| 2010 | 2011 | ||||||
| Price: | 2.15 | EPS | $0.00 | $0.00 | |||
| Shares Out. (in M): | 21 | P/E | 0.0x | 0.0x | |||
| Market Cap (in $M): | 45 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | 10 | EBIT | 0 | 0 | |||
| TEV (in $M): | 55 | TEV/EBIT | 0.0x | 0.0x | |||
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Hudson Technologies (Hudson: $2.15)
Target Price (6-18 ms): $8.00-$12.00+ (+272-458%)
Summary:
Overview of the Opportunity:
Hudson Technologies (HDSN; http://www.hudsontech.com/) is a leading recycler and distributor of newly-manufactured ("virgin") and recycled ("reclaimed") refrigerant gasses as well as a provider of decontamination services for large cooling systems. The industry is highly fragmented and Hudson is the leader and only publicly-traded participant with an approximate 20% market share. Hudson is a microcap with a market capitalization of $45 million and an enterprise value of approximately $55 million. Management owns 33% of the company. There is no sell-side coverage of Hudson. At its current price per share of $2.15, Hudson is trading at just under 10x its prior peak operating EPS of $0.22 of 2008, at 5-7x our estimate range for 2010 and at less than 2-3x our EPS estimate range for 2012-2014.
New rules established by the US Environmental Protection Agency ("EPA") went into effect in January 2010 that are fundamentally changing the economics of Hudson's business. The EPA has capped the amount of the leading US refrigerant gas (known as "R-22," with 60% share) that can be produced each year at 80% of expected demand. The maximum production permitted will ratchet down each year through 2014 in order to maintain a 20% shortfall in supply relative to demand. The stated purpose of this phase-down is to drive up the price of R-22 in order to stimulate the gas reclamation industry and cut down on the venting of used greenhouse gases into the environment. The EPA's theory is that since reclaimed gas is sold for the same price as virgin gas, a higher gas price will allow the recyclers (such as Hudson) to offer the greater economic incentives to contractors to collect and recycle used gas rather than venting it into the environment, as they currently do more than 90% of the time.
The last time the EPA phased out the production of a predecessor refrigerant gas in the mid 1990's ("R-12"), the price of R-12 increased from $1.00 per pound to over $28.00 per pound over a seven year period. For the reasons described below, we believe the phase-out of R-22 will substantially increase the economics of Hudson's reclamation and distribution business and we see a clear path to EPS in approaching or exceeding $1.00 per share by 2012, with the ramp-up beginning over the next-few quarters. A conservative multiple of 8-12x would suggest a share price of $8.00-12.00+ over the next 12-18 months.
Background:
The following is a background on the US refrigerant gas market that leads to an explanation for why Hudson's addressable market is about to expand substantially. You can read Hudson's investor presentation which helps give some background on the EPA mandate at:
As further background, this posting on Dupont's website directed at their distributors and contractors explains the urgency in building up the reclamation market: http://www2.dupont.com/Refrigerants/en_US/reclaim/index.html.
The total US refrigerant market is estimated at approximately $1 billion and is divided between the Building and Industrial channel (approximately 30%) and Residential and Light Commercial (approximately 70%). Hudson distributes new and reclaimed refrigerant gasses primarily to the smaller Building and Industrial channel. In the larger Residential and Light Commercial channel, gas is shipped by the manufacturers to distributors, who in turn sell to local contractors. The most common gas used is R-22, accounting for more than 60% of gas sales. Three large producers Honeywell, DuPont and Arkema, account for 87% of R-22 sales. Therefore with the EPA mandated quotas, they are creating an oligopoly with almost total pricing power. By Federal law, no new producers are permitted to enter the virgin R-22 gas production market and total annual production is now limited by EPA allocations.
