Hudson Technologies, Inc. (HDSN) Q4 2018 Earnings Report, Transcript and Summary

Greetings and welcome to the Hudson Technologies' Fourth Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. I'll now turn the conference over to your host, Jennifer Belodeau of IMS Investor Relations. Ms. Belodeau, you may begin.

Thank you. Good evening and welcome to our conference call to discuss Hudson Technologies' financial results for the fourth quarter of 2018. 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 now take a 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. Please understand that these statements involve a number of risks and assumptions, and since those elements can change and in certainties cases, are not within our control, we would ask that you consider and 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 businesses and our performance and the factors that could cause our actual results to differ materially. With that out of the way, I'll turn the call over to Kevin. Go ahead Kevin.

Good evening and thank you for joining us. 2018 was a challenging year characterized by one of the most difficult selling seasons we've experienced in the company's history. Severe price corrections for most of the refrigerants we sell, cooler than normal seasonal temperatures, and the emergence of a just-in-time buying pattern from our customers resulted in lower demand throughout the traditional nine-month selling season. During the fourth quarter, however, we did see a 38% increase in the number of pounds of certain refrigerants sold, with much of this growth coming from the Aspen Refrigerants customer base. The volume increase was an unusual welcome development as our fourth quarter is typically characterized by negligible sales volume. Although the demand increase was offset by lower pricing, nonetheless, we were pleased to see increased order activity from our customer base. Overall, we ended the year with an 11% volume decrease, but the increase in volume in the fourth quarter allowed us to make up some of the overall shortfall that was experienced during the selling season. While it's true that our 2018 selling season was very disappointing, it is also true that Hudson remains a leading supplier in the growing refrigeration and cooling sector. Refrigerant is needed for air conditioning and refrigeration systems. And while our industry is currently navigating a challenging period, the market for cooling systems remains strong. We're optimistic about the long-term opportunity and believe that our expanded geographic reach, robust distribution network and presence at two key points in the supply chain position us for continued growth. As many of you know, 2019 is the final year of R-22 production with production set at just 4.5 million pounds and no new virgin production permitted starting on January 1st, 2020. We've often mentioned that R-22 systems have an average lifespan of 20 years and we cited estimated replacement or upgrade rates of 5% to 7% per year. Additionally, the EPA has published data showing the expected R-22 demand for 2020 to be 50 million pounds, so it's largely been expected that within the completion of the production phase down, it will be a supply/demand imbalance for R-22. While we do believe that there will be a supply/demand imbalance, given the recent market behavior and our visibility today, the demand for R-22 may not be as high as the EPA data indicated. Based on recent data from JPMorgan, we now believe that the annual replacement rate is closer to 7%. Additionally, we estimate that with the spike in the use of substitutes during the 2013 and 2017 cooling seasons, the R-22 demand may be approximately 20% lower than the 50 million pound demand cited by the EPA or approximately 40 million pounds. Additionally, JPMorgan data indicates that they believe there are 50 million R-22 air conditioning units operating in the U.S., not including the millions of units in the refrigeration, in large commercial and industrial sectors. With that data in mind, we therefore still believe the demand for R-22, as with the previously phased-out CFC refrigerants, will have a 20-year tail. Since our last call in November 2018, the price of R-22 had remained in the $10 to $11 per pound range. Originally, we are seeing some weakness in the price of R-22 to $9 per pound. While this may impact our 2019 selling season, Hudson does believe that with the removal of virgin supply, the R-22 market will begin to behave in a true supply/demand manner. Moreover, particularly with our acquisition of Airgas, now Aspen Refrigerants, we have begun to focus on HFC refrigerants and on maximizing our ability to sell these as well as R-22 and CFCs that were phased out 24 years ago, but are still needed by some users. We are also preparing for the day that HFO refrigerants, which are designed to replace HFCs, become more widely used. For those of you who followed Hudson over the years, you've heard us discuss our decades of experience and our ability to manage the tough periods when we find ourselves adversely impacted by elements not within our control. We can't control pricing changes and demand levels, but we can implement strategies, such as heightening our marketing efforts, expanding our portfolio of products and services to appeal to a broader customer base, and reducing expenses. For example, our acquisition of Aspen increased our capabilities as a provider of HFC refrigerants and significantly expanded our customer base. With this acquisition, we now also have a presence further down the supply chain, selling to industrial customers, municipalities, and large manufacturing plants. We believe that the HFC business will continue to be a price-competitive business. And now that we have moved to nearly all of the higher cost HFC inventory from 2018, we should have more stable margins with these refrigerants. Additionally, we're optimistic about the positive momentum we're seeing for the regulation of HFC refrigerants. Whether the process first occurs at the state level, through new legislation or through the actual ratification of the Kigali Amendment, with the anticipated phase down of HFCs, we expect to see the establishment of an allocation system as well as a tightening in the supply/demand balance that will likely result in increased pricing. We believe HFCs represent a tremendous growth opportunity for our company. From a cost control perspective, during the fourth quarter, we closed our Puerto Rico facility and began the process of closing our national reclamation facility. After careful evaluation and consideration, we believe the capabilities and capacity available at our Champaign, Illinois; Ontario, California; and Smyrna, Georgia facilities will more than meet our needs today and can readily be expanded, as needed, for the future. 2018 was a difficult year, but we remain confident in the long-term opportunities associated with both R-22 and HFCs. We have been a leader in the refrigerant and reclamation industry for a long time because we have learned to innovate and evolve during the challenging periods to become a stronger business. We remain focused on meeting the challenging needs of our customers and are remaining agile on the face of fluid market dynamics. We have the people, the technology and the distribution network to leverage and grow our leadership position. Now, I'll turn the call over to Brian to review the financials. Go ahead Brian.

