Hudson Technologies, Inc. (HDSN) Q3 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Hudson Technologies Third Quarter 2017 Earnings Conference Call [Operator Instructions] At this time, it is my pleasure to turn the floor over to your host John Nesbett of IMS. Sir, the floor is yours.

Good evening and welcome to our conference call to discuss Hudson Technologies' financial results for the 2017 third quarter. On the call today, we have Kevin Zugibe, Chairman and Chief Executive Officer; and Brian Coleman, President and Chief Operating Officer of Hudson. Of the call this afternoon, management will review its third quarter results and provide an overview of its combined operations including its acquisition of Airgas-Refrigerants which closed on October 10, 2017. Importantly, there is a slide presentation, which will accompany the discussion. This slide presentation can be accessed on the Investor Relations section of the company website. Please go to www.hudsontech.com, click on the Investor Relations tab in the upper right-hand corner and select the Events & Presentations tab, which is the fourth in the dropdown menu. When you reach Events & Presentations page, you’ll see the slide deck on the right-hand side of the page. This is a user control deck, so viewers will be responsible for advancing the slides and management will prompt you, as they advance through the deck. Okay, I’ll just 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 of 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 these 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 call over to Kevin. Go ahead, Kevin.

Good evening and thank you for joining us on the call tonight. We’ll first review the third quarter results and then we'll turn the slide deck to discuss the enhanced market opportunity represented by the close of the Airgas-Refrigerants or ARI acquisitions and to provide an overview of our operations as we move forward, we will include a pro forma financial information. So first let me turn it over to Brian to provide details of our third quarter results. Go ahead Brian.

Thank you, Kevin. Revenues for the third quarter ended September 30, 2017 were $24.7 million, a decrease of 29% as compared to the $34.9 million in the third quarter of 2016. The revenue decrease was primarily driven by decreases in both volume and price of certain refrigerants sold. During the quarter we realized approximately $2.9 million of revenue for the DOA contracts noting that order fulfillment began in late July and therefore did not have the full three month contribution for this quarter. On an overall basis, gross margin declined to 21% as compared to 34% in the same quarter last year. This quarter's gross margin was negatively impacted by the price reductions on all refrigerants including R-22. This contrast with the 2016 gross margin which was significantly impacted by substantial price and demand increases R-22 due to the perceived shortages in the marketplace during the 2016 quarter. Operating expenses for the quarter decreased to $3.6 million compared to $4 million in the previous year quarter. The decrease in 2017 is primarily due to higher stock compensation expense, professional fees and the 2016 third quarter offset by $1 million in non-recurring fees incurred in the third quarter of 2017 related to the ARI acquisition. Net income for the quarter was $2.1 million or $0.05 per basic and diluted share compared to net income of $4.8 million or $0.14 per basic and diluted share in the third quarter of 2016. As we previously disclosed, we expected to see declines in price and volume during the third quarter of 2017 for all refrigerants. However the magnitude of the decline was greater than anticipated. At the time of our second quarter 2017 earnings release, R-22 prices had decreased to about $18 per pound and the pricing pressure continued through the end of the third quarter of 2017 with R-22 prices declining further to the current level of about $16 to $17 per pound. Additionally as anticipated HFC prices also came down further impacting our results for the third quarter. To give you some context around the price declines, the R-22 refrigerant sales season took a different trajectory than the HFC market. In the first quarter of 2017, producers aggressively raised their price on R-22 and one producer got out ahead of others and aggressively sold product in the first quarter that otherwise have been available for sale later in the season. This advance selling activity created excess supply in the marketplace and put a strain on pricing. Additionally we had a cool May and early June in the North and Northeast, an area which typically drives a significant amount of seasonal R-22 demand. With the cool temperatures we saw a slower start to the cool season, these factors coupled with the rise in demand for substitutes, which we believe reached approximately 30% of the overall potential R-22 demand created pricing pressure on R-22 particularly in the latter part of the 2017 cooling season. Regarding HFCs around the time of our first quarter call, we saw signals of global market disruption and predicted that we may see volatility in HFC pricing for the cooling season. As it turned out there was a severe although temporary supply and demand imbalance. This disruption began to subside in the third quarter of 2017 with a flood of Chinese suppliers refrigerants which in turn create a rapid reduction in HFC pricing that returned levels similar to the beginning of the year. Despite these declines for the nine-month selling season, Hudson recorded revenue growth of 18% to $115.8 million, gross margin of 30% which was at the high-end of our targeted 28% to 30% range, and net income improved to $16.4 million or $0.39 per basic and $0.38 per diluted share. We often discuss the importance of looking at our business through the perspective of nine-months selling season rather than a quarter-to-quarter basis and this year illustrates the supply demand of balances that can occur on a quarterly basis. Our balance sheet at September 30, 2017 which excludes ARI reflects cash from approximately $44 million, inventory of $63.8 million and approximately $115 million of working capital. Now, I’ll turn it back to Kevin.

