Nov 2, 2016
Executives
John Nesbit - IMS Kevin Zugibe - Chairman and CEO Brian Coleman - President and COO
Analysts
Steve Dyer - Craig Hallum Ryan Merkel - William Blair Gerry Sweeney - ROTH Capital Shawn Boyd - Next Mark Capital
Operator
Greetings, and welcome to the Hudson Technologies Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode.
A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Mr. John Nesbit of IMS.
Thank you Mr. Nesbit, you may begin.
John Nesbit
Good evening and welcome to our conference call to discuss Hudson Technologies’ financial results for the 2016 third quarter. On the call today we have Kevin Zugibe, Hudson’s Chairman and Chief Executive Officer; and Brian Coleman, Hudson’s President and Chief Operating Officer.
Kevin will review the Company’s business operations and future growth strategies, and Brian will review the financials and immediately thereafter, we will take questions from call participants. Let me 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, or predictions about the future are forward-looking statements.
Although they reflect our current expectations and are based on the best view of the industry and of our business as we see them today, they are not guarantees of future performance. These statements involve a number of risks and assumptions, and since these elements can change, we would ask that you interpret them in that light.
We urge you to review Hudson’s Form 10-K and other SEC filings for a discussion of the principal risks and uncertainties that affect our performance and other factors that could cause our actual results to differ materially. Okay.
Now, I’d like to turn the call over to Kevin. Go ahead, Kevin.
Kevin Zugibe
Good evening and thank you for joining us. I hope all of you had a chance to review our third quarter 2016 earnings release issued this afternoon.
We are very pleased to we have delivered strong third quarter results, culminating in record revenues, significant gross margin improvement, and enhanced profitability. In the third quarter, our revenue growth and margin improvement resulted primarily from higher average pricing on certain refrigerants including R-22 as well as some improved pricing on HFC-based refrigerants.
Additionally, we saw an increase in the number of pounds of certain refrigerants sold during the quarter, and for the nine-month sales season, we achieved our targeted volume growth rate between 10% and 12%. R-22 versus an HFC remains the most widely used refrigerant, we continue to see incremental price increases throughout third quarter with the greatest price increases coming towards the end of the quarter.
Currently, we are seeing R-22 price at over $18 per pound. Additionally and as previously announced, during the quarter, we were awarded as the prime contractor of substantial Department of Defense DoD contract.
As discussed in our last call, we expect to see volume from this contract in the second half of 2017. Also on a noteworthy development for our industry, just two weeks ago, the parties at the Montreal Protocol reached the global agreement to amend the protocol to provide for a phasedown of hydrofluorocarbon or HFC compounds by 85% between now and 2047.
The amendment establishes different time tables for all developed and developing countries leading to a reduction in global production and use of HFCs. The U.S.
is now in a position to ratify and begin the process of creating a systematic solution to comply with the terms of the amendment. HFCs have been the next generation refrigerants developed as an alternative to CFCs and HCFCs such as R-22, which were designed to have zero impact on the ozone layer.
However, although HFCs have zero ozone depletion properties, as climate science advanced, HFCs were determined to have high global warming effect and efforts began to find alternative gases that have less impact on the climate as well as on the ozone layer hence the call for the HFC phase out. The industry has begun to commercialize alternatives for HFCs including hydrofluoroolefins or HFOs as well as a range of natural alternatives.
These transitional changes are currently most evident in the automotive air conditioning market whereby new cars have gone from R-12, a CFC to R-134a an HFC, and now to 1234yf an HFO refrigerant. All of these changes are as a result of ozone and global warming science and other precursor to the much larger HFC phasedown that we are about to begin.
The recent agreement of the parties in Montreal Protocol has been called the major policy step forward in the global effort to reduce greenhouse gas emissions. Because nearly all new equipment, as well as the equipment that is replacing R-23 units uses HFC refrigerants, reclamation will be a key element to facilitate in orderly phasedown.
