Equities

In Part 1 on the ‘Water Stocks’ I wrote about three companies – SciDev (SDV), De.Mem (DEM) and CarbonXT (CG1). The wire focused on SDV and why the Fund had taken a position, although the fund also had (and has) positions in DEM and CG1.

However, for CG1 I wrote that:

“I’m going to label this as ‘one to watch’ for the time being. The only missing piece of the puzzle is the balance sheet. If and when that is resolved I think it becomes a very strong buy...”

The same day the note was published CG1 went into a trading halt and eventually raised a total of $6.4m. This cash now gives them the ability to execute on their growing pipeline as they move towards sustainable profitability.

They are at an inflection point in earnings where any further contract wins will drop substantially to the bottom line. These points in the business cycle often coincide with favourable share price performance.

This wire will explain the thesis for buying CG1, which is now the largest of the three positions in the Fund.

The CarbonXT Business

Firstly, a primer on what CG1 does.

CG1 develops and manufactures (through two facilities in the US) powdered and pelletised Activated Carbon (AC) products. Their technology is unique in the market and is protected by 9 patents and one exclusive licence over a patent.

AC is used to remove mercury and other pollutants from industrial flue gas and wastewater streams produced by coal fired power plants, air & water purification, landfills, heavy manufacturing, natural gas plants and so on.

It is a consumable product resulting in consistent, repeat business. Once a customer enters a long-term contract (typically 3-5 years) and integrates it into their pollution management processes they are very sticky. To date, CG1 have never lost a customer.

The flip-side of an industry with sticky customers is a relatively long sales cycle as customers want to extensively test the product, knowing that once in the cost of replacement is high and they are unlikely to change for many years.

Powdered AC, primarily used by coal fired power plants, is injected into the plant’s flue gas where it absorbs mercury and allows the customer to meet its regulated emissions targets.

This is a market heavily driven by regulation, primarily the Mercury and Air Toxics Standards (MATS), implemented in 2016. This set of laws limits the allowed concentrations of mercury in air, water, soil, food and drugs.

Power plants are the largest emitters of mercury in the US and are driven by MATS to purchase activated carbon to mitigate mercury pollution and comply with the regulatory standards. CG1 saw this as the most attractive market to build a business from before expanding into new products and industries.

US plants have invested billions in CAPEX to build the equipment to scrub mercury which require the AC consumables, provided by the likes of CG1.

Powder generated $9m of revenue last year (+47% over FY18) and will likely grow at c.10% in FY20 as the company focuses resources on the faster growing pellets business. There is significant value in the powder business which is being increasingly reflected in new regulatory proposals like the updated Effluent Limitation Guidelines.

The powdered AC market in North America is worth US$150-$200m a year and, because of CG1’s unique product capabilities (non-brominated, greater efficiency vs competitors, US manufactured), there is a good chance they will grow their share of that pie in coming years.

While competitors can be hard to displace in the powder business, owing to the stickiness of customers, the next year or so will see a churn event as the first contracts entered into post MATS implementation in 2016 are rolled off (typically 3 years), and customers increasingly go in search of non-brominated solutions, of which CG1 is the only high quality supplier who’s product is designed for use in coal power plants.

We’ll look at this in detail later but the key point is that the powder business either has upcoming tailwinds to accelerate organic growth and may also be of increasing strategic value to competitors looking to respond to changing regulations and industry preferences.

In the near term the pellets business is the growth engine. It has gone from near zero in FY18 to $9.3m revenue last year and is likely to come in between $14-$18m this year.

Pellets have a much larger addressable market across a broader number of industries that are largely underpenetrated, meaning no competitor (or contract) to displace. The sales cycle is shorter, margins are higher and customers are similarly sticky as in the powder business.

CG1 appear to have the best product in the market, are the only US-based manufacturer and are price competitive.

Pellets have opportunity in air & water filtration, heavy manufacturing, wastewater, landfills and more. International expansion is also possible off the back of the growing pipeline of interest for CG1 pellets.

As mentioned, pellets will do anywhere from $14m-$19m of revenue this year based on company guidance, and gross margins will trend higher over the year (est. 35-40%). We should not only see new contract wins for pellets in FY20, but entirely new verticals and geographies opening up which will keep expanding the addressable market.

CG1 have given total revenue guidance of $24-$29m in FY20, which would represent growth of 31-58% over FY19. At these revenue levels they will be profitable and cash flow positive.