Thanks Brian. As a reminder, there is a slide deck that will accompany remainder of our discussions this evening which can be accessed on the Investor Relations section of the company website at hudsontech.com under the Events & Presentations tab. Please refer to Slide 1 for the safe harbor statement. As we’ve outlined on Slide 3, on the call tonight we’ll discuss the industry trends and market behaviors that have guided our strategy to-date and the continued opportunities we anticipate as we move forward. We'll then go over to details of the acquisition, followed by an overview of the financials including pro forma financial information for the acquisition of Airgas-Refrigerants for the six months ended June 30, 2017 and year ended December 31, 2016. Then we’ll open it up to Q&A. So beginning on Slide 5 we outlined the market opportunity related to the phase out of R-22 despite some conflicting options - opinions put forward recently about the EPS, aftermarket demand estimates there is no disputing the fact that production for R-22 will be zero at the end of 2019. At that time, there will still be a large installed base of R-22 equipment that will continue to need R-22 refrigerant in order to run safely and efficiently and based on its studies of the industry and data gathered from the industry participants, the EPA has estimated aftermarket demand of R-22 systems at £50 million for 2020. The most efficient and safest way to operate in R-22 system is by using R-22 refrigerant. As production of version R-22 is phased out, we believe we have tremendous opportunity to build the marketplace needs through our reclamation capabilities which essentially position Hudson as a producer of R-22. Regarding stockpile information we'd like to clarify the difference between stockpile which we’ve been referring to for many years and inventory. It’s always been recognized that there is a large supply of R-22 inventory held for aftermarket by wholesalers, retailers, contractors, end-users at hundreds and thousands of locations as businesses grow out the country. As the EPA was writing the final rule covering the allocations for the 2015 to '19 years, it was apparent to us that there was also a stockpile of R-22 which is product held for sold by certain companies at the top of the chain, these files have not yet been introduced in the conference and we’re not being accounted for in the calculations from these allocations. We worked very hard to get the EPA to write 114 letters which would allow them to obtain information on the stockpile volume which EPA could then utilize when calculating allowances for the final rule. EPA follow through by writing 114 letters in 2013 and 2014 and these letters identify specific volume levels held by primarily allocation holders which we believe represented approximately 95% of the stockpile volume which was not considered by the EPA in its previous calculations. We believe the inventory held throughout the market chain is similar to every other year but we believe the stockpile has significantly reduced. In addition, it should be noted that we're continuing to pay approximately 50% of the sales price for use refrigerants and as the sales prices decline, so as our buy price during this season. Moreover the contractor accidentally mixed two different refrigerants, the reclamation process required separation of the different refrigerants. Hudson was not only one of the first prime reserve market, it also is one of the first separate refrigerants going back to the 90s.The economics for processing mix refrigerants are typically more favorable and 50% pricing structure for used refrigerants. However there is significantly lower amount of mix refrigerant available when compared to reclaim old refrigerants. On Slide 6, we take you through the evolution of our industry to help highlight why this acquisition positions us so favorably for long-term growth. As we often discuss the ongoing phase-out of HCFC refrigerants and the expected future phase-out of HFC refrigerants represents a tremendous growth opportunity for Hudson. Hudson has experience in managing the shift from one class of gas to the next, the current phase-out of HCFCs is similar to what happened with chlorofluorocarbons CFCs and what is expected to happen to HFCs. And to be clear Hudson is an industry leader when it comes to development of best-in-class technology for the reclamation or recycling of all refrigerants whether these refrigerants are contaminated or mixed. With the addition of ARI, we are well positioned to serve our customers during the ongoing phase-out of HCFCs and to serve an expanded customer base during the future phase-down of HFCs. In the near-term we expect a benefit from ARIs higher volume of HFC sales as the industry shifts from R-22 to HFCs. Hudson is historically focused more on the legacy R-22 business while ARI brings a very strong HFC business. As our industry continues to evolve, we expect our combined expertise and capabilities will increase our access to legacy as well as next generation gases allowing us to expand and diversify our product offerings, application capabilities and our customer base. The strength and depth of our combined operations position Hudson for continued growth and profitability as the industry transitions to new technologies and gases. On long-term basis we remain encouraged by the opportunities that R-22 will provide for many years to come and also by the understanding that the industry transitions away from R-22 the role of next generation refrigerants HFCs will increase as nearly all new equipment including the equipment that's replacing R-22 units runs on HFCs. These HFCs have also been identified for phase-down beginning in 2019 and we believe these phase down represents a significant long-term opportunity for Hudson and since they have a larger installed base we anticipate that the HFC reclamation opportunity has the potential to be larger than the R-22 opportunity. Of course it's important to remember that while reclamation is very important part of our long-term strategy combined with that capabilities our long-standing business of distributing all urgent refrigerants to diverse base customers across the country. This broader customer base depends on