In addition to virgin gas, suppliers such as Hudson produce and sell reclaimed gasses. Over time, refrigerant gasses pick up contaminants such as oil, water and various acids. In the 1990's, order to cut down on greenhouse gasses, the EPA made it illegal to vent used gases. Producers such as Hudson purchase used gasses and purify them using a reclamation process. The reclaimed gasses are chemically identical to new virgin gas and are re-sold at the same price as virgin gas. For years, virgin R-22 sold for only $1.00 per pound, so Hudson could only afford to offer distributors $0.10-0.15 per pound for the used gas. This provided very limited incentive for contractors to collect used gas, particularly since their distributors typically would charge them $50.00 to collect the used gas on pallets and ship it to a recycler. Moreover, the venting of used gas is virtually impossible for the EPA to monitor and enforce. Therefore, today, despite being illegal, the EPA estimates that approximately 93% of used refrigerant gas continues to be vented into the environment rather than turned in for reclamation. Of this limited reclamation market size (estimated to be approximately $40 million annually), Hudson currently has an approximate 20% share. In the Residential and Light Commercial channel, Hudson theoretically should have close to a 100% share because it has been able to negotiate national deals with DuPont and Arkema (and regional deals with several Honeywell distributors) to be the national reclamation source for their distributors. Hudson was able to negotiate these deals because of its nearly 20 years of experience in the sector, is one of only three nationally to be certified by the Air Conditioning, Heating Refrigeration institute and has significant manufacturing capacity. Hudson has a state of the art reclamation facility currently operating at only 50% capacity and recently opened a second 60,000 square foot facility to increase production capacity.
Because of the low manufacturing cost involved with reclamation, Hudson is happy to pay out close to 50% of the price of virgin gas to distributors who turn in used gas as prices rise. The problem is that until recently, the price of virgin gas has been too low for Hudson and other reclaimers to provide enough economic incentive for the gas to be turned in. This has begun to change, as the price of R-22 has risen from $1.00 to $4.50 per pound over the past few years due to prior, less restrictive production caps implemented by the EPA (new production was limited roughly to the amount of expected demand). This has allowed reclaimers such as Hudson to offer more money for used gas and in turn is encouraging distributors to incentivize their contractors to collect and turn in used gas. Recently, as producers have begun to warn distributors of coming shortfalls later this year (see link to DuPont site, above), many distributors have begun waiving their $50.00 processing fee for used gas collection. R-22 production is limited to 110 million pounds in 2010 compared to a demand level estimated at 137 million pounds.
With a significant shortfall coming, prices virtually have to rise because that is the only way for gas reclamation to increase from the estimated 10 million pounds of recent years to the 27.5 million pounds that will be needed to fill the virgin gas shortfall. In the 1990's, the EPA passed similar legislation to phase out a predecessor gas called R-12. At the time the law was passed, R-12 had an estimated 20% share of the refrigerant gas market and was selling for $1.00 per pound. Over the next 7 years, the price of R-12 soured to over $28 per pound. It was this dynamic with R-12 that gave Hudson an opening into the industry, when their new and patented reclamation process drove many producers including DuPont to exit the reclamation business. Hudson went public in 1994 at $6.00 per share and quickly appreciated to $28.00 per share by April 1995 in anticipation of the impact of the R-12 phase-out. At the time, the impact of the R-12 phase-out was limited because R-12 accounted for less than 20% of the refrigerant gases in use at that time, and the outlawing of gas venting by the EPA did little to discourage the refrigeration service industry from venting other types of gas. Today in contrast, with R-22 accounting for greater than 60% of refrigerants in use, and given that current refrigeration machinery (with an average useful life of 20 years) cannot use new substitute gasses without a retrofit, the impact of the R-22 phase-out on Hudson's financials should be much more profound than what they experienced in the 1990's.
