Description

PFAS and the EPA’s Catalyst

Amidst the rollercoaster ride on which ADES has taken investors for the last several years, I believe a tremendous catalyst has been completely overlooked.   Please take a look at GoAnywhereGuy’s writeup on 5/19/21 for background: I thought the original concept was excellent, but of course with cigar butt investing sometimes the path to riches takes a detour!  The EPA is finally about to force municipalities to limit levels of a family of toxic fluorinated chemicals known as PFAS (Per- and Polyfluoroalkyl Substances).  As far back as 1950, studies conducted by 3M showed that these chemicals could build up in our blood causing major health risks.  PFAS have been called “forever chemicals” because they can take over 1,000 years to degrade.  They are used in a range of products from firefighting foam to non-stick cookware and have been linked to cancer and hormonal dysfunction.  A growing chorus of major retailers, from Amazon to Lowe’s to McDonald’s, are adopting policies to phase out and ban PFAS from all products and packaging that may contain them, and the ambulance chasers have taken notice!  

One of the key suppliers of these chemicals, 3M, reached a $10 billion settlement in June 2023 with a host of US public water systems to resolve water pollution claims tied to PFAS.  The company said the settlement would provide the funds over a 13-year period to cities, towns and other public water systems to test and treat contamination of PFAS.  

And on 3/14/23 the EPA finally proposed the long awaited PFAS framework - maximum contaminant levels of 4 PPT for PFOS and PFOA, and for 4 others, a limit for a mix of them.  The EPA envisions finalizing the regulation by the end of 2023.  https://www.epa.gov/sdwa/and-polyfluoroalkyl-substances-pfas

The American Water Works Association (AWWA) believes that to meet the proposed standards (likely to be enacted in the next few months with 3 years to comply), more than 5,000 water systems (out of about 50,000 nationwide) will have to develop new water sources or install and operate advanced treatment, and another 2,500 water systems in states with existing standards will need to adjust existing PFAS treatment systems.  PFAS removal can be performed using ion-exchange membranes and reverse osmosis membranes as well as activated carbon, but the EPA recommends using granular activated carbon (GAC) as the most efficient removal method.  

The largest manufacturer of GAC in the US is Calgon Carbon, which was purchased by the Japanese chemical manufacturer Kuraray Co (ticker 3405 JP) for $1.3B in 2018.  The company has about 150M pounds of capacity (a blend of virgin and reactivated) earmarked for water treatment, which is about 40% of the total demand (350M pounds).  They are adding another 50M incremental pounds in a $185M ($3.70/lb) brownfield expansion in Mississippi (to be completed in 4Q23) which sounds like a lot (nearly 15% supply boost) but the market will likely still be quite undersupplied.  Kuraray cited this report https://www.awwa.org/Portals/0/AWWA/ETS/Resources/Technical%20Reports/CFPUA%20Case%20Study%20Report_FINAL.pdf?ver=2021-01-19-095055-317 by the American Water Works Association (AWWA) in 2021 that estimated that activated carbon-based treatment plants capable of providing drinking water to roughly 200,000 people would incur a capital cost of $46M and annual operating costs of $2.9M to get PFOS levels down to 40 ng/L (or 40 PPT).  Scaling that up to the whole US population, assuming about 75% of the PFAS removal is handled by GAC which in turn accounts for 50% of the operating cost, we get a total market opportunity of $1.9B (and note the EPA is proposing a much lower limit of 4 PPT which would presumably be far more GAC-intensive).  Kuraray is expected to generate about $900M in revenue from their total GAC production of 520M for a blended average price of about $1.75/lb.  If we assume a bit higher price for the water treatment piece ($2.00/lb) we can come up with an incremental demand figure of $1.9B / $2.00/lb = 950M lb.  If just 10% of this potential were crystallized, it would represent a nearly 30% increase in demand.  

