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Edited Transcript of HDSN earnings conference call or presentation 8-Nov-17 10:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 Hudson Technologies Inc Earnings Call

PEARL RIVER Nov 17, 2017 (Thomson StreetEvents) -- Edited Transcript of Hudson Technologies Inc earnings conference call or presentation Wednesday, November 8, 2017 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brian F. Coleman

Hudson Technologies Inc. - President, COO and Director

* John Nesbett

Institutional Marketing Services, Inc. - Founder and President

* Kevin J. Zugibe

Hudson Technologies Inc. - Founder, Chairman of the Board and CEO

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Conference Call Participants

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* Gerard J. Sweeney

Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst

* Ryan James Merkel

William Blair & Company L.L.C., Research Division - Research Analyst

* Steven Lee Dyer

Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Hudson Technologies Third Quarter 2017 Earnings Conference Call.

(Operator Instructions) At this time, it is my pleasure to turn the floor over to your host, John Nesbett, of IMS. Sir, the floor is yours.

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John Nesbett, Institutional Marketing Services, Inc. - Founder and President [2]

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Good evening, and welcome to our conference call to discuss Hudson Technologies financial results for the 2017 third quarter. On the call today, we have Kevin Zugibe, Chairman and Chief Executive Officer; and Brian Coleman, President and Chief Operating Officer of Hudson. On the call this evening, management will review its third quarter results and provide an overview of its combined operations, including its acquisition of Airgas-Refrigerants, which closed on October 10, 2017.

Importantly, there is a slide presentation, which will accompany the discussion. This slide presentation can be accessed on the Investor Relations section of the company website. Please go to hudsontech.com. Click on the Investor Relations tab in the upper right-hand corner and select the Events & Presentations tab, which is the fourth in the drop-down menu. When you reach Events & Presentations page, you'll see the slide deck on the right side of the page. This is a user-controlled deck, so viewers will be responsible for advancing the slides. Management will prompt you as they advance through the deck.

Okay. I'll just now take a moment to read the safe harbor statement. During the course of this conference call, we will make certain forward-looking statements. All statements that address expectations, opinions or predictions about the future are forward-looking statements. Although they reflect our current expectations and are based on our best view of the industry and of our business as we see them today, they're not guarantees of future performance.

These statements involve a number of risks and assumptions, and since those elements can change, we would ask that you interpret them in that light. We urge you to review Hudson's Form 10-K and other SEC filings for a discussion of the principal risks and uncertainties that affect our performance and of the factors that could cause our actual results to differ materially.

Okay. With that, I will now turn the call over to Kevin. Go ahead, Kevin.

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [3]

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Good evening, and thank you for joining us on the call tonight. We'll first review the third quarter results, and then we'll turn the slide deck to discuss the enhanced market opportunity represented by the close of the Airgas-Refrigerants or ARI acquisition and to provide an overview of our operations as we move forward. We will include a pro forma financial information.

So first, let me turn it over to Brian to provide details in our third quarter results. Go ahead, Brian.

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [4]

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Thank you, Kevin. Revenues for the third quarter ended September 30, 2017, were $24.7 million, a decrease of 29% as compared to the $34.9 million in the third quarter of 2016. The revenue decrease was primarily driven by decreases in both volume and price of certain refrigerants sold.

During the quarter, we realized approximately $2.9 million of revenue for the DLA contract, noting that order fulfillment began in late July, and therefore, did not have a full 3-month contribution to this quarter.

On an overall basis, gross margin declined to 21% as compared to 34% in the same quarter last year. This quarter's gross margin was negatively impacted by the price reductions on all refrigerants, including R-22. This contrast with the 2016 gross margin, which was significantly impacted by substantial price and demand increases for R-22 due to the perceived shortages in the marketplace during the 2016 quarter.

Operating expenses for the quarter decreased to $3.6 million compared to $4 million in the previous year quarter. The decrease in 2017 is primarily due to higher stock compensation expense and professional fees in the 2016 third quarter offset by $1 million in non-recurring fees incurred in the third quarter 2017 related to the ARI acquisition.

Net income for the quarter was $2.1 million or $0.05 per basic and diluted share compared to net income of $4.8 million or $0.14 per basic and diluted share in the third quarter of 2016.

As we previously disclosed, we expected to see declines in price and volume during the third quarter of 2017 for all refrigerants. However, the magnitude of decline was greater than anticipated. At the time of our second quarter of 2017 earnings release, R-22 prices had decreased to about $18 per pound, and the pricing pressure continued through the end of the third quarter 2017 with R-22 prices declining further to current level of about $16 to $17 per pound.

Additionally, as anticipated, HFC prices also came down, further impacting our results for the third quarter. To give you some context around the price declines, the R-22 refrigerant sales season took a different trajectory than the HFC market. In the first quarter of 2017, producers aggressively raised their price in R-22, and one producer got out ahead of others and aggressively sold product in the first quarter that would otherwise have been available for sales later in the season. This advanced selling activity created excess supply in the marketplace and put a strain on pricing.

