Description

Pearl River, NY-based Hudson Technologies, Inc. (Nasdaq:  HDSN) is a U.S. environmental services business focused on selling virgin and recycled refrigerants, and it also works with customers improve the energy efficiency of cooling & heating systems.  Refrigerants are chemicals that used in cooling/refrigeration process. Hudson’s market positioning, service offering, and established footprint should allow it to benefit immensely from the government-mandated phase-out of a particular type of highly used refrigerant called R-22.  

Once contaminated, refrigerants like R-22 can be reclaimed, recycled, and resold; reclaimed refrigerants have comparable efficacy as virgin refrigerants.  Demand for reclaimed R-22 should increase dramatically as virgin supply is reduced by government mandate in the coming years; along with significant volume increases, the price of R-22 should, in theory, move considerably higher with far less supply available.  In preparation for this eventuality, Hudson purchased the #2 player in its category in October 2017, moving its U.S. market share from 25% to 40% (along with other benefits). As a result of this acquisition and the government phase-out of R-22, Hudson’s revenues, earnings, and cash flows should move significantly higher over the next 3-5 years.

Hudson’s stock price has been extremely weak since September due to significant declines in R-22 pricing caused by excess channel inventories and aberrationally cold weather this spring, increased financial leverage, along with the release of several highly flawed short reports by the same author.  Current valuation is attractive (8x 2018 earnings, 4x 2019 EBITDA, and a 30% FCF yield), and earnings growth should be massive through 2020. With a view towards the future, Hudson’s stock price offers considerable upside.

The Company

Hudson was founded in 1991 by Chairman and CEO Kevin Zugibe to take advantage of the eventual phase-outs of refrigerants such as chlorofluorocarbons (CFCs), most commonly known under the brand name, Freon, and hydrochlorofluorocarbons (HCFCs) like R-22.  Prior to 1991, Zugibe was a utility engineer for HVAC applications, and he predicted the eventual financial benefits for reclaiming refrigerants and created Hudson for this express purpose.  Zugibe still owns 8.5% of the Company, and management and the Board of Directors cumulatively own 17% of the Company. Compensation is reasonably low. Insiders have been exercising Hudson options but not selling them, and they have been purchasing a small amount of shares at open market prices very recently.  Management is incentivized to do the right thing for shareholders, but their capabilities as managers are middling.

Roughly 90% of revenues is generated from the sale of refrigerants, both virgin and reclaimed, including Freon, R-22, hydrofluorocarbons (HFCs), and replacement blends.  Virgin and reclaimed R-22 is roughly 70% of total sales, and Hudson is the largest independent distributor of virgin product in the United States. Virgin product gross margins are roughly 20%, while reclaimed R-22 sports gross margins closer to 45%.

The balance of sales is derived from services for industrial and large commercial users of refrigerants.  The Company’s remediation services uses mobile refrigerant cleaning equipment to service customers’ large cooling systems.  It also provides energy engineering services that help monitor and interpret data, enabling customers to maximize the performance of their cooling systems.  This service business benefits from both recurring revenues and economies of scale.

In June 2016, the U.S. Department of Defense (DoD) awarded Hudson with a 10-year, $400 million contract for the management and supply of the DoD’s refrigerant needs.  This contract may open up doors to future sizeable government contracts from other agencies. Fulfillment of this contract began in late July 2017; this project is just getting started.

Essentially, Hudson is a one-stop shop for refrigerants.  Beyond distribution and reclamation services, Hudson services include onsite cylinder refreshments, certified lab testing, and the ability to remove cross-contamination (a cylinder holding multiple types of gas).  Hudson is one of the few companies with the ability to reclaim mixed gas. Lastly, Hudson benefits from a nationwide network due to its coast-to-coast facilities.

Virgin refrigerant product is produced by Honeywell, Chemours, and Arkema, while reclaimed product has been recycled by companies like Hudson and is now indistinguishable from virgin product.  The distribution and sale of virgin refrigerants is low margin and predictable. As R-22 production is phased out, volumes for HFCs such as R-410A should partly mitigate the decline. Hudson contracts supply from large chemical producers and has sales contracts with refrigerant wholesalers.  Until HFCs are phased out in the next decade, Hudson will remain a price taker of this product.

Today, aftermarket consumption of refrigerants is largely R-22 (65% of the market), 33% HFCs, and 1% CFCs.  These chemicals are not consumed because they operate in a closed system; refrigerants need to be replaced every few years due to impurities or leaks.  When replacement is necessary, the HVAC contractor can either replace the entire cooling system at a high cost ($6,000-$10,000 or more), or just remove the dirty refrigerant and replace it with virgin or reclaimed refrigerants ($400 - $1,500).  Materials cost for replacing dirty R-22 in an A/C unit is estimated at less than $200. Thus, the decision to recharge an R-22 A/C unit with reclaimed refrigerant instead of replacing the equipment with a new R-410A machine or doing an R-22 retrofit is entirely based on cost.  Even if R-22 prices triple from current levels, there is little comparison from a price perspective.

