ADA-ES (ADES) is a unique company on the verge of extraordinary earnings and cash flow growth, driven by a business relatively insulated from economic cycles, competitive threats and whose performance is generally uncorrelated with other portfolio investments. The main value driver of the company monetizes government tax credits by partnering with investors. Given the extremely attractive returns for all parties, we are confident that ADA's monetization of its tax assets is a matter of when, not if. Although the stock is up strongly, we believe ADA-ES still has an upside of 70% to our target price of approximately $51/shr over the next twelve months as multiple near-term catalysts continue to de-risk the story and drive share price towards its intrinsic value.
ADA's products control the emission of mercury, acid gasses and CO2 in the coal-burning electric power generation industry. The company conducts four main business activities: Refined Coal ("RC"), Emissions Control ("EC"), Enhanced Coal (reported as part of the Refined Coal business) and CO2 Capture. ADA's main driver of value in our analysis is its Refined Coal segment and we ascribe essentially no value to its three other businesses. Any value creation by these divisions will provide upside to our estimates.
ADA's Refined Coal business is conducted through the Clean Coal Solutions JV ("CCS"), which is held 42.5% by ADA-ES, 42.5% by NexGen and 15% by Goldman Sachs ("GS"). ADA and CCS financials are reported on a consolidated basis. The business takes advantage of Section 45 of the Internal Revenue Code, which offers a tax credit of approximately $6.50 per ton to reduce mercury and NOx emissions by at least 40% and 20%, respectively. The credit expires on December 31, 2021 and increases every year based on expected inflation.
Refined Coal is created by applying proprietary chemicals, via a bolt-on apparatus (the "RC Facility"), to coal before it travels to the power plant boiler. This process creates Refined Coal, which reduces pollutants in the byproduct after the coal is burnt.
Twenty-eight of these facilities, costing CCS approximately $37 million in total, were built by CCS and approved for operation (aka "placed in service") between 2009 and 2011. The placed-in-service process entails construction of the RC Facility at a host power plant (not necessarily its final home) and extensive testing to ensure that the level of emission reduction necessary to qualify for the tax credit is achieved. The window to construct and place RC Facilities in service ended Jan 1, 2012; the tax credit is currently closed to new entrants.
Monetization of the tax credits is achieved through a symbiotic relationship among three parties: 1) CCS, 2) a monetizer (or "RC investor") and 3) a utility (coal power plant). To lower its own tax liabilities, ADA also acts as the monetizer ("self-monetization") for some of the RC Facilities.
The following is what the arrangement looks like for each of the players:
The monetizer's cost to obtain the tax credit is roughly the same as the credit itself. In other words, to receive $6.50/ton in tax credit, it costs the monetizer $6.50/ton in 1) lease payments and 2) operating costs. The monetizer benefits mainly from tax shields, which we'll expand on later. Therefore, on a per ton basis, rent to CCS is calculated as the tax credit for the year less operating costs and utility payments. The operating costs consist primarily of labor to run the facility (approximately eight people round the clock) and RC chemicals.
The following is the estimated rental revenue for a typical 3.0mmtpa facility, with tax credits escalating per Management's estimates as well as operating costs and utility payments grown at 3% inflation post-2013:
For example, referencing the above table, a boiler producing 3.0mmtpa in 2013 at $3.50/ton in rent ($6.50/ton tax credit less ~$2.00/ton operating costs less $1.00/ton utility payment) equals about $10.5 million in 2013 rent (3.0 * $3.50). Payments are made on a quarterly basis. Depending on the level of operating risk the monetizer prefers, the payments can be structured to be 100% fixed or to have a component contingent upon the RC facility's tonnage in that particular quarter, which may vary due to seasonality or changes in electricity demand. We'll expand on this later.
The operating cost (i.e. the $2.00/ton) is comprised of fixed and variable components, resulting in a degree of operating leverage. Fixed costs per facility, regardless of tonnage, are estimated at approximately $2 million per year and variable costs are estimated at about $1.33/ton. Payments of about $1.00/ton are made to the utilities for allowing the RC operation on their land and boilers.
The monetizer benefits from tax shields (depending on the specifics of their tax situation) that arise from deducting all or a portion of operating costs, utility payments, depreciation and rent payments.
