Hudson Technologies Inc /Ny Q2 FY2022 Earnings Call

Good afternoon, everyone, and thank you for joining the Hudson Technologies Second Quarter 2022 Earnings Call. I am pleased to introduce your host, John Nesbett. John, you have the floor.

Thank you, Ali. Good evening, and welcome to our conference call to discuss Hudson Technologies' financial results for the second quarter of 2022. On the call today are Brian Coleman, President and Chief Executive Officer; and Nat Krishnamurti, Chief Financial Officer. I'll 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, and 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 our business, as we see them today, they are not guarantees of future performance. Please understand that these statements involve a number of risks and assumptions. Since these elements can change and, in certain cases, are not within our control, we would ask you to consider and interpret them in that light. We urge you to review Hudson's most recent Form 10-K and other subsequent SEC filings for a discussion of the principal risks and uncertainties that affect our business and our performance and other factors that could cause the actual results to differ materially. Okay. With that, I will now turn the call over to Brian Coleman. Go ahead, Brian.

Good evening, and thank you for joining us. Our second quarter results showed continued strength with substantial revenue growth, significantly enhanced margins, and increased cash flow and profitability. We're seeing consistent momentum as the selling season unfolds. Our second quarter results reflect sustained strength in the price of certain refrigerants. In addition to record revenues for the second quarter of 2022, gross margin increased to 55%, as the average selling prices remained consistent with the levels achieved during the first quarter of 2022. At these pricing levels, we maintained a higher average selling price without material appreciation in the cost basis of certain refrigerants. During the second quarter, we continued to achieve exceptionally high gross margins, although we believe margin performance for the full year will moderate slightly due to increases in inventory costs and anticipated stabilization in the sales price during the balance of this season. With our visibility today, we've raised our expectations for the full year blended gross margin and believe it will be at least in the mid-40% range, with longer-term gross margins settling around 35%. We remain focused on developing strategic working relationships with customers who recognize the long-term value in Hudson's ability to provide them with sustainable refrigerant products and services as the industry transitions to cleaner equipment and refrigerants. We believe a shared vision for the circular economy of refrigerants is an important component of our customer relationships. As we discussed before, 2022 marks the start of the industry's compliance with the AIM Act, which mandated a 10% step-down in production and consumption allowances for virgin HFCs in both 2022 and '23 and a 40% baseline reduction in 2024. Additionally, the Act mandates a much more aggressive and faster phasedown than what we previously saw with the R-22 phaseout and promotes the use of reclaimed refrigerants to meet demand as virgin production steps down. HFCs are currently the most commonly used refrigerant, so as a leading reclaimer with the fastest state-of-the-art technology and decades of proprietary knowledge, Hudson is uniquely qualified to fill the anticipated HFC supply gap with reclaimed refrigerants as virgin production is phased down. In addition to the opportunities we're seeing related to the AIM Act, we're also forming new partnerships as certain industry participants are working to comply with initiatives set forth by various states and the federal government. California has led the way with the requirement that OEMs use a minimum of 10% reclaimed refrigerant in the factory-charged equipment. Many other states are advancing their own set of regulations on the uses for HFCs. Hudson is ideally suited to assist OEMs in meeting these requirements, and we're focused on growing our brand recognition and reach within this audience. Additionally, we're seeing increased interest from the OEM market, not just at the factory level, but equally important at the field service level, as states and the federal government have dealt and continue to deal with chemical reductions and new equipment and servicing rule-makings that will evolve over time. We just announced a new strategic alliance with Lennox National, whereby Hudson will be the exclusive supplier of certified reclaimed refrigerants to Lennox for the aftermarket support of their residential HVAC systems. This alliance highlights Hudson's capabilities as a resource for our industry partners, and we look forward to expanding our relationships to assist compliance and transition to the use of reclaimed refrigerants by OEMs and others. Hudson has a long and successful history of assisting our industry through prior transitions to more environmentally friendly and efficient next-generation cooling equipment and refrigerants. We believe this latest phasedown presents us with a tremendous market opportunity to continue to expand our leadership role as a steward of the industry's ongoing transition. Looking ahead, as we reported in this afternoon's press release, given the pricing dynamics to date for the current selling season, we are increasing our previously stated 2022 forecast and also updating our long-term targets. Based on current pricing levels, we should see revenues in excess of $290 million for the full year 2022. While we continue to believe gross margin performance for the full year will moderate due to increases in inventory costs and anticipated stabilization in sales prices during the balance of the season, with our visibility today, we now believe the full year blended gross margin will be at least in the mid-40% range. As it relates to the AIM Act implementation, we have seen an accelerated shift to what we expect will be significantly higher sustained profitability for the business going forward. Assuming further HFC price increases related to HFC phasedown and applying a slower pace to price increases than we saw in 2022, we are targeting an annualized revenue of greater than $400 million by 2025, with gross margins remaining above historical levels, but moderating over the next three years to approximately 35%. This shift we're seeing to significantly increase profits for the business provides considerably enhanced financial flexibility for us to invest in our long-term growth while also continuing to reduce debt. These long-term targets are conservative, and there are certainly factors that may impact such targets. For example, these targets make very modest assumptions on the reclaim front. Conversely, just like everyone else, we are watching the economic signals within our industry and the broader economy as a recessionary environment could potentially create some headwinds. Thus far, the HVAC aftermarket has stayed very strong, particularly given the mandated phasedown. Our industry could potentially be more insulated than other markets, but we're keeping an eye on it. As we move through the completion of our traditional selling season, we remain focused on meeting the needs of our long-standing customers and continuing to foster and promote sustainable cooling practices. We are committed to providing the products and services to enable our industry-wide transition to cleaner refrigerants and more efficient equipment. As a leading reclaimer, Hudson is uniquely positioned to reduce refrigerant waste and the harmful venting of refrigerants into the atmosphere by driving forward the technology and the incentives that enable our industry partners to recover, reclaim, and reuse refrigerants. Our EMERALD brand of reclaimed refrigerants is gaining market recognition. Our reclamation capabilities and portfolio of on-site services provide a solid platform for us to grow our leadership role as a steward of environmentally sound, sustainable refrigerant management. This is a pivotal time for our industry and an exciting time for our company. As the refrigerant industry continues to evolve, we remain well-positioned with our capabilities and product offerings to meet customer demand for all refrigerant types, including CFCs, HCFCs, HFCs, and next-generation HFOs. We are a long-standing participant and proponent of the circular economy of refrigerants. We believe our historical and consistent role as an industry leader will only grow as our customers and partners seek a seamless transition to more efficient and environmentally friendly cooling systems and refrigerants. Now I'll turn the call over to Nat to review the financials. Go ahead, Nat.