In terms of timing, the company has stated they will be sustainably cash flow positive from 2H20 onwards, supported by a recent large contract win for pellets (Purafil worth $3m+ per annum) that kicks in 3Q20.

The December quarter may be cashflow negative as they ramp volumes to fulfil Purafil and the cash receipts come in the following month. From the March quarter onwards I would expect them to be sustainably cash flow positive, which matches up with their stated guidance.

What is supporting the company’s optimistic outlook is recent momentum in contract wins and an existing base of trials worth a potential $20m of revenue per annum.

Most of this is for pellets, for which the company has achieved conversion rates >50%. I think it is reasonable to expect news on further wins early in the new year. At the AGM the Chairman signalled their expectation of near term contract wins.

The current revenue run-rate is c.$23m (inc. Purafil) at which point the company is roughly breakeven. This is an inflection point for earnings with any further contract wins to drop substantially to the bottom line.

The company is now in a net cash position and has $60m of tax losses (due to prior investment AC and clean coal products, the latter was cancelled) meaning EBITDA will convert mostly to free cash flow for many years.

CG1’s Competitive Advantage & Regulatory Drivers

CG1 operates in highly regulated markets.

To understand the growth drivers and value of CG1’s business you need to have a general overview of the regulatory environment and the company’s product differentiation in this changing landscape.

Firstly, CG1’s AC is as effective (arguably more effective but equal at the very least) than competitors, while also being far more efficient, resulting in significantly lower volumes of CG1’s product being required vs competing products to achieve the same result.

They are price competitive, helped by the fact they are the only US-based producer of pellets while product manufactured in China is subject to tariffs. This is strategically important beyond just avoiding tariffs, as US-based customers increasingly prefer to deal with US-based manufacturers where certainty around supply and quality is typically higher.

Price competitiveness is also driven by the company’s access to very low cost carbon feedstock.

It is worth noting that the company recently stated they have been winning new contracts on product quality alone without being the cheapest option.

In the pellets business, CG1’s technology allows the product to be tailored to a client’s specific requirements and designed to capture specific chemicals. This level of customisation is a differentiator in the pellets market and is allowing the company to push into new industries.

Now for the important regulatory piece.

CG1’s AC powder is non-brominated, while all other competing products contain bromine or bromide, which is causing increasing regulatory and industry concern as a corrosive and pollutant.

Competitors use brominated AC because it increases the ability of the product to absorb mercury, which is the primary goal in complying with MATS.

In contrast, CG1’s products use a patented non-brominated process to do the same, as good or better than competing products.

The call to eliminate bromide has been underway for many years. Back in 2015 the American Water Works Association (AWWA) even sued the Obama administration for not including any explicit limitations on bromide in the coal fired power plant industry.

This push has not slowed down. The AWWA again sent a letter last year to the EPA calling for rules to eliminate bromide from wastewater due to the risk it poses to community drinking water.

In November of this year, the EPA published new Effluent Limitation Guidelines which for the first time proposed the phased limitation on bromide emissions, amongst a number of other pollutants. A good summary of what these proposals will do is linked here.

These proposals encourage industry to make active decisions to reduce the levels of bromide in their flue gas wastewater. If they do so they will be rewarded with an extended period to comply with the defined limitations and resulting lower operating costs. If they do not make active changes then the limitations (and enforced higher costs) will be brought forward.

Industry was already moving away from brominated products before these guidelines were released, but any increased regulatory pressure brought about by these new ELG proposals will only force the issue for competitors and customers.

What the EPA appear to be doing is acknowledging the health risks caused by bromide and other pollutants and setting the stage for the eventual introduction of more explicit rules, but balancing that with the Trump administration’s desire to reduce costs for the coal fired power plant industry.

This combination of motives appears to be a net positive for CG1.

The most common suggestion by the anti-bromide proponents is for the installation of membrane filtration systems (think what DEM does, but on a much larger scale, likely into the billions across the industry) to filter bromide and other dangerous elements from wastewater. In 2015 the EPA ruled this out as being too expensive to enforce upon industry.

The cost of these large scale membrane filtration systems has fallen since 2015 but they are still multi-million dollar CAPEX projects. Some plants may choose to go this route but it remains unlikely that the EPA forces them to do so, particularly while Trump is in charge and the competitiveness of the coal plant industry remains a priority.

