Arq, Inc. (ARQ) Q1 2017 Earnings Report, Transcript and Summary

Good morning, my name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Advanced Emissions Solutions Q1 2017 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator Instructions] Thank you. Ryan Coleman, Investor Relations, you may begin your conference.

Thank you, Lisa. Good morning, everyone, and thank you for joining us today for our first quarter 2017 earnings results call. With me on the call today are Heath Sampson, President and Chief Executive Officer; as well as Greg Marken, Chief Accounting Officer. This conference call is being webcast live within the Investor's section of our website. A webcast replay will also be available on our site, and you can contact the Alpha IR Group for Investor Relations support at 312-445-2870. Let me remind you that presentation and remarks made today include forward-looking statements as defined in Section 21E of the Securities Exchange Act. These statements are based on information currently available to us and involve risks and uncertainties that could cause actual future results, performance and business prospects and opportunities to differ materially from those expressed and/or implied by these statements. These risks and uncertainties include, but are not limited to, those factors identified on Slide 2 of today's slide presentation in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2017, and other filings with the Securities and Exchange Commission. Except as expressly required by the securities laws, the Company undertakes no obligation to update those factors or any other forward-looking statements to reflect future events, developments or change in circumstances or for any other reason. In addition, it’s very important to review the presentation and today's remarks in conjunction with the Form 10-Q and the GAAP references in the financial statements. So with that, I'd like to turn the call over to Heath Sampson. Heath?

Thanks, Ryan, and thanks to everyone for joining us this morning. Let's start on Slide 3, as I like to provide a review of our strong start to the New Year. Our first quarter results serve as affirmation that our transform business model is working. Refined Coal or RC distributions from Tinuum remain strong and as projected. Tinuum was able to close another RC facility in late March with an existing tax equity investor. In addition to strong distribution from Tinuum, the quarter was also highlighted by the continued validation of our chemical's offering in the EC business. We again reduced our indirect operating cost by 43% year-over-year, and we drove nearly $9 million of net income during the period. Our cash position increased substantially from last quarter, up $15.2 million, and we fully expect to be a generator of strong free cash flow for the foreseeable future. As a result of our strong results and our updated projected future cash flows of $275 million to $300 million by the end of 2021, we have also announced new plans of $10 million tender offer of our stock today. I'll outline the specifics of this stock buyback later in the call. But when coupled with our expected $0.25 per share quarterly dividend, this forms the foundation of a balanced approach to capital allocation. I'm thrilled with the hard work of our team and eager to build on this solid start in 2017. So let's talk a little more specifically about our high-level results. RC distributions from Tinuum were strong and in line with our expectations at $14.7 million. This was a $9.8 million increase over the $4.9 million we received in the first quarter of 2016. Also, as mentioned, we were able to lease an additional facility to an existing tax equity investor in late March. This facility has historically burned an excess of 5 million tons of coal per year and is royalty bearing. We expect annual distributions resulting from the lease of this facility to be on the higher end of the $5 million to $7 million per year range that we typically project for new closures. Now I'd like to take a few minutes to offer a deeper dive into some changes we're seeing in the tax equity environment. Please turn to Slide 4. As you know, our team and Tinuum remained intently focused on identifying new tax equity investors. We are operating multiple sales channel as we look to identify and complete transactions with new investors. These include direct sales, broker-assisted sales that we mentioned last quarter, sales to one of our potential buyers and sales to larger entities that might be capable of leasing or buying a significant number of remaining facilities. Our investors need to understand that this is a very complex and fluid process filled with starts and stops. Impacting this process in 2016 was a political and tax environment that made perspective tax equity investors somewhat uneasy about coal-related tax equity investments. For example, I can tell you that on multiple occasions, we were down in the sales process with a perspective investor and one of the members of the investors team pulled back to support the transaction in the 11th hour usually out of fear around the uncertainty that was in the market in 2016. The refined coal tax equity market has shifted more positively because of recent actions from the IRS and an improving political environment. We have a political administration that is more favorably disposed to the coal industry, which is helping to rebalance large corporate investment decisions to a more rational point. Although not efficiently published to the market, it was disclosed in a legal newsletter that the IRS has recently sent a technical advance memorandum or simply put an adverse ruling to a non-Tinuum tax equity investor. This is very significant, because the broader market had slowed since early 2016 when this IRS memorandum was first rumored to be in discussion. Although the ruling is not favorable for this specific investor, we believe Tinuum's approach and typical structure, which is distinct from the situational issue, has been validated. Specifically, tax equity investors in our facility had meaningful participation in the commercial ups and downs of their investments; they are real investors. I don't want to get in the weeds on this topic, but they are two takeaways here for you. First, we believe that the soundness of Tinuum's typical investment structure has been further validated as a result of these recent communications. To add credibility to that statement, it's worth reminding our investors that even in the face of this difficult environment last year, we believe we closed more transactions than the rest of the industry combined. The second key takeaway is that the recent events that have come to light have provided some clarity to a situation that was extremely cloudy. The great news is, as a result of this IRS action and increasingly more favorable political backdrop, we reopened a number of conversations with past potential tax equity investors that have moved to the sidelines until they received better perspective around this situation. There is still a lot of work to be done, and again, this remains a very complex dialogue. But it's important for our investors to know that we are growing cautiously more optimistic about our ability to close more RC facilities over the next several quarters. Switching to the EC side of the business. The first quarter saw another strong performance with our chemical business, as exhibited by better-than-expected revenue for the period. Specifically, we had $7.4 million of EC revenue with $5.1 million in legacy equipment sales and $2.3 million in chemical sales. Chemical revenues were up 400% year-over-year, which validates the continued commercialization and monetization of our chemical technologies as well as the depth of our IP portfolio. Based on the strong revenue growth and growing pipeline, we remain confident in our ability to attain the 20% to 40% share of the $100 million market opportunity, the goal we laid out on previous earnings call. Our EC business model is not cash-intensive. It is resource like high margin, recurring and we remain committed to growing into a strong, viable component of our overall business. I'd now like to turn the call over to Greg Marken, who will review our first quarter financial results. Greg?

