HUDSON TECHNOLOGIES INC HDSN
July 27, 2013 - 6:59pm EST by
vfm343
2013 2014
Price: 2.34 EPS $0.30 $0.00
Shares Out. (in M): 26 P/E 0.0x 0.0x
Market Cap (in $M): 58 P/FCF 0.0x 0.0x
Net Debt (in $M): 22 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Industrial
  • Regulatory action
  • Out-of-Favor

Description

The Hudson Technology (“HDSN”) and the associated Hydrochlorofluorocarbons (HCFC) reclamation industry investment thesis is not entirely new to the VIC community as there have been a couple of write-ups posted in the past and periodical discussion posts on the topic. On March 28th bowd57 exited the recommendation (great timing) post the EPA Final Ruling on HCFC production allocation caps and since then the stock has dropped by approx. 50%. The drop that started with the EPA Final Ruling in March only amplified after the recent prelim second quarter guidance by the Company that projected towards much lower Q2 revenue and earnings than expected (due to approx. 30% drop in HCFC price as result of the Final Ruling and this seasons long winter). The drop in the stock price is an opportunity to reenter the stock as at current stock levels, as I see limited downside (EV of approx. $1.0 per share if inventories are included as cash) and an upside of 60 – 100% by late 2014 of mid 2015. Near term catalyst for the stock is in December post the EPA’s final ruling announcement on 2015-2019 consumption cap. The thesis might take longer to realize depending on the how quickly the existing inventories are deployed to fill the supply-demand gap.

Note – I have included a brief History section at the end of the write-up. Readers not familiar with the industry are encouraged to read the section first before diving into the remaining write-up) 

Company, industry overview and the wait for the Home Run:

HDSN is a virgin (new) and reclaimed chlorofluorocarbons (CFC) based refrigerant seller to the air-conditioning and refrigeration industry.

1)   Virgin refrigerants sale: Virgin refrigerants are purchased by the Company from suppliers and resold typically at wholesale

-          Currently this segment accounts for most of the Company’s revenues

-          Gross margins is around 30%, much lower than the reclamation segment

-          Virgin refrigerant was approx. a $1.0 billion industry in 2010

-          Top three manufacturers dominate about 85%+ of the production and supplies

2)      Reclaimed refrigerants: Reclamation is the reprocessing of used and recovered refrigerants in order to restore the substance to a specified standard. The process allows the refrigerant to be re-used thereby eliminating the need to destroy or manufacture additional refrigerant. The Company purchases used or contaminated refrigerants from many different sources. The refrigerants are then reclaimed using the Company's high speed proprietary reclamation equipment and resold to the market.

-          Gross margin is around 40-50%. Major factor that drives the gross margin is the purchase cost of the used refrigerant as the cost to reclaim the reused substance is minimal

-          Biggest reclamation agent (appox. 35 certified reclamation agents) with ~20% market share and top patented reclamation technology

-          Currently, only about 4% of the HCFC demand is reclaimed in US

 

Post the Montreal Protocol and the Clean Air Act regulation, EPA is supposed to lay out the production caps for HCFC with the purposes of phasing out the substance completely by 2020 (current production level is approx. 63mm pounds per year). EPA’s objective is to reduce the supply of virgin refrigerant available in the market and increase HCFC prices, thereby motivating users to increase reuse/recycle/reclaim the existing HCFC substance in the market or to switch to newer non Ozone Depleting Substance (ODS) using air conditioners and refrigeration systems. The Company and investors have been waiting for this tipping point that will drive the market to reclamation as the primary industry. The switch will not only boost the reclamation production level for HDSN but the increase in prices will also act as a windfall on the revenue and earnings.

Why hasn’t the thesis played out since the beginning of the HCFC phase out in 2010?

