Catalytica Energy Systems CESI
December 28, 2004 - 11:42am EST by
2004 2005
Price: 2.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 45 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Investment Thesis
Catalytica Energy System (CESI) provides pollution and emissions control services to the power generation and transportation industries. CESI is a micro cap company with a market capitalization of $44.72 mil, sales of $4.929 mil LTM and net cash on balance sheet of $38.921 mil. The stock price is currently $2.50, the 52 week high was $4.26 and the 52 week low was $1.66.
CESI with its cash on balance sheet, interesting institutional ownership and portfolio of pollution control technology presents an interesting investment opportunity. If the CESI technology is adopted there is significant upside. If technology is not adopted, the cash on balance sheet offers downside protection. I think CESI stock should trade above $3.00 in 2005 as its Xonon technology for gas turbines enters production and there is new natural gas based power plant construction.

Company Background
CESI offers catalyst regeneration services to power generation and transportation industries that use selective catalytic reduction (SCR) systems to reduce NOx emissions. NOx is the generic term for a group of highly reactive gases, all of which contain nitrogen and oxygen in varying amounts. Many of the nitrogen oxides are colorless and odorless. However, one common pollutant, nitrogen dioxide (NO2) along with particles in the air can often be seen as a reddish-brown layer over many industrial areas. Nitrogen oxides form when fuel is burned at high temperatures, as in a combustion process. The primary sources of NOx are motor vehicles, electric utilities, and other industrial, commercial, and residential sources that burn fuels
CESI business activities include the design, development, manufacture and servicing of pollution control products based on proprietary catalyst and fuel processing technologies to reduce NOx emissions. CESI offers a commercially available catalytic combustion solution, Xonon Cool Combustion, that enables natural gas-fired turbines to achieve ultra-low NOx emissions. CESI is also actively pursuing the development of NOx reduction solutions for mobile, stationary and off-road diesel engines and fuel processing systems for proton exchange membrane (PEM) fuel cells used in vehicular applications.

Valuation - CESI’s cash cushion creates a cheap option on CESI’s pollution control technology

Margin-of-safety - CESI has $38.921 mil. in cash on balance sheet and has an equity market capitalization of $44.72 mil. (17.890 mil shares @ $2.50). Total debt is $3.08 mil. Net cash per share is $2.003. The current price is $2.50.

The critical question is what is cash burn. For 2004 the company expects to burn 17-18 mil. Anticipated cash at end of 2004 assuming $18 mil burn rate for 2004 is $34.682 mil. Projected net cash per share at end of 2004 of $1.766. The company expects to burn cash in 2005 but has not provided a dollar amount. Assuming they burn around $9 mil in cash, the projected cash at end of 2005 will be $25 mil. or $1.397 per share. The $9 mil. is a very aggressive cash burn projection that assumes CESI to have the same cash burn as in 2004 adjusted for SCR-Tech LLC purchase. Management expects cash burn to be reduced in 2005 as CESI pollution control technology is adopted and cost cutting measures are implemented.

The worst case downside I see for this investment is CESI trades to $1.40 over 2005 if there are no positive events and cash burn is around $9 mil. I don’t see CESI burning through its cash reserves.

CESI main holders are

Morgan Stanley Private Equity 18.831%
Baupost Group 14.533%
Farallon 12.716%

I think it is highly unlikely that these investors will let management burn through its cash reserves indefinitely.

CESI’s management projects US NOx pollution control market today to be a $3 billion range. Even if CESI’s management is overly optimistic and the market is $1 billion, one-third of the projected $3 billion, that still leaves a large market for NOx pollution control services. It is difficult if not impossible to value CESI or its competitors like ADA-ES (ADES) or Fuel-Tech (FTEK) on current (or near term) free cash flow or other traditional value metrics. But CESI has strong cash on balance sheet position that provides investors with a cheap option on its technology while providing for downside protection if the technology does not work out.

Positive Short Term Catalyst

SCR-Tech LLC Acquisition – CESI purchased SCR-Tech LLC in 2004. SCR-Tech has pollution control technology that is currently adopted by coal power plants. In my channel checks, I have heard a lot of positive things about SCR-Tech LLC – their technology, employees and customer service. Growth of the SCR-Tech pollution control technology for coal power plants could present significant upside to CESI.

Adoption of CESI’s Xonon-equipped gas turbines. CESI Xonon technology tested and already ready for use with Kawasaki gas turbines. Xonon-equipped GE gas turbines are scheduled for completion of full scale tests in 1Q. 2005.

Poison Pill Modification – CESI has modified its poison pill to allow existing large share holders to purchase additional shares without triggering the poison pill.

Positive Long Term Catalyst

Long term economic and environmental trends support catalytic pollution control technology. CESI technology is tied mainly to natural gas power generation. The collapse of the Merchant IPP (Calpine, Mirant, AES) has negatively affected CESI. Natural gas power plants are viewed negatively by the market today. I would take the contrary position – natural gas power generation will be the primary source of new power plants in the US in the next 20 years. The cap ex for building new coal power is too high. Nuclear power is politically dead. Where will electric power generation come from in the next 20-30 years?

I have checked with power plant operators at AES who use CESI and SCR-Tech products. They are positive on CESI and SCR-Tech technology and service. I expect positive news flow from CESI on technology adoption as natural gas power plant construction picks up over the next couple of years. AES is building new gas powered power plants in California. Calpine has created short term liquidity till 2007 and has stated that it plans to complete all its power plants projects (all natural gas powered) that are under construction.

Global warming and environmental and pollution control regulations are all positive factors for CESI technology adoption.

Risk Factors

Technological Obsolesce – A new technology or competitor.

Not a lot of trading volume/


Modification of Poison Pill, New Gas Power Plant Construction, SCR-Tech LLC acquisition
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