Description

Advanced Emissions Solutions Inc (ADES) is an interesting situation, chock-full of catalysts:

• Company’s financials not current as in the midst of an accounting review/restatement, with its auditor having resigned
• As a consequence of the delayed filings, it was delisted from Nasdaq (on Feb 2015 – the stock was down over 50% the week of the delisting with volume peaking at almost 90x the prior trading volumes) and now trades in the pink sheets
• Management has recently changed, with a new CEO as of April 2015 (had joined as CFO in September 2014), and a new CFO and a new VP of Risk, Process & Controls, both appointed in June
• Announced in February 2015, its intention of separating its Emissions Control business (“BadCo”) from the Refined Coal business (“GoodCo”), having hired Moelis & Co as adviser, and is currently right-sizing BadCo
• In addition, ADES has a net cash position, and its stake in the Clean Coal Solutions (CCS) JV should generate operating cash flow of over $130M/year once fully ramped, compared to a EV of sub $300M.
• Finally, the stock has recently suffered a decent pullback (down ~15% over the past week) driven by the Supreme Court decision challenging the EPA’s recent mercury emissions mandate 

Background:

lpartners and leverage both did a much better job explaining the company and its various businesses than what we would attempt (the reason for reviving the idea is that since their write-ups, ADES has faced accounting and listing issues, and to be fair, operationally the ramp did not occur as quickly as the Company had anticipated).  Thus, I will just provide a quick overview here, focusing on Emissions Control and Refined Coal:

Emissions Control basically sells equipment for power plants to reduce pollutants and emissions.  There was an equipment bubble driven by new EPA rules that required companies to be compliant by a certain date, which caused a surge in sales which have now been on decline.  ADES has been right sizing the division to acknowledge the lower baseline going forward.  In addition, it is possible that ADES is able to successfully reinvent this business, perhaps around chemical solutions, given the recognized R&D talent at the company.  However, it is a show-me story and therefore, I will ascribe it a zero value and turn our focus to the more important Refined Coal (RC) division (note we are also going to ignore other potential technologies such as Enhanced Coal or CO2 capture – assume these are free call options). 

Just two quick points on Emissions Control – ADES has indicated that it will look to separate this division, either through a spin-off, a sale or even a closure.  The idea is that money generated from the RC division will not be used to support Emissions Control or fund its reinvention. We believe that while the separation could technically occur at any point (original press release in February mentions a potential early 2016 date), it is unlikely that it will happen until the accounting review is complete and ADES is again current.

The other point refers to the recent setback to the EPA’s mandate to reduce pollutants from coal-fired power plants, with a 5-4 defeat by the Supreme Court.  The decision claimed the EPA did not conduct a proper risk reward analysis in passing the law, disregarding the onerous costs to the impacted companies, potentially outweighing the benefits.  The implication to ADES is that some of the required equipment purchases could be postponed or even cancelled.  Note however, that the decision does not strike down the rule but requires the EPA to review and rewrite it taking costs into consideration.  While a negative for the Emissions Control segment, this could accelerate the decision to close the business.  The ruling should also have no bearing on the RC segment. Interestingly, however, the ADES stock suffered the largest one-day drop amongst the various players affected, such as CCC, ALB, CBT, etc;

Refined Coal: this essentially consists of ADES’ stake in its Clean Coal Solutions (CCS) JV.  Again, for brevity, I will rely on the prior write ups for the more in depth review, but essentially CCS installs units that have been pre-approved (there are 28 of those) to coal burning facilities at power plants.  Proprietary chemicals and additives are applied to the coal, via these bolt-on units, on the conveyor belt as the coal travels to the power plant boiler. These facilities, as per the Section 45 of the IRS, provide tax credits (currently at ~$6.70/ton, as these are adjusted by inflation) if mercury and NOx emissions are reduced by a certain amount.  There is essentially an insurmountable regulatory barrier to new entrants: a new competitor or even CCS is unable to certify new units, given the units had to be approved for operation prior to December 31, 2011. We believe there is only another company of significance providing similar solutions, Chem-Mod, owned by AJ Gallagher. To put the market opportunity in perspective, ADES believes there are 850 coal fired plants in the US.

There are three players in the equation: CCS as the operator, the owner of the units (such as Goldman Sachs, which utilizes the tax credit and operating losses to lower its tax liability), and the utility (which not only gets paid by the owner of the unit to run those, but also benefits from reduced level of emission).  CCS may also choose to retain some of the units to reduce/eliminate its own tax liabilities.

As mentioned, Goldman Sachs is not only an investor/owner of units, but they also acquired a 15% stake in the JV in 2011 for $60M.  The other owners of the JV are NexGen and ADES, each with a 42.5% stake.

The tax benefit, however, is only valid for 10 years, so essentially the business could disappear by the end of 2021. It is possible that after that period, CCS can continue to sell the chemicals that are needed to treat the coal, and perhaps even outside the 28 units to other coal-fired power plants. While this means that there could be some value beyond 2021, let’s just focus on the “bird in hand”.

