Hudson Technologies (HDSN) has been cut in half from its peak price in late March to its current level of $2.34. The cold spring (coldest in U.S. since 1996) and larger-than-expected EPA allocation for production of virgin R-22 (HCFC-22) in 2013 and 2014 led to a ~30% near-term decline in R-22 prices and reduced profitability for 1H13. For 1H13 (to be announced next week), EPS is expected to be $0.17-0.18, down from $0.29 for 1H F12.

I recently explored this idea with a positive bias (as I traded the stock last year) yet as I learned more about the competitive dynamics of the R-22 market and spoke with management, my view quickly soured. I now think that HDSN is not investable and may be an interesting short idea, especially after any rallies.

The bullish view is that the overall trend of mandated annual step-downs in virgin R-22 production will continue through 2019, supporting R-22 prices and growing the R-22 reclamation market (HDSN's target market for which it is the “industry leader”). This idea has been written up four times before (12/28/08, 6/18/10, 1/25/12 and today). Most recently, Bowd57 made a great trading call. This write-up tries to outline more of the long-term fundamentals and share some concerns I found.

Current R-22 Reclamation Market:

R-22 is a commodity: the price of virgin R-22 is the same as the price of reclaimed R-22. More clearly, it is a dying commodity because systems that use R-22 are no longer being built and all existing systems that use R-22 are being gradually replaced or retrofitted with other refrigerants that do not harm the ozone layer. Now, new systems are often using R-410A, which does not harm the ozone layer. R-410A, which is becoming the industry standard, costs substantially less at $4-5 a lb (versus $8-10 for R-22).

The U.S. EPA HCFC Allocation Rule for virgin R-22 went into effect on April 3, 2013. Total industry-wide allocations for virgin R-22 production are now as follows:

2010: 110 m lbs

2011: 100 m lbs

2012: 55.4 m lbs (final rule 4/3/13)

2013: 61 m lbs (final rule 4/3/13)

2014: 51 m lbs (final rule 4/3/13)

2015-2019: TBD (final rule expected late 2014/ early 2015)

2020: 0 m lbs (mandated complete phase-out by end of 2019)

Today, the total market for R-22 (virgin and recovered) is about 100 lbs, per the company. Currently, about 20 companies sell virgin R-22, and three of those - Dupont, Honeywell, Arkema - have about 85% market share. About 10 m lbs of R-22 is reclaimed (per the company) and another 3-10 m lbs of R-22 is recycled by large companies. Note that the vast majority of used R-22 is vented into the environment rather than recovered (recycled or reclaimed). There is a large inventory of R-22, perhaps as much as 90 m lbs per EPA. That means that in 2013, the 100 m lbs of R-22 demand will be met with roughly 61 m lbs virgin supply, 10 m lbs reclaimed, 3-10 m lbs recycled, and 19-26 m lbs of inventory. That means the reclamation market today is about $80-100 m, consisting of 10 m lbs at $8-10 a lb.

Going forward, virgin R-22 production will be stepped down to zero (2020). Meanwhile, demand for R-22 (virgin, recycled, or reclaimed) will also eventually go to zero (maybe 2025-2030) as the industry gradually shifts to few/no systems which use R-22. As R-22 prices stay high and as systems gradually wear-out (over their 10-20 year useful lives), companies will replace or retrofit their systems with non-ozone-harming refrigerants, especially R-410A.

About 34 companies sell reclaimed R-22, with HDSN often mentioning its 20% market share and “industry leading” position. However, I doubt that HDSN is actually the “industry leader” as I believe AirGas (NYSE: ARG) has perhaps 30% market share. Other competitors include National Refrigerants (private; refrigerants.com) also with maybe 20% and Diversified Pure Chem (private; divpc.com) with maybe 5%.

Current HDSN Financials (2012/2013):

In 2012, HDSN had sales of $56.4 m and EBIT of $14.9 m, which is EPS of $0.34 (fully taxed). So far in 2013, guidance for 2Q13 implies 1H13 sales of about $38.4 m, slightly ahead of 1H12 sales of $37.1 m. However, profits are down for 1H13, with EPS expected to be $0.17-0.18, down from $0.29 for 1H12.

So, here is a company that focuses on re-producing a dying commodity (with 33 competitors) that is trading above 10x F13 EPS. If we take F12 instead, then the stock is trading at 7x EPS (fully-taxed), which also seems like a full valuation for a re-producer of a dying commodity (with 33 competitors).

