Hydrodec (AIM:HYR) is a clean-tech oil re-refining group with operations in the USA and Australia. Their USP is a world leading, unique proprietary technology which is best in class and protected by a 20 year US patent. to re-refine used and contaminated waste oil to produce, market and distribute SUPERFINE™ carbon neutral, transformer oil and naphthenic base oil using an almost zero emissions process. The award of the US patent reinforces the strength of their technological offering and market leadership. Hydrodec is the world’s only oil refining business to receive carbon credits.
The technology is a proven, highly efficient, oil re-refining and chemical process. The contaminated waste oil is currently processed at two plants at canton, Ohio, US and New South Wales, Australia respectively, with distinct competitive advantage process that delivers very high recoveries (>99%), producing transformer oil that tests ‘better than new' at competitive cost and without environmentally harmful emissions. The process also completely eliminates PCBS, a toxic additive banned under international regulations. Very Importantly, the process can be repeated infinite times.
In 2016, Hydrodec received carbon credit approval, enabling its product to be sold with a carbon offset and creating an incremental revenue stream. The Group is now generating carbon offsets through the re-refining of used transformer oil. This is a highly distinctive feature, confirming (as far as the Board is aware) Hydrodec as the only oil re-refining business in the world to receive carbon credits for its output. This is a significant endorsement of the Company's proprietary technology and standing as a leader in its field, Hydrodec is moving towards a uniquely environmentally friendly business model within the refining and re-refining industry, founded upon a world-leading technology.
Historic Issues leading to the 2018 Opportunity
In December 2013, Hydrodec’s Ohio plant suffered a major setback caused by a huge fire, which arguably set back the company for a three-year period whilst the plant was re-built and production gradually ramped back up. This setback coincided with World Oil prices falling to $30 leading to significant margin pressures and resulting operational losses. This is all in the past now, and, as I will demonstrate below, the company is entering 2018 with its strongest ever operating and financial performance and is in the midst of a huge transformation as it crosses into profitability for the first time in its history and aims to exploit a US$2.8bn market.
As I explore the investment case, it’s important to firstly acknowledge the sheer strength of the world class, patented technology and the size of the market within which it operates.
Market Size & Opportunity
MarketsandMarkets research forecast that the global transformer market is set to grow from US$1.98bn to US$2.79bn by 2020, of which Hydrodec has 2016 revenues of US$16.8m (a market share of 0.01%) so the opportunity is vast.
The new Canton plant is running at 61% capacity in 2017 which is now operating at EBITDA positive for the first time in the company’s history. This leaves significant room for growth and since June 2017, WTI prices have risen over 75% which in turn is propelling margins from 10% in Q1 2017 to 19% in Q1 2018
The company also intends to capture significant market share by licensing its technology to 3rd parties and expects to obtain a 5% royalty (this will be covered later) but clearly, the size of the market and with licensing opportunities, the company has an enviable competitive advantage and has issued this bold statement about its plans:
The proprietary, best in class, technology re-refines used naphthenic transformer oil, both non-PCB and PCB-regulated, into sustainable, high quality SUPERFINE™ oils for re-use for original purpose.
In 1992, the Australia’s government-backed Commonwealth Scientific and Industrial Research Organisation (CSIRO) conducted research for the nation’s power industry to find a way to deconstruct the potential cancer-causing organic compounds, polychlorinated biphenyls (PCBs), from used naphthenic transformer oil. The result was nothing short of remarkable:
· The hydrogenation process cleans and restores the hydrocarbon molecule
· An almost zero emission process producing no hazardous waste products
· Industry-leading recovery rates (>99%), and good operating efficiency; and
· A clean, consistent transformer oil product which is ‘as good if not better’ than new transformer oil, and meets all relevant industry standards for unused transformer oil.
