Arq Inc. ($ARQ) Memo
Vertically-integrated producer in an inflecting, supply constrained commodity
My favorite opportunities are overlooked companies that operate in growing oligopolistic industries and sell to price-insensitive customers. Bonus points if there is incentive-aligned management with a track record of operational excellence.
Arq is one of those companies, and activated carbon one of those markets. The AC market is projected to grow three- to five-fold by 2030, driven by increasing awareness and regulations around PFAS (forever chemicals) in the water supply. Further, AC is an oligopolistic market, with the largest producer serving over half the market, and Arq, the main publicly traded player, producing 20% of North American supply.
Market Overview
The GAC market is estimated at around 350 million pounds per year. Calgon Carbon, bought by Kuraray, a Japanese chemicals manufacturer, has production capacity for about 200 pounds. After the upgrades to the Red River facility are complete, Arq should have 25 million pounds of GAC capacity (on top of its existing PAC production), with the option to build to expand to 125 million if the market supports it.
In 2023, the EPA under Biden proposed a PFAS framework which limits maximum contaminant levels for forever chemicals at 4 parts per trillion—a single drop in 20 Olympic-sized swimming pools. To filter PFAS, the EPA has previously recommended GAC as part of its standard treatment train. Utilities like American Water Works have also said ”[GAC] will be the primary treatment method we use for PFAS remediation because it's a proven and more cost-effective treatment option for our systems.“ At least under the Biden administration's EPA, water utilities are expected to comply by 2027. To this end, American Water Works recently signed a contract with Calgon Carbon despite the administration. I estimate this takes out 20% of Calgon's supply for the next decade.
Taken as a whole, this incremental demand from water utilities is projected to create a deficit equivalent to the market's entire production capacity today, even before accounting for new GAC markets (e.g., biogas).
Pricing for PAC/GAC is fairly opaque, as no major producers publish pricing information. Still, there are some clues out there. An old ValueInvestorsClub post estimated that Kuraray enjoyed an average price of $1.75 / lb for GAC and spent roughly $3.70 / lb for its brownfield expansion. This aligns with Arq's estimate that "the cost to build greenfield sites today is between $5 to $7 per pound of production dramatically impacting the economics others can realize through their investment dollars. Brownfield sites may be less expensive at between $3 to $5 per pound of production." Finally, municipal procurement documents from a year or two ago suggest ~$0.80 / lb for PAC and $1.75 to $2.25 / lb for GAC. Arq has good visibility on PAC prices, which have sustained double digit year-over-year increases for the past several quarters.
Because part of the thesis is predicated on GAC price increases, it's a useful exercise to consider: at what price would it become unsustainable for water companies? Arq estimates this level to be around 2-4% of opex, representing a 2-3x from today's levels.
All of this is to say that the GAC market is extremely undersupplied today. Arq management estimates that it would take ~2 years for new production to come online, given the time it takes to get environmental permits, order long lead-time materials, and build the facilities. Further, a new upstart would need visibility on demand to get financed. At today's uneconomical prices, there is also no incentive to do so.
Science Overview
I've been discussing GAC as a commodity. This is not entirely accurate, as the quality of produced GAC varies a bit and the willingness to pay has various considerations. To understand those, we have to get a bit into the science.
Activated carbon is a technical sale
Activated carbon is produced by heating carbonaceous raw materials (wood, coconut shells, coal). The process of thermal “activation” creates pores on the surface of the material which is found to be useful in “adsorbing” (think adhesion) pollutants that it encounters.
Properties such as surface area, pore volume, surface chemical functionalities and particle size and form can be specifically engineered to selectively target various contaminants and optimize lifecycle costs. For PFAS filtration, you need bituminous coal waste, and there is a limited available source of new suitable bituminous coal in North America. Arq is vertically integrated and uses its own lignite coal waste for its powdered activated carbon and bituminous coal for its upcoming granular activated carbon offering.
Activated carbon is a consumable in that its efficacy declines after a period of usage, so new carbon must be purchased from time to time, though it can be “reactivated” to recover some of its adsorption capabilities.
In my conversations with them, the Arq team asserts that their GAC has been demonstrated to perform up to 10x more effectively than the Calgon benchmark. This accords with my conversations with utilities customers who corroborate that Arq products perform better than competitors like Norit and Doneau. Customers extensively test AC in situ before buying and some are willing to pay higher prices for product which won't cause problems down the line "We have seen situations... [cause] a shutdown in the process."
Alternatives to GAC
For water purification, the two main “alternatives” to AC are ion exchange membranes and reverse osmosis. I use scare quotes because, to be sure, they are often used all together, rather than strictly substitute goods. Ion exchange (IX) positively charge ions on one end and draw out pollutants through a membrane. Reverse osmosis (RO) similarly involves passing water through membranes several times, and loses a lot of water in the process. One water treatment facility I spoke to says that they recover 80% of the water from RO, meaning they have to reject 20% as waste. Both can yield higher quality filtration results than AC but tend to be very costly to run (electricity) and maintain (waste byproducts) compared to AC. It is also noteworthy that there is some research to suggest IX is more effective for short-chain PFAS than AC, though the marginal improvement is something like 98% vs 90% filtration. Only one of the many water districts I spoke to is planning to use IX alone (Nantucket Water, which recently declared a state of emergency to filter PFAS in its water). See this link from a water system in Wellesley on why they choose GAC over IX.
If that was too much science, then the tl;dr is simply that the EPA recommends activated carbon as part of its standard treatment train for filtration, and particularly for PFAS filtration, and I think you’d be hard-pressed to find many water utilities that don’t have some sort of activated carbon treatment in their mix.