Thank you, Heath. Let's start on Slide 6 to review our first quarter financial results. Let's begin with total revenue, which was $7.4 million for the first quarter. This was down from $22.4 million from one-year ago, primarily as a result of lower equipment sales, which was expected. As a reminder, current revenue from equipment sales is being recognized from previous equipment sales contracts using the completed contract method. Looking forward, the second quarter will likely see over $20 million in revenue recognized from these legacy equipment contracts and then we expect equipment revenue to taper off materially through the middle of 2018. As Heath mentioned, chemical revenues came in at $2.3 million, which was larger than originally expected. It is worth mentioning, our margins on those chemical sales came in slightly lower than we previously projected, due to ongoing field testing of these technologies with one large customer as well as higher-than-expected cost of customer acquisition. Despite this, we fully expect to return to 30% to 40% margins in the next few months. And while the chemicals market is a highly competitive environment, our pipeline remain strong, our offering is superior, and as important, it is very cost effective. As Heath mentioned, earnings from equity method investments, which generally represent our RC distributions, were up over 145% to $13.8 million. We had $1.7 million of royalties earned from our RC intellectual property, which was up nearly 50% as newly leased facilities in 2016 had royalty streams attached. Moving on to expenses. Our total operating expenses, exclusive of cost of sales, were $5.2 million for the first quarter. This figure was down significantly from $8.4 million in the first quarter of last year and is approaching the $13 million to $15 million run rate that we set as our targeted annual operating cash cost structure. We believe that this is a good run rate moving forward and are confident that we can operate efficiently at that level. We will continue to evaluate further potential SG&A reductions to meet that cost basis targets. Net income more than doubled year-over-year to $8.7 million, while cash and cash equivalents also more than doubled and now exceed $28 million. As a result, our balance sheet has been significantly strengthened over the last year, and we're now in a great position to drive value-enhancing capital allocation as Heath mentioned. As we continue to Slide 7, you can see that legal payroll and rent expenses were all much lower during the period. It's worth noting that rent is not expected to remain at this lower levels moving forward, as this quarter's figure include some positive impacts related to recently moving our corporate headquarters to a smaller space. Depreciation and amortization nearly doubled year-over-year. However, this increase was also driven by the Company's recent headquarters move, which led to accelerated depreciation. This was a one-time acceleration, and the Company expects for depreciation and amortization expenses to recede back to previously observe lower levels in the future. Receivables were down during the first quarter, largely driven by legal matters completely settled during the period. A significant portion of these settlements were covered by our insurance, but had to be recorded for accounting purposes. Let's go on to Slide 8, where you can see our cash flow update. Stronger RC distributions as well as solid royalty collection in chemical revenues drove strong cash flows. As a result, our cash position is significantly higher on both a year-over-year and a sequential basis. The 115% year-over-year increase was largely attributed to higher operating and investing cash flows as well as $5 million of restricted cash that was released during the period. I'd like now to turn the call back over to Heath to discuss our go-forward strategy. Heath?

