Clearsign of growth

Clearsign Technologies (NASDAQ: CLIR) is the first pre-revenue company that I have invested in. The company is very close to commercializing a game-changing technology in combustion systems with ExxonMobil and other customers with significant scale. Clearsign’s technology costs much less, produces far less emissions, and presents as the sole viable update to a 65-year-old combustion treatment method that is as expensive as it is antiquated. Competent leadership, proper incentives, viable commercialization roadmaps, and environmental tailwinds support a $500m valuation (~3x current valuation).

Potential customers are industrial furnaces, boilers, refineries, and any facility that employs large-scale combustion systems. These facilities constantly balance between generating revenue and pollution: how long can combustion systems operate (ie revenue generation) while keeping NOx (nitrogen oxides) emissions low enough to comply with increasingly strict environmental regulations. The most common solution is a post-combustion treatment process. Run the combustion system; pass the resulting NOx into a catalyst chamber comprising porous ceramics, precious metals, and gases; circulate the mixture to reduce NOx before release to atmosphere. This process, known as SCR (selective catalytic reduction), is expensive because of the use of precious metals, cumbersome because of the need for gas circulation, and unstable because of the constant need to replace porous ceramics clogged by pollutants.

Clearsign provides an ingenious solution. Its key IP (known as Clearsign Core) allows the combustion system to produce less NOx in the first place, eliminating the need for post-combustion treatment.

Combustion begins with an ignition of a flame. This flame initially burns at very high temperatures that produces high levels of NOx. As fuel and air mix with the flame, temperatures decline and exponentially less NOx is produced. Clearsign Core reduces the duration and intensity of peak flame temperatures. The technology allows fuel and air to mix properly before starting ignition, resulting in shorter and lower peak flame temperatures and lower NOx emissions than standard combustion.

The technology has other means to reduce peak flame temperatures. It “separates” the source of a single, large flame into numerous, shorter flames that can be more easily mix with fuel to lower peak temperatures. Its mechanism also employs radiation cooling that cools the flame quickly.

Clearsign provides the aforementioned benefits at much lower prices compared to the current SCR solution. A third-party engineering consultant found that Clearsign Core (originally named Duplex) provided 80-90% lower startup and maintenance costs compared to SCR (see tables below). Clearsign Core is currently the most cost effective solution to meet strict NOx emission standards (under 2.5 parts per million, or 2.5ppm) set by California and Texas, which set the standard for the rest of the country to eventually follow.

In spite of valuable IP, Clearsign had a difficult start as a public company. Its IPO in 2012 was build on a ground-up, complex redesign of combustion systems. Its technology today started as an offshoot to the original technology. Clearsign invented a flame management system that significantly reduced NOx emissions as a complement. Clearsign did not sell any combustion systems, but found large refineries owned by Tesoro and Delek wanting its flame management system. However, all the company had to show, after 7 years and and 5 equity raises, was less than $2 million in cumulative sales. Its stock declined from $4 at initial offering to a low of $1 in 2018.

Poor execution capped the sales potential of its technology. Management failed to account for extensive pre-installation testing, after-sales support, and customization required by complex refinery operations. The high cost of failures in combustion systems made refinery operators extremely careful in adopting new technologies. They demand multiple demonstrations and field-testings, and require a comprehensive maintenance system. Clearsign, as a startup, had limited resources that were perceived as risky. The company required collaborations with other vendors to get to market, but was unable to find partners because of its insistence on standard licensing deals. A typical deal require partners to pay Clearsign large upfront cash as a licensing fee, but partners were unwilling to pay for startup technology without proven traction. Without partners, Clearsign could not commercialize its valuable IP.

The company’s fortunes began to turn when Robert Hoffman, a veteran investment manager, bought a 20% stake and joined the board in July 2018. He repealed the attempt of a ridiculous proxy battle by a sketchy investment banker. Anthony Digiandomenico was an owner of MDB Capital, focusing on micro-caps and purporting to be “Wall Street’s only intellectual property-focused investment bank” (not kidding), albeit with history of misrepresentation (see Red Flag #3 in link). Digiandomenico owned only 112,733 shares of CLIR (less than 1% of 1% shares outstanding) when he submitted a proposal to replace the board and management on November 9, 2018. Luckily for CLIR shareholders, Hoffman stood his ground, convinced Digiandomenico to back down, and prevented the escalation of the proxy battle to an all-out war.

