Sunday, November 7, 2021

Advanced Emissions Solutions: Another Informal Liquidation

We're at the end of earnings season for small caps, this could be stale in under a week (ADES reports 11/10), Advanced Emissions Solutions (ADES) is a $130MM market cap with no debt and by year-end should have ~$90MM in net cash as one of their two business segments is running off due to the expiration of a tax credit.  The company announced strategic alternatives in May, likely intending to sell the remaining business segment and effectively liquidate the company.  Similar to other informal liquidation ideas lately (LAUR, PFSW, RVI, JCS, BSIG, etc), the downside is protected by the cash generated from monetizing one business segment that could be returned to shareholders either by a tender offer or a special dividend, with upside coming from an M&A event for the remaining segment.

This is an unoriginal idea, it appeared in the comment section of my Laureate Education post (might have appeared earlier but I can't find it) and other investors have shared their views with me given the similarity to others I've written up, there is also an excellent VIC long thesis on the situation.  If you've read it, you can probably stop here.

In 2011, the U.S. government implemented a 10-year tax incentive program (IRS Section 45 Tax Credit) to motivate electric utilities to use cleaner burning coal and reduce emissions.  That tax credit is expiring at the end of 2021.  Within ADES's refined coal segment, they own a 42.5% interest in Tinuum Group, which is basically a royalty business on the tax credits power plants receive utilizing their services.  In their Q2 press release, ADES is projecting $30-$40MM after-tax to be distributed to ADES from this runoff segment by year end.  Add that to the $57.3MM of cash on the balance sheet as of 6/30, and the cash balance should be roughly $90MM.  There are 18.85 million shares outstanding, that's $4.75/share in net cash on a ~$7.00 stock.

The remaining segment is an activated carbon business, Advanced Purification Technologies ("APT").  Out of their Red River Plant in Louisiana, APT produces chemical products primarily used to purify coal fired power plants (reduces mercury emissions) but they've also made efforts to diversify into other end markets like industrials and water treatment plants that aren't in secular decline.  APT was acquired by ADES in late 2018 for $75MM from Energy Capital Partners who had originally built the Red River plant for $380+MM (*correction, ADES originally built it, see first comment*).  Coal usage has declined faster than was underwritten a decade ago when the plant was built; the original greenfield investment wasn't money well spent.  Although, with natural gas prices moving up significantly this year, maybe the coal-to-gas fired plant conversion theme will slow?  As part of the acquisition, ADES also acquired the on-site lignite coal mine (Five Forks) that is used as an input to produce activated carbon, interestingly the mine operations are subcontracted out to old friend of the blog NACCO Industries (NC).

The APT business continued to struggle after ADES acquired it, covid didn't help either, but back in September 2020, ADES entered into a 15 year supply agreement with competitor Cabot (CBT) to supply activated carbon in North America that results in two important things: 1) diversifies the APT business away from coal into other end markets (also provides some revenue certainty to a buyer); 2) rationalized the competitive market by facilitating Cabot's exit from the industry.  Earlier this year, they entered into a second supply agreement with Cabot to supply international markets for 5 years.  On the negative side, Cabot had ADES take ownership of their Marshall Mine (on-site lignite mine of Cabot's plant) and immediately shutter it, reclamations efforts have begun (again, being performed by NACCO), but importantly for Cabot, the asset retirement obligation moved from its balance sheet to ADES.  The remaining ARO is about $12MM to ADES (there is a cost sharing agreement between ADES and CBT), 70% of the work/cost is to be completed in the first two years, but it could have a long tail and make a sale of APT more challenging.

Currently the APT segment is roughly breakeven, but appears to be inflecting, per the press release describing the Cabot supply agreement inked in Q4 2020:

We expect our production to ramp up incrementally during a 4-5 quarter transition period, which when complete is expected to yield the following net impacts to our current operations:
Incremental annual revenue growth of 30% - 40%;
Incremental annual EBITDA growth of $10 million to $15 million; and
Diversified end markets will reduce our power generation exposure to less than 50% of product portfolio.

