Hudson Technologies Inc (HDSN) 2018 Q2 法說會逐字稿

Greetings, and welcome to the Hudson Technologies Second Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, John Nesbett of IMS. Thank you, Mr. Nesbett. You may begin.

Good afternoon. On the call today, we have Kevin Zugibe, Chairman and Chief Executive Officer; and Brian Coleman, President and Chief Operating Officer of Hudson. I'll take a quick moment to read the safe harbor statement.

During the course of this conference call, we will make certain forward-looking statements. All statements that address expectations, opinions or predictions about the future are forward-looking statements. Although they reflect our current expectations and are based on our best view of the industry and our businesses as we see them today, they are not guarantees of future performance. These statements involve a number of risks and assumptions, and since those elements can change, we would ask that you interpret them in that light. We urge you to review Hudson's Form 10-K and other SEC filings for a discussion of the principal risks and uncertainties that affect our performance and other factors that could cause our actual results to differ materially.

Okay. With that, I will now turn the over to Kevin. Go ahead, Kevin.

Good evening, and thank you, for joining us. As we discussed on our first quarter call, our 2018 selling season commenced with a just-in-time buying model, and we got off to a very slow start. Unfortunately, the selling environment remained sluggish through April, due largely to the cool spring, with price declines and stagnant demand impacting the refrigerants we sell.

As the warmer weather commenced, starting in May, we saw volumes rebound, and for the last 2 months, volumes have increased. And we've begin to close the gap, but we're still behind last year's overall volume pace.

The Hudson ASPEN team possesses enormous industry experience but this year has presented unique challenges. While we've seen price and our volume declines in one refrigerant or another in the past seasons, this year, we have seen declines in both volume and price for nearly all refrigerants. As a result, our second quarter performance was extremely disappointing, particularly due to the price decreases that occurred through June of this year. Now with the arrival of warm weather 1 month into the third quarter, we have a seen stabilization in prices.

During the first 4 to 5 months of this year, there were several factors, which have created significant headwinds, such as customer buying patterns, supply and demand levels and weather, all negatively contributing to our results. But once the warm weather kicked in through the entire country, we have clearly seen customers actively buying refrigerant to meet the demand. Unfortunately, we think this demand has come a little too late to reverse the negative pricing and volume trends that have occurred through the second quarter.

In recent years, R-22 pricing has been increasing incrementally as we move closer to the 2019 production phase out, which is anticipated to create a supply shortage for the installed base of R-22 equipment. This season, however, the pricing trend has reversed course. Based on our experience with the CFC phase-out in the mid-90s, it's not uncommon for pricing to move up and then come back down at times throughout the phase-out process.

As we look to next year, we're mindful that there will only be another 4.5 million pounds of virgin production allowed. We believe that this additional supply, plus any remaining stockpile, could fall short of meeting the overall demand, which is why similar to the CFC phase-out, we expect to see higher, more stable pricing as normal supply demand economics will apply to R-22.

We believe the customers changed their typical buying behavior this year based upon their experience in the 2017 season and have been hesitant to stock inventory. Last season, our customers saw increased pricing early in the season, followed by significant declines for all refrigerants toward the end of the season, which resulted in lower-than-normal margins. As a result, this year many of our customers adopted a just-in-time buying approach, keeping very little inventory. While demand in the latter half of the second quarter improved with the warmer temperatures, demand never reached typical second quarter levels.

To give you a sense of the overall pricing dynamics, since our first quarter conference call in May, R-22 has declined to approximately $10 to $11 a pound, and HFC pricing declined approximately 40% from the first quarter through the second quarter.

Given these pricing headwinds and with 2/3 of our selling season complete and the visibility we have today, we don't anticipate that we'll be able to make up the shortfalls of the first and second quarter during the remainder of the selling season. Therefore, we don't expect to meet the revenue and gross margin targets that we set forth in early May.

Assuming refrigerant pricing remains at current levels, we believe our revenues for 2018 should be approximately $200 million. While we anticipate the 2018 selling season to be challenging, it certainly has proven to be even more difficult than we would've expected.