The current replacement gas for R-22 is known as R4-10A, which is part of a class of gas refrigerants known as HFC's, which are the next generation of gasses after HCFC's such as R-22. R4-10A currently sells near $4.00 per pound so Hudson realizes similar profits on distribution and reclamation of this gas as it does currently with R-22. R4-10A cannot be used with machinery designed to run R-22, and since refrigeration equipment has an average life of 20 years, demand for R-22 will remain for some time, even as the price continues to rise. Note however that there are signs that the EPA has realized that the only way to grow the reclamation market is permanently raise the prices of all refrigerant gasses. Recently, the House of Representatives passed legislation that would begin to phase-out the production of HFC's in 2012 in order to drive up the price of that product. The bill is currently sitting in the Senate. An eventual passage of this bill would help to ensure an attractive price structure in the reclamation industry for many years to come, even after demand for R-22 begins to phase out.
Impact of R-22 Phase-Out on Hudson's Financials:
As prices for R-22 continue to rise and the reclamation market expands, Hudson's gross profits stand to benefit from several factors:
(1) Improving price. As Hudson targets a roughly constant gross margin, its gross profit dollars should increase as R-22 pricing goes up. This is also true for its virgin gas distribution business, where management also believes it can maintain gross margins as prices rise.
(2) Improved Mix. Hudson should be able to realize gross margins of at least 50% in its reclamation business compared with only 30% in distribution. This is because Hudson can essentially charge whatever it wants for used gas, balancing the trade offs of volume and margin (management views 50% plus as the appropriate target). As the reclamation business grows, Hudson's gross margin should expand as a result of increasing mix of reclamation sales.
(3) Increased Market Share. As the reclamation in the Residential and Light Commercial channel picks up, Hudson's market share should rise as a result of its national and regional agreements with DuPont, Honeywell and Arkema. In theory, Hudson should control 100% of the incremental flow from this channel representing 70% of the refrigerant market.
A Set-Back in 2009:
As the price of R-22 began to increase, Hudson's gross profit began to expand. The Company generated 5 years of double digit sales growth leading into 2008, where they generated a record $0.22 of operating EPS. Hudson's share price broke out of its long-term $1.00+/- range to briefly reach $3.00 per share. In 2009 however, Hudson suffered a significant setback. First, the financial crises of late-2008 disrupted traditional industry ordering patterns, as refrigerant customers postponed repairs and other non-essential work and distributors drew down existing inventory and held off on placing new orders. Then, the spring of 2009 turned out to be one of the most mild on record with no days in excess of 90 degrees until late in the summer. This allowed distributors to continue drawing down on existing inventory without the need to place new orders. This impacted Hudson's volumes and also had the surprising impact of temporarily lowering the price of R-22, from the $5.00-range reached in 2008 to around $4.00 per pound.
As the summer approaches, R-22 spot pricing has recently edged up to $4.50 per pound. Management believes that distributor inventories are low coming out of 2009 and as the first hot days of summer approach, orders and pricing should begin to increase. On their recent Q1 earnings call, management indicated that both order pace and pricing were accelerating toward the end of the quarter. There have already been at least 2 90+ degree days in the Northeast (2 more than last year) and in total, the East Coast is thus far having an above-average temperature summer thus far. The benefits of this should be reflected in Hudson's current quarter.
Earnings Potential:
The following table illustrates the profit potential for Hudson in 2010 and over the next few years under various scenarios. The "Base" Case for 2010 shows Hudson quickly getting back toward peak EPS levels achieved in 2008 using current spot pricing and no increase in market share. The scenarios for 2011/2012 show that with even a modest increase in pricing and market share (with prices assumed to be well below the $28.00 ultimately realized for R-12) that Hudson's EPS could approach or exceed $1.00 per share over the next few years.
