Description

Summary

On January 1, 2020, marine vessels will have to comply with a new low-sulfur bunker fuel regulation known as IMO 2020. This is a winning lottery ticket for Liqtech (LIQT) as it will drive significant demand for its silicon carbide filter. Our expected payout is $0.50/share in annual EPS, an absurd amount to suggest considering the stock is at $1.45 and the company has not been EPS (or even EBITDA) positive in the last 6 years.

While our estimates may appear dubious, only government regulation (and perhaps technology) could spur such transformation in stalwart end markets. Proof of concept could come on the November 14 earnings release as management is expected to provide an initial backlog disclosure.

Situation Overview

At its core, Liqtech is an R&D outfit that focuses on the development of silicon carbide (SiC) membranes for various filtration applications. While the company’s membranes offer significant advantages, Liqtech has had difficulty disrupting and displacing incumbents in entrenched industries. The only consistent revenue driver has been the sale of diesel particulate filters (DPF).

IMO 2020 imposes a global 0.5% cap for maritime sulfur emissions. To comply, ships will either 1) use low sulfur fuel (LSFO), at a 60% price premium, instead of high sulfur fuel (HSFO), 2) convert to LNG, or 3) install an exhaust gas cleaning system, i.e. a scrubber, and use HSFO. LIQT makes the filter for scrubbers.

Investment Thesis

LIQT will be a prime beneficiary of significant scrubber demand created by IMO 2020. This should translate into $0.50 of 2020 EPS and a $6-10 stock. For our thesis to work, we need to believe 1) IMO 2020 will be enacted, 2) a portion of ships will install scrubbers, and 3) LIQT will provide the filter for a portion of those scrubbers.

While the investment carries above average risk, recent regulatory events combined with framework/supply agreements with 7 of the top 10 OEM manufacturers provides some mitigation.

Investment Point #1: IMO 2020 Will Be Enacted

Central to our thesis is the implementation of the regulation, which imposes a 0.5% cap on maritime fuel emissions from the current 3.5% beginning January 1, 2020. Ships will either use LSFO (60% higher cost than HSFO), install a marine scrubber at a cost of $2-10mm and continue burning HSFO, or convert to LNG. Some ships may elect to do nothing and risk enforcement, but the penalties are high, and it will be difficult to skirt the rules if ships port in developed countries.

We will keep the discussion of IMO 2020 brief as nearly ever sell-side firm and maritime industry body has published extensive reports on the subject. Please see the appendix for links to several reports for more background information.

While the regulation has been in the making for years, most industry participants believed the implementation date would be delayed or there would be no implementation at all. The industry lobbied extensively against the regulation due to the added fuel cost and capex. Additionally, many vessel owners publicly derided the scrubber option and opted to take a wait and see approach.  Maersk, the industry bellwether, was vocal in early 2018 about not installing scrubbers. However, sentiment began to change in early 2018 when it became apparent IMO was steadfast. Gamesmanship began to crack in Q2 as scrubber orders started to get placed. In September, Maersk reversed course and decided to install scrubbers on a limited number of vessels.

We believe sentiment will only get better based on some recent developments. IMO’s Marine Environment Protection Committee (MEPC) convened on October 24 to discuss implementation. Running up to the meeting, there was speculation IMO may delay the regulation. A group of 5 nations and 3 industry trade groups submitted an appeal on August 31 to implement an Experience Building Phase (EBP), which many viewed as an attempt to delay the sulfur cap. This gained further steam when President Trump publicly called for the delay of IMO after IEA predicted it would be a $100bn headwind to GDP. This posed some risk but two positive events came out of the MEPC meetings:

1.       MEPC ruled against endorsing an experience building phase (EBP)

2.       MEPC instituted a Carriage Ban, which prevents vessels from carrying non-compliant fuel (i.e. HSFO) unless a scrubber is installed

Both are significant positives for IMO 2020 and a LIQT investment. Dismissing the EBP further cemented the IMO 2020 regulation. The Carriage Ban helps with enforcement by empowering port states to check whether vessels leaving their waters have enough compliant fuel on board for their entire journey. Prior to this, industry participants believed ships would carry both fuels and only switch to LSFO while near port.

Additionally, some industry players believe failure to adopt the sulfur cap could render a ship “unseaworthy” and cause it to lose its insurance coverage. This provides a further enforcement measure.

The change in sentiment can be monitored via scrubber orders/installations. Q2 saw minimal scrubber orders as ships took a wait and see approach on the regulation. However, there has been a surge in Q3 orders indicating to us the sentiment has shifted. DNV GL puts out a monthly estimate and as you can see, there has been significant changes in only the last few months (note: the graph below only includes the current order book and not projections).

