MagneGas Corporation — Securing future through sales of cutting gas

MagneGas is a technology company that has developed a plasma-based system, the plasma arc flow refinery, for the sterilisation and gasification of waste. This process generates a hydrogen-based fuel, MagneGas2, as a by-product which is sold as an alternative metal cutting fuel to acetylene. Management has built up a direct sales network for cutting gases in California, Florida, Louisiana and Texas through a sequence of acquisitions. This is complemented by a network of US distributors. The plasma arc flow system is currently being trialled for the sterilisation of sewage, manure and landfill leachates (waste water draining from landfill sites) in the US and Europe.

Total revenue grew by 34% year-on-year during Q118 to $1.2m with like-for-like sales rising by 4%. Pre-exceptional operating costs were similar to prior year levels, as costs related to developing the gasification technology were replaced by the costs associated with the additional sales capacity represented by the first two acquisitions. Operating loss, including $0.6m non-recurring costs, widened by $0.4m to $2.9m. The balance sheet moved from $0.6m net debt at the end of FY17 to $1.2m net cash at the end Q118, though we note that most of this is allocated to the Trico acquisition. Another indication of the improved balance sheet situation is that at the end of December 2017, current liabilities exceeded current assets by $1.3m, but at the end of Q118, current assets exceeded current liabilities by $1.8m.

Since our estimates are based solely on revenues derived from the sale of industrial gases and associated equipment, we have 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 regards to historical multiples (2.9x vs 2.4x) and a substantial discount to the mean for both 2018 (0.9x vs 3.5x) and 2019 (0.6x vs 3.3x). While some discount for MagneGas’s small market capitalisation is justified, its exceptionally strong projected sales growth should counteract this, at least in part. We see potential for significant share price appreciation as the full benefit of the Trico acquisition becomes clear and once management has resolved the financing gap.

The plasma arc flow system is still being trialled and has not yet been installed on a large-scale industrial basis. While trials have shown that the sterilisation process is an EPA- (Environmental Protection Agency) compliant treatment for pig manure, the equipment has not yet obtained US Department of Agriculture (USDA) subsidised equipment eligibility status. The metal working industry is conservative and therefore cautious about switching to a new cutting gas. As the company is not yet cash-generative it is dependent on securing external finance. During Q118 this was provided from the issue of convertible preferred stock, which was highly dilutive. Further financing is required. Our estimates model a $23.0m funding gap.

MagneGas has developed a patented technology for plasma arc gasification of hydrocarbon waste. The technology is used to convert butanol produced from corn into its second generation innovative cutting fuel called MagneGas2. MagneGas2 is sold into the metal working market as a safer, more efficient and cost-effective replacement for acetylene. The company also sells a variant of the gasification technology for sterilising bio-contaminated liquid waste such as pig manure or water draining from landfill so that it can be sold for use as a fertiliser or irrigation purposes rather than incurring a cost on disposal. The gasification units may also be used to convert many types of hydrocarbon-based waste into syngas or biodiesel, both of which can be used as substitute fuels.

MagneGas was founded in 2007. It is headquartered in Tampa, Florida and currently employs almost 80 people. In order to accelerate adoption of MagneGas2 and achieve economies of scale, management has recently acquired several small distributors of metal cutting gases and ancillary equipment in the Greater California and Greater Texas regions, while maintaining a network of distributors elsewhere in the US. Management’s intention is to scale up sales of cutting gases and complementary products in the US and Europe so that the resultant profits can be used to help finance R&D on the gasification technology.

Press releases from MagneGas note that customers include a global automotive manufacturing company based in the mid-West US who uses MagneGas2 at two of its sites; a heavy equipment rental company which uses MagneGas2 to repair vehicles; the New York City Department of Transportation; one of the largest recycling and waste disposal companies in the US which uses MagneGas2 in the maintenance and repair of its fleet at six locations; Pinellas County Fire Department in Florida; contractors working on NASA’s Kennedy Space Centre; major international bridge builder, Condotte; and a US army contractor for official use on a US army base for fire-rescue needs.