We've been in this industry a long time, and we've weathered difficult market conditions and remain optimistic about the long-term opportunities in the markets in which we operate. Our acquisition of ASPEN has added seasoned industry professionals, enhanced our portfolio product offerings and diversified our customer base, both of which strengthen our ability to navigate periodic downturns in our industry. The depressed prices also allows us to replace our higher-cost inventory with much lower cost basis products, which we believe will improve our margins as we begin to sell that product in future periods.

The 2019 results are expected to make clear the strengths and benefits of the Hudson/ASPEN combination.

We see many similarities between the current HCFC phase-out and the CFC phase-out of the mid-90s. Our experience and success in navigating through the CFC phase-out taught us that price increases are not linear and often have corrections along the way. We are now in the middle of one of those price corrections. And although R-22 pricing is currently lower in the short-term, over the longer term, for R-22, we expect to see significantly higher prices.

Likewise, the expected phasedown of HFCs should follow a similar trajectory and we believe represents an even larger opportunity as it will be a broader installed base of HFC equipment. Moreover, the Trump administration's recent action to roll back vehicle emissions standards should not in any way signal a lack of support for the Kigali Amendment since the dynamics of the auto efficiency issues very different than Kigali. Support for Kigali in the industry is almost universal, and there's a -- and there's considerable support among Senate Republicans, with more than a dozen already on record in support of Kigali and an HFC phasedown.

As it relates to emission standards, the auto industry was seeking a uniform federal standard as opposed to a patchwork of state standards, whereas the refrigerant industry is seeking -- is actively seeking the phase-out. We have seen no evidence of any business group coming out in opposition to Kigali. Consequently, we are confident the Kigali Amendment will be ratified.

Lastly, we are currently operating under a waiver and amendment to our term loan agreement, which runs through August 14. And discussions are continuing with our term loan lenders to secure an amendment of the term loan's existing total leverage ratio, financial covenant and certain other items, which we expect to complete an amendment on or before August 14. Such an amendment should provide us with enhanced financial flexibility to weather through today's challenging market conditions. As we move through the remainder of 2018, our focus remains on meeting the needs of our customers and growing our leadership position to capitalize on future opportunities as the industry involves to new equipment and refrigerants.

Now I'll call -- I'll turn it over to Brian to review the financials. Go ahead, Brian.

Thank you, Kevin. For the second quarter ended June 30, 2018, Hudson recorded revenues of $58.1 million, an 11% increase compared to $52.2 million in the comparable 2017 period. The increase is primarily related to the acquisition of ASPEN Refrigerants, offset by price declines of $17.5 million and volume declines of $3.1 million in 2018 when compared to 2017 period.

During the second quarter of 2018, we've recognized a $14 million inventory write-down due to a decline in the selling price of certain refrigerants that occurred in the quarter. We also recognized an additional $18 million write-down for the previously recorded step-up in inventory bases associated with the acquisition of ASPEN Refrigerants, which had previously been reflected as a non-GAAP adjustment. Due to the impact of these items, net loss for the second quarter was $28.6 million or $0.67 per basic and diluted share compared to net income of $8.5 million or $0.21 per basic and $0.20 per diluted share in the second quarter of 2017.

Non-GAAP adjusted net income for the quarter, which excludes the impact of these write-downs was $0.2 million or $0.00 per diluted share compared to non-GAAP adjusted net income of $9.1 million or $0.21 per diluted share during the second quarter of 2017.

Adjusted EBITDA was $4.7 million for the second quarter of 2018 as compared to adjusted EBITDA of $15.3 million for the second quarter of 2017. A detailed reconciliation of these items is presented in today's release.

As Kevin mentioned, we are working closely with our term loan lenders to secure a waiver and amendment of our term loan that would waive compliance with the existing total leverage ratio covenant and provide new total leverage ratio covenants for the periods ended June 30, 2018, through September 30, 2019. It should be noted that we had a leverage ratio violation as a result of the price correction and inventory write-downs. We are servicing our debt, and we still have significant availability within our working capital line. We appreciate the support we are receiving from our lenders in this process and expect to finalize an amendment on or before August 14. And as such, we plan to extend the filing of our second quarter 10-Q to correspond with the anticipated amendment.