The phase out of HCFC-22 (or “R-22”) started with EPA’s 2010 Final Ruling whereby it reduced production allowance by a percentage of the estimated demand (80% in 2010 decreasing to 71% in 2014) and expected the market to meet the rest of the demand primarily via reuse/recycle and reclamation of the refrigerant. The ruling was supposed to kick-start the reclamation industry but then a couple of unforeseen factors stalled the industry from taking off, including:

-          Suppliers challenging the EPA Final Ruling and the court ruling in supplier’s favor leading to delays in implementing the allocations for the year 2010 and 2011

-          Excess inventory available in the market from the pre-ruling pileup and weak 2009 demand due to cool summer, did little to motivate reuse and reclamation

-          Uncertainties around the final allocation did not help the reclamation industry either

-          That said, the prices of HCFC have fluctuated between $4.0 - $12.0 per pound with the speculation on the final ruling and the future supply-demand gap

Why buy the stock now?

-          The stock has had a significant drop recently and back to its 2010 level. Current EV is only $25mm or approx. $1.0 per share, if one includes the inventory of $50mm (ignoring selling premium) as equivalent to cash

-          The reclamation industry is still in its initial phase as we are only in the 3rd year of the 10 year phase out process

-          Reduction in the allocation amounts will be very high post 2014 given EPA as to prepare the industry to transition from the 50mm pound consumption allowance in 2014 to zero pounds in 2020 (Approx. 10mm pounds or 20% reduction per year). Also post 2014, per the Protocol, consumption cannot be more than 60mm pounds which puts a cap on the amount EPA can allocate in production and import of virgin HCFC

-          In December 2013, EPA is likely to announce the consumption allowance caps for 2015-2019 which will be the next catalyst to restart the reclamation industry.

  • As phase down since 2010 hasn’t done much to increase the reclamation industry and the 13mm pounds of recoupment allocated to suppliers in March, I would assumes that EPA would come down pretty hard on the consumption caps going forward
  • Also, in the recent analysis to project the servicing needs and set the consumption caps on suppliers, EPA has assumed 70% of the large retail food stores servicing needs to be met by recovered and reused R-22 refrigerant, which I believe is very high at least for the first couple of years. This should either exhaust the inventories sooner or overburden the reclamation industry

-          Below is an estimate of the R-22 servicing need and supply options that would drive the prices, quantity processed by the reclamation industry and a rough HDSN valuation

 

 

Quantities expressed in million pounds     2012 2013 2014 2015 2016 2017 2018 2019 2020
Max ODS Consumption per Montreal Protocol(1)   152.7 152.7 152.7 61.1 61.1 61.1 61.1 61.1 0.0
Virgin R-22 Consumption Cap Proposed by EPA(2)   55.3 62.8 50.9 42.1 33.3 24.5 15.7 6.8 0.0
                         
Expected Total R-22 Servicing Demand (2013)(3)   123.9 112.9 101.2 85.5 73.5 63.2 54.3 46.7 40.1
Supply - Demand Gap- After Consumption Cap   68.6 50.0 50.3 43.4 40.2 38.7 38.7 39.8 40.1
                         
Demand Expected to be Met due to Retail Reuse(3)     12.1 10.1 8.4 6.8 5.5 4.4 3.5 2.9
Supply - Demand Gap- After Retail Reuse       37.9 40.1 35.1 33.4 33.2 34.3 36.3 37.3
                         
Demand Expected to be Met by Existing Inventory                    
Beginning Inventory         100.3 78.3 56.2 34.2 12.1 0.0 0.0 0.0
Surplus Inventory Drawdown(4)         22.0 22.0 22.0 22.0 12.1 0.0 0.0 0.0
Ending Inventory       100.3 78.3 56.2 34.2 12.1 0.0 0.0 0.0 0.0
                         
Supply - Demand Gap- After Cons Cap + Inv Drawdown   15.9 18.1 13.0 11.4 21.1 34.3 36.3 37.3
                         
Demand to be met by Reclamation Industry(4)       15.9 18.1 13.0 11.4 21.1 34.3 36.3 37.3
HDSN Market Share          20% 20% 20% 20% 20% 20% 20% 20%
HDSN Reclamation Quantity         3.2 3.6 2.6 2.3 4.2 6.9 7.3 7.5
                         
