utilizing internal combustion engines remains a compelling option. The tide is turning, and conversations are shifting. The cost realities and engineering limits for electric solutions for heavy-duty applications are becoming clear to OEMs. We remain committed to the idea that there will be a full suite of options in the future, but it's increasingly evident that electric solutions do not meet the needs of heavy-duty long-haul transport, while hydrogen HPDI does. Following IAA, we spent time in Brussels and Washington, DC, where we engaged policymakers and OEMs who are looking more seriously at internal combustion engines and alternative fuels while recognizing these will play a larger role in the solution for a lower emissions future. In Brussels, we presented our hydrogen HPDI fuel system to key policymakers, highlighting its ability to substantially reduce CO2 emissions and align with EU decarbonization goals. It's crucial to become part of the conversation now as work is underway to shift sentiment given that internal combustion engine technologies are being recognized as part of the solution for our future. Our message is clear: the lowest cost CO2 abatement is using internal combustion engines fueled by HPDI technology, representing the most cost-effective pathway to deep decarbonization of long-haul road freight. In Washington, DC, we participated in the Hydrogen Americas Summit, exploring the topic of hydrogen mobility applications. One focal point of the discussion was examining opportunities for widespread mobility decarbonization through hydrogen combustion, an area where hydrogen HPDI can lead for heavy-duty transport. Every discussion we have with industry participants and policymakers is a win, as we advance our story and highlight our lower cost solution for using advanced internal combustion engines with hydrogen to contribute to decarbonization in the long term. Engines equipped with our fuel system provide a superior combination of attributes compared to fuel cell systems, diesel-fueled engines, and spark-ignited internal combustion engines, including greater efficiency, higher power density, and lower total cost of operation. We genuinely believe we have the solution for hydrogen utilization in heavy-duty transport and remain committed to disseminating our message and educating potential OEM customers on the unique and significant opportunities our technology brings. As our analysis has made clear and as industry observers have noted, internal combustion engines fueled with hydrogen or biomethane can achieve equal or greater CO2 reductions compared to fuel cells while preserving manufacturing and capital investments. Our hydrogen HPDI fuel system offers more power, more torque, and a more efficient use of hydrogen, thus providing the best opportunity for hydrogen internal combustion engines in real-world usage. Biomethane, along with the growth we've witnessed this year in usage in heavy-duty transport, is an area we are excited about as 100% biomethane in HPDI achieves 100% well-to-wheel CO2 reductions. Let me emphasize that again: HPDI with 100% biomethane achieves 100% well-to-wheel CO2 reductions. As the share of bioLNG increases and the size of the deployed fleet grows, the total CO2 reductions well-to-wheel accumulate rapidly. Continuing this momentum is vital to mitigating the full effects of climate change, and the speed of that mitigation is paramount. With the increasing substitution of renewable fuels like biomethane, our products can further decrease transportation's greenhouse gas impact, and they do so much more affordably than battery electric vehicles, for example. HPDI with natural gas and renewable natural gas works effectively and efficiently. It's available now and can help lower operating costs while helping fleets achieve their carbon reduction targets. Pay attention to what is happening in Europe right now; support for renewables and biomass continues to increase in the wake of the EU energy crisis. In the third quarter, the European Parliament voted to increase the share of renewable energy from 40% to 45%, and while a bio-based joint undertaking is estimated to allocate $2.4 billion for private investment in biomass infrastructure by 2024. Why talk about biomethane, you might ask? Because biomethane is today's hydrogen. It's available, it reduces greenhouse gases, it's affordable, it's scaling right now, and HPDI works today with biomethane and will work with hydrogen tomorrow. The development and testing of our hydrogen HPDI fuel system solution is a key step to providing our customers with a pathway to significant emissions reductions. I want to provide an update on some of the projects we have underway. We recently announced impressive test results from our joint demonstration program with Scania. As you know, we applied our hydrogen HPDI fuel system to Scania's 13-liter CBE1 platform. Scania’s next-generation, best-in-class engine is intended for Euro VII on-highway emission standards. Test results using our hydrogen HPDI