Investment Point #2: To comply with IMO 2020, there will be significant demand for marine scrubbers

Of the 60-90k vessels worldwide, there are 20-22k vessels that are in the sweet spot for scrubber adoption (i.e. their size and fuel consumption make the economics attractive).  It is also estimated that 65% of the 1,200 new builds each year will install a scrubber. There are many factors to consider in making an IMO compliance decision (NPV, payback period, size, location, age, value, routes, etc.). Again for brevity’s sake, we provide a list of reports in the appendix that go through the full details of this analysis. For those looking purely for the financial analysis, we would recommend Goldman’s 9/5/18 IMO 2020 report, JP Morgan’s 9/19/18 IMO 2020 Scrubber Update, and DNB Markets 9/13/18 IMO 2020 report.

There are three key themes to address:

1.    Growth in the scrubber market

2.    Mix shift from open-loop to hybrid/closed-loop

3.    Mix shift from centrifuge to filtration

Growth in Scrubber Market: In 2017, there were around 370 scrubber installations. There are estimated to be around 2,000-4,000 ships installed with scrubbers prior to IMO implementation and around 5,000-8,000 by 2026. There is a timing issue between orders and installations. Order volume will far exceed installations due to the capacity constraints at the OEMs and shipyards. Additionally, there is usually a 3-6 month lag between when OEMs get orders and suppliers receive orders. We expect around 1,500-2,000 scrubber installations in 2019, 2,000-2,500 in 2020, and 2,500-3,000 in 2021. Some recent commentary on the order flow is below:

• "The order book is largely sold out for 2019 and [has moved] into 2020 at this point in time, with some order bookings already into 2021.” – Alfa Laval (Q3 2018 Earnings Call, Oct 24, 2018)

• “The market will continue '19, '20 and beyond to retrofit on existing ships. And of course, all the new builds will most likely be equipped with equipment like this for the future.” – Valmet (Analyst/Investor Day, Sep 18, 2018)

• "We are having already today scrubber orders which are beyond 2020. Already '21, probably '22" – Wartsila (Q3 2018 Earnings Call, Oct 23, 2018)

Mix Shift from Open-Loop to Hybrid/Closed-Loop: In 2017, hybrid/closed-loop systems accounted for only 20-30% of scrubber installations. This created an addressable market of around 80 systems for Liqtech, which makes the filtration for the water cleaning unit of hybrid and closed-loop systems. We believe that over the next several years, hybrid/closed-loop will capture the majority of market share. This will significantly increase the addressable market for Liqtech.

Many vessel owners view hybrid or closed-loop scrubbers systems as superior to open-loop designs given the potential for future regulations that ban open-loop. Critics of open-loop designs take issue with the system’s wastewater discharge, which contains captured air pollutants from a vessel’s engine exhaust. Because the discharge is released into the ocean and can contain heavy metals and other pollutants, critics say open-loop is merely transferring pollutants from air to sea. In September, an official of the Chinese Ministry of Transport stated he was unsure if China would allow open-loop scrubbers within its coastal waters. This led to much speculation about other jurisdictions banning open-loop, and while China has since denied claims that it would institute a ban, the concern remains that more strict future regulations could limit where vessels with open-loop systems may operate.

As a testament to this mix-shift, Alfa Laval (#2 market share), introduced a hybrid scrubber system. Previously it only sold open-loop systems.

Mix Shift from Centrifuge to Filtration:  Hybrid/closed-loop scrubbers currently utilize two types of processes to separate pollutants from the discharge water: filtration (45% market share) and centrifuge (55% market share). Instead of forcing wastewater through a membrane, a centrifuge separates the waste by spinning it. While the upfront costs for both technologies are comparable, there are several downsides with centrifuge, including 1) higher operating costs, 2) larger footprint, and most importantly 3) discharge quality. It is far easier to measure and ensure compliance using filtration (which physically will not allow certain sized particles to pass through a membrane) versus centrifuge, which offers less accuracy.

Centrifuge has been the incumbent technology and filtration was only introduced a few years ago. Since IMO 2020 sets specific discharge limits, the water cleaning unit has received much more scrutiny. Vessels (who opt for scrubbers) obviously want to ensure compliance and the OEMs (from a liability standpoint) want to ensure they meet the technical endpoints. We believe filtration is the safest way to ensure compliance.

Investment Point #3: LIQT will garner its fair share of the scrubber market

We believe the market will shift towards both hybrid/closed-loop and filtration, which will vastly increase Liqtech’s addressable market from 80 units in 2017 to 1,400-2,000 in 2019+. We think LIQT can garner 25-50% of this market.