Thanks, Greg. I'd like to take a moment to review our go-forward strategy for next year in each of our business segments. First, let's address our RC segment. Slide 10 provides reminder of the facilities Tinuum has in place and those that are waiting tax equity investors. The slide has been updated for the new leased facility in March, and thus, Tinuum now has 14 leased facilities that have the potential to provide volumes of $40 million to $50 million tons per year of refined coal. Of the 14 non-operating facilities, some are already installed and awaiting investor, while others are yet to be installed. The challenge is not finding power utilities. The challenge centers on finding tax equity investors. If we can help Tinuum find investors for these 14 facilities, we have the ability to roughly double Tinuum's production to a $100 million tons per year. Slide 11 provides you with our traditional quarter-by-quarter review of Tinuum's operating volumes. As a reminder, the 14 facility was leased in March. So we'd expect to see an uptick in tonnage to process next period. Overall, you can see solid consistency in terms of performance, which is reassuring as this throughput supports our future cash projections. Slide 12 shows you a royalty versus non-royalty schedule in terms of production facilities. The bar on Q1 shows you that the number of royalty-bearing facilities do not change quarter-on-quarter. However, the new facility Tinuum leased in March is royalty bearing and replaces a smaller royalty-bearing unit at another generator. That generator was serving two units with one RC facility. However, the royalty-bearing unit is no longer running. Moving forward, we expect most of the non-leased facilities to be royalty bearing if and when they are leased by a tax equity investor. Let's pivot to the Emission Control segment on the business on Slide 14. I'd like to review the market opportunity for our chemicals business again briefly. This area of our business is a key focus of ours morning forward, as we aim for the EC segment to cover our corporate costs as well as the RC business cost. Although we underestimated a long sales cycle of displacing incumbent technologies, we are better positioned in the marketplace because of the superior patented technology. To ensure we gain market share, we are enhancing our offerings that will better position us as a more meaningful service provider to power generators. Our work over the last year has defined a total market between $400 million to $600 million in consumables annually within the North American mercury control space. Of that, we believe that our current chemicals business has a market opportunity of approximately $100 million. We currently only have a few percentage points of the market, but believe we can attain 20% to 40% of the opportunity over the next few years. The key here is we're talking about recurring revenues, backed by strong patented technology in the operating cost model. With that, let's move to another exciting part of our discussion today, as I like to outline our new capital allocation strategies. First, on Slide 16, you can see what supports our future capital allocation program. With the addition of Tinuum's 14 leased facility and the contributions from the EC business, we are projected between $275 million to $300 million in future cash flows ADES. Please move to Slide 17. As you've seen in our releases yesterday, we've taken a number of steps to start – put our strong cash position and projected cash flows to use and to create shareholder value. This includes a $10 million tender offer, which stated more simply is an accelerated way to repurchase our stock. Given our low float and the restrictions on how many shares we can purchase of stock on a daily basis, our team concluded that this is the most tax-efficient, shareholder-friendly way to execute a meaningful buyback of our stock as opposed to a drawn-out share repurchase program. This modified Dutch auction tender offer will allow us to purchase up to 925,000 shares of stock at a price per share between $9.4 to $10.8. The maximum aggregate purchase price will be $10 million, and the tender offer will expire at 12 mid-night Eastern Time on June 7, 2017, unless extended or withdrawn. This again will be funded with cash. Again, traditional share purchase would take a significant