· Very importantly, this process is repeatable infinite times
The Patented Hydrodec Hydrogenation Refining Process:
Carbon Credit Project Approval
In September 2016, American Carbon Registry ("ACR") has approved Hydrodec's patented technology as a carbon offset project in the voluntary carbon offset market, creating an incremental revenue stream for the Company and establishing Hydrodec (as far as the Board is aware) as the only oil re-refining business in the world to receive carbon credits for its output.
Hydrodec of North America ("HoNA") is now generating offsets through the re-refining of used transformer oil, which would otherwise ordinarily be incinerated or disposed of in an unsustainable manner. The announcement can be found here
On the 12th July 2017, Hydrodec entered into a management services agreement in respect of the sale of all carbon credits generated by Hydrodec of North America ("HoNA") with 3Degrees Inc.
This is another significant step forward in leveraging the accreditation gained from the ACR for the Hydrodec process in 2016. Using 3Degrees will also ensure the process of monetising the carbon credits will be as efficient as possible without calling on management time.
Hydrodec anticipates that going forward it will generate 50,000 to 60,000 tons of carbon offset
annually and expects it could earn up to $5 per ton from the ongoing generation of such credits based on recent industry publications. The announcement can be found here.
This is a very interesting time to be accredited as the only oil re-refining business in the world to receive carbon credits for its output.
The world’s largest O&G companies are under pressure to reduce their carbon footprint. Click here and here for recent headlines from Shell, about the pressure it’s facing from shareholders to reduce its carbon footprint. Also, Exxon Mobil is under similar pressure click here
And finally, a generic headline of the O&G industry in general can be found here
Hydrodec is in a very interesting space here and clearly it has a business model that would be very valuable either on a wide scale licencing of its tech, or it could be a full takeover target by a big player.
This is a game-changer for Hydrodec and they have made no secret of their ambition to licence their world class, patented tech and estimate that royalties would be around 5%. Confirmation of the first licencing agreement would be ground-breaking for the company and provide opportunities to capitalise on that US$2.8bn market opportunity.
Hydrodec have recently advertised for a role of a ‘Group Process Engineer’. One of the key objectives of this role is:
- Work with appropriate business groups within Hydrodec to support licensing of the proprietary Hydrodec technology to outside interests. Organize and direct pre-commissioning, commissioning and training activities for new licensee operations. Work directly with engineering companies and construction contractors to ensure new licensee facilities are designed & constructed per Hydrodec requirements.
Clearly Hydrodec are preparing the ground for Licencing of their tech and an announcement of a deal could have a very significant positive effect on the SP due to the size of the market opportunity and the first deal always provides the blueprint for other deals to be negotiated
The job advert and role-spec can be found here.
Company Structure & Assets
Hydrodec has assets on the balance sheet (excluding debt and as at 30th June 2017) of $39.9m, producing a company net asset figure of $19.9m (£14.31m) after the deduction of $20m of net debt. The company has a MCAP of £10.82m and is therefore trading at a 24% discount to its net assets of £14.31m
The balance sheet appears highly geared with $20m of net debt. The directors took this route to avoid painful dilution to shareholders in order to finance the company through the difficult period in the aftermath of the Canton fire and collapsing world oil prices.
It’s important to note that roughly half of the debt is on finance lease arrangements at interest rates c.4% and repayable on a 7-year term so this debt is reducing within the normal course of business.
Within the remaining element of the $20m debt, there is c$7.3m owed to the company’s largest shareholder and NED Andrew Black. It is his support for the business that has carried them through the difficult times and therefore avoided the need for the company to raise equity funds and dilute shareholders at the low points. Andrew has very recently (28th Dec 2017) agreed to renew these facilities for a further 12 months until the end December 2018, the announcement can be found here
My personal opinion is that this structure lays the foundations for a significant re-rate of the share price given that in 2014, the company had a MCAP of £90m with the same shares in issue and facing into significant headwinds at that time. The company is now the strongest it’s ever been, and passed a significant milestone in 2017, generating positive EBITDA for the whole of 2017, with increasing profitability in the second half. This is the first time in its history that it has generated a positive EBITDA for the year.