Presumably ADES should start to see some improvements in Q3 results given that 4-5 quarter timing (the backdrop for their remaining coal exposure seems positive as well) and hopefully hear some hints the Red River plant's utilization rate is ramping, this is a high fixed cost business so the operating leverage can be pretty huge.  ADES bought the business for 4.2x EBITDA back in 2018, implying $17-18MM in EBITDA, it doesn't seem unreasonable that the post-covid run rate (including the CBT supply agreement) is above that number.  Conservatively assuming that the APT segment is worth what ADES paid in 2018, $75MM, netting out the $12MM in ARO, gives a $63MM "remainco" valuation or $3.35/share.  Add that to the net cash and its at least an $8.10/share stock, that's probably conservative on both sides, coal is surprisingly hot (meaning the remaining royalty could be closer to $40MM) and APT should be worth more than $75MM post CBT deal.  But I'm not an engineer, only have a loose idea of what activated carbon is based on YouTube, this is clearly more a situation I like (rhymes with others that have done well with recently) more than the business itself.

Other thoughts/notes:

  • ADES has $93.8MM of federal NOLs, in order to protect against a change of ownership that would eliminate the NOL, the company put in a plan in place effectively prohibiting anyone from acquiring more than 4.99% stake in the company.  Given the small market cap, the plan limits the potential pool of investors.  Also leads itself to a liquidation mindset as the NOL should provide a tax shield.
  • In March, ADES felt confident enough in the trajectory of the business to institute a price increase.
  • The Red River plant is a low-cost (reportedly the lowest-cost AC producer), underutilized asset, that thesis alone could appeal to PE buyers.

Disclosure: I own shares of ADES

35 comments:

  1. I've been around this one for a long time. The section 45 refined coal business is snake oil. It meets the letter of the law, but actually does very little. As a tax payer, good riddance.

    ADES was the original developer of the Red River plant when they massively overestimated the size of the activated carbon market for mercury control and managed to sucker ECP into financing it. ADES basically walked away from it and then bought it back years later for pennies after ECP got worn out. The Cabot / Norit relationship is more interesting as Norit (prior to being bought by Cabot) sued and won a case against ADES for stealing their IP to build Red River in the first place.

    The cash is real and coal based activated carbon in the US is an oligopoly with some positive secular trends (water treatment) and some current cyclical benefits (coal usage positive year over year).

    As a company, ADES should be put out of its misery though. Hopefully at a price a good deal above this.

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    1. Ah ha, thanks, didn't know the history with Norit and the IP.

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  2. Interesting about the plant; I had no idea of its history.

    As usual, there are a lot of interesting names out there; seems somewhat likely that TGNA will sell itself before year-end, with another puff at that cigar butt in a busy (overheated?) M&A market. Rumblings at THS as well; like TGNA a decent, cash-generating company with some challenges that I could see someone overpaying for. Some slight takeover tussling over one of my long-time faves and larger holdings RRD, with possibly interesting readthrough to QUAD and SXP.TO (I am a sucker for dinosaurish businesses with one foot in print). I continue to expect big things from PBI...one day...maybe.

    And have just started my annual look at CELP, an overleveraged provider of a whole passel of services to energy, industrial and utility customers, mostly pipeline inspections with a whole bunch of other stuff thrown in. They got into trouble, issued expensive prefs, cut their too-large distribution too late, and are looking at a credit facility maturity in May 2022. The core business generates a nice amount of cash, but is variable enough that taking on the debt level they did was an act of (unsurprising in this area) optimism. Insiders own most of it, though a lot of that's through the accruing prefs so there's less-then-perfect alignment among classes.

    I have to believe that a combination of:

    Catchup on modest deferred maintenance by clients
    Modest new investment by clients
    Diversification of business
    New regulations that require greater inspections of facilities

    Will all provide some modest tailwind to the business for at least the next few years, but will it matter? Am just starting to get a normalized cash flow and looks like $10-15 million a year, which should be enough to support a new credit facility (even w/some concessions) and start chipping at the prefs, but it's not exactly a slamdunk that this will happen and that, if it does, resumption of distributions will be, say, a 2- and not 5-year year story (or that insiders won't gobble up the rest). It's not so different from TISI, another maybe-decent, possibly-very-cheap business with a threatening balance sheet.

