HDSN - Inventory Management: A Little Accounting Exercise On Hudson Technologies

2023-05-13 03:39:18 ET

Summary

• Hudson Technologies reported Q1 earnings.
• Inventory, COGS and debt were the three items I was waiting for to assess the company's health.
• In this article, we go over these three aspects to assess if my bull-case is still intact.

Introduction

Hudson Technologies ( HDSN ) has once again reported earnings and I believe it is time to consider a main aspect to detect and discern whether the bull-thesis is still intact or not.

A Few Thoughts On Earnings Season

Earnings season can be both exciting and stressful for investors. A ton of new expected and unexpected data come out and everyone tries to draw new valuations and conclusions on the investments made or the ones that are in the pipeline.

It can be difficult to keep up with tons of information. Therefore, it becomes ever more important to outline a few key ideas or data to look for to assess how things are going. This is what I am learning to do between one quarterly report and another: go over the whole investing thesis and identify what I will be focusing on as the report is published.

Key Focus On Hudson: Inventory and Debt

In Hudson's case, the key aspect I knew I would look at was one item on the balance sheet: inventory.

Why inventory? Well, if history teaches us something, Hudson already faced one a major downturn because of inventory. In 2017, in fact, there was a severe supply and demand imbalance, as Kevin Zugibe - former Hudson Technology founder and CEO - explained during the Q3 2017 earnings call.

This was caused by a flood of Chinese suppliers refrigerants that caused a rapid downfall in HFC pricing.

Why was that a problem for Hudson? Hudson is not a virgin refrigerant supplier. It actually is the leading U.S. refrigerant reclaimer. Therefore, Hudson purchases used refrigerants and purifies them to sell them once again to end-users. If a flood of virgin supply causes a sudden drop in refrigerant prices, Hudson can run into the risk of carrying a refrigerant inventory at an average price that is higher than the current market price for refrigerants. This leads Hudson towards a loss, that can be quite big. In fact, Hudson is forced to sell its reclaimed refrigerants at a price that can be lower than the original purchasing price of used refrigerants.

On the other hand, in the past two years we have seen very good gross margin growth because of the exact opposite situation. Demand grew while supply shrunk, causing refrigerant prices to increase quickly. This made Hudson able to sell reclaimed refrigerants with a wider-than-expected margin on the price it had bought used refrigerants for.

How Hudson Manages Its Inventory

FIFO and LIFO

Now, let's get to the main topic of this article: inventory management.

Most of us know about FIFO and LIFO. But, since some may now know about these two systems, let's take a few minutes to summarize what they are.

FIFO stands for "first-in; first-out". LIFO stands for "last-in; first-out".

This means that the FIFO method sends out the oldest available item first, while LIFO does the exact opposite by retrieving the last item first.

According to which method a company uses, we can have a different inventory value.

In fact, under the FIFO method, the earliest purchased goods are sold first. As a consequence, this cost is expensed while the most recent cost of a purchased item remains on the balance sheet. The LIFO method does the opposite: the oldest purchased item is carried on the balance sheet, while the latest purchased item, being the first that is sold, is expensed.

Let's make an example to see this difference in action.

Let's imagine that a company reports at the beginning of a year an inventory of 10 units at an average cost of $10 per unit.

Then the company buys 10 more units at $15 per unit. After a while it buys once again 10 additional units at $25 per unit.

In the meantime, the company sells 23 units.

What is the cost of goods sold and the inventory value at the end of the period?

Why is that? Under FIFO we sell first the ten units at $10 each, then we sell the next 10 units bought at $15 and then we add another 3 units bought at $25. This gives us $325. The remaining 7 units are reported as inventory at an average price of $25 each.

LIFO starts from selling the 10 units bought at $25, then adds up another 10 units purchased at $15 and then takes 3 more units bought at $10. This gives us a higher COGS and a lower inventory value.

We can see how FIFO had the advantage of having a better valuation of inventory because the balance sheet reports a number closer to the current market value of inventory. At the same time, FIFO has the disadvantage of matching the revenue from the sale of inventory with an old (and maybe outdated cost). LIFO is the exact opposite: it has a worse valuation of inventory, but it provides a better matching between sales and costs. This had the advantage of a higher COGS which reduces income taxes.

Implications for Hudson

Hudson explains in its reports that its inventories of refrigerant products available for sale

are stated at the lower of cost, on a first-in first-out basis, or net realizable value. Where the market price of inventory is less than the related cost, the Company may be required to write down its inventory through a lower of cost or net realizable value adjustment, the impact of which would be reflected in cost of sales on the Consolidated Statements of Operations.

Last year the company explained to investors how the improving gross margin that topped 50% were

primarily attributable to higher selling prices in the quarter, which in the context of our FIFO approach to inventory favorably impacted our gross margin performance.

