Axion International: Upward Momentum Has Just Begun With A Game-Changing Contract
Matthew Dow (seeking alpha)
I'm a firm believer that you should always be willing to think out-of-the-box when it comes to your investing style, and not always follow the same principles with every investment. Although in general I consider myself a value investor, sometimes I stray from these principles when I find a small cap growth story which I think has tremendous market disrupting potential (despite some questionable near term financials). With this thought in mind, about 2 years ago I happened on the tiny company Axion International ( OTCQB:AXIH), an intriguing $30m dollar nano cap. This company specializes in composite plastic infrastructure products (railroad ties, i-beams, t-beams, tongue and groove boards and pilings) which are used as an environmentally friendly replacement for more traditional materials such as wood, steel, or concrete. The innovative products have captured the attention of several mediaoutlets, including Fortune Magazine in April of 2012. The company licenses a number of patents exclusively through a partnership with the Rutgers University Materials Science and Engineering School. The technology used transforms recycled consumer and industrial plastics into very durable composite materials.
Although the growth potential for the products was seemingly huge, the primary risks associated with the company have been its relatively weak capital position with a lot of convertible debt and warrants outstanding coupled with the fact that it is still not producing positive cash flow. Revenues have grown substantially from under $2m annually in 2009 to around $6m in 2013, but previously the company had stated it needed to scale significantly higher (>$20m) in order to start generating real profits. Even the previous auditor had cast a substantial doubt that the company could continue as a going concern based on its capital position and the fact that growth was not accelerating fast enough to keep up with substantial operating expenses.
However in the past few weeks a major positive catalyst has arrived that is a big game changer for the company, and I've now become an investor myself. In Late November it was announced that they were purchasing the assets of a recycling plant in Ohio to start a new subsidiary which would offer recycled plastics as a direct product, and the plant would also be used as part of the company's vertical integration strategy for its own construction materials. On December 3rd, the company announced a $42m contract with a major US thermoplastics company. This means that overnight, the company will increase yearly revenues from about $6m to $20m (contract will pay $14m annually for 3 years). The stock has gone in 1 week from about $0.63/share to just at $1 at the time of writing. Average daily volume before the announcement was 50k shares, and in the 5 days since volume every day has been between 177k - 680k. This gets nothing short of a "WOW" factor, as clearly bigger investors are starting to move in. In the short term I expect the momentum to continue as clearly some larger funds have been buying. This is a company that before this announcement had only 1% of shares held by institutions and no Wall Street following. So over the next few months there is now a substantial opportunity for investors, as the stock should now see continued buying pressure especially as it is near $1/share which will allow more funds to own it.
Longer term through 2014 there are many other positive factors for the stock. Below I've highlighted 10 factors to summarize the overall investment thesis, to explain why I believe this stock is heading much higher in the near term. The recent run-up is only going to be the beginning of getting this company on the map as a legitimate growth story and disruptor to the current status quo in the industrial markets it serves.
Factor 1: Major Deal with New Plastics Recycling Subsidiary will Increase Revenues over 300%
Axion bought in new management a few years ago, as the company wanted to shift from product development and engineering towards manufacturing and marketing. To do so Steve Silverman was named as CEO in early 2011 after he joined the company the year before. Silverman came from the electronics company Archbrook Laguna, where had worked for about 15 years as a sales executive and vice president. He had an impressive track record there, as VP of operations and business development he led growth in sales from $250m to $1B in just 5 years. In the past few years now with Axion, the company has been successfully in growing revenues, but progress is still probably slower than hoped as they need to scale quicker in order to become profitable:
Revenues have increased from only about $1.9m in 2010 to over $5m in 2012. Through 9 months in 2013, the company already had $4.5m in revenues and expected to be slightly above where it was in 2012 for the full year.
In terms of profits, this has not been a very pretty picture. The company has struggled with margins, mostly because it has been trying to scale its manufacturing enough where it could efficiently source raw materials for consistent prices and improve utilization rates. An additional major factor has been favorable pricing that was given to its first big Class I Railroad customer which has frequently been more than 50% of revenues in certain quarters. This favorable pricing however should end in the near-term, as I'll discuss later in the article. Below we can see that operating margins have been sharply negative, as the company has had higher SG&A expenses in order to try and ramp-up their go-to-market strategy. Several wealthy insiders have provided the company with funding via convertible debt instruments in order to keep it afloat.
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Looking ahead, the revenue picture will drastically change for the company starting now. With a new $42m contract over 3 years in place, Axion will see an immediate boost to at least $20m/year in revenues.
The deal will be renewable for 12 month increments after that. After buying the assets of a recycling plant in Ohio, Axion formed a new subsidiary called Axion Recycled Plastics Inc. The business will operate out of the Ohio plant and a second Texas facility that the company has already been using for manufacturing its other products. The new customer will purchase what is called HDPE HMW (High Molecular Weight High Density Polyethylene) in monthly volume commitments. This deal will get Axion on the map in this market and should also lead to more deals as well assuming they can show solid execution. The Recycled Plastics subsidiary will produce what is called "HMW pellets", which are essentially small plastic beads that are used as raw materials into other processes by thermoplastic companies.
In terms of long term growth, I actually think that Axion's core market of making composite building materials is where the game-changing potential is. In the recycled plastics industry there is more competition and margins are not likely to be impressive. However this new deal is very significant in several ways for the company, for example:
1) It provides stable long term revenues (at least 3 years)
2) It pushes the market capitalization high enough to garner more attention from professional investors
3) It Establishes in-house recycled plastics facilities which will improve gross margins for the composite building products
Factor 2: Market Valuation Reset has only just Begun
Until recently, Axion has been valued on an EV/Revenue multiple in the range of 3-5x through most of 2012 and 2013:
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Now that Revenues are set to be about $20m per year, this same valuation would be a market cap of $80m, or a share price of $2.58, implying the stock could still more than double from its current level. I expect that the market will not value the plastics recycling with as high a potential for further rapid growth, so I think this valuation is probably getting ahead of ourselves. However even if you assume only 2-3x EV/Revenue then it would still be $40-60m, which is still at least 33% upside from today's price and perhaps significantly more.
Factor 3: Price over $1.00/share, Wall Street Aggressive Growth Firms Will Now Start to Notice the Company
At the time of writing the stock price has been hovering very close to $1/share. This would be a significant milestone for the company as this will be the first time in more than 2 years since this has occurred. When the company first went public it was significantly higher than this, but as part of its further funding for development it issued a large amount of convertible instruments which served to increase the fully diluted share and lower the stock price. Moving up over $1 will have several positive impacts. This makes the company more "legitimate" and should allow it to gain more attention from professionals, both from the buy and sell side. From this perspective the company can only go up, as it had less than 1% of outstanding shares owned by institutions and no formal Wall Street analyst following. Also if it can stay over this level the company could consider to list on the NASDAQ.
Factor 4: Class I RailRoad Customer with favorable pricing is becoming less of a factor
One of the main margin issues the past few years has been that the company gave very favorable pricing to its 1st major railroad customer as part of a 3 year contract. This was a $15m dollar deal that the company signed in February 2011. This has served to generate well over 50% of revenues over this period, but this percentage has been trending down over 2013 as the customer base is broadening significantly. Axion does not disclose the name of the customer of details on the pricing over than that it was very favorable and essentially has meant it was difficult if not impossible for them to turn a profit during this period with the heavy reliance on this customer.
However the 3 year period is now ending in early 2014. On the most recent conference call, Silverman stated that they have continued a close relationship with this railroad and have done further testing of higher grade composites in 2013 with support faster rail traffic. All indications are that the relationship will continue with new contracts when this one expires and very likely for more favorable terms to Axion now that it has proven itself.
Factor 5: Market Opportunity in Construction Verticals Remains Large
AXION's range of ECOTRAX® (Railroad ties) and STRUXURE® infrastructure products (bridges, construction mats, boardwalks, etc) address several sizeable market verticals. In the U.S. alone some statistics:
20 million rail ties are purchased each year according to the Railway Tie Association. The North American wood construction mat market is estimated at over $500 million in annual sales. This is a new area for the company that they just entered last year. They have concluded several successful trials in 2013, and have just announced their first real orders in November. Over 700,000 bridges are structurally deficient and/or need repair in the U.S. To date the company has not garnered significant business here yet, but they spent several years proving the technology successfully including trials with the US Military where army tanks are using the bridges without any issue All together and these represents a portion of an enormous market - tapping into an overall $3.3 trillion infrastructure market over the next five years according to market research. Even if AXION is able to capture 0.01% of the market in the US for Bridge repair (70 bridges) in the coming 5 years and continue to grow its Rail tie business at double digit rates than Axion will be worth well over $100m. 
Factor 6: Through Further Customer Diversification, Opportunities are Mounting
AXION products are now utilized by a diverse customer base from industries including rail, bridge infrastructure, mining, and oil & gas. The Company is expanding its sales pipeline, increasing manufacturing capacity, and reducing its cost of raw materials with a goal of improving profitability near term.
In terms of backlog, as of November the company reported up to $50m in sales opportunities through 2014 which included 84 active opportunities at 57 customers. This is not even counting the major new customer in the recycling plastics division.
If the company is able to convert 20% of its pipeline for next year then it could see revenues of about $25m in 2014. What is significant here is the diversity of the customer base, which is now coming from around the world. For example recent deals have been made with railroads in Russia and Australia, two of the largest rail networks in the world. This diversity will improve the chances of follow-up sales as well.
Factor 7: Technology Patents are exclusively Licensed in Most Major Markets to Axion
The technology used by Axion is licensed from Rutgers University in a long standing relationship that began already in the early 1990s when engineers first met with a Class 1 Railroad to talk about and determine specifications for the first composite railroad ties. Axion has exclusive manufacturing rights to use the technology in:
North America South America the Carribbean South Korea Australia Saudi Arabia UAE Russia Africa (except South Africa) China (co-license) In the other territories including Europe, there is a 2nd licensee that Axion works together with. However Axion is the only producer of its ECOTRAX® (Railroad ties) and STRUXURE® products, so it is not really competing directly with the 2nd licensee. The company can also grant sub-licenses to manufacturers who want to exploit the technology in areas with Axion doesn't operate. To date this hasn't occurred, but if the adoption continues to grow rapidly this could be another potential revenue stream for the company to explore more seriously.