Hudson to have all refrigerants available to meet the aftermarket needs. Turning out to the acquisition, this is an exciting and transformative time for our company since we last spoke with you we have achieved a major milestone by completing the acquisition of ARI which was a subsidiary of Airgas and Air Liquide company operating as a refrigerant distributor and EPA certified reclaimer in the U.S., sourcing and reclaiming refrigerants for sale to a variety of end users which is complimentary for our business. Brian will take us through additional financial details later in the call but in short we acquired ARI for $209 million and finance the deal with a combination of balance sheet, cash and new debt, no additional equity was issued for this transaction. At June 30, 2017 trailing 12 month pro forma revenue of the combined business is approximately $275 million. Transaction is expected to be accretive to earnings beginning one year following the close of the transaction. The acquisition strengthens our leadership position in the industry and expands our abilities to meet the needs of our customers both through refrigerant distribution, as well as reclamation. The addition of ARI doubles the size of our business by bringing a complementary product portfolio, growing and diversifying our customer base and significantly growing our sales and distribution capabilities. ARI also brings a strong management team and season employee base. With many folks with over 20 years of experience in our industry, there were various competitors before this acquisition and their strength and skill set has become increasingly apparent now that we've started working with them. Our common staff is already hard at work integrating our systems and operations. Slide 8 highlights the strategic benefits of the addition of ARI which we expect will strengthen our current operations by providing a number of benefits. ARI's large customer base positions Hudson for future revenue growth with the anticipated future phase-down of HFCs the acquisition better leverages the strength of both will come in combined entities. The expanded customer network significantly increases access to use refrigerants and strengthens our distribution capabilities across the United States. This acquisition brings cross-selling opportunities of Hudson services to ARI's existing customer base. The acquisition brings increased processing capacity to support the anticipated growth in reclamation volume from the ongoing phase out of HCFC production and expected future phase-outs. Finally we expect synergy opportunities associated with refrigerant procurement anticipating benefits to the gross profit margin and further SG&A reductions. Slide 9 depicts how complementary these two businesses are. Airgas-Refrigerants was part of Airgas which was a [indiscernible] company until it was acquired by Air Liquide in 2016. After the acquisition, the ARI division became non-Corp or Air Liquide which created the opportunity for us to acquire the business and more importantly purchase the business at a fair price. Although there are lot of complementary elements to the two businesses, why I wanted ARI does not have is a suite of service offerings that we have. So our combined operations will now have access to a new and significantly larger audience for our service offerings including our engineering assessments and optimization tools to companies and government entities looking to maximize their energy efficiency and sustainability initiatives. Slide 10 provides a snapshot of Hudson's new expanded operations. The math shows the extended geographic coverage of the combined operations and with a close our customer base is now growing to more than 7000. Today we have approximately £2 million of additional reclamation processing capacity and have grown our employee account to more than 250 including ARIs experienced leadership team, as well as the seasoned base of sales and operational employees. With our industry-leading technology well-established customer relationships and our robust distribution network, Hudson has been at the forefront of the refrigerant industry for quite some time. The addition of ARI significantly advances our leadership role, establishes us as the premier refrigerant and reclamation provider in the U.S. Our increased scale leads us well-positioned to meet the needs of our customers throughout the current phase-out of HCFCs and through the industry shift to the next generation HFCs which will also been identified for future phase-down. Slide 11 shows our enhanced reclamation market share which we estimated approximately 35%. We estimate that approximately half the market share is now captured by two companies. The balance is very fragmented so we view the new scale of our company with expanded reaching capabilities as a meaningful competitive advantage as reclamation begins to play a larger supply role. Slide 12 illustrates how our acquisition of ARI has given us a new presence further down the supply chain. Hudson has very strong relationships with HFC supply houses and this acquisition complements that channel by adding channels directly to end-users. By having stronger presence further down to supply chain, we will be able to better assess Airgas for reclamation. Our reclamation model is straightforward and provides us the opportunity to realize gross margins close to 50% on the claimed gas. It accomplishes by buying back dirty gas or roughly half the market price, purifying it to versus spec and reselling it at market prices. Also when we acquire mixture cross-contamination gas which requires use of our proprietary fractional distillation systems to separate the mix gases, we pay less for that mix gas - that mix refrigerant. This was advantageous in the ARI acquisition as we were able to take title to significant quantities of mixed gas at very low cost. With our acquisition of ARI, we are positioned to be both the leading reclaimer and distributor throughout the U.S. This acquisition also allows us to have a dual strategy of harvesting and selling refrigerant both at the wholesaler and end-user levels within the overall refrigerant aftermarket space. Now I’ll turn the call over to Brian to review additional financial information.

