MagneGas — Acquisitions drive trebling in revenue

Total revenue grew by 201% year-on-year during Q218 to $2.9m. Stripping out the impact of acquisitions, of which the most recent purchase, Trico, generated $1.4m revenues, like-for-like sales were flat as sales resources were focused on the geographies addressed by the acquisitions, which is where management sees better growth potential and higher profit margin opportunities. Investment in sales teams and marketing campaigns based round MagneGas2 as a lead product have driven strong revenue growth for Complete Welding (San Diego) and Green Arc (East Texas and Louisiana). However, while Trico (Sacramento) won numerous customers in the agricultural sector, this was offset by the loss of a major customer through market consolidation. Gross margin declined from 45% to 32% because of GAAP treatment of acquired inventory, which marks the value up to the current retail price. Stripping out this effect, gross margins were broadly stable at 44%, as improved purchasing power was offset by a less favourable product mix. Operating costs increased by $0.8m to $4.3m, mainly as a result of the ongoing operating costs of the acquisitions, although there were one-off costs of $0.1m related to the Trico transaction. Operating losses widened by $0.3m to $3.4m. Q217 benefited from $1.4m positive movement in the fair value of derivative liability, so net loss widened by $1.3m to $3.5m.

Net cash used in operating activities during Q218 totalled $4.0m as management reduced vendor balances, accrued expenses and other short-term liabilities. Cash used in investing activities was only $0.1m as the cost of the Trico acquisition, which completed in early April, was recognised during Q118. Net cash from financing totalled $2.8m, $2.6m of which was from drawing down Series C preferred stock. Net cash (netted against capital leases, notes payable and promissory notes) reduced from $1.2m at the end of March to $0.4m at the end of June. The use of preferred stock was significantly dilutive. During Q218, Series C convertibles converted into 7.7m new shares of common stock. Between 1 July and 8 August, a further 10.8m new shares of common stock were issued as more of the Series C convertibles were drawn down. As part of the drive to strengthen the balance sheet so it can finance further acquisitions through senior debt, at the end of June management completed a $556k convertible preferred offering with its investment banking partners to clear accrued financing expenses. These preferred shares have already been converted, leading to the issue of 2.4m new shares of common stock during July. Further financing will be required during H218. If necessary, this can be satisfied through further draw-down of Series C preferred stock (estimated c $8m remaining), although we have modelled the funding gap satisfied through issue of debt, as per Edison policy.

Revenues: we expect a modest improvement in sales in Florida following the expansion into Pasco County and continued growth from the acquisitions, reflecting the new clients that were secured in Q2. Noting that annualised revenues have fallen since May, some of which is seasonal, we revise our FY18 revenue estimate downwards.

Gross margin: we expect gross margins to rise to above historical levels in Q318, since the inventory acquired with the acquisitions has been worked through, plus there is the benefit of greater purchasing power arising from economies of scale. Noting management’s prediction that the installation of a bulk industrial gas fill plant at its Clearwater facilities in Florida, which it expects will be fully operational by the end of 2018, will improve combined gross margin by 3–5pp, we model a further improvement in FY19.

Operating costs: Q218 operating costs were distorted by $90k on consulting relating to the Trico acquisition, $60k on computer and IT integration activities, and higher than normal travel expenses relating to personnel training and other integration-related activities. Going forward, operating costs will exclude these one-off items and will benefit from staffing changes implemented in Q218 that are expected to save more than $50k/month. However, now that there is more detailed information about the incremental operating costs (including depreciation) associated with Trico, we increase our FY18 and FY19 operating cost estimates.

Management’s stated strategy is for MagneGas to become financially self-supporting by building up sales of cutting gases and associated equipment. Part of this will be through investment in sales teams in the recently acquired businesses, using MagneGas2 cutting fuel as a way of attracting new clients and opening new outlets, such as the one in Pasco County, Florida. Part of the sales growth will be through further acquisitions. Management estimates that the group will break even at around $20m annual revenues.

In July, management announced that it had formed a wholly-owned subsidiary based in London, UK. The newly founded company will be used as a vehicle for applying for EU grants without relying on the joint venture (JV) with Infinite Fuels. Management has already identified two European Commission-sponsored grants. One of these could potentially provide funding to develop the fourth generation of the gasification equipment, the other a multi-year agricultural sterilisation project based in north-east Europe. Longer-term, the UK subsidiary will act as a base for marketing, producing and selling MagneGas2 in the UK and mainland Europe. Developing the fourth generation gasification equipment is important because a much larger area is exposed to the plasma arc in the updated design. This will potentially enable the unit to process pulverised solids such as plastic waste and reduce total production costs by at least 90%, helping MagneGas take significant market share in the global cutting-fuel market.

MagneGas has already demonstrated it can compete successfully for EU funding, having won a $7.2m grant with JV partner Infinite Fuels. The final stages of government administration with regard to this grant are currently being completed, potentially unlocking funding for a biowaste-to-energy project in northern Germany and enabling the JV to start paying consulting fees to MagneGas. Management is also making progress in its discussions with port authorities in Amsterdam, Rotterdam, Antwerp and Hamburg, where it has identified concentrated clusters of users of metal-cutting fuel.

In May 2018, MagneGas achieved its first major milestone on the 18-month pilot with one of the largest dairy farms in Florida. It gave a successful live demonstration of the sterilisation technology at the farm to representatives from the US Department of Agriculture (USDA), the Dairy Farmers of America, the International Dairy Journal and other independent dairy operators, as well as local government representatives. Following this demonstration, the USDA invited MagneGas to present its findings at the Soil and Water Conservation Society’s International Annual Conference on Culture, Climate and Conservation. Management has begun to explore complementary technology opportunities, such as water filtration, that potentially extend the appeal of the waste-water sterilisation proposition.

MagneGas continues to make progress on using waste streams from a major medical company located in Florida to fuel the gasification unit. This would potentially reduce the cost of production further, as currently the medical company pays a fee to dispose of the material.

Although we expect MagneGas to start generating revenues from the sale of sterilisation equipment or provision of sterilisation services towards the end of FY18, these sources are treated as upside to estimates. Consequently our estimates are based solely on revenues derived from the sale of industrial gases and associated equipment. We have therefore selected a sample of listed companies supplying industrial gases for our valuation. We note that MagneGas is trading at a small premium to the mean with regard to historical EV/sales multiples (2.5x vs 2.4x), and a substantial discount to the mean EV/sales multiple for both 2018 (0.8x vs 3.5x) and 2019 (0.6x vs 3.3x). While some discount for MagneGas’s small market capitalisation and level of losses is justified, its exceptionally strong projected sales growth should counteract this, at least in part. While there is potential for significant share price appreciation as the full benefit of the Trico acquisition becomes clear, this is being held back by the commentary in the most recent SEC filing, noting substantial doubt about the company’s ability to continue as a going concern.