Good morning. Welcome to Arthur J. Gallagher & Co.'s special conference call to provide background on its clean energy investments. Participants have been placed on a listen-only mode. Your lines will be open for questions following the presentation. Today's call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during the conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. These forward-looking statements are subject to certain risks and uncertainties that will be discussed on this call and which are also described in the company's reports filed with the Securities and Exchange Commission. Actual results may differ materially from those discussed today. It is now my pleasure to introduce J. Patrick Gallagher, Jr., Chairman, President, and Chief Executive Officer of Arthur J. Gallagher & Co. Mr. Gallagher, you may begin.
Thank you, Claudia. Welcome, everybody. Thank you for being with us on our special call this morning. We appreciate it. We think it's important that we go through a detailed review of our clean coal investments. Before I turn this call over to Doug Howell, our CFO, I want to be very clear about one thing. The punchline in this presentation is that we hope to generate cash from these efforts. If you look at page 27, 28, and 29 of our presentation, you'll see that the use of that cash will be put to use in building out our core brokerage and risk management enterprises. We're excited about this effort. I want to turn the call over to Doug to take you through the details of the presentation. Doug?
Thanks, Pat. Good morning, everyone. I'm going to spend about 30 minutes trying to push through the first 50 pages of this presentation. Then we'll go to Q&A. We asked you to hold an hour and a half for this call. We think that the Q&A is a very important part of that. First of all, I hope you have the presentation open in front of you, because I will be referring to pages in the presentation that we filed frequently throughout our call today. We're doing this as a way to continue to improve transparency. We have received a lot of questions over the last year or so about the investments, how they work, what do they look like, what are we going to do with the cash, how does the accounting work?
I'm hoping that today will be a way to orient you in terms of what's going on with these investments and what we're intending on doing with the cash. We picked this timing because we thought it'd be after the spring break period, yet before earnings season really kicked off in full swing, because we wanted you to be able to have an hour to an hour and a half to really understand these investments. We just don't get that amount of time when we're doing our quarterly calls. What I want to do now is just move into the presentation. Page three is an outline of what we're going to talk about today. My first page I want to talk about is page four. When we have a clean coal investment, page four is a simplified overview.
These investments, between the physical plant and the chemistry, when combined with conventional coal, and they're used in a utility, they reduce mercury, nitrogen oxides, and sulfur dioxide. This process also provides other benefits to the utilities in making coal a cleaner source of fuel for the U.S. Many people have asked me, what do these things look like? Let's turn to page five. Page five is a picture of a clean coal plant. You'll see in the green circle, these are the storage units where we store the chemicals. In the orange oval, that's the mixer. You can see a temporary conveyor belt putting the coal into the mixer, and if you look kind of behind that larger conveyor belt, you'll see the clean coal coming out and being returned into the stack.
This portion of the plant costs about $1 million to build, and then obviously it can be depreciated over time, so it's about a $600,000 after-tax cost. After those components are built, if you turn to page six, what we do is we put the components in housing, and we connect it permanently to the host utility. In the red circle, you can see all the components that go into housing the clean coal plant. You'll see how coal runs up the conveyor belt. It drops down into the mixer. The storage facility you can see there in green. As the refined coal returns back up into the utility where it's burned. The cost to connect and house a plant is approximately $4 million, and then we get to depreciate that over time. After tax, it's about $2.4 million.
Page seven shows an illustration of where this clean coal plant sits in a general schematic of a coal power facility. You can see that the clean coal plant sits between the coal yard and the boiler or the furnace, the rest of the schematic shows you how water turns into steam turns a turbine, and electricity is generated and goes out on a transmission line. That's a generalized view of the location of the plant. When it comes to building the plant and putting these investments together, page eight provides you the steps, and I think it's important to go through these steps. Step one is we actually build the plant, and we place it in service prior to December 31st, 2011.