ADES is working on a multi-phased $95M upgrade to its Red River powder activated carbon (PAC) plant as well as the Corbin, Kentucky plant it acquired from Arq.  Once successfully completed, Red River should have 60 million pounds of GAC capacity and 60 million pounds of PAC production.  If Kuraray was willing to spend $3.70/lb for its brownfield expansion, one could logically conclude that ADES’ GAC production alone should be worth $220M. Note also that ADES, unlike Kuraray, is vertically integrated, with a 30 year supply of bituminous coal reserves.

Before we dive into valuation let’s take a step back and do a history lesson.  ADES, through a $75M acquisition in late 2018 of Advanced Purification Technologies (APT) from Energy Capital Partners, entered the activated carbon (AC) business.  APT had a 45% share of the North American mercury control powder activated carbon (PAC) market (selling to coal plants to mitigate air pollution), with a state-of-the-art plant in Red River, Louisiana with 150M pounds of annual capacity, built for about $400M. 

https://s21.q4cdn.com/799184823/files/doc_presentations/2018/11/ADES-Investor-Deck.pdf

It appeared to be a great deal - the plant is the largest, lowest cost and most efficient AC plant in the US and ADES acquired it at 4.2X EBITDA.  However, with the shift from coal to gas powered generation (both due to declining gas prices and environmental concerns) coupled with high operating leverage, even $75M may have been too rich.

On 5/10/21, ADES announced a strategic review “to assess a range of strategic alternatives to maximize shareholder value”.  With a market cap at the time of roughly $100M and net cash expected to hit $80M by the end of the year as the company sunsetted its refined coal royalty business, the value attributed to the AC business was down to $20M.  There seemed to be substantial upside to the stock if the company could find a buyer for the AC business (or for the whole company).

Unfortunately, management went the opposite direction: on 8/19/22 ADES announced a deal to merge with Arq, an emerging environmental technology company that converts coal mining waste into a micro-fine carbon powder for use in environmentally sustainable products. 

https://s21.q4cdn.com/799184823/files/doc_presentations/2023/02/ADES-Arq-Acquisition-Call-Presentation-FINAL.pdf

Arq had built a $80M processing plant in Corbin, Kentucky with annual processing capacity of 100K tons of mining waste and received investments from Peabody Energy, Mitsubishi and Vitol, but it had not generated any revenue prior to the acquisition.  The capex needs would be substantial, with ADES expecting to invest up to $95M in capex to upgrade existing infrastructure at its Red River plant and Arq’s Corbin plant.  And to add insult to injury, ADES restructured the deal terms to retain ownership of the combined company and circumvent the shareholder vote, effectively cramming the deal through.  With that backdrop, let’s take a look at the valuation.

Valuation

ADES has 33M fully diluted shares outstanding, so at $1.83 the market cap is $60M.  The company as of 6/30/23 had $58.8M of unrestricted cash and $21.4M of debt for an enterprise value of $23M.  With $95M in capex over ‘23 and ‘24 and a base business (PAC) that is likely only marginally EBITDA positive (though likely improving into ‘24 as gas and coal prices recover) the company will likely seek an ESG bond to fund them through completion of the plant upgrades.  This is yet another reason why the stock is trading at such nosebleed levels.  Assuming they use the cash and take on an additional $30M in debt, the EV will be about $110M.  Given the tightness of the market and the quality of their GAC product, I think pricing will be closer to $3.50/lb and they will achieve a mid teens EBITDA margin implying EBITDA of about $30M and an EV/EBITDA multiple of under 4X.  Since we are looking at an oligopoly with multi year demand growth exceeding supply, and given the mid teens EV/EBITDA multiples of companies in the water treatment and infrastructure space (XYL, WTS, PNR) I think it’s fair to say that upside is substantial here.

Catalyst

Earnings 11/8/23 after close.  We should have a good update on timing of the EPA proposal now that the comment period is long over.  

We should also get an update on the capital projects and financing, removing a major overhang on the stock.  

Finally, the PAC coal business should show at least some stabilization with the improving pricing backdrop.