Power Solutions Is A Rocket Ship, But How High Is Too High? - PSIX

Last November I wrote about Power Solutions International, a high growth natural gas engine company trading at a very reasonable price. Since then, shares have rocketed 150%.

Growth has been strong since I wrote, but multiple expansion is responsible for most of the gain. In November, PSI traded at 11.6x trailing operating income. Now the company trades at a much loftier 27.4x trailing operating income.

In my original post, I noted Power Solutions would be eligible for an uplisting after filing its 2012 annual report. Sure enough, PSI wasted no time, announcing a listing on the NASDAQ in late May.

But enough self-congratulation from me. The question on my mind is: what now? Is Power Solutions International's huge increase in value justified by its business performance and outlook? Or is this rise predicated more on hype?

In November, at 11.6x trailing operating income, Power Solutions didn't have to keep growing at 30%+ annually to justify its valuation. Plenty of solid companies growing at 8-10% per year trade at that level or higher. So long as the company continued to operate profitably and make good decisions, investment profits were likely. Even at 15% growth, less than half of what PSI had historically achieved, a 11.6x trailing operating income multiple falls to 7.6x in three years. At some point, the stock price of a successful, growing company has to rise, else its valuation multiple will compress to the point where the company will be irresistible to a competitor or a private equity firm.

27.4x trailing operating income, on the other hand, is an entirely different story. At that multiple, Power Solutions absolutely must maintain its torrid growth to justify its valuation. If revenue growth were to slow for any reason, the resulting multiple compression could spell a very sharp decrease for PSI shares.

Valuation multiples are expressions of expectations. The higher the multiple, the higher the expectations and vice versa. When a company with a low valuation multiple (and low associated expectations) experiences slow growth or loses market share or takes a restructuring charge, its share price is usually not punished severely. It's like playing dodgeball: nobody expects the kid picked last to last long. On the other hand, a high valuation multiple company that misses a revenue forecast or whose product is rejected by consumers can fall a long, long way.

It's about risk. No matter its valuation multiple, Power Solutions International faces the very same risks. Natural gas prices could rise, derailing the trend toward natural gas engines. Competitors with larger R&D budgets like Westport could out-innovate. A product recall could destroy confidence in PSI's engines. At a low valuation multiple, a disappointment is just a bump in the road. At a high valuation multiple, a disappointment is a disaster, a reason for questioning a company's entire story.

Maybe Power Solutions International will continue to perform flawlessly and the share price will rise to $50, $60 or even higher. But at 27.4x trailing operating income, the risk is just too high. A single setback could send the share price tumbling.

Power Solutions International is a success story that has gotten ahead of itself. I'll be moving it to the "Inactive Ideas" section and going looking for the next cheap, growing and unlisted company!

No position.