That's important that it's in by that date, and all of our plants have been placed in service before 12/31/2011, because that makes them a qualified plant. Next, we connect the plant to the utility. We'll connect it and house it, and you can see that cost of $4 million. Because these are investments, we will sell off a majority portion of the investments. Generally, in this design, in this schematic, what we've said, we are selling off 51% of it, and we end up holding 49% of it. At that time, we relinquish control. We become a minority partner, and really it runs like any other partnership or LLC would, and in this case, the partners require unanimous approval to do anything further. We step out of the control position in step four.
If we turn to page nine, we get some questions from time to time about the operations, who's running it. The piece to focus on is the LLC manager. It's the third box down on the left side of the page. We have a professional manager that really manages the day-to-day operations of the plants going forward. They're the ones that arrange for Taggart, who's our operations manager. They're the ones that arrange for the logistics and the chemical. They coordinate much of the legal activity and the accounting and tax activity. Gallagher then sits as a position of a non-controlling partner and basically the day-to-day operations are controlled by the LLC manager. You can see that some of these words in here are red or are kind of a burnt red color.
Those are partners that we've dealt with in our past over the last 20 years that have a lot of experience in doing clean coal plant operations. On the right side, you can see that ChemMod is the recipe card or the chemical that we use, and Gallagher acts as the manager in that. Turning to page 10, we get some questions on really what happens. We mix conventional coal with this recipe that we call the ChemMod solution. Let me just walk through page two and give you a simplified view. The ChemMod recipe is a patented combination of dry and wet chemicals.
When it gets mixed with the coal, and then prior to being put into the boiler, when it heats up in the boiler, mercury, nitrogen oxides, and sulfur dioxides react with this ChemMod solution, and as it cools, a chemical bonding occurs, and it captures the mercury, and becomes part of the ash rather than being released in the air. To qualify these plants and this solution together to receive tax credits, laboratory tests must prove that the mixture of the coal and the chemicals reduce mercury by more than 40%, or you can take out 40% of sulfur dioxide, plus reduce nitrogen oxides by more than 20%. That is what qualifies to receive a tax subsidy from the government. ChemMod achieves these levels when used in these plants. Actually, we've shown that with an additional rate, they can actually achieve higher levels of that.
To qualify for the tax credit, you have to meet the 40/20 information. The captured materials do not release from the ash unless it's reheated to over 3,000 degrees. Frankly, when it's in the ash, it actually improves the ash. It's a stronger ash that can be used in making concrete. I've had some people ask me to simplify it even further than that, and so I said, imagine a chocolate candy, where the chocolate center represents the mercury, et cetera, and the hard candy shell outside represents the ChemMod solution. These coated chocolates drop into the ash, and they can be disposed of or used in concrete. We've also found that a ChemMod solution helps improve the efficiency of the boiler, and it helps extend the life of certain of the utility components.
Moving on to page 12, one of the questions that we get a lot is, does a clean coal plant comply with the new mercury standards when they're using the ChemMod solution? There is a different standard for Section 45 tax credit qualification and the new mercury standards. We believe that some of the utilities that are currently using our plants and the ChemMod solution, do meet the new mercury standards. We also believe that other utilities that are using it may comply with a slight modification. There is a difference in the standard to receive a tax subsidy or tax credit than the new standard, but we think that the ChemMod solution can do that for the utilities with a slight modification. Turning to page 13, we get a lot of questions about how much have we invested in the ChemMod solution.
You can see on page 13 that beginning in 2004, we started sponsoring the inventor, and through 2008, we increased our ownership to 42%. We've got $13 million of cash that we put into this venture, and the accounting requires an impairment as you go on. We have nothing on our books for the asset. There is $1 million of cash in the company today. Basically, with the run rate that we think that we're going to get from ChemMod, we should have all of our cash out of this investment, recouped from this investment by mid-2013. I want to turn to page 14 for a minute and just pause where we are so far. I want to summarize what's on the balance sheet related to these efforts.
In the orange section, you'll see there that we have 14 2009-era plants that are carried on our books. Right now, for about $10.4 million, we have 15 2011-era plants that are carried on our books for $20.5 million, and then ChemMod is on our books for $1 million. We have about $32 million carried on our balance sheet related to our efforts thus far to build plants and develop the ChemMod technology. If this whole program were to go sideways, and we would need to abandon all of our efforts, we would take a $32 million pre-tax charge, which would be $18 million net of tax, and that would be the exposure to the company. We got $31 million into the project right now. With the balance sheet behind me, turn to page 15.