Here is a chart of the number of shares in issue which demonstrates the massive achievement by the BOD to navigate the historic issues with the support of Andrew Black and avoid shareholder dilution:
2017 Trading Performance
2017 has been a transformational year for HYR. Due to the tougher environment of 2014-16, it’s new CEO, Chris Eliis (with his Chartered Accountant background and previously the Chief Financial Officer of HYR) cut costs and HYR has emerged a much leaner company with a significantly lower cost base.
It has also reshaped the business by improving the mix of re-fined oil to the higher margin ‘Transformer Oil’ as we can see from the slide below, taken from the AGM presentation in June 2017:
The holy grail of any business is to cut costs and at the same time improve sales margins.
HYR are demonstrating this clearly, but it’s important to note that the WTI Oil price were around $41 in June and has since risen by 75% to $72
2017 Q3 Trading Performance
Q3 is historically the strongest quarter of the year and HYR produced the strongest quarterly EBITDA performance in the groups history, producing EBITDA of $330,000 (an improvement of $605,000 over Q3 2016, which was negative $275K). This confirms HYR is entering the inflection point and is heading towards generating cash and soon to be underlying profitable.
WTI prices increased during Q3 and in to Q4 and remained so into 2018, so this bodes well for continuing the 2017 trends of increasing margins.
Within the Q3 update, the company also announced the award of a two-year agreement to supply up to 7.6 million litres annually of its SUPERFINE transformer oil to a major transformer original equipment manufacturer ("OEM"). To put this contract into perspective, it is the supply of the higher margin transformer oil and HYR sold 8.7m litres of this in the first six months of 2017. So if this contract delivered the annual 7.6m litres (3.8m litres for six months) it increases the transformer oil sales by a massive 44%.
This contract is with a major transformer US OEM manufacturer so it is a good indication of further contract wins to come.
It’s also important to note that in Q3 2017, the Canton plant only performed at 61% capacity (as in H1 2017) so this leaves tremendous room for growth with these new contracts.
The full Q3 Trading Statement can be found here
2017 (as a whole) Trading Update
Traditionally, Q4 and Q1 are slower periods due to seasonality. The Christmas shutdowns in both Australia and the US affect both the availability and collection of feedstock as does periods of extreme cold weather.
HYR announced its full trading update on 29th January 2018 for the whole of 2017 and the company announced it was its best performance in its history, generating EBITDA of $450K for the year. This included c. $100K for Q4 which was its slower period and also in the midst of the deepest freeze on record early December (in the US), leading up to the Christmas break. Against this backdrop, the Q4 $100K generated was another positive achievement for the company.
Margins continued to expand substantially, growing to 14.5% in 2017 (up from 5.2% in 2016) and the sales mix of higher margin transformer oil increased to 52% of total oil sales (up from 40% in 2016).
The company again flagged that the availability of feedstock is constraining plant utilisation which remains at 61%, however, they continue to work on securing the number and value of significant feedstock contracts which will drive an increase in plant utilisation. This hamstring also presents the opportunity because when they sort it (and WTI in the mid 60’s is helping) the Canton plant has significant scope to ramp up production from its current 61% utilisation. As the price of oil rises, the fixed transportation element of the feedstock price becomes less as a proportion of total price and allows the company more flexibility in what they pay. The company is also raising selling prices of their products to reflect the quality of the product and that in turn will allow them to pay more for feedstock whilst maintaining margins.
The company outlined its bullish 2018 forecasts which are to increase its plant utilisation to ‘at least’ 70% and to improve the sales mix to ‘at least’ 60% high margin transformer oil.
The combination of higher margins plus a 15% increase in plant utilisation will drive further, significant increases in EBITDA and push the company into profitability and beyond. This is without the strategic plans coming to fruition such as licencing the tech. Indeed, the company specifically stated:
“As well as focusing on expanding the number and value of significant feedstock contracts to increase throughput in our existing operations, the Group will continue to pursue other strategic growth initiatives that will ultimately seek to accelerate the Group's overall profitability” … this bodes well for an exciting 2018 ahead!