During the first half of 2018, we generated approximately $8.6 million in positive operating cash flow and paid down approximately $10.6 million of debt. We believe we should generate approximately $30 million of free cash flow in 2018, primarily from the reduction in inventory levels and a onetime tax benefit related to the recent tax law changes.

As of June 30, 2018, we have approximately $37 million of availability in our revolving credit facility with PNC.

I will now turn the call back over to Kevin.

2018 has been challenging, but this is not the first difficult selling season we've faced. The ASPEN acquisition strengthened our organization, and with our combined long-standing experience, breadth of the products and service offerings and our established and expanding customer base, Hudson remains a leader in the refrigerant reclamation business.

We're optimistic about the long-term market opportunity and are poised for growth as our industry moves towards the final production phase-out of R-22 in 2019 and transitions to new technologies and refrigerants.

Operator, we'll now open the call for questions.

(Operator Instructions) Our first question comes from the line of Steve Dyer with Craig-Hallum.

Guys, I didn't see a balance sheet in the release today. And I'm not sure the extent to which you can comment or not, but I guess, generally, interested in your inventory level. You, obviously, had the write-down in the quarter -- inventory and then debt level. And then I guess, just assuming prices stay on this level, do you feel like you've taken an adequate write-down? You don't expect any more?

Yes, so the reason that we don't have the balance sheet included currently is due to fact that we're delaying the filing of the 10-Q to coincide with the amendment. Ultimately, the way that amendment is constructed will affect possibly the way the balance sheet is constructed. So that's really the reason at the moment that we haven't included it.

As it related to some of your questions, hopefully, I get all the pieces, inventory definitely is down, I mean, certainly it's not because of the write-down but it also was down as we probably previously stated as our intention is to continue to sell out the inventory through this entire season, and then begin to reload at the lower prices that are available today compared to what the price availability was at the fourth quarter of last year. So as we also try to stay relative to inventory, it is expected that reductions in inventory generates cash and that's part of why we were suggesting we should have $30 million of free cash flow this year. It's really because of our intent is to lower the inventory balance. And certainly, back to the acquisition of ASPEN, we bought a fair amount of inventory in that transaction and we -- we're expecting to bring those overall levels down.

As it relates to, I think, to debt part of your question, the debt overall is $10 million lower this year than December. So that also is -- been an intent of ours is to lower inventory and lower the debt in a corresponding fashion. So I think I covered all the pieces to your questions. But maybe I missed something, Steve?

Well, I guess just lastly, if you take out the dollar value of the inventory and how that can move around with pricing, I mean, would you anticipate that from a volume or a pound standpoint you'll kind of be where you want to be, call it, exiting Q3, since Q4 is generally pretty quiet? I mean, are you confident you can kind of get through it all and take your medicine this year and set yourself up better for next?

Yes. No, absolutely. That is our expectation. That was our intent, particularly in examining the write-down and working with BDO, our independent auditors, through this whole process. And also, frankly, with our lenders as well.

Got it. I'll just ask one fundamental question. Curious, obviously, last year with the price spike in 22. I think we saw a higher use of substitutes and a lot of our checks are suggesting that a lot of the dirty gas is coming back mixed, suggesting that there's still a use of substitutes. Is there likelihood or possibility that a lot of those moves to substitutes are sort of permanent because people realize that they could do it and, I guess, get away with it? Or do you still anticipate kind of 22 levels going forward to really ramp the way you had kind of always envisioned?

Well, I think I'd say, we still believe really our projections of where it will go are the same because, actually, the supply gap is going to be enormous -- the demand compared to where the supply is coming from, from reclaim, from any other source, this convergence is going to go away very quickly here, or any kind of stockpile, there's a big gap there. So even with stock -- with drop-ins just like the CFC phase-out, and there were the -- those men to, there's always a room for those. 22, by far, is the best gas for the equipment. So the only thing pushing that in the past was the differential in price. 22 being so much higher, some people would try taking a shortcut, use a less-efficient gas, and do a cheaper job for the customer. Right now, the differential is not that great. The custom -- the performance capacity efficiency is so much better for 22. We're buying the 22. Much higher prices than we'd ever buy the dirty gas on in the system. Even HFC is certainly not substitutes. So the growth in substitutes, we haven't necessarily seen any kind of a spike. Will they be around? They'll be around. They'll always be around, even in the past and the future. So there's a big gap for the 22 phase-out, for the 22-needed equipment. But there'll be always something like a substitute as a percentage of the market. How big? We just don't know.