amount of time in the open market, and the tender offer allows us the flexibility to balance our shareholder return program with our broader focus on our Company's long-term goals and near-term priorities. I'd also like to provide an update on the previously disclosed dividend schedule. While we recognize that investors have been looking for formal announcement, it was more prudent to implement the tender offer before making any potential dividends official. We continue to expect the formal June announcement of the dividend, which will be a recurring quarterly dividend of $0.25 per share. Taking together, if we execute the full value of the tender offer and then implement our dividend program, we are looking at a return of up to $32 million to shareholders, which is roughly 15% of our market cap today. I'd also like to mention that tax equity protection plan that we also announced yesterday through our historical net operating losses and accumulation of tax credits from running RC facilities in the past, we have strong tax assets that need to be protected. As a result, this plan has been put in place to provide protection for our tax assets by working to prevent a change of control from an IRS perspective, which could nullify a significant amount of this asset value for our shareholders. Since we have a rather concentrated shareholder base and we are relatively close to triggering a change of control per the IRS rules, we will evaluate all request to buy our stock above the established thresholds to ensure that, that specific trade request doesn't increase the risk of a change of control. Lastly, I'd like to provide some color on our go-forward M&A strategy as well. Given our potential to generate additional free cash flow as well as our NOL and tax credit assets that I just discussed, we have been evaluating accretive M&A opportunities. As a result, we started to engage in conversations with a number of bankers that focus on the fragmented fossil fuel market in the U.S. and/or the broader energy market. I want to reiterate that we have a rigorous set of criteria for M&A candidacy, which requires any potential deal to be EBITDA positive and have revenue and expense synergies. Our M&A approach will be patience as we must be sure that any deal fits our designated criteria, and we must be confident in a seamless simulation of any merger or acquisition as our current infrastructure could support the deals we consider. Additionally, we'll be piloting other technologies in our IP portfolio in our focused effort to commercialize and monetize that area of the business. This continued commercialization may present M&A opportunities as well. It is a major competitive advantage to have more offerings and be more significant to our power generators. Expanding on the future cash flows and potential allocation plans for the company from the previous slide, Slide 18 provides a summary that indicates the current value of our stock reflects a discount to our expected future cash flows, absent of any individual investor assumptions related to a discount rate as well as a high-level picture of why we believe that the recently launched tender offer may provide value to shareholders. Let's conclude today's prepared remarks on Slide 19 and recap. We have outlined an explicit set of priorities and goals for 2017. These priorities include: helping Tinuum increase the number of RC facilities placed with tax equity investors; completing the remaining EC equipment commitments on time, on schedule and on budget; capturing an increased share of the $100 million chemical technologies opportunity; further evaluating the commercial feasibility of other complementary patented technologies we have in our EC portfolio to expand our market opportunities; evaluating a dynamic and fragmented fossil fuel market in the U.S. or the broader energy market to potentially provide partnership or M&A opportunities; and finally, executing against the balanced capital allocation program to distribute and create value for our shareholders. I'd like to thank our team and extended team at Tinuum for their perseverance and commitment to getting results. Lastly, I truly appreciate the continued support from our shareholders. We have all come a long way and should be excited for the future. With that, we'll open the line for questions. Operator?