Additionally, we had a cool May and early June in the North and Northeast, an area which typically drives a significant amount of seasonal R-22 demand. With the cool temperatures, we saw a slower start to the cooling season. These factors, coupled with the rise in demand of substitutes, which we believe reached approximately 30% of the overall potential R-22 demand, created a pricing pressure on R-22, particularly in the latter part of the 2017 cooling season.

Regarding HFCs, around the time of our first quarter call, we saw signals of global market disruption and predicted that we may see volatility in HFC pricing for the cooling season. As it turned out, there was a severe although temporary supply and demand imbalance. This disruption began to subside in the third quarter of 2017 with a flood of Chinese supply of refrigerants, which in turn created a rapid reduction in HFC pricing that returned to levels similar to the beginning of the year.

Despite these declines, for the 9-month selling season, Hudson recorded revenue growth of 18% to $115.8 million; gross margin of 30%, which is at the high end of our targeted 28% to 30% range; and net income improved to $16.4 million or $0.39 per basic and $0.38 per diluted share.

We often discuss the importance of looking at our business through the perspective of 9-month selling season rather than on a quarter-to-quarter basis. And this year illustrates the supply and demand imbalances that can occur on a quarterly basis.

Our balance sheet at September 30, 2017, which excludes ARI, reflects cash of approximately $44 million, inventory of $63.8 million and approximately $115 million of working capital.

Now I'll turn it back to Kevin.

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [5]

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Thanks, Brian. As a reminder, there's a slide deck that will accompany the remainder of our discussion this evening, which can be accessed on the Investor Relations section of the company website at hudsontech.com, under the Events & Presentations tab. Please refer to Slide 1 for the safe harbor statement.

As we've outlined on Slide 3, on the call tonight, we'll discuss the industry trends and market behaviors that have guided our strategy to date and the continued opportunities we anticipate as we move forward. We'll then go over the details of the acquisition followed by an overview of the financials, including pro forma financial information for the acquisition of Airgas-Refrigerants for the 6 months ended June 30, 2017, and the year ended December 31, 2016. Then we'll open it up to Q&A.

So beginning on Slide 5. We outlined the market opportunity related to the phaseout of R-22. Despite some conflicting options -- I'm sorry, opinions put forth recently about the EPA's aftermarket demand estimates, there's no disputing the fact that production of virgin R-22 will be 0 at the end of 2019.

At that time, there will still be a large installed base of R-22 equipment that will continue to need R-22 refrigerant in order to run safely and efficiently. And based on its studies of the industry and data gathered from the industry participants, the EPA has estimated aftermarket demand of R-22 systems of 50 million pounds for 2020. The most efficient and safest way to operate an R-22 system is by using R-22 refrigerant. As production of virgin R-22 is phased out, we believe we have tremendous opportunity to fulfill the marketplace needs through our reclamation capabilities, which essentially position Hudson as a producer of R-22.

Regarding stockpile information, we'd like to clarify the difference between stockpile, which we've been referring to for many years, and inventory. It's always been recognized that there is a large supply of R-22 inventory held throughout the market by wholesalers, retailers, contractors and end users in hundreds of thousands of locations of businesses throughout the country.

As EPA was writing the final rule covering the allocations for the 2015 to '19 years, it was apparent to us that there was also a stockpile of R-22, which is product held for storage by certain companies at the top of the chain. These pounds have not yet been introduced into commerce and were not being accounted for in the calculations for needed allocations.

We worked very hard to get the EPA to write 114 letters, which will allow them to obtain information on the stockpile volume, which EPA could then utilize when calculating allowances for the final rule. The EPA followed through by writing 114 letters in 2013 and '14, and these letters identified specific volume levels held by primarily allocation holders, which we believe represented approximately 95% of the stockpile volume, which was not considered by the EPA in its previous calculations. We believe the inventory held throughout the market change is similar to every other year, but we believe the stockpile has significantly reduced.

In addition, it should be noted that we're continuing to pay approximately 50% of the sales price for used refrigerants. And as the sales prices decline, so is our buy price during the season. Moreover, if the contractor accidentally mixes 2 different refrigerants, the reclamation process requires a separation of the different refrigerants. Hudson was not only one of the first reclaimers on the market, it also is one of the first to separate refrigerants going back to the '90s.

The economics for processing mixed refrigerants are typically more favorable than the 50% pricing structure for used refrigerants. However, there is significantly lower amount of mixed refrigerant available when compared to reclaimable refrigerants.

On Slide 6, we take you through the evolution of our industry to help highlight why this acquisition positions us so favorably for long-term growth. As we often discuss, the ongoing phaseout of HCFC refrigerants and the expected future phasedown of HFC refrigerants represented tremendous growth opportunity for Hudson.