And maybe to add to -- because we've had questions about, does Hudson have capabilities of handling cross-contaminated refrigerants? The answer is, absolutely. And we've had that technology since probably mid-90s. Possibly, your channel checks have seen reporting, let's say, higher percentages, possibly, than what we're seeing. Certainly, the amount of cross-refrigerant we're seeing today versus 10 years ago is higher, but it's not significantly higher or it's not significantly reducing our ability to reclaim refrigerants or get a yield of refrigerants. And also to the extent that there have been increases in returns across contaminated refrigerants, as part of our CapEx spend and globally handling reclamation, we do have resources in that area as well.

Let me just -- not to prolong the answer, let me just tell you, Steve, cross-contaminated growth, yes -- and we've said it's growing every year. The main reason for that is the replacement equipment for 22 is 410A. So a contractor now has 2 types of gas he's using for 410A and 22. Very easy to get 410A in a 22 system or vice versa. So yes, gas we knew would grow and it did. So we have technology to split them apart. It's not necessarily -- it does happen with substitutes in there too, but it's not necessarily about a lot of the gas -- when we have cross-contaminated gas, it's just someone with the newer equipment 410A getting into 22.

Our next question comes from the line of Gerry Sweeney with Roth Capital.

Kevin, I think in the commentary you mentioned that you're looking at, I believe, doing $200 million of revenue this year. Granted it's a difficult market and things could shift around, but that sort of implies a pretty good second half to this year. Is this -- the ARI acquisition that -- they -- just in time, they sell directly to the customers so they have sort of elongated sort of season. Is that what's going to drive the second half?

Well, not necessarily. But it is that too for the fourth quarter. The difference really why we feel that is really this just-in-time compared to other years. We expect volumes for the third quarter to be absolutely stronger than they were third quarter last year. So as third quarter was heavy earlier-season buying, people had inventory on their shelves, needed less in the third quarter. In the just-in-time model, what we're seeing is, people don't carry a lot, they're going to need more in the third quarter if it continues warm. So we expect volumes to be stronger this third quarter than last year. And then yes, with the ASPEN acquisition, they're stronger than we are in the fourth quarter because of the types of customers that they serve.

Okay. I think that's what my checks were showing were smaller buying patterns, but customers coming back more often. And some of my checks had said, they had not seen much of a drop-off for second half of July into August of sales, which -- when the traditionally had done so. Is that what you're seeing as well?

Yes. It's -- that's what I think we said in the prepared remarks were, we saw volumes start picking up in the latter part of the quarter, even certainly in July where it was really slow to come. And once the heat started -- northeast drives an awful lot of sales. And we were actually not too warm until June. And now it's been hot everywhere, and we're seeing the volume definitely increase. It was hard to close the gap, but we've definitely made up a lot of ground. So yes, and so we expect that to continue in the third quarter as long as it stays warm.

Okay. Obviously, we don't have the balance sheet and cash flow items, but, I mean, just by some quick calculations, I think operating cash flow -- you had a little bit of negative operating cash flow in the second quarter. And I think that was up a hair just based off of Q1 and just some numbers you gave on a 6-month basis. Are you collecting a bunch of dirty gas? Repositioning for next year? And what are you paying for dirty gas?

So what's happening now is, let's say, in the reclaim market, we're paying around $5 a pound for the dirty gas. And to put it into context, last year, we could've paying $11 possibly, or maybe a hair over $11 at some point. So clearly, to the extent that we have reclaimed R-22 refrigerant, the dollars in inventory will end up being half, let's say, what they were last year just because we're paying about half of what we paid last year. The same thing could be said too, though, with regards to HFCs. HFC pricing probably hit bottom in mid-June-ish time frame. And so we're buying HFCs now and probably will be continuing to buy them. And we're probably buying them 30% lower than we would've been buying them in the fourth quarter last year, give or take. So definitely, we're buying inventory. We're not trying to be aggressive in buying inventory right now. But more times than not, that purchases are really going to be benefit '19 more so than it would '18. I'm sorry, that's because of our FIFO inventory still going through the inventory we bought coming into this year with unfortunately the volumes being lower than we expected.