Thank you, Kevin. For the quarter ended December 31st, 2018, Hudson recorded revenues of $25.7 million, an increase of 5% compared to $24.6 million in the comparable 2017 period. Gross margin for the fourth quarter was 12%, consistent with our gross margin in the fourth quarter of 2017. Our DLA contract continues to progress and we saw revenue contribution of approximately $4.8 million in the fourth quarter. As Kevin mentioned, during the fourth quarter, we saw a 38% increase in number of pounds of certain refrigerants sold, which was partially offset by lower pricing. We're pleased to have seen an uptick in customer orders during the quarter. From a cost control perspective, during the fourth quarter, we closed our Puerto Rico facility and began the process of closing our national facility. Given the capabilities and capacity of our Champaign plant and newly acquired Smyrna facility and in an effort to control costs given the difficult 2018 selling environment, we took the opportunity to consolidate some of our operations and had improvements for additional capacity to our existing facilities. Additionally, we've implemented several efficiency initiatives during the fourth quarter. And with the Nashville expected to be close by March 31st, 2019, we anticipate a reduction in cash expenses by more than $3 million annually. During the fourth quarter of 2018, the company recorded a net loss of $8.1 million or a loss of $0.19 per basic and diluted share as compared to a net loss of $5.2 million or a loss of $0.12 per basic and diluted share in the same period of 2017. The fourth quarter 2017 net loss was reduced by $7.4 million benefit related to the Tax Cuts and Jobs Act, which no such benefit was recognized in the fourth quarter of 2018. Looking to full year 2018, Hudson reported revenues of $166.5 million, an increase of 19% compared to $140.4 million in 2017. Despite the increase in revenues, the company experienced negative gross margins in 2018 due to non-cash inventory write-down of approximately $35.9 million and an additional non-cash amortization of inventory step-up in basis of approximately $3.7 million. The company recorded a net loss for 2018 of $55.7 million or a loss of $1.31 per basic and diluted share, which included inventory adjustments totaling approximately $39.6 million and non-recurring expenses of $6.1 million as compared to net income of $11.2 million or $0.27 per basic and $0.26 per diluted share in 2017. Full year 2017 net income includes the aforementioned $7.4 million benefit, while no such benefit for the 2018 period. As we've previously announced, during the quarter, we secured definitive amendments to our term loan and revolving loan credit facilities. For the term loan, we reset the maximum total leverage financial covenant through December 31st, 2019. For the revolving credit facility, we replaced the existing fixed charge coverage ratio through June 2019 with the EBITDA covenant calculation. The minimum fixed charge coverage ratio of 1:1 will recommence with the quarter ended September 30th, 2019. For the year ended December 31, 2019, the term loan leverage ratio is set at 5.7 times, which was derived from slight increases in revenues over 2018, mainly as a result of expected higher volumes in 2019 when compared to the 2018 annual EBITDA of $20 million -- approximately $20 million. We expect to be reporting EBITDA data through 2019, which would compare to our lenders' outlook. We are pleased with these new amendments, we have strong liquidity, and these new facilities provide us with a solid financial platform and flexibility for the coming years. At the close of 2018, despite the challenging market conditions, we generated approximately $36 million in positive operating cash flow. Additionally, we paid down $37 million of debt and had approximately $37 million of availability at December 31, 2018 and we are expecting to generate at least $20 million in operating cash flow for 2019. I would now turn the call back over to Kevin.

