Advanced Emissions Solutions: Recut Deal w/ Arq, Torpedoes Shareholder Vote

Typically, I don't like to write about stocks that I don't own but I'm going to break that soft rule here, as mentioned in the Year End post, I sold my shares in Advanced Emissions Solutions (ADES) ($59MM market cap).  My original post outlining the thesis from November 2021 is here, as usual, the comment section is worth going through for a blow-by-blow of the events.

This afternoon, ADES published a press release announcing their merger with Arq Limited had been completed.  That required a double take and a quick click since the merger as originally constructed required a shareholder vote to complete, and no such vote was held.  

To take a step back, in May 2021, ADES announced it was pursuing strategic alternatives as the run off in one segment was generating a lot of cash, but that business was coming to an end due to the expiration of a tax credit, leaving just their Activated Carbon business (Red River plant) which is subscale for a public company.  According to the background section in the original deal's S-4 filing, ADES received several non-binding indications of interest from private equity firms shortly after publicly announcing a process for their remaining Activated Carbon business for between $30-$50MM.  However, ADES flipped to being a buyer and in August 2022, finally entered into an agreement with Arq Limited for a reverse merger where ADES would acquire Arq for cash and stock.  It was a very SPAC-like deal (here's the SPAC deck) with a pre-revenue startup and rosy revenue outlook several years out.  Shareholders who were expecting a liquidation type transaction revolted, sending the shares from $6.41 immediately prior to the deal announcement (to be fair, it had spiked over the previous week after ADES management indicated a deal was near on their Q2 earnings call) to a $3.86 on the close, then drifting all the way down to $2.20/share in December.  For context, as of 9/30 the company had $86MM of cash or $4.50/share, if they sold the Activated Carbon business to one of the PE firms, shareholders could have netted somewhere in the area of $6.50/share.  Much lower than I originally penciled out, but well ahead of where shares trade today.

With that value discrepancy, you'd expect an activist to come in and attempt to break the deal, force a quick sale of the Activated Carbon business, distribute all the cash and reap a nice tidy profit.  However, that was impossible because ADES has a rights agreement preventing anyone from crossing the 5% ownership threshold in order to maintain their NOLs and tax credits.  That 5% ownership limit in combination with the small market cap prevented most funds from owning shares (its individual investors who are getting screwed here).  In a strange twist, the original transaction with Arq Limited would qualify as an ownership change, therefore eliminating the NOLs and tax credits, but the rights agreement protecting those tax assets was still in place.  Despite that, there was some hope that shareholders would vote the deal down (like MTCR that was discussed in my SESN post comments) or it would be terminated before to save the embarrassment, forcing the company into a liquidation.

That brings us back to today, ADES recut the merger with Arq presumably to circumvent the shareholder vote by issuing a new series of preferred shares (this kind of rhymes with the shenanigans over at AMC with the APE preferred shares) to Arq shareholders as consideration.  

The preferred shares feature a 8% coupon and are convertible to common stock at a $4/share conversion price if approved by common stock holders.  Common stock holders have no reason not to approve the conversion, saves the 8% coupon the company can't afford (it will be cash flow negative for the next couple years, even under their rosy projections) and it would convert at an above market price.  The debt financing is also to a related party, a board member of Arq (will also be on the new ADS board) that pays 11% cash coupon, plus a 5% PIK.  

While the deal is optically better for ADES shareholders (not saying much, presumably does preserve the tax asset, but questionable whether the combined company ever generates significant taxable income), it likely would still get voted down, after hours trading reflects this as well, shares were down ~16% as of last check.  Hard to speculate on motivation, but management owns little stock and probably wants to keep their well paying jobs.  Apologies to anyone that followed me into this situation, I hope I'm missing something.  None of this smells right.

Disclosure: No position

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