    So: maybe interesting, probably not. Maybe more interesting is NRP, which is somewhat more committed to using copious regular and windfall cash flows to simplify its own capital structure, starting with calling of its PIK prefs early next year, which is possibly exciting.

    Don't know if any of that's of interest, or even worth reading!

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    1. Thanks for the brain dump, sincerely always appreciate, I'll add them to my research list. I did look at RRD and passed earlier in the year, I haven't played that split up well at all, owned DFIN for a couple years and sold before it multi-bagged.

      Speaking of dinosaurish print businesses, have you been following the ODP saga at all? Sycamore (Staples) first tried to buy the whole thing, now might just buy the retail, doing a spin, etc., proforma B2B business might be cheap.

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    2. Yeah, I played neither the RRD split nor the ODP story (to which I've also only paid intermittent attention) well at all--always did options and got timing wrong when the better stance would have just been a long. Last looked a few months ago; will look again now. Thanks!

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    3. ADL - I must have missed this comment months ago. Did you end up buying CELP? I have been in and around the name for many years. I loaded up last year ~$2 / share thinking with oil prices having recovered, they should be able to re-do the credit facility and get back to high teens EBITDA. It has recovered very strongly recently which has been great to see and I sold a tiny amount. I'm worried about how much that pref keeps accruing effectively shrinking the public equity. But on the flip side, the public equity is essentially levered 10:1 so I look at it as a levered bet on the oil servicing market.

      They shuttered Brown so they probably won't get to 20mm EBITDA again. I'm guessing they should be able to get to double digit EBITDA by next year which is about 10x EBITDA including the accrued prefs as debt. Any updated thoughts?

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  3. ADES and JXN both looking pretty good, IMO!

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    1. Yep. The APT segment inflecting nicely at ADES, and JXN going to pay out nice dividend, maybe that'll attract yield pigs compared to BHF that has just gone down the buyback route. About 7% on today's close.

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  4. Any thoughts on KD?

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    1. I haven't really looked it at, spinoffs are having a moment again, lots of them, but I tend to find the smaller ones more interesting or ones where there's a clearly different shareholder base. But I'll add it to my research list backlog.

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  5. Does somebody know something? Stock dropping like a rock.

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    1. I don't know something. But seems like just typical microcap volatility to me.

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    2. A lot of people have been in this for a while and are happy to see it back over $7. Might be a little profit taking.

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    3. You are probably right. I may be reading too much into it. But this the biggest drop in last 3 months and the fact that it is coming after the company said that they are making progress on strategic alternatives and after posting decent results, spooked me a bit.

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  6. Any thoughts on MSGN? Looks like the Hospitality Segment is worth ~40% of EV (I take adjusted operating earnings as NOI and 7% cap rate) despite producing only 24% of 'normal' revenues + cash-rich balance sheet + promising development pipeline + valuable intangibles. Insider selling and weak pre-covid earning power as negatives. Certainly not a pure recovery play but maybe interesting as sum-of-the-parts

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  7. MSGE, sorry. Long day:)

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    1. I no longer own it, but I love grab bag asset type companies like MSGE. But for me to get comfortable with it, need to get comfortable with the Sphere, for me it just doesn't click, the price tag is just incredible. I'm going to Vegas for a work conference in February, plan on making a detour to check it out. Maybe I don't "get it" because I'm not a gamer, seems like it could be a huge eGaming venue, but its a bet the company type bet. I got burned with the Seaport in HHC, didn't want to make the same mistake here.

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  8. Do you have any idea about current plant utilization levels?

    In the current 10q "high utilization of the Red River plant" is mentioned several times as a reason for reduced margins (having to purchase inventory). (Side note I also thought current inventory purchasing was still due backlog from the April plant fire).

    Current annualized adjusted EBIDTA of ~ 17m is below the proforma adjusted EBIDTA stated in the 8k at time of plant acquisition (18m), at which time they also mention low plant utilization as potential source of increased profitability.

    These don't jive: high plant utilization should increase adj EBITDA, but it's unchanged from time of purchase. Also, seems like water purification and other PAC uses outside of power generation are higher margin. APTs end market diversification subsequent to Red River purchase therefore should exponentiate EBIDTA and plant utilization curve.

    Hopefully my rambling makes sense.

