Description

Thesis:

HDSN is an opportunity to buy an undervalued company with several near term catalysts that make it a likely double in relatively short order.  Because all these catalysts are totally unrelated to broader economic conditions, HDSN is a rare opportunity in a horrible economy to invest in a stock that should do well regardless of how badly the US economy deteriorates.

Hudson Technologies is poised to benefit from the oncoming enormous supply/demand imbalance due to the phaseout of r22 refrigerant.  At 4x trailing Mkt Cap/EBIT, the market is pricing in peak earnings.  To the contrary, I think peak earnings are likely at least 2-3 years off, and that enormous price increases in 2009 and 2010, combined with greater demand for reclaimed gas, will result in HDSN more than doubling profits next year, with 2010 a potential blockbuster depending on how several key issues play out.  Management has put their money where there mouth is, and took several million in debt about one year ago to buy stock. 

Background & History

Hudson sells virgin R22 gas and also reclaims (recycles it).  The majority of their revenue comes from virgin sales, in which Hudson acts as a distributor for Dupont—the company does not disclose but I estimate about 2/3rds of revenue comes from virgin sales. 

R22 is refrigerant that is used in a variety of cooling systems.  In the course of regular maintenance the gas often needs to be replaced, creating consistently reliable demand for replacement r22  gas.  When repairs are done, the contractor will usually come out and vent the existing gas in order to do the repair.  He can either capture this gas (which he is supposed to do by law, but which generally no one does), or he can just vent it into the atmosphere.  It’s a pain to capture it, and there is no economic incentive to do it (actually, there is usually a disincentive, as distributors until recently would charge contractors for sending the dirty gas back to reclaimers), so unsurprisingly all this gas was vented.  Venting HCFCs into the atmosphere is not good for the environment.  The EPA banned CFCs in the 90s, and are following a similar playbook with R22 (an HCFC).

In 1996, production on R22 was strictly limited (sorry for formatting):

Date Consumption Cap ODP Weighted Quantity Quantity Expressed in
R-22 Metric Tonsa
Jan 1, 1996 Consumption freeze capped at 2.8% of the 1989
ODP-weighted CFC consumption plus 100% of
the 1989 ODP-weighted HCFC consumption 15,240 ODP-metric tons
b
  277,091 metric tons
Jan 1, 2004 35% reduction of the cap 9,906 ODP-metric tons  180,109 metric tons 
Jan 1, 2010 65% reduction of the cap 5,334 ODP-metric tons  96,982 metric tons 
Jan 1, 2015 90% reduction of the cap 1,524 ODP-metric tons  27,709 metric tons 
Jan 1, 2020 99.5% reduction of the cap 76.2 ODP-metric tons  0 metric tonsc
Jan 1, 2030 100% reduction of the cap 0 ODP-metric tons 0 metric tons

Supply cuts were then mandated in 2004, 2010, 2015, and 2020.  The first cut occurred in 2004, but did not result in much in the way of price increases.  The EPA overestimated demand, and so instead of bringing supply below demand, this mandate had the effect of getting supply/demand close to one another.  It also consolidated power into the two big suppliers (Dupont & Honeywell), who control 85% of the market.  Starting in 2005 both began upping prices on R22.  From ~$1 pound in 2004, all the way up to about $4 in 2007, and with anticipations for $8-10 next year.  The cut in 2010 is going to be particularly brutal: supply will be cut in half (from 2004 levels), and demand will certainly overshoot supply by a wide margin.  This expectation has caused some of the price run-up leading into 2010.  Many wholesalers, contractors, and reclaimers we talked to expect $20+ R22 by 2010.   As the price of R22 goes up, HDSN sales go up substantially with flat volume, and they’ve also been able to get slightly better margins.  This results most incremental sales falling to the bottom line, since sales increases are due to pricing and don’t carry much in the way of incremental costs.

Though substitutes for R22 do exist, they either are poorly distributed or require large expenditures to retrofit existing systems.  Most wholesalers I’ve talked to said they have no plans to carry drop-in substitutes (which don’t require retrofitting, but either don’t work well or for other reasons aren’t popular), or, in most cases, just didn’t know that they exist.  The substitutes they do carry generally require retrofitting, and most customers don’t want to expend that capital, especially in this economy, to retrofit their systems.

Reclaimed Gas
The big opportunity for HDSN is in reclaimed r22 gas.  As I mentioned earlier, currently contractors take dirty gas and vent it rather than capturing it.  But, as the price of R22 has increased, and with the supply shortage looming, distributors and wholesalers are rolling out incentives to get contractors to capture dirty gas and bring it back to their stores (they also see this as helping to drive foot traffic).  They are making it easier to return the gas, and they are also paying for it (rather than before, where they used to charge contractors).  With economic incentives flipped, and with higher prices resulting in better economics for reclaimers, reclamation of r22 is becoming much more popular and profitable.  I talked to one reclaimer who said that a year ago, he was making almost nothing on r22, whereas now he’s making about $2-$3 per pound.  Contractors are also calling a lot to inquire about this, which they never did before.

