HDSN -- an evaluation

HDSN attracted my attention back in July when I was doing stock screening. Here is my evalution of this stock.

What does HDSN do
Hudson Technologies, Inc. (HDSN) is a leading provider of innovative and sustainable solutions for optimizing performance and enhancing reliability of commercial and industrial chiller plants and refrigeration systems. In addition, Hudson sells refrigerants and provides traditional reclamation services for commercial and industrial air conditioning and refrigeration uses.

Refrigerant and Industrial Gas Sales
Hudson sells reclaimed and virgin (new) refrigerants (including CFC, HCFC and HFC) to a variety of customers in various segments of the air conditioning and refrigeration industry, and sells industrial gases to a variety of industry segments.

Refrigerant Management Services
Hudson provides a complete offering of refrigerant management services, which primarily include reclamation of refrigerants, laboratory testing through Hudson’s laboratory, and banking (storage) services tailored to individual customer requirements. Hudson also separates “crossed” (i.e. commingled) refrigerants and provides re-usable cylinder refurbishment and hydrostatic testing services.

RefrigerantSide® Services
Hudson provides decontamination and recovery services that are performed at a customer’s site through the use of portable, high volume, high-speed proprietary equipment, including the patented Zugibeast® system. In addition, Hudson also provides predictive and diagnostic services for its customers to predict potential problems in air conditioning and refrigeration systems before they occur. Hudson has been awarded several US patents for its SmartEnergy OPS TM , which is a system for measuring, modifying and improving the efficiency of energy systems, including air conditioning and refrigeration systems, in industrial and commercial applications.

Industry Background
Effective January 1, 1996, the Clean Air Act, as amended (the “Act”) prohibited the production of virgin CFC refrigerants and limited the production of virgin HCFC refrigerants.

Effective January 2004, the Act further limited the production of virgin HCFC refrigerants and federal regulations were enacted which established production and consumption allowances for HCFC refrigerants and which imposed limitations on the importation of certain virgin HCFC refrigerants. Under the Act, production of certain virgin HCFC refrigerants is scheduled to be phased out during the period 2010 through 2020, and production of all virgin HCFC refrigerants is scheduled to be phased out by 2030.

In April 2013, the Environmental Protection Agency (“EPA”) published a final rule providing for the production or importation of 63 million and 51 million pounds of HCFC-22 in 2013 and 2014, respectively. In October 2014, the EPA published a final rule providing further reductions in the production and consumption allowances for virgin HCFC refrigerants for the years 2015 through 2019 (the “Final Rule”). In the Final Rule, the EPA has established a linear annual phase down schedule for the production or importation of virgin HCFC-22 that started at approximately 22 million pounds in 2015 and reduced by approximately 4.5 million pounds each year and ends at zero in 2020.

HFC refrigerants are used as substitutes for CFC and HCFC refrigerants in certain applications. HFC refrigerants are not ozone depleting chemicals and are not currently regulated under the Act. However, certain HFC refrigerants are highly weighted greenhouse gases that are believed to contribute to global warming and climate change and, as a result, are now subject to various state and federal regulations relating to the sale, use and emissions of HFC refrigerants. In addition, federal legislation has been proposed that, if enacted, would impose limitations on the production and importation of certain virgin HFC refrigerants. Hudson expects that HFC refrigerants eventually will be replaced by HFOs or other types of products with lower global warming potentials.

The Act also mandates the recovery of CFC and HCFC refrigerants and also promotes and encourages re-use and reclamation of CFC and HCFC refrigerants. Under the Act, owners, operators and companies servicing cooling equipment utilizing CFC and HCFC refrigerants are responsible for the integrity of the systems regardless of the refrigerant being used. In November 2015, the EPA published a proposed rule that, if enacted, will extend these requirements to HFCs and to certain other refrigerants that are approved by the EPA as alternatives for CFC and HCFC refrigerants.

Moat of HDSN
According to the industry background above, it is clear that

  1. The production of yesterday’s refrigerant CFC is completely prohibited;
  2. The production of today’s refrigerant HCFC is gradually fading and will be completely phased out by 2020;
  3. Limitation on the production of tomorrow’s refrigerant HCF will happen soon (from 2019 as Hudson expected).

As a consequence, the price appreciation of these refrigerants is inevitable. Using R22 (one type of HCFC) as an example, its price has increased from $11 per pound in May 2016 to $20 per pound in March 2017. On the other hand, we can also notice that reclamation of these refrigerants is significantly encouraged. This will make Hudson a strong player in the field as it has a ~25% market share in refrigerant reclamation.