Hudson has experience of managing the shift from one class of gas to the next. The current phaseout of HCFCs is similar to what happened with chlorofluorocarbon or CFCs and what's expected to happen with HFCs. And to be clear, Hudson is an industry leader when it comes to the development of best-in-class technology for the reclamation and recycling of all refrigerants, whether these are refrigerants are contaminated or mixed.

With the addition of ARI, we are well positioned to serve our customers during the ongoing phaseout of HCFCs and to serve an expanded customer base during the future phasedown of HFCs.

In the near term, we expect to benefit from ARI's higher volume of HFC sales as the industry shifts from R-22 to HFCs. Hudson is historically focused more on the legacy R-22 business while ARI brings a very strong HFC business. As our industry continues to evolve, we expect that our combined expertise and capabilities will increase our access to legacy as well as next-generation gases, allowing us to expand and diversify our product offerings, application capabilities and our customer base.

The strength and depth of our combined operations position Hudson for continued growth and profitability as the industry transitions to new technologies in gases. On a long-term basis, we remain encouraged by the opportunities that R-22 will provide for many years to come and also by the understanding that as the industry transitions away from R-22, the role of next-generation refrigerants, HFCs, will increase as nearly all new equipment, including the equipment that's replacing R-22 units, runs on HFCs.

These HFCs have also been identified for phasedown beginning in 2019, and we believe this phasedown represents a significant long-term opportunity for Hudson. And since they have the larger installed base, we anticipate that the HFC reclamation opportunity has the potential to be larger than the current R-22 opportunity.

Of course, it's important to remember that while reclamation is a very important part of our long-term strategy, combined with that capability is our long-standing business of distributing all virgin refrigerants to a diverse base of customers across the country. This broad customer base depends on Hudson to have all refrigerants available to meet the aftermarket needs.

Turning now to the acquisition. It's an exciting and transformative time for our company. Since we last spoke with you, we have achieved a major milestone by completing the acquisition of ARI, which was a subsidiary of Airgas, an Air Liquide company, operating as a refrigerant distributor and EPA-certified reclaimer in the U.S., sourcing and reclaiming refrigerants for sale to a variety of end users, which is complementary to our business.

Brian will take us through additional financial details later in the call, but in short, we acquired ARI for $209 million and financed the deal with a combination of balance sheet, cash and new debt. No additional equity was issued for this transaction.

At June 30, 2017, trailing 12-month pro forma revenue of the combined business is approximately $275 million. The transaction is expected to be accretive to earnings beginning 1 year following the close of the transaction. The acquisition strengthens our leadership position in the industry and expands our abilities to meet the needs of our customers both through refrigerant distribution as well as reclamation.

The addition of ARI doubles the size of our business by bringing a complementary product portfolio, growing and diversifying our customer base and significantly growing our sales and distribution capabilities. ARI also brings a strong management team and seasoned employee base. With many folks with over 20 years of experience in our industry, they were very respected competitors before this acquisition, and their strength and skill set has become increasingly apparent now that we have started working with them. Our [command staff] is already hard at work integrating our systems and operations.

Slide 8 highlights the strategic benefits of the addition of ARI, which we expect will strengthen our current operations by providing a number of benefits. ARI's large customer base positions Hudson for future revenue growth. With the anticipated future phasedown of HFCs, the acquisition better leverages the strength of both -- the combined entities.

The expanded customer network significantly increases access to used refrigerants and strengthens our distribution capabilities across the United States. This acquisition brings cross-selling opportunities of Hudson services to ARI's existing customer base. The acquisition brings increased processing capacity to support the anticipated growth in reclamation volume from the ongoing phaseout of HCFC production and expected future phaseouts. Finally, we expect synergy opportunities associated with refrigerant procurement, anticipating benefits to the gross profit margin and further SG&A reductions.

Slide 9 depicts how complementary these 2 businesses are. Airgas-Refrigerants was part of Airgas, which was a publicly traded company until it was acquired by Air Liquide in 2016. After the acquisition, the ARI division became noncore for Air Liquide, which created the opportunity for us to acquire the business and more importantly, purchase the business at a fair price.

While there are a lot of complementary elements to the 2 businesses, the one element that ARI does not have is a suite of service offerings that we have. Through our combined operations, we'll now have access to a new and significantly larger audience for our service offerings, including our engineering assessment and optimization tools to companies and government entities looking to maximize their energy efficiency and sustainability initiatives.

Slide 10 provides a snapshot of Hudson's new expanded operations. The map shows the extended geographic coverage of the combined operations, and with the close, our customer base has now grown to more than 7,000.

Today, we have approximately 2 million pounds of additional reclamation processing capacity. And we have grown our employee count to more than 250, including ARI's experienced leadership team as well as a seasoned base of sales and operational employees.

