Description

Thesis

Hudson Technologies is a refrigerant gas distributor and recycler that is consolidating its dominant market position with the recently announced acquisition of Airgas Refrigerants. The acquisition will be highly accretive to the company by increasing its recycling capacity and significantly expanding its customer base. Further, as production of virgin R-22 refrigerant is phased out by law by 2020 the company’s high margin recycling volumes will likely quadruple as HDSN becomes the de-facto producer. Combined EPS will rise to $1.20 by FY19 (8x) and $1.65 by FY20 (sub 6x), making the current stock price unsustainably cheap.

Summary

Hudson Technologies provides solutions across the refrigeration industry including commercial air conditioning, industrial processing and refrigeration systems. The company was founded in 1991 and is based in Orangetown, NY and has grown to capture a 25% market share in the R-22 reclamation space. The company is becoming the de facto producer of this much needed refrigerant as the virgin supply continues to decline on an accelerated volume step-down mandated by the EPA.

R-22 product.

Hudson distributes and recycles a wide array of refrigerant compounds with its current main focus on HCFC’s, namely R-22 which is 85% of the reclamation market. This gas is used primarily in older A/C units and is recycled as units are shut down as venting is illegal due to damaging effects on ozone depletion and global warming. Also older units tend to leak gas and need a regular maintenance re-supply of R-22. This is much cheaper for the owner than changing to a new system, and ensures a very long tail of demand. Traditionally manufacturers like Honeywell, Dupont, Arkema have produced this refrigerant creating ‘virgin’ supply, but the EPA has been phasing it out of production and importation by 2019 due to its damaging effects to the ozone layer. The alternative to the virgin gas is reclaimed R-22, which is Hudson’s core competency. Reclaiming the refrigerant is a technically difficult process that requires EPA approval for purity standards. Hudson was one of the pioneers in the recycling space and its CEO, Kevin Zugibe, is an engineer who founded the company that has more than two dozen patents to his name.

In 2016, we estimate the demand for R-22 was around 58m lbs. Virgin production allowed by law was 18m lbs. The balance was supplied from a quickly dwindling “manufacturer’s stockpile” (accumulated over the years in advance of the phase-down) we estimate at 30m lbs, and recycling of 10m (disclosed by the EPA). In 2020, we estimate demand at around 45m lbs. Virgin supply will be 0 by law. Manufacturer’s stockpile we estimate will be minimal, say 5m lbs. Which means that the recyclers will need to supply close to 40m lb of product, 4x the amount from last year. HDSN will have 40%+ market share of recycling, post its acquisition of Airgas.

The price of R-22 can see significant fluctuations and the market may use it in the short term as a leading indicator for Hudson’s performance. We believe this is short-sighted. The price has been in a strong upward trend exactly as management predicted, from $4 in 2011 to $20 this year as the supply is constrained due to the EPA restrictions. There’s a clear historical precedent from the earlier phase-out of the R-12 gas (even more damaging to the environment) which the company still recycles and sells today. The price of R-12 topped out at $30/lb and remained consistently in the $20-$30 range. Recently, R-22 prices fell from $22 in June to about $18 in mid-August. This has largely been attributed to one producer’s temporarily flooding the market with supply earlier in the year. Given the phasing out of R-22 production, our, and management’s expectation is that the gas will shortly resume its upward trend.

Pricing pressure can also come in the form of substitute gases. However, substitutes are not as good and therefore have have two drawbacks. One, they are not as efficient and increase the operating costs of the A/C units to the end client. Second, they can break the system, and contractors are therefore reluctant to use them and be stuck with a catastrophic bill in such case. For these reasons, the use of substitutes is typically in the single digits as a percent of volume.

Reclamation Services

In order to create EPA-approved reclaimed R-22, Hudson reduces the gas’ contaminants through oil separation and other filtration processes. The company has a patented business model around how the refrigerant is distilled, dried, and chemically treated. They provide this service to contractors and high volume users as well as through wholesalers and distributors. Hudson was able to capture a 25% market share using one facility due to the efficiency of its process. It has added 3 other facilities in the past to help with auxiliary parts of the business. Refrigerant and reclamation services make up over 96% of Hudon’s existing revenue with the small remaining amount coming from their Refrigerant Side service segment, which we expect will grow as the recycling volumes pick up and Airgas is integrated.

