Two Ideas: Advanced Emissions Solutions & A Bitcoin Proxy

Panic causes tunnel vision. Calm acceptance of danger allows us to more easily assess the situation and see the options. — Simon Sinek

Advanced Emissions Solutions $ADES

In Environmental Concerns: Ideas on Long Side we discussed the lack of progress in reducing global emissions since the Paris Climate Agreement was signed by 190-plus countries in December 2015. At a high level we suggested Advanced Emissions Solutions as a potential long idea that could benefit from increased regulatory pressure to control emissions.

$ADES owns a 42.5 per cent stake in a joint venture with Goldman Sachs and Nexgen Refined Coal called Tinuum Group. Tinuum is awarded tax credits when it produces refined coal — coal that has been processed to reduce emissions when burned.

In the American Jobs Act of 2004 there was a provision to encourage the use of chemically treated coal to reduce the emissions from US power plants. To qualify for the refined coal tax credit, producers “must have a qualified professional engineer demonstrate that burning the refined coal results in a 20 per cent emissions reduction of nitrogen oxide and a 40 percent emissions reduction of either sulfur dioxide or mercury compared with the emissions that would result from burning feedstock coal”. The tax credit was designed to increase with inflation and was valued at US dollars 6.91 per short tonne produced in 2017 and US dollars 7.10 per short tonne in 2018. As an added bonus, some operating expenses incurred in running a refined coal facility are also tax deductible, making the tax credit’s effective value in 2018 as much as  US dollars 9 a tonne.

The tax credit, as originally structured, was not easy for refined coal producers to take advantage of. The policy required producers to increase raw coal’s market value by 50 percent to qualify for the tax credit. This clause made cost-conscious utilities unwilling to buy refined coal.

A policy edit to the structure of the tax credit in 2008 by senators from Montana and Iowa, two coal producing states, however, removed the market value clause. The removal of this clause made it possible for refined coal producers to benefit from the tax credit even if they sold their product at a loss. This shift in policy incentivised  the creation of Tinuum and other refined coal producers like it.

Tinuum financed the construction of facilities to produce refined coal situated next to coal-fired power plants. The window to construct these facilities closed in 2011 and the tax credits expire in ten years from commencement of operations. Republican Senator John Hoeven from North Dakota, also a coal producing state, has, however, introduced legislation to extend the tax credits by another ten years.

On average, each facility cost between US dollars 4 and 6 million to construct.  Tinuum constructed 28 of them, making it the second largest operator in the refined coal space.

How does Tinuum benefit from the tax credit? 

1. Power plants lease refined coal facilities from Tinuum at say a rate of US dollar 4 per tonne of refined coal (plus, at times, additional royalty commissions) — 42.5 per cent of which goes to $ADES

2. The refined coal facility is used to process feedstock coal and generate a tax credit at the prevailing inflation adjusted rate. Operating the refined coal facility costs power plant owners a further US dollars 3 per tonne.

3.  Power plant owners receive the ~US dollars 7 per tonne in tax credits and at the same time the operating expenses  incurred in running the refined coal facility and the lease payment to Tinuum are tax deductible. At a marginal tax rate of 21 per cent, the power plants tax bill is reduced by approximately US dollars 1.47 per tonne.

Tinuum presently has 20 of 28 refined coal facilities (representing 55 to 65 million tonnes of refined coal capacity) contracted to the owners of coal-fired power plants.  In 2019, it has an opportunity to increase the utilisation of its idle facilities. A number of tax advantaged refined coal facilities that began operations in 2009 have seen or will see their tax advantaged status lapse during the year. One of the 20 operational facilities was contracted and brought online in January 2019. Management expects a further 12 millions tonnes of refined coal capacity to be contracted over the course of 2019.

Based on the 20 contracted facilities through 2021, when the tax credits expires, $ADES’s share of net refined coal related cash flows from Tinuum is estimated to be between US dollars 200 and 225 million. To put that into perspective the market capitalisation of $ADES is US dollars 248.8 million.

