Long Shot: Hudson Tech Is Cleaning Up

 | Aug 06, 2012 | 7:00 AM EDT
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Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.

Nothing attracts my attention like a company blowing away the numbers, and I get even more interested when there are compelling reasons that have some level of sustainability. One such name that recently popped up on my radar is Hudson Technologies (HDSN), a New York-based company that recycles used R-22 refrigerant.

R-22 is considered a greenhouse gas that depletes ozone, as so is being phased out by all signatories to the Montreal Protocol, including the U.S. Because the U.S. was not making sufficient progress on reducing the use of "virgin" R-22 in new air conditioners and refrigerators, the Environmental Protection Agency added more stringent limitations starting in 2012, which should reduce virgin R-22 usage by 55% vs. 2011 levels. As supply of new R-22 declines, the price has risen between 2x to 3x over the last year. Hudson is capitalizing on this trend both in its sales of virgin R-22 -- for which it is a distributor -- and, more important, in its service to recycle the refrigerant.

The simplest way to dispose of used R-22 -- for instance, in an air conditioner being disposed of -- is to vent it, which is against the law. With elevated prices, the economic incentives for recycling are sufficiently high, and companies like Hudson are creating good businesses in recovering R-22; they're required to pay for it, thus creating the incentive not to vent. This is both good both for Hudson's bottom line and for the environment. Hudson has around 20% of the reclamation market.

The price increases for R-22 are driving huge upside for Hudson Tech. It has started putting up gross margins at 2x or more than last year, and it's blowing away Street estimates. Two analysts cover the name, and the small-cap specialist Singular Research does an excellent job on them, so I pay close attention to their analyst Greg Garner. He was looking for $0.10 in earnings per share for the second quarter and $0.25 for the year. Last week Hudson reported $0.20 for the second quarter alone. Absent a major dislocation in its market, I estimate the company should earn $0.80 or more this year. That's not bad for a stock trading at $3.27.

 Clearly you need to be careful of inflated expectations. Hudson rallied meaningfully before the earnings report, and it sold off meaningfully after it. Investors were disappointed with the conference call, in which management was not sufficiently prepared and struggled to answer important questions. I believe this is a communication issue more than a fundamental problem with the business, and I believe the tailwinds in their business should last for awhile.

The clear risk to the story is in the long term: What happens when R-22 is phased out? Fortunately, the firm's recycling technology is applicable to many refrigerants, and no matter what gases are used, refrigeration and air conditioning are not going away. I think with near-term profit upside and the ability to move into adjacent markets, the company can post stellar earnings for years to come. This story certainly has some lets, yet the shares are at perhaps 5x 2012 EPS, so I am not paying up for it.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider ­­­­HDSN to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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