I did not find information concerning Hoffman’s long-term track record. However, his written responses in the proxy contest showed him to have sound business logic, focus on fundamentals, a long-term outlook, and transparent communication (see highlights below from 14A filed on December 6, 2018):

The second most important decision that Hoffman made for Clearsign, after settling the proxy battle, was the hiring of Jim Deller as CEO in January 2019. Deller spent his entire career, all 28 years, in combustion systems and had a doctorate in flame chemistry. That Deller left a comfortable job as director at Honeywell to join Clearsign validated the company’s technology and sales potential. His deep understanding of technical underpinnings and commercialization processes made him the most invaluable addition to the company after Hoffman. Hoffman described Deller as such:

While younger investors might not grasp the analogy, Jim is the Bart Starr as opposed to the Joe Namath of the combustion industry. As investors get to know Jim, they will discover that he will never be like Broadway Joe and “guarantee victory”, nor will he ever be the flashiest guy in an investor conference. Conversely, like Bart Starr, he will be the understated field general getting the most out of his team while, at the same time, being the most important cog in driving that team to victory and making the clutch decisions when it is most important.” -Q119 earnings call

Clearsign has gained significant traction under Deller. He simplified the core technology for easier “plug-and-play” installation at customer sites. He found partners by abstaining from licensing deals in favor of revenue-share collaborations without upfront investments. He recruited leaders in sales and engineering. He steered the company through Covid-19 and secured a license to sell in China amidst complex US-China relations. Notable customers and partnerships include:

  • ExxonMobil and Zeeco. The oil major will be testing Clearsign Core in calendar Q3 2021, after completing a year-long exhaustive qualification of the technology. If successful, this would be the most vital validation of Clearsign Core in company history. Equipment required for Exxon’s testing would be fabricated by Zeeco, a household name in the global refining and petrochemical industry. The collaboration with Zeeco in manufacturing, sales, and research is a transformative partnership that solidified Clearsign’s commercialization efforts.
  • An unnamed European oil major, likely Shell or Total. This company placed an order for Clearsign Core on February 2, 2021.
  • California Boiler and a North American major energy infrastructure company who purchased Clearsign Core in October 2020. The technology has been installed, and revenues would be recognized in financial Q1 2021. This project was sold by California Boiler, which is Clearsign’s channel sales partner.
  • World Oil and the California South Coast Air Quality Management District (government emissions regulator in Southern California). Clearsign Core is so promising that the emissions regulator in California had agreed to fund 1/3 of a demonstration project with World Oil, a recycler of motor oil and antifreeze. The demonstration has been delayed for a year because of Covid, and would likely be completed by early 2022.
  • Beijing heating district and Jiangsu Shuang Liang Boiler Company (simplified as JSL Boiler). Clearsign cleared government testing of its technology in China, and obtained a license to sell in China. The northern districts in China received central heating during winters from numerous industrial boilers (combustion system for heating) operated by the government, unlike individual boilers in homes in the United States. Clearsign had also signed a collaborative agreement with JSL Boiler, the top boiler manufacturer in China. Sales efforts just began in May 2021.

In thinking about valuation, I suggest readers consider Buffett’s quip: “you don’t need to know a man’s weight to know that he is fat”. Precision matters less in this thesis than directional accuracy. The most obvious markets for Clearsign are the 14,000 industrial combustion systems in refineries and petrochemical plants in Texas and California, and 350,000 heating furnaces in the northern districts of China. In the table below, assuming modest market shares and retrofit prices (about 10% cost of SCR), I estimate a near-$5-billion opportunity.

Combustion systems in CA and TX [A]14,000
Initial addressable market [B]10%
Revenue per retrofit ($m) [C]$1.0
Maintenance revenue over 10 years ($m) [D] $0.5
Revenue potential ($m) [A*B*(C+D)]$2,100.0
  
Firetube boilers in northern China350,000
Initial addressable market2.5%
Revenue per retrofit ($m)$0.2
Maintenance revenue over 10 years ($m) $0.1
Revenue potential ($m) $2,625.0
  
Total revenue potential ($m)$4,725.0

Three tailwinds may further expand the opportunity. One, pollution emission standards are expected to become more stringent over time in the US, China, and other developed countries, regardless of political affiliations. The regulatory tailwind would become stronger over time as more resources are devoted to managing climate change. Two, the slow pace of innovation and performance improvements in SCR provides a clear opportunity for Clearsign to take share. Providers of SCR are mature companies that compete largely on price. While the maturity of SCR presents a high barrier to entry, Clearsign has shown sufficient traction to be a viable substitute. Three, Clearsign is currently testing adjacent products such as flares and sensors that complement its core technology.

Clearsign is valued at about $160m today, which appears to significantly undervalue its potential. Judging from the $5-billion revenue potential over the next decade, it should be reasonable to estimate a valuation at $500m (1x annual sales). Margins are likely to be high (~30-40% EBITDA margins) given management’s plan to create an asset-light technology provider that relies on a network of partners for fabrication, sales, and customer support. In any new technology, commercialization is often the biggest risk. A successful demonstration with ExxonMobil in calendar Q3 later this year would significantly mitigate the risk and place Clearsign on the path towards realizing its true valuation.