Thoughts on Advanced Emissions Solutions – ADES

Advanced Emissions Solutions, Inc. trades at a price that does not reflect the optionality of its pollution control assets. These assets include various “refined coal” power plants, emissions-reducing chemicals, and intellectual property. While only the refined coal facilities currently produce meaningful cash flow, the company’s other assets could have significant value.

“Refined Coal” – Tinuum Group, LLC

Let me first say that “refined coal” or “clean coal” are nothing more than marketing terms. Burning coal to generate power is a filthy process and no current technology can remedy that. But there are ways to reduce the impact of coal pollution and limit the release of mercury and nitrogen oxide into the atmosphere. “Refined Coal” plants have been fitted with equipment that treats coal and the resulting combustion gasses, resulting in less pollution and environmental impact. The US government wishes to encourage these technologies and has provided special tax incentives to operators who employ them.

Advanced Emissions Solutions, through its investment in Tinuum Group, LLC, owns many coal-fired power plants equipped with these technologies. About half of these have been leased to various operators, including utilities and non-utility financial investors interested in generating tax benefits. Simply from the plants now in service, Tinuum will earn hundreds of millions in lease revenues between now and the end of 2021. After that, the tax provision that created the incentives for using refined coal technology sunsets and presumably, Tinuum will receive no further cash flows.

Tinuum signed another plant lease at the end of March, bringing the number of plants in service to 14. Another 7 refined coal facilities are equipped and ready for an investor, and Tinuum can install its technology at another 7 if demand materializes. Acquiring new operators for the remaining plants has been a challenging process for Tinuum, given some uncertainty over IRS treatment of various types of investors in refined coal and general uncertainty over the future of coal-generated power. But the company feels the worst of the uncertainty is behind, and is optimistic about placing idle plants into service.

Advanced Emissions Solutions owns 42.5% of Tinuum, and expects its share of distributions to total $275-300 million between now and the end of 2021. Depending on Tinuum’s success in leasing out additional plants, the total distributions to Advanced Emissions Solutions could be much higher. By the company’s estimation, each additional plant leased to an operator could add $5-7 million in annual distributions.

Emissions-Reducing Chemicals

Advanced Emissions Solutions once did a large business selling emissions control equipment. But this turned out to be an unattractive business model and the company has exited, choosing instead to focus on its proprietary chemicals. In 2015 and 2016, coal-fired power plants by and large installed mercury-scrubbing equipment to meet environmental mandates. These systems now require chemical consumables that keep them running effectively and make them last longer by reducing corrosion. Advanced Emissions Solutions estimates the total annual market for these consumables is $400-600 million, and the market for the specific product types that Advanced Emissions Solutions offers is around $100 million. Thus far, the company has managed to capture only a small portion of this market. But the company believes its offerings are competitive, and the industry seems to be agreeing. Chemicals revenue grew over 400% quarter-over-quarter to $2.3 million. If the company’s products continue to take market share, the chemicals business could be a very valuable one for Advanced Emissions Solutions.

Intellectual Property

Advanced Emissions Solutions holds 36 US patents, plus additional international and/or pending patents. Some of these patents are related to technology used at the Tinuum facilities, for which the company receives royalties. Others relate to the chemical business. The company is seeking ways to monetize these and other patents, whether through licensing or outright sales. It is very difficult to quantify any potential outcome and I will not venture a guess as to if, when, or how much gain the company could ultimately achieve. Nonetheless,  the company’s intellectual property is both a competitive advantage and a potential source of cash.

Company Background and Strategy

One reason the market has been slow to recognize the value of Advanced Emissions Solutions is the company’s tumultuous past. Under the previous management team, the company suffered from very poor capital allocation: a high research & development spend with little to show for it and under-utilization of Tinuum’s assets. Operating costs ballooned, and the company even got into trouble with its financial filings, becoming delinquent and being delisted. New management came in in 2015 and quickly set about reducing costs, restating the financials and focusing on efficiency. The result is greatly reduced costs and a new focus on getting the most out of the company’s best assets. The company also settled some lingering litigation and returned to the NASDAQ.