Thank you, Brian. For the second quarter ended June 30, 2022, Hudson reported revenue of $103.9 million, an increase of 72% compared to revenues of $60.5 million in the comparable 2021 period. The growth was driven by increased selling prices for certain refrigerants during the quarter. Gross margin was 55% for the second quarter of 2022 compared to 36% in the second quarter of 2021. The gross margin increase is mainly due to the significant increase in selling price, without a material appreciation in the cost basis of certain refrigerants sold. While we achieved a 55% gross margin for the first half of the year, mainly due to increased pricing and lower cost, we expect gross margin performance for the full year to moderate to at least the mid-40% range, as costs catch up to the stabilized selling price during the second half of the year. SG&A for the second quarter of 2022 was $7 million or 6.7% of revenue compared to $6.8 million or 11.2% of revenue in the second quarter of 2021. We recorded operating income of $49.8 million in the second quarter of 2022 compared to operating income of $14.4 million in the second quarter of 2021. The company recorded net income of $39.8 million or $0.89 per basic and $0.84 per diluted share in the second quarter of 2022 compared to net income of $11.3 million or $0.26 per basic and $0.24 per diluted share in the same period of 2021. Net income during the second quarter of 2022 also included a tax benefit of $11.6 million associated with the release of an income tax valuation allowance as a result of increased profitability. During the second quarter of 2022, the company also paid down an incremental $10 million of term loan debt, resulting from improved performance and increased cash flow, thus reducing its leverage ratio to 0.73:1 for the trailing 12 months ended June 30, 2022, declining significantly from a leverage ratio of 4.18:1 for the trailing 12 months ended June 30, 2021. The company's availability, consisting of cash and revolver availability at June 30, 2022, was $93 million. As we continue to generate additional cash flow, we expect to: one, further delever our balance sheet; two, ensure we have adequate inventory on hand; and three, consider other opportunities as they arise. We have strong liquidity, and our term loan and revolving loan credit facilities provide us with a solid financial platform and flexibility as we look forward. I will now turn the call back over to Brian.