What other areas does Advanced Emissions Solutions operate in?

In December 2018, the company acquired ADA Carbon Solutions (ACS). ACS owns and operates an activated carbon manufacturing plant focused on “mitigating mercury emissions” from coal-fired power plants.

In its first full quarter since acquisition, ACS contributed US dollars 14.6 million in revenue to $ADES.

Management’s plan is to cross-sell ACS’s solutions to existing customers and also expand the mercury mitigation solutions services into other adjacent segments. One adjacent market they intend to target is the municipal water treatment market, a highly fragmented sector “comprised of many producers and re-sellers”.  Management does not expect the entry into adjacent markets to require incremental investments to be made by the company.

Investment Thesis

$ADES currently trades at trailing twelve months earnings of 6.9 times and a dividend yield of 7.50 per cent with return on equity of 46 per cent.

Given the majority of the company’s market value is covered by its share of Tinuum’s contracted cash flows, we see $ADES as a cheap call option on (1) the potential increase in tax credit by another 10 years, (2) contracting of Tinuum’s remaining 8 refined coal facilities through 2021 and (3) the activated carbon segment.

A Bitcoin Proxy

Famed short-seller Jim Chanos, using his Twitter alias Diogenes (handle: @WallStCynic) recently tweeted:

“How the F is this bitcoin nonsense being resurrected again? Are people really this stupid?”

We do not know if buyers of bitcoin are being clever or not so clever. We do not know what is driving the buying. Maybe it is the employees of Lyft, Uber, Zoom or Pinterest, newly minted as millionaires, using a portion of their winnings to buy bitcoin. Or Chinese capital fearful of an imminent devaluation of the renminbi finding a way around capital controls by buying bitcoin. Or [insert here whatever is the narrative du jour for crypto-aficionados or crypto-sceptics].

What we do know is that it has been going up and it may go higher still.

Our aim here is not to argue for or against bitcoin. There are far smarter and far more informed people on both sides of the argument for any contribution we may have to make the debate to be value accretive even at the margin. Rather, we have found the process of buying and selling bitcoin somewhat cumbersome and want to suggest a proxy for those that may want to trade bitcoin and not necessarily own it.

The below is a normalised chart of bitcoin and The Bitcoin Group ($ADE.GY) starting 31 December 2016. The Bitcoin Group is a holding company focused on investing in businesses and technologies in the fields of cryptocurrency and blockchain. Presently, the holding company owns one asset: 100 per cent of the shares of Bitcoin Deutschland AG, the only German authorised trading platform for bitcoin.

XBTUSD Curncy (XBT-USD Cross Rat 2019-05-16 10-53-39.png

So if you want to trade bitcoin but find the whole process a bit cumbersome, The Bitcoin Group might be worth a look. As the chart seems to suggest, it has been a pretty good proxy to buying bitcoin, at least since the beginning of 2017.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

European Growth Surprise

 

“Commerce flourishes by circumstances, precarious, transitory, contingent, almost as the winds and waves that bring it to our shores.” — Charles Caleb Colton

 

“Politicians know that structural reforms – to increase competition, foster innovation, and drive institutional change – are the way to tackle structural impediments to growth. But they know that while the pain from reform is immediate, gains are typically delayed and their beneficiaries uncertain.” — Raghuram Rajan

 

 

Following four quarters of negative growth surprises, the European economy positively surprised for the first quarter of 2019. Based on preliminary data, the Euro Area’s GDP grew 1.2 year-over-year and 0.4 per cent quarter-over-quarter. Quarter-over-growth was up from the 0.2 per cent recorded in fourth quarter last year and ahead of the 0.2 per cent growth anticipated by the ECB as recently as March. As an added boost, Italy emerged from its third recession in a decade.

 

In March, the ECB revised down its GDP growth projection for this year to 1.1 per cent from 1.7 per cent last December. If forthcoming data confirm the gradual improvement in the economy, the ECB may well need to revise its GDP growth projections in June. The performance of the European economy during the last quarter may yet prove to be fleeting given transitory effects.