Thank you, Kevin. In order to frame the scale and value of our acquisition of ARI on Slides 14 through 17. We provided pro forma financial information for the six months ended June 30, 2017 and the 12 months ended December 31, 2016 and the footnotes of these tables are available in the appendix. While the 2018 selling price of R-22 will likely start off lower than the 2017 levels, we believe the pro forma combined financial results provide a good view of the scale of the business, cost structure and long-term earnings power of the combined entity. If you turn to Slide 14, it provides a summary pro forma information for the six months ended June 30, 2017 and the 12 months ended December 31, 2016. You'll see that on pro forma basis the combined business has a similar margin profile to standalone Hudson business in these periods. However the pro forma results and specifically ARI historical results have been negatively impacted by the non-cash amortization of the step-up in basis of inventory of approximately $3.7 million and $7.4 million for the six months ended June 30, 2017 and the 12 months ended December 31, 2016 respectively. These non-cash adjustments are related to the purchase price allocation and are being reflected as if the acquisition occurred on January 1, 2016. It should be noted that the historical results of ARI would not require these adjustments. Slide 15 and 16 simply provide the full pro forma income statements for the six months ended June 30, 2017 and the year ended December 31, 2016 for your reference. There are a lot of numbers here on the slides, the important thing to focus on each of these slides is one, both businesses have similar scale and roughly similar margin structures absent any pro forma adjustments associated with the acquired inventory. And two, in the pro forma adjustments column, the two large numbers of the non-cash inventory step-up adjustment that we summarized in the previous slide and the interest of financing fees as if the transaction occurred at the beginning of these periods presented. If you turn to Slide 17, you'll see the pro forma balance sheet at June 30, 2017. On a combined basis at June 30, 2017, you will see strong pro forma working capital of 131 million and shareholders' equity of 123 million. Off note, you will see that on pro forma basis at June we had approximately 188 number of inventory. We do expect that during the 2018 and 2019 periods, we will see declines on overall inventory balances and in the 2019 period, an increase in inventory turns as we begin to rely on a greater percentage over clean products of R-22 for sale to serve the R-22 demand. This is a strong balance sheet that has flexibility and liquidity as we look to grow our business. Slide 18 is a high level overview of the acquisition financing. The net acquisition price was $209 million subject to post-closing adjustments. The acquisition is being financed with available cash and on an enhanced asset based lending facility borrowings of the 80 million from PNC and a new term loan of approximately 105 million with GSL Capital Partners. At closing there was excess availability within the PNC facility of approximately $50 million. No additional Hudson equity was issued to finance this transaction. Upon closing, our total leverage ratio as defined in the credit facilities was approximately three times pro forma adjusted trailing 12 months EBITDA. Given our strong profitability and expected growth going forward, we believe this is a reasonable leverage ratio. Slide 19 provides a more important - provides a few more important aspects of our liquidity position and ability to de-lever going forward. First, a large portion of the purchase price was for inventory and other tangible assets. On a pro forma basis, approximately 27% of the purchase price is allocated to intangibles including goodwill. Also we anticipate that we will increase our inventory turns as the R-22 market is served by greater portion of reclaim refrigerants. Finally, with the prepaid 30 million of our term loan without penalty should we choose which provides additional financial flexibility. We are heading to next selling season in a strong position to further enhance our balance sheet and with our strong foundation for long-term growth. On Slide 20, we provide our target margin profile for the upcoming 2018 selling season and for 2019 and beyond. Before we get to specific targets, I’d like to run through in more detail refrigerant pricing dynamics we are seeing now and how these dynamics relate to our historical experience and the acquired inventory. As mentioned earlier, when we announced the second quarter 2017 results, R-22 prices had decreased to $18 a pound. This pricing pressure continued through the end of the 2017 cooling season with R-22 prices declining to the current level of between $16 and $17 per pound. With the cooling season over, we expect to see very little sales activity in fourth quarter and the price level to close of the cooling season has historically been a starting price point when we begin the next cooling seasons. With that in mind, we're anticipating that the R-22 refrigerant pricing will remain at current levels for the start of the calendar 2018. It may increase since the selling season gets underway certainly that has been the case in the past. But once they're conservative, our pricing expectations until we enter 2018 sales season. If R-22 price remains flat in the mid-teens we would expect 2018 revenues to be at levels similar to the pro forma consolidated 2016 levels. Correspondingly 2018 gross margins with - that will be closer to historical gross margins of approximately 25% with operating margins in the mid-teen range. These margin assumptions would be the result if we had this relatively flat pricing dynamics for R-22 for all of the 2018 cooling seasons. As a reminder, 2018 purchase price accounting could affect earnings by as much as a approximately 17 million related to the one-time non-cash impact from the acquired inventory. We will of course break this out for you as the year progress, so you can see the cash earnings of the business. Looking beyond 2018, it's our belief that the R-22 prices should increase as we go closer to the final phase out of the R-22 production enabling us to return to the gross margin and operating margin ranges we previously targeted. To echo what Kevin said earlier, the addition of ARI is a strategically significant change for Hudson strengthening our offerings, our personnel and our geographic reach to fortify our leadership position and the refrigerant of reclamation industry. I will now turn the call back over to Kevin.

