Description

Liqtech (LIQT) was written up by Woolly18 in Nov 2018 at $5.8/shr (split-adjusted). The stock is now at $8.0/shr but we think the risk-reward has significantly improved. We estimate earnings will be $1.2-$2.3/shr a couple years from now versus sell-side consensus of $0.9/shr and think that intrinsic value is anywhere from $10-$30/shr. While this very wide range reflects the unpredictability of Liqtech’s rapidly growing market, we think that at today’s stock price permanent impairment of capital is highly unlikely and a very large discount to intrinsic value is quite likely. The implementation of IMO 2020 and greater clarity as Liqtech reports should act as imminent catalysts.

Situation Overview

We highly recommend reading Woolly18’s writeup for detailed background. Briefly, IMO 2020 regulations coming in on Jan 1, 2020 mean that ships globally will be limited to 0.5% sulfur content in their emissions. To comply, most ships will either have to switch to low-sulfur fuel that is currently 40% more expensive than high-sulfur fuel, or install scrubbers. Liqtech manufacturers silicon carbide filtration systems for closed-loop and hybrid scrubbers. As a result, IMO 2020 has been a massive stroke of luck for the company, which 18 months ago was struggling to survive.

In their writeup, Woolly18 identified 3 points that needed to be true for Liqtech to be a multi-bagger:

1. IMO 2020 will be enacted,

2. A portion of ships will install scrubbers,

3. Liqtech will provide the filter for a portion of those scrubbers.

While these points were each uncertain to a significant degree back in Nov 2018, we think that they are now virtually certain: With 5 months to go it is clear that IMO 2020 is not being delayed or cancelled. Just under 10% of the fleet has ordered scrubbers to be fitted by then, with orders not being higher only because the major suppliers are producing at full capacity and cannot take any more orders for 2019. Roughly 80% of these are cheaper open-loop scrubbers and the remaining 20% are the closed-loop or hybrid scrubbers that Liqtech supplies systems for. Liqtech is doing better than most investors would have expected and has seen its market share actually increase from around 40% to over 50% for the closed-loop and hybrid market.

The stock is volatile and having doubled from a low in December it has pulled back 25%. While the ride will likely continue to be wild, we think the risk that Liqtech fails to capture the opportunity of IMO 2020 has now faded. There is still the considerable uncertainty as to what intrinsic value is but in our mind this has now shifted up to $10-$30/shr. Today’s stock price of $8/shr therefore offers an attractive near-term entry point with permanent impairment of capital very unlikely and a discount to intrinsic value likely to close over the next 6-24 months as IMO 2020 kicks in. Liqtech next reports on Aug 14.

Why this opportunity exists

Liqtech is an under-followed company which had a market cap of just ~$20mm 18 months ago having seen its stock fall over 90% since its IPO in 2011. The company has never made a substantial profit and management had failed to deliver on all of its major promises up until IMO 2020 started being taken seriously by shipowners. While Liqtech has delivered extremely impressive order growth since then and the stock has soared, we think the company’s future and value is still poorly understood and will only be priced in by investors as it continues to deliver.

The stock has come down 25% since two of the largest scrubber OEMs (Alfa Laval and Wartsila) reported a slowdown in scrubber orders in mid-July. We think the market looked at these results and extrapolated a long-term reduction in demand for Liqtech’s systems. This is incorrect for 3 reasons:

1.   What matters for scrubber demand is the price spread between high and low sulfur fuels and this has not changed. The slowdown over the last few months is temporary and because the major scrubber OEMs are fully booked until 2020, so shipowners who place orders today will not have them fitted by Jan 1, 2020. Since they are now going to miss the deadline anyway many are choosing to wait and see what the price spread between high and low-sulfur fuels turn outs to be on Jan 1 before making an order:

Wartsila President of Marine Solutions (July 18, 2019): “we have sold out already earlier deliveries for this year, so any scrubber delivery or scrubber order coming in would be for delivery next year. And we have a situation where many customers are in a bit of a wait-and-see mode because they have lost the 1st of January opportunity anyhow and they expect the biggest spread on the fuel then than what we have at the moment. So they will wait and see that how much is the spread developing even if the business case is there today.” 

Alfa Laval President & CEO (July 17, 2019): “this last quarter, there has been orders in the market that have not gone our way… we already are past for any supply in the market, the 2020 deadline... I think maybe that we've seen a tendency that with a 2- year, 2-plus-year payback for a larger vessel to implement the scrubber, perhaps the lifetime guarantee of Alfa Laval global service and Alfa Laval product quality with long lead times has been rather to put the backlog, get something installed and get it to work and get the payback for the period that they were looking at.” 

What really matters for orders then is how this spread develops, and right now the forward curve is actually pricing it to increase and result in a sub-2 year payback for investing in scrubbers (discussed below). As we reach 2020 and shipowners have certainty we should therefore see a resumption in the pace of orders. Since Liqtech is fully booked until Q2 2020, any temporary reduction in orders will not actually impact production. 