Accounting review:

On March 2014, ADES initiated an accounting review going back to 2011 and has delayed subsequent filings.  KPMG argued that the revenue recognition for equipment contracts in the Emissions Control segment should have followed a cost to cost methodology to measure the progress on the contracts rather than labor hours.

It is important to note that the accounting issues were essentially related to the Emissions Control business, and not CCS, which has its own separate auditors.  Given the overarching nature of the review, the accounting pertaining to the JV ownership and the sale of the stake to Goldman Sachs were being examined, but the actual audited financials of the CCS operation, should not be impacted.

Not surprisingly, relations between ADES and KPMG were strained (just a few months prior, KPMG had signed off on a secondary done by ADES), and supposedly, knowing that it was going to be fired, KPMG resigned on January 23, 2015, causing the ADES stock to drop 42%.

In mid June 2015, ADES announced it had hired Hein & Associates as their new auditor. The feedback we got on the auditor is that it knows the industry well, which could imply a quick review process and audited financials, followed by a relisting.  

Valuation:

Assumptions:

Gains in sale offset the capex associated to installation of units. This is very conservative, as monetization of units typically starts at $1/ton, which for a 3M ton facility would obviously imply $3M, which is the high end of the capex required to install each of the remaining units.

Flat rental contribution, which is not the case as it increases proportionately with the adjustments to the tax credits.

Payments to ADES from CCS occur in the year they are generated – this is probably slightly on the aggressive side: there is requirement of at least 70% distribution with the accumulated balance paid at the end (2021).

Also note that those cash contributions are essentially an operating cash number, as there is no interest burden and the retained units (and existing accumulated tax credits) should shield CCS from taxes.

Given the finite life of the tax credit, it is unfair to place a multiple to the cash flows, so a DCF is more appropriate (and we conservatively assume no residual value).  The question then becomes which discount rate to use.  One may disagree here, but our rationale was to look at the cost of equity for various utilities.  Once the units are up and running, there essentially is no churn and low risk to the cash flows (many of the contracts are take-or-pay to CCS, with the owner of the units taking the risk of volumes actually processed). Those tend to range in the high mid-single digits to low double digits. To account for some risk related to potential ramp of units, we use 15%. 

Thus, the value of ADES’ stake in CCS alone is worth $24.50.  Feel free to assume no value for everything else – Emissions Control and a net cash position (in terms of balance sheet, the last update provided by ADES at the end of January, showed in excess of $36M in cash and “minimal” long-term debt – assume that is enough to cover the residual audit costs and any potential detraction of value from Emissions Control).

 If we were to use a discount rate of 8%, the value would be close to $30/share.

As far as downside, let’s assume no additional units are deployed, which is contrary to ADES’ assertion that at least 6 units are currently in the installation process. In this case, assuming the same 15% discount rate, the value would be $10.75. A more realistic scenario is one where only those 6 units are used and the remaining 6 units are never deployed, yielding a value of $17.85.

Risks:

Long sales cycle - The main risk in our opinion is the timing of the ramp of the units. Reading past transcripts and presentations, one would have already expected all units to be up and running, however that is still not the case.  A big chunk of the blame has been placed on the slow decision-making pace of the utilities and the permitting process. Other factors causing delays are the need for approval from the PUC (Public Utility Commission) as well as PLR (Private Letter Rulings) by the IRS re the tax credits. In their most recent presentation, ADES indicates that the units that are not operational are all either being installed or in advanced stages of being assigned a home, with the indication that all units will be operational by end of year 2016. 

Delay in accounting restatement, implying an increased cash drain as well as delay in potential separation of Emissions Control.

Regulatory – could the tax benefit be curtailed? In recent discussions we have had, that seems unlikely that a decision would be reversed mid-course after many firms have made the investments accordingly; in fact, it seems that the risk could be to the upside if the tax benefit gets extended beyond 2021

Potential competition on remaining units from Chem-Mod for coal-fired power plants – does not seem as a huge concern, as seems most units have been earmarked, and the market is likely big enough to accommodate all units available.

Deployment of cash – will ADES be using the cash generated by CCS to invest in other ventures or support Emissions Control? Management and the board have been vocal in that they will not use that cash to pollinate other investments and that it will be returned to shareholders. The main comfort we have is the very concentrated shareholder base including the presence of investors in the board (Coliseum Capital), which should keep the Company honest regarding uses of cash. Note that now that the ADES stock is trading OTC, there is no need for funds to file ownership, so indications of no position can be misleading.

Faster than expected erosion in Emissions Control – the recent Supreme Court decision could impact the business, but in our mind, if that is indeed the case, it will just accelerate the decision to close down the business rather than allow it to become a detractor of value.

Catalyst

Installation of remaining CCS facilities

Completion of accounting review, becoming current in filings and subsequent relisting

Separation of Emissions Control