The company focused initially on the development of plasma gasification equipment to sterilise bio-contaminated liquid waste, but in the process it discovered that the synthetic gas produced as a by-product of the process was a better metal cutting gas than acetylene. It carried out further development on the process to optimise the properties of the syngas and reduce the cost of production. Exhibit 1 compares the properties of the resultant fuel, MagneGas2, with acetylene. Importantly, metal that has been cut with MagneGas2 behaves under stress in the same way as metal cut using acetylene. This was confirmed during independent tests by Certified Testing Laboratories in Florida. As MagneGas2 has similar properties to acetylene it is easy for users to switch gas type without extensive training. MagneGas2 is produced from a renewable feedstock. Since May 2017 it has been produced from butanol derived from corn. The renewable aspect does not appear to be a significant factor in purchasing decisions in the US, but it may be more significant as MagneGas begins to address the European market.

MagneGas2 is not the only fuel which is presented as offering superior cutting characteristics to acetylene. The international provider of industrial gases, Praxair sells StarFlame 3 which like MagneGas2, burns at a hotter temperature than acetylene and gives cutting speeds that are 15-50 times faster than acetylene. Like MagneGas2 there is less clean-up required after welding, further improving workshop efficiency. StarFlame is a propane variant with an additive from Chemtane Energy. Baker’s Gas and Welding Supplies in the Detroit area is a smaller player that offers a propane with an additive that produces a hotter flame than acetylene and thus cuts faster.

These alternatives to acetylene are based on propane, which is a non-renewable energy source while MagneGas2 is made from butanol obtained from maize. Management believes that this makes MagneGas2 the only renewable cutting fuel currently available. Our desk research identified Sradco, a Missouri-based engineering consultancy, who has developed a three-stage gasification system that produces acetylene from hydrocarbon waste but this does not appear to be in commercial use. Colorado-based Petrogen has developed cutting torch systems that run on gasoline, diesel and kerosene (paraffin, so could potentially be used with bio-diesel produced for other applications).

In reality the competition is from established suppliers of traditional cutting gases: acetylene and propane, which. compete primarily on price. Management currently offers MagneGas2 at a similar price to conventional cutting gases, with the enhanced safety and efficiency benefits providing a differentiator. Improvements in yield from the next generation gas production equipment currently under development (see below), should enable management to undercut the price of conventional cutting gases.

We note that as MagneGas2 fuel represents only 3-5% of sales made by its welding supply operations, these will provide a contribution towards funding the development of the sterilisation and gasification equipment regardless of the competitive position of MagneGas2. However, organic growth within these operations is dependent on securing MagneGas2 sales.

The core technology was originally developed by the current CEO’s father, Dr Ruggero Santilli, for use in rural waste-to-energy applications. A wide range of liquid wastes containing hydrocarbons are passed through a plasma arc where a very strong electric field sterilises the bio-contaminants in the waste without adding chemical disinfectants. In the process, the waste releases a mixture of gases that burn without the emission of pollutants such as nitrogen dioxide. MagneGas is not unique in offering a plasma gasification technology, but it is unusual because its patented system enables fluid to pass efficiently through a submerged plasma arc. (We note that several of the patents expire in 2018, though others referring to the plasma arc extend to 2029 and 2030.) In sterilisation mode, the waste is passed through the arc the minimum number of times required to deactivate the bio-contaminants. In gasification mode, the feedstock is passed through the arc multiple times to achieve the highest possible gasification rate. The exact composition of the resultant gas depends on the initial waste stream. MagneGas2 is produced from butanol. Its composition is shown in Exhibit 2.

In October 2017, MagneGas announced that it had completed designing a prototype fourth-generation reactor after four years of work. In this updated design, a much larger area is exposed to the plasma arc. It is expected to extract around 90% of the useful gas in the first pass through the plasma arc, so that the feedstock only needs to pass through the system once or twice rather than the six to eight times in the current iteration. Simulations predict that this will reduce the amount of power required per cubic metre by 75% and increase the gas production rate for the same amount of power by at least five times. This would reduce total production costs by at least 50%, making MagneGas2 significantly more cost effective to produce than acetylene and roughly on a par with the cost of propane. The resultant price advantage should improve profits and give MagneGas an immediate ability to take significant market share in the global cutting fuel market.