Our next question comes from the line of [Aman Giuliani] with B. Riley FBR.

I just wanted to clarify one thing. You said debt was $10 million lower, but you said debt was from December. I just want to clarify that from damage done in 2017 versus the end of Q1 '18?

Yes, no, it was for the 6 months. The reported information we gave is a 6-month trend, not a quarter trend.

Got it. Okay. And then I see a $2.9 million nonrecurring expense. Just wanted to get a bit more color on that.

Most of those expenses are coming from the -- like the ASPEN transactions, so as we continue to wind down the transition. And we have previously shared with you all that we expected the last step of the transition to be completed in the second quarter, it was. We'll probably have some residual expenses in the third quarter. But we don't expect after that to have much more in terms of these nonrecurring expenses, primarily related to the ASPEN acquisition.

Got it, okay. And then one more for me. Just could you give me a bit more color on how the DLA contract is progressing?

So DLA, again, is continuing down the path we thought. Their revenues were roughly just shy of $5 million for the quarter, which, again, is putting us closer to that run rate of $5 million a quarter run rate this year. That's where we felt we would head, and that's where it's heading now.

(Operator Instructions) Our next question comes from the line of Paul Dircks with William Blair & Company.

Just a couple for me. First of all, you guys had mentioned HFC pricing though the quarter bottoming out mid-June. Perhaps you could talk to us a little bit about what those dynamics have been thus far in the third quarter and just some of the dynamics through this year, how did they trend relative to your expectations? And why are we so confident that the pricing bottom is in?

Well, what we said in our prepared remarks, since probably mid-June, it appears all refrigerants, HFCs, 22, have stabilized. Now we can't say for certain that it's solely due to weather. But certainly, up until that moment in time, possibly many companies in our industry, including Hudson, had too much inventory and were looking to adjust pricing relative to that. Since we are getting lots of phone calls, someone commented, and that's the situation right now, no one is really making large orders. So they are calling very frequently. Price isn't as much a discussion anymore. It's more can you get the product here tomorrow kind of a thing. So to say that we could guarantee that we're at the bottom, we can't say that for sure. But certainly, we've had a significant price correction. When you look at HFC prices, specifically, we're not at the all-time low relative to the pre-tariff days, but we're not that far from it. We're pretty darn close to it. And the pricing dynamic today we think is such that there was a little bit more shipping and blending expenses in today's environment versus what would've been back about 3, 4 years ago. So we -- it's difficult to say guarantee-wise that we're at a bottom, but we believe we are at the bottom. And we've seen strengthening of price in the month of July as the warm weather has continued.

Got it, that's helpful. Where exactly are HFC prices through July relative to last year July 2017?

We're below all those prices. Now that's -- we probably never will cross because we did get a price correction in HFCs, and particularly 410A, in the third quarter last year that was very severe. But we probably will this entire third quarter sell below that low.

Okay. That's helpful, appreciate that. And then just one more for me. If customer buying behavior, perhaps thinking back to the last major cycle of depressed prices and then returning out of that cycle to more normalized buying behavior. When exactly in the following year after the last time of depressed prices did customer buying behavior normalize to where it wasn't so much just-in-time? And do you sense that we'll have any view into that normalized buying behavior before next spring? Or is this simply waiting around until August -- or excuse me, April or May of 2019 before getting a little bit more comfortable with what customers will be doing?

So that's a good question and probably little difficult to answer. What may have exacerbated this year more relative to prior years is how cool it was for how long, and particularly in the north and northeast this season. So it is difficult to compare one season to another season and then say the past is a predictor of the future and so forth. We'll go into the season spending probably a lot of time thinking about our inventory levels and managing that and trying to assess buying behaviors as best we can, but we're probably going to be cautious about that based on how this year played out and the just-in-time model we've seen.