While growth in the scrubber market is clear, how can we be certain LIQT will garner its fair share? Over the last several months, LIQT signed three framework agreements with OEMs, which provide some visibility into orders. A review of each agreement is below:

1. March 21 Agreement: We believe this agreement could be with Yara as the company has publicly discussed their close relationship (see 3Q17 earnings call). The framework agreement has an initial term for 2018 and 2019 and provides that more than 95 systems are estimated to be delivered during the initial term. While this is only an estimate, management’s recent comments suggest these will be achieved. We estimate the contract value at $43mm. Most importantly, this agreement requires a minimum number of orders contain a Liqtech filter. Yara’s order book is currently at $400mm and at record levels (see page 18).

2. April 11 Agreement: This framework agreement has an initial term for 2018 and 2019 and is estimated for a minimum of 35 systems to be delivered. The first 14 systems to be purchased under the framework agreement have already been identified. Most importantly, this agreement requires that a minimum number of orders contain a Liqtech filter. We estimate the value at $16 million.

3. October 1 Agreement: This framework agreement is with one of the world’s largest marine scrubber manufacturers to develop a new product for the treatment of marine scrubber wastewater. Management said on its October shareholder call that they expect to deliver 80-100 systems in 2019 and several hundred in 2020. We estimate the 2019 value at $23mm and the 2020 value at $88mm.

These three agreements provide for $82mm in order value. There may be some timing issues between orders and deliveries so it might not all be recognized in 2019 revenues. Needless to say, the one analyst covering the stock (Craig-Hallum) has 2019E revenues of $27mm.

Beyond those agreements, management has disclosed that it is working with 7 of the top 10 scrubber manufacturers. From our research, we believe competitors are small and nascent (however, competition is inevitable). Liqtech does have a first mover advantage, has spent years conducting trials with the OEMs and ship owners, and has IP. It took roughly $60mm and 10 years to develop its SiC membrane.

Liqtech currently has capacity to produce 250 units/year ($80-100mm in revenue and $0.30-0.40/EPS). Additionally, the company said it will be at full capacity by Q4 next year. Based on that, we think it will make the decision to expand. The company has publicly said it will cost $3mm to double capacity. We build a small equity raise into our model to account for that.

Valuation

We will be the first to admit there are a lot of “ifs” in our model and valuation is inherently tricky. There are no good comps. The closest we found are ERII and FLS, which trade at 20x 2019 EPS. There are a lot of similarities in the business model and history between ERII and LIQT (no surprise that ERII’s former CEO and CFO are on LIQT’s Board). In lieu of debating the right valuation ad nauseam we give a brief overview of our approach and leave the reader to pick their own method.

First, if our numbers are in the ballpark, there is no reason to believe this company should not garner at least a 15x multiple. That puts the stock at $7.50 based on our 2020 EPS number. This also implies about 9.4x EBITDA, which does not seem too crazy given the growth trajectory.

Second, we look at a case study of HDSN, which is a refrigerant company that was also expecting rapid growth based on regulation. In 2016, estimates increased 50% on rising expectation that regulation would drive significant growth. EV/EBITDA, which averaged around 7-8x, expanded to 11-12x and P/E multiples expanded from an average of 12-15x to 19-25x. While this is not a perfect comparison, it does provide an example of what valuation could look like for an obscure micro-cap company that sees rapid growth based on regulatory adoption.

Where We Would Expect Pushback

While the returns could be large, the investment does have above-average risk. We want to proactively address areas we expect to receive pushback.

1. Liqtech has continuously missed its goals, why should this time be any different? Over the last five years, the company has touted its superior membranes and how it was going to disrupt 5-10 different end markets, none of which came to fruition. Historically the company blamed a longer than expected sales cycle and hesitation by customers to adopt new technology. The former CEO/Chairman was also highly promotional.

The key difference now is that regulation is driving adoption. The current CEO summed it up well:

“You’re perfectly right, we've been very bad at projecting the business. But now we finally see that we have some help from legislation, and in a market where we have already proven our technology and we have some very strong partnerships with potential customers.” –Sune Mathiesen, CEO, March 30, 2017

2. Will earnings peak in 2021 and is that a fair metric for valuation? Some may argue that after the pent up scrubber demand wanes, our $0.50 EPS estimate will look more like peak earnings and not normalized earnings. Our stance is that the company will hit an elevated level of earnings which will persist for a multi-year period (our best guess is the run-rate will be $0.50). We believe scrubber demand may remain at 2021 levels through 2025. The company also has several other end markets for their SiC membranes they are exploring and should have a steady stream of maintenance revenues on installed systems once the warranty expires  (we give them zero credit for both). Additionally, peak earnings could actually be much higher as the company has discussed the potential to triple capacity if appropriate (which would yield $0.75/EPS).