solution, which requires limited redesign of the cylinder head and no redesign of the external gas exchange system or crankcase ventilation system, show performance with a peak brake thermal efficiency of 51.5%. This is complemented by a 48.7% Brake Thermal Efficiency at road load conditions. This is a significant achievement given that the 50% Brake Thermal Efficiency mark with diesel has been seen as the industry's loftiest goal, and we've been able to eclipse this number by 1.5 percentage points, truly validating our technology. Additionally, we demonstrated that hydrogen can be combusted at the same compression ratios as the diesel engine uses without the limitations that all fuel-injected hydrogen engines struggle with. The fact that we've achieved higher BTE over and above the best-in-class engine, simply by modifying the fuel system while retaining the engine architecture and the on-engine HPDI fuel system component, demonstrates the tremendous value and best-in-class performance that HPDI offers. What truly excites us is the strong potential for industrialization and a commercial product launch. This isn't just a laboratory test. Hydrogen HPDI has all the ingredients to be turned into a product appreciated by truck drivers and fleet owners. The feedback from the announcement has been significant. OEMs have been reaching out to us. We remain very optimistic that the compelling benefits of hydrogen HPDI will lead to commercial availability later this decade. We're proud to partner with Scania for this demonstration program, and we look forward to the next steps. In addition to our work with Scania, we also have a program underway with TUPY and AVL aimed at combining advanced material and testing technologies with hydrogen HPDI. We anticipate being able to detail the results of this collaboration in late in the first quarter of next year. And just a reminder, hydrogen HPDI offers a lower total cost of operation, nearly 20% lower than a fuel cell vehicle over just five years and 580,000 kilometers. For the truck customer, it's a lower upfront acquisition cost with a proven design and durability. For the OEM, it's a familiar product and the ability to reuse substantial investments that have already been made in powertrain manufacturing and supply chain. A nearly 20% reduction is a significant number and is steering conversations with more potential OEM partners, as is the opportunity to avoid new investments in fuel cells, batteries, and motors, and to reuse existing engine manufacturing assets. The results from the work we continue to do in these projects are informing our current customers and other energy players, and importantly, are bringing us new potential OEM customers. Now switching focus to the rest of the LPG market. Despite the headwinds which I discussed earlier, we are seeing strong demand and higher sales in key markets like Poland, Algeria, and Peru. The large and increasing price advantage of LPG compared to petrol is driving our results also in the Netherlands, Italy, and Turkey. We are implementing price increases to mitigate the effect of inflation. To date, we've achieved some success with margin resets in the quarter. Surely, we have more work ahead of us since there's no sign that inflation is going away. Fuel and geographic diversities are important core aspects of our overall offering. We can pick up market share in areas where the spread between petrol and alternative fuels is favorable. This includes growth in new markets like Thailand, Peru, and Bolivia, all emerging markets with regulations emphasizing the need for cleaner transportation. In Peru, for example, we're seeing a growth trend emerge. The price of LPG compared to gasoline is nearly $0.70 a liter cheaper. This is a significant spread in a cost-sensitive market. In India, despite the recent narrowing of the spread between CNG and Petrol, the overall trend continues to be positive. Currently, in the Indian market, the average running cost of a CNG-fueled vehicle has jumped from INR 1.2 per kilometer to now INR 2.6 per kilometer. But the running cost of gasoline-fueled vehicles is nearly double that at INR 5.1 per kilometer. This favorable operating cost advantage for CNG supports our positive outlook for our business in India. In fact, at IAA, we met with several Indian OEMs who expressed interest in many of our solutions, including HPDI with methane and hydrogen. The CNG filling network in India is expanding quickly, with the government committed to increasing the number of filling stations by 10,000 by the end of the decade. Westport is poised to benefit as the impact of products we offer are used in all OEMs. In summary, despite some macro headwinds that we faced, high fuel costs and a continued focus on carbon emissions create opportunities for our business as both industry operators and end customers look for lower-cost options. What we're seeing in key markets with LPG is a clear example of that. With that, I'd like to turn it over to Richard to go through our financials.

