|Shares Out. (in M):||27||P/E||0.0x||0.0x|
|Market Cap (in $M):||58||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-3||EBIT||0||0|
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LiqTech International (LIQT - NYSE) is a micro-cap based in Denmark with an advanced filter technology which offers compelling advantages in producing cleaner water for drinking, agriculture, fracking, ship ballast discharge, food, medicine, waste water and other applications. Its technology makes possible substantial reductions in energy cost and increases in throughput, thereby lowering the cost of cleaning water and other fluids. Its technology is so broadly applicable that it doesn’t need to achieve all of its long term goals to be a five bagger or more. However, based upon valuation and various uncertainties that exist over the next year or so, LIQT is more risky than average, even for a micro-cap stock, so I will start with the risks to save you time if any of these are deal breakers, and discuss them in more detail later.
Risks: On current numbers LIQT is certainly no bargain, with an EV of $58MM, LTM sales of $12.7MM and losses of $5MM. Sales have been dropping fast in the last two years, so it doesn’t even look like a growth company, although in fairness the weak top line reflects a legacy business and disguises the growth of the promising part of the company.
LIQT was founded in 1999 and went public four years ago, not with an underwriter but by a reverse merger with a shell. One party connected with that transaction has been a big seller.
While the company expects a big jump in revenue in this and succeeding years, with a goal of $100 million in three years, that depends largely upon its success in converting various companies, who have been testing its filters, into active customers, a process that in my experience usually involves unexpected delays. Even if the orders do show up as the company expects, it will also need big improvements in production yield to get the cost down enough to achieve the positive EBITDA that it has projected for this year. While the company will have enough cash if it meets 2014 revenue and margin targets, problems with either orders or production yields could force a dilutive capital raise.
There is at least one longer term risk as well, stemming from the fact that LIQT’s current technology lead is based more on know-how than patents, perhaps leading to more intense competition in future years. Since LIQT probably won’t attract competitors unless it achieves considerable success first, that bothers me less than the near term challenges.
Business and Technology: LIQT’s unifying theme is that all its filters are made out of silicon carbide (“SiC”), an extremely hard, durable, and heat resistant ceramic material that is widely used in cutting tools, auto parts, and electronics. LIQT is the only company focusing solely on making SiC filters, which offer extremely high performance though at a relatively high price. The material itself is not patentable, nor is the general concept of making filters from SiC. Production of SiC filters is still as much an art as a science, with minuscule variations in the moisture of the material and other subtle elements making the difference between a good filter and a reject. LIQT has only one direct competitor, although there is strong competition from those making lower performing and lower cost filters out of other materials, primarily alumina oxide in the mid-price and performance range, and various polymer materials at the low end.
LIQT’s filters are used in removing undesirable substances from gases and liquids. The primary commercial gas application is for diesel particle filters (“DPF”) that remove soot from diesel exhausts. This business is very volatile, based entirely upon the degree with which environmental officials around the world tighten and enforce their mandates. DPF sales peaked at $17MM in 2011 when certain deadlines were strongly enforced, and have since plummeted to about $7MM in 2013, when diesel owners in various jurisdictions (primarily CA) were allowed to procrastinate. LIQT’s DPFs are more durable than those made of other materials, but also more expensive. While there may be some growth in the market as various jurisdictions (Beijing is a leading candidate for obvious reasons) tighten the allowed particulate emissions and extend rules from only vehicles to include off road equipment and generator sets, I never like businesses where the products are bought only because fickle government bureaucrats occasionally force people buy them. The performance of LIQT’s DPFs may be too good for the sweet spot of the market.
LIQT big opportunity is in its SiC liquid filters, where the need exists in most applications independent of environmental regulations, and SiC’s performance gives it big advantages over conventional filters. The biggest edge in every application is SiC’s very high flux, which means that liquid will flow through the filter from 40% to several times faster than conventional filters with the same pore size. That means that the filter can be smaller for any given need, and that energy costs to pump the fluid will be much lower. LIQT’s SiC filters are not bothered by any level of acidity or alkalinity, extremely high temperatures, or any solvents, concentration of oxidizers, or any other components of the liquid being filtered.