Advanced Emissions Solutions’ operating costs have been slashed in half, from over $40 million in 2015 to a $20 million annual run rate for the most recent quarter. In previous presentations, management guided for ultimate annual corporate costs of $12-14 million. That seems optimistic to me, but I think $15-16 million is very much achievable.

Capital allocation policy has been revamped. The company just completed a tender offer for 6.2% of its shares, paying $9.40 for a total of $12.9 million. Advanced Emissions Solutions also initiated a dividend and now pays a generous 25 cents per quarter. This dividend is very well supported by Tinuum’s regular distributions. Going forward, the company will focus on returning capital to shareholders, investing in the growing chemical segment, and potentially on acquisition opportunities if they can find compelling deals.

Just recently, the company implemented a tax asset protection plan. Advanced Emissions Solutions has over $100 million in net operating loss carryforwards, which will shield the company from taxation for some time.

Valuation

Evaluating Advanced Emissions Solutions’ worth in full is a challenging process. However, I believe the value of Tinuum in its current state alone, less corporate costs, equals the company’s enterprise value. Any potential value from additional facility leases by Tinuum, growth in the chemical business, or monetization of the company’s intellectual property would only increase value.

My very conservative short-hand valuation incorporates $275 million in distributions received from Tinuum between now and 2021, less $16 million in annual corporate costs over the same period. Discounted at 10%, the present value of the Tinuum distributions less corporate costs equals $158 million. To this figure I would add the $10 million in cash the company holds following their tender offer and dividend payment. Finally, I would credit the company for its NOLs at 10 cents on the dollar. (Normally, I am very skeptical of the value of NOLs. However, given that Advanced Emissions Solutions is already producing substantial profits, I think it is very likely the NOLs are fully utilized.) That adds another $10 million, for a very rough valuation of $178 million.

As I write, the company’s enterprise value is $181 million. So all of the company’s positive optionality is valued by the market at $3 million. Again, the company possess multiple levers for achieving a much higher value, the easiest of which seems to be the potential for additional facility leases by Tinuum. It should be clear that I believe Advanced Emissions Solutions is worth substantially more. However, I think that highlighting the company’s very limited downside is most appropriate in this scenario where the timing and amount of additional value from unproven assets is uncertain.

Alluvial Capital Management, LLC holds shares of Advanced Emissions Solutions for clients. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Ocean Yield ASA – OCY:Oslo / OYIEF:OTC

Just a quick post today to talk about what I think is a very interesting company – Ocean Yield ASA. The company was created in 2012 from assets owned by the Norwegian industrial giant Aker ASA, which remains the majority shareholder. Ocean Yield’s business model is very simple: it purchases ships, then leases them to high-quality global shipping companies under long-term charters. In order to deploy more earning assets and produce a more attractive return on equity, Ocean Yield employs meaningful leverage. Ocean Yield pays out the majority of its earnings in dividends (hence the business name) and strives to increase the dividend as its fleet grows.

This is the business model employed by nearly all leasing companies, as well as banks. Borrow short, lend long, and earn the spread. There are risks to this business model, but first let’s take a look at the types of ships that Ocean Yield currently owns. The company’s fleet is modern and fuel-efficient, crucial to ensure the vessels will have strong residual values once their leases are concluded.

Chemical tankers make up roughly one third of the fleet. Chemical tankers are specialized ships that tend to see more stability in dayrates, making them an attractive sector for Ocean Yield. Since its founding, Ocean Yield has growth its fleet at a steady pace. The company intends to grow its fleet by $350 million annually. Fleet expansion is funded operating cash flow as well as debt issuance.