As mentioned, the host utility receives $1.00/ton in payment from the monetizer, along with the added benefit of cost-free emissions regulation compliance, which is estimated by Management to be worth $1-4/ton.
CCS receives the $3.50/ton rent payment from the monetizer with no direct operating costs, which are paid by the monetizer (we estimate approximately $6-7 million in CCS overhead per annum until all facilities are monetized and $3-4 million thereafter). Of the $3.50/ton, ADA's portion is 42.5%, or about $1.50/ton before overhead. For certain facilities that utilize ADA's proprietary technology, ADA also receives a royalty that brings their portion to about 50%. We'll expand on these elements later.
CCS also chooses to permanently self-monetize certain facilities and plans to generate enough credits to fully offset tax liabilities resulting from its earnings. CCS operates as a pass-through entity and does not directly pay taxes; its income passes through to its owners' books and is taxed at the parent's respective tax rate. Tax credits generated by CCS are also distributed pro-rata to its owners and used to offset taxes owed. To self-monetize a facility, CCS pays the same $2.00/ton in operating costs and $1.00/ton to the utility to receive the $6.50/ton in tax credit. With the benefit of tax credits, Management expects an effective tax rate of 10% at the ADA level, which would then be offset by approximately $100 million of NOLs.
We estimate that ADA will permanently self-monetize five facilities producing approximately 12 million tons per annum of Refined Coal over the next eight years.
In certain situations, CCS also temporarily self-monetizes facilities that have completed permitting between CCS and the utility but not yet between the utility and the monetizer. This is done in order to 1) demonstrate the facilities work as intended and 2) put them to good use (i.e. generating credits for CCS) during the remainder of their permitting process.
Recall that to self-monetize a facility, CCS's cost structure looks like:
- Zero revenue (tax credits are off-balance sheet)
- $3.00/ton in operating expenses (plus tax shield)
Upon monetization, CCS's cost structure looks like:
- $3.50/ton in revenue
- Zero operating expenses
In other words, switching a facility from self-monetized to monetized results in an overnight positive swing of ~$6.50/ton. During 2012, CCS was self-monetizing two facilities permanently and two temporarily. Of the latter two, one was monetized in February 2013 and the other is expected to be monetized with Goldman Sachs by the end of 2Q 2013. These self-monetizations have resulted in optically depressed earnings that do not represent the true earning power of ADA. Upon monetization, such facilities will quickly become revenue generating instead of adding to expenses.
Additionally, for self-monetized facilities CCS purchases raw coal from the utility to refine into Refined Coal, which is sold back to the utility for the same price. These raw coal purchases and sales directly offset each other and have no effect on gross profit. However, it is important to note that reported gross margin unadjusted for these coal sales will be quite low due to the offset. Upon monetization, these coal purchases and sales will be taken on by the monetizer. We've excluded coal purchases and sales from our analysis.
As more contracts are completed and both utilities and monetizers become familiar with the process, Management expects the remaining facilities to self-monetize for no more than a couple of weeks, if at all, before they are fully contracted.
An additional consideration is the technology used in the RC facilities. There are three technologies to keep track of: CyClean, M45 and Pulverized Coal ("PC"). CyClean was the first technology proven to be viable in reducing pollutants to a level necessary to qualify for the tax credit; M45 was introduced in Sept 2011 and expands ADA's market for RC beyond CyClean, which is limited to cyclone boilers. For M45 facilities, ADA is first paid a royalty by CCS for use of the technology, which brings ADA's piece of the rev/ton closer to 50% rather than 42.5% (ADA's ownership of CCS). Depending on the size of the facility, this works out to incremental economics of approximately $.20-.25/ton over non M45 facilities. With Cyclean and M45 technology, RC facilities are viable for approximately 120 out of the 1,200 total boilers that require MATS compliance.