The effect of this robust performance is that SiC filters should have a useful life many times that of conventional filters, a big advantage where the filter is submerged or used where removing and replacing filters requires that the process be halted. SiC filters will always cost more initially than conventional ones, but the long life, higher performance, lower energy costs, smaller footprint, and imperviousness to a variety of chemical and thermal challenges means that there are some markets where, over time, SiC lifetime costs are the lowest, allowing it to gain a large percentage of the filter demand. Some of these are potentially multibillion dollar markets:
Pre-filters for reverse osmosis: The need for drinking water is intense in various parts of the world where available water from the ocean, lakes, or underground is not fit to drink due to salt or other impurities. Reverse Osmosis (“RO”) is a solution, but the water has to be cleaned up quite a bit before it goes through the most critical membrane. SiC appears to be ideal for this application, and LIQT is starting to get orders from equipment makers in many countries, particularly in the Middle East where it recently announced some orders from Saudi Arabia. Pre-filtering with a LIQT filter increases plant output, significantly lowers energy costs, which are very high for RO, and extends the lifespan of the RO membrane. In many RO plant designs the flux of the pre-filter is the limiting factor in the plant’s output; swapping out the existing pre-filter system with a LIQT SiC filter will allow greater production of drinking water without having to construct a new plant.
With a Danish university LIQT is trying to design a SiC filter with pores tiny enough to remove the salt, thereby replacing RO membranes entirely. To give an idea of the challenge, the company’s current water filters mostly have pores with a diameter of 40 nanometers, although it has been developing filters with pores of 10nm and below. To filter out salt, the pore must be about 1nm. This project is a long shot and at least a few years away, if ever, from success, but I like that the company is giving potential bonanzas applications like that a try. In general, the smaller the pore size, combined with the high flux and naturally sturdy characteristics of SiC, the more potential applications open up to the company.
Produced (aka Flowback) Water: This is the water that comes up with the natural gas and oil in fracking wells. The mix of chemicals in that water makes it unsuitable for disposal or reuse in wells without substantial filtering. Much of that water is transported, sometimes great distances, to water processing plants. A leader in that business, the $7+B revenue FMC Technologies (FTI-NYSE), is trying out LIQT’s filters on an exclusive basis with growing minimum purchase requirements. FTI believes that the high flux, small footprint and lower energy needs of LIQT’s technology might allow it to set up mobile processing plants that can handle the contaminated water onsite or at least closer to the wells, at considerably lower cost, allowing it to gain market share.
Ballast Water: A growing problem is the spread of non-native species when ships take on ballast water and dispose of it in some other port. Regulations are gradually tightening in various countries and internationally. The high flux of SiC filters, which allows them to take up less space and use less energy than conventional filters, is attractive to ship owners who don’t want to give up more ship real estate than necessary to clean ballast water before discharge.
Food, Medicine, other Industrial: LIQT filters are starting to be used in applications such as the production of salad dressing, cleaning oily waste water, ground water remediation, the treatment of tailings from coal and aluminum production, cleaning municipal swimming pools, and waste water treatment plants. A new application which may have a lot of potential is harvesting algae, which is of great interest to the cosmetics industry and as food for fish farms.
Marketing: LIQT is a small company, and its market opportunities are all in industries where big companies are well established. Accordingly, rather than being stretched thin by doing marketing to end users and have to face the difficulties of serving multiple fields without a reputation for quality or service, LIQT is wisely, IMO, seeking relationships with known vendors in those markets.
FMC Technologies in the produced water (fracking) field is a good example, except with a slightly different model, in that if all continues to go well FTI will buy LIQT filters and install them in equipment of its own design, becoming itself an end user charging customers (the drilling companies) a fee to process their produced water.
In other applications the model is somewhat different. LIQT seeks alliances with companies who already sell and service equipment used in whatever their particular specialty is. LIQT looks at its relationship with these equipment vendors as having two phases. Initially, LIQT will sell them SiC filters made in an industry standard form factor, so the partner can continue to sell its existing line of equipment, but substituting higher performing SiC filters for polymer, alumina oxide, or whatever else the vendor was previously providing with that equipment.
The second phase, though, will be more lucrative for both parties. That is when, instead of selling its existing line with a LIQT filter, the partner can introduce new lines of equipment optimized to take advantage of SiC’s characteristics, i.e., equipment that is much smaller, and can use less powerful, lower cost pumps, thereby consuming less energy to operate. This will let its partner undercut competitors and gain market share by offering superior price/size/performance compared to standard industry offerings.
LIQT has dubbed its marketing strategy “Intel Inside” after the dominant microprocessor company. It doesn't want to be in the specialized equipment business; it lacks the depth, breadth, reputation, and capital to do that right. Instead it wants to ally itself with powerful partners in a variety of fields, and let them initially market existing equipment with better filters, then sell their systems newly designed to make best use of SiC’s characteristics, as they think best, just making sure that they stick with LIQT filters as key component.