We look forward to applying our reclamation capabilities to assist with the systematic and global phaseout of HFCs, as well as next generation refrigerants as the industry continues to evolve. Our ability to reclaim all HFCs represents an even larger recommendation opportunity beyond the R-22 phaseout as HFCs have been continually replacing the CFC and R-22 based system.
We’re pleased with our strong performance in the third quarter and with the results of the 2016 selling season. We continue to build on our established reputation in the industry as a longstanding advocate for the orderly phaseout of high global warming gases.
And we believe the strong reclamation program in essential to facilitate and accelerate the phaseout of these harmful gases. Additionally, we believe, we’re uniquely positioned to play a key role as our industry continues to transition to the development and use of next generation climate and ozone-friendly technologies in refrigerants.
With that, I’ll hand the call to Brian to provide our detailed financial results.
Brian Coleman
Thank you, Kevin. Revenues for the third quarter increased 61% to $34.9 million as compared to the $21.7 million in the third quarter of 2015.
The revenue increase was primarily driven by an increase in the price per pound of certain refrigerants and higher volume of certain refrigerants. Gross margin increased to 34% as compared to 20% in the same quarter last year, primarily to an increase in the price of R-22 refrigerants as well as improved pricing for HFCs.
Operating expenses for the quarter increased to $4 million compared to $2.5 million in the previous year quarter. The increase is primarily due to approximately $1 million in non-recurring expenses related to the stock compensation and fees associated with the recently award government contract.
Additionally, there were approximately $200,000 of computation professional fees incurred in connection with the transition to a new CFO, who was announced earlier in the quarter. Net income for the quarter increased to $4.8 million or $0.14 per basic and diluted share compared to net income of $1.1 million or $0.03 basic and diluted share in the third quarter of 2015.
Our balance sheet remains strong. As of September 30, the company had $67 million in inventory compared to $62 million at December 31, 2015.
Our inventory levels typically tend to increase towards the end of the refrigerant sale season as we prepare for next year. At the end of the quarter, we had approximately $28 million of availability under our credit facility and approximately $56 million in working capital.
I’ll now turn the call back over to Kevin.
Kevin Zugibe
Our 2016 refrigerant selling season was very strong and we’re encouraged by the growth opportunity being presented by the ongoing phaseout of R-22 and by the future phasedown of next generation HFCs at the beginning of 2019. We continue to work in Washington as well as in the industry to position reclaimed refrigerant as the first choice for system owners while servicing the installed base due to the significant environmental benefits.
As evidenced by the recent agreement to amend the Montreal Protocol, there’s increasing international concern around global warming that will likely drive additional phaseouts and the subsequent adoption of reclamation across all classes of refrigerants. Reclamation provides an immediate opportunity to achieve dramatic reductions in greenhouse gas emissions by reducing the need for the production of new molecules of refrigerant gas without having to make immediate investments in new equipment and technology.
As a leading provider of reclaimed refrigerants with significant infrastructure and capacity, Hudson has consistently led industry toward alternative sustainable solutions for servicing the refrigerant aftermarket and we believe we’ll continue to play a significant role in the orderly and global phaseout of these gases and in the evolution to more environmentally friendly refrigerants. Operator, we’ll now open the call to questions.
Operator
At this time, we’ll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Steve Dyer of Craig Hallum.
Please proceed with your question.
Steve Dyer
Just wondering, given that the R-22 pricing of late and through the course of the last three, six, nine months, what differences you are seeing in behavior, both, are you seeing reclamation volumes starting to change meaningfully on the reclaimer side, and then I wonder if you’re seeing any change in the use of substitutes on the other hand?
Kevin Zugibe
Well, on the last part, we’re not really seeing substitutes, we’re not seeing any change there at this point. Again anything can change, we saw that I think in 2013 for a little bit, but we haven’t seen that again.
There are substitutes out there and we would expect potentially that could happen. With the growth for reclaim, obviously as the prices are coming up, more people are paying attention to it.
I would say at this point we can’t tell in the season exactly. But again, refrigerant sales season, we can tell by the first three quarters, reclamation is really the last three quarters.