ADA plans to introduce a new technology this year that will allow the RC Facilities to run on Pulverized Coal boilers - this represents a significant opportunity to increase both annual tonnage and revenue per ton as compared to CyClean and M45. With PC technology, the available universe of boilers expands to 80%, or approximately 950, of the 1,200 boilers that require MATS compliance. The estimated annual tonnage for each boiler also increases to approximately 5mmtpa as opposed to the 1-3mmtpa boilers ADA would be able to target otherwise. The broader opportunity set will give CCS increased leverage over utility operators, who are less likely to drag their feet with the knowledge that CCS has another 5mmtpa boiler they can deal with right down the street. Importantly, all PC facilities will use M45 technology and net higher revenue/ton for ADA.
However, management expects chemical costs to be more expensive for a PC facility than for a non-PC facility. We have assumed PC chemicals (i.e. variable costs) to be twice as expensive, which may be a conservative assumption. Management expects these chemical costs to come down as the process is refined.
PC technology was certified as eligible for the Section 45 tax credit in late 2012 and ADA recently completed four plant-specific tests to measure effectiveness as well as the downstream collateral impact on the rest of the plant (e.g. ash, emissions, etc.). Management expects to monetize the first PC facility in 2H 2013 and ultimately operate 12 of its 28 RC facilities on PC boilers. In total, Management estimates full capacity production of approximately 109mmtpa out of 28 facilities, 14-16 of which will be M45 facilities (including 12 PC boilers producing approximately 60mmtpa in aggregate).
At the beginning of the contract, the monetizer makes a one-time cash prepayment based on the estimated tonnage of the plant for anywhere from $1.00 - $6.00 per ton (to be negotiated on a facility-by-facility basis). This is booked as deferred revenue by CCS and amortized on a straight-line basis over 2-4 years. Using the same numbers as in the previous example, CCS receives anywhere from $3-18 million (3.0mmtpa * $1-6/ton) on the day of monetization. We'll expand on the reason for the relatively large range later in the write-up.
The following is what revenue and cash would look like from a facility monetized on the first day of 2013 with $3.50/ton in prepayment and 100% fixed rent payments:
Note that this example is illustrative and uses a non-escalating payment. That $3.50 (B) rental payment/ton escalates every year in lockstep with the tax credit as explained previously.
CCS is obligated to distribute at least 70% of its cash flows to ADA (42.5%), NexGen (42.5%) and GS (15%) every year until 2021, when it is our assumption that they distribute out all remaining cash in the entity. GS is guaranteed to make a 15% annual return on the $60 million investment that gave them a 15% stake in CCS; this is tested at the end of the tax credit's life in 2021 and any shortfall when accounts are trued up is paid 50/50 by NexGen and ADA. Our analysis doesn't see GS's guaranteed return becoming an issue.
The following is an approximation of the economics for an RC investor with current pricing and a 3.0mmtpa facility:
As you can see, past 2016, the lease payments and operating costs essentially cancel out the tax credit. The monetizer benefits from tax shields that arise from deducting all or a portion of the costs related to the lease arrangement. Assuming that the monetizer is able to fully deduct expenses, our estimated IRR comes out to be quite high. This could represent a source of significant upside for ADA if the IRR were to be bid down. Management has indicated that other tax credit schemes have settled to the 20% area after the market climbs the initial learning curve.
The monetization process involves several steps, including operating permits from the state, approval from the Public Utility Commission (PUC) in regulated states, approval from coal and transportation companies, approval from plant owners, Private Letter Rulings (PLR's) from the IRS, and contracts negotiated amongst CCS, the monetizer and the utility. The process is as time-consuming as it sounds - currently monetized facilities have taken anywhere from 6-12 months to complete the process. Things move glacially slow in the power industry and every arrangement involves a completely different set of lawyers, accountants, IRS representatives, plant managers, etc. However, as the kinks in the approval process are ironed out and precedent is established, we think monetizations will speed up meaningfully. Additionally, Management expects that in some cases they will be able to monetize more than one RC facility per PC boiler, significantly reducing the process' complexity.
In August 2012, the United States Court of Appeals for the Third Circuit reversed a ruling that allowed the NJ State Authority to essentially sell to Pitney Bowes tax credits earned from the rehabilitation of a historic NJ boardwalk property. The ruling was overturned on the basis that Pitney Bowes had no meaningful risk in the project; its capital contributions would be made only after the tax credits had been earned. This ruling delayed Refined Coal monetizations as RC investors digested the implications of the decision and sought to ascertain the 'hurdle' level of risk the IRS would require for such contracts.