Future R-22 Reclamation Market (2020):

With no more R-22 systems being built and with virgin R-22 production ceasing in 2020, existing R-22 systems will have to be: 1) replaced (usually with a system that uses R-410A, which is inert to ozone and is becoming the new industry standard), 2) retrofitted (using a different refrigerant that is compatible with R-22 systems, like R-407C or DuPont's ISCEON M099), 3) used with recovered R-22 that is recycled (which could become common for large companies like supermarkets), 4) used with recovered R-22 that is reclaimed (HDSN's target market), or 5) used with R-22 inventories, if available.

We know that in 6.5 years (in 2020) virgin R-22 will not be produced. It is unclear how big the reclamation market will be at that time. All new systems being built today do not use R-22. Existing systems that use R-22 are being replaced and retrofitted at a rate such that the demand for R-22 in 2020 may be down to 40-50 m lbs (or less) from its current level of 100 m lbs. Inventories and recycling (by larger companies) could supply half of the demand, which leaves half of the market for reclaimed R-22, or 22.5 m lbs a year. With current pricing of $8-10 a lb that’s a $180-225 m market, roughly double the market today. That is significantly less than the $800 m market that the company continually alludes to in its investor presentation.

Future HDSN Financials (2020):

With 20% market share (maintaining its market share of 20%, which will be difficult as competition will intensify with 34 competitors competing on price) of a $200 m (shrinking) reclamation market in 2020 and perhaps $20 m in other refrigerant sales and $5 m in service offerings (up from $4.2 m in 2012), that's company sales of $65 m.

Anecdotally, today reclaimers typically buy dirty gas (feedstock) at about half of the price of virgin R-22 and then take $1-2 per lb to process/purify it, which implies gross margin well below 50%. The company is targeting (i.e. hoping for) 35+% long-term gross margin.

Meanwhile, per HDSN, SG&A should approach $10 m a year long-term as the company doubles its R-22 capacity by adding a second shift.

So, even if the company hits its 35% GM goal and maintains its market share against 33 other competitors, with $10 m SG&A, that's $12.75 m EBIT, or $7.1 m NI (with $1 m interest and 40% taxes), or EPS of $0.27 with 26.4 m FDS. 6x (a dying market for R-22 refrigerants) implies a $1.61 stock, a decline of 31% over 6.5 years. Those economics are based on the company maintaining its competitive position in a shrinking commodity market with 34 competitors. If/when the company’s competitive position deteriorates (with AirGas and 33 others competing on price), then earnings potential will be substantially less, possibly zero. Eventually, the reclamation market will be zero (when virtually all units are replaced or retrofitted, perhaps in 2025-2030). Both the competitive dynamics and shrinking market at that time (2020) could be especially problematic considering the company’s net debt position.

Some of the catalysts to the short:

1. Founder/CEO/Chairman Kevin Zugibe (who has over 4 m shares including options) has been a size seller above $4 over the last year

2. Future market size for reclaimed R-22 likely to be considerably less than expected ($800 m per HDSN investor presentation). The refrigerant R-410A is rapidly becoming the standard for new and replaced units. The price for R-410A is about $4-5 a lb, well below R-22 at around $10 a lb. Meanwhile, various retro-fits, such as R-407C or DuPont's ISCEON M099, are emerging. Also, larger companies (e.g. large supermarkets) can choose to recycle R-22 themselves (instead of reclaiming it). In addition, there is a large inventory of R-22 of as much as 90 m lbs. As a result, we believe the reclamation market will be more like $200 m, not the $800 m that company continually illustrates. Eventually, the reclamation market will be zero (when virtually all units are replaced or retrofitted, perhaps in 2025-2030).

3. Company has a net debt position and its credit facility of $40 m expires in June 2015

4. No clear, long-term competitive advantages for HDSN other than being an incumbent with some market share. AirGas and the 33 other competitors will increasingly compete on price, which could put HDSN out of business (given its debt), in our opinion. AirGas may already have more market share than HDSN in R-22 reclamation.

5. Seasonality and adverse weather patterns affect results, compressing a whole year’s EPS (like this year)

6. Two customers were 28% of 2012 sales

7. Recent stock issuance of 2,737,500 shares and 1,368,750 warrants (strike of $2) on 7/7/10