Thanks Brian. Hudson remains a leader in the refrigerant and reclamation business with the expertise, innovative technology, and well-established distribution network to drive continued growth. With the addition of the significant experience and strength of our Aspen team, we are focused on meeting and exceeding customer expectations by providing any refrigerant any place at any time and as we work to further increase our market share. Operator, we'll now open the call to questions.

At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Steve Dyer from Craig-Hallum. Please proceed with your question.

Thanks. Can you hear me good?

Yes.

Yes.

Good afternoon. A couple of things. First off, this is, I guess, the time of the year when you start to have some sense as to how your customers are feeling about the year, inventory, anticipated buying patterns. What do you sort of expect for this year? Do you expect it to remain just in time? Do you feel like there's a replenishment that needs to go on? Any color there would be great.

No, I think we clearly feel it's operating in just-in-time. There hasn't been any -- it operated that way all last year, going into the fourth quarter, I think that's why the volume was higher, because they didn't have the inventory. But I think they don't want to carry it right now. I think the -- certainly, pricing has made that happen starting in 2017. So, I don't think anything's changed. I think they're going to buy as they need. And I think that, again, when it gets warm, and that's when we'll see the volume increase. They're not going to start loading their shelves in advance, we don't believe.

Okay. Question on reclamation. Would you expect growth from the reclamation business this year? Or is that -- would you anticipate that's more kind of a 2020 and after when it's -- when R-22 is completely phased out?

So, we actually saw a slight downtick in reclamation in the 2018 year. We haven't -- we don't -- we haven't seen the reported data yet for the total reclamation market from EPA. That probably will come out around June. But we were down about 13%. We think that the primary driver for that is the significant reduction in what we paid for the used gas. So, if you compare it to 2017, we're paying something in the neighborhood of $10 to $12 a pound for used R-22. For the latter half of 2018, we're paying only about $4 a pound. So, there's been a significant change in the economics, where the contractors were recovering the R-22. We've always expected or wanted, at least, to see growth in reclaim before 2020. We haven't seen that to-date. We've often said that we think economics drives behavior. The other thing to think about when we had the phase out of CFCs in the mid-90s, the reclaim market really just took off within one to two years after the virgin production ceased. Now that may create some chaos with supply/demand and someone down the line if that same activity occurs here, meaning that reclaim starts to really grow in 2020 and 2021. But we do our best to prepare for the growth. We have the capacity. We certainly have been doing quite a lot of marketing with the wholesalers to try and induce contractors to bring the gas back. But when you're paying $4 a pound, there's not a lot of economic incentives to get people to do what they should do relative to the law.

So, absent a price increase, just presumably driven by natural supply and demand in 2020, 2021 and thereafter, what is the prospect in your view to sort of induce that behavior, to bring back dirty gas?

Well, we definitely believe there's going to be price increases in the long-term, absolutely. There's nothing that tells us that the price of 22 shouldn't be back in the $20s and maybe beyond that. And there are times that we've said, maybe it goes to $30 a pound as was the case with the CFC phase out, and some of the CFCs still are trading above that level. So, we still believe that's going to happen. What is difficult to say is what year is that going to happen and when is it going to rebound. We certainly still believe that 2019 is the last year of any material stockpile in the supply chain. So, we do think there is the possibility of higher prices later this year in R-22 and we certainly do think there will be higher prices of R-22 next year, 2020. So, we do expect to start to pay again higher economics, which hopefully then induces folks to return more gas.

Got it. Thanks Brian. And then one last question from me and I'll hop back in the queue. So, just kind of knowing the carrying cost of the inventory you have on your books. If we were to assume that prices generally don't move much, let's say, for the rest of the year, how would we think about gross margins? Is it possible to kind of get back into that mid-20s range that I think, at one point, was pretty conservative? Or is that a stretch sort of given what's sitting on the books right now?

So, we think that we should get back into the mid-20s this year. It may not be until the second half of the year. It all depends on the remainder of the R-22 volume that we have at the higher price. So, with regards to HFCs, most of the HFCs are gone. There's very little HFCs left at higher prices. But there was a certain amount of R-22 on the Hudson side of the house that would run into the second quarter of this year. On the Aspen side of the house, there are going to be probably a longer period to run off all that inventory that came with that acquisition. But as soon as we get through that higher level of 22, that's when we're going to start to release, let's say, that $4 a pound or $5 a pound R-22. So, we should see higher margins and levels near the historical margins in the second half of this year.

Okay, got it. I'll hop back in queue. Thank you.

Our next question comes from the line of Ryan Merkel from William Blair & Company. Please proceed with your question.