So an improved sales mix leading to higher margins and a 15% growth in plant utilisation will lead to another jump in EBITDA, whilst the company is now also generating an income from the sale of its carbon credits.
It’s important to note that the margins are rising in tandem so this adds a third element/growth driver and finally, the company has been reducing costs so put all four components together (Rising plant output, improved sales mix, rising margins and reduced costs) and its clear that 2018 will be a very successful year, building on the record 2017.
The full announcement can be found here
The company announced on 4th April 2018 that Chris Ellis CEO has resigned due to an illness of a close family member. Lord Moynihan, the Chairman of the Company, will take up the position of Executive Chairman and Interim Chief Executive Officer while the Board considers the composition of the senior executive team going forward. Andrew Black also assisted with an additional working capital injection of £500K which will be interest free and bear no arrangement fees. The full announcement can be found here
Q1 2018 Trading Update
Q1 is notoriously the most difficult quarter for HYR due to feedstock collection, which is vital to drive the plant utilisation. Q1 suffered some weather-related setbacks in terms of sourcing the feedstock which caused a ‘headline’ disappointment with the revenues for Q1. However, there are also a number of underlying positive trends that need to be considered here. HYR say the weather disrupted their main partner G&S ability to supply their budgeted volumes of feedstock and also othersources of supply were similarly impacted.
Firstly, despite the revenue drop, I calculate that the Gross Profit for Q1 will be ahead of Q1 2017 and also it will produce a higher EBITDA than Q1 2017 (although lower. than the recent quarters of Q3 & Q4 2017), but still EBITDA positive at company level, driven by (as the company states) materially higher Canton EBITDA than the same period last year.
By way of example:
In Q1 2017, Gross Profit Margins at the Canton plant (which is where the majority of revenue comes from) were 10% and revenue was $4.5m so Gross Profit would have been $450K
So looking at Q1 2018, based on a revenue of $3.5m and a gross margin of 19%, overall Gross Profit will have been $665K, so despite the weather-related setbacks, still ahead of $450K Q1 2017.
We know they were EBITDA positive in Q1 2017 (from the Q1 2017 trading update) so assuming most other expenditure in the P&L statement are constant (which it should be as the main variable costs are within the Gross Profit section) then they will have produced a higher EBITDA than Q1 2017.
To support with the working capital requirements, Andrew black recently lent another $500K and also the vintage credits receipt of $190K will help too.
That brings us to the future. It’s now becoming clear that margins are trending up particularly in the US as they improve the sales mix and also raise prices due to the quality of the product.
These underlying trends are actually very positive and we can see from their commentary that they are focused on growing the core US business, where there is a strong demand for their product.
If they manage to obtain a strategic deal/partnership to secure increased sustainable feedstock (especially in the US) then the underlying trends of the business will shine through which will have a sharper, more significant impact. The Canton utilisation was 61% last year, so there is huge scope for ramp up of utilisation.
The work “concluding with Simmonds & Co” signals they are closing in on something and also, they see “scope for new partnership arrangements” to facilitate increased supplies of feedstock.
There are execution risks (as with all small companies) and it’s down to the execution of the board, but I see much stronger underlying business trends in the making and underpinned by demand for the superior & higher margin superfine product as evidenced by the 2-year sales order with the US OEM.
Patience required but on receipt of a Feedstock deal/partnership, the underlying business will, as the board say in the RNS “materially improve the Group EBITDA and cash-flow generation going forward”.
At 1.45p HYR is trading at a 25% discount to net asset value in the balance sheet (ie, after the debt is deducted from the net assets on the balance sheet) so there is comfort that net assets are worth much more than the current MCAP.