Importantly, the next-generation technology will also enable the technology to be used to convert solid material such as waste plastic, bio-mass, wood chips and coal to a useful gas, opening many new feedstock opportunities. Management hopes to have a working small-scale model by the end of FY18 and a full-scale test unit by the end of FY19.

The same patented technology is used as for gasification. However, in this mode liquid waste such as sewage or leachate from landfill is passed through the plasma arc the minimum number of times needed to kill any bacteria or other pathogens including E. coli and faecal coliforms. It also breaks down any pharmaceutical residue such as hormones in the waste. The technique may potentially be effective in breaking down toxic polychlorinated biphenyls which were widely used as an additive in electric transformer oils until they were banned. The process meets US Environmental Protection Agency standards for converting the liquid waste from a class B material to a safer class A waste. In one day a single stationary plasma arc flow refinery can sterilise 363k litres of sewage containing 0.8% total suspended solids. The process can be used on agricultural, municipal and industrial wastes to make them suitable for use as irrigation water or fertiliser, both of which have monetary value. For example, it costs €80/tonne to dispose of untreated sewage in landfill, but the treated product may be sold for €20/tonne as the process has little impact on the nutritional content of treated material used as fertiliser. Modest amounts of useful gas are given off as a by-product, which helps off-set the cost of sterilisation. MagneGas has also developed a smaller unit which can be mounted on a pick-up truck and shared by several farms in the same neighbourhood. The production cycle for the equipment is typically six to nine months.

Since the fourth generation technology will be able to process a range of pulverised waste materials, once commercialised it may be deployed in Europe in waste-to-energy plants that process waste collected locally and produce heat and electric power for local consumption. As discussed in our PowerHouse Energy note, gasification is an attractive alternative to incineration as the extremely high temperature process breaks down toxic dioxins and furans, there is no ash to dispose of and any inorganic materials form a glassy slag which can be used as an aggregate for road-building, subject to the appropriate permits. The waste-to-energy conversion efficiency is not comparable with conventional turbines, but this is not a barrier to deployment in this application, as the waste would incur fees of €80/tonne or more if it was sent to landfill, so operators of waste-to-energy plants are able to charge for destroying the waste, in effect subsidising energy production.

Using the gasification technology for co-combustion

Since MagneGas2 burns at such a high temperature it can potentially be burnt together with coal to reduce toxic emissions from the coal as improving energy generation efficiency. Development of this application has been suspended as the use of coal in power stations is being phased out in favour of natural gas.

Our competitive review indicates that Coaltec Energy is the only other company currently manufacturing gasification equipment for the sterilisation of leachates and manure. It has developed a system for producing a fertiliser material from cow manure. This can process up to 200 tonnes of raw manure each day. Coaltec appears to be at a similar stage to MagneGas, in that it is working on projects to prove the technology.

We note that there are dozens of companies globally developing waste-to-energy gasification equipment, some of which use plasma arc technology to achieve the high temperatures required. Exhibit 4, which is not intended to be exhaustive, lists those companies which appear to have operational projects. We note that some projects have failed because of issues securing large volumes of waste and transporting it over a long distance to supply a single large-scale plant. Since MagneGas’s equipment is small scale, it can be located close to a source of waste, circumventing this problem.

Sales channels already established in the US

MagneGas first introduced its renewable metal cutting fuel in 2010 through third-party US distributors. In 2014, management decided to start selling the gas directly. Potential customers prefer to purchase their cutting gases and cutting equipment from the same supplier, so management acquired a local company, ESSI, which already sold the range of products required. The ability to offer a differentiated product such as MagneGas2 facilitates introductions to new customers who will also purchase complementary products. Between 2013 and 2017 total sales (including other cutting gases and cutting tools) grew at 39% CAGR. This compares very favourably with the conventional cutting gas market which management estimates had a CAGR of only 2-3%. Sales of complementary products are significant. Management estimates that it makes $33 ancillary sales for each $1 of MagneGas2 sold. It has taken steps to expand the portfolio of complementary products eg adding calibration gases to the offer in July 2016 and cutting tools in May 2017.