When released into the atmosphere, R-22 depletes the earth’s ozone layer.  Historically, HVAC contractors would just vent out the gas into the atmosphere because supply houses would charge them a fee to return dirty refrigerants for disposal/reclamation.  With regulatory changes, contractors have a double incentive to return dirty gas back to the supply houses: 1) it is illegal to vent refrigerants into the atmosphere, and 2) the supply houses are now paying contractors for returning dirty gas.  

In late 2014, governments across the world came to a global agreement on HCFCs like R-22 (the Montreal Protocol).  The EPA and other foreign environmental government agencies mandated a global phase-out schedule for HCFCs; in the United States, virgin production of HCFCs was immediately reduced from 50 million pounds in 2014 to 22 million in 2015.  By 2020, no U.S. company is allowed to produce or import virgin R-22; the only source for those of us who still own R-22 units will be reclaimed R-22. In 2014, Americans purchased 60 million pounds of R-22, and this number is expected to fall at a 5-8% annual clip due to the fact that A/C units have a ~20-year life.

One of the potential risks to this investment is the possibility for the Trump Administration to retract its commitment to eliminating the use of R-22.  Based on a number of conversations that I have had (including the EPA itself), it is clear that it is in no domestic party’s benefit to keep R-22 around.  The producers have moved onto producing other refrigerant chemicals like R-410A, and it appears that they are not even producing R-22 anymore. They are importing it from some foreign supplier.  With no R-22 machines produced since 2011, the machine producers do not have incentive for the EPA to violate the Montreal Protocol either, as they are producing HFC machines.

Inventories in the channel or at the producers should fill part of the aforementioned R-22 volume gap, but this too will eventually be depleted and reclamation will be the major contributor to meeting demand.  Within two years of the EPA announcing this phase-out, the price of R-22 doubled from $7/lb to $14/lb. Current channel checks show pricing at $11-12lb; at these prices, the reclamation market could reach $700 million in size, although Hudson thinks that $1 billion is possible.  With higher prices, which is probable in the years ahead, this market could be far larger than that. Given that Hudson now has ~40% U.S. market share in reclamation, this offers a considerable market opportunity for Hudson over the intermediate period ahead.

Beyond that, R-22 reclamation has very high margins.  Hudson buys dirty gas from supply houses that purchased the gas from contractors, and Hudson then removes particulate matter from the dirty gas.  The clean gas is then resold back to the supply houses, who then sell the refrigerants to contractors. Typically, Hudson buys dirty gas at 50% of the price that it can be resold back to the supply houses.  As previously mentioned, gross margins for reclamation are ~45%, well above the gross margins for the sale of virgin gas (20%).

On August 9, 2017, Hudson entered into an agreement to acquire Airgas-Refrigerants, a subsidiary of Airgas, Inc., for $220 million in cash. Airgas was recently purchased by Air Liquide ($20 billion company), making this subsidiary non-core to Air Liquide.  The acquisition was consummated in October 2017. Benefits from this acquisition include:

• Better positioning in the HFC market.
• Broader customer network to provide Hudson with increased access to refrigerant for reclamation while also strengthening virgin distribution capabilities.
• Adding incremental reclamation processing capacity.
• Enhancing Hudson’s geographic footprint and a bigger sales force.
• Complemental distribution channel that is direct to large contractors (and thus has better margins than Hudson’s core business).
• Enhanced exposure to HFCs.

The trailing 12-month revenues for the combined business is roughly $250 million, and, according to management, this transaction is expected to be accretive to earnings beginning one year after the transaction close, but, with the fall of R-22 prices, that simply is not going to happen.  Adjusting for the combined business, 2016 pro forma EPS would have been $0.48.

Prior to the transaction, Hudson was operating on a net-cash basis.  After closing on the transaction in October 2017, it now has a $150 million asset-based lending facility from PNC with $80 million drawn.  In addition, it has a new term loan from GSO Capital of $105 million. This now implies that Hudson has a net debt/2018 EBITDA ratio of roughly 6.8x, but I expect that number to fall as EBITDA spikes and debt is paid down.  On a pro forma basis, inventories of refrigerants stand at $170 million, representing roughly 61% of current enterprise value. The Company expects to increase inventory turns as it sells acquired supply of gas and increases reliance on reclaimed refrigerants, but that is unlikely to transpire until R-22 prices turn northwards again.