Good morning and thank you, David. Despite a challenging macroeconomic and geopolitical environment, I want to start by highlighting that fundamentally, Westport delivered better performance year-over-year in the third quarter of 2022. However, this is not readily apparent due to the negative impact of foreign currency translation from the weakening of the euro against the US dollar. Total revenues for the third quarter 2022 decreased 4% to $71.2 million compared to $74.3 million in the same prior year period, primarily driven by the weakening euro. Excluding the impact of foreign currency translation, total revenues increased by 10%, mainly due to a rebound in the performance of our independent aftermarket business and the resilience and growth in the portfolio of OEM businesses like delayed OEM, electronics, and hydrogen. This is a remarkable achievement given the significant challenges presented by the impact on sales volumes on volatile LNG and CNG fuel prices, sanctions on Russian customers, inflationary pressures on production, and continued supply chain disruption. Loss from operations of $10.9 million and a net loss of $11.9 million for the third quarter of 2022 compared to a net operating loss of $8.6 million and a net loss of $5.8 million for the same prior year period. The increase in operating loss was driven mainly by a $2.6 million unrealized foreign exchange loss caused by the depreciation of the Canadian dollar and euro against the US dollar. In our adjusted EBITDA calculation, we exclude unrealized foreign exchange gains and losses to better reflect the underlying performance of our business. For the quarter, adjusted EBITDA was negative $4.5 million compared to negative $1.4 million in the same prior year period. Adjusting for the unrealized FX loss in the prior year period, the operating loss decreased by $1.2 million year-over-year due to higher gross margins generated in 2022, driven primarily through increased sales in multiple OEM businesses and a more normalized sales mix of heavy-duty OEM systems parts. However, this better performance was offset by the loss of equity income from the termination and sale of the Cummins Westport joint venture. The comparative result in 2021 included $3.8 million in equity income from the joint venture. Turning to our business segments, OEM revenue for the third quarter of 2022 was $44.1 million, down 8% compared to the prior year quarter. The 16% decrease in the average euro rate versus the US dollar for the third quarter was the main driver for the decrease in revenue. However, this was partially offset by higher sales in delayed OEM, fuel storage, hydrogen, and electronics. The impact of Russian sanctions was significant to our light-duty OEM business, as we generated approximately $3 million less than the prior year quarter. The impact from the Russian-Ukraine war on CNG prices also negatively impacted our sales volumes in the European market. On a positive note, we saw an increase in light-duty OEM sales to our Indian OEM customers for the period. In our heavy-duty OEM business, our sales volume to our initial OEM launch partner decreased 16% compared to the same prior year period, but remains comparable on a year-to-date basis. This is a direct result of the unfavorable pricing differential between LNG and diesel in Europe. Higher LNG prices continue to cause a significant challenge in demand for LNG trucks, which is expected to temper our expected volume growth for our OEM launch partner until relative LNG prices return to a more favorable equilibrium. The operating loss of $7.3 million for the segment was comparable to the prior year due to better gross margin. Gross margin improved to $4.7 million, or 11% of revenues from the third quarter compared to $3.1 million or 6% of revenues in the prior year. We saw a strong increase in gross margin driven by increased sales in multiple OEM businesses, as discussed before, and a more normal mix of HPDI systems components, along with higher engineering services revenue. In the third quarter of 2021, we had a higher sales mix of spare parts in our heavy-duty OEM business for warranty purposes that had lower margins. The improvement in gross margin was partially offset by the annual contractual price reduction to our OEM launch partner and a decrease in margin in our light-duty OEM businesses due to a higher mix of sales to emerging markets that generate lower margins. Further, we continue to experience higher production input costs from supply chain challenges and inflation in logistics, energy, and other costs, which we have only partially been able to pass through to our OEM customers. Research and development expenses for the third quarter were $6.5 million, slightly higher year-over-year. Our heavy-duty OEM R&D continues to focus on the development and demonstrations with potential OEM customers of next-generation HPDI fuel systems, particularly with the use of hydrogen. Our light-duty OEM R&D is focused on the development of new LPG fuel systems to meet upcoming Euro 7 standards. Now turning to independent aftermarket. Our business continues to be resilient in the face of macroeconomic challenges with some positive encouraging trends. Revenue for the quarter increased by 3% to $27.1 million compared to the