***Update 1/24/12***

Channel checks confirm R-22 prices have DOUBLED as the producers anticipate close to 45% production allocation reduction as per recent EPA notices. Note that there was only $10m of inventory in Q3 2011, whereas historically the company has ended the years 2010, 2009, 2008 with $18m, $16m, $23m respectively. Historically, Q4 is always the heaviest inventory load, which means it should be more than the Q1 2011 $18m inventory. Strong possibility that the company stocked up on even more cheap inventory in Q4 given their strong confidence in rising R-22 prices and comprehensive understanding of the industry environment. HDSN could be trading close to NCAV if they doubled a big bet on their inventory. This is substantial hidden value. Hudson is in an even better position currently as the producers have decided to reserve R-22 sales to existing customers only. We should see a stronger balance-sheet emerge and reclamation to soon reflect their untapped earnings power.

**Update 1/9/12**

HDSN continues to be a favorable risk/reward scenario especially after the recent EPA announcement, which affirms the ongoing thesis. With an EV of only $23m, it does not take very precise math to realize that the reclamation segment alone will generate much more than that over the next few years. Even using a market size of 20m lbs, which is below the EPA's lower bound target of 27m lbs for the reclamation market size, HDSN would be worth $2.54 per share. Further upside is implied by the EPA's willingness to allow up to 47m lbs of R-22 demand to come from reclamation. See newly added model.

Back of the envelope:

Market Cap: $38m
NCAV: $15m ($5m cash, $7m A/R, $10m marketable inventory, $7m total liabilities)
EV: $23m

Sum of parts
Distribution Segment: $1m EBIT business x 5 multiple = $5m
Service Segment: $1m EBIT business x 5 multiple = $5m
Reclamation Segment: $5m - $10m EBIT business x 5 multiple = $35m
NCAV = $15m
Total: $60m or $2.50 per share

Highlights from recent EPA announcement:

"EPA understands that reclaimers can stay in business only if reclaimed gas can be profitably sold for a price that does not exceed the price of virgin gas, and the price of virgin gas will increase only when the supply has contracted.

Currently virgin HCFC-22 is priced at around $4.50 per pound; some industry representatives suggest that this price would have to exceed $8.00 per pound for reclaimed HCFC-22 to become competitive.

Interviews suggest that anywhere from 25% to 80% of servicing demands could be met by increasing the utilization of existing machinery and increasing the number of operational shifts in a week. This analysis uses 12,500 MT (27m lbs, 22% of market) as a low bound for reclamation (consistent with the 2009 Final Rule), and 35% of total servicing demand in 2012 (19,700 MT, 43m lbs) as the higher bound. EPA is seeking comment on this assumption in the propose rule for 2012 through 2014."

The EPA is asking for industry comments over the next 30 days and will reduce supply by an amount between 11% to 47%. Dupont had previously recommended a 20% cut, while all the reclaimers will likely propose the maximum reduction. Therefore the reduction should be significant, which corresponds to the newly adjusted reclamation market size of between 27m lbs to 43m lbs. A larger reduction would result in a larger market, which has enormous impact on Hudson's bottom line. The reclamation market in 2010 was only 8m lbs, so the EPA is implying that it expects the market to triple. At the same time, the producers now have a great excuse to raise prices. Whether the EPA ultimately chooses 11% or 47%, the lower bound of the market is way more than enough for Hudson to triple in value, but I welcome the 47% reduction as healthy optionality. The $8.00/lbs "competitive barrier" as mentioned by reclaimers is higher than I assume and would also offer dramatic upside.

It is quite clear at this point that the reclamation market is expanding and R-22 prices will increase. There are a few key reasons why Hudson will inherit these benefits:

1) Relationships: Hudson does 100% of Dupont and Arkema's reclamation, and neither have any desire to enter this business. In fact, they have already failed in the past and ultimately partnered with Hudson. Dupont even ended up owning a stake in the company, and still does. This is a complementary extension to their long-term relationship on the distribution side, where Hudson is one of their largest distribution channels. Other reclaimers such as ICOR have acted as competitors to the suppliers, and therefore have been denied even virgin gas allocations.

