The Solvency Crisis and Fuel Tech Scenario Analysis

This article was originally published forMorningstar GrowthInvestorsubscribers on March 17, 2008.

When I wrote recently that there were still some lumps to come despite the Fed's liquidity actions, I didn't think we'd get to the "blowup" stage this quickly. The  Bear Stearns  collapse illustrates the nature of financial companies--once you lose the confidence of your customers and counterparties, you're sunk. Short of a full government bailout, the current solvency crisis will pass when the housing prices stabilize. Unfortunately, I don't think we're close to equilibrium with house prices.

A friend sent me a housing and mortgage presentation recently that made two key points. First, a potential purchaser's "buying power" has been significantly reduced. As recently as last summer, a homebuyer could obtain a loan equal to more than 8 times his or her gross annual income. Today, that leverage ratio has dropped to about 5 times gross income, and credit standards will only get tighter. That is a substantial loss of purchasing power and can only have a negative effect on house prices.

Second, lending standards began a slow slide in 2000 and then really fell off a cliff in 2005. The worst of those 2005 loans carried two-year teaser rates, and not surprisingly they started to default right on schedule in early 2007. The bad news is that we're still slogging our way through all these bad loans written during 2005, 2006, and early 2007. Moreover, it takes an average of 15 months from the first missed mortgage payment to the liquidation (i.e., sale by auction) of the home. So all those 2005 loans that defaulted in early 2007 are attached to homes that are headed to foreclosure/liquidation right about now. All the evidence suggests that this is only the first wave of what may be a tsunami of liquidations. My advice, as it has been all year long, is to sit tight and hold on to cash. There's going to be a great time to buy stocks, but for now, let's be patient.

Fuel Tech Scenario Analysis
After taking another look at  Fuel Tech (FTEK) after its earnings announcement, my colleague John Kearney stuck with his $53 per share fair value estimate. I agree with John's assessment, and I think Fuel Tech's management took a very conservative stance with its 2008 financial guidance. Fuel Tech is a company with a wide range of outcomes, and we've attempted to estimate Fuel Tech's value in three different scenarios: a base case, a pessimistic case, and an optimistic case.

I've published part of John's financial model for Fuel Tech on the GrowthInvestor Web site, mgi.morningstar.com (spreadsheets are available only to GrowthInvestor subscribers). In the spreadsheet, you can switch between the three scenarios by clicking links nears the top of the page. Scenario 1 is our base case ($53 fair value), or what we think is most likely to happen, while Scenario 2 is the pessimistic case ($14 fair value) and Scenario 3 is the optimistic case ($92 fair value). The key assumptions in each case are:

1. How fast will the Air Pollution Control (APC) business grow?
2. How much of the addressable U.S. coal-fired market will Fuel Chem capture?
3. How much of the addressable Chinese coal-fired market will Fuel Chem capture?
4. How much of the addressable Indian coal-fired market will Fuel Chem capture?
5. How much of the addressable European coal-fired market will Fuel Chem capture?
6. How much of the addressable Russian coal-fired market will Fuel Chem capture?

I've published another spreadsheet that summarizes the key assumptions in each scenario. As you can see, in our $53 fair value base case, we assume that the APC business grows significantly and Fuel Chem achieves a fair amount of success in the U.S. and international markets. You can also see that the current market price is close to our pessimistic scenario, which assumes middling growth for the APC business and very little success for Fuel Chem. I'm willing to take the view that Fuel Tech's business will perform much better than the market currently expects. All the Fuel Tech insiders who have been buying significant amounts of stock recently seem to think so as well. 

		Introducing the New Morningstar GrowthInvestor
	GrowthInvestor is a timely, interactive service that uses the Morningstar approach to picking and analyzing stocks to help you find great growth-oriented stocks.		It includes frequent e-mail communications from the editor with buy/sell guidance, investing ideas, and breaking news. Plus, access to a robust companion Web site. Learn more.
	$149.00 for a 1 Year subscription