prior year period. Despite the significant impact of foreign exchange translation discussed previously, higher sales in Eastern Europe as well as in Algeria and Peru generated higher revenues year-over-year. Our focus on entering new markets and better competing in the markets we are currently in has enabled us to offset some of the loss of revenue to the Russian market from sanctions as a result of the Russia-Ukraine conflict, an impact of approximately $4 million for the nine months to date in 2022. Gross margin was $6.6 million or 24% of revenues for the quarter, down slightly compared with the same prior year period. The decrease in gross margin and gross margin percentage was mainly the result of higher production input costs occurring in material, transportation, and energy costs. Looking ahead, support of LPG pricing is creating a promising demand trend for our business as Westport continues to address in certain markets for customers looking to save money on fuel costs. Finally, I'd like to touch on liquidity. Our cash position decreased by $11.7 million during the quarter to $86.5 million. The decrease was primarily from net cash used in operating activities, modest capital expenditures, and repayment of $3.6 million of debt. Our net cash flow used in operating activities was $8.6 million in the third quarter, a decrease of $5.8 million from net cash used of $14.4 million compared to the same prior year period. The decrease in cash used was driven by net changes in working capital, specifically in inventory. Our inventory levels have remained consistent since the second quarter of this year due to lower than expected sales volumes in Russia and the timing of delivery of some tenders in the independent aftermarket that we anticipated in the third quarter that have been pushed to the fourth quarter, resulting in less of an inventory reduction than expected. Our net cash used from investing activities in the quarter was $2.5 million, primarily driven by our investments in capital expenditures for the expected growth in our portfolio of OEM businesses. Net cash flows used in financing activities were $3.6 million for the third quarter, as we continue to pay down our debt, and we anticipate that we will pay down an additional $3.1 million in the fourth quarter of 2022. We remain focused and disciplined with our capital allocation and resources to execute our strategic and operating plans and, as such, improving profitability and liquidity. Although we saw some improvements in gross margin this quarter, we continue to see pressure on gross margin from inflation, and this is an area we continue to work to improve. Work continues with our customers in both OEM and independent aftermarket to implement price increases and other actions to improve our cost structure. As David highlighted, we do see positive signals of growth in our business and a path to profitability as sales volumes grow in our heavy-duty and light-duty OEM businesses. We are also optimistic about a continued improvement in 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 my closing remarks, I'd like to welcome Bill Larkin to the Westport team. Bill joined us in early October, and he will step into the role of Chief Financial Officer following Richard's resignation. Having previously served as CFO of Westport Innovations and Fuel Systems Solutions, the deep industry expertise and capabilities he brings will be instrumental in realizing our growth and profitability goals. Finally, as this will be Richard's last earnings call with Westport, I wanted to take this opportunity to thank him. Since he joined Westport, Richard has led us through a critical period and has positioned us for long-term success by strengthening our financial position. Richard has been a valuable member of our management team, and we wish him all the success in the future. Before we close, let me touch on the written notice we received from NASDAQ last week regarding the company not being compliant with the minimum bid price requirement. As we highlighted in our press release yesterday afternoon, we have 180 calendar days to regain compliance until May 2, 2023. Let me be clear: we fully intend to resolve the deficiency and regain compliance with NASDAQ's Listing Rule. Our operations are not affected by the receipt of the notification nor is there any impact on the listing of our common shares, as we continue to trade normally. Finally, let me close with a few final points. Westport delivers market-ready transportation solutions to OEMs, fleets, and individuals that deliver cleaner technology affordably right now. We remain encouraged by the long-term outlook for our business and are here as just three reasons why. First, low and zero emissions transportation is our future, and HPDI is our story; performance and efficiency, even better with hydrogen, provides an affordable solution to the market. Second, the growth of our LPG business continues to address underserved markets that look for clean solutions without spending on expensive electric vehicles. 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 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'll now begin the question-and-answer session. Our first question is from Eric Stine with Craig-Hallum. Please go ahead.

Good morning, everyone.

Good morning, Eric.

Hey, so you mentioned, obviously, some interaction coming out of a number of the demonstrations you've done and conferences with some Indian OEMs on HPDI. I'm wondering if you can provide a little more detail outside of India, I don't know whether it's by number of OEMs, accelerated talks with OEMs, anything just providing more details and also how the greater brake thermal efficiency plays into those discussions?

Yes, gladly, Eric. I think we had the chance, as you know, to bring our truck to the Long Beach show back in May, ACT Expo, and then we had our truck at the Hanover show in September. The combination of these events was really fantastic for us. And frankly, what we've been doing with the truck, the roadshow we referenced just a moment ago, has been very effective in terms of getting the truck in the hands of key individuals at OEMs around the world. As an example from Hanover, I spent time with nine different OEMs at the senior executive level, sometimes CEO, sometimes CTO, and sometimes Head of Purchasing. So a really great audience, frequently large contingents from OEMs came to our stand to discuss and review our technology. These conversations were invaluable because, in the grand scheme of things, our technology isn't as well known as it needs to be. Having the truck and showcasing our innovation is changing things for us as we market this important technology to the industry. So those discussions mentioned about Indian OEMs, but also Chinese OEMs, European OEMs, and North American OEMs—we are truly covering all major markets globally. I also had the opportunity to spend a week in Japan recently meeting with OEMs there. So, fundamentally, we're covering a broad base and receiving a fabulous response. Additionally, we pile on with our recent results from our project demonstration with the Scania engine. This is just an extraordinary result. I remember in my career many years that the US Department of Energy had hundreds of millions of dollars in funding available for companies to demonstrate a pathway to achieving 50% brake thermal efficiency. To put things in perspective, most of the engines on the road today in all markets operate with a brake thermal efficiency in the range of 43% to 45% or even 46%—which represents an improvement over prior decades. The goal that the DOE has held for long has been 50% Brake Thermal Efficiency from a diesel engine. Now, our ability to apply hydrogen HPDI to Scania’s engine showed a peak brake thermal efficiency of 51.5%, representing a tremendous achievement. It sets the stage for what we can accomplish next in terms of the full mapping and capabilities of the engine as we continue our development projects with customers. It is an incredibly exciting time for us. We've been in production with HPDI using methane for quite some time, and these trucks are well-received in the marketplace. Our ability to illustrate our path from fossil natural gas to biomethane and then ultimately hydrogen in the future is compelling for OEMs globally.

Yeah. No, that's great. And good segue, I guess. My next question was just going to be how the data points—which clearly, I mean, other OEMs are watching closely—play into others beyond your launch partner today to consider LNG as that interim solution for those who may be saying that they're not looking to move to HPDI utilizing LNG if they are willing to wait for hydrogen in five-plus years. Are you seeing that movement, or is that something that you expect to see going forward?

We're seeing it, and we're expecting to see more of it, is the short answer, but let me just expand a bit. Fundamentally, I'll tell you in the marketplace there has been so much pressure from various constituencies around the world, getting basically every segment—the media, investors, OEMs, and fleets—all focused just on zero, and this notion that electrification is the shiny object that we must pursue, along with fuel cells being the necessary technology for moving forward—the idea that hydrogen equals fuel cells has pervaded the industry in every market globally. So, when we show up with hydrogen HPDI and hand people the keys to a truck, they realize that there’s another attractive economic path available. All of the OEMs we are talking to around the globe have billions of dollars invested in engines, in internal combustion engine manufacturing, in the supply chains for that manufacturing, in delivery, and how that engine fits in the vehicle, ultimately servicing those engines. We have a substantial installed base of capability and manufacturing around internal combustion engines. So when we demonstrate that we can retain that internal combustion engine and make it run on zero carbon hydrogen, while providing more power, more torque, and more efficiency than you can achieve with diesel or natural gas engines, that becomes exciting. The next logical step in the conversation is: Given that there isn't a massive installed base of hydrogen—this technology that Westport provides also works on methane and biomethane—why wouldn’t we begin that transition now? Summarily, with respect to methane, we spent a significant portion of our discussions with customers at Hanover helping them understand the public data regarding the efficiency and capabilities of our products. I believe there is a significant number of stakeholders within the public domain—including media, investors, and customers—who think all natural gas engines are the same, that they all involve a spark plug, lower compression ratios, a three-way catalyst, delivering 15% lower torque, and significantly reduced efficiency. Thus, we have been dedicating time both at our events and privately with OEMs to help them understand that the product we have in the market today with our lead OEM customer preserves all of the capability of diesel in terms of power, torque, and efficiency. Therefore, in real-world applications and testing, it's delivering a 30% lower consumption of natural gas. So, whether it's natural gas or biomethane, reducing the fuel cost by 30% utilizing HPDI as opposed to a spark plug is not as well known as it genuinely must be. We are actively working to clarify this and pointing to the relevant data in the marketplace. I think the combination of dramatically better fuel consumption figures—with all of the power and torque—utilizing methane, biomethane, and the potential path toward zero carbon hydrogen is compelling for OEMs around the globe.

Okay. Thanks, David.

My pleasure. Look forward to seeing you soon.

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

Good morning.

Good morning, Rob.