Keep all eyes peeled for an announcement about a feedstock deal/partnership in the coming days/weeks/months because that will contribute significant and very material value to this company.
The full Q1 2018 announcement can be found here
Exit of AVIVA shareholding and introduction of new large investor
Throughout the difficult periods of 2015/16, Aviva (a large holder) were persistently selling down their holdings which further hampered the share price and drove it down to a historic low point in October 2017.
With a holding of 95m shares (12% of the company) this was a painful process and any share price gains in 2017 warranted due to the turnaround of the business was quickly sold into by Aviva, destroying already beaten down investor optimism. Why buy when you know Aviva will sell and drive the price cheaper?
A significant breakthrough came on 1st November 2017 when a sudden spike in buy volume took hold and cleared the remaining 57m Aviva shareholding in one afternoon. It is believed to have been an orchestrated move by High Net Worth individual buyers wishing to remove Aviva from the share register. In one swoop, Aviva were gone and the holdings announcement can be found here
New investors had previously emerged in early October with Hugo Bulmer buying a 3.4% stake in the company. This has totally transformed the share register and removed the brakes on the SP. The announcement can be found here
On 27th October 2017, the Board’s remuneration committee approved new BOD 1.65p options for the Chairman and CEO in which the vesting conditions and the interests of shareholders are well aligned with these key members of the Board in the coming months.
The Options will only vest, and become exercisable, if the average mid-market closing price for an ordinary share exceeds 3p for a period of any 90 consecutive calendar days ending on or before 31 December 2018
That is a very short timeframe for options and clearly to exceed 3p for 90 consecutive days, the share price will need to be well into 3’s or 4’s to ensure that any volatility in the 90-day period doesn’t drop the SP below 3p for even 1 day!
This is a significant announcement and clearly signals the confidence of the entire board on a very successful 2018. The announcement can be found here
One important feature of HYR is the BOD holdings and consequently their ‘skin in the game’. This is excluding the options covered above.
Here is a breakdown of director holdings and purchases as at October 2017 NOTE: AVIVA have since reduced their's to Zero
These are some serious holdings and as you can see, most of the purchase prices were much higher than today’s price and underpins their absolute desire to avoid dilution
News flow to drive sentiment and the Share Price
Here’s the point I would normally paint the picture of the valuation via the financials, however, the company is growing significantly and moving into profitability, so at this point, a financials read would be subjective.
In order to justify my SP target of 5p, I would highlight the following news flow which will be price sensitive and drive further SP momentum:
· The company is now EBITDA positive and has material upside once a feedstock deal partnership is secured. Clearly, the group is concluding it’s work with corporate advisers Simmons & Co and are looking to develop partnerships that will significantly increase feedstock to match the growing demand for their products in the world’s largest market – the USA. Positive news here will be transformational for the company
· Margins are rising with a significant increase in WTI Oil prices
and due to demand for their product. Margins at 19% in Q1 2018 and WTI had trended higher since then
· Recent 2 year contract with a US OEM will drive further growth
· The plant is only operating at 61% capacity and forecast to increase by 15% to ‘at least’ 70% in 2018
· Additional Margin rises are forecast in 2018 due to a sales mix improvement to ‘at least’ 60% higher margin transformer oil (up from 52% in 2017)
· Licensing is a game changer and news looks to be close given the job advert and this could be transformational
A 5p share price would equate to a £37m MCAP, which for a company with $20m in net assets and producing sharply higher EBITDA in 2018 (on a successful feedstock deal) would seem entirely reasonable. News of a lucrative licencing deal would drive an even higher valuation in my opinion as this would potentially drive revenues and profitability much higher.
The market has only just begun to re-rate the company and given it previously valued the company (with the same shares in issue) at £90m leaves a significant path for shareholder growth. Indeed the £90m valuation was at a much more difficult time for the company, when it was loss making and facing into headwinds of a declining WTI market.
The current £10m MCAP looks far too low to me and will re-rate accordingly.