ADA-ES (ADES)

I find it harder and harder to predict macro trends. Perhaps everything will work itself out with time. Perhaps there will be inflation. Perhaps there will be deflation. No matter what happens I want to find an investment that can generate cash flow in any scenario. Right now, I believe that ADA-ES (NASDAQ: ADES) can do just that.

Business

ADES develops technologies and services that companies can use to lower their emissions. They operate in three segments, Refined Coal (RC), Emissions Control (EC), and CO2 capture.

Refined Coal

Thanks to Section 45 (part (7)) the renewable tax credits are extended to Refined Coal as long as there is a reduction of >20% of nitrogen oxide and >40% of either sulfur dioxide or mercury.

ADES designed materials that could work in cyclone reactors to reduce mercury via a halogen bonding. They have since updated it (M-45) to use urea, just like Hug Engineering does in heavy duty diesel trucks. M-45 is designed to work in fluidized bed reactors, which gives ADES a much wider range of coal power plants that they can help.

This is the cash cow. Each facility generates on average $3.3M in operating income. That's based off of 15 facilities and a run rate operating income of $50 million per year. ($50M/15=$3.3M). If we take the $50 million segment income and run a discounted cash flow we can see how undervalued this is.

If only those facilities get up and running the math is simple. 15 facilities will run from 2013 until 2021, 2 will be shut down in 2019 (they opened up two years earlier than the rest ). Therefore for 2013-2019 could see operating cash flow of $50 million. 2020 and 2021 will see operating income of $46 million. For 2012 I've taken my estimate for operating income of the RC segment, which I peg to be around $19 million on a maximum capacity of 30 million tons of coal (Q2 2012 Conference Call).

I believe this is conservative because in the Q1 2012 Earnings call management said "Based on the progress with the first 15 units, we expect that our RC EBIT run rate will exceed $25M per year by the end of the second quarter, and we are comfortable with the guidance that by the end of 2012, expect the RC facilities to be generating pre-tax income of $50M per year.

So I've done a sample model. I believe that operating income could look like this...
2012: $19M ($25M EBIT run rate is 12.5M for H2 2012, plus the $7M for the other two facilities)
2013-2019: $50M
2020-2021: $44M
Discount rate 12%

NPV of operating income is $251M

Remember, they have the right to 28 facilities. The model I've constructed brings the remaining plants up slowly over 2013. I estimate (this is a guess at best) that operating income in 2013 will be around $67 million. What's great here is that barely any more facilities have to be up and running to get a decent value.

If all 28 facilities are up and running I estimate a NPV of $397M, again using a 12% discount rate.

Goldman Sachs bought their 15% JV portion for $60M. ADA-ES owns 42% of this giving ADA-ES roughly a 3X larger stake than Goldman. So Goldman must believe that ADES is worth at least ~$180M.

Using a couple of points of data we can fairly safely say that the RC segment is undervalued. Insurance company Arthur Gallagher (AJG) apparently thinks there is significant value in modified coal with their 42% investment in Chem-Mod. AJG has 29 investments in LLCs that control coal plants.

What does AJG think they will make for income?

In an April 11, 2012 conference call, AJG believed that they could generate $16.5M per quarter in after tax profit from their clean energy investments.

"We’ve put this in a tabular form here, and again what I’ve done in the first two columns is I’ve just recapped that we’ve got 29 plants, that we’ve got 31 to $32 million invested in, and we believe that the earnings that will run through the P&L ultimately can be about $16.5 million per quarter in net after-tax earnings to Gallagher." April 11, 2012 Conference Call

$66M/year isn't too bad for 29 plants. From slide 20 they believe that ultimately Chem-Mod could reach ~150-200 million tons of coal per year, with the 33 qualified plants owned by other investors contributing 100-140 million tons per year.

Therefore, I believe that AJG has directly invested in capacity of 50-60 million tons per year, which is roughly in line with what ADES has. The CFO of ADES told me that they are expecting about 50 million tons per year of RC as their baseload projection. Depending on a couple of factors this could rise up to 70 million tons of RC per year.

On page 47 of their 10Q they believe that 12 of their plants (2009 era plants) could potentially generate ~$4.3M of net after-tax earnings per quarter through 2019. Their 2011 era plants (5 total) are expected to generate $8.0M of net after-tax earnings per quarter through 2021. Annualized this works out to $49.2M....which is pretty close to my math for 15 plants. I will claim this as further confirmation bias.

While it's hard to drill into exact numbers with each plant I don't think it's necessary. A back of the envelope calculation will get you reasonably close and keeps returning you to the same conclusion: RC should generate significant cash flows for ADES.

What happens if coal prices rise or fall substantially?

In my conversation with the CFO it was made quite clear that these amounts will not fluctuate for ADES. While ADES may not have any upside (downside) like a monetizer such as AJG or Goldman has if coal prices go up (or down), they will continue to have predictable cash flows as long as they execute. I think this is very important in today's monetary environment.

One final point worth mentioning about RC is that it controls mercury at no cost to the utility. While not every plant in the country will benefit those that can take advantage of RC, reduce mercury, and save money will likely do so. I can't think of a plausible economic reason not to.

Other Business Segments

There are two other segments to ADES. Enhanced Coal(EC) and Activated Carbon Injection/Dry Sorbent Injection make up Emissions Control (ACI/DSI), and CO2 capture. The later is still a science experiment but is not costing the company money. I spent very little time researching CO2 capture and consider it a free call option.

The other two segments will not generate the absolute cash flows that RC should generate, they still could be significant thanks to the Mercury and Air Toxics Standards(MATS) program.

MATS requires compliance by 2015. Their CFO said that he expects orders to start flowing through next year.