I think you mentioned in your script some hydrogen revenue in the quarter or in the year. Could you kind of elaborate on the revenue you're getting from hydrogen at this point?

Yes. So we have, let's say, two areas I would classify as being hydrogen. So we've been discussing hydrogen HPDI a lot, and I would categorize our revenues in that context as relatively modest—really low single-million dollar figures from multiple OEMs, primarily in a cost recovery mode. We’re partnering with them to demonstrate our technology on their engines. The other aspect of our hydrogen business relates to hydrogen fuel system components that we supply to connect fuel storage—700 bar and 350 bar tanks—to fuel cells. We’ve been involved in that business through our GFI brand for over a decade, and we are witnessing great growth. We are currently a leader in that technology, with products available for companies like Plug Power and other fuel cell manufacturers in both North America and China and increasingly in Europe, as European OEMs begin to develop their own strategies regarding fuel cells in their product mix. So that's a crucial part of our business that continues to expand and keep us very engaged.

Okay, great. Thank you. And then you sort of alluded to a path to profitability. I know you don't provide guidance, but what's your view on that trajectory? Can you be profitable in 2023? And what might that depend on?

Yes, with respect to our profitability trajectory. It has been evident for some time that our joint venture with Cummins concluded at the end of last year. This led to a step function reduction in our profitability trajectory. However, we anticipate profitability growth that will ultimately get us to a profitable state. That is where I referred to our previously discussed mid-decade goals being a bit further out. The $1 billion revenue and 20% gross profit targets we are fully committed to, but after COVID and subsequent supply chain issues, along with the war in Russia, we have had setbacks to that timetable. Nonetheless, we see that coming. It's fundamentally driven by growth, Rob. So we need to see our HPDI volume growing along with the hydrogen storyline we're currently promoting, which will help significantly. We are beginning to observe a decrease in natural gas prices in global markets from the extraordinary peaks following the initiation of the war in Ukraine by Russia. That dynamic and changes to the landscape of natural gas flows—coupled with increased exports from the US and ongoing developments on new natural gas pipelines and LNG terminals—will take some time. We are witnessing a decrease in natural gas prices, and this will facilitate our growth, which is crucial to achieving profitability.

Great. Thank you. I'll turn it over.

Thank you, Rob.

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

Just quickly on the margin strength for the quarter relative to last quarter, is there anything unique this quarter compared to last quarter? And then going forward, should we continue to expect gross margins at the 16% level?

Why don't I handle that one, Amit? The biggest difference that we had this quarter compared to last quarter was increased performance within our OEM businesses, which include electronics and hydrogen. Our fuel storage did very strong and delayed OEM. That said, we also had a particular HPDI component, which had a lower margin because of the replacement of that component, and that has now improved. So, in terms of performance with heavy-duty, that has also improved. This should carry through slightly. But in terms of modeling out a specific percentage, it does move around a little bit. However, yes, we do expect a bit of improvement.

Understood. Thank you for that, Richard. With all the macro challenges you guys are facing, in that context, what are the drivers of.

Hey Amit. I apologize. I'm really struggling to hear you. There seems to be a connectivity issue perhaps with your phone as I can't get your whole question. I heard macro-environment.

I was just trying to say if there are any solutions to this foreign exchange pressure?

I can discuss foreign exchange briefly. We are naturally hedged as the majority of our revenues are in euros, and the majority of our expenses are also in euros. This softens the impact on our bottom line from foreign exchange. Unfortunately, it does not help the top line as we report in US dollars, which leads to currency conversions. This translation impacts about 70% of our business in Europe, hence why we call it out during our earnings announcements. I would say our underlying business had an overall performance improvement of about 10% during this turbulent macroeconomic and geopolitical environment.

Understood. That's helpful.

I am going to move on to the next caller, if that's all right. We seem to have difficulty hearing Mr. Dayal. The next question is from Colin Rusch from Oppenheimer. Please go ahead.

Thanks so much, guys. Can you talk a little about the progress that you're making on engineering subcomponents for the hydrogen system? Obviously, producing a vehicle is a big deal, but getting ready for mass production is another level of preparation. Just curious about how that's coming along.