Consequently, subsequent contracts are now structured such that the monetizer takes on more operating risk, which is done in two ways: larger up-front payments and/or 100% fixed rent payments. This is where the variability in prepaid rent comes into play: a monetizer that chooses to make a larger up-front payment would be more comfortable with a larger component of rent contingent upon tonnage and vice versa. The monetizer will take on as much operating risk as they feel they need to ensure the IRS doesn't deny them the use of their tax credits somewhere down the road. This risk appetite varies depending on the monetizer. At the end of the day, CCS expects to receive generally the same amount of cash over the life of the contract regardless of whether it comes in the form of up-front payment or rent payment.
The IRS has also recently restarted issuing PLRs (Private Letter Rulings), which give RC investors feedback on parameters for the RC investments and should serve to quicken the pace of monetizations.
CCS's first three facilities were monetized with Goldman Sachs: two in the second quarter of 2010 for a total of $9 million in prepayment and a 3rd in the first quarter of 2012 for $9.3 million in prepayment. The 4th facility was monetized in the third quarter of 2012 with a wealthy individual for $1.5 million in prepayment. Upon the monetization of its 5th facility (~3.5mmtpa) with a new third-party investor in February 2013, ADA received a $20 million prepayment and is expecting an additional $5 million upon the receipt of a PLR from the IRS later this year. This prepayment was on the higher side (~$7.15/ton) because the monetizer wanted to take on additional risk and minimize any future headaches with the IRS.
As of April 2013, ADA has eight operational facilities: five monetized with RC investors producing approximately 15.0mmtpa in aggregate, two small permanently self-monetizing facilities producing approximately 1.2mmtpa in aggregate and one temporarily self-monetizing facility producing approximately 4.0mmtpa. This latter self-monetizing facility (ADA's 8th facility) and another (ADA's 9th facility) are expected to close in Q2 2013 and in Q3 2013, respectively, with Goldman Sachs. Together, they produce approximately 7.0mmtpa and are expected to generate approximately $22.2 million in prepayment ($15 million in cash plus ~$7.2 million of deposit already received from GS). Of the remaining 19 facilities (i.e. 10th through the 28th), seven (~25mmtpa in aggregate) are in various stages of permitting and 12 (~60mmtpa in aggregate) are pursuing options to use PC technology. Management has indicated that they expect to complete all 21 remaining monetizations by the end of 2014.
Here's a recap of ADA's other businesses:
ADA's activated carbon injection systems ("ACI") and dry sorbent injection systems ("DSI") provide low capex solutions to MATS regulations. Management anticipates the need for 400-600 ACI systems (at $0.6-$1 million each) and 200-400 DSI systems ($2-$3 million each) before the April 2015 compliance deadline, translating to a total market size of approximately $1 billion. ADA expects to maintain a combined ACI and DSI market share of approximately 35%. This business is not expected to be meaningful past the MATS deadline in 2015.
In Oct 2008, ADA and Energy Capital Partners entered into the Carbon Solutions JV for the purposes of funding and constructing an activated carbon ("AC") manufacturing facility in Red River Parish, Louisiana. Norit sued ADA, its partners and two former employees for infringement of manufacturing trade secrets; as a result of the settlement reached in Nov 2011, ADA relinquished all equity interest in Carbon Solutions and agreed to make the following payments:
- $33 million to Norit in August 2011 and $2 million to Carbon Solutions in November 2011.
- $7.5 million over three years to Norit commencing June 2012 and $1.6 million over 16 months to Carbon Solutions commencing November 2011. A balance of approximately $6 million remains outstanding as of year-end 2012 and is expected to be paid by mid-2014.
- Royalty to Norit of 10.5% for the first three years beginning mid-2010 and 7% for the following five years based on all sales of AC from the Red River plant not sold to a certain customer. We estimate such royalty payments to be approximately $2-4 million per annum until 2018.
Depending on the assumptions in our model, the EC business generates anywhere from $20 - $46 million of cash in total through 2015, roughly equal on the low end to total estimated remaining Norit litigation costs of about $23 million through 2018. To be conservative, we assume legacy litigation costs offset any earnings generated by this business and we ascribe no value to EC in our write-up.