Thanks, Nat. We're pleased with our strong performance thus far in the 2022 selling season. We're well positioned for continued growth as we capitalize on the market opportunities to enhance our leading role as a provider of sustainable products and services for the refrigerant and reclamation industry. Operator, we'll now open the call to questions.

Your first question is coming from Ryan Sigdahl. Please mention your affiliation and ask your question.

Nice results.

Thank you, Ryan. You faded out for a second. Are you still there?

I am. Can you hear me?

Yes, that's better.

Yes.

Sorry.

Good. So I want to start with gross margins. Obviously, extremely impressive in the quarter and year-to-date. So we know there's some transitory price benefit flowing through the gross margin line. But it feels like that would have been bigger the last two quarters than it would appear. So it seems like structural or normal gross margins ex that price were better this quarter. I guess, can you break out how much was from the price increase versus what you would call structural or normal gross margin within that 55%?

It's probably difficult to try to bifurcate it. But certainly, when you go back, let's say, over the last six months, as we went through Q1, there were further price increases through Q1 itself. We reported pricing in the last earnings call for HFCs, on average, around $14 a pound. That $14 basically was consistent throughout the entire second quarter, and that's consistent today. So at some level, Q2 had the benefit of that higher price throughout the entire period, whereas Q1 would not have. But as it related to our overall inventory costs, there really wasn't as much of an increase in the cost basis of our sales as we thought we might have seen. As a result, we ended up with the gross margins reflected in today's press release.

Maybe looking out further, Brian, 2025 targets, 35% gross margin. Historically, you've always talked about kind of 30% as the normal gross margin, and that was what your 2024 targets were. So I guess what's giving you confidence to raise that by 5 points?

It's relying on reclaims certainly, some growth in reclaim, but I'd say we're using a very conservative growth in reclaim. We're not even reflecting reclaim volumes that would reach the height of the R-22 HCFC phaseout, but getting close to that. So we just believe that we will see price increases from where we are today. We certainly don't know how the overall economy could affect short-term results. But on a long-term basis, when you get into that 2024 period and a 40% reduction in the overall annual availability of HFCs, you would have to expect, to the extent there was any inventory coming into the AIM Act or using the other expression of stockpile coming into the AIM Act, that through that period, it would be consumed. Certainly, by 2025, possibly sooner, we really would start to see tightness in a normal economic balance of supply and demand, with anticipated price increases and certainly increases from the levels we're at today.

And then maybe following up on that. So it sounds like channel inventory is still pretty tight. But can you comment on both R-22 as well as HFCs, what you see as far as channel inventory? And then secondly, can you comment on reclamation growth or how that has trended on each of those categories?

So as it relates to R-22 and pricing, it still remains pretty constant and probably will remain constant for the foreseeable future. The sale price is in the low 30s, mid-30s. At this point, we would not expect people to carry 22 inventory down the chain. We would expect that people are just buying 22 as they need it and will continue that pattern and expectation for, again, the foreseeable future. So no changes there and wouldn't expect to see changes for several years to come. As it relates to HFCs, there could be a little bit more inventory in the chain than normal. We're not certain if some buyers could have thought about, let's say, having a little bit more inventory now in anticipation of 2023 and '24. We don't think it's overly material, but we're not certain as to what that level is, but we would think it might be a little bit higher HFC inventory in the chain or downstream. Was there a third part?

Reclaim.