With our industry-leading technology, well-established customer relationships and our robust distribution network, Hudson has been at the forefront of the refrigerant industry for quite some time. The addition of ARI significantly advances our leadership role and establishes us as the premier refrigerant and reclamation provider in the U.S. Our increased scale leads us well positioned to meet the needs of our customers throughout the current phaseout of HCFCs and through the industry shift to the next-generation HFCs, which has also been identified for future phasedown.

Slide 11 shows our enhanced reclamation market share, which we estimate at approximately 35%. We estimate that approximately half the market share is now captured by 2 companies. The balance is very fragmented, so we view the new scale of our company with expanded reach and capabilities as a meaningful competitive advantage as reclamation begins to play a larger supply role.

Slide 12 illustrates how our acquisition of ARI has given us a new presence further down the supply chain. Hudson has very strong relationships with HFC supply houses. And this acquisition complements that channel by adding this channel directly to end users.

By having stronger presence further down the supply chain, we will be able to better access dirty gas for reclamation. Our reclamation model is straightforward and provides us the opportunity to realize gross margins close to 50% on reclaimed gas. We accomplish this by buying back dirty gas at roughly half the market price, purifying it to virgin spec and reselling it at market prices.

Also, when we acquire mixed to cross-contaminated gas, which requires use of our proprietary fractional distillation systems to separate the mixed gases, we pay less for that mixed gas and that mixed refrigerant. This was advantageous from the ARI acquisition as we were able to take title to significant quantities of mixed gas at a very low cost.

With the acquisition of ARI, we are positioned to be both the leading reclaimer and distributor throughout the U.S. This acquisition also allows us to have a dual strategy of harvesting and selling refrigerant both at the wholesaler and end-user levels within the overall refrigerant aftermarket space.

Now I'll turn the call over to Brian to review additional financial information.

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [6]

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Thank you, Kevin. In order to frame the scale and value of our acquisition of ARI, on Slides 14 through 17, we provided pro forma financial information for the 6 months ended June 30, 2017, and the 12 months ended December 31, 2016. And the footnotes of these tables are available in the appendix.

While the 2018 selling price of R-22 will likely start off lower than the 2017 levels, we believe the pro forma combined financial results provide a good view of the scale of the business, cost structure and long-term earnings power of the combined entity.

If you turn to Slide 14, it provides a summary of pro forma information for the 6 months ended June 30, 2017, and 12 months ended December 31, 2016. You will see that on a pro forma basis, the combined business has a similar margin profile to the standalone Hudson business in these periods. However, the pro forma results, and specifically ARI historical results, have been negatively impacted by the noncash amortization of the step-up in basis of inventory of approximately $3.7 million and $7.4 million for the 6 months ended June 30, 2017, and the 12 months ended December 31, 2016, respectively. These noncash adjustments are related to the purchase price allocation and are being reflected as if the acquisition occurred on January 1, 2016. It should be noted that historical results of ARI would not require these adjustments.

Slides 15 and 16 simply provide the full pro forma income statements with 6 months ended June 30, 2017, and the year ended December 31, 2016, for your reference. There are a lot of numbers here in the slides. The important thing to focus on, on each of these slides is, one, both businesses have similar scale and roughly similar margin structures absent any pro forma adjustments associated with the acquired inventory. And two, in the pro forma adjustments column, the 2 large numbers are the noncash inventory step-up adjustment that we summarized in the previous slide and the interest and financing fees as if the transaction occurred at the beginning of these periods presented.

If you turn to Slide 17, you'll see the pro forma balance sheet at June 30, 2017. On a combined basis, at June 30, 2017, you will see strong pro forma working capital of $131 million and shareholders' equity of $123 million. Of note, you will see that on a pro forma basis at June, we had approximately $188 million of inventory. We do not expect that during the -- sorry, we do expect that during the 2018 and '19 periods, we will see declines on overall inventory balances, and in the 2019 period, an increase in inventory turns as we begin to rely on a greater percentage of reclaimed products of R-22 for sale to serve the R-22 demand. This is a strong balance sheet that has flexibility and liquidity as we look to grow our business.

Slide 18 gives a high-level overview of the acquisition financing. The net acquisition price was $209 million, subject to post-closing adjustments. The acquisition is being financed with available cash and under the enhanced asset-based lending facility borrowings of $80 million from PNC and a new term loan of approximately $105 million with GSO Capital Partners.

At closing, there was excess availability within the PNC facility of approximately $50 million. No additional Hudson equity was issued to finance this transaction. Upon closing, our total leverage ratio, as defined in the credit facilities, was approximately 3x pro forma adjusted trailing 12-month EBITDA. Given our strong profitability and expected growth going forward, we believe this is a reasonable leverage ratio.

Slide 19 provides a more important -- provides a few more important aspects of our liquidity position and ability to delever going forward. First, a large portion of the purchase price was for inventory and other tangible assets. Our pro forma basis of approximately 27% of the purchase price is allocated to intangibles, including goodwill. Also, we anticipate that we'll increase our inventory turns as the R-22 market is served by a greater portion of reclaimed refrigerants. Finally, we can prepay $30 million of our term loan without penalty should we choose, which provides additional financial flexibility.

We're heading to next selling season in a strong position for further -- to further enhance our balance sheet, and we have a strong foundation for long-term growth.

On Slide 20, we provide our target margin profile for the upcoming 2018 selling season and for '19 -- 2019 and beyond. Before we get into specific targets, I'd like to run through in more detail refrigerant pricing dynamics we're seeing now and how these dynamics relate to our historical experience in the acquired inventory.

As mentioned earlier, when we announced the second quarter 2017 results, R-22 prices had decreased to $18 per pound. This pricing pressure continued through the end of 2017 cooling season with R-22 prices declining to the current level of between $16 and $17 per pound. With the cooling season over, we expect to see very little sales activity in the fourth quarter. And the price level at the close of the cooling season has historically been the starting price point when we begin the next cooling season.

With that in mind, we're anticipating that the R-22 refrigerant pricing will remain at current levels for the start of the calendar 2018. It may increase as the selling season gets underway. Certainly, that has been the case in the past. We want to take conservative pricing expectations until we enter the 2018 sales season. If R-22 price remains flat in the mid-teens, we would expect 2018 revenues to be at levels similar to the pro forma consolidated 2016 levels.

Correspondingly, 2018 gross margins with -- that would be closer to historical gross margins of approximately 25% with operating margins in the mid-teen range. These margin assumptions would be the result if we had this relatively flat pricing dynamic for R-22 for all of the 2018 cooling season.

As a reminder, 2018 purchase price accounting could affect earnings by as much as approximately $17 million related to the onetime noncash impact for the acquired inventory. We will, of course, break this out for you as the year progresses so you could see the cash earnings of the business.

Looking beyond 2018, it's our belief that the R-22 price should increase as we move closer to the final phaseout of the R-22 production, enabling us to return to the gross margin and operating margin ranges we previously targeted.

To echo what Kevin said earlier, the addition of ARI is a strategically significant change for Hudson, strengthening our offerings, our personnel and our geographic reach to fortify our leadership position in the refrigerant and reclamation industry.

I will now turn the call back over to Kevin.

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [7]

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As the founder of this business and as its largest shareholder, I believe this is a very exciting and transformative time for our company. We are growing Hudson from a $50 million company in 2012 to a $250 million company today, thanks to our ability to deliver double-digit organic growth and execute on strategic acquisition opportunities.

With the close of the ARI acquisition, we have doubled the size of our company, positioning Hudson as the premier refrigerant and reclamation company in the U.S. Hudson has always been the clear leader in our industry with respect to using engineering expertise to drive sales, while the ARI group, that is now part of Hudson, has always been known as the best in the industry for sales and distribution.

We've enhanced our capabilities and our portfolio of comprehensive solutions, heightening our ability to serve the needs of our now significantly larger customer base. The ongoing phaseout of R-22 and future phasedown of next-generation HFCs continue to represent a significant growth opportunity for our company. Our long-term tenure in the industry, best-in-class technology and long-standing relationships have enabled us to establish a leadership role in the industry, and we believe we are uniquely positioned to leverage our strength to capitalize on the evolving industry landscape. As our industry continues to introduce next-generation climate and ozone friendly technologies and refrigerants, Hudson will be there to meet their needs.

We thank our existing employees and shareholders for their support, and we welcome our new ARI colleagues to the Hudson family.

Operator, we'll now open the call to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Ryan Merkel with William Blair.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [2]

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So first of all, nice job presenting all this information. Really good job with the slide deck. There's a lot here to get through. So I want to start by going back to the stockpile, which has created a little uncertainty recently. You gave a lot of the reasons why R-22 is a little bit weaker this year, and most of those sound transitory. What you didn't mention was the stockpile as a reason that was driving down R-22 prices. So would you just confirm for us if that is true. And secondly, do you think the stockpile is largely gone at this point? Or what year do you think it will largely be gone?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [3]

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So when we're talking about this year's season of pricing, it wasn't so much use of stockpile that we think affected the price of 22. It was more the action of one particular producer over all the others, shelving a lot of supply out into the marketplace in the first quarter during a period of time typically when no one is using R-22. Typically, R-22 is consumed or used by contractors in that April, May, June time frame. Most of the seasonal part of our business comes from the North and Northeast. So it's really just that activity by one producer particularly that forced a lot of supply out into the chain in the first quarter coupled then with the cooler spring and the fact that contractors didn't necessarily have a lot of demand or emergency calls. They were able to start to use, let's say, a slightly greater pace substitute R-22 products. And just to clarify, in case I made a mistake, I apologize if I did, that the substitute demand probably represents 20% of the total overall 22 demand. Those were the impacts primarily related to pricing. But to kind of go back to the second part, I think, of your question relative to stockpile, we always have believed that the stockpile would have been consumed predominantly through this 2017 into the 2018 period, and we didn't expect and we still don't expect that there will be a significant amount of stockpile available for 2019 and '20.

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [4]

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And when we said the producer at the beginning of this year went early, it wasn't with stockpile gas. They wouldn't have had much stockpile. We believe this was saying the yearly supply [heated] early, not extra inventory.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [5]

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Got it. So the stockpile narrative is false. It's basically the conclusion. Secondly, Brian, you mentioned that if R-22 prices are flat in '18 and you gave some financial metrics. I appreciate you being conservative there, but just talk to us. There is a pretty good chance that R-22 prices rise. And if they don't rise in '18, they’re certainly going to start rising in '19 and '20 due to the supply-demand dynamics, correct? So you still expect R-22 prices to march towards 30?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [6]

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We believe they're going to -- if it's not next year, which again, we don't have reason one way or another to see it moving next year. We just can't tell. So we're trying to be conservative because we don't have any indication of that. But definitely expect, for us internally at Hudson, that starting in '19, we should definitely see us getting back. Now we've seen this many times before with multiple gases and including R12, just to remind us of 2013, which had, by '14, started marching right back up again. We still have HCFCs phaseout with R12. They seem to back up at times. Certain emphasis can do that and we feel like we're there. We don't know -- again, as you said '18, we'll do it. But we do believe by '19, it will start marching up again.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [7]

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Okay. And then just lastly and I'll turn it over. You've had ARI for about a month now. Just give us initial impressions. And then how did the business perform this quarter just given the decline in volume and pricing in the industry?

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [8]

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Well at this point, what I can tell you is we're certainly very pleased with what -- we're happy to get into this with them. We're happy to close this. But what we've learned since then has made us much happier. Obviously, they're a much stronger outfit than maybe we were giving them credit for. We thought they were excellent, but they are definitely -- we're very complementary businesses but they're quite different. We go to market differently, which is all good. Every part of that is actually good for both companies. And they're just very strong in areas that we're not, and we can see why we'll be able to leverage on both sides. We'll help them but they'll really help us with our existing customers. So it pleasantly supplies put that way.

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [9]

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The other part, too, to their business, and we've talked about this, that is complementary, its customer base is complementary. They have far more customers than we have. And these customers are typically end users downstream. In some respects, these customers could be less susceptible to seasonality and they could be more correlated to, let's say, 24/7 type cooling such as supermarkets or a chemical facility. But also typically, as it relates to end user buyers, they are less price sensitive and less susceptible to sharp increases and decreases within a given season. So they will likely smooth out any of the ups and downs that we'll have, and they'll likely be able to attain a slightly higher margin -- gross margin because of where they sell in the chain.

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Operator [10]

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Our next question comes from Steve Dyer with Craig-Hallum.

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Steven Lee Dyer, Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst [11]

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I guess if we go back a little bit, I'm just curious as you kind of talked about the use of substitutes and the increase. In your view, as you sort of think about it, is that a byproduct of sort of how rapidly price increased pretty quickly early in this year or the perception of kind of lack of availability? What sort of drove that? And then as you think about kind of the use of substitutes and how people will do that over time, what's kind of -- how do you think that works? What are the kind of associated impacts? I mean, is there a magic price level where you saw a very different behavior, et cetera?

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [12]

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Again, I don't think it's the actual number, the price number. We think it's how it happened, and this bigger shock came out early in the year. And so a combination of really early in the year, a lot of gas got jumped early by the producer at a high price. So here's your inventory on your shelves, very high price. They weren't used to that at a time when -- again, that's -- when you're in the first quarter, you're not using gas primarily. You lower your shelves. Contractors start using the gas closer into the second quarter if it's hot. And if it's not hot like it wasn't this year, it was cool spring, they have time on their hands. Am I going to try and experiment with a new gas? I'll try an alternative. The gas is really shockingly high all of a sudden. It just jumped over the winter. Yes, all of those things seem to be a shock to the system to contractors when they tried this. So we think that was more of it. It was really how fast it jumped up first quarter in price. It was really, again, the trajectory of the price quickly with the cold spring. I actually put a lot more credence to the cold spring and that effect to us. But long term, we've seen this. We always know they're going to be there. They were during the 12s, the R12 phaseout. They'll always be available, but nobody even claims R-22 is going to do more capacity from a performance point of view. Obviously, it's the best gas for the system. If you have time on your hands because you're not busy because of the cold spring, yes, you might do it. If you're busy, you want it in and out, you're going to use R-22. So we get some heat next year. We definitely -- people are not going to take the time off to be playing with other gases they're going to use the fastest, most efficient gas. They're going to get off the customer site to get to another site, and that's -- so it's not even a question to us what they'd rather use. So it's not just -- well, could it make its way into the 20s and go up? Yes, it certainly can. It's just how fast it goes up.