Market Opportunity

  • $1 billion non-reclaim refrigerant aftermarket
  • $1 billion reclamation opportunity by 2020
  • Department of Defense contract with maximum value of $400M
  • 5-year contract with 5-year renewal option
  • start from July 2017
  • add 40M to yearly revenue (40% of FY2016 revenue)

Q2 results
Record revenues of $52.2 million, up 51% YOY

“During the second quarter, which is the midpoint of our nine-month refrigerant sales season, our results were particularly strong as we saw increased sales volume for refrigerants and benefitted from incremental increases in the average selling price for R-22 (one type of HCFC) refrigerant as well as a temporary increase in pricing for HFC refrigerants.”

“In addition to the evident gains we are realizing through our sales of virgin refrigerants, we also see a tremendous opportunity associated with our ability to reclaim refrigerants as we enter the final years of the R-22 production phase out, which will be completed by the end of 2019, and look toward the anticipated phase-down of HFC refrigerants. As the industry transitions to new technology and next generation refrigerants, Hudson, as a leading reclaimer, is well positioned to apply our reclamation capabilities to help fill demand for refrigerants as virgin production is phased down and eliminated. We remain focused on leveraging our expansive distribution network, decades of experience and long-standing customer relationships to capitalize on opportunities that arise from the evolving industry landscape.”

Quarter Financial Highlights
Revenue: $52.2 million, up 51% YOY.
Gross margin: 33%, compared to 30% in the prior year period.
Adjusted EPS: $0.20, up 43% YOY.
Recurring Revenue: ~10% of total revenue

More on revenue and EPS
Revenue (in millions)


	Q1	Q2	Q3	Q4
2015	22.1	28.6	21.7	7.3
2016	28.2	34.6	34.9	7.8
2017	38.8	52.2

Adjusted EPS


	Q1	Q2	Q3	Q4
2015	0.06	0.08	0.03	-0.03
2016	0.09	0.14	0.14	-0.05
2017	0.13	0.2

TTM EPS growth: 82%

Acquisition
In the Q2 conference call, the CEO of Hudson spent a lot of time to introduce their acquisition of Airgas-refrigerants, Inc. The transaction is expected to close in later 2017. He said, “we’re very pleased to announce our agreement to acquire Airgas-Refrigerants (or ARI), which we believe represents a major milestone for our company. The addition of Airgas-Refrigerants is expected to double the size of our business (~250 million), provide a complimentary product portfolio, significantly grow our customer base and enhanced our sales and distribution capabilities.”

I summarize the importance of the acquisition as below:

  • It will help Hudson to get fully prepared before the phase-down of HFCs as ARI is ahead of Hudson on HFC sales.
  • It will expand the geographic foot point of Hudson. ARI has 30 refrigerant stocking points over US while Hudson has none.
  • It will provide large audience (come from ARI’s customers) of energy management tools for Hudson. This will help to improve recurring revenue.

Management team
From the acquisition I have mentioned above, we might feel that the management team of HDSN is prudent and forward-looking. I believe the ship is well armed and ready for a fight as refer to the HCFC phase-out and big HFC market.

Risk Factors
Adverse weather or economic downturn could adversely impact our financial results. Cooling season will generate pressure on both price and demand of refrigerants. Our business and financial condition is substantially dependent on the sale and continued environmental regulation of refrigerants. Changes in government regulations relating to the emission of refrigerants into the atmosphere could have a material adverse effect on Hudson’s services and products.

Our business is subject to significant regulatory compliance burdens. The refrigerant reclamation and management business is subject to extensive, stringent and frequently changing federal, state and local laws and substantial regulation under these laws by governmental agencies, including the EPA, the OSHA and DOT.

Issues relating to potential global warming and climate change could have an impact on our business. Refrigerants are considered to be strong greenhouse gases that are believed to contribute to global warming and climate change and are now subject to various state and federal regulations relating to the sale, use and emissions of refrigerants. Climate change or related legislation and/or regulations may impose additional compliance burdens on us and on our customers and suppliers which could potentially result in increased administrative costs, decreased demand in the marketplace for our products, and/or increased costs for our supplies and products.

Conclusion
HDSN seems understand the current and future refrigerant market very well and has been fully prepared for the challenges ahead. As long as the Ice Age does not come, I believe their revenue will continue grow, so as the stock price.

Alex

25 Likes

Hi Alex,

First, thank you for bringing this company to the board. One of the things that makes this board so great is that we all help each other evaluate ideas – and finding new ideas is kind of a big part of investing! Evaluating them, equally so.