 

Automotive sales declined month-over-month in each of last four months of 2018 — plunging 11.4 quarter-over-quarter, on a seasonally adjusted basing, during the fourth quarter — triggered by the introduction of tougher emission standards by  European regulatory authorities. The new standards have been drafted with the intent giving consumers a more realistic picture of fuel economy by compelling automakers to test vehicles in conditions more representative of real-world conditions. The transition to the new regulatory regime upset the apple cart, automakers struggled to complete testing and certification in a timely manner — impacting production and leading wide-scale inventory shortages.

 

More than half of automakers’ production losses were recouped in first quarter of this year.

 

Part of the slowdown in 2018 was also driven by the draw down of inventories, which led to weakness in intermediate goods production following a significant upcycle in 2017.  The downward inventory trend was partly reversed in the first of quarter of this year and the correction may still have a few more months to run.

 

Construction activity during the first quarter of this year may also have been exaggerated. A relatively mild winter, particularly in February and March,  boosted construction activity.  In February, construction output jumped by 3 per cent month-over-month. (March data is not yet available.)

 

The non-transitory positives were accelerating wages, healthy levels of job creation and robust consumer spending. Fixed investment by business also continued to expand at a healthy clip driven by high levels of capacity utilisation  — Italy is the exception of course, the economy continues to operate below levels recorded in 2008.

 

There were no signs of a pick-up in exports from Euro Area, based on January and February data. Global trade, however, is no longer declining and may not be headwind to growth in 2019, especially if the US and China reach some sort of agreement in their trade dispute in the near term and Europe avoids an escalation of trade tensions with the US.

 

The positive growth for the first quarter have been reflected in an uptick in European money supply M2 — defined as currency in circulation plus overnight deposits plus deposits with an agreed maturity up to 2 years plus deposits redeemable at a period of notice up to 3 months.

 

European M2 growing at an annual pace of 5 per cent, outside a recession, has in recent years translated into the economy expanding between 1 and 2 per cent. With M2 growth still range bound, we see limited capacity for the European economic growth to further surprise to the upside forth rest of 2019 barring a remarkable recovery in global trade or in global auto demand.

 

EHGDEUY Index (Eurozone Real GDP 2019-05-03 06-44-13

 

Turning to equity markets and with the MSCI Europe Total Return Index up almost 14 per cent year-to-date in US dollar terms, the question is whether a broad exposure to European equity markets warranted?

 

The chart below compares the MSCI Europe Index to the year-over-year growth in European money supply M1 advanced by 12 month. (M1 is the ECB’s narrow measure of money supply which comprises only currency in circulation plus overnight deposits i.e. highly liquid money that can be spent immediately.)

 

Based on the chart below the European equity markets may already priced in the good news.

 

MXEU Index (MSCI Europe Index) E 2019-05-03 06-25-31

 

Another time series we chart against the MSCI Europe Index is the ratio of the narrow measure of money supply M1 to the broader measure of money supply M2, once again advanced by twelve months. Based on the comparison of the two time series, the historical relationship suggests that there may yet be upside in Europe still.

 

The historical relationship makes sense, as M1 expanding at a faster rate than M2 — the composition of money supply shifting from a less liquid form to a more liquid one — was a leading indicator for increased capital expenditures. This relationship, in our opinion, is not as robust as it used to be as the ECB has eliminated the opportunity cost for individuals and businesses in holding cash in demand deposits, rather than placing it in higher yielding time deposits. Two-year deposits yield as little as 3 basis points today while businesses could earn as much 120 basis points prior to the Global Financial Crisis and as much as 300 basis points during the Eurozone crisis.

 

MXEU Index (MSCI Europe Index) E 2019-05-03 06-31-54

Exposure to Euro Area equities should be based on bottom stock selection to identify value opportunities, in our opinion. While we think broad based equity exposure to non-emerging Europe should be avoided at this stage.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.