So, we still have more reclamation to go to know where we’ll end up in the year. But at this point the growth -- I’d say the growth trajectory isn’t, believe it or not, isn’t as steep as it was last year.
We seem to be having a little bit better of a curve going up. Although it’s been very good road, season still has long life left before the end of the year.
But from the reaction and the psychology in the market, it looks like more people are obviously realizing that this is getting to be serious now. So, we’re seeing more people get involved; more people getting onboard with programs than we have ever seen.
So, that usually means that it’ll be more again. So, we’re not -- we just look at the sales season for now, we can’t quite tell where it it’ll end for the year.
Steve Dyer
And then just for a follow-up, wondering if you could give, if there’s any updates kind of on the DoD award; timing, it sounds like it’s still maybe second half of next year? Does that require any -- whether it’s working capital or any -- would you expect any expenses to sort of gear up to that in the first half of the year?
Kevin Zugibe
Not really. We’re going through this period, which is a 12-month period of transition, which was part of the contract for which there is fees associated with that.
So, there are some nominal amount of fees that we are getting. But in terms of capital cost, we think there will be capital costs going forward relative to the contract.
But we think as it relates to typically our annual spend, let’s just say annually we spend about $1 million, which is sort of less than our annual depreciation and amortization expense, the total dollars that we spend will increase. It’s just that we may be shifting dollars that might have supported additional capacity into the reclaim area towards some additional spend relative to support this contract.
On an overall basis, we don’t think it’s going to be material or materially affect what our annual spend has been and we think that will be true for the foreseeable future.
Operator
Our next question comes from the line of Ryan Merkel of William Blair. Please proceed with your question.
Ryan Merkel
So, I want to ask first on gross margin, another nice beat there. I think usually, seasonally, it’s down sequentially if I am correct; and this time, it was up.
So, can you just walk through why that was and what really drove that gross margin beat?
Brian Coleman
It really was the increases in the 22. So, we did expect increases in 22 this season.
We did think let’s say throughout the season, we would end up in the upper 20s. We didn’t necessarily think we would get as high as 30%.
We certainly didn’t necessarily think that the third quarter could be 31%. But really the R-22 pricing increased, but particularly increase during that third quarter probably at overall greater rate than it might have in the first six months or during beginning of the season.
So the whole will driver to the higher gross margin then let’s say one might have thought about is really because the price of 22 was up.
Ryan Merkel
So, then, we think about next year, what’s the reasonable gross margin target you think and what if the increase in R-22 for the season wasn’t as strong that was this year, would that impact your gross margin improvement?
Brian Coleman
Probably, again, going into next year, we would think our gross margins should be in the upper 20s, possibly maybe close to 30, but we really won’t have a good feel for that or an answer for you all for that until we get into let’s say the earnings call for the fourth quarter. because at that point in time, we will have a better understanding where 22 is; we would have -- this is a time in the year where we’re laying plans for next year, also trying to understand dynamics of the marketplace relative to pricing and so on.
We still think there is upper trajectory in the price of 22; by no means do we think we are out of sealing [ph] yet, we don’t see any side that would cause us to think so. So we are still anticipating further price increases on 22.
Again, we don’t want to predict how rapid and how large they might be. We would tend to try to measure this in a more conservative way.
That’s why we might think next year that possibly gross margins for the 2017 season are in the upper 20s to maybe 30, but maybe not higher than that. But we will be talking about that most likely in connection with the fourth quarter earnings call.
Operator
[Operator Instructions] Our next question comes from the line of Gerry Sweeney of ROTH Capital. Please proceed with your question.
Gerry Sweeney
I wanted to talk a little bit about the revenue. As we exited the second quarter or in the second quarter call, you could mentioned volumes, there was a line in the press release essentially saying volumes were little bit lower and then obviously in this quarter especially, volumes were a little higher and you did mention should you get hit 10% or 12% growth year-over-year.