I appreciate your work in bringing this company – you did a great job! Note to anyone else who brings a company to the board: the real value is not in simply pointing out the company, but in how you make your case for it. It’s fine to say, here are a few things I own, and here’s how they’ve done. But if you say a little about what the company does and why you like it, and how they make money and what their results have been, then you deserve a response from the board. You’ve done that with Hudson Technologies (HDSN), Alex, so I’m taking on the role of board ambassador for a minute to respond. Ha

Also, I’ll say at the outset that this isn’t the type of company that interests me. However, I think the reasons why might be instructive to some. At the very least, perhaps someone can show me where I go wrong. Anyway, let me tell you some of the things I look for that HDSN doesn’t seem to have. I think that would be the best way to explain why I’m not interested.

Gross Margin

One thing I love about most of the companies I own is that their “COGS” (if that’s even the right thing to call them) are very low. This results in extremely high gross margins – many times in the neighborhood of 70% - 80% for true SaaS companies. Why is high gross profit margin important? As I said in a post earlier today, it’s because the expenses [these types of companies] have are largely due to marketing to new customers and R&D to grow the business. Cut down on that and you drive a lot of $$ to the bottom line. In other words, these high gross margin companies have a lever to pull. They are intentionally spending a lot to gain customers, and as long as they can grow that makes sense to do. But it also provides a level of protection for when growth slows: they should be able to cut down on these non-fixed costs.

HDSN’s gross margin was about 33% in the June 2017 quarter. That’s up from 30% in the June 2016 quarter, but I’d imagine it would be hard to improve past a certain point, since a large part of their costs are surely products.

Recurring Revenue

Here’s another thing that provides a level of protection. To me, that’s the reason it’s important to have recurring revenue. If you sell a product, let’s say you sold 100M worth in the Jun2016 quarter and 150M in the Jun2017 quarter. Great, you’re up 50%! But in the Jun2018 quarter, to keep growing, you have to sell that same 150M first, and then sell 50M more just to grow at 33%, or 75M more if you want to grow at 50% again. Companies with subscription revenue don’t have to sell the 150M again! It’s almost impossible to overstate this point.

You said HDSN has roughly 10% recurring, and this just doesn’t provide the same level of safety.

Shares Outstanding

Average shares outstanding during the Dec2016 quarter were 36.5M. Six months later, in the Jun2017 quarter, it was up to 43.6M, up 19%. Obviously dilution can hurt, but more importantly, I think they issued a bunch of shares to raise money, and so that leads to several questions: Why did they issue them? To pay off debt in preparation for their big acquisition? Since they’re now cash flow positive (and even GAAP EPS profitable), I’m wondering why they felt they needed to dilute shareholders.

Acquisition

I don’t want to say much here because I haven’t looked very thoroughly. This is probably why they issued the shares recently. I don’t even know how they’re paying for the acquisition. Debt? More shares? Both? Obviously all that needs to be investigated, but the point I really want to make here is that this throws a wrench in the whole thing. This isn’t a small bolt on. It’s doubling the size of the company. What will the result on margins be? What will go wrong? All these are unknowns now, and a little scary. It reminds me of Synchronoss, who likewise had gotten to the point of profitability and was just cranking out beats each quarter, and then made a big acquisition and has been a disaster ever since.

Conclusion

This company may have a bright future ahead, but for me it goes in the “too difficult” pile. The non-recurring revenue is a flag, and it’s a business where I am unable to clearly understand why they will succeed and others will fail. But more importantly, all the unknowns of how the acquisition will pan out, to me, make it impossible to evaluate. So I will be staying away from this one. Good luck, and I hope that all this is somehow helpful!

Bear

18 Likes

Nice write-up, Alex. You’ve piqued my interest but, before I explore further, I’d like to understand the competitive landscape. I don’t know anything about this niche market. Are there a lot of players? Is HDSN the “big dawg”? Don’t mean to make you work a bit harder but…

I would not want to restrict my investments to companies with recurring revenue and very high GMs; Honeywell and Ross Stores (to name just two by way of example) have been very good to me over the years!

As for being diluted, that is a danger that comes with the territory when you invest in smallcaps, while acquisitions can be justified as well as unjustified.

I generally avoid smallcaps unless the figures are exceptionally persuasive. You have to be good at the game like Scott Black and I am not! Have given this no more than a glance. So cap. would be my personal concern here, but I also demur over ROIC being well under my threshold (ROIC > 16 is usually a prerequisite for investment) and I am having trouble coming up with an accurate future sales growth rate, which is essential to establishing value.