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    1. The rambling does make sense, hopefully some of the other commenters come back and can chime in with more intelligent thoughts than me. I took it more as a product mix issue of why margins are low, demand is coming from their coal power customers unexpectedly which they're trying to diversify away from, when they don't have the inventory available they have to purchase it. But I could be way off.

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    2. I think it's hard to conclude much from the 2018 8-K pro forma EBITDA of $17.6M (24% margin); the adjusted EBITDA seems to be very adjusted. 5.2M comes from annualizing the gross margins from contracts obtained in the second half of 2018, 3.8M from the one-time cost of achieving synergies, and 2.5M from the estimated synergies post-acquisition. The assumption that gross margins would stay at 2018 levels was unrealistic, given the low demand for APT products in later years, and annualizing the H2 2018 contracts could have baked high utilization assumptions into the pro forma adj EBITDA, depending on how they did the calculations. The CEO at the time (who has since left the company) may have painted a rosy picture here to justify the transaction.

      From the latest 10-Q, it really does seem like demand exceeds plant capacity, rather than just clearing out the April backlog: "Offsetting these improvements from higher product volumes for the three months ended September 30, 2021, gross margin was negatively impacted by having to purchase inventory, rather than produce it, due to increased demand for our products and high utilization of the Red River Plant."

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    3. Thank you for the insight. It begs the question of why the 380m plant was originally built if it was to cap out around 20m aEBITDA. I guess the hope is 2021 price increases and better product mix really bump EBITDA?

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  9. Cabot announced that they're selling off their Norit purification division to One Equity Partners last week: https://www.businesswire.com/news/home/20211126005280/en/Cabot-Corporation-Signs-Agreement-to-Divest-Purification-Solutions-Business

    Any thoughts on this development? It seems like ADES might be a reasonable target for OEP to acquire as well.

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  10. Pretty ho-hum results and no SR resolution. Plant fire still with a stranglehold on margins (once these echoes fade, what's the next excuse?!). They are generating cash flow and speaking highly of inroads on APT tech/uses and potential future customers. 15-20% of contracts are renewed annually allowing for slow germination of rate increases/inflation protection. I can't decide if I want to bite here and buy more in mid $5s as it's well protected. I don't want it to be, but I can't help but wonder if a catalyst ever comes/this is a dying business that fades into value purgatory.

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    1. I added a bit today. I hear you on the continual excuses but it is a pretty exceptional operating environment today, lots of areas of labor/supply chains are extremely strained. I also tend to be on the side that a sale process like this one takes longer than investors expect, probably only a handful of strategic buyers, both sides need to be ready to transact. They also received $10.6MM from Cabot in an accelerated payment (was to be paid out over 13 years) for the remediation at the Marshall Mine, that was buried in the 10-K.

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    2. Do you think Cabot's sale of the purification segment is a good comp for the APT business?

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  11. So here we are. Another quarter and no update on a now long in the tooth strategic review, I liked this idea initially, but my interest is waning,

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    1. I feel that. It's not confidence inspiring that the language has remained the same.

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    2. I'd say we can wait and hear what they say on the conference call. But we know that too will be canned and they don't take real Q&A.

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  12. They did amend retention agreements fwiw.

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  13. Q1 2022 : Lastly, we remain pleased with the strategic review process and will provide additional updates as appropriate.

    Q4 2021: Lastly, we continue to undertake our previously announced strategic review and remain focused on fulfilling our customer commitments and running the business efficiently as this process progresses.

    Q3 2021: Lastly, we continue to undertake our previously announced strategic review and remain focused on fulfilling our customer commitments and running the business efficiently as this process progresses.

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  14. Well, this time they did indicate “ hopeful that we can provide an update soon”

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  15. Oh, where did you hear that? Was it in the conference call?

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    1. Yeah, it was on the conference call, but your point still stands, they've said essentially the same thing for several quarters now. I'm just guessing the buyer pool for Red River is pretty small, needs to be the right time/price for both the buyer and seller. This isn't a portfolio of sunbelt apartments are fairly easy to move with an unlimited buyer pool.

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  16. No point is that they change the wording to being pleased with the progress in Q1 release to we are working on it in the previous releases, which is slightly positive.

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  17. Meant changed from we are working on it.

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