How much of this was a better third quarter volume shifting in the third quarter and was that just sales shifting because of the price of R-22 going up and guys not wanting to hold inventory or is there anything changing in the market as to how some of these sales are developing?
Brian Coleman
We don’t think so. That’s why, again, we like to look at this, so we suggest everyone should look at this as a nine-month season.
We weren’t let’s say disappointed that the volume might have been down a little bit in the second quarter because we didn’t see any permanent trends that would cause us to think that there was some permanent change in demand or customers or the like. So, that’s why we say, we never can quite measure how and when someone will buy.
But you know throughout this season, as well as warm days early, typically May, June, you’re going to have a good year, good season. And it always seems to play out.
Because we have a strategy to add customers and then try to sell more products and services to the existing customer base, we’ve been able to for many, many years now attain that volume growth in that 10% to 12% range. The last part of your question, I think was, is there anything different in this third quarter or this season relative to other years in terms of buying behaviors or inventory, we don’t think so.
People bought. Certainly prices improved toward the tail end of the season, because I think as Kevin mentioned a few minutes ago, technologically people are believing more that there is a tightness in supply.
And so I think that helps anyone in this industry to take little bit advantage on a price basis. So, I don’t think there is any unusual events here.
It just was a good season and we continue to execute in the ways we think we can.
Gerry Sweeney
Okay. And then just jumping back to the reclaim side, obviously -- I mean, I look at reclaim as we’ve got some great acceleration in price in the last couple of years, 5, 10, 15, close to 20 now.
But the next sort of leg of growth for Hudson is reclaim pounds just growing. And it sounded like reclaim activity was okay, not great.
But as we go into next year and volumes come down, what do we need to see -- what needs to happen to this reclaim activity to increase, because there is going to be a pretty large gap between production and aftermarket demand?
Kevin Zugibe
The reclaim season isn’t over. So, I mean part of where we are today, sometime when it’s hot year, the returns are slow while it’s hot, and then they catch-up later.
And it’s kind of looking back to this timing of refrigerant sales why one quarter’s result isn’t necessarily indicative of another. So, we still have more time in terms of return, still several -- there is a good bump and it has yet to come.
So, we’ll measure it. We certainly, as we do this time of year, have dialogue with our customers what worked, what didn’t work, what we could change.
So, we’re going to go through all those typical things that we do every year about the programs and certainly continue to find ways to expand it and if we need to modify some of the strategies, we’ll do. But we still are happy with what’s happening in terms of the volume growth and we are expecting to continue to see growth reclaim.
Operator
Our next question comes from the line of Avril Cole with Cole Capital. [Ph] Please proceed with your question.
Unidentified Analyst
Two questions. One on R-22, can you be more specific in terms of what the average price per pound that it was being sold at this past quarter and how much of an increase that was year-over-year?
Brian Coleman
The increase year-over-year at this point is above 40%, when you look at where we are now relative to where we were a year ago. We typically talk about these price increases though in terms of the season.
And so, back to for example last year, where we had seen prices probably let’s say seven to 10, this year, we’ve seen it from 10, mid-10 to 18. So, you’d see that the gallop was so much greater this year.
But in terms of pricing, most of the sales for this particular quarter would have been more at that $15 number than $18 number because most of the sales that one has typically -- and again there’s never anything perfect, most of the sales in the third quarter are going to happen in July as opposed to September. Our customers typically are destocking their cooling equipment and their inventories in that July period to August because they’re beginning to stock the heating equipment they need.
So, in terms of price improvements in the third quarter, you generally get a significant benefit of that left spikes in prices if you will because the volumes would have tailed off by September.
Unidentified Analyst
And then as a follow-up, if you look at your R-22, you would see on-hand the inventory, you hold how much R-22 typically, is it a month of supply, four months of supply; how well stocked are you that helps to supply when the season begins?
Brian Coleman
Really just answer is it doesn’t matter what refrigerants, probably an answer across the board for all refrigerants. Typically our strategy is to hold or acquire inventory certainly within the third and fourth quarter in advance of the sales season, which will happen typically in the first and second quarter.