Production: LIQT manufactures its products in two factories in Denmark and one in Minnesota. I’ve been to neither yet, although hope to see at least one later in the year. They appear to be relatively high fixed cost operations that result in high unit costs and therefore low gross margins now, when production is well below capacity, as is now the case, but should provide operating leverage if the company meets its growth targets. Working with SiC requires very high temperatures in the furnaces. Even though LIQT is only one of two companies in the world making any serious effort to make filters from SiC, there is still big room for productivity and cost improvement. A surprisingly large amount of its output is rejected for quality reasons. The company believes it has a handle on the issues and expects significant yield improvements over the next year, but that remains to be seen.
Between the hoped for improvements in yield and quality, and higher volume that will divvy up the fixed costs over more units, the company is targeting gross margins on its liquid filters to reach at least about 50%. The competitive advantage of SiC filters over alternatives is less in the diesel exhaust market, so even with optimized production, prices have to take into account stronger competition, so margins on diesel exhaust filters are not likely to get much above 25%. The company has ample capacity now, but will have to add some furnaces over the next few years if growth hits plan. They are not that expensive.
Although LIQT has limited patent protection, there is a lot of art and know-how that goes into making its SiC filters. The company feels that a manufacturer with plenty of experience using SiC for products other than filters could get into the business, but might need a couple of years of trial and error to catch up to where LIQT is now, at which time LIQT hopes to be more advanced, have lower costs, and have worked with its equipment manufacturing customers long enough that they would be reluctant to switch filter vendors.
LIQT also has a small product line of kiln furniture, which it sells to other users of very high temperature furnaces. That exists mainly to make use of excess capacity and I expect would be eliminated if demand for its filters pick up enough.
Finances, Projections, strategy, etc: LIQT’s finances are fine if sales take off in 2014 and production yields improve, as management has promised. By offering holders of warrants a deal last September to exercise them early, the company raised over $4MM and claims it does not expect to need to raise any capital this year, except perhaps to finance an acquisition, or something else outside the normal course of business.
LIQT has an aggressive growth target of sales of $100MM in 2017. Shorter term, It has stated that break-even requires revenues of about $18MM this year, and that it expects to do well above that, presumably in the $26MM range, versus about $12-$13MM in 2013.
Some of that represents a bounce back in the DPF market, as CA and some other places, including possibly Beijing, crack down more on diesel emissions. DPF sales have plummeted from over $17MM in 2011 to roughly $7MM in 2013, but should stagger back to about $10MM in 2014. Assuming the trivial kiln furniture line is flat, that would leave $14MM in revenues to come from liquid filters, more than double 2013’s sales. It might happen, or it might not, depending upon how quickly all the “successful tests” that LIQT has reported get converted to actual orders.
Q4 2013 numbers have not been released yet, but were certainly in the red, as is likely in Q1 and Q2, and possibly Q3 in 2014. My big concern is that a shortfall in sales this year will result in lower margins, and require a capital raise before the market sees enough progress in new orders to justify a much higher price. I wish I could say that isn’t a risk and one can safely buy the stock today, but I can’t.
I am more confident in the long term, because I think the advantages of LIQT’s technology are compelling enough in applications with very big addressable markets that the company could indeed get to $100MM in revenues, if not in three years then not too long beyond that. With the mix being nearly all higher margin liquid filters with gross margins in the 50% area, and selling and marketing expense being modest because most sales will be to the makers of the equipment that use the filters, rather than to the end users, operating margins could easily come in at 20+%, enough to get the stock to somewhere around $10, assuming by then shares outstanding have risen to 35MM versus about 27MM today.
Although I personally have a larger position in this one than I should, given the near term uncertainty, a wiser micro-cap investor than myself should learn more about the story now, and be prepared to jump in should it be clear that management’s promises of strong revenue growth and profits in 2014 are well founded.
For more information, start with the website (http://www.liqtech.dk) and drill down into the various applications and product offering pages. The company’s contact person is its Chairman, Aldo Petersen, who, when you can reach him, is very informative. Unfortunately, his other business interests keep him busy and he can take a while to respond. In the interim, I’ve found Don Weinberger, at Wolfe Axelrod Weinberger, the company’s IR firm, very helpful, at 212-370-4500.
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