There are several ways to become compliant and each method of compliance will not be a one size fits all solution. While some plants can use scrubbers to become compliant they also will spend $100 million or more for the luxury.

As luck has it, EC ACI, DSI, and EC all offer emissions control for much less money.

DSI is an effective method to reduce emissions and has been used for over 20 years. ADES expects to install over 200 DSI units at $3 million per unit.

ACI is a well known method for reducing mercury. It's so well known that ADES is paying royalties to Norit for the activated carbon it sells. This is a razor/razorblade business that only costs $1 million for equipment and then recurring activated carbon. There are some issues with using activated carbon though so between those problems (explained below) and the royalty payments ADES wants to get away from this. They still expect to sell about 600-700 ACI units over the next three years.

EC requires no capital equipment but results in about $2-$4 million higher fuel costs. Basically EC is a bromine additive applied to the coal (either at the mine or at the plant). Plants will see $1-$4/ton savings by using EC compared to methods like ACI. Some plants will sell their fly ash to cement manufacturers and clean fly ash is worth about $1-$2/ton. ACI does not produce clean fly ash(but there is research being done into making low carbon fly ash).

EC also allows a wider range of coals to be used, so additional savings can be seen by plants choosing to use cheaper and dirtier coals.

ADES has made the bankrupt Arch Coal a believer in EC. Arch made an investment in ADES to get the right to use EC at their mines. Luckily for ADES investors, EC is not limited to just Arch Coal. ADES has the right to offer EC to anyone else. This is good if a plant wants to choose alternative coals but still benefit from EC.

Arch could potentially treat 140 million tons of coal per year, according to the CFO of ADES. At $1/ton to ADES let the imagination run wild.

Valuation

One could slice and dice valuations (as I have) all day long. I'll try to keep this simple.

RC should generate at least $50M in operating income in 2013

Emissions control could see an average of $100 million in revenue per year for the next three years (the CFO repeated that number and walked me through some of the logistics). At 25% operating margins this works out to $25 million in operating income.

I'll assume CO2 capture remains a science project but neither hurts nor helps them.

My base case indicates $75 million in operating income, less $20 million in corporate SG&A (to be conservative, it's currently at a $16 million run rate) and a 10% corporate tax gives you earnings of around $50 million. Not bad for a company with a $240 million market cap.

Slap a 10X multiple on it because of the recurring stable cash flows for a few years and a fair value for the company could be around $500 million. A dollar selling for 48 cents. This is my base case but I think there is a lot more upside. It really doesn't matter, I just wanted to show that it's cheap.

Risk Factors

An investment in ADES is not one for the faint of heart. I can think of many things that could go wrong and will try to spell them out as clearly as possible. Ultimately, I find it difficult to believe that ADES isn't on the verge of generating significant cash flows.

1. If coal does become an economically unfavorable fuel (due to MATS there is the chance that some plants will shut down. For the RC segment this may not be a big deal. AJG spells out the risk of coal demand sinking in a clear manner.

"Page 37 – there’s a lot of questions that happen—what is the likelihood demand of coal? We do run the risk that some of these facilities will want to displace coal with natural gas. They could choose to shut down their utilities—excuse me, shut down these plants. These plants are portable. We can move them to other utilities, so if we have a utility that shuts down, we would pull them out of the housing and connections. That would probably cause a write-off of 2 to $4 million, and we’d move the plant into a different location hopefully at a utility that would continue to burn it.

Page 38 is a graphic where we show here that it’s projected through 2035 that the U.S. demand for coal actually may rise slightly. As total consumption—as total need for electricity increases, coal in this graphic looks like it will be a viable part of the U.S. energy source for a long period of time.

Page 39 shows you they’ve been burning about a billion tons of coal in the U.S. per year for U.S. electrical generation for a long time, and if that happens for the next 10 years, we should be in pretty good shape." April 11, 2012 Clean Energy Conference Call

It's worth mentioning that coal provides 45% of the electricity in the US. Not all coal plants can convert to natural gas, so coal needs to stay economically favorable or the US risks massive energy shortages. 

2. Right now ADES has 8 plants up and running, with another 9 coming online soon. If the additional RC plants don't receive PLRs (Private Letter Rulings) from the IRS

3. I think another risk will be the amount of cash coming in. What will management do with the money if they start generating the amount of cash they expect to? I don't really have a great understanding of the capital allocation abilities of management.

Insider ownership hopefully will stay high and I can only hope that capital allocation follows insider ownership. CEO Michael Durham owns 244K shares, which is roughly 6X his total compensation in 2011. CFO Mark McKinnies owns 86K shares, equaling 4.7X his total compensation. COO Jean Bustard owns shares worth 4.8X her total compensation in 2011. 

For these three executives at least 20% of all their shares are held in a pension account. While I have no idea what their pension fund balances (individual) are, I feel good that this motivates them to act as long term business owners. 

4. Political Risk is high here as well. Perhaps a new administration or Congress decides to totally ax the tax credit. Perhaps the EPA is overruled on MATS and coal plants are deemed economically necessary.  It seems unlikely given that multiple technologies can make plants compliant, most of them are cheap and low CapEx meaning any small increases in price could be passed onto the consumer with relative ease. 

5. Intellectual property risk. We only have to look at the Norit litigation to see the IP risk.

Conclusion

While the future is always unknown, I believe that ADES is on the verge of gushing cash flows. The confirmation from companies like Arthur Gallagher and Goldman Sachs certainly don't hurt for RC. ADES is no one-trick pony though and can help coal plants of different ages and technologies meet new air emission requirements in a cost effective and low capital manner.

An exact fair value is hard to pin but I believe that ADES is too cheap to need an exact value. With insiders aligned to think long-term shareholders may be rewarded for years to come. Further research will be done to contact more coal plant operators and understand PLR. Long ADES