As the founder of this business and as a largest shareholder, I believe this is the very exciting and transformative time for our company. We've grown Hudson from a $50 million company in 2012 to a $250 million company today. Thanks to our ability to deliver double-digit organic growth and execute on strategic acquisition opportunities. With the close of the ARI acquisition, we have doubled the size of our company positioning Hudson as the premier refrigerant and reclamation company in the U.S. Hudson has always a been clear leader in our industry with respect to using engineering expertise to drive sales while the ARI Group is now part of Hudson as always been known as the best in the industry for sales and distribution. We've enhanced our capabilities and our portfolio of comprehensive solutions helping our ability to serve the needs of now significantly larger customer base. The ongoing phase-out of R-22 and future phase-down of next-generation HFCs continue to represent a significant growth opportunity for our company. Our long-term tenure in the industry, best-in-class technology and long-standing relationships have enabled us to establish a leadership role in the industry and we believe we're uniquely positioned to leverage our strength to capitalize on the evolving industry landscape. As our industry continues to introduce next-generation climate and ozone friendly technologies in refrigerants, Hudson will be there to meet their needs. We thank our existing employees and shareholders for their support and we welcome our new ARI colleagues to the Hudson family. Operator, we’ll now open the call to questions.

[Operator Instructions] Our first question comes from Ryan Merkel with William Blair. Please state your question.

So first of all nice job presenting all this information, really good job with the slide-deck there is a lot here to get through. So I want to start by going back to the stockpile which has created a little uncertainty recently you gave a lot of the reasons why R-22 is a little bit weaker this year and most of those sound transitory. What you didn't mention was the stockpile as a reason that was driving down R-22 prices. So would you just confirm that for us if that is true. And secondly do you think the stockpile is largely gone at this point or what year do you think it will largely be gone?

So when we're talking about this year season on pricing, it wasn't so much uses to stockpile that we think affected the price of 22. It was more of the action of one particular producer over all the others showing a lot of supply out into the marketplace in the first quarter during a period of time typically when no one is using R-22 typically R-22 is consumed or used by contractors in that April, May, June timeframe most of the seasonal part of our business comes from the North and Northeast. So it’s really just that activity by one producer particularly that forced a lot of supply out into the chain in the first quarter, coupled then with the cooler spring and the fact that contractors didn't necessarily have a lot of demand or emergency calls, they were able to start to use let's say a slightly greater pace substitute R-22 products. And just to clarify in case I made a mistake I apologize if I did that the substitute demand probably represent 20% of the total overall 22 demand. Those were the impacts primarily related to pricing, but to kind of go back to the second part I think of your question relative to stockpile. We always have believed that the stockpile would have been consumed predominantly through this 2017 into the 2018 period and we didn't expect and we still don't expect that there’ll be a significant amount of stockpile available for 2019 and 2020.

And when you said producer in the beginning of this year went early it wasn’t with stockpile gas they wouldn’t have much stockpile at least this was saying the yearly supply he did early not extra inventory.

So the stockpile narrative is false it basically the conclusion. Secondly, Brian you mentioned that if R-22 prices are flat in 2018 and you gave some financial metrics. I appreciate that you're being conservative there but just talk to us there is a pretty good chance that R-22 prices rise and if they don't rise in 2018 they’re certainly going to start rising in 2019 and 2020 due to the supply demand dynamics correct, so you still expect R-22 prices to march towards 30?

We believe if it's not next year which again we don't have reason one way or another to see it moving next year, we just can't tell. So we’re trying to be conservative because we don’t have any indication of that but definitely expect for us internal at Hudson that starting in 2019 we should definitely see us getting back. Now we've seen this many times before multiple gases and including R-12 this remind us of 2013 which advanced by 14 started marching right back up again, we saw it in CFC phase-out in R-12. They seem to backup at times certain emphasis could that and we feel like we’re there we don't know - again as you said 18 we’ll do it but we do believe by 2019 it will start marching up again.

And just lastly and I’ll turn it over, you had ARI for about a month now just give us initial impressions and then how did the business perform this quarter just given the decline in volume and pricing in the industry?

At this point I want to stay is we’re certainly very pleased with what - we're happy to get into this rhythm, we’re happy to close this but we've learned since then has made us much happier obviously they were much stronger outfit and maybe we're giving a credit for we thought they were excellent, but they’re definitely – we've very complimentary businesses but they were quite different. We go to market different which is all good every part of that is actually good for both companies and they’re just very strong in areas that we're not and we could see why we deal the leverage in our both sides. We'll help them but they’ll really help us with our existing customers. So it pleasantly suffice to put that way.

The other part to their business that we’ve talked about this that its complementary, its customer base is come from bases complimentary they have far more customers than we have. And these customers are typically end users downstream. At some respects these customers could be less susceptible to seasonality and they could be more correlated to let's say 24/7 type cooling such as supermarkets or chemical facility. But also typically as it relates to end user buyers they’re less price sensitive and less susceptible to sharp increases and decreases within a given season. So they will likely smooth out any of the ups and downs that we’ll have and they’ll likely be able to attain a slightly higher gross margin because where they sell in the chain.

Our next question comes from Steve Dyer with Craig Hallum. Please state your question.

If we go back a little bit, I'm just curious as you kind of talked about the use of substitutes and the increase, in your view as you sort of think about is that a byproduct of sort of how rapidly price increase, pretty quickly and early in this year or the perception of kind of lack of availability what sort of drove that. And then as you think about kind of use of substitutes and how people will do that over time what’s kind - how do you think that works or what are the kind of the associated an impacts is there a magic price level where you saw a very different behavior et cetera?

And again I don’t think it was actual number, the pricing number, we think is how happened and the sticker shot came out early in the year and so combination of real low in the year a lot Alaska jumped early by the producer at high price. So here is your inventory and your sales very high price they won’t use that at a time when again - when you in your first quarter you’re not using gas primarily you’re loading yourselves. Contractors start using the gas closer into the second quarter if it's hot and if it's not hot like it wasn't this year, it was cool spring it had time on their hands I am going to try experiment with the new gas I'll try alternative, the gas is really shockingly high all of sudden just jumped over the winter. Yes, all those things seem to be a shock to the system to contractors and they try this. So we think that was more of it, it was really how fast it jumped up first quarter price which way again the trajectory of the price quickly with the cool spring. I actually put a lot more credence to the cool spring so that affect to us. But long-term we've seen this. We always know they are going to be there. They were down to 12 to New York 12 phase out. They’ll always be available but nobody even claims R-22 is going to do from a capacity or performance point of view. Obviously its best gas for the system. If you have time on your hands because you’re not busy because the cool spring hey, you might do it. If you're busy you’re going in and out you’re going to use R-22. So we got some heat next year we definitely people are not to take time off to be playing with other gases they can use the fastest most efficient gas, they’re going to get off customer site to get to another site. And that’s so - it’s neither a question to us what they would rather use so it just not could it make its way into 20s and go up, yes certainly can is it how fast it goes up.

And maybe to add just to talk this, we saw exactly the same thing happened in the second quarter 2013 with regards to a spike in R-22 substitutes. So we’ve been talking about substitutes probably since 2010/2011 whatever we always said we typically expect them to be roughly a single digits of the overall supply side, with R-22 demand but in that 2013 year we had that same pricing dynamic that we talked about happened in the beginning of this year a huge spike relative to the price point that exited the 2012 year seem to create this ability for contractors to say, hey let me try these substitutes but if the focus on the phone here have recalled that was sort of one season event '14, '15 and '16 these substitute products retracted to less than 10% or single-digit. This is now let's say repeated itself a second time and as Kevin said, it appears to be correlated to a cooler spring but also these significant price increases that happened at the beginning of the year, as opposed to those other years I mentioned where we saw success of price increase through the season.

I guess Kevin turning to the combined model where you talk about gross margin in the mid-20s and operating margins kind of more in the mid-teens. Did I hear it right or I am assuming correctly that assumes sort of R-22 pricing and overall refrigerant pricing about where it is and then if that were to move up there would be upside to those numbers and then also what if any does that sort of include for synergies or the acquisition?

Yes, so those numbers are really assuming a very let's say flat lower price for R-22 and no real improvement of pricing of R-22 which is not what we expect and certainly not what we've seen before. But because we’re at this particular point we haven't entered the season and typically we’ll talk about pricing dynamics and margin expectations when we report the fourth quarter which we normally announce at the end of February or beginning of March and we'll be in a position at that point to see what the pricing dynamics are. So because we’re well before this particular observable time starting 2018 year, we just proposed from a conservative point of view looking at the pro forma 12/31/2016 numbers recognizing in that particular year the pricing of R-22 were in the mid-teens that's probably a good reference point to start. It doesn't mean that's really our expectation and certainly if the past is the predictor of the future, we’re likely see price increases in 2018 on R-22, but at this moment we were referencing them and we will obviously beginning an update report the fourth quarter results.

And in addition what you said and what you asked about the synergy and we’re not including on that end on the procurement of the gas, we do believe critical mass of the company's that from a gross margin point of view drive obviously our cost of goods down. We do believe that on the procurement side that we're in much better position we ever been before and we haven’t factored that in yet although we’re expecting it.

I guess then lastly from me and I’ll pass it over just commentary on maybe the early days of the DoD program and sort of how that's ramping and what if anything or how much that assumes sort of on a ramp going into next year?

Look at it so it started as we probably thought it would and so we wouldn't change on where we think we’ll continue ramp rate but little bit things blips you run into new agencies coming in from inspections everything else, you have a win, you have a back step and that you have those things which we kind of expected we still don’t know where they come from, we feel much better now but you get those blips in the beginning. Very happy with where it’s going. And so we do think that trajectory that we originally said maybe closer to 20 million per year kind of number. In the beginning we do believe will head to back, we had to get pass some points we’re working through a couple more right now, but we really like the program very excited about it we want to get as much of that $400 million set aside as we can.

Our next question comes from Gerry Sweeney with ROTH Capital. Please state your question.

Thanks for the detail and on that note just take a look at the pro forma income statement. It looks like Airgas did about 36% gross margins while it was 2016 and 2016 was a pretty solid year but if I remember correctly or my sources are correct, Airgas was probably 10% to 15% R-22 reclaim and the rest of it was distribution business therefore what I’m trying to get at it seems like Airgas distribution business has a pretty good margin profile maybe better than yours?