There is a very attractive, cost effective alternative: CG1’s non-brominated AC powder.

Not only does it remove the issue of bromide being in the AC, but it is just as effective as the alternatives at removing mercury and other pollutants, while being far more efficient and avoiding large upfront CAPEX.

The company has already seen this occurring in an increasing number of Request for Proposals (RFPs) specifying the need for non-brominated solutions, one of which CG1 won earlier this financial year with the largest US South East utility that explicitly called for non-brominated AC. The ELG proposals released in November will only accelerate this trend.

The industry is very clearly moving away from brominated AC, the only question is how quickly. In time it is likely that all customers will demand a non-brominated AC solution.

This creates an interesting dynamic for CG1’s competitors, who have failed thus far to introduce a non-brominated product that is as effective as their current brominated products. It is this dynamic that is pushing up the value of CG1’s powder business.

They are uniquely placed as the highest quality, non-brominated AC producer in the US at a time when the entire power plant industry is gradually shifting towards non-brominated solutions.

As the roll off of early MATS contracts begins it opens up the US$150-$200m market to CG1, or the competitor who decides to buy them.

The company will either 1) have significant tailwinds to grow this business themselves, or 2) become a target of acquisitive (and much larger) competitors who want to take advantage of this growth opportunity and lock up the market for non-brominated solutions.

One thing the market may have missed is that CG1 have already disclosed they are in discussions with peers, which most likely relates to the need for competitors to respond to the changing regulatory landscape and the possibility of working with CG1 to do so.

Whether anything strategic happens, and what the ‘discussions’ with industry participants pertain to, I can’t be sure. But the trend towards non-brominated AC is underway and will likely accelerate, increasing the value of CG1’s powder business, and competitors will have to respond.

The Pellet Opportunity

Most of the growth in the business currently is coming from pellets. This product has the potential to grow in high double digits for a number of years as new applications, industries and geographies open up.

Momentum is building. In the last couple of months the company has secured >$4m of annual recurring revenues from new contracts and this momentum is likely to continue as the large trial base continues to convert.

As the higher margin pellets become a larger proportion of total revenues it will lift gross margins for the business.

It is also worth noting that some of the potential deals in trials are larger than the current largest contract.

The company’s pellet manufacturing facilities in the US have annual capacity of 7,000 tonnes. The company expects to run at >80% capacity in FY20 and it is possible that another large contract could fill the remaining capacity very quickly.

While the company has not yet made any commitments it is likely that if one or two large contracts drop they will decide to expand their pellet manufacturing capacity.

They’ve stated that a US$3m investment (A$4m) will be able to double their capacity for pellets. That A$4m spend opens up a potential $20m of additional annual revenue at 35-40% gross margin.

Post the recent capital raising the company is in a position to self-fund this CAPEX if and when they need to, particularly given they would likely do so off the back of a large contract win that they could borrow against.

At the current share price it makes sense to fund it with debt. If the stock re-rated materially then raising equity to fund expansion makes more sense. It will just depend on the timing and where the stock is trading at the time.

My best guess is that they secure sufficient large contracts early next year to warrant capacity expansion, the stock re-rates to reflect the growth and inflection in earnings and they have the option of debt or equity to do so.

Whenever they do commit to expand pellet capacity it is a significant catalyst, as it opens up capacity for another $20m of annual revenues and signals the company’s confidence in their outlook.

Pellets is the business to watch with new (and potentially quite large) contract wins likely to occur in the near term.

Why Is There An Opportunity?

CG1 listed in 2018 at 70c. The IPO proceeds of $10m were primarily used to build out the company’s manufacturing facility. None of the large shareholders sold any shares.

So why did the stock halve and why is it now an opportunity? The reason is a bit counterintuitive.

Revenue for pellets went from approximately zero in FY18 to $9m in FY19, surpassing the expectations set in the prospectus and delivering a beat to revenue guidance.

A large utility customer entered into a contract for CG1 pellets with anticipated first year volumes of 1,500 tons per annum. The customer then decided to purchase more than double those volumes (3,600T) and CG1 were forced to ramp production at their Minnesota plant much faster than anticipated.

The decision was either 1) tell the customer they could not fulfil their desired volumes and lose their business or, 2) ramp volumes as fast as possible but sacrifice margins in the near term to do so. They chose the latter.