[Operator Instructions] Our first question comes from the line of Amit Dayal from Rodman & Renshaw. Your line is open.

Thank you. Good morning, guys.

Good morning.

Just talking about the chemical sales, it looks like the numbers have come in slightly stronger than what we had anticipated. Do you think you guys are in a position to maintain sequential growth on this front going forward?

Yes. Since we have such small percentage of the market right now, our expectation is to get to that 20%, 40%. So the timing of these next two quarters could be lumpy, because of our starting from such a small base. But based on what we have been doing, based on success of our demonstrations, we do expect to continue to grow to get to that 20% to 40%. What happens in each quarter is a little bit lumpy. I won't get too specific on what that number is going to be each quarter, but you should expect an increase and progression towards that market share that we talked about.

And in regards to the equipment sales backlog, if you will, or revenue recognition remaining, can you give us a number on how much is now pending that needs to be recognized or deployed?

Well, our backlog is in our Q – in our 10-K, sorry. So that backlog that we disclosed in our 10-K is the majority of that, and we don't have that in front of us. But if you look at it, the majority of that is going to runoff this year with the bulk of it, as Greg talked about, to be about $20 million or so in this quarter. Then we probably have another...

Pretty immaterial amounts coming through in the second half of 2017 with very immaterial amounts going into 2018.

Understood. And then on the RC front, you closed one transaction maybe a month ago, I guess. Do we expect any other deals to potentially come through before the end of the second quarter? Or should we look for any developments later in the year on this front?

Yes. So consistent with what I've said before, predicting RC closures within a quarter time frame, I stay away from. We have a lot that's going on and lot of discussions. So we feel good about stuff closing this year in 2017 and over the next several quarters. So we'll just update you as they come through and close.

Understood. And then just maybe jumping back to the chemical sales margins side, you said margins were a little over this quarter. Could you give us some color on where margins...

So the reason for – as we are demonstrating and moving to having a more commercial contract, it's costing us more than we thought to get through these demonstrations improve our technology. So those costs are affecting our margin. As we get up and running with these specific customers that we have, then it would normalize those costs would obviously be not there anymore because the customer would be acquired. And that's why we expect it to normalize back to our 30% to 40% expected margin.

Okay. Understood. And then on the M&A side, my last question. Are you focusing on the consumable market? Are you looking at something else to maybe diversify the portfolio offerings? Any color on where the focus is?

Yes. So it's both. It is broad for many reasons to ensure that we're opportunistic, but there is advantages for juridification. There is also advantageous for being close to our current technology. So we are evaluating both. And that's where we are in the process of doing. Again, we'll stick to that criteria that we've laid out, and be patient with it, so both on it.

All right. Thank you, guys. That’s all I have.

Thanks for the questions.

Our next question comes from the line of Patrick Wolff, Grandmaster Capital. Your line is open.

Hi, thank you. I'm a new investor. And first of all, I want to congratulate you guys. You obviously have been doing a terrific job and just well done. And I'm sure you are all motivated to keep it up, but it's easier to tell from the outside. My specific question is around the political climate, but very specifically, around the EPA review of its rules that was mandated a couple of months ago by President Trump and how it might affect MATS? And if the EPA does a review and radically changes its economic assessment of costs and benefits, first of all, how likely do you think that would be? And secondly, what impact would that have on your various businesses? And then I have a follow up. Thank you.

Yes. Okay. So you're referring to MATS, which is the mercury rules that were put in place, those regulations in 2015 and then finalized in 2016. So though the EPA has – or is in the process of reviewing those again, the consensus across the marketplace with our customers as well as other providers in this that it's most likely that MATS will stay in place. And MATS – again, what that market affect is our chemical business on our EC side. If for some reason that, that was overturned that would not be good for our business. But again, it's unlikely, because the majority of the investment that had to be made in equipment has occurred over the last four years, five years or so. So everyone is up and running, and it's working, and it's providing the mercury reductions that were put in place. So again, the marketplace thinks it's unlikely, but we'll wait and see what happens with the EPA and that would be detrimental to our EC business. The Refined Coal business, though that is also mercury control and NOx control, it should have no impact. So the majority of our cash flow should be secure regardless of what comes out of the EPA related to MATS.

Okay. That's very helpful. Thank you. And then the follow-up, I was interested to learn about the IRS letter that you had talked about in your comments. Maybe you could expand a little bit on that? That's not an angle that I had been – at least, I had been aware of. I'd love to know, first of all, how can we investors just get up to speed and learn more about the issue? And secondly, can you expand upon why you think this is actually a favorable development?

Yes. So the ruling that came out from the IRS, if you understand the rules around how the stuff works, this was for a specific investor that is not a Tinuum investor. And this announcement came out from a legal newsletter. So the market has known about this, but it's not public yet. When it becomes public and the IRS issues it, who knows? And that's when I think the broader market would get understanding. But because this was disclosed by this legal newsletter, I wanted to mention it, because I think it's a valuable part of – for everyone to understand. For us, internally, and for people in the tax equity market that have the structures like we have, we feel good about that and that specific ruling, that again was announced in this newsletter, provided an opportunity to talk about it and also to understand how the IRS ruled in this specific example. We know how they ruled, and we know that based on that ruling, we don't do that which is why we feel good about our current structures that we put in place at Tinuum. And again, that ruling has been rumored to be out there for a number of months, since early 2016, and it really froze the market. So because that now has come out and it's more visible to everybody, that's why we are more encouraged about having conversations primarily with new people, and we would be able to articulate why our business model at Tinuum and our structure is the right one to follow. So it just provides more clarity to the marketplace that wasn't there in early 2016.