Factor 8: Margins set to Increase with Larger Scale and Vertical Integration
As of the first quarter of 2013, AXION has begun to shift its manufacturing strategy from subcontracted manufacturing to operating its own facility to produce its products to the highest quality standards, while allowing it to capture larger margins. The Company is now focused on the vertical integration of its operations, adding more components to the value chain. The company has a few of its own manufacturing lines now fully operational as of late 2013, where it is operating 24x7 in its Texas facility. Also now with the new plastics recycling business, the company will control all key components of the supply chain making it fully vertically integrated. The Company's current manufacturing capacity, both subcontracted and internal, can support $30 to $40 million in sales. Since sales have been less than $10m the past few years the company will now be able to take on larger contracts without substantially increasing capital expenditures in the near term.
Factor 9: ROI over competing products is Clear
AXION's green technology combines 100% post-consumer and post- industrial waste, and through an extrusion process transforms these materials into structural building products. This has a lot of advantages over traditional building materials. For instance:
Unlike wood, AXION's products are resistant to moisture, rot, and insect damage. Unlike steel, they are non-corrosive. And unlike concrete, AXION's products are lighter and easier to transport than concrete. So there are clear advantages over all of the major building materials that you would typically find for railroad ties, bridges, boardwalks and construction mats. Of course due to the relatively higher complexity in production, the upfront price is significantly more - according to company commentary on average about double the upfront purchase cost.
However the total ROI is clear because the products last much longer and have lower maintenance cost and transportation costs. Also at the end of the useful life the materials are 100% recyclable and made into new AXION products.
Factor 10: Larger Wins to be Expected in 2014 as Trials are Progressing Successfully
A final point to note is that the company has been progressing according to plan for a few years now on numerous trials, mostly with the railroad industry. It's important to note that these industries are notoriously conservative and require extensive engineering checks and rigorous trials before they will adopt any new products. The CEO has stated that adoption and awareness of their product is their biggest challenge for wide scale growth. So even though the value proposition seems to be clear cut as described above, all of these industries have a "prove it to me" attitude. Recent progress is trending in the right direction, and includes:
Construction mat trials concluded successfully as of November. Sales opportunities being quoted. This is a completely new revenue stream for the company. A second Class I Railroad trial is commencing, and a third Class I is in discussions The company can show 13 years of successful tests on Railroad track in Colorado. So the fact that the company spent over a decade in perfecting the products before trying to aggressively move to market is a big plus. To date there have been no major customer trials which didn't have a satisfactory result. In 2013 the first purchase order for Russia was announced. Russia has one of the biggest rail networks in the world, and the value proposition is even stronger due to very rough climate and weather in much of the country which causes rot and damage to traditional wooden ties. Financial Risks - Debt and Dilution
A company like Axion doesn't come without risks, and in this case it is probably not for the faint of heart, and should be kept to the speculative part of your portfolio.
The biggest risk to the company is due to its capitalization structure. As of November, the company had $7.8m in assets and $3.6m in current liabilities, which includes some derivative liabilities. Beyond that however there are 8% convertible promissory notes of more than $7m and 10% preferred stock warrants. In total the liabilities are more than $10m implying a significant stockholder equity deficit, and this doesn't even include a few million more that will be part of the new plastics recycling subsidiary. Some of these notes do however go out several years (principal due in August 2017) and as long as the company continues to scale up its business and win some more big deals this will probably not be as big an issue in the long run as it appears.
However as operating cash flow has been sharply negative until now, any major economic downturn or business slowdown will be a big issue for the company, so this is the biggest risk to the investment.
In addition worth mentioning is that the company has recently become a Delaware corporation and increased its total issuable shares to 250m from the previous 100m recently. As the company continues to scale its manufacturing in the coming years it may need further equity financing.
The Bottom Line
Axion is an intriguing nano cap company that has a unique set of products with huge potential. Due to its exclusive patents, the company does not have any direct competitors that make the exact same type of composite materials, and they should be able to significantly grow market share as the construction, railroad, and mining industries realize the value proposition for these products even further. There are other makers of composite type building materials, but the addressable market is very large and Axion has advantages in that its products have been engineered and tested in conjunction with Rutgers for more than 15 years. Most importantly the recent major contract of $42m will go a long way to legitimize this company both with Wall Street analysts and institutional investors.
This should cause a period going into 2014 of further re-factoring on the stock price, and I believe momentum investors today have an excellent chance to ride the stock another 30-50% higher in the coming few months, after it has already popped 50% in the last week.
Looking out longer term and the market potential is still very promising for green friendly building products, and as the company has been slowly but surely increasing capacity and winning more deals this should result in a strong base of recurring revenue once customers fully trust the products and have successfully passed trial phases. I expect that buy and hold investors should also garner significant alpha over the long run if they enter a position today in Axion. |