Yeah, thank you for the question, Colin. You're correct that demonstrating a vehicle is a big milestone for us, and we're happy about that. For our demonstrators, we have utilized off-the-shelf components that are already in production for our natural gas products. From our perspective, those demonstrators are working well. We fully recognize, however, that there is some optimization and validation we must pursue in this period to prepare for future hydrogen products. I would suggest that those production hydrogen products will target a launch time frame somewhere between 2025 to 2027, as the normal cycle for OEMs will require full development and validation of the calibration and hardware, which incorporates the engine, our fuel systems, fuel storage, and overall vehicle integration. We’re making progress with modest investments as most of our hardware is largely already in production. We do expect some adjustments as you can imagine; for instance, when developing the injector, we conduct computational fluid dynamics analysis on the combustion system to evaluate its differences with hydrogen compared to natural gas, making necessary modifications to the nozzle. The ongoing testing and development of novel patterns suitable for our clients’ engines and hydrogen fuel are well underway. That is, I would say, a normal part of our business, with a few adaptations due to hydrogen.

Okay. That's super helpful. And then maybe I missed it, but can you just give us an update on how the HPDI 2.0 ramp in China is progressing, along with any signals regarding inflection points?

Yes. Thank you for that. We haven't discussed it much in this call thus far. There has been progress, but we are cautious about calling any timing on when the product might hit the market. A positive development on a global scale is the observation of decreasing natural gas commodity prices—which, as I mentioned, serves as a backbone for any natural gas product in China, which is being sold primarily based on total cost of ownership. And that fuel price must return to a more favorable position to make any natural gas product in China commercially appealing. That said, our customer is still performing essential preparations to be ready to launch the product. Therefore, I do not have specific timing to share with you, but I can confidently say that they are actively working toward that goal.

Perfect. Thanks, guys.

Additionally, I should add, we’re spending a substantial amount of our efforts engaging with customers throughout China regarding hydrogen. Hydrogen infrastructure in China is, in fact, more developed than that of other markets, boasting more than 1,000 hydrogen stations, according to recent figures. Thus, the push for hydrogen in China is robust. You may have observed a number of announcements regarding hydrogen spark-ignited engines running low-volume demonstrations, but we view hydrogen HPDI as a significantly superior product since it provides more power, torque, and efficiency than can be achieved with spark-ignited hydrogen. We believe this constitutes an essential part of what we're doing that will yield benefits in the future.

That's quite helpful. I appreciate the color.

Next question is from Jeff Rossetti with Cowen and Company. Please go ahead.

Good morning.

Good morning.

David, you mentioned earlier that you expect to release results from your AVL 2P demonstration at the end of Q1. I was wondering if you could provide any findings you might expect and how it might be differentiated from Scania. And if there was any update regarding testing with Cummins?

Absolutely, Jeff. To start with AVL 2P, we have the engine in our test cell with our hardware integrated into it. Their OEM engine features our hardware, and we’re in the development phase. Results for this collaboration depend on our partners at AVL and 2P, and we hope to provide some information—if not concrete data— to the market in Q1 as we indicated. We expect outcomes similar to those we've seen with other engines, which indicate that applying our hydrogen HPDI technology to an engine, formerly diesel, will yield about a 20% power improvement, a 15% torque enhancement, and a 10% increase in efficiency. These are significant figures; typically, you don't experience double-digit percentage growth across all three metrics simultaneously, yet we have accomplished this on numerous engines. Some results are already available through various platforms, and we’ve shared significant details regarding our Scania efforts. For AVL, we are excited about the potential contributions that TUPY can make concerning the engine structure. Having increased engine pressure capabilities can enhance the engine and ultimately improve our fuel system performance. We eagerly anticipate advancing through the development process and sharing results once we have permission to do so.

Great, and I appreciate the detail you provided on your path to commercialization of hydrogen HPDI. I noted you referenced 2025 through 2027 as a potential commercialization timeline. Are there any milestones that you're targeting for 2023 to put you on that path?

Expect in 2023 that you’ll hear more from us about developments like the AVL and TUPY projects, for instance. We anticipate more OEMs will emerge to test our fuel systems on their engines. Moreover, with existing OEMs like Scania and others, there will be further milestones we expect to announce. Road demonstration fleets could be forthcoming as well. Consider some of the initiatives we've seen in the fuel cell sector—Hyundai and others have demonstrated fuel cells in various locales. I believe similar efforts should be attainable for us as well. Our demonstration vehicle, which we've showcased in Long Beach and Hanover, is a driving prototype that can tow significant freight—40 tons, for instance—all on hydrogen, emphasizing zero-carbon hydrogen utilization. Establishing demonstrator vehicles involves certain certification and exemption processes, but we expect to announce additional activity regarding this initiative in 2023 for anticipated deployments in 2024, 2025, and 2026. This outlines the path we envision ahead.