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [13]

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And maybe to add to this, we saw exactly the same thing happen in the second quarter of 2013 with regards to a spike in the R-22 substitutes. So we've been talking about substitutes probably since 2010 or '11, whatever, we've always said we typically expect them to be roughly single digits of the overall supply side to the R-22 demand. But in that 2013 year, we had that same pricing dynamic that we talked about happen at the beginning of this year. A huge spike relative to the price point that exited the 2012 year seemed to create this ability for contractors to say, hey, let me try these substitutes. But if the folks on the phone here have recalled, that was sort of a one-season event. '14, '15 and '16, the substitute products retracted to less than 10% or single digits. This is now, let's say, repeated itself the second time. And as Kevin said, it appears to be correlated to a cooler spring but also these significant price increases that happened at the beginning of the year as opposed to those other years I've mentioned where we saw successive price increase through the season.

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Steven Lee Dyer, Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst [14]

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Got it. That's very helpful. I guess kind of turning to the combined model where you talked about gross margins in the mid-20s and operating margins to kind of more in the mid-teens, did I hear it right or am I assuming correctly that, that assumes sort of R-22 pricing or overall refrigerant pricing about where it is? And then if that were to move up, there'd be upside to those numbers? And then also, what, if any, does that sort of include for synergies of the acquisition?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [15]

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Yes. So those numbers are really assuming very, let's say, flat, lower price for R-22 and no real improvement in pricing of R-22, which is not what we expect and certainly not what we've seen before. But because we're at this particular point where it haven't entered the season -- and typically, we'll talk about pricing dynamics and margin expectations when we report the fourth quarter, which we normally announce the end of February or beginning of March. And we'll be in a position at that point to see where the pricing dynamics are. So because we're well before this particular observable time starting 2018 year, we just propose, from a conservative point of view, looking at the pro forma 12/31/2016 numbers, recognizing in that particular year the pricing of R-22 were in the mid-teens. That's probably a good reference point to start. It doesn't mean that, that's really our expectation. And certainly, if the past is the predictor of the future, we're likely to see price increases in '18 on R-22. But at this moment, we were referencing them and we will obviously be giving an update when we report the fourth quarter results.

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Kevin J. Zugibe, Hudson Technologies Inc. - Founder, Chairman of the Board and CEO [16]

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And in addition, we said -- on what you asked about synergy, we're not including on that end the procurement of the gas. We do believe critical mass of the companies that from a gross margin point of view, will drive obviously our cost of goods down. We do believe that on the procurement side, that we're in a much better position than we've ever been before. And we haven't factored that in yet, although we're expecting it.

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Steven Lee Dyer, Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst [17]

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Got it. Makes sense. I guess then lastly for me and I'll pass it over. Just commentary on maybe the early days of the DoD program and sort of how that's ramping and what if anything -- or how much that assumes sort of on a ramp going into next year.

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [18]

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So starting as we probably thought it would and so we will change the number. We think we will continue with the ramp rate. But there are little things and blips you'll run into, new agencies coming in, from inspections to everything else. You have a win. You have a back step. And you've had those things, which we kind of expected. We just didn't know where they'd come from. We feel much better now. But you get those blips in the beginning. Very happy with where it's going. And so we do think that trajectory that we originally said, maybe closer to $20 million per year kind of number in the beginning. We do believe we'll head toward that. We just had to get past some points. We're working through a couple more right now. But we really like the program, very excited about it. We want to get as much of that $400 million set aside as we can.

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Operator [19]

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Our next question comes from Gerry Sweeney with Roth Capital.

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Gerard J. Sweeney, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [20]

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And on that note, just taking a look at the pro forma income statement, it looks like Airgas did about 36% gross margins while it was 2016. And 2016 was a pretty solid year. But if I remember correctly, or if my sources are correct, Airgas was probably 10% to 15% R-22 reclaim, and the rest of it was distribution business. Therefore, what I'm trying to get at, it seems like Airgas' distribution business has a pretty good margin profile, maybe better than yours?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [21]

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Well, possibly there's a little confusion. The 10% or 15%, I think, was related specifically to the reclaim market or their share of the reclaim market. And that ultimately then turns into really a source of supply, which goes to inventory than sales. I don't think there was any further disclosure about their volumes of R-22 or the like. But to go back for a moment, whether it be R-22 or HFCs, because their customer base is different and because it's downstream, it's likely they'll be able to achieve higher gross margins than we will. Now we are working through some comparative allocation of expenses and the like. So their gross margin, as presented here, should be similar to what ours would have been. It should be. But I think there'll be some additional reclassification of expenses that occur over the next couple of quarters. But at the end of the day, they should have higher gross margins usually than we like.