2.   Alfa Laval and Wartsila primarily supply open-loop scrubbers, whereas Liqtech supplies systems for closed-loop and hybrid. Orders for open-loop scrubbers are partly slowing as it is increasingly banned at major ports (e.g. Singapore, Fujairah) because they essentially filter out the sulfur that would enter the air and instead discharge it into the sea. Closed-loop scrubbers condense the sulfur and keep it onboard the ship. As a result, orders for closed-loop and hybrids remain relatively strong according to DNV data (see below).

3.   The slowing for Alfa Laval and Wartsila is disproportionately large because they are losing market share due to being fully booked until 2020. While historically they had over 40% share, this is now below 30% again according to DNV data. 

A key piece of data is available from DNV, which tracks scrubber orders in real-time here: (https://afi.dnvgl.com/Statistics) (Go to Statistics > Scrubber Statistics). 

Unfortunately, DNV does not make historic data available so we have had to piece together the timeseries below based on articles written at the time and snapshots we took manually:

Note that DNV reports the number of ships that have ordered scrubbers whereas Liqtech reports the number of scrubbers ordered. Larger ships can require more than one scrubber. In addition, DNV’s numbers are understated because they do not record all orders. For example, Pacific Green (PGTK) in May reported an orderbook of 105 scrubbers from named clients and another 12 from unnamed clients. DNV recorded only the named ones and Pacific Green told us they believe a lot of scrubber orders are not being announced because companies do not want competitors to know they are ordering them. 

Assuming that half of orders in May were received before Liqtech reported on May 14 and that the DNV data is understated by 1/3 suggests that the hybrid & closed market received ~190 orders between the Jan-May 2019 while Liqtech received ~120 orders. This is roughly in line with Liqtech’s commentary that its market share has grown to over 50%. 

Making the same adjustments suggests that the hybrid & closed market has received another ~120 orders since Liqtech reported. Liqtech’s order book is therefore likely to have increased to ~270 as of today. 

It is probably not a good idea to be overly precise with this data, but it seems fair to say that the market has overreacted in its concerns about orders for Liqtech’s filters.

Valuation

Not only does the growth of the scrubber market have a wide range of outcomes, the value of these orders to Liqtech is also uncertain as management have historically been promotional and their guidance is all over the place. This is our main concern, but we think that at today’s stock price the business is significantly undervalued even interpreting their words very conservatively.

At the investor day on June 3, management stated their current capacity is $60mm revenues per year and that this will increase to $150-200mm in July 2020. They also talked about an ASP of $400k, implying capacity is currently 150 systems per year, increasing to 375-500. They expect to hit the increased capacity some time down the line, but not initially. Management have also talked about incremental EBIT margins anywhere from 60-75%. This sounds too high so use 40-50% in our Bear and Bull cases. For what it’s worth, incremental margins were 42% in Q1 for the scrubber business excluding non-recurring costs and management expect this to improve as this was the first quarter of their ramp up. 

With an orderbook of “more than” 220 as of June 3 that is now probably ~270 and growing, and a delivery time of 4-5 months, it seems safe to say that once Liqtech ramps up they will be delivering ~200 systems a year even in a Bear case. At a $400k ASP and incremental EBIT margins of 40% this translates into ~$30mm EBIT per year and earnings of $1.2/shr. If they produce 300 systems per year (vs capacity of 375-500) at 50% incremental margins this translates into ~$60mm EBIT and earnings of $2.3/shr. 

This is far above sell-side consensus for EPS of $0.6/shr in 2020 and $0.9/shr in 2021.

Other things worth considering are:

-     We think orders will decline but not fall off a cliff after the initial 2020 boom. Payback periods on choosing scrubbers ahead of low-sulfur fuel are likely to be around 2-3 years long-term (see below), making scrubbers an attractive option for many shipowners. Most estimates for the global fleet range from 30,000-50,000 and only 3,000-4,000 will be fitted with scrubbers by 2020, leaving several years of pent-up demand. Additionally, Liqtech say up to 80% of newbuilds are being fitted with scrubbers. Assuming that the real number is 60%, 1,600 newbuilds per year and 35% market share for hybrids & close loop suggests close to 350 additional units per year in Liqtech’s market where it has over 50% share today. 

-     Liqtech has signed framework agreements with 3 large OEMs. One of these is widely believed to be with Wartsila and only kicks in from H2 2019 as Wartsila introduce a new scrubber combining Liqtech’s membranes with traditional centrifugal technology (our primary research confirms this to be true). While Liqtech have backed off from their initial claim that this agreement will produce hundreds of orders per year, they still believe that Wartsila could be their largest client. This seems possible as Wartsila is the world’s largest OEM. The other agreements are believed to be with Yara Marine for at least 95 orders in 2019 and an unknown OEM for at least 35 orders in 2019. When Liqtech reported in May the 35-order agreement was already exceeded and the Yara one was well on track. Together, these agreements alone are likely to result in significant further orders in H2. 