HDSN Resale of Virgin R22 (% of virgin R22 production)     6% 6% 6% 6% 6% 6% 6% 6%
HDSN Resale of Virgin R22 (Lbs)         3.8 3.1 2.5 2.0 1.5 0.9 0.4 0.0
                         
Total R22 Sales         6.9 6.7 5.1 4.3 5.7 7.8 7.7 7.5
Expected R22 Price / Lbs         $8.00 $8.00 $8.00 $8.00 $8.00 $8.00 $8.00 $8.00
Total Sales         $55.56 $53.37 $41.02 $34.14 $45.48 $62.32 $61.39 $59.61
Gross Margin         35% 35% 35% 35% 35% 35% 35% 35%
Gross Profit         $19.4 $18.7 $14.4 $11.9 $15.9 $21.8 $21.5 $20.9
SG&A %         12% 12% 12% 12% 12% 12% 12% 12%
SG&A         $6.7 $6.4 $4.9 $4.1 $5.5 $7.5 $7.4 $7.2
EBT         $12.8 $12.3 $9.4 $7.9 $10.5 $14.3 $14.1 $13.7
Net Income         $8.31 $7.98 $6.13 $5.10 $6.80 $9.32 $9.18 $8.91
                         
Equity Value (PV 10) $40.59                      
Debt $22.10                      
Cash + Inventory $50.00                      
Mkt Cap $68.49                      
Shares O/S 26.35                      
Price per Share $2.60 (Current Scenario)                  
                         
        Expected Stock Price - Scenario Analysis        
        Gross Profit        
        30.0% 35.0% 40.0% 45.0% 50.0%        
    R22 Price per Pound $6.00  $1.96  $2.21  $2.47  $2.72  $2.97        
    $8.00  $2.26  $2.60  $2.93  $3.27  $3.60        
    $10.00  $2.57  $2.98  $3.40  $3.82  $4.24        
    $12.00  $2.87  $3.37  $3.87  $4.37  $4.88        
    $14.00  $3.17  $3.75  $4.34  $4.93  $5.51        
    $16.00  $3.47  $4.14  $4.81  $5.48  $6.15        
    $20.00  $4.07  $4.91  $5.75  $6.58  $7.42        
                         

 

(1)   Montreal Protocol guideline on % of Baseline reduction in consumption and production (75% of baseline in 2010, 90% in 2015, and 99.5% in 2020)

(2)   Consumption caps for 2012, 2013 and 2014 based on EPA 2013 Final Rule. 2015-2019 own estimate based on gradual step down to 0 pounds in 2020

(3)   Servicing demand and Retail Store Reuse estimate for 2012 – 2014, and 2020 based on EPA Vintage Model. 2014 – 2019 own estimates – gradual step down from 2014 to 2020. Refer to EPA’s “Analysis of HCFC-22 Servicing Needs in the U.S. Air Conditioning and Refrigeration Sector: Additional Considerations for Estimating Virgin Demand (Adjustment Memo)” for the most recent methodology and assumptions behind the vintage model. http://www.epa.gov/ozone/title6/phaseout/OverviewMemo.pdf

(4)   Inventory drawdown and reclamation demand in my model are higher and lower, respectively, than the EPA estimates as I believe inventory will be consumed faster in the initial years.


Upsides to the valuation are:

-          HDSN captures a higher market share of the reclamation industry. This is highly possible given the Company is widely known in the reclamation market and has excess spare capacity and ability to add additional shifts to its operations

-          The estimated $12 - $16 R22 prices in the scenario analysis are very reasonable estimates. During the phase out of CFC, the price increased from $1.0 to $28.0. Similarly, during the phase out of R22 in Europe, prices increased from $1.0 to $30 per pound

-          I have not modeled the service side of the business which is currently in the initial phases. Though the revenues and earnings are currently very minimal, they can be a meaningful part of the operations in the coming years

Possible Downsides (Strike Three…?):

-          If demand for R22 turns out to be below EPA estimates, price and reclamation demand would be severely impacted. I believe this is the only major treat and a reason for downside bet

-          HDSN not able to increase or retain current market share of the reclamation industry

-          Changes in regulation not in favor of the reclamation industry

 


History:

-          With discovery of Antartic ozone hole in 1985, the governments recognized the need to introduce measures to control the usage of chlorofluorocarbons (CFC) and several Halons

-          Montreal protocol, a treaty designed to protect the ozone layer by phasing out the production of Ozone Depleting Substances (ODS) (refrigerants containing chlorine —CFC and HCFC) was adapted in 1987, and came into force in 1989 when 29 countries ratified it; subsequently around 190 countries have adopted the protocol

-          The phase out is set over a 40-year period that began in 1995, and schedules for refrigerants vary by how harmful it is to the Earth’s ozone layer

  • CFCs were the first refrigerant on the schedule to be phased out given their highest ozone depleting potential
  • CFCs have now been almost completely phased out
  • HCFCs, which are transitional substitutes for many high ODS and are currently being phased out now in a gradual step down manner

-          In response to this agreement, the United States amended the Clean Air Act, adding provisions to establish a schedule to phase out the use of CFC and HCFC compounds

Phase out schedule:

-          In 2010: 75% reduction in consumption below baseline, and can only be used in equipments manufactured before 2010. New equipments cannot use the compounds (HCFC-142b and HCFC-22). No restrictions on production and consumption of HCFCs until 2010 as the 75% reduction was met by phase-out of higher ozone depleting substances

-          In 2015: 90% reduction in consumption

-          In 2020: 99.5% reduction in consumption. No production and no importing of HCFC-142b and HCFC-22.

-          In 2030: No production and no importing of any HCFCs

-          Consumption = Production + Import – Export. And so excess demand for HCFCs can only met by reused, recycled or reclaim existing HCFCs

-          In 2009, Environmental Protection Agency (EPA) put a allowance system ruling in place (2009 Final Rule) to control the production and consumption of HCFCs thereby allocating individual suppliers amount of HCFCs they can produce per year from 2010 – 2014

-          With the phase-out in motion, R22 prices started rising. Meanwhile, some of the allowance holders filed a petition to review the allocations and the court ruled the decision in the manufacturers favor and asked EPA to promptly resolve the matter. Following the court ruling, EPA recasted production and consumption allocation for 2011

  • R22 prices dropped as the industry anticipated higher production allowances

-          In Jan 2012, EPA introduced the Proposed Rule to address consumption and production schedule for years from 2012-2014

  • EPA proposed reductions of 11 - 47% from the levels established in the 2009 Final Rule
  • The reduced EPA numbers were supported by its new estimates - reduced anticipated demand for new production as EPA estimated high level of existing inventory in the market and higher spare capacity in reuse/reclamation industry
  • R22 prices spiked to approx. $12.0 from appox. $4.0-5.0 on back of new reduced production numbers

-          Finally on March 27, 2013, EPA finalized the 2012 Proposed Rule where it stuck with the lower end of the 2012 Proposed Rule (as anticipated by the industry and EPA’s ‘No Action Assurance Letter’) but added recoupment allowances of approx. 6.5mm pounds each for 2013 and 2014 that was not expected by the market

  • Since March, R22 prices have dropped by approx. 30% to around $8.0 per pound level. The longer winter and mild summer in May – June this year impacted demand negatively and has been another reason for lower R22 prices

Below table shows EPA's initial (2009), prosposed and final consumption caps on R-22:

 

 

2009 Final Rule

2012 Proposed Rule

2013 Final Rule

 

 

High

Low

 

2010

           110.2

                -  

                -  

                  -  

2011

           100.1

                -  

                -  

                  -  

2012

              89.7

            79.8

            55.3

                  -  

2013

             79.1

            69.2

            56.5

              62.8

2014

              68.6

            58.0

            44.5

              50.9

 

 

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Next near term catalyst - EPA Final Ruling sometime in Dec 2013
Q2 earnings on July 30th, though I don't anticipate any positive reaction in the stock post the annoucement.
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