3. How will the company scale production? From our conversations with management, we believe they have been very thoughtful regarding potential capacity constraints given the production volume they expect to see. We believe they have the plans and people in place to double (or triple) capacity if the demand hits.

4. If the situation is so great, why has there not been any insider buying? The CEO owns 1.4mm shares (1.9%) and is the only insider with material ownership. From our understanding, management and board members are not wealthy individuals. The CEO and CFO earn around $250k per year. The CEO has been at the company for nearly five years and has a lot invested, both professionally and monetarily. He also believes friends and family own another 2mm shares. The CFO joined only a few months ago. We can only hypothesize that given the framework agreements the company has been negotiating this year, perhaps there was no open window to buy stock. Needless to say, even a small open market purchase would lend some credence to the story.

Risks to Scrubber Demand

There are several risks to scrubber adoption we are monitoring:

1. Lawful noncompliance via FONARs – Several IMO 2020 observers have pointed to the possibility that vessel owners will continue to burn high sulfur fuel, without installing a scrubber, if compliant fuel is unavailable for purchase at a given port. In such instances, when arriving at port, vessel owners would submit a fuel oil non-availability report (FONAR) to the port authority. This leaves the port authority with the responsibility to determine if the report was submitted in good faith. If port authorities are too lenient with FONAR oversight, vessel owners could file FONARs repeatedly as a means to avoid both the more expensive low sulfur fuel and capital intensive scrubber installation.

2. Spread between high and low sulfur fuel – The argument for scrubber installations hinges on an adequate spread between high and low sulfur fuel. The greater this spread, the shorter the payback period of an investment in a scrubber system. Currently the consensus view is that come January 1, 2020 the spread will be wide enough to provide a scrubber payback period of approximately 2 years, which for many ship owners is an attractive proposition. This view may prove incorrect as it assumes that pricing for the low sulfur fuel blend (0.5% sulfur content)—a specification standard which has not yet been brought to market—will resemble pricing of currently available low sulfur fuels like marine gasoil (MGO). If the low sulfur fuel prevailing post January 1, 2020 is cheaper than MGO, the spread will be narrower than initially anticipated. Further, this spread could narrow if refineries are able to bring compliant low sulfur fuel to market quicker than expected, or if high sulfur fuel is less available than expected due to greater demand from noncompliance, greater demand in non-bunkering end markets (e.g. power generation), or reduced production at refineries. For further discussion on this topic, we recommend reviewing Euronav’s 3Q18 transcript. Our view is that ships are going to have to make an IMO 2020 compliance decision well before the threat that spreads narrow. This event won’t be known until mid-2020 and if shippers like Euronav turn out to be incorrect, they will be years behind on the scrubber waitlists and their ships will charter at disadvantaged rates. Therefore, we believe compliance decisions will have to be made well before a change in spreads.

3. Inadequate enforcement – There has been much speculation surrounding the degree to which the new sulfur cap rules will be enforced and the strength of penalties. While the Pollution Prevention and Response (PPR) sub-committee of the IMO is charged with implementing enforcement mechanisms, enforcement authority ultimately resides with flag states. This could be problematic as some flag states may lack the resources needed for enforcement, may lack commitment to enforcement, and/or may assess low fine amounts that invite non-compliance. While there is currently no clear and consistent penalty for non-compliance, Euronav recently suggested penalties could be assessed on the net value gained on a voyage, as a penalty per day of non-compliance, or as a fixed amount. As an example, currently in US emission control areas (ECAs) EPA regulations call for civil penalties of $25,000 per violation per day. Further clarity on a more consistent enforcement framework should follow the PPR’s next meeting set for February 2019.

Appendix:

IMO 2020 Reports

1. DNV guidance paper: “Global Sulphur Cap 2020 - extended and updated; Compliance options and implications for shipping – focus on scrubbers”

2. SEB IMO 2020 Report

3. Platts special shipping report (from May 2017): “Tackling 2020: the impact of the IMO and how ship owners can deal with tighter sulfur limits”

4. IHS Markit white paper: “Refining and Shipping Industries Will Scramble to Meet the 2020 IMO Bunker Fuel Rules”

5. Argus Media white paper: “IMO, IMO it’s off to sea we go….”

IMO 2020 Compliance Decisions (source: Bloomberg)

Catalyst

1. November 14 earnings release as management is expected to provide an initial backlog disclosure

2. Scrubber orders