2) Bargaining Power: As virgin R-22 becomes phased out and more scarce, Hudson has a powerful bargaining chip for collecting dirty gas by swapping out its virgin R-22 from the distribution side. None of the competing reclaimers have a large distribution side, and most are not on good terms with the major producers.

3) Reclamation Power: Hudson has the largest capacity and best technology. Most reclaimers can handle only about 100k lbs annually, while Hudson already has capacity for at least 3m lbs. Large volumes of dirty gas will come through the channels where Hudson is already positioned on the mass distribution side. Needless to say there are tremendous benefits of scale since SG&A is fairly constant and Hudson's reputation is unmatched. Competitors use backwards technology that involve flushing dirty gas with virgin gas, which is totally inefficient and will become even more obsolete once virgin supply is further reduced. Reclamation can be more tricky than it sounds, since contamination requires separation techniques at the molecular level. Hudson has been doing this for over 15 years and has amassed a ton of data to model technical solutions. Most of their equipment is designed in-house and requires tremendous operating experience.

Expect an EPA final ruling in February and R-22 prices to soar as the first half of the year is buying season.

**UPDATE 8/4/11: Conference call points out R-22 prices have slightly decreased and hurt Q2 gross margin as a result of FIFO accounting. Management also mentions that the EPA has been investigating the supply stockpiling in order to make necessary revisions, likely in the form of stricter supply regulation, in order to improve reclamation.

-------Original Writeup-------

Company: Hudson Technologies (NASDAQ: HDSN)
Market Cap: $40M
Stock Price: $1.68 (as of Aug 2, 2011)

Hudson Technologies (NASDAQ: HDSN) is a $40M market cap distributor and reclaimer of refrigerants. The company is on its way toward peak earnings this year as recent EPA regulations are taking effect in the industry – revealing the hidden value in their smaller reclamation segment, which can grow to outsize their primary distribution segment. The EPA is phasing out the production of the widely used R-22 refrigerant to create a supply shortage that would need to be filled with reclamation (recycling) of R-22 since demand is still significant given the massive existing installed base. Hudson is a leading reclaimer with a 20% market share positioned to benefit as reclamation increases along with the spot price of R-22. The reclamation market will need to at least triple in the upcoming years in order to meet demand, which offers a huge opportunity for Hudson’s reclamation division to capture 50% gross margins, but more importantly would dramatically impact gross margin dollars that could total more than the current market cap.

Several near term catalysts are expected to positively impact the stock, including Q2 earnings released after market today August 3rd, a revised EPA policy in upcoming months, and incremental profits from a 70% gross margin reclamation JV in Europe that was recently announced. The stock has suffered a 35% decline from its peak in 2010 as the market has gotten impatient with the R-22 market and overall macro conditions, despite the company delivering outstanding results to lead a massive industry tailwind. At $1.68 per share today, HDSN stock offers 100%+ upside potential driven by organic profit generation with limited downside risk.

Financials (as of June 30, 2011)
• $26M Current Assets: $3M cash, $9M A/R, $14M inventory
• $12M Total Liabilities
• TTM Revenue $41M; TTM Operating Income $3.4M
• Q1 2011 Revenue $13.8M; Operating Income $2.0M
• Q2 2011 Revenue $14.7M; Operating Income $1.5M

• It is important to point out that the $14M of inventory is comprised mostly of R-22 refrigerant, which is expected to spike significantly in price given the EPA regulation to phase out production of the gas by 2015. I am comfortable assigning full value to the current assets since R-22 is an appreciating item and A/R historically reverts to much lower levels later in the year. Based on the above, HDSN has an EV of $26M and is trading at 5x this year’s estimated EBITDA of roughly $5M.

The company has three segments of business, though revenue is reported on a consolidated basis:

Distribution (~70%)
- Hudson buys directly from the 3 main virgin gas producers Honeywell, Dupont and Arkema and resells to wholesale distributors, contractors, and large end-users
- Includes R-22 gas, R-410A (the replacement gas), and others. As R-22 moves towards reclamation, R-410A will be a larger mix in the distribution segment
- 20-30% Gross margin