And reclaim. Reclaim continues to be somewhat disappointing. Now I will say, it's still early in the contractor mind that HFC has a value. When I say early in Q2, Q2 would probably be the first time that a contractor could have heard that they would be paid for HFC refrigerants, whereas last season and for decades, they likely were charged. We do think, as we've said before, with regards to reclaim, that reclaim typically picks up on the back half of the season. As the contractors are going through their busy season on repairs, they start to accumulate recovered gas and then start to send it in towards the back end. But this then points really to the importance of the Lennox announcement. This is a new initiative that Lennox is really taking a very big bold step in trying to reach out to the Lennox dealers and encourage them to recover refrigerants that they might not have previously done or not previously returned to Hudson Technologies as the preferred reclaimer. This is very significant for us. I mean, we're talking about thousands of potential dealers in their programs. This is one step, I think, towards a way commercially that participants in this industry can really support that circular economy, and we all share in the environmental benefits of recovery, which is the only means of reducing emissions and then the reuse of that refrigerant. So this is a very significant relationship, and we're looking forward to working with Lennox International and the Lennox dealers.

Maybe last question for me, just following up on the Lennox. What type of exposure business do you have with Lennox or I guess those thousands of dealers at Lennox authorized dealers today? And then any math or, I guess, rough numbers you could lay out of what type of incrementals this could be for Hudson?

Well, all of it ought to be incremental. There's likely very little direct relationship we have with the Lennox dealers. Certainly, the way Lennox is promoting this program, they're taking it very seriously at all of their events and putting forth the importance of this program, not only for today but for the long term. So it would be difficult at the moment to quantify the overall benefit. At the end of the day, as you know, all recovered refrigerant that we reclaim goes into inventory and is resold. It becomes part of that blended overall gross margin, which, for the moment, we're targeting that longer-term gross profit range at that mid-35%, above what we were previously targeting at the low 30% range.

Our next question is coming from Chip Moore. Please state your affiliation and pose your question.

And congratulations on the continued strong results. I wanted to ask about the outlook, I guess, for this year, more on the volume expectations side, $290 million would apply at the low end, not a lot of top line growth in the back half of the year. Are you maybe being conservative on pricing or labor and part shortages throughout the industry? Just what are some of the puts and takes on that revenue estimate?

I would say, historically, any of the estimates that we provide are always tended to be on the conservative side, intended to try and just reflect status quo. Obviously, we're focused on growing relationships, particularly the strategic relationships we've talked about, and we'll continue to do that. Some of those relationships will be public, and some will not. Typically, any forward-looking information we provide, we would tend to do so in a very conservative way.

Perfect. Understood. And one more on the outlook. As we look to 2025 and that path to mid-30% margins, I think you talked about being conservative on reclaimed. But just based on the phasedown, how would you think about that path? Would it be more of a step change or a steady increase? Or any thoughts there?

It's challenging to assess as we have observed fluctuations over time. When analyzing prices over extended periods, there tends to be a more jagged pattern rather than a straightforward linear progression from one figure to another. Nonetheless, we believe the pricing estimates for 2025 are too low and do not reflect the potential tightness in supply and demand for our product. Additionally, we should consider future opportunities; we are generating a substantial amount of excess cash. Nat and the team have managed to negotiate the repayment of debt this year. We made some debt repayments in Q2 and plan to continue this trend throughout the year. We anticipate that our debt could be at zero by 2024. With manageable cash flow, we will be in a position to explore acquisitions and other investment possibilities in the business. As we have mentioned before, the AIM Act presents some challenges, particularly regarding reporting. This year, we are investing significantly in our ERP system to meet the reporting requirements set by the EPA under the AIM Act, which include both outbound sales and inbound returns. Additionally, the current draft of the AIM Act will necessitate a requirement for usable steel, which will also require significant investment. We expect further disruptions and consolidations, and we see these as opportunities to utilize our excess cash flow during that anticipated period. Therefore, I consider our target to be conservative and achievable, particularly when we look at the European market and the opportunities that lie ahead.

That's very helpful, Brian. And maybe one follow-up there on sort of the acquisition side with this strong profitability you're seeing and opening up some flexibility. Just maybe you could talk about the pipeline or what you're seeing? Obviously, we saw one of your competitors scoop up an asset in Florida. Would you be looking at those types of deals or more broad-based? Any color there?