ARI Acquisition

On August 9th, Hudson announced the acquisition of Airgas-Refrigerants, Inc. (ARI), an Airgas subsidiary, in a cash deal worth about $220 million. ARI maintains about a 15-20% market share in the refrigerant space and had trailing 12 month revenues of $250 million as of March 31, 2017. The main expected benefits to this acquisition are mostly top-line focused with few major near term cost synergies. ARI’s distribution business will also help with the transition from HCFCs (R-22) to HFCs (R-410A) - which is the next category of gas to be phased out a few years down the line. As they did before, the management team is already looking past the current phase-out (R-22) and preparing years in advance.

In terms of improving operations, the ARI acquisition will help strengthen the direct sales channel in the contractor space, rather than going through supply houses. This is a deal that Hudson has been after for more than a year because of the complementary distribution channels between their company and ARI. The combined entity will have a five-year exclusivity contract with Airgas to be its sole supplier of refrigerants. In addition, Hudson will obtain seven million lbs of R-22 which, at $21 per pound, would amount to a value of close to $150 million. This is about two thirds of the $220 million purchase price and as we discussed above R-22 inventory is very valuable given the dwindling supply dynamics.

Management

Hudson has a strong, founder-led management team. Most of the key leaders have been with the company for over a decade. Kevin Zugibe has been the CEO since inception and has an engineering background with several refrigerant cleaning patents in his name. He founded Hudson while he was a power engineer at  Orange & Rockland Utilities, focusing on HVAC applications. Kevin remains a large shareholder and owns over 10% of Hudson’s shares outstanding.   

Brian Coleman has been the President and COO since 2001 after joining the company in as CFO in 1997. Prior to joining Hudson, he was a partner with BDO USA (formerly BDO Seidman) as an auditor. Brian’s compensation in 2016 was around $670K, which is reasonable for a president and COO of this size business.  

CFO Nat Krishnamurti is the newest member of Hudson’s management team, coming onboard September of 2016 after the previous CFO retired following eighteen years with Hudson. Nat has been the CFO at two other public companies and has over 20 years of accounting, finance, and operations experience at PWC.

Risks

• Oversupply of R-22 from aggressive production is the most prominent short term risk to the core business, but difficult to see pricing getting weaker for an extended period of time

• If the acquisition is blocked by Department of Justice, this would have an adverse impact on Hudson’s stock price in the short term, even though the market does not give much value to this deal currently. However, the recycling volume spikes will continue at HDSN’s current 25% market share, leading to $1 eps by 2020, with the stock currently trading at 9x that is cheap

• Increase in market share of substitute products which would lead to price pressure. This is not a major concern as described above

• Regulatory risk if EPA were to change R-22 production rules; this is a very remote possibility as the phase-down was established in 1993, it is generally good for US domestic producers which have ramped up production of next generation gases, and any change would require legislation

• Irrational pricing or volume dumping behavior from existing competition (in line with earlier this year), which could impact R-22 pricing; we believe this would only be a short-term phenomenon.

Valuation

Even after the increase in stock price given news of the acquisition and strong quarter, the valuation is very attractive. While 2018 will have decrease in gross margin due to purchase accounting for inventory, this will not affect cash generation. Debt will be temporarily higher after the acquisition closes (<3x Debt/EBITDA) but it will quickly be paid down to around 1.5x by FY20. We see combined EPS at $1.20 by FY19 (sub 8x) and $1.65 by FY20 (sub 6x), making the current stock price unsustainably cheap. Once the market understands the recycling volume dynamics we believe the stock will hit $20.

Catalyst

Catalysts

1. Airgas acquisition is finalized quickly

2. Short-Term price reversion for R-22 back into the $20s; the market currently sees $21/lb paid for ARI inventory as expensive vs August $18 price

3. Spike in R-22 volumes in 2018, 2019, 2020 as the virgin supply is completely phased out

4. Significant increase in volume and revenue from the new Department of Defense supply contract which started in August