Just like a bank making loans, Ocean Yield seeks to lease its ships to highly creditworthy shippers. Below is the breakdown of Ocean Yield’s counterparties. The list is rather concentrated, but these shippers do represent some of the largest and best-capitalized around. Ocean Yield’s average charter term is quite long at 11.4 years at quarter’s end. Some of the leases include purchase options or other customizations that make the lease more attractive for the ship’s operator.

The credit performance of Ocean Yield’s lessees has been generally good. But being that shipping is a highly cyclical industry and shippers tend to carry high leverage, Ocean Yield has had to restructure leases on more than one occasion. Restructuring tends to involve accepting lower lease payments, and may result in receiving one-time cash payments or securities from the distressed shipper. Thus far, Ocean Yield has managed these disruptions without serious losses.

Counter-party risk is one major risk that Ocean Yield faces. Another is residual value risk. The annual earnings of each of Ocean Yield’s ships is essentially its lease revenue less depreciation. But what happens if at the end of the lease, the ship turns out to be worth far less than its book value? That means that economic deprecation was higher than accounting depreciation, and accounting earnings exceeded economic earnings. That’s a bad scenario. Ocean Yield must be careful to invest in ships that will maintain their value at least as well as their accounting depreciation schedule would success, in order to be sure that reported profits are not illusory. Ocean Yield must also take care to invest in ships that are not in danger of obsolescence due to changes in technology or regulations. A large write-down in a ship’s value could wipe out a huge amount of reported profit.

The third major risk to Ocean Yield’s business model is financing risk. Ocean Yield carries about $1.36 billion in net debt versus $2.32 billion in tangible assets. The company’s equity ratio is 35.2%. Liquidity is good, as the company has $264 million of available liquidity. Still, the company would be negatively affected by rising interest rates or a disruption in credit markets.

Ocean Yield has a solid history of increasing revenues and profits since its inception. The fourth quarter of 2016 was a notable exception with a writedown on a vessel extinguishing nearly all profits. EBITDA declined from Q4 2016 to Q1 2017 because for one of the company’s ships, Lewek Connector, the associated lease went into default and the vessel was re-leased at a lower rate while restructuring talks take place.

Nonetheless, profits excluding one-time items have continued to rise. The company has increased its dividend apace, and now pays $0.74 annually. Quarterly dividends have grown at an annualized pace of 14% since the first quarter of 2014.

On an annualized basis, Ocean Yield is currently producing earnings of 89 cents per share. Shares are quoted in Norwegian Krone, but the company operates in US dollars. The current share price of NOK 65 is equivalent to USD 7.70, for a P/E ratio of 8.7 and a dividend yield of 9.6%. Both Ocean Yield’s earnings and dividend could rise as the year progresses once the company’s newbuild containerships and gas carrier begin contributing. In addition to the already announced fleet additions, the company maintains its $350 million fleet growth target.

So, what’s it worth? I never like to pay too much for leasing companies. They don’t typically enjoy significant operating leverage as they grow, and like other leveraged business models, there is always the risk of a blowup if they get too aggressive on the lending/leasing side or if credit markets lock up. Ocean Yield does have the benefit of a deep-pocketed backer in Aker ASA, but the risk is never entirely mitigated. A lot depends on the company’s efforts to grow its fleet responsibly and avoid over-paying for ships. Still, I do think the company’s good track record deserves a valuation higher than 8.7x trailing annualized earnings. I would be happy to buy shares up to 10x trailing earnings, which works out to 1.6x book value. Some might ask why a business made up of nothing but ships which anyone can buy should be worth more than book value, but I would counter that expertise in leasing and navigating the complex world of global shipping is worth quite a premium. Ocean Yield and other lessors seem to be providing a valuable service where traditional banks have withdrawn. At least for now, Ocean Yield is capable of earning a high return on equity, and that merits a premium to book value.

Alluvial Capital Management, LLC does not hold shares of Ocean Yield ASA. Alluvial may buy or sell shares of Ocean Yield ASA at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.