Hudson Technologies (HDSN) is a distributor and recycler of refrigerant gases. The company is poised to benefit from an EPA mandated phase out of virgin gas production of the leading refrigerant that will boost market pricing and volumes of reclaimed refrigerant where Hudson is the dominant player. Hudson stock remains depressed due to investor fatigue with the slow to develop shift in market dynamics and a general lack of Street recognition. The stock trades at 2-3X projected earnings when the market shifts, while the EPA is set to finalize substantially reduced virgin gas production quotas in the coming months. In the meantime, the company has expanded market share and is substantially profitable.
HDSN operates three business lines: aftermarket refrigerant distribution, reclaimed refrigerant sales, and refrigerant services. The only breakout by segment that HDSN provides in their filings is refrigerant sales (combined distribution and reclamation) versus service revenues. In the trailing twelve months refrigerant sales contributed 90% of revenues or $40.1 million, with service revenues at 10% or $4.5 million. Reclamation is currently a small piece of refrigerant revenues, probably somewhere in the $7 million range.
Aftermarket Refrigerant Distribution
Refrigerant gasses are used in air conditioning and refrigeration units. They need to be replaced periodically due to leaking or gas loss during servicing. Hudson buys refrigerant, mainly from the big three producers (DuPont, Honeywell, and Arkema- who control approximately 90% of the virgin refrigerant market) and distributes it to contractors , large end users, and other distributors for aftermarket use.
Management targets gross margins of 30% in this segment and they have generally ranged from 20-30%. The refrigerant aftermarket is driven by demand for cooling (primarily air conditioning) and is generally a low single digit grower although it does have some exposure to weather and the economy. Cool summers reduce demand and in a weak economy customers can temporarily delay unit maintenance. HDSN saw refrigerant revenues drop in 09 due to customer inventory destocking at the onset of the recession, but refrigerant segment revenues have grown double digits percentages every other year since 2005:
Although the company does not explicitly break out new versus reclaimed refrigerant sales, the sense from management is that revenue growth has come primarily on the back of increased market share on the distribution side. The overall refrigerant market has been flat and reclaimed sales have been perennially weak.
Hudson is the largest refrigerant reclaimer in the US with two adjacent facilities in Champaign, Illinois and a management estimated 20% market share. The business model here is that HDSN will pay the end user or distributor for their used refrigerant gas and bring it back to their reclamation facility. Contaminants are separated out of the gas, the gas is laboratory tested to insure purity, and the gas is repackaged and sold at the market price for virgin gas. Management targets 50% or higher gross margins on reclaimed gas, which they think they can easily hit in a more robust environment for reclamation.
While there are several smaller players in the reclamation industry, HDSN is the industry leader both in terms of production capacity and sophistication of their process. The major refrigerant producers left the reclamation market years ago and do not appear to have a desire to get back into it, probably due to its small size relative to the virgin gas market.
While there are not huge barriers to entry in the reclamation business, HDSN does have some noteworthy competitive advantages. HDSN has strong relationships with the major gas producers. HDSN serves as the exclusive national reclaimer for DuPont and Arkema and has smaller deals with Honeywell distributors. These relationships allow HDSN to utilize the producers’ extensive distribution networks to ensure a supply of used gas for reclamation. The gas producers’ local distributors serve as collection points for end users to drop off dirty gas for reclamation.
Large scale reclamation technology is proprietary. The EPA (Environmental Protection Agency) commissioned a 2010 report on reclamation practices, which noted the vast difference between the systems of the smaller and larger reclaimers in terms of quality and efficiency. HDSN has the largest reclamation capacity and is widely regarded in the industry as having the most advanced reclamation technology.
HDSN provides refrigeration diagnostics and preventative maintenance, as well as energy optimization solutions. The company has attempted to position their client-site services as their growth engine for over a decade, but have not had much success. Service revenues have ranged from $3.5-4.6 million since 2005, although they are on the upswing in the past year. HDSN does not disclose gross margins for the segment, but management gives the sense that they are significantly higher than on the distribution side.
The heart of the investment thesis in HDSN surrounds the phaseout of HCFC refrigerant gasses, particularly R-22, which is being mandated by the EPA. R-22 is currently the most widely used refrigerant and the primary target of the EPA phaseout. The Montreal Protocol is an international agreement, to which the US is a party, that phases out the production of various gasses damaging to the ozone layer. The phaseout of CFC gasses (of which R-12- branded as Freon- was the most popular) has already been completed. HCFCs such as R-22 are less damaging to the ozone than CFCs, but they too are being phased out per the next steps in the Protocol.
The Protocol calls for a gradual reduction in HCFC production from a baseline level leading to an eventual total ban on production. The EPA has chosen to accelerate that schedule to target a total ban on R-22 production by 2020. They are implementing the phaseout by allowing a declining percentage of R-22 demand to be met by virgin production. As virgin gas production is phased out the EPA wants to increase the usage of reclaimed gas to make up the gap in demand. Reclaimed gas is not subject to the limitations of the Montreal Protocol. However, R-22 prices must be high enough for reclaimers to be able to offer gas users enough of an incentive to bother to return the gas and not just vent it into the air. While venting of R-22 is technically illegal, the EPA cannot enforce the rule and venting is a widespread practice with the EPA estimating that over 90% of dirty gas is currently vented. The EPA’s plan is that limited virgin gas supply due to the declining allocations will cause R-22 prices to rise and spur reclaimed gas to fill in the demand gap.
In the EPA’s target scenario HDSN would benefit in several ways:
- Higher R-22 prices would equate to more gross margin dollars on the distribution side (even assuming gross margin as a percentage remains a consistent spread between what HDSN pays producers and what end users pay HDSN).
- Higher reclaimed gas sales volumes would boost reclaim revenues.
- Higher R-22 prices would boost reclaim gross margin percentage as less of the selling price would need to be given to the end user to buy the gas back.
What’s Happened So Far?
The EPA started the more aggressive phaseout of R-22 with the 2009 Final Rule that went into effect in January 2010. Firstly, the EPA banned the sale of