But in addition to that, the difference in this year, we really hadn't seen -- as Brian said, we hadn't seen before where all the refrigerants primarily were affected. So the models we've looked at, the -- if we do -- if we compare, yes, we had a good feeling of when it starts leveling off. But that was usually one refrigerant had a problem, it wasn't unusual the group. And so you get the effect on, say, 22, because HFCs, which is primarily what happened. To make margins, someone had to start selling their 22 inventory because they weren't making it on HFCs. We hadn't seen that before. But I think we feel comfortable with it that -- of Brian's opinion is on it. But that was the biggest different I think as we haven't -- this is exactly what we've seen before where they all were pretty much affected.

Our next question is a follow-up question from the line of Gerry Sweeney with Roth Capital.

Thinking a little bit out loud here and trying to figure this out. So as we go through this season and we're looking at FIFO inventory, you're bringing dirty gas in at $5. At what point do you deplete your more expressive inventory and then start to sell this new gas coming in?

So there's a slightly different answer between the Hudson normal inventory and then the inventory acquired from ASPEN. So as it would relate to Hudson, generally speaking, in any one particular season, we ought to be able to liquidate the inventory we bring into the year. We generally -- our inventory turns, while they're not significantly greater than one time, they're probably 1.4, 1.5, so in that kind of mid-range. So we should deplete Hudson's inventory this year, whether that be 22 or otherwise. The slight difference now, though, at ASPEN, and this was something we talked about and probably disclosed and really was originally related to that accounting we had to do with the step-up of basis and all the stuff was that, we did get more than 1-year supply of 22 on the ASPEN's books. But back to this whole accounting and step-up of basis, all that stuff is eliminated. And as a result, let's just say, now their 22 has much more normal or realistic costing structure now that the accounting step up is gone.

So also on that front, does this step-up on Q3, Q4 impact some of the -- we were looking at some adjusted EBITDA and adjusted numbers. Does that go away now since that step-up has been written down essentially?

Yes, a lot of this accounting and trying to reconcile the non-GAAP is going to go away. Absolutely, yes.

Okay. Dare I ask what price it was written down to? I mean, you said $10 to $11. I mean...

There's two different things. So this step-up in basis is a very unique accounting nuance relative to allocation of the purchase price in an acquisition. It's not really related to GAAP of going concern net realizable value concept. It's an independent concept relative to redistributing the purchase price amongst the fair value. And back to that outcome, you're kind of -- it's not precisely this, but you're kind of forced to mark up to market at the acquisition date, which you normally would do on a cost basis or a net realizable value. So you end up with a little perverse outcome, which is why we were -- had been, in fact, trying to do a reconciliation between GAAP and non-GAAP because the outcome was not normal and perverse to some extent. But it is in accordance with GAAP. So...

Got it. And then one other question, then I'll jump back in queue, in case there's another call. What's your market intel in talking to people out there on the streets, scuttlebutt, what have you? I hear different things in terms of how much inventory stockpile is out there. Obviously, virgin R-22 is going to what, 4.5 million pounds next year. And the market demand has got to be substantially higher than that. So you hear different things. People are selling R-22 at some cheaper prices for volume just to help out some other margins because they're getting wacked on HFCs, things like that. Whether or not -- how much of that is true, I don't know. But curious if you could comment on any market intelligence in terms of how much stockpile is out there, and what's going to happen.

Again, we don't have definitely, obviously, accurate numbers on what the stockpile is. From the best of our knowledge from talking to people, talking to, really, allocation holders, people who may have had some gas, we definitely think it's significantly down, especially since there was good volume out there at one point because of trying to make up the difference on HFC. So we do think a good amount of it went out. How much of it is left? Hard for us to say. We can't imagine a ton left. We haven't heard that there is. We haven't heard that it's gone, but -- and there's been enough supply. That's why this industry certainly hasn't been really running as a supply demand curve here, because again, there's been enough supply, and that's because of the extra amount with the stockpile. When will that deplete? Hard for us to guess. But as long as someone has it, they're not making money on HFCs, they'll keep feeding this kitty here to try and make up the shortfall. And so we'll know once it's out because probably prices will start coming back up on 22.

There are no further questions in the queue. I'd like to hand the call back to management for closing comments.

Okay. I would like to thank our employees, our long-time shareholders, those who recently joined us for their continued support. And thank you, everyone, for participating in today's call. And we look forward to speaking to you after the third quarter results. Thanks.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.