Therefore, investors were not to be mistaken when making their own valuation of the company. Hudson has always said that the gross margin target is between 30% and 35%. This was also explained last year with the following words:

What we're trying to suggest right now is we certainly did better on a gross margin basis relative to more FIFO inventory than a sustainable level. We think that low 30s is the sustainable level. But we also think we could do better than that now, to the extent that we see growth in reclaimed volume. And that probably will start to happen in somewhat the later years. So, we are expecting growth in HFC reclaimed in 2022. But because the used gas return comes in on the back half of the year, typically relative to the season, you're usually going to see that growth go into inventory in 2022 and see the margin improvements until 2023 when you sell out that reclaimed gas.

Let's get to the point. To understand if Hudson's results are sustainable we need to forecast what the average reclamation price could be and if there will still be a significant gap between this and the reselling price.

Unlike 2017, there is almost no chance to see a new flood of virgin refrigerant supply, since R22 have been phased out and the AIM ACT has started to regulate the HFC phase-down. Congress requires a stepdown of 10% from baseline levels in 2022 and 2023, and establishes a cumulative 40% reduction in the baseline for 2024.

This means that, in Hudson's words, "reclamation will be critical to maintaining necessary HFC supply levels to ensure an orderly phasedown".

There is enough to believe prices will remain high, especially if we consider Hudson estimates an install base of over 125 million HFC units.

Let's now look at the last quarterly report to see if there is evidence of increasing or decreasing used refrigerant prices.

First of all, we see that on the balance sheet, inventory went a bit down compared to the prior quarter. While it was $145 million at the end of December, it is now $137 million. However, compared to the same quarter of the prior year, it went up since in Q1 2022 it was $101 million.

What does this mean? If we look at the YoY data, we understand that during this year used refrigerant prices increased. However, compared to the past quarter, it seems like these prices came down a bit. We remember, in fact, that FIFO is the best way to get close to the current market value of an item.

So, it seems like used refrigerant prices are not increasing anymore and may actually stabilize or even come down a bit.

We can now move on to the income statement, to gather the other piece of information we need: the cost of goods sold.

Here is the income statement. I chose to show it fully because it is quite simple and it enables us to spot a few interesting things.

We see revenues decreased by 8.4%. As Brian Coleman, President and CEO of Hudson, explained during the earnings call:

revenues down slightly due to a combination of lower selling prices for certain refrigerants as well as a decrease in demand compared to the first quarter of 2022. It's not unusual for us to see pricing pressure in light of volume in the first quarter of any year since during January through March time period, large portions of the country are still facing winter weather and not yet thinking about turning on air conditioning systems.

In other words, Q2 and Q3 are usually much easier quarters to compared due to a more predictable weather which drives demand for reclaimed refrigerants.

If we zoom out to March 2021, where revenues came in at $33.8 million, we also see that selling prices remain quite high.

More important is the second line with the cost of sales. We see a 21.6% increase which led gross margins to moderate YoY because the gap between inventory costs and sale prices narrow down.

The gap is narrowing and this means inventory costs are rising faster than sale prices are. Still, Q1 gross margin was 39%, which is 4 percentage points ahead of Hudson's goal of 35%.

During the earnings call, Hudson reported R22 prices are still strong at more than 30$/lb. Pricing for HFCs are in the $10/lb range, down from the peaks seen in 2022. This helps us understand why revenues were still high, though moderating a bit. So far, R22 make up the largest reclaimed refrigerant sold by Hudson, since it has been completely phased-down. HFCs are beginning to be reclaimed as the AIM Act gets implemented.

Debt And Interest Expense

As we move towards the bottom line, we also see interest expense decreasing significantly. This is because Hudson is paying down quickly as much debt as it can. Therefore, we see interest expense decrease by 75% YoY because Hudson was laser focused on reducing its outstanding debt. As a matter of fact, the company reduced its total debt by 56% from $100 million at the end of Q1 2022 to $43.6 million at the end of this last quarter. With interest rates soaring, this debt reduction has made Hudson save a lot of money. Furthermore, the company didn't need to borrow any additional money against its revolver loan.

Overall, the company seems to have learned its 2017 lesson and is using the strong cash flow generation of the past year to deleverage and strengthen its balance sheet. This is particularly important because Hudson's real threat is not really a recessionary environment, but a mis-management of its inventory. In fact, cooling and refrigeration are somewhat insulated from a recession as they are not discretionary items people can just quit using. Actually, in tough economic times, people prefer to repair their AC units rather than replacing them. And repair benefits Hudson because it increases the lifecycle of older systems that need reclaimed refrigerants.

With Hudson's current balance sheet, I am comfortable the company can face any unexpected event.

Conclusion

The last earnings report doesn't make me change my buy rating on HDSN stock. I see a company in shape, with a better balance sheet compared to a year ago. As we read though inventory and COGS we see that the gap between inventory costs and sales prices is narrowing but still allows the company to have a gross margin close to 40%. This is high profitability.

I still see intact the valuation I shared in my previous articles, confirming a price target of $17. Given the current price, we could be before a possible 2x soon to come.

For further details see: