On Wednesday, shares of ailing provider of boiler optimization and air pollution reduction solutions Fuel Tech Inc. (FTEK) staged a major rally as headlines of an apparent major Q3 earnings outperformance started to attract momentum traders.
While revenues indeed outperformed expectations of the single analyst currently covering the company due to a recovery in the specialty chemicals segment, reported bottom line profitability was solely the result of a one-time 2.6 million insurance claim settlement as outlined in the 10-Q (emphasis added by author):
During the fourth quarter of 2018, the Company was notified of certain non-conformance issues with a U.S. customer associated with equipment that requires remedy under the warranty provision of the contract.
During the second quarter of 2020 a charge of $1,150 to remedy this non-conformance issue was incurred. Offsetting this amount was a reversal of $499 of expense to reduce the allowance of doubtful accounts that had been previously reserved. The Company has completed all work associated with this issue.
During the third quarter of 2020, the Company settled an outstanding claim with our insurance provider for these remediation efforts and recorded a receivable in the amount of $2,589. The settlement is recorded in the cost of sales line on the Consolidated Statement of Operations and in the Insurance Receivable line in the current asset section of the Consolidated Balance Sheets. Collection of the funds was completed in October 2020.
In addition, backlog continued to decrease, now down almost 35% since the beginning of the year and down 23% sequentially to just $6.4 million as the company continues to struggle with the fallout from COVID-19:
(…) we have experienced some deferred decision-making on the part of some customers due in part to uncertainty created by the effect of COVID-19 pandemic (…)
While management remained upbeat about winning new business in the company’s air pollution control business segment, commentary was largely unchanged from the Q2 report:
(…) we remain intensely focused on providing custom-engineered solutions that fulfill the unique needs of each of our customers, and expect the final decisions to be made on multiple projects by the end of the year which, if Fuel Tech’s bids are selected, would increase backlog for 2021 and beyond by $10 to $15 million.”
That said, the company’s cash flow performance improved during the quarter with free cash flow roughly at break-even levels after using $3.6 million in the first half of the year. Unrestricted cash amounted to $9.4 million at the end of Q3. Fuel Tech has no debt other than a $1.6 million promissory note related to the government’s Paycheck Protection Program (“PPP”).
The company’s cash position should improve meaningfully this quarter due to the collection of the above discussed $2.6 million settlement payment.
Valuation remains reflective of the major revenue declines experienced by the company in recent years. Remember, the company recorded sales of $56.5 million in FY2018 but reduced coal-fired electricity demand has since caused revenues to fall off a cliff, down 46% in 2019.
Mostly due to the impact of COVID-19, sales will come down further this year with revenues of $16.3 million so far recorded in the first nine months of 2020.
At an assumed share price of $1, enterprise value calculates to a measly $12 million, which simply reflects the reality of a money-losing business in secular decline.
While Fuel Tech’s Q3 results indeed showed meaningful improvement over the first half of this year, reported profitability was solely the result of a large one-time insurance settlement gain.
In addition, the company’s backlog continues to shrink, now down almost 35% since the beginning of the year.
With the business being in secular decline, there’s little reason to own the stock even at the current discounted valuation.
Given the issues discussed above, investors should use Wednesday’s rally to sell existing positions or outright short the shares. As momentum traders are moving to assumed greener pastures, I fully expect the share price to be back below $0.80 at the end of this week at the latest point.
That said, while the borrowing rate of 13.5% is not an issue for a short-term trade, shares are currently hard to borrow at Interactive Brokers.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in FTEK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.