Thanks very much.

My pleasure.

The next question is from Chris Dendrinos with RBC Capital Markets. Please go ahead.

Hi, thank you. I just wanted to hone in a little bit more on some of your comments regarding policy. I think one of the bigger investor concerns is that most incentive programs currently focus more on battery technology. Relative to your discussions in Brussels and Washington, what has been the reception of policymakers to technologies that might not be precisely zero emissions, and what is their understanding of the technology today?

Yes, it's an essential question, Chris, and thank you for raising it. It's critical for us to devote time with our trucks and teams to speak and inform policymakers around the world because, merely two years ago, there was a lack of awareness or understanding regarding internal combustion engines with hydrogen. As it stands, most people—and I would say virtually all individuals—believe that if it's hydrogen, it must be a fuel cell. So we've taken the responsibility to educate and expand understanding of the potential unveiled through our tests and our demo trucks, and that is the work we are continuing to pursue. Based on my experience in the industry, it's standard for regulators to draft regulations for technologies they have confirmed will work. This was the case with the US Department of Energy for decades—they promote and demonstrate technologies so regulators may construct regulations around them. This modus operandi is true across the industry. Therefore, as we inform policymakers and demonstrate what is achievable, it will subsequently enable them to draft regulations that promote and improve the climate regulatory landscape because we can make big improvements in long-haul trucking CO2 emissions by 15% by 2025, and 30% by 2030 in Europe. Furthermore, everyone in Europe is brainstorming how to implement tougher standards. With a technology like hydrogen HPDI capable of delivering a 98% reduction in carbon emissions affordably, we will significantly impact fleet averages given the fleets that utilize it. Thus, we are excited about the future.

Got it. Yeah, thank you. I guess, switching gears really quickly, focusing maybe on some of your inventory levels. I think you previously mentioned you were looking to monetize some of that or draw down to have a more effective use of working capital. Can you provide any updates on that process? What are you thinking right now and possibly the capability to monetize some of that?

Yes, an excellent question. I must admit that our inventory is too high, at levels we do not wish to sustain. So, we are actively working to reduce that inventory. I would state two driving factors for that situation: First, on the electronics side—the industry experienced chip shortages during the pandemic, which is not a new issue. Several of our suppliers came to us and stated they need clarity and certainty about what we require, requesting orders for materials 18 months in advance. We had to lock these orders in, meaning we are holding onto quite a bit of inventory of chips, we anticipate unwinding that as supply chains normalize. That could unlock about $6 million to $8 million of inventory connected to electronics. The second aspect of our HPDI inventory is considerably higher than necessary, primarily because we haven’t seen the sales volume growth that we anticipated. We built inventory based on projected demand, deterrence stemming from the Russian-Ukraine war and high LNG prices. However, we do expect to monetize this inventory, particularly as we transition products into regions like China in partnership with Weichai. That said, managing our inventory to convert it to cash is higher on our priority list. Thank you, Chris.

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

Thank you very much, and thanks, everyone, for joining our call this morning. The top line for our company indicates we've faced a tremendously challenging environment, and the challenges persist, but we are continuing to progress. Our revenues have gone up 10% year-over-year absent foreign exchange, and amidst rising natural gas prices, both CNG and LNG, alongside the repercussions of the ongoing war in Russia, I believe a lot of prospects recognize that by 2025 and 2030 in Europe, we need significant strides in CO2 reductions across long-haul trucking. European policymakers are considering how to elevate standards. Our hydrogen HPDI technology is not just viable; it offers a 98% reduction in CO2 emissions at an affordable price. This will have a substantial impact on fleet averages of customers that use it. So, we see a bright future ahead. We appreciate the chance to speak with all of you today and respond to your inquiries. I look forward to connecting with investors at the Craig Hallum Conference next Thursday in New York City, followed by an upcoming Capital Markets Day on December 8 in Toronto. I look forward to continuing the conversation and expanding your understanding of the bright and promising future for Westport Fuel Systems. Thanks again for your time. Have a great day.

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