HDSN has a relationship with Dupont where they do some reclamation of Dupont’s gas, which helps HDSN get some of Dupont’s dirty gas supply.  HDSN also hired a former Honeywell exec who has been traveling the country for much of the past year building relationships with Honeywell distributors to help HDSN lock up supply.   Inventory build at HDSN has been high, in large part because HDSN has been investing all their operating cash in building inventory of dirty and virgin gas.  Also, as prices have increased, working capital requirements have also gone up.  When prices finally stabilize in 2010 or 2011, FCF should catch up with Operating income, but for now most cash generating by the business is going into building both virgin and dirty r22 inventory.

Upside:
2009 should be a blockbuster year, as prices are expected to double over 2007.  I’d encourage anyone interested here to call wholesalers of r22, and I’m confident you’ll hear what I heard: prices are going up a lot, and everyone knows it.  Also, now that incentives for contractors have changed, and prices have picked up, profits from R22 reclamation at HDSN should also increase substantially.  This combination of much higher prices on virgin r22 sales and more volume of higher margin reclaimed r22 sales should boost gross profits by 50%+ next year.  With a relatively fixed cost base, I would not be surprised to see operating profits more than double.  Given current valuations, which seem to be pricing in a cyclical peak, I believe this should clearly be a winner in 2009.

In 2010, HDSN’s performance is a bit more uncertain.  The reclamation market should take off in 2010, as mandatory supply cuts create an enormous supply/demand imbalance.  HDSN seems well positioned to capture a big part of the reclamation market (they claim to currently have 50% market share, but market data is poor, and is also highly regional, making this tough to confirm).  I suspect with their Honeywell and Dupont relationships that HDSN should do well here, but it’s not a lock.

The bigger question mark is what happens to HDSN’s supply of virgin R22 in 2010.  I assume that HDSN will see volume drop by 50% (on par with supply cuts at Dupont), in which case with a 100% price gross profits on virgin should be roughly flat year over year.  That said, it is also possible that Dupont either decides to take away more or less supply from HDSN in particular.  HDSN claims that their strategic relationship with Dupont means that they expect NO volume decrease at all, and that instead smaller distributors are the ones who are likely to have supply taken away from them.  I am skeptical this will play out but if it does 2010 should be a monster year.  There’s also a chance that Dupont cuts out HDSN more than their other suppliers, in which case 2010 would likely be flat or potentially even down a little, though this seems unlikely.

Management:
One thing that gives me some confidence here is how much management has put of their own money into the stock. The CEO has been running HDSN since 1991, but it wasn’t until last year that he really put a lot of money behind the stock.  He had a family friend take out a mortgage on a $4M property, and then used the money to buy HDSN stock.  He also has to pay the mortgage payments on the house as well.  The timing seems to have been good, as operating performance increased substantially, and the CEO sold back a small portion of the stock he purchased for 4x his money in only a few months.  That’s not a bad track record, and gives confidence that management believes the opportunity in front of them.  The CEO isn’t a wealthy guy (though he is moreso now, because of his timely buy of stock), so this buy was very significant for him personally.

The most recent sales are a bit unusual, and I’ll talk about them more in the risks section.  I believe that with the most recent sales, the CEO has essentially gotten rid of the bulk of the debt he took out, and that future sales are more likely to indicate his thoughts on valuation than the most recent sales.


Risks:
Though I think 2009 is likely in the bag, I have a few more long-term concerns here that are worth mentioning:

1)    Cash flow has been poor.  Management says they are reinvesting in inventory, which makes sense (big price increases require more working capital for the same volume), but this is something I’ll be watching closely to see if it persists.  The inventory turn is also much longer than I would have thought, and it’s possible that with their FIFO accounting some of the profits have been gains on inventory.  I’ve done some work here and am comfortable that the effect of this is minimal, but would of course encourage others to do this themselves as well, as it’s not straightforward and I may very well have made a mistake here.
2)    2010 is a big question mark in a variety of different ways, but in particular with regards to virgin r22 volume coming from Dupont.  If Dupont chooses to cut supply heavily at HDSN, it’s likely that most benefits from price increases and increased reclaimed volume will be offset by decline in virgin sales in absolute dollars.  We will likely re-evaluate this risk midway through 2009 when I have better visibility

Conclusion:
Though not without it’s share of risks, HDSN is a unique opportunity to purchase a company whose prospects are almost entirely independent of the broader economic issues facing economies around the world, where management recently bought a sizeable amount of stock, and where, if a few things go right, this could be a multibagger regardless of what happens with the world economy.

Catalyst

**2009 Q1 & Q2 results, which are seasonally strong and should show strong pricing increases.