In June 2010, ADA entered into a license agreement with Arch Coal - utilizing ADA's RC technology, Arch Coal applies chemicals to mined coal and sells this "Enhanced" coal to utilities at a premium over untreated coal (PRB coal currently ~$10.50/ton). ADA's royalty will be 50% of that premium, up to a cap of $1/ton. Management estimates between $1-4/ton of benefit for utilities (i.e. costs they would not need to incur for other emission control methods). Additional opportunity exists to create and sell Enhanced Coal directly to utilities at a higher margin. While we think there could be tremendous opportunity here past 2015 given the 600 million tons of PRB coal burned every year, the business is not expected to be meaningful until 2016. Enhanced Coal is currently cash flow neutral and we ascribe no value to this segment in our valuation.
ADA's CO2 Capture business is essentially a reimbursed R&D expense - ADA bids for research contracts and the R&D expenses incurred for it are reimbursed by the DOE and industry participants. We do not expect the business to burn cash. As of YE 2010, ADA had unearned contracts of $18.8 million, which are projected to be recognized on a straight-line basis at ~$3 million per annum until 2016. ADA has the right to commercialize any inventions it creates as a result of these projects. While any technological breakthrough could add significant value, this business is young and we ascribe no value to CO2 Capture in this writeup.
We valued the RC business using a DCF analysis given the finite cash streams, applying a discount rate of 15% until all facilities are monetized at the end of 2014 and 8% thereafter. We felt that a 15% discount rate accounts for the higher risk during the next 1.5 years as monetizations are still in progress and the lower 8% discount rate represents a proxy for the monetizer's secured debt coupon (likely lower than 8%), which is the kind of creditor CCS would be when all facilities are contracted.
Additional assumptions include:
- CCS distributes 90% of its cash flows to its owners
- Monetizations at a pace of 2-4 per quarter (fully leased in Q4 2014)
- For all remaining facilities: $3.50/ton in prepayment; 100% fixed rent payments
- 28 total facilities
- 12 PC facilities
- 16 M45 facilities (including 12 PC facilities)
- 5 self-monetized facilities producing approximately 12mmtpa
- 108 million ton annual capacity
- Costs grow at 3% inflation
To calculate the NPV of ADA's share of the Refined Coal business, we valued 1) cash flows distributed to ADA from CCS 2) 42.5% of the cash flows retained at CCS and 3) M45 royalty revenue. Offsetting the value of the RC business is the unallocated corporate overhead (i.e. not allocated to any of the ADA's four business lines), estimated at $18 million per annum times a multiple of 8.0x. We assume this unallocated SG&A adds no incremental value as we've been unable to obtain guidance from Management regarding what exactly is spent on beyond vague inferences to future value enhancing initiatives. Our analysis includes the effect of the approximately $100 million of NOLs ADA possessed at the end of 2012. Allocated operating expense for the RC business is incorporated in the business segment analysis.
The following is our DCF schedule:
We have a very detailed model that includes the other divisions of the company. Although not included in our valuation, ADA's other operations are included in the following summary of our consolidated projections:
Management owns 6.8% of the company and the CEO, Mike Durham, has a significant portion of his personal net worth invested in the company. Management is further incentivized through bonuses paid upon the attainment of certain milestones.
- Regular monetizations; one additional monetization expected by June 2013 and at least one more in the quarter ending September 2013, with acceleration thereafter due to PC technology
- Pulverized coal - PC facility monetizations during second half of 2013
- Management has indicated that they intend to return cash to shareholders through dividends and buybacks.
- Lowering of monetizer IRRs, resulting in higher proceeds to CCS and ADA
- Emissions Control, Enhanced Coal & CO2 Capture businesses bearing fruit
- $18 million per annum of unallocated SG&A used to create shareholder value
- Placement of multiple RC units per PC boiler and contracts with multiple plants of the same utility holding company speeding up the pace of monetizations
- Lower-than-expected PC facility operating costs
- Monetization delays - a one-year delay in the completion of monetizations would lower our target price by approximately $4/shr
- Failure of PC technology
- Management imprudently deploying expected cash hoard on value destroying endeavors
We had long exposure to ADES at the time of submission (5/14/13). We have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.