Alas, 2018 was a very tough year for Hudson (ticker HDSN). Based on my analysis below, however, I think the stock could be a multi-bagger. Currently trading around $1, with the rest of the street thinking the company is in trouble of bankruptcy, I think we could reasonably see it move up to $8/share over the next 2 years. Indeed, I think in a few years, the company will be doing $60MM of EBITDA compared to a $175MM EV today…
To recap a tough 2018:
The company, which supplies refrigerants for HVAC systems, just completed the acquisition of Air Products refrigerants business, ASPEN, when 2018 had two factors that pressured results:
- Pricing on refrigerants in 2018 declined across the board
- Customers left little inventory on the shelf, and moved to a just-in-time purchasing model. This was a consequence of pricing behavior
To give a picture of how bad it was, 1H’18 sales were up 22%, mainly from the ASPEN acquisition, but EBITDA was down 70%. Yikes. The company also took on only debt to fund its acquisition and was ~10x levered. Double yikes. The stock plummeted to around $1 after peaking around $9 in 2017.
These two negative factors that pressured results can be traced back to events of 2017.
- Prices on refrigerants in that year were increasing rapidly, so customers bought early to get ahead of further increases in pricing.
- As pricing leveled off coming into 2018, customers had to devalue their inventory to re-align with market pricing. As a result, buyers were much more cautious with their inventory levels in 2018.
- This caused further pressure on pricing in a catch-22, circular fashion.
Pricing has since stabilized since Q2’18 and inventory in the channel remains relatively low.
What was going on with pricing?
Before I start, I should give some historical context that will provide a better picture of the market.
Refrigerants go through phase-down cycles due to environmental regulations. Chlorofluorocarbons (CFCs) were used from the 1930s through the 1990s. But with awareness on their ozone depleting effects, the Montreal Protocol introduced the phase down of CFCs. We then moved to HCFCs and then HFCs and then HFOs and I am sure there will be many more acronyms to come. The point is, as concern over global warming and depletion of the ozone advances, new regulations (across the globe) and new refrigerants are introduced.
R-22 refrigerants, a type of hydrochlorofluorocarbon or HCFC, has been one of the most widely used refrigerant, but is being phased out. Pricing had been increasing in 2017 as customers wanted to get ahead of the phase out of new production, which limits new supply in the market.
As such, no new production of R-22 can be produced by 2020. To be clear, this does NOT mean you can’t use R-22 anymore. Many HVAC machines have 20+ year lifespans and often would require retrofitting for the new refrigerant types to work, which is more expensive than just using the same refrigerant.
Looking forward, though one could see a re-stocking event occuring in 2019. Pricing should also increase for the refrigerants they sell, which I will touch on below.
Why is pricing going up?
Demand for the old types of refrigerants remains relatively steady, but supply goes down dramatically (i.e. to zero). Given the offset, pricing moves up as well. Only 4MM pounds can be produced in 2019 and then moves to 0 in 2020+. The EPA projects that aftermarket demand will be ~50MM pounds by 2020. As a result, the company expects that R-22 will move like other previous refrigerants. It thinks that pricing will move from $10-11/lbs to $30/lbs.
To state the obvious, pricing on Hudson’s products should improve. First from the lack of new supply and second if demand increases as customers re-stock inventory. This should also drastically improve margins, as price increases drop to the bottom line.
Hudson is also the largest provider of reclamation services, summarized in the graphic below. These reclaimed refrigerants can and will replace/displace virgin production. Reclaimers will provide 100% of R-22 following 2020. There are over 50 million residential and light commercial systems using R-22 in 2018. This should bode well for Hudson, who has 35% market share.
What happens when R-22 is phased out?
A question you have to ask yourself is whether or not Hudson has a business following the eventual phase-out of R-22. Obviously, the terminal value of the company has a lot to do with its valuation.
In 2016, the Montreal Protocol reached an agreement to phasedown HFC compounds by 85% between bow and 2047. HFCs are the next generation compounds, meant to phase-out HCFCs (like R-22) and CFCs. While these HFCs were designed to have zero impact on the ozone layer, they have determined that HFCs still have a high global warming effect. Lo and behold, we have a new product (and acronym) coming out, called HFOs that will reduce both global warming impact and ozone depletion.
But for the next few decades, HDSN will not only work to reclaim R-22, but then will switch to reclaiming the HFCs providing a long-lead time to the business. In addition, emerging market countries tend to ratify global warming protocols at later dates and use older refrigerant types for longer. As such, these markets will likely continue using older technology for longer.
Reclamation is not all the HDSN does. I should also take a step back here to also note that you can think of Hudson like a distributor of virgin product. It also sells refrigerants to customers from its suppliers. For example, in 2016, Hudson was awarded a $400MM contract to the Department of Defense to supply refrigerants, gases, and other related items to the military. This is a 5 year contract with a 5 year renewal option. As an aside, the value of this contract does not appear to be factored into the stock price today.
What do we think the company is worth?
On a PF basis, Hudson and ASPEN generated $255MM of sales in 2017. Given changes in pricing plus volume improvement from JIT ordering patterns unwinding, I think it’s not unreasonable to see sales move past $300MM in 2020. Remember, R-22 will move from $11/lbs to $30/lbs over time, which is a huge uplift.
The company has stated this will result in 20% margins (though I think that’s conservative given pricing). Assuming the business is worth 8x, I think the stock is worth $8/share, which is significant upside from today’s levels.
Why am I not concerned with the leverage?
As of today, HDSN remains highly levered (~9x) and it was required to get a waiver from its banks on its covenants. Banks typically are willing to do this if they view the challenges the business is facing as 1x in nature. At the end of the day, they don’t want to take the keys and run the business themselves. Most of the time in bankruptcy, the company haircuts its debts in Ch.11 and continues operating.
Hudson is still able to manage its debts and paid down $37MM of debt in Q3’18. The term loans also does not come due until 2022, a point at which HDSN (hopefully) is rocking and rolling again.
As I’ve said in the past, I like these situations. Every dollar of debt paid down will accrue to the equity!