Hey guys. Good afternoon.

Hey Ryan.

Hello Ryan.

So, first, what are the OEMs doing with pricing for R-22, are they talking about raising prices for this season?

Right now, the OEMs are not necessarily coming to the forefront of price increases and so forth. And we've actually seen a slight decline, just really in the last week, with prices going below $10. It again doesn't seem to make sense to us for the OEMs to support lower prices. We expect them to support higher prices, but it's been somewhat cool. And as we said before, we expected 2018 -- sorry, 2019 to really begin as a just-in-time market and that's how it's begun. And the volumes, let's say, in January and February were a little bit below where we thought they could be, but we're not necessarily surprised by that relative to the weather. We are seeing warmer weather now beginning to take place in places like Florida and Texas and we're seeing volumes begin to pick up. So, it's difficult to say why someone will want to sell the price at a little bit lower today unless they had a poor January and February and try to make it up with volume.

Okay. Just for a little context, when typically would the OEMs come out with their price letters for the season?

There's never really been any predictability to that or any particular correlation to other commodities or to weather. They've historically just done it, I guess, at their will. And sometimes, they've done it to help sort of make a quarter. Sometimes they've done price increases that will be effective day one of Q2, for example, which is just a signal to say, buy in Q1 sort of. So, there's never really been a very prescribed way that they've been modifying prices.

Okay. So, we shouldn't look at the lack of the OEMs trying to push price as any kind of negative. They'll just do what they do, and we can't really predict it.

Yes. From year after year, you never know. It could be long -- any particular year could be long periods where there's no price increases or no even any kind of conversations. So, this isn't odd. It's just we never know whether we'd expect something.

Okay. And then what market intelligence can you share on R-410A prices? Obviously, that -- last year, they were down, and that hurt your business. What are you expecting this year?

We're really expecting HFC prices, let's say, for the foreseeable future, whatever that might mean, one year, two years, whatever the foreseeable future might be, to really remain at fairly low levels with tight margins. The impetus to change that is some sort of phase out structure relative to the use of HFCs. And we've always been focused on the Kigali Amendment because the Kigali Amendment is a global treaty that the U.S. State Department helped negotiate and U.S. industry helped support. But the reality is on this current political climate, we've not seen the State Department send the treaty to the Senate for ratification. What's been happening, let's say, over the last year, particularly, is quite a number of states, it might be 20 now, states have begun to implement their own HFC restrictions. And also, there's currently a Bill that's being drafted that would, in essence, create an HFC phase out structure similar to Kigali, but it would -- if passed, obviously, if passed, wouldn't necessarily need to ratify Kigali. It would, in essence, accomplish the same thing. So, there's lots of different paths going on here to phase out HFCs. We think it's going to happen soon, but that's probably going to be the stimulus to change the pricing dynamics that we're seeing today on HFCs.

Right. So, the biggest thing for us, Ryan, if you remember, is us getting out of the higher cost inventory on the HFCs, which we pretty much have. So, although the prices, we think, are going to stay down for the foreseeable future, obviously, we're buying at a much lower number, too.

All right. Okay, helpful guys. I'll pass it on. Thanks.

Thanks.

[Operator Instructions] Our next question comes from the line of Gerry Sweeney from ROTH Capital. Please proceed with your question.

Hey good afternoon Kevin and Brian.

Hey Gerry.

Hey Gerry.

Want to touch base on that $9 per pound pricing you mentioned. I did a bunch of channel checks, and my sense was there was not much volume at least through mid-February, that's when I completed on and anything that -- prices were above $10, but there were different -- some movement of gas at $9, there were some movement of gas above $10. But from what I was hearing, not much of anything was selling, so people didn't feel like that was a very accurate reflection of pricing. Any -- has sales picked up in the last couple -- two weeks or so? And are those prices more at $9?

Well, again, the $9 number only just recently happened. I've only seen it on a few occasions, but it was the first time it drifted that direction. But again, as you said, this just-in-time model's been going since last year. It's going right now, what do you call it, operating that way. It's been pretty cool. So, the season really hasn't kicked in, so it's difficult to tell how strong a price -- it isn't like locked in or anything. A little bit of volume can change that in a heartbeat. So, we're not stopped that that's where the price is, but we have seen it for the first time down there recently. But as you said, volume has been weak there because the season really hasn't kicked in still.

Are your volumes lower this year versus last year? Especially -- I mean, I'm not expecting much of a pre-buy. That's for sure.