In FY19 revenue grew rapidly (+188%) to $18m as pellet volumes increased, but margins fell from 23.6% to 19.2%, compared to margin guidance of up to 38%.

This story is better told in two halves, as they sacrificed margins in 1H19 to keep the customer happy and meet their volumes, but were able to quickly adjust in 2H19 to return margins closer to long term expectations.

The share price obviously didn’t react well to this margin pressure as it meant they beat on revenue but missed on earnings. However, the company undoubtedly made the right decision for the business in the long term and it is now presenting an opportunity.

That large utility customer has continued to purchase in volumes similar to FY19, and is expected to do so throughout FY20. Margins recovered in 2H19 and will continue to trend higher both from ongoing manufacturing efficiencies and the growing portion of pellet revenues.

While the share price has fallen since IPO the business momentum has been strong and is accelerating. Revenues are ahead of where they were expected to be at the time of IPO.

All of the upside that justified the IPO price at 70c is still there, but the market is yet to recognise it.

Thinking About Valuation

This set up reminds me of Advance NanoTek (ANO) 12 months ago. Or Clover Corporation (CLV) 24 months ago.

A business with regulatory tailwinds driving revenue, rising gross margins, a flat fixed cost base, operating leverage, competitive differentiation, scale benefits, sticky clients and large competitors that need to adjust to incoming regulations, quickly.

There is some crossover in the share register between CLV and CG1 too, with Washington H Soul Pattinson a large shareholder in both.

These stocks provide an idea of the type of re-rate that can occur when things go right. The recurring revenues and fixed cost base allow these businesses to be valued on run-rate or forward metrics as it can be extrapolated out a number of years. The regulatory tailwinds provide comfort around the extent of the growth runway and is usually reflected in a premium multiple.

The other comparables are the likes of SDV and DEM. SDV has the more similar business model but they are all exposed to the same or similar thematic.

CG1 has more revenue, more gross profit and (potentially soon) more earnings than SDV or DEM. The balance sheets are not too dissimilar. The product differentiation is arguably the strongest with CG1.

Yet it has the smallest market cap of the group at $36m, despite the other stocks also looking reasonable value (Fund owns all three).

SDV and DEM are capped at $64m and $45m, respectively, leaving CG1 as the clear outlier.

There is strategic value in CG1’s products as regulations drive industry change. None of this is priced into the stock, but it should be.

I could build an argument that the powder business alone is worth near the current CG1 market based on the existing secured contracts and the first mover advantage it would give a competitor as industry shifts entirely to non-brominated AC.

The cost base was reduced dramatically when they had to respond to margin pressures in ramping volumes for the large customer, and they’ve been able to sustain it as the business has grown. Fixed costs are run-rating at approximately $7-$8m per annum.

In terms of numbers, I would expect CG1 to approach the mid to upper end of their $24-$29m revenue guidance in FY20. I think they can be run-rating at c.$30m of revenue as they exit this financial year.

If they can grow to a $40m run-rate in FY21, generate gross margins of c.38% and allowing for a modest (+15%) increase in the cost base then EBITDA would be running at $4-$5m, and growing quickly. That would be a cash earnings multiple of less than 10x on the current share price for a rapidly growing business.

Put that on a multiple akin to SDV, CLV or ANO and the share price could trade anywhere from 2-4x the current share price. They need to convert contracts and ramp volumes, but the multi-bagger potential is there.

CG1 is now at an inflection point with rapidly growing revenues & cash flow, regulatory tailwinds and an addressable market that continues to expand as the large base of trials converts to contracts. Meanwhile the strategic value of its powder business keeps rising.

Disclaimer: The author owns share in CG1 through the Capital H Inception Fund.

Note: Hat tip to Joshua Baker for his assistance on the research included above. Follow him on Livewire, it will likely be profitable.



Stephen Colman

Crazy amount of work done by both yourself and JB on this one, Harley! Awesome write up. I think this will be another superstar performer for you.

Param Singh

Thanks for a very well written and very detailed analysis.

Harley Grosser

Thanks Stephen, hope you're right!

Harley Grosser

Much appreciated Param.

Justin Crome

You sold me at the intro... guess I should read the rest. Interesting space this water business. Very nice of you to lay out this here for us all. But you've been doing that for a while now....

MJ JK

Harley, Great analysis, what do you think of SciDev (SDV) recent announcements ie The ProSol and Highlands acquisition - all strategic and all income generating companies which compliment SDV's Products.