Possibly there is a little confusion, the 10% or 15% I think was related specifically to the reclaim market or their share of the reclaim market. And that ultimately then turns into really a source of supply which goes inventory than sales. I don’t think there was any further disclosure about their volumes of R-22 or the likes but those to go back for a moment whether it be R-22 or HFCs because their customer base is different and because it’s downstream, it’s likely they'll be able to achieve higher gross margins then we will. Now we are working through some comparative allocation of expenses and the like so their gross margin has presented here should be similar to what ours would've been but I think they’ll be some additional reclassification of expensive that will occur over the next couple of quarters. But at the end of the day they should have higher gross margin usually than we might.

And I'm going to throw out there and let’s see if you give it us, but obviously they've got a pretty large significant inventory. How much of that inventory, I mean one of the key questions is I think was there's a step up in inventory and cost et cetera but how much if you will non-technical term, how much of a deal did you get on that inventory on that x the adjustment. Were you able to get some of that below market prices lower than where you are at just want to see what the true inventory value is and then also how much R-22 verses HFCs and things like that?

Well I mean at the end of the day what we're doing is repaying for the business and we're paying a total at this case is subject to further adjustments but $209 million for the business. We have to though allocate that purchase price amongst the assets acquired. So in this case under the following GAAP, we have to modify the current costing structure of their inventory to reflect something more closer to market value and that's what we've done here in the adjustment and that total adjustment inventories is about $70 million and that's where we discussed earlier that this will get amortized and likely hit the P&L next year or some amount of it will hit next year and we’ll be separately disclosing non-GAAP reconciliation for all that. At the end day we’re then left to acquire the remainder of the purchase price and then this case about 27% of total purchase price went to intangible assets which relatively speaking is a fairly low percentage, it’s certainly lower than the percentages that would have been correlated to acquisitions that Airgas would have made to bring this business together many years ago to.

And then also as we look it out to next year in terms of pricing between you and national refrigerant you’re going to have I guess 50% of the reclaim market according to your charts. And with the virgin production coming down at what point do you and Hudson and national refrigerants I guess at what point do you become the price setters as opposed to the virgin producers because their production is going down, you guys are going to be the people with the supply and at 50% combined market share. Can you start eventually studying the price of a gas at least initially?

So your question ties into let’s say the question about stockpiles as well.

Yeah.

We assumed that most of the stockpile, large majority stockpile would be consumed and used up by the time we get through the end of next season. So assuming we're right on that then certainly in 2019 we'll have a market that's based more on supply and demand and typical economics. So we would expect then as the reclaimers in totality not just the two of us but all the reclaimers would be able to react to and have R-22 pricing more in line with demand and not necessarily affected by - and I believe that might control the overall supply side. So if our assumptions on stockpile are right, then it’s that 2019 year that's likely where we have this more normalized supply demand and pricing structure and that certainly Hudson and all the other reclaimers will have more than influence in that.

And then one final question, you mentioned £50 million EPA sort of estimate of aftermarket demand. How much confidence do you have in that number today?

We have the same sort of confidence today as we did back in 2014. A lot of the problems we saw with the EPA's modeling and had demand at a very high number in the 14 to 15 years were related to applications and equipment whose end-of-life would have been completed by let's say 2015, 2016, 2017. An example of that would be for example window units. We don’t think there is a lot of R-22 demand that goes to service window unit, EPA's modeling had quite a lot but there really aren’t many - if any at all R-22 window units left in the marketplace. So we triangulated ourselves a £50 million number and that seems to correlate to what the EPA's modeling get you to in those years and some of the errors if you will or some of the questions we might have had about the model, those factors would have been modeled out certainly by the time we get to 2020 as well.

And then at 20% substitute is that 20% off the 50 million so the tenants over R-22 market is really £40 million because 20% has been taken by substitutes.

If you're kept with that percentage, it would stay at 20, yes.

If it stays yes, okay, got it.

Any other questions?

Operator?

John, do you know if there are other questions.

There are a few more people queued up for questions. The operator seems to have dropped off. Hold on.

John, should we help people that need to call - what should we do next?

So at this point we'll conclude the call. There are two other questions but we'll call out those people but the operator has disconnected it. So we'll conclude the call. Thank you everybody for calling in. If you have any follow-up questions, please call our office at 203-972-9200 and we’ll be happy to set up a follow-up call. And thank you really for participating and we look forward to speaking with you next quarter.