Industrial gases are heavily used in the shipping, rail, oil and gas industries, by utilities, in super-ports, for demolition and for construction of heavy infrastructure. This means that Houston and the San Diego/Long Beach/Los Angeles corridor are the number one and number two markets for industrial gas in the US and California and Texas are largest markets in the US by state. The Houston area is booming as petroleum and natural gas markets continue to recover after Hurricane Harvey. San Diego has the potential to be one of the key markets given the proximity to Coronado Island and the massive US military presence, as well as a wide range of utility, commercial shipping, rail, logistics and infrastructure operators in the bay area. Management estimates that the Greater California market has the potential to generate in excess of $100m revenues annually for MagneGas. MagneGas acquired sales outlets in both of these key markets during the first four months of FY18. Management intends to make further acquisitions in these regions, providing it can do so without incurring too much share dilution, as the recent acquisitions were funded through the issue of preferred stock.

The combined scale of operations following the recent sequence of acquisitions gives MagneGas stronger purchasing power, thus improving margins, and also helps it pursue larger national accounts. We note that in March 2018, MagneGas signed its first multi-year industrial bulk gas contract, emphasising its enhanced market profile. Having a direct sales operation in a region with a high density of current and potential customers helps profitability by making it worthwhile to install gasification technology in the area rather than shipping the gas from the production facility in Florida, thus significantly reducing logistics costs. There is already a MagneGas2 production facility at one of the company’s locations in Texas. Management also intends to install one in the California region. Increasing turnover in one location also helps improve profitability as gas cylinders, which cost several times more than the gas they contain, are used and refilled more quickly, reducing the cylinder/gas overhead. This project will incur minimal capex as MagneGas will redeploy equipment that became surplus to requirements when it switched to using butanol as feedstock, thus substantially improving production efficiency. In addition, management intends to develop its own plant in Florida for filling cylinders with non-proprietary gases so it can save costs by purchasing these in bulk. Management expects that this plant will become operational by the end of FY18 and should improve gas margins by 10-15pp.

In November 2017, MagneGas announced that its three largest cutting gas distributors, Holston Gases in Tennessee, Haun Welding Supply in New York State and AWISCO in the New York metropolitan area, had all agreed to significant increases in MagneGas2 purchases. This represents a minimum three-fold increase in sales from these distributors from Q417 onwards. Now that Green Arc in Texas, which has its own MagneGas2 production equipment, is part of the group, management intends to secure new distributors in the Mid-West US who can be supplied from this facility.

Preparing for European launch

The European Union (EU) is an attractive market for MagneGas because of the Renewable Energy Directive that sets a binding target of deriving at least 20% of energy requirements from renewable sources by 2020. The EU is also, according to management estimates, the second largest market for industrial gases globally. For the last 10 years, the company has been working with Berlin-based Infinite Fuels, a developer of alternative energy production equipment that reacts biomass with electricity to produce useful hydrocarbon fuel from bio-wastes. MagneGas is in the process of forming a JV with Infinite Fuels, completion of which is dependent on the latter securing c €2m equity finance which is a requirement for it to receive a €6.0m (US$7.2m) grant from the European Commission. If successful, this will cover much of the start-up costs of launching production and sales of MagneGas2 in Germany. Management expects that this funding will act as a catalyst to attracting additional capital in Europe.

In addition to the activity with Infinite Fuels, management is evaluating setting up operations at one or more European super-ports ie Rotterdam, Amsterdam, Antwerp, Marseille, Hamburg, Copenhagen, or Calais. Each of these locations has several hundred potential users of MagneGas2, all of which are larger than the current largest single client. Super-ports in other regions, eg Dubai, Japan, Singapore and South Korea, are also near-term targets. We note that MagneGas is already actively marketing its products and services in Houston and Los Angeles. Management estimates that the potential client base in a single port area could be addressed from a team of three to five people, cost less than $1m to set-up and generating multiple millions of dollars of EBITDA a year. Such an operation would be wholly owned by MagneGas.

Between 2014 and 2016 MagneGas undertook a pilot study at the largest pig farm in Indiana. This verified that the process works at scale to eliminate E. coli and faecal coliforms, has a beneficial impact on total suspended solids, which is a parameter used to assess the quality of waste water and meets EPA standards. Importantly, it enables hog manure to be treated as a class A rather than class B waste so it can be used as a high-nutrient, low-odour fertiliser. Management is currently in the process of establishing a commercial pilot treating pig manure in North Carolina. Starting in Q119, it intends to monetises the technology through providing a sterilisation service and sales of manure feedstock and reclaimed water. Management estimates that there are 1,700 hog farms in the local area, collectively producing 15m tons of waste each year, which represents an attractive potential market.

In Q417, MagneGas formally launched an 18-month pilot with one of the largest dairy farms in Florida. The primary purpose of the pilot is to evaluate the efficacy of the sterilisation process for cow manure. It is jointly funded by the USDA through a $432,000 grant, which represents 50% of the pilot costs and is a key step to obtaining USDA subsidised equipment eligibility and gathering sufficient data to move ahead with commercialisation within the agricultural industry. This grant builds on the hog industry study. In May 2018, MagneGas achieved its first major milestone on the project by giving a successful live sterilisation demonstration at the farm to representatives from the USDA, the Dairy Farmers of America, the International Dairy Journal and other independent dairy operators, as well as local government representatives. MagneGas will continue to submit results from the pilot to the USDA for the remainder of the project’s duration.

In December 2017, MagneGas announced it had received a preliminary order for a sterilisation unit to be delivered into the southern Italian market in FY18. The unit will be used primarily for the sterilisation of agricultural waste. The transaction may be structured as a service contract with MagneGas receiving revenues as waste is processed. Management expects the project to be funded in part by an Italian grant designed to support waste reduction and carbon emission reductions. This order follows on from one for a small sterilisation unit from an Italian client who has verified that MagneGas’s sterilisation process positively impacts chemical oxygen demand in landfill waste water and the client intends to scale up the project.

In July 2017 MagneGas announced that one of its distributors in Italy had completed several years of using the technology to reduce the chemical oxygen demand of leachates and had placed a $140k order for sterilisation equipment. MagneGas will sell the distributor components that will be assembled according to MagneGas’s instructions. The finished unit will be installed at a purpose-built facility that will treat leachate in return for a disposal fee, which may potentially be shared with MagneGas. Following an initial period of operation, MagneGas and its distributor intend to deploy the technology on multiple sites for treating leachates throughout Italy later in 2018. The technology significantly reduces the disposal costs of landfill wastewater and represents a strong value proposition for landfill operators. Since much of the EU regulation regarding leachate is standardised, this presents a very large addressable market across much of the EU landfill industry.

A northern California municipality is currently evaluating a proposal for deploying the technology in a waste water sterilisation programme. If successful, this would represent the first for public-private partnership in the US for waste-water sterilisation, realising revenues by the end of FY18.

MagneGas is in discussions with an international medical manufacturing company. It has demonstrated that its gasification technology can convert contaminated ethanol, which is one of types of medical waste produced, into a useful fuel. This gives a route for potentially reducing the cost of MagneGas fuel by 20-25% by taking the waste ethanol as a feedstock. The volume of gas potentially produced from processing all of the waste ethanol produced by this medical manufacturing company far exceeds the amount of cutting gas that MagneGas could sell, so management has plans to convert the remainder to bio-diesel using a catalytic process. Management notes that this medical manufacturing company has another 30 types of waste stream which could potentially be pulverised and converted to useful gas in the next generation of gasification equipment (see above).