Business history
Arq sells activated carbon solutions for water and air purification, and count many water utilities systems as their customers. The current form of the company began in 2021, when Advanced Emission Solutions‘ (formerly, ADES) merged with Arq to expand product offerings to include bituminous-based GAC.
In the years following, they began upgrading their Red River and Corbin facilities to enable industrial scale GAC production. The PAC business has historically served coal plants, and was accordingly sensitive to the relative cost of natural gas.
Their current CEO, Bob Rasmus, took office in 2023, immediately buying millions of dollars in stock with his own money (which has appreciated considerably) and receives a negligible salary. Under his leadership, margins have improved dramatically as a result of aggressive cost-cutting (which included slashing executive bonuses) and pricing measures. He has also begun diversifying the business outside of the coal industry.
Some highlights and lowlights of Rasmus's time so far as CEO:
Highlight: improved margins and profitability by cutting costs (including forgoing executive bonuses in 2023 to save $2 million in costs) and loss-making contracts, driving a streak of double digit pricing gains in PAC business and 6%+ gross margin improvements from 24.1% to 30.6%.
Neutral: Rasmus had to raise equity financing despite an initial comment that shareholders wouldn’t be diluted. I'd say this is excusable given that he first tried to negotiate debt terms; after debtholders wouldn’t play ball, Rasmus received an opportunistic PIPE offer at around $5.75.
Lowlight: The capex estimated to upgrade Red River ballooned from $40 million to $80 million as a result of poor consultant estimates and work products. Given Rasmus's intense focus on costs, I suspect this was just a bit of Murphy's law at work. At the risk of being too pollyannaish, I'd argue that this is another plausible "barrier to entry" that explains why the industry is supply constrained.
Arq has remained capital disciplined. Rasmus has repeatedly said that he would only expand Red River capacity if they were pulled by the market to do so. So far, they have contracted over half of the 25 million pounds of nameplate capacity, which was scheduled to have been ready for production EOY 2024. (EDIT: Management has informed me that latest guidance for completion is Q1 2025).
Even with the ballooned costs, management estimates ~3 year payback, suggesting around $20 million EBITDA per year.
In the last month, Arq mentioned that they had paused contracting for the time being, which I suspect contributed to the subsequent price decline on fears that sales had slowed. However, Arq mentioned that they are focusing on diversifying their end markets, and particularly finding end markets which are willing to pay a premium for their higher-purity products, such as in biogas. Rasmus has stated that they could fill all 25 million pounds with water utilities markets if they wanted to, so I am not worried about filling demand.
Finally, they generally sign contracts for 1-5 years. The price is defined in year 1 with upward only mechanism, which enables them to capture optionality as the supply deficit comes to a head.
Valuation
There are several ways to win with ARQ.
On an EV/EBITDA basis, Arq is undervalued when compared to water utilities & clean tech comparables (9x vs. 14x average). I don't bet on multiple expansion alone, but as Rasmus continues to improve margins and GAC pricing inflects upwards, I think Arq's low multiple could stand to re-rate. Even if it doesn't, the low multiple offers a margin of safety from here.
Rasmus is still aggressively searching for ways to reduce costs at both the Red River and Corbin plants, which will continue to drive margin improvements, albeit at a slower pace than before.
Arq has good visibility into the legacy PAC business and pricing going forward, and pricing gains remain strong.
As Arq starts producing and selling GAC, I believe that GAC pricing is likely much higher than what the market is implying. Management has repeatedly said, even with capex overruns, that the Red River upgrades will take ~3 years to pay back, suggesting at least $20M EBITDA contribution from GAC, resulting in $30M total EBITDA assuming run rate production—well above the $17M consensus this year and even the $26M consensus for 2026.
This all assumes that GAC pricing remains relatively stable. There is significant additional optionality as GAC pricing inflects upwards, or Arq continues to secure higher-value contracts.
Given the above, a few back-of-the-envelope scenarios on where Arq goes from here:
Assuming no re-rate, then Red River, once fully ramped, should add $20M to EBITDA. On the same 9x multiple, this represents 43% appreciation.
Assuming a modest rerate to 11-12x and some additional margin and pricing improvements, a 2x becomes possible.
If GAC pricing goes the way of uranium, there is multibagger potential.
Risks
The Trump administration has postponed the rollout of the Biden era guidelines around PFAS limitations in industrial wastewater. However, this is only on the polluter side; utilities are still liable for monitoring PFAS in the water supply. It’s possible that the utilities might drag their feet.
I am not very concerned here as forward-looking utilities like American Water Works have already committed to buying a great deal of carbon. Essential Utilities said something similar about the developments from the administration: “Yes. I would say, if anything, we would not expect a backing off on the limit. So the 4 parts per trillion probably stays in place, at least to our best estimate. But even if there was a slowing in the compliance period, we would expect to continue to meet the current pace. We've talked to our regulators in the states that are particularly impacted by this and regulators, both on the environmental side and on the economic side have suggested that we stay the course and complete the work and then get it recovered.”
Further, Trump's pick for the EPA, Lee Zeldin, has a record of voting for PFAS rules and other clean water regulations, in part influenced by his Long Island constituency’s struggle with the forever chemicals.
It's possible that capex overruns and delays stymie the Red River upgrades for a few more months. We will learn more on the Mar 5 earnings call how the upgrade, slated to finish by EOY 2024 (EDIT: Q1 2025), has gone. Nevertheless, the upgrades are in the final innings of completion.
Disclaimer: This memo is for informational purposes only and does not constitute investment advice. The author has a position in the aforementioned security. Readers should conduct their own thorough research and consult with a qualified financial advisor before making any investment decisions. Investing in the stock market involves risk, including the potential loss of principal.