And so, as a consequence, our inventory turns are fairly low; and that’s true for all refrigerants. We do that because our industry from a production side or on acquisition or product side could never operate in a just in time model, because it’s extremely seasonal.
Particularly when you get warm weather, let’s say from St. Louis across to Washington DC in north, once that kicks in, the volume increases are very significant.
And no producers or the industry could produce enough in that short window of time to operate in that just in time model. So, historically, we’ve always looked to purchase in advance of the season typically more in the third and fourth quarter to carry the inventory into the season.
Unidentified Analyst
And then just finally, obviously you guys have utilized FIFO accounting which in the current environment has been helping you have a stellar year here in 2016. But it kind of creates a situation where it’s tough for you to kind of grow your profits for 2017.
So, I’m just wondering, does the FIFO accounting make the most sense or would you better off over time actually using micro accounting?
Brian Coleman
Well, we couldn’t go to LIFO now once you’ve established, FIFO. But I don’t think the accounting methodology really matters frankly.
It really is, again, as we said right now, each season is a standalone season. One of the earlier questions and answers were our gross margins won’t necessarily be higher next year than this year.
We may or may not see 31% gross margins, for example in the third quarter of 2017. What we look at is a season and for example back to the -- answer to the earlier question, starting next year, believing or thinking about upper 20s to about 30% on the gross margin for 2017 probably isn’t [ph] a reasonable view, certainly it’s something we’ll provide more clarity when we report the fourth quarter because then obviously we will understand where the pricing in 22 is.
But to be specific to the answer about gross margins, it’s extremely difficult to predict gross margins for the future unless you are able to exactly predict the price of 22 for the future.
Operator
Our next question comes from the line Shawn Boyd of Next Mark Capital. Please proceed with your question.
Shawn Boyd
Couple of quick ones. As we think about the recent amendment of Montreal Protocol, are you seeing any lift in the market yet on prices on agencies due to that; are you seeing anything out there in the field related to that?
Brian Coleman
In terms of let’s say the announcement, the announcement in and itself would not necessarily affect any pricing conditions whatsoever. I am not sure how many earnings calls you’ve listened into, but probably some of the longer, shareholders have heard this whole sage of ups and downs on this HFC pricing, mainly due to the Chinese lowering the price consistently to a point at which an ITC case was presented to indicate that the Chinese were dumping product and selling at prices below what U.S.
manufacturers could produce it at. So, we probably currently are benefiting and have benefited during the season more on higher prices in HFC as a result of ITC case and probably that would be true for the next season for example as opposed to relative to the specifics that there is a global amendment to the Montreal Protocol and so forth.
But this development of the amendment to Montreal Protocol is absolutely extremely significant for Hudson Technologies, not necessarily next quarter or next year, but absolutely for the long term. At the end of the day, what we have now seen from both the high side and what we are expecting to see with regards to 22, will likely repeat itself relative to HFCs.
And if you want to put it in perspective as to where the 22 opportunity was to where it is today, with these phaseouts, the price of 22 is likely at least going to be 20 times greater as a result of the phase up and what the pricing was relative to before the phaseout. And so, to look at the HFC opportunity, it’s likely that it’s going to follow a very similar pattern and we may see something like 20x growth in the pricing of HFCs.
Now that will be over a long period of time but it very seems plays out the way we look at the past to predict the future. The HFC phaseout likely going to be larger than this R-22 phaseout, because it’s a 100% of the market.
Shawn Boyd
Got it. So near term it’s really driven by the ITC decision longer term, think about that from Montreal Protocol?
Brian Coleman
Correct.
Shawn Boyd
Okay. And then just for perspective again, this has been a while, in terms of your refrigerant and reclamation sales, that line as I recall pretty much mimics to of broader market, which would split roughly 70% R-22, 30% HSCs?
Brian Coleman
That was true maybe a couple of years ago. Last year, we thought it might be more like 65, 35.