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Gerard J. Sweeney, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [22]

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Okay, got it. And I'm going to throw it out there and let's see if you agree with this. But obviously, they've got a pretty large significant inventory. How much of that inventory -- I mean, one of the key questions is -- I think was there's a step-up in inventory and cost, et cetera. But how much -- if you will, non-technical term, how much of a deal did you get on that inventory, on that ex the adjustment? Did you -- were you able to get some of that below market prices lower than where you're at? I just want to see for what the true inventory value is and then also how much R-22 versus HFCs and things like that?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [23]

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Well, I mean, at the end of the day, what we're doing is we're paying for the business and we're paying a total -- in this case, it is subject to further adjustments, but it's $209 million for the business. We have to, though, allocate that purchase price amongst the assets acquired. So in this case, other than -- following GAAP, we have to modify the current costing structure of their inventory to reflect something more closer to market value, and that's what we've done here in the adjustment. And that total adjustment to inventory is about $17 million. And that's where we've discussed earlier that this will get amortized and likely hit the P&L next year or some amount of it will hit next year. And we'll be separately disclosing a non-GAAP reconciliation for all that. At the end of the day, we're then blessed to acquire the remainder of the purchase price. And in this case, about 27% of the total purchase price went to intangible assets, which relatively speaking is a fairly low percentage. It's certainly lower than the percentages that would have been correlated to acquisitions that Airgas would have made to bring this business together many years ago, too.

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Gerard J. Sweeney, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [24]

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Got it. And then also, as we're looking out to next year in terms of pricing, between you and National Refrigerant, you're going to have like a 50% of the reclaim market according to your charts. And with the virgin production coming down, at what point do you and -- Hudson and National Refrigerants, I guess, at what point do you become the price setters as opposed to the virgin producers? Because their production is going down. You guys are going to be the people with the supply. And at 50% combined market share, can you start eventually setting the price of the gas at least initially?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [25]

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So your question ties into, let's say, the question about stockpile as well. We've assumed that most of the stockpile, large majority of the stockpile would be consumed and used up by the time we get through the end of next season. So assuming we're right on that, then certainly in 2019, we'll have a market that's based more on supply and demand than typical economics. So we would expect then as the reclaimers in totality, not just the 2 of us, but all the reclaimers, we'd be able to react to and have R-22 pricing more in line with demand and not necessarily affected by an oligopoly that might control the overall supply side. So if our assumptions of stockpile are right, then that 2019 year is likely where we have this more normalized supply and demand and pricing structure and that certainly Hudson and all the other reclaimers will have more of an influence on that.

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Gerard J. Sweeney, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [26]

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Got it. And then one final question. You mentioned 50 million pounds EPA sort of estimate of aftermarket demand. How much confidence do you have in that number today?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [27]

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We have the same sort of confidence today as we did back in 2014. A lot of the problems we saw with the EPA's modeling and had demand at a very high number in the '14 and '15 years were related to applications and equipment whose end of life would have been completed by, let's say, 2015, '16, '17. An example of that would be, for example, window units. We don't think there's a lot of R-22 demand that goes to service window units. The EPA's modeling had quite a lot. Well, there really aren't many, if any at all, R-22 window units left in the marketplace. So we triangulated our sales at $50 million -- 50 million pound number, and that seems to correlate to what the EPA's modeling gets you to in those years. And some of the errors, if you will, or some of the questions we might have had about the model, those factors would have been modeled out certainly by the time we get to 2020 as well.

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Gerard J. Sweeney, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [28]

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Okay, got it. And then that 20% substitute, is that 20% off of that 50 million pounds? So the R-22 market is really 40 million pounds because 20% has been taken by substitutes?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [29]

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If you cap with that percentage, it would stay at 20%, yes.

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Gerard J. Sweeney, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [30]

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If it stays. Okay, got it.

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [31]

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Are there other questions?

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John Nesbett, Institutional Marketing Services, Inc. - Founder and President [32]

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Operator?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [33]

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John, do you know if there are other questions?

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John Nesbett, Institutional Marketing Services, Inc. - Founder and President [34]

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There are a few more people queued up for questions. The operator seems to have dropped off. Hold on. Doug, are you there?

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Brian F. Coleman, Hudson Technologies Inc. - President, COO and Director [35]

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John, should we have people that need to call, call? What should we do?

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John Nesbett, Institutional Marketing Services, Inc. - Founder and President [36]

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So at this point, we'll conclude the call. There are 2 other questions, but we'll call out these people. But the operator has disconnected. So we'll conclude the call. Thank you, everybody, for calling in. If you have any follow-up questions, please call our office at (203) 972-9200, and we'll be happy to set up a follow-up call. And thank you for participating, and we look forward to speaking with you next quarter.