Reclamation (~20%)
- Hudson buys used / dirty gas through buyback programs from distributors and contractors and removes impurities such as oil, dirt, and water. Hudson uses proprietary technology for fast-speed recovery and has one of the largest reclamation capacities in the country
- 1 of 3 companies to have a certified lab for approving ARI Standard 700, which qualifies reclaimed gas to be labeled as virgin gas
- Reclaimed gas is packaged and sold at same price as virgin gas
- R-22 is the larger opportunity today, but Hudson is able to reclaim most other gases as well, including R-410A if that ever becomes replaced in the long-term
- 50% Gross margin

Service (~10%)
- Provides on-site refrigerant reclamation services and energy optimization
- ~$4M revenue, high gross margin

Industry Overview

Refrigrants are the chemicals inside air conditioners that are needed in order for air conditioners to performing cooling functions. R-22 refrigerant is used for A/C applications, including window units, packaged terminal units, residential and commercial unitary A/C, chillers, dehumidifiers, water and ground source heat pumps, and non-light duty mobile A/C in buses, trains, etc. Leaks and contamination in these systems require the refrigerant to be refilled. The existing tank must be emptied before a fresh charge. The refrigerant must also be removed before equipment is disposed. The EPA is tackling the amount of R-22 being illegally released into the air rather than properly disposed of.

R-22 is a regulated HCFC that falls under the Montreal Protocol, an international treaty for protecting the ozone layer. In the U.S., the EPA has expedited the phase-out schedule to exceed the treaty requirements, imposing the following limits on production:

Supply

Year EPA R-22 Allocation (in million lbs.)
2010 110
2011  100
2012  90
2013  79
2014  68

In 2015, the allocation schedule for 2015-2019 will be announced, and by 2020 the production of the gas will be completely banned.

Demand

Year EPA projected R-22 Demand (in millions lbs.)
2010 138
2011 127
2012  117
2013  106
2014  96
2015  85
2020  40

Source: www.epa.gov/ozone/title6/downloads/servicingdemand.pdf

The EPA has conducted a thorough analysis on the demand equation based on the existing installed base’s loss rate and equipment lifetime of 15-20 years. The demand estimate is fairly reliable given the EPA’s ODS Tracking System, which tracks actual production and consumption (including import and export) by U.S. companies. The forecast, however, may actually underestimate the demand from newly installed R-22 systems. Although the EPA has banned manufacturing of units pre-charged with R-22, manufacturers have exploited the loophole with “dry-shipped” units that do not contain R-22, though one can easily install the refrigerant separately. Manufacturers such as Lennox International have reported continued strong sales in such units, and contractors are still in love with the R-22 setup. Many contractors and technicians have mentioned that customers are reluctant to switch over to the new R-410A refrigerant since R-410A is still more expensive than R-22, and even if R-22 price rises the refrigerant is only a minor component cost. Repairing an R-22 system is also the economical option relative to the expensive nature of replacing the entire system, which could include high labor cost associated with changing the pipes embedded inside buildings. It is clear that R-22 units are here to stay for many years to come, as they have a 15-20 year equipment lifetime to begin with, and can be further extended by swapping out the main compressor component for only a fraction of the cost of installing a whole new unit.

R-22 Prices Will Rise

Notice there is an intentional ~20% supply shortage relative to demand – the EPA encourages the shortage to be filled by the reclamation market. R-22 prices used to be $1 per pound in the early 2000’s, but the major producers Honeywell, Dupont, and Arkema raised prices between 2006-2008 all the way up to $5 per pound in anticipation of the EPA regulated phase-out. As a result, reclamation volume increased since buyback programs were able to offer the same 50% buyback incentive, but the dollar amount made it more worthwhile for the technicians to turn in the dirty gas for $2.50 per pound compared to $0.50 per pound. Importantly, there are basic fixed dollar amounts such as shipping that must be overcome for reclamation to be economical. Reclamation will increase much more dramatically when the incentives reach the tipping point over the fixed hurdles. Some reclaimers already are offering to pay for shipping, or arrange for pick-up, in order to make it easier for the contractors. In some instances, they will leave a large tank for the contractor to fill up over time, and swap out the tank when it gets filled. These buyback programs are improving as technicians / contractors become more aware and accustomed, and there may be an inherent build-up in dirty gas collection at the distributor level that creates a lag for large reclaimers like Hudson. We’ve talked to nearly all the certified reclaimers (there is a short list on the EPA website), and Hudson is well acknowledged as the leader in the space. Most of the reclaimers are small local businesses that process about 100,000 lbs annually, while Hudson handles about 2 million lbs at their centralized plant in Champaign, Illinois. Since only 3 labs are certified to approve sample quality of reclaimed R-22, most of these reclaimers will work with Hudson regularly, and may even outsource to Hudson on certain occasions. Hudson also processes reclamation for Arkema, Dupont, and has hired a previous Honeywell executive to further extend their reach. Hudson has had strong relationships with these 3 major producers for over a decade as their distributor and go-to reclaimer.

Year R-22 Reclamation Market (in million lbs.)
2000  7.1
2001  4.3
2002  4.9
2003  4.4
2004  7.2
2005  6.2
2006  8.5 * R-22 Price Increases
2007  8.2
2008  10.0 *R-22 Peak Pricing
2009  7.5
2010  8.0
 
Year HDSN Revenue (in millions)
2000  $15.5
2001 $20.8
2002 $20.0
2003 $18.0
2004 $14.6
2005 $19.2
2006 $23.5
2007 $26.9
2008 $33.2 *Strong impact from peak R-22 prices
2009  $24.2 *Weak economy, industry reducing working capital / inventory
2010  $37.2 *Recovering from pent-up demand

At today’s R-22 spot price between $4 and $4.50, reclamation is still only a small part, about 7%, of the R-22 supply, which will move to 100% reclamation after 2015 – meaning over 85 million pounds of R-22 will be processed, or 10 times the current reclamation market. The R-22 price in Europe, which is a few years ahead of the U.S. in terms of HCFC control, is about $15 per pound, and 100% comes from a reclamation supply. Even if you assume R-22 stays at $4, and Hudson being well positioned with 50% current excess capacity to process such large amounts or roughly 20% of the market, Hudson would earn gross profit of 50% * [17 million pounds * $4.00 per pound] = $34 million. Rising R-22 prices will dramatically magnify the returns to this side of the business which is currently obscured by the larger distribution segment. To put this into perspective, a typical A/C unit will use a standard 30 lbs. tank of R-22, which is a small replacement cost that will last quite a while. R-22 price can increase multi-fold and still discourage spending thousands of dollars for a new R-410A system. R-12, the standard refrigerant prior to R-22, was phased out similarly and rose from $1 per pound to $28 per pound over a few years. R-12 was replaced more quickly though, since it was not nearly as dominant as R-22 currently is (over 60% of installed market.)

Historically, selling cost has been roughly 5% of revenue and general and administrative cost is roughly $3.7M and will only ramp slightly even at much higher revenue. Hudson’s distribution network developed over the past 20 years requires very little incremental effort as their same customers turn in gas to be reclaimed. At the same time, Hudson has consolidated its capacity to one large facility in Champagne, Illinois, which requires minimal maintenance capex. Capex for 2011 is estimated to be about $1M, which should include their equipment contribution to the JV in Europe. As such, the company offers significant operational leverage and ROA as the ASP and unit volume increases.

Why is the Stock Cheap?

-R-22 prices disappointed overly optimistic predictions leading to investor fatigue
-Stock piling of R-22 in the supply chain has led to a more orderly response
-Conversations with HVAC engineers / contractors confirm that industry had prepared in advance, but inventory will need to be replenished soon
-Anyone in the industry will tell you that R-22 prices will go up eventually, but hard to pinpoint timing; Market is not focused on the long-term
-Reclamation has not picked up yet since incentives at current R-22 prices / availability have not reached the tipping point for ground level participation
-The producers have let prices stagnate in order to secure market share, but will likely increase prices again in order to maximize profits through the next annual deduction
-Company issued 2.7m shares and 1.3m warrants at $2 per unit in July 2010 in order to raise much needed cash due to increasing working capital strain as prices go up
-Thinly traded volume ~30k shares per day

Catalysts

Q2 earnings on August 3
The industry stocks up on R-22 seasonally before the summer, making Q2 their strongest quarter historically. For Q1 2011, Hudson reported $13.8M in revenue, compared to $9.1M in Q1 2010. Q2 2011 reported $14.8M in revenue, compared to $16.1M in Q2 2010. The company has earned $3M pre-tax for the first half of 2011. Q2 results hinted refrigerant price increases, though lower volume weakened their results. Tomorrow’s conference call should better explain the gross margin decrease and overall industry conditions. Based on exceptionally high temperatures throughout the year, the depleting excess stockpile out in the market, and a seasonal pattern for reclamation to be strongest in Q3 as producers run low on their production capacity, I estimate HDSN to generate close to $5M pre-tax for FY2011.

EPA Announcement Before 2011 Year-End
Arkema has recently won a law suit against the EPA which will entitle them slightly more allocation of the pie through the transfer of allocation from a different HCFC. Their increased share will likely come from a smaller producer. At the same time, the EPA is well aware that R-22 and reclamation numbers haven’t been picking up as expected, and may consider other revisions that could speed up the process. Remember that production is not the culprit for HCFC emissions; the EPA’s aim is to minimize the amount that is being released into the air while on the job. Their policy will likely reflect economical incentives, such as measures designed to raise R-22 prices, in order to encourage reclamation and proper disposal of used refrigerants. Since annual allocations are announced a couple months before the year ends, producers may hesitate to raise prices before their market share is secured. Following the announcement and annual supply reduction, I suspect the producers will once again demonstrate their oligopolistic pricing power as they did from 2006-2008.

JV in Europe
The company recently announced a 40% JV in Europe for their reclamation and energy optimization services. The investment risk is minimal since Hudson is only contributing equipment that costs less than $500,000. Management states that the European reclamation market is a 70% gross margin business since 100% of the R-22 supply is from reclamation, and R-22 prices are 3-4x compared to the U.S. Accretive earnings are expected starting in 2012.

Ownership

-CEO / Founder since 1991 Kevin Zugibe owns 27% of HDSN

-31% owned by insiders

-Becker Drapkin Management filed a 13G for 8.4% passive ownership in May 2011. They are known to be activists and have gained board seats in 7 out of its past 10 13D filings, and have had positive impacts in their involvement with Ruby Tuesday, Hot Topic, and Plato Learning. However, they do not seem to be activists in this case.

-Marathon Capital Management is a 7.2% passive owner, viewed as long-term investors similar to Becker Drapkin.

Valuation

At $40M market cap I think investing in HDSN is a “no-brainer” considering the company will likely generate $15 to $20 million annually as the R-22 supply phase-out becomes more steep, reclamation reaches a tipping point in the U.S., and Hudson’s operations in Europe produce additional earnings. Without being overly precise and using very conservative multiples ranging from 3x to 5x, HDSN can be valued in the range of $45M to $100M market cap, or $1.90 - $4.20. At the current price of $1.68, I think the pay-off has asymmetric low risk / high reward with several near-term catalysts to drive value and reveal a hidden champion segment.

Disclosure: Long HDSN

Why is the Stock Cheap?

-R-22 prices disappointed overly optimistic predictions leading to investor fatigue
-Stock piling of R-22 in the supply chain has led to a more orderly response
-Conversations with HVAC engineers / contractors confirm that industry had prepared in advance, but inventory will need to be replenished soon
-Anyone in the industry will tell you that R-22 prices will go up eventually, but hard to pinpoint timing. Market is not focused on the long-term
-Reclamation has not picked up yet since incentives at current R-22 prices / availability have not reached the tipping point for ground level participation; Market is ignoring the segment until it demonstrates
-The producers have let prices stagnate in order to secure market share, but will likely increase prices again in order to maximize profits through the next annual deduction
-Company issued 2.7m shares and 1.3m warrants at $2 per unit in July 2010 in order to raise much needed cash due to increasing working capital strain as prices go up
-Thinly traded volume ~30k shares per day

At $40M market cap I think investing in HDSN is a “no-brainer” considering the company will likely generate $15 to $20 million annually as the R-22 supply phase-out becomes more steep, reclamation reaches a tipping point in the U.S., and Hudson’s operations in Europe produce additional earnings. Without being overly precise and using very conservative multiples ranging from 3x to 5x, HDSN can be valued in the range of $45M to $100M market cap, or $1.90 - $4.20. At the current price of $1.68, I think the pay-off has asymmetric low risk / high reward with several near-term catalysts to drive value and reveal a hidden champion segment.