However, will keenly follow the discussion, so thank you Alex. Certainly an interesting company.

Should have said ‘ballpark’ future sales growth rate, not ‘accurate’ (which is obviously impossible)!

Hi Bear,

Thank you so much for your pertinent comments. They make me think more thoroughly and help me better evaluate a company. Let me try to elaborate more on some of your doubts.

Gross Margin

The nature of business determines that HDSN’s gross margin could not be as large as most SAAS companies. I don’t think it is fair to compare (cross-section wise) the gross margin of two companies that come from different industry sectors. What matters to me is if there is still room for further improvement of gross margin (or other metrics). I notice that there is chance for HDSN to brace a larger gross margin in the future due to R-22 reclamation, see this recent SA article, https://seekingalpha.com/article/4104008-hudson-cool-stock. Below is the most related paragraph,

With Legislative tailwinds and the subsequent rising cost of R-22, producing or purchasing at wholesale and selling is not a feasible option. Management knows this and understands that its reclaim segment has much higher margins. Typically, HDSN can purchase tainted freon for approximately a 50% discount to market price which means they purchase contaminated freon at about $10. With a cost of reclaiming and transporting freon at 10% of that price, operating margin becomes about 50%. Assuming SGA and other expenses consume 5% of that margin or $1.13/lbs, that provides an EBIT margin of 45%. As the price of R-22 increases, this will cause EBIT margin to increase as well which will enhance shareholder value as the firm becomes more focused on this portion of its operations.

Recurring Revenue

You said HDSN has roughly 10% recurring, and this just doesn’t provide the same level of safety.

It is an issue. But it should not be a reason for moving a fast growing company out of your radar. Not to mention that HDSN has opportunities to further increase their recurring revenue through the new acquisition.

Share Outstanding

Average shares outstanding during the Dec2016 quarter were 36.5M. Six months later, in the Jun2017 quarter, it was up to 43.6M, up 19%.
Why did they issue them? To pay off debt in preparation for their big acquisition? Since they’re now cash flow positive (and even GAAP EPS profitable), I’m wondering why they felt they needed to dilute shareholders.

There are two reason to issue more shares: pay the debt and prepare for the acquisition of ARI. Below is the evidence that I got from the 2017Q1 CC transcript.

One analyst in the QA section asked,
Given the cash (coming from capital raise) on the balance sheet and the small amount of money that we spend on the corporate development initiatives in the quarter. Just wondered if you can give us an update on kind of what you’re seeking out there? Are these potential acquisition similar to like Polar that you did couple of years ago? Are you looking for geographic reach? Are you looking for access in the new customers? What way you’re thinking about here?

And the CEO answered like this,
We’re looking for everything. We – a little bit of everything honestly. There is – when you’re trying to grow certain areas that you’re very strong at, you look for better ways to market, maybe into other markets that the same products that we deal with really work for our industry, for our infrastructure of plants that we’re not touching today.
But it could be an overlap into what we’re already doing. There’s a whole bunch of areas right here so, nothing has changed and anything we’ve said over the last couple of months meaning what we see ahead of us.
We like what we see ahead of us. We’re quite excited about the prospects. And if anything its gone up our confidence in our interest level in this, but they would be very accretive for our company – for our company we went to touch them.

And then in the 2017Q2 CC, HDSN announced a new acquisition (ARI) to expand their reclamation market, HFC business, and geographic reach. It seems that this acquisition has been on HDSN’s schedule for a long time. I just love the management team as they are professional, prudent, and forward-looking.

Acquisition

I don’t even know how they’re paying for the acquisition. Debt? More shares? Both? Obviously all that needs to be investigated, but the point I really want to make here is that this throws a wrench in the whole thing. This isn’t a small bolt on. It’s doubling the size of the company. What will the result on margins be? What will go wrong? All these are unknowns now, and a little scary. It reminds me of Synchronoss, who likewise had gotten to the point of profitability and was just cranking out beats each quarter, and then made a big acquisition and has been a disaster ever since.

HDSN is expected to acquire ARI for approximately $220 Million via cash and new debt. The firm does not expect to issue more equity to fund this transaction. ARI is the next leading competitor in the reclamation industry. This acquisition suggests that HDSN is following through with its expectations of industry consolidation.

Synchronoss (SNCR) has been on my radar before. I am sure that HDSN will not be the next SNCR. For more detail about the acquisition, please have a look at their ppt slides which could be found in the below link:
https://seekingalpha.com/article/4097131-hudson-technologies…

Thanks for your sharp thinking. I have learned a lot from answering your inquiry.