Well, we probably, in the first quarter of 2018, had a mixture of some pre-buying, but we also had definitely just-in-time buying. So, definitely, our volumes were low in the first quarter of 2018 compared to any previous, let's say, first quarter structure because historically, all the first quarters, we had that preseason buying. So, it's difficult to say precisely that this year, let's say, has a full 90 days of just-in-time and last year might have had 80 days or whatever. So, we're not really too hung up on, let's say, the potential of volume being lower in 2019 versus 2018. There'd probably be more factors, like weather and things like that, that will affect that. But for sure, the price -- the sale price in Q1 of 2018, on average, would be higher than Q1 of 2019 because really, all the price corrections that occurred started in April. And as you know we have pretty severe price corrections across the board in all refrigerants.

Got it. My expectation is volume probably doesn't pick up until April. I mean when you start getting the -- maybe the East and Midwest starting to warm up. I mean is that sort of a fair way of maybe gauging the market?

Well, yes, for just-in-time, that's for sure. The first quarter -- before our volume was made up of preseason buying. So, without that, yes, April is probably a good bet.

Okay. And then switching over - I did take a look at the balance sheet. It looks like debt was flat, but inventory was down about $4.5 million. Is that -- I'm not sure if that's maybe some cash flow-related stuff, you had some more sales in the quarter and maybe you get a -- receivables are up but -- you don't have the cash flow statement in the press release. But anything to read into that? I would expect maybe debt to come down with inventory.

Well, I mean, when you're in this time of year, you're not necessarily generating cash from operations at all. So, if you reduce your inventory, you're probably just to washing out, let's say, loss from operations from a cash flow perspective. But that trend probably is always true for us relative to the fourth quarter. But really, the thing to continue to focus on is how we manage the inventory and we still believe that we can release more dollars at an inventory or free up working capital. And any freeing up of working capital in that regard, we would use that cash proceeds to pay down debt. Our goal is to continue to lower our debt, and we definitely expect to lower our debt in the 2019 year.

Yes. And that would sort of lead onto the next question was how much inventory do you need to run your business in today's environment? And that's a little bit of a tricky question because there's the dollars and then there's the pounds and you don't necessarily give us the pounds. So, you've had -- I mean, this inventory, can you get it down to $80 million? Is it $75 million? Is it, I mean--?

Well, let's say, we'll definitely probably have lower pounds any particular quarter in 2019 and 2018 just because we're not going as a long on inventory as we previously would have. And we're mainly talking now about HFCs. Much of last year's HFC problem and then the price correction was we bought a lot of refrigerant late Q4 2017, Q1 of 2018, expecting a lot of HFC sales in Q1 that never happened. And then we got caught with a price correction with too much inventory, if you will. So, definitely, we're managing the HFC inventory differently than we would've at the beginning of 2018. But then the other side of the coin is, as you said, it's really about the dollars, not so much the pounds, particularly on R-22. Because in R-22, again, we could carry the same number of pounds, but because we're paying half the price relative to used gas, we therefore need half the dollars. So, definitely, we feel like we could free up whatever the number might be, $10 million, $20 million certainly in inventory with, let's say, a flat sale price environment that we have here because we did enter the year with some high price inventories still.

Okay. I'll jump back in line.

We have reached the end of the question-and-answer session, and I'll now turn the call back over to management for closing remarks.

Well, there's my second question?

Gerry, do you have a question?

No. Well, yes, what about the tariffs. HFCs, there was a little bit of talk of maybe some tariffs coming through. There were maybe some questionnaires put out there.

If you're talking about the general basket tariff relative to September of 2018 and the 10% tariff, refrigerants were not included in that basket. So, as it relates to the components of these HFCs, which all these HFCs, for the most part, are made of multiple different refrigerants, there's no tariffs. There was the tariff case a couple of years back, where there was about a 200% tariff placed on packaged or completed refrigerants from China. But basically, everyone is circumventing, which may not be the right word, but people aren't bringing in packaged product any longer from China. Hudson and other companies are bringing components, right.

Yes. And then -- that's what I heard. There was some rumor maybe -- and I haven't dug into it that far. But just some questionnaires about I think HFC plans or different things going out, and it felt like there may be somebody poking around on the components side, maybe potential tariffs.

I mean, that is possible, certainly. Say it another way, the arguments put forth by the coalition relative to packaged product certainly probably could be applied to the components as well.

Got it. I appreciate it. I'll stop right there.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I'll now turn the call back over to management for closing remarks.

Again, I'd like to thank our employees, our long-time shareholders, and those that recently joined us for their support. Thanks everyone for participating in today's call and we look forward to speaking with you after the first quarter results.

This concludes today's conference and you may disconnect your lines at this time. Thank you for your participation.