It’s too early; there isn’t enough data out yet to state where we are this year in terms of what the mix is, but it might be now 60-40, 60% 22 and 40% HFCs. We have to remember, the HFC are growing sort of from a two-fold basis, just overall growth in the market and let’s new construction, that terminology, it’s going to be an HFC system.
But in addition to the extent that the 22 units are going away, which they are, they are being replaced by an HFC system as well. So, there is a fairly substantial growth each year on HFC volumes and a slight decline each year on the 22 volumes.
Shawn Boyd
Okay. I appreciate it.
And last thing for me is on the DoD contract. So, can you help us just -- I know you said that we should start to expect revenue starting in the second half, but is it a one quarter implementation or four quarter implementation?
How long should we expect that to take to ramp?
Kevin Zugibe
It’s difficult to say. We would certainly think our first year of the contract, we may not on an annual basis achieve the same levels we might expect in future years.
So probably the first year of the contract, the revenues might be lower than later years. But that may not necessarily be the way to look at this, because there is nothing specific on annual basis, it’s really to aside how this is set up and can you achieve the full set aside there in term of the contract.
Shawn Boyd
Okay. And then just last clarification point and then I’ll jump off here, on the operating expenses.
If I understood it, we had about $1 million in non-recurring. So, we should probably see that OpEx jump drop back this quarter?
Brian Coleman
We probably had you could 1.2 million because we also had the 200,000 in the whole transition, the fees associated with the new CFO. It might be another 18 years before we go through that.
Jim was with us for quite a long time and did a great job for us. But certainly we had a spike here in this quarter with those charges and those we would look at as non-recurring.
Operator
Our next question comes from the line of Steve Dyer of Craig Hallum. Please proceed with your question.
Steve Dyer
Just a follow-up question on the DoD contract. It sounds, I guess, I’m trying to understand maybe from a modeling perspective how to think about the revenue cadence and maybe you don’t even know at this point.
I mean, my understanding is for 10 years up to $400 million. Give any visibility as to how close to that you’ll get and how sort of linear or regular the revenues will be on that?
Brian Coleman
We don’t really have visibility as to let’s say how linear it is. Back to the earlier question, we do think it’s more likely than not our first year will be slower than later years, whatever words you want to use around that.
Part of our responsibility for serving the contract is also it’s marketed and to create awareness in various agencies that the contract exists and that they should consider procurement through the contract as opposed to their own existing budgets. So, there’s work there and we may have talked about this before, there’ll be some incremental increases in SG&A, particularly the selling side, the marketing side to support that.
But in terms of let’s say -- I’m not sure if the second part of the question was like seasonality; it doesn’t look like this procurement has a seasonal attribute to it, nor does it look like this procurement to the extent you wouldn’t benefit because of some sort of military action or some sort of surge, it just looks like standard every day kinds products that are used or consumed that are within the contract itself.
Operator
Our last question comes from the line of [indiscernible]. Please proceed with your question.
Unidentified Analyst
Just a quick question; is there any opportunities for acquisitions in your business?
Brian Coleman
We’ve looked at acquisitions and actually completed a few little over two years ago, approximately two years ago. When we look at the reclamation market, there are a couple of large organizations and then there’s a lot of small companies, owner-managed companies typically.
The remainder of those organizations probably have very low single-digit market share. And we’re not necessarily inclined at this point to say that there’s an acquisition or roll up strategy there; it’ll be lot of work likely.
We have talked in the past about some of our services, in particular energy optimization services, and whether there might be some complimentary companies that are already performing services that are similar or might be enhanced or we could enhance what they already offer and that those might be candidates for acquisitions. But in this space right now in terms of particularly reclamation, we don’t necessarily see acquisitions on the horizon, but certainly we’d be open minded.
Operator
There are no further questions over the audio portion of the conference at this time. I would now like to turn conference over to management for closing remarks.
Kevin Zugibe
I’d like to thank our employees, our long time shareholders and those that have recently joined us for their continued support. Thanks everyone for participating in today’s conference call and we look forward to speaking with you after the fourth quarter results.
Thank you.