Yes. I mean as it relates to reclamation and reclaimers in general, there possibly will be folks that are going to exit the business because of some of the difficulties I described. There are certainly folks that we would think would be good partners and maybe others that might not be. We do think there's a tremendous opportunity on the service side. When we first started to think about service and take our patented equipment into the field, so the equipment we use to reclaim refrigerants in our plants is also very portable. We started to create various services at the middle end of the CFC conversions. Looking back now, we have quite a lot of data and relationships with the OEM service groups, end-users that are now operating on HFC such as 134a, for example, that over the next 5 to 15 years, they're going to have to find ways to convert those systems to HFO or next-generation technologies. We think we have a very significant solution for those conversions, not only to help in the conversion, but more importantly or just as importantly, to pay for the recovered gas that subsidizes that new equipment. We do think the service area, particularly on the larger systems, is an opportunity for growth for us as well.

Our next question is from Gerry Sweeney. Please state your affiliation and ask your question.

ROTH Capital. Just speaking on acquisitions, taking a little bit of a step back. You mentioned reclaim's still a little bit disappointing, and we saw a little trouble with that with R-22. I think you sort of were touching upon this, but in some of your questions and answers earlier. But is there an opportunity to get larger or more entrenched on the service side, either through acquisition or building out, getting closer to the gas to give you an opportunity to reclaim it? If yes, how do we go about doing that? Is that something you're looking at?

Yes, the answer is definitely yes. Being close with contractors makes a lot of sense. When you think about the announcement with Lennox, it's difficult for us to add value in the process of residential applications. The systems are just too small. On the flip side, when you talk about large commercial and industrial, that's the sweet spot for our services. And there's a different set of contractors typically that will work on those larger systems versus, let's say, the residential-like commercial. So it's a two-pronged approach to the marketplace. Finding excellent partners like Lennox International helps us with the residential side. But working also with the large OEM chiller groups, some of which eventually may have needs for reclaim in the factory charge as well, I think will help us enhance our recovery rate and growth in reclamation as we move forward.

On the Lennox side, are there any incentives or policies in place that affect the dealers, such as warranty issues that arise if an outside or non-approved recycled refrigerant is used, which might encourage more business for you?

Well, you really want to look at Lennox's messaging. They are very serious about sustainability. They are also very serious to ensure that their equipment that's in the installed base will be serviceable to its end of life. They're taking the responsibility as an equipment manufacturer very seriously to ensure that there will be supply to meet the servicing needs of the installed base. So I think there's lots of teeth in what they're looking for. It's part of their mission, and we would expect there to be significant growth as a result of this relationship.

Got it. My final question is regarding utilization capacity. I understand that the reclaim hasn't been as strong as you would like. However, there are inherent challenges with HFC gas compared to R-22. R-22 was a single molecule, while HFCs are not. Do you have sufficient capacity to handle HFCs, particularly mixed HFCs, in the coming years? Or will there be a need to expand that capacity?

So we've been fractionally distilling refrigerant since about 1995. We probably have, within our organization, the greatest proprietary knowledge about fractional distillation refrigerants. Back to capacity, we're constantly adding capacity because as we saw the introduction of HFCs into the HCFC applications like the R-22 and 410A, we were starting to see increases in cross-contamination for probably well over a decade now. Inherent in our annual CapEx spend has been dollars devoted to support that need. We'll continue to do that. At the end of the day, most of our CapEx needs or spends are really about just handling cylinders and again, trying to equate what we're looking to do with the propane industry, particularly in the late '90s when they started the exchange programs, being able to handle many more cylinders coming in the door. Our relationship with our customers is to return empty cylinders in approximately two business days. We're trying to help them manage their overall steel inventory or steel fleet while also promoting the recovery and reuse of refrigerants. At the end of the day, we feel confident that our current capacity and any future dollars spent for capacity will not be materially different than what you've seen historically because historically, we've had to deal with these problems.

Sirs, there appear to be no more questions in the queue. So at this time, I will turn it over to you.

Well, thank you, operator. I'd like to thank our employees for their continued support and dedication to our business. I want to again thank our longtime shareholders and those that have recently joined us for their support. Thank you, everyone, for participating in today's conference call, and we look forward to speaking with you after the third quarter. Have a good night, everybody.

Thank you. Ladies and gentlemen, this does conclude today's conference call. You may disconnect your lines at this time, and have a wonderful day. Thank you for your participation.