HDSN - Hudson Technologies: Why Investors Cheered At Q2 Earnings

2023-08-07 12:53:58 ET

Summary

• Hudson Technologies reported strong Q2 earnings, leading to a 20% increase in stock price.
• The company's business of refrigerant reclamation is benefiting from the phase-down of virgin HFC production.
• Hudson is effectively managing inventory and reducing debt, leading to improved financials and cash flow.

Introduction

Hudson Technologies ( HDSN ) reported Q2 earnings a few days ago. In the past few months, while the stock saw some weakness during the cold season, I went over my bull-case on Hudson, highlighting how expected tight virgin refrigerant supply is for sure a big tailwind that has yet to impact Hudson's results.

After Hudson reported earnings, the stock soared 20% upwards, with the share price climbing from $8.60 to around $10.50. What explains this big move? Investors may know how Hudson is a rather volatile stock. But this characteristic alone doesn't explain such a move. What have investors seen in the report? In this article, I would like to give my answer.

Summary of previous coverage

Those who don't know Hudson, should know that it is the U.S. leader in refrigerant reclamation. It owns the technology (and the patent) to retrieve used refrigerants and reclaim them to make them available once again to the consumer. Its business model makes the company to hold two key spots in the market: reclaimer and reseller. Why is this business so special? Since the AIM Act was passed, it has been ruled by Congress that virgin HFC production will be phase-down in the next 15 years. In particular, while in 2022 and 2023 the act mandated a 10% step-down in virgin production and consumption allowances, in 2024 a 40% reduction is scheduled. This will create more demand for reclaimed refrigerants, since virgin supply will be tighter. Since HFC equipment, according to Hudson, has an anticipated lifespan of 20-plus years, Hudson will play an important role in reclamation.

We have also learned how there is one major risk for Hudson: inventory management. In fact, Hudson uses the FIFO approach . This means that it sells on a first-in first-out basis. If used refrigerant prices increase, the company will at first see a benefit on its margins since it will sell at a higher price those refrigerants it purchased before the price surge. But if refrigerant prices decrease sharply, the company could end up selling at a loss because it would sell at low prices those refrigerants it purchased at a high price.

This explains why in Q2 last year we saw a gross margin at 50%, while now margins are coming down a bit.

Q2 Earnings Review

As said, even though Hudson doesn't disclose much information about its inventory (we don't know the volumes, for example), we have to rely on its report to see what is happening.

First of all, starting from the income statement, we see the following three lines for the second quarter:

Revenues came down mostly because of lower selling prices. At the same time, the cost of sales increased because Hudson is starting to sell higher-priced reclaimed refrigerants. Therefore, while in Q2 of 2022, gross margin was around 44%, in the past quarter, it came down to a more sustainable 40%.

Mr. Brian Coleman, CEO of Hudson Technologies, explained this situation during the last earnings call :

the 2022 selling season was exceptional due to sale prices rising at a much faster pace than inventory costs. So as we move through the 2023 season, we are facing a difficult set of quarter-to-quarter comparisons. [...] As expected, we saw a narrowing in the gap between inventory cost and sale price to more historical levels. And as a result, gross margins moderated to 40% in the quarter."

During the earnings call, Hudson confirmed that HFCs are currently in the $10/lb price range, down from the peaks seen last year.

If we look at inventories, we had $145 million reported at the end of 2022. At the end of Q1 2023, inventories were down at $137 million. Now, they are at $134 million.

What does this show? On one side, we could think Hudson is clearing its stock at a faster speed than it is refilling it. But, since we don't have any data about this, we could actually assume that Hudson is operating as usual and that refrigerant prices are coming down. FIFO, in fact, is the best way to manage inventory reporting always a value close to the current market value of an item. Since the decline in inventory value is not so sharp, we can believe prices are stabilizing. This is very good news for Hudson because it reduces the risk of price volatility.

Here I see one of the reasons why investors cheered: more important than revenue growth is refrigerant price stability, because it enables Hudson to manage more efficiently its stocked refrigerants.

In addition, Hudson has repeatedly stated it targets gross margins at 35%. Since this quarter we saw a 40% gross margin, investors have more than one element to believe that high gross margins will be seen still for a little while.

Interest expense and debt

If we look at the income statement, we also see how interest expenses are decreasing quickly:

This means Hudson is aggressively paying down its debt, thus reducing quarter after quarter its interest expenses. In fact, at the end of 2022, the company still reported $39 million of long-term debt, while at the end of the first six months of this year, the company had only $25 million of long-term debt.

As a consequence of strong earnings, the company reported $92.7 million of retained earnings which go to strengthen the total stockholders' equity of $211 million, making the balance sheet much stronger compared to the stockholder's equity of $175 million reported last year.

During the second quarter, Hudson generated $10.6 million of cash flow from operations. During the same quarter, Mr. Nat Krishnamurti, CFO of Hudson, reported:

the company paid down an incremental $10 million of term loan debt resulting from improved performance and increased cash flow, reducing its leverage ratio from 0.32 to 1 for the trailing 12 months ended June 30, 2023. This represents a significant decline from a leverage ratio of 0.73 to 1 for the trailing 12 months ended June 30, 2022. The company reduced total outstanding debt by 31% from $46.8 million at December 31, 2022, to $32.5 million at June 30, 2023. As you know, interest rates have risen almost 500 basis points over the last year. So this debt reduction has provided significant savings for the company. [...] since the refinancing in March 2022, the company has paid down approximately $67.5 million of term loan debt, resulting in $6.8 million of savings on interest, inclusive of any prepayment fees.

Takeaway

This report shows once again how Hudson is going through a favorable cycle. In addition, it seems to be managed well-enough to take advantage of a situation where the company is achieving strong results with strong cash flow generation. Using cash to strengthen the balance sheet, by further delevering it while ensuring an adequate inventory is on hand, is a smart decision. Therefore, I still consider intact the valuation of my previous articles, considering the target price for the stock around $17, which is a 70% upside from where we are now.

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