And a final question, and maybe this is something to take off-line, but is there any way that you can explain just in some specificity, what it is about the ruling, I mean the expected ruling? And what it is about what Tinuum does that are distinct from each other?

Yes. So in a simple terms, in all tax equity in general, including refined coal, an investor has to be a real investor. They have to take the commercial risks of ups and downs. That is the primary objective of being an investor. If you do that, if you hear to that, the spirit of that and your contracts reflect that, you're going to be okay. If you wanted to look at some rulings that came out in a different – it's called the Boardwalk case, and this was a couple of years ago, and it was in housing credits. But that really help establish why an investor needs to be a real investor. If you read that, you'll get some context around the structures that should be in place, and that we at Tinuum have been in place as well. So that's the high level. There's a lot more behind that, and we can talk about that off-line. I can educate you more.

The next question comes from the line of [Steve Santos, RBC], retired. Your line is open.

Hi. Good morning, gentlemen. Very nice quarter. Thank you. I just have a couple of basic questions, I guess. Number one, on this IRS letter that you referred to, is it a correct summary to think that this may have had some impact on the difficulty you appeared to be having in closing the RC investors? And are you thinking this will provide some clarity going forward?

Yes. It has had an effect on the market in general and for sure us. There are specific investors that we were talking to that actually went on the sidelines until there was clarity around this situation. So direct impact as well as this kind of broader indirect impact. So we are encouraged that this has come out, because it provides a clarity and allows us to reengage on those other previous conversations as well as establish new conversations. So it's been a positive impact coming out.

Okay. Hopefully so. Also, could you give a quick summary as to this, what I interpret as a poison pill on these preferred shares that you'll be issuing to us? Are you able to comment on this at this point?

Yes, yes, so yes, it is a poison pill, but we explicitly call it a tax asset protection plan, because that's the sole purpose of it. We have valuable tax credits, NOLs and tax assets on our balance sheet. And if there was a change of control, and I won't get into the rules around what the IRS has on those, but if there was a change of control that could occur by shareholders trading, that would trip the IRS rules and then we would lose a significant portion of those tax assets. So that is the reason why we put that in place. And then how it works, it's not that we don't want shareholders to come in and out. What we want is to ensure that we are aware of that, so we can properly approve and analyze whether or not there would be a change of control or at risks to that change of control. If it was, then again we'd allow it. So it really is a plan we put in place to ensure we had visibility and control the trading at these certain levels to ensure we protect those tax assets. That's the primary objective of why we put this in place.

And if I read the disclosure, you have the ability to absorb any individual or group of investors from that. You wouldn't simply not trigger that classification, is that correct?

Yes. I think I understand you question. It's correct. We have the ability to look at that and analyze that. If we saw that it was going to add risk or trigger, we wouldn't allow it. If it didn't, we'd allow it. So the simple way just gives us visibility to ensure that we don't trip that change of control per the IRS rules.

Okay. Good. And lastly, the $5.3 million in tax allocations with $113 million NOLs and tax credit on the books, is it a safe assumption this is simply GAAP accounting method that will be zeroed out by the end of the year?

So when we reversed a portion of the valuation allowance at the end of last year, once we did that, it was going to have a P&L impact going forward rather than just a balance sheet impact on the change in valuation allowance. To the extent that we are utilizing deferred tax assets other than tax credits, it would be a non-cash impacting situation at the end of the year to the extent that we've utilized tax credits during the year, 25% of that would result in a cash payment, just due to rules on how much you can offset tax expense related to tax credits and not have to pay cash. End of Q&A

There are no further questions at this time. Mr. Heath Sampson, I'll turn the call back to you for closing comments.

Well, great. Thanks, again, to everyone for your time today and your continued support. I look forward to updating you all in the progress during the next earning results call. Have a great day, everyone.

This concludes today's conference call. You may now disconnect.