VIC writeup:

Description

ADES is a relatively straightforward, deep value idea – the quintessential cigar butt with excellent downside protection, and potential for quick (<12 months) and substantial returns.

ADES TODAYADES has two divisions today: i) its sunsetting refined coal royalty business ("RC"), and ii) its activated carbon ("AC") business, Advanced Purification Technologies ("APT") which was acquired in late 2018. RC is sunsetting (cash flows going to zero) by end FY21 due to scheduled expiration of S45 tax credits. Over the remaining three quarters of FY21, RC will generate distributions (net of all taxes, costs etc.) to ADES of $50-$60M - these are highly visible, contracted distributions.ADES at 3-31-21 had $27M net cash ($52M cash, $13M debt, and a mine retirement obligation of $12M, noting that remaining senior debt will be repaid in Q2-21), and as such - by end FY21 - ADES will have ($27M + $55M RC cash flows) = ~$82M net cash. At today's market cap of $98M, the implied value of ADES' APT division is thus ~$16M.The ADES equity bet here is that APT is worth a lot more than $16M, and that this value will be crystallized promptly.THE APT DIVISIONADES acquired APT in late 2018 for $75M from Energy Capital Partners – it was a complete disaster and resulted in a fire sale for ECP who built a 150M lbs capacity state-of-the-art AC plant in Red River, LA for ~$350-$400M about a decade ago, on the hope mainly the plant would be fully utilized selling AC products to coal plants to mitigate air pollution. Utilization was far lower than ECP (and ADT’s competitors) anticipated as the US coal generation fleet got destroyed by cheap natural gas and renewables. ADES’ acquisition of APT presentation here is very helpful – https://s21.q4cdn.com/799184823/files/doc_presentations/2018/11/ADES-Investor-Deck.pdf - and if you want a further primer on the industry (and one of two large competitors to APT, Cabot’s AC operations) then Norit’s 2012 F1 is also very helpful: https://www.sec.gov/Archives/edgar/data/1527273/000119312512121241/d226874df1.htm.

While ECP destroyed their LPs' capital, there's nothing fundamentally wrong with Red River - in fact, at 150M lbs capacity it's the largest, lowest cost, and most efficient AC plant in the US. Like any other commodity throughput plant, it has very high operating leverage - about 50-60% of every dollar of revenue above ~$50M drops to the EBITDA line, which you can easily see in historical financial results (see p13 of 11-16-18 presentation).

ADES knew when they acquired it on the cheap from ECP in late 2018 that coal generation was declining and to get throughput (and thus profitability) up, they needed to pivot to other AC markets (water purification, industrial etc.) – of the 3 major AC players in the US, APT had by far the most exposure to coal generation. The asset drastically underperformed in 2019-2020 due to: a) continued and even more rapid declines in the coal generation fleet, and b) COVID. Absent the depths of COVID (Q1-Q2 2020, when the red ink flowed), the APT division was running at around $50M p.a. revenue and breaking even (with variability from quarter to quarter) at the EBITDA level.Despite having a miserable last 5+ years (especially 2019-20), it seems clear that APT is now on the cusp of a sustainable turnaround driven by:1) 2 x long-term supply agreements with Cabot (announced 9-30-20 and 2-4-21), which will ramp up over the course of FY21 and - with Red River's high operating leverage - should lead to sustained profitability (EBITDA run-rating around $15, perhaps $20M by end FY21). Importantly the 15-yr (and, dollar wise, more substantive) agreement with Cabot US will see APT supply to end markets not associated with coal power generation (while the 5yr European agreement is for power generation / mercury removal, but diversifies geographical exposure);

2) Cabot (one of the two largest competitors to APT, the other being Calgon/Kuraray) finally folding the tent on its own AC manufacturing in Marshall, Texas (and ceding it to ADES via the supply agreements) is a long-awaited rationalization of industry AC capacity which will support pricing; and

3) In evidence of the rationalizing industry structure and improving price environment, ADES announced on 3-29-21 that it is raising prices 10-15% on its AC products.

Q1-21 results showed the early stages of progress - APT did $17M revenue and $2.2M EBITDA (best quarter in over 2 years) - but as the Cabot supply agreements continue to ramp through the course of FY21 (mgt. guidance is full Cabot production won’t be reached until late 2021), the 10-15% price increase announced 3-29-21 runs through their book, and APT optimizes inventory run cycles, APT by end FY21 should be running at higher profitability than it has in many years. Since 2015 the best APT had done was 2016 - $80M revenue and $20M EBITDA - and management on the Q1-21 CC guided that FY21 will be the highest annual volume and most diversified mix the plant's produced, suggesting FY21 (at least by year's end) will be run-rating in excess of $80M revenue & $20M EBITDA.Thus - while coal headwinds (still ~50% of APT's mix) will persist - the positive shift is clearly underway and you are getting into APT at an implied ~1x EBITDA multiple. Maintenance capex is ~$5M p.a. on Red River, so knock that off from EBITDA to approximate unlevered FCF.

You don't need it here to make good money but suffice to say Red River / APT could conceivably do a lot more than $20M EBITDA if they really nailed the turnaround and successfully replaced declining coal exposure with growing end markets – the plant's never gotten above ~70% utilization, and obviously ECP didn't spend $350-$400M on a plant that tops out at $20M EBITDA. At a guess, if APT somehow got close to 100% utilized, it could do $50M of EBITDA (magic of ~50-60% operating leverage).

Another point worth adding is that the sunsetting of the RC tax credit will force coal generators to switch to AC to comply with mercury control – see pp9-10 of the acquisition presentation. ADES has confirmed this opportunity still exists but given efforts to diversify APT’s exposure away from coal generation, I put no value on it.

WHAT IS APT WORTH?There are a various data points out there to triangulate to a value for ADES' APT division being worth a lot more than the market implied valuation of $16M:- APT bought it for $75M from ECP in a firesale (distressed / end of PE fund life / impairment scenario). APT under ECP control was averaging about $15M EBITDA in 2015-17 before coal generation's demise rapidly accelerated - as above ADES appear on the way to not only meeting but bettering that performance, with much better visibility (due to long-term Cabot agreements), much better end market mix (i.e. less coal generation), and better margins.

The degree of discount on APT's implied $16M valuation is so large and obvious that false precision isn't required here - it is obviously worth a lot more than $16M.

WHY DOES ADES EQUITY TRADE SO HORRIBLY?

Aside from the obvious – small cap / no liquidity, RC cash cow sunsetting, and coal exposure – two reasons why I think the price hasn’t moved despite the APT inflection becoming obvious, debt being fully repaid by Q2-21, and the strategic review being announced are:

i) The cancellation of the $0.25/quarterly dividend in conjunction with Q1-20 results cratered the stock price, suggesting the marginal buyer was yield-focused retail; and

ii) APT has what is an effective poison pill against companies acquiring >5% interests, in order to protect its $93M tax loss carryforward & NOL assets. This inhibits institutional buying.

WILL APT'S UNDERVALUATION EVER GET CRYSTALLIZED?

Yes, I think so - ADES formally hung the "for sale" sign up with announcement of a "strategic alternatives review to maximize shareholder value" in conjunction with its Q1-21 results. ADES largest shareholders are institutions (hedges, mutuals, and Apollo) who are underwater on their ADES investment who ought to be motivated to get it done. ADES' CEO is an interim CEO (former CFO) - the permanent CEO left in mid-2020, and the current CFO is also temporary. The temporary CEO's missions - staunch the bleeding in APT and turn it around, harvest the RC cash flows, and pay off the debt - have all been ticked. The Q1-21 10Q Subsequent Events section revealed management has a $2.4M retainer to stick around until the earlier of 6-30-22 or CoC transaction.

There's nothing left for the board and management to do here except assist the advisers in running a clean sales process and exit.

RISKS

Given the egregious undervaluation ascribed to the APT division, APT's successful turnaround to profitability and much improved end market exposure, >$4/share net cash, and delevered balance sheet, losing money from here would require extraordinarily bad capital misallocation. It might happen, but shouldn't.

Coal generation will continue to decline and so APT remains on a treadmill to an extent, but law of small/large numbers suggest the drag on APT's results should wane.

Calgon acting irrationally (e.g. expanding production at $3.40/lb when they could simply buy the industry’s lowest cost plant, Red River, for far less) is also a risk – Kuraray is a Japanese conglomerate and I don’t pretend to understand their capital allocation framework.

I do not hold a position with the issuer such as employment, directorship, or consultancy.I and/or others I advise hold a material investment in the issuer's securities.