Alex

4 Likes

Hi, putnid,

To be honest, I don’t understand the refrigerant market either. As Saul has said, however, we don’t need to know everything about an industry before investing. Below is what I found regarding the players in refrigerant market,

HDSN is the largest reclaimer in a highly fragmented industry with HDSN, Airgas, and National Refrigerants making up a little over 50% of the industry and the remainder divided amongst approximately 30 firms. After the acquisition, HDSN will have a market share of roughly 45%.

Alex

1 Like

Hi strelna,

Thank you for your comment.

Share dilution is due to the fact that HDSN was preparing for the acquisition of Airgas then. I have discussed it in my reply to Bear, so I will not repeat here.

For the acquisition, I think it is justified. You may want to have a look at their ppt slides which can be found in the below link:
https://seekingalpha.com/article/4097131-hudson-technologies…

Can you elaborate more on how you calculate the ROIC of HDSN? I don’t quite understand your criterion, i.e. ROIC > 16. Much appreciated.

Alex

Thanks for the response, Alex. I’ve grown more interested and have begun doing a bit more research. It seems to be a solid company claiming a dominant position in a growing niche market. I was thinking that the hurricane damage in TX and FL will likely require repair/refurbishment of a good number of refrigerating/chilling units. What I learned is that Hudson has a recycling center in Puerto Rico. I don’t know the implications of that.

Return on Invested Capital (ROIC) is a common measure of management effectiveness. Some corporations consider it a primary measure of management effectiveness. Hudson offers a respectable ROIC, ~ 16% over the past year, but much greater recently.

https://www.gurufocus.com/term/ROIC/HDSN/ROIC-/Hudson-Techno…

Yeppers, I’m interested, but I gots me more pondercating to do.

2 Likes

Alex,

Very thoughtful and thorough response! I hope it was clear that my #1 concern is the acquisition. The rest of my points were maybe more like yellow flags, but the acquisition is a bright red one. Not that they necessarily aren’t handling it well, just that I don’t feel like an outsider like you or I can possibly evaluate something so complex*. One point that I may have glossed over is the sheer magnitude. This is a 380M company buying a 220M company. When I said it’s not a simple bolt-on, that was a bit of an understatement.

One reason HDSN has been successful in becoming profitable in the last 2 years is because they have done a great job of keeping costs in check. Revenue grew more than 40% in 2015 and more than 30% in 2016, but Expenses (including COGS) only grew 26% and 21% respectively.

*The reason I say it’s impossible to evaluate this acquisition is, can you answer the following?

  1. What are ARI’s margins currently?
  2. What will integration costs be?
  3. What will be total quarterly expenses for the combined company going forward?
  4. What issues will come up that add unexpected costs?

The first question I ask out of ignorance, but I assume we don’t know, since ARI is part of a larger public company. The other three to me appear unanswerable.

Anyway, I’m impressed with your research. I just encourage you to consider what you may not be able to know, no matter how much research you do. What perhaps the management team cannot even answer at present. How much risk that might add, and how different the picture could be in the future because of the acquisition.

Best,
Bear

2 Likes

Hi, putnid,

Thank you so much for your explanation on ROIC. I love the website, gurufocus. I found it very powerful.

Regarding the impact of the hurricane on HDSN, I may need to check the percentage of business HDSN has in TX and FL. Will go back to you when I find the data.

Alex

1 Like

Hi Bear,

Thank you for adding more comments on the acquisition. I agree with you that nobody (not even the management team) can answer the questions that you have listed. This acquisition is truly a potential risk.

I should not have only looked at the bright side of a stock. Evaluating risks is way more important. Thank you for sharing your wisdom with me.

Alex

Thank you for sharing your wisdom with me.

Would be totally unfair for me not to. Any wisdom I have has been gleaned from this board and from Saul.

Bear

1 Like

Hi putnid,

I could not find the data regarding the hurricane damage to refrigerating/chilling units in TX and FL, although I tried very hard. Since I did not see any news on this topic after Harvey and Irma, I guess there is no need to be too serious about it. Please let me know, if you have different opinions.

Alex

Hi, Alex-

I was somewhat surprised to see Hudson’s share price erode after the hurricanes. I was expecting an upswing But, given the fact I don’t really understand the company, that’s not altogether unexpected. I’m still interested in the company but, truth be told, I’m more in a profit-taking mode than buying mode at this time. I’ve raised a 15% cash pile and am waiting to see where the Market goes from here.

I will note that I’m not thrilled with the lack of insider buying at Hudson:

http://www.nasdaq.com/symbol/hdsn/insider-trades