Hudson Technologies: Earnings Scenarios:
Current Share Price:
$2.15
2010E Case
2012 Potential Scenarios
2008A(1)
Base(2)
Upside
Downside
Base
Upside
R-12 Pricing
MARKET ASSUMPTONS
R-22
Market Size ($ mm)
$650
$620
$758
$704
$938
$1,173
$2,933
Market Size (lb mm)
162.5
137.8
137.8
117.3
117.3
117.3
117.3
EPA Limit on Virgin R-22 Producton
162.5
110.2
110.2
89.7
89.7
89.7
89.7
Expected Shortfall (mm lbs)
0.0
27.5
27.5
27.6
27.6
27.6
27.6
Reclamation market size (mm lbs)(1)
10.0
27.5
27.5
27.6
27.6
27.6
27.6
R-22 Price / lb
$4.00
$4.50
$5.50
$6.00
$8.00
$10.00
$25.00
Estimated Total Reclamation Mkt Size
$40
$124
$152
$165
$221
$276
$689
HDSN Estimated Market Share
20.0%
20.0%
22.5%
22.5%
25.0%
30.0%
25.0%
Other Refrigerant Gasses (ex. R-22)
Market Size ($ mm)
$350
$357
$379
$364
$387
$546
$546
Market Size (lb mm)
87.5
89.3
89.3
91.1
91.1
91.1
91.1
Price / lb
$4.00
$4.00
$4.25
$4.00
$4.25
$6.00
$6.00
Total Refrigerant Gas Market ($ mm)
$1,000
$977
$1,137
$1,068
$1,325
$1,719
$3,479
HDSN Est'd Mkt Share - Distribution
2.5%
2.5%
2.5%
2.5%
2.5%
2.5%
2.5%
COMPANY ASSUMPTONS
Revenue(1)
Distribution (Virgin Gas)
$25.2
$24.6
$28.7
$26.9
$33.4
$43.3
$87.7
Reclained Gas Sales
8.0
24.8
34.1
37.2
55.1
82.7
172.3
Total
$33.2
$49.4
$62.7
$64.1
$88.5
$126.0
$260.0
Estimated Gross Margins
Distribution (Virgin Gas)
32.9%
30.0%
30.0%
30.0%
30.0%
30.0%
30.0%
Reclained Gas Sales
45.0%
45.0%
47.5%
47.5%
50.0%
50.0%
50.0%
Estimated Gross Profit
Distribution (Virgin Gas)
$8.3
$7.4
$8.6
$8.1
$10.0
$13.0
$26.3
Reclained Gas Sales
3.6
11.2
16.2
17.7
27.6
41.4
86.2
Total Gross Profit
11.9
18.5
24.8
25.8
37.6
54.4
112.5
Company Gross Margin
35.8%
37.5%
39.5%
40.2%
42.5%
43.1%
43.3%
Estimated SG&A
$5.9
$7.6
$9.0
$9.2
$10.0
$10.0
$10.0
Approximate EPS
$0.22
$0.29
$0.44
$0.47
$0.81
$1.33
$3.14
Implied P/E
9.8x
7.3x
4.9x
4.6x
2.6x
1.6x
0.7x
(1) Note: Primary alternative to reclaimed gas is to invest money to retrofit equipment to be able to use newer HFC gasses. While retrofitting could account for some of the virgin gas shortfall, it must be noted that in 2008,
even without an EPA-engineered shortfall, reclamation was able to capture 4% market share (10mm lbs). Therefore, it is quite possible that reclaimed gas sales will meet or exceed the amount of the engineered shortfall.
Conclusions:
Hudson's enhanced earnings potential should begin to be evident on their Q2 earnings call with expected improvement in year-over-year performance and what should likely be positive commentary around pricing and volume trends. Management also believes there are a few sell-side firms that would potentially launch coverage of Hudson upon seeing further proof of the expansion of the reclamation industry. Hudson's stock price jumped from approximately $1.00 to nearly $3.00 per share in Q1 simply as a result of the finalization of the EPA phase out mandate of R-22. Since then, Hudson's share price has retreated to $2.15 on low volume as the market awaits the summer selling season and evidence of the R-22 phase-out beginning to drive up pricing. While the shares should be volatile along with the markets over the next few months, an entry price here offers substantial upside potential should the scenarios illustrated above unfold as expected. Evidence of $1.00+ EPS potential could drive Hudson's share price to the $8.00-$12.00 level, which would offer a catalyst-driven return of 2-4x over the next few years. Meanwhile it is trading close to 10x the eps of 2008 - which was 2 years before the phase out and one would think that the EPA actions directionally need to drive eps up from there.
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