Post-acquisition, Hudson now has ~40% market share in the refrigerant market, while National Refrigerants (private) holds about 10%, and A-Gas (private) holds another 5%  Beyond that, there are 30+ mom-and-pop operations peppered across the United States. None of these players have enough scale or access to capital to become another Hudson.  Thus, as the market moves from virgin production to reclaimants, Hudson may possibly transform from a price taker of R-22 to a price setter. As R-22 price continues to rise, it should be increasingly difficult for the smaller players to fund working capital, given the inventory needs for managing dirty gas inventory; this could allow the smaller players to cede even more market share to Hudson primarily, and possibly followed by National Refrigerants and A-Gas.

The price of R-22 has recently declined from the low $20s in 1H 2017 to $11-12 today, after tripling in 2.5 years.  On Hudson’s recent earnings calls, management communicated that the rapid rise in price caused one producer to dump its supply early and an increasing number of contractors & consumers switched to R-22 replacements.  These replacements are not as efficient as R-22, but often void the warranties of A/C units. Many of these replacement gases complicate things by the need to alter existing equipment for compatibility. These alternative gases are unlikely to crowd out the use of reclaimed gas, but they could cap the pricing on reclaimed products.  

Beyond that, the long, cold spring has had a material impact on pricing.  In many parts of the United States, people have not yet turned on the air conditioning to see if they need servicing.  With less demand of calls to your local HVAC guy, the demand for R-22 is less, and supply houses are trying to move product.  Thus, prices have fallen significantly thus far this year, impacting 2018 cash flows and earnings at a critical time when Hudson bought a bunch of high cost inventories and simultaneously picked up a fair amount of debt..

The stock price has been terrible this year, which is primarily a result of a wicked cocktail of increased financial leverage, a short-seller who is prolific on Seeking Alpha, and crappy spring weather.  However, at the end of the day, the long-term thesis remain intact. With less R-22 production, reclamation volumes and prices both will rise; reclamation sales have materially higher margin. And, with some hot weather, R-22 prices should stop feeling downward pressure.  But, if you are concerned about the stock price for the balance of 2018, then you probably should not own this stock. This is a 2019 and 2020 story, but I would be very surprised to see the stock stay at sub-$3 levels for very long.

I cannot point to a long-term market-clearing price for R-22.  But, with only slowly eroding demand (5-8% per year) and rapidly diminishing supply, one would think that prices long-term have nowhere to go but upwards.  Other driving forces for the price of R-22 include:

• Shortage of raw materials.
• Anti-dumping and tariff lawsuits.
• Summer temperatures.
• Phase-outs and threats of phase-outs.
• Distributor competition.
• Contractor competition.

It should be noted that prices are pretty stable in the winter months, as prices start to move in March as A/C units in the southern states of the United States start to kick on once again.

The stock does not pay a dividend, nor do they do share buybacks.  Typically, the Company has used its cash for tuck-in acquisitions and capex.  A good example of a smart tuck-in was a small $5 million acquisition that they did in 2015 that gave them to capabilities to win the $400 million DoD contract.  Future free cash flows over the intermediate term ahead are likely to be used for paying down debt.

Over the long-term, management believes that gross margin can be 35%+, with an EBIT margin of 25%+.  Gross margin expansion should be driven by a mix shift away from virgin refrigerant sales toward higher margin refrigerant sales and the energy services business.  Revenue growth is expected to grow at a double-digit CAGR.

Risks

• Competition.
• Balance sheet leverage.
• Double-digit short interest.
• Regulation.
• Acquisition integration.
• Weather.
• Execution.
• Stock volume liquidity.
• Banks not giving them a break on covenants if R-22 pricing stays low.

Valuation

Given the nature of the business, lack of comps, a transformative acquisition, and regulatory requirements, using a comparative multiples approach or a FCF analysis provides limited value here.  The two key drivers at this point for valuation are the price of R-22 and the earnings multiple applied for this business. It seems to me that very significant earnings growth is in the queue here, and the stock price simply is not reflecting that growth and massive free cash flow generation.

I do believe that R-22 prices have nowhere to go but up, my model is using current R-22 prices of $11.50, but rising to $15 by 2020; management believes that R-22 prices will eventually exceed $30.  Reclaimed R-22 volumes are projected to increase from 14 million pounds in 2017 to more than 45 million pounds in 2020, when Hudson and other reclaimers are the only source of R-22. When you do the math, you get $1.84 in earnings in 2020 – not too shabby for a sub-$3 stock price.  You can use whatever earnings multiple you want for this stock, but the potential upside is glaringly high. And, if you use a higher price for R-22, earnings will increase significantly.

Disclosure

My firm has an economic position in Hudson and may choose to buy more or sell stock at any point without informing the Value Investors Club Community.

Catalyst

• Time.

• Paying down debt.

• More government service contracts.

• Successful integration of the Airgas acquisition