Arq, Inc. quarterly report, Q3 FY2016

Business context and reporting period

Advanced Emissions Solutions, Inc. (ADES) filed this unaudited Form 10-Q for the quarter ended September 30, 2016, with year-to-date results through that date. The filing identifies ADES—not Arq, Inc.—as the registrant; verify that this is the intended filing. ADES supplies emissions-control equipment, chemicals, technologies and services, and earns significant income from its refined-coal investments and related royalties.

Financial performance and liquidity

Q3 gross margin is not separately stated in the filing. Reported revenue reflects equipment, chemical and consulting sales; equity-method earnings and royalties are presented outside reported revenue. Q3 equity-method earnings were $10.7 million, including $9.8 million from Tinuum Group, and related-party royalties were $2.1 million. Nine-month equity-method earnings were $30.1 million and royalties were $3.9 million.

At September 30, cash and cash equivalents were $7.6 million, restricted cash totaled $8.8 million, current assets were $27.6 million and current liabilities were $29.0 million, resulting in negative working capital of approximately $1.4 million. Total assets were $40.5 million and total liabilities were $40.8 million. The company reported no borrowings or notes payable at quarter end. Its bank line had no borrowing availability because of historical covenant violations and was extended only through November 27, 2016; the company was discussing renewal or replacement.

Material changes versus prior comparable periods

• Net income improved from losses in 2015, despite a nine-month decline in reported revenue. The improvement chiefly reflected higher recognized Tinuum Group distributions and substantially lower operating expenses, rather than a return to positive core operating income.
• Q3 reported revenue rose 22%, led by equipment sales and chemicals. Nine-month equipment sales declined 6%; chemical revenue rose, while consulting revenue fell.
• Operating expenses excluding direct cost of revenue fell 56% in Q3 and 51% year to date, reflecting restructuring, lower headcount, reduced professional costs after the financial-statement restatement, and reduced R&D activity. Headcount was down approximately 76% year over year for the nine-month period.
• Cash declined by $1.7 million over the first nine months, but investing cash flow was boosted by $24.7 million of Tinuum Group distributions classified as distributions in excess of investment basis. Financing cash use included repayment of the short-term related-party credit agreement.
• ADES sold its RCM6 interest in March for $1.8 million cash, with the buyer assuming the associated note; it recorded a $2.1 million gain. It also settled a DSI-related note for $0.3 million versus approximately $1.1 million owed, recording a gain.

Outlook, risks, contingencies and unusual items

• Management said forecasted liquidity from cash, distributions, royalties and operating results should fund continuing operations even if new financing is not obtained, but emphasized dependence on executing contracts, receiving Tinuum distributions and royalties, and growing emissions-control chemical and service sales. This is conditional commentary, not quantified earnings guidance.
• Management expected royalty income for the remainder of 2016 to exceed Q3 levels, based on anticipated production and a higher effective per-ton royalty rate. It also expected continued declines in long-term equipment contracts as deadlines for key emissions standards had passed, while anticipating growth in chemical demand.
• Tinuum Group distributions and tax-equity investors are important uncertainties. ADES reported 13 invested facilities generating rental income, while retained facilities generating Section 45 tax credits fell to zero from five a year earlier. Reduced facility operations lowered royalties and tax credits.
• Legal and settlement accruals totaled $21.8 million, including $16.7 million related to the Norit royalty award. The $4.0 million securities settlement and up to $0.6 million derivative-settlement legal fees were recorded with matching insurance receivables; court approval remained pending. The SEC staff proposed a $0.5 million civil penalty, subject to SEC approval.
• Two emissions-control systems passed performance testing in Q3, allowing deferred revenue recognition; approximately $0.9 million of costs were incurred to resolve performance issues. A terminated sales-type lease produced a $0.9 million gain; the $3.6 million termination payment was received in October 2016.
• Disclosure controls and procedures were reported ineffective at September 30 due to previously disclosed material weaknesses. Remediation was ongoing. The company also retained a full valuation allowance against deferred tax assets.

Important facts for investors to verify

• Confirm the issuer identity: this filing is for Advanced Emissions Solutions, Inc., not Arq, Inc.
• Assess the sustainability and cash conversion of Tinuum-related earnings, including the accounting for distributions when the investment carrying value is zero.
• Check renewal or replacement of the unavailable bank line, the November 27, 2016 expiration, restricted-cash release prospects and near-term liquidity.
• Track Tinuum facility operations, tax-equity financing, royalty-bearing tonnage and the risk of further reductions in distributions or royalties.
• Confirm final court and SEC approvals and insurance funding of settlements, and monitor Norit royalty obligations and performance guarantees.
• Review progress in remediating internal-control material weaknesses and the effect of continuing cost reductions on operating capacity.