MagneGas’s strategic direction and growth profile has been transformed by the appointments of CEO Ermanno Santilli in June 2012, replacing his father, Dr Ruggero Santilli, and CFO Scott Mahoney in December 2016, replacing Dr Santilli’s daughter, Luisa Ingargiola. Prior to joining MagneGas as executive VP of international relations in 2009, Ermanno was employed by Ingersoll Rand Company between 2003 and 2009, most recently as vice president of climate control business, global rail and aftermarket. In this capacity he oversaw a department that generated over $270m sales and $80m operating income, managing sales, business development, product management, warehousing and dealer development. He also drove development of new business and rail markets in Australia and India. Scott brings 17 years of financial and distressed situation management experience. Prior to joining MagneGas, Scott was CFO of Phoenix Group Metals, an auto core supply and automobile recycling company based in Phoenix, Arizona. He has also served in several entrepreneurial roles in the oil industry, raising over $200m in equity and debt capital for previous projects in the Permian Basin, Eagle Ford, Williston Basin Rockies and mid-continental US and managing 13 acquisitions in the sector. Luisa Ingargiola and Dr Santilli’s wife, Carla, who previously served as directors, Luisa as executive VP of capital markets and Carla in a non-executive role, have recently stepped down from the board.

Total revenue grew by 34% year-on-year during Q118 to $1.2m. Stripping out $110k from the San Diego acquisition and $156k from the Texas acquisition, like-for-like sales grew by 4%. Gross margin declined from 42% to 35% because of GAAP treatment of acquired inventory, which marks the value up to the current retail price, though there was some benefit from better pricing and terms on some products related to higher volumes. Management expects margins to trend back to prior year levels as the acquired inventory is worked through, which it estimates will take place during Q218 and Q318. Operating costs were distorted by $0.6m consultancy and integration costs related to the three acquisitions, rising by $0.4m to $3.2m. The year-on-year reduction in pre-exceptional operating costs reflects substantially lower R&D costs as the company has switched focus from technology development to selling cutting gases and associated products. (We note that it no longer leases property from the Santilli family.) Operating loss, including the $0.6m non-recurring costs, widened by $0.4m to $2.9m. Q117 benefitted from $0.8m positive movement in the fair value of derivative liability, so net loss widened by $1.2m to $3.0m.

After adjusting for non-recurring costs and the distortion introduced by GAAP accounting described above, net cash used in operating activities during Q118 reduced from $1.5m to $1.2m y-o-y. Investing activities included $2.8m cash for acquisitions, of which $1.0m was pre-payment for Trico in San Francisco, $1.0m was the cash element of the consideration for Green Arc Welding in Texas (the remaining $1.3m was satisfied through the issue of 1.0m new shares), the remainder for Complete Welding in San Diego. $0.6m was invested in capital equipment – primarily gas cylinders. MagneGas raised $7.6m (net) through drawing down preferred stock, resulting in a $1.5m increase in cash to $2.1m. Of this, $1.0m is allocated for the balance of the consideration for Trico. With cash-burn at $240k/month according to management estimates, further financing will be required during H218. If necessary, this can be satisfied through further drawn-down of Series C preferred stock.

The balance sheet was strengthened significantly during the period, moving from $0.6m net debt at the end of FY17 to $1.2m net cash at the end Q118, though we note that most of this is allocated for the Trico acquisition. Part of the Point Financial Promissory Note agreed in November 2017 was repaid, leaving $0.2m (net of $0.1m debt discount) outstanding for payment by end November 2018. The only other material debt remaining is $0.5m relating to the sale and lease back of gas cylinders. Importantly, at the end of December 2017, current liabilities exceeded current assets by $1.3m but at the end of Q118, current assets exceeded current liabilities by $1.8m.

On 16 January 2018, MagneGas effected a 1-for-15 reverse stock split intended to increase the per share trading price so as to satisfy the minimum bid price requirement of $1.00 per share for continued listing on the NASDAQ Global Market.

Our model treats revenues from equipment sales, fees for sterilising waste and any benefit from expansion into Europe as upside. It is based on the following assumptions:

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 regards to historic multiples (2.9x vs 2.4x) and a substantial discount to the mean for both 2018 (0.9x vs 3.5x) and 2019 (0.6x vs 3.3x). While some discount for MagneGas’s small market capitalisation 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.