-     Liqtech is now signing the first contracts for a servicing business. Management say 25% of customers are signing up with an ASP of $45k per year. This could add a useful $0.30/shr of recurring earnings in a few years’ time. 

-    Liqtech has $0.8/shr in cash after their equity raise in May. Management say this was partially to insource manufacturing as they ramp up production, but also for growth opportunities in the markets for NOx reduction on ships, water treatment and power plants. The CEO made a big deal about this at the investor day, saying the NOx market in particular was more attractive than scrubbers. We don’t place any value on this because Liqtech has repeatedly failed to break into these markets, but think investors may get over-excited by such large growth opportunities. The stock was up on the equity announcement and the investor day. For what it’s worth, management say this time is different because they have proven themselves in the scrubber market and that has caused customers who rejected them 5 years ago to come back.

We will let the reader decide what an appropriate value for a business like Liqtech is rather than have a long debate here, but assuming an 8-12x multiple on earnings once the business has ramped up plus cash gives a value of between $10-$30/shr. We think this extremely wide valuation range is an honest reflection of the uncertainty in Liqtech’s growth. But at today’s stock price of $8/shr it seems that permanent impairment of capital is highly unlikely, a very large discount to intrinsic value is quite likely, and IMO 2020 will act as an imminent catalyst to realize that.

Other Things to Monitor

Spread between high and low sulfur fuel prices. The spread between fuels is around $200/mt today and can be monitored here (compare MGO vs IFO180): 

https://shipandbunker.com/prices/av/global/av-g20-global-20-ports-average

At a $200/mt spread, various research houses and companies estimate the payback on a scrubber to be roughly 2 years. We think this is a little optimistic and will vary depending on the size of the vessel, routes, utilization etc but is in the right ball-park. 

Importantly, this 40% spread should initially widen after IMO 2020 kicks in, thus strengthening the case for scrubbers. The new rules should mean that demand and prices for high-sulfur fuel drop substantially while prices for low-sulfur fuel increase. As refineries adjust and new capacity comes online the spread should then narrow. How soon this happens and what it narrows to is tough to predict, but the forward curve is pricing the spread to widen to around 70% and $300/mt in early 2020 and still be over 40% and $200/mt in 2022. Some shipowners have been asked about this on recent calls but are largely dismissing the facts as they stand and adopting a wait-and-see/hope-for-the-best approach as they are very capital constrained.

It is worth noting though that we and others are using the price of MGO as a proxy for the new 0.5% sulfur fuels but this is not strictly correct: MGO typically has only 0.1% sulfur but the IMO cap is set at 0.5% versus 3.5% currently. So the new fuels should not be quite as expensive as MGO. Assuming a linear relationship between sulfur content and the spread suggests the ‘real’ spread is slightly lower at around $180/mt rather than $200/mt, but we will not know whether this is correct until 2020.

Oil prices. Bunker fuel is ultimately an end-product of oil and so a 50% decline in the price of oil would lead to a similar decline in fuel prices and the $ value of the spread even if the percentage spread remains constant. We do not try to predict oil prices but think that with an average 2+ year payback period for scrubbers today declining with forward prices we have a large margin of safety.

Fuel availability. One concern some shipowners have is whether high-sulfur fuel will continue to be available at most ports. From the commentary of major ports and refineries it seems that high-sulfur fuel will largely be available, but the concern is over minor ports around the world and we do not see a way to get a good handle on this before 2020. On the flip side there are also concerns about low-sulfur availability. 

Management. We do not think management are good capital allocators. None of the products they have invested in have made sustained profits and the company was barely surviving until they got lucky with IMO 2020. We think that management want to build a broader water treatment company, which we consider a major risk. When asked about the recent equity raise and the opportunity cost of issuing more shares at the investor day, the CEO seemed not to understand the question and talked about how the stock traded up on the day so the market is rewarding them for growth. While the CEO owns $3mm of stock, which we think is a big deal for him (comp was $366k in 2018), we think he will chase growth rather than returns. We therefore want to be investors in Liqtech as the value of the scrubber business becomes recognized by the market over the next 6-24 months but need to mindful about our position as the valuation becomes increasingly dependent on new growth opportunities.

Management are also promotional! While they have delivered ahead of expectations in terms of orders and we can track the market in real time on DNV, we have yet to see what margins these will be at. Management have talked about 60-75% incremental EBIT margins even when we pushed back on this number during our conversations. We therefore think using 40-50% in our valuation should be conservative enough, but there is a risk that it will not be and there are no peers we can compare it to. For what it’s worth incremental margins were 42% in Q1 for the scrubber business excluding non-recurring costs and management expect this to increase. 

Catalyst

Implementation of IMO 2020 and greater clarity as Liqtech reports