Really, we're just teeing up on page 15 as a transition slide that really these investments that we're carrying on our books produce two value streams to Gallagher. We get the earnings off of the clean coal plants, and we get the royalty stream off of ChemMod. I want to take you through each of those. Page 16 is a graphic that just starts and shows you where the profits emerge off of these plants. What this is showing you is that if you take a per ton of coal that we produce a refined coal or a clean coal on, what these plants or these LLCs receive is they receive a $6.40 subsidy from the U.S. government to create clean energy. Actually, yesterday, they released the new number for 2012. It's $6.47, but our estimate when we were putting this together would be about $6.40.
Where does that go? If you look at the next graphic, you can see that about a third of it goes to material and operating costs. A third of it goes to Gallagher, both as a developer of the project and from an investor in these projects. A third of it goes to other partners. This is assuming that it's about a 40% tax rate, and it's assuming that Gallagher owns somewhere between 40% and 49% of these projects, kind of a blended 40%. Turning to page 17, I just expand there the $2.27 cost. People have asked, "What does it really cost to produce this, and where does it go?" You can see that the materials that we use are $0.80, working from the bottom left. Labor and other plant operating costs cost about $0.72 a ton.
The utility, we pay them rent for putting these plants on their property, or we give them a discount on the coal they produce of about $0.45. There's a license fee that goes to ChemMod, about $0.30. It's important to also know that not only does the utility, the reason why they participate in these projects is that they've got a financial incentive to participate in it, but they also receive the improved environmental results basically for free, and they get a better ash and favorable operating results. The utility is part of this process, and they have a financial incentive and an environmental incentive. It's very important for everybody to understand that this technology works to help the utility solve new emission standards. What happens then? Gallagher gets about $2.06.
We have some internal costs of our staff of about $0.15 a ton. Net-net, Gallagher gets about a $1.91 profit per ton that's produced through these coal ventures after you assume our less than 50% ownership, a tax rate. A $2 per ton hits the bottom line. Turning to ChemMod. Recall, we showed you the graphic earlier that Gallagher owns 42% of the recipe card. When ChemMod gets royalty income, about $0.50 a ton pre-tax or $0.30 a ton after tax, there are costs inside of ChemMod to administer it of about $0.05 per ton. The 58% other owners get $0.14 a ton, and Gallagher gets about $0.11 a ton of profits as a result of the ChemMod recipe.
You take the $1.91 on the previous page of profits to Gallagher and $0.11 here, you get, just again, think $2 per ton is what Gallagher gets as a result of investing in these projects. It's also important to understand with ChemMod, that ChemMod has licensees other than Gallagher. Gallagher has 29 plants that it will be using the ChemMod solution in, but other licensees of ChemMod, it's our understanding there's about 33 other plants out there that will run the ChemMod solution in their qualified Section 45 plants. We think that the total consumption between Gallagher and ChemMod's other licensees could be 150-200 million tons per year that are using the ChemMod solution. That represents about 15%-20% of what we believe is the U.S. annual coal consumption. All of these projects are based on the developmental phase of mercury reduction.
The next step for ChemMod is to get a pure mercury control user. No revenues have been generated yet from the other 80% of the coal potential in the U.S. Remember, it is different to qualify from Section 45 than it is the new mercury standards. We believe with just using more of the ChemMod solution will help these utilities qualify for those new mercury standards. 21 is another pause page. This is really a recap of what we've said in our earnings release in the past. We've put this in a tabular form here. What I've done in the first two columns is I've just recapped that we've got 29 plants, that we've got $31 million-$32 million invested in.
We believe that the earnings that will run through the P&L ultimately can be about $16.5 million per quarter, in net after-tax earnings to Gallagher. When you put this all together Now, these are ultimate run rates. When we get all the operational tweaking done at the plants, as we get these things working better, we think that we can make about $16.5 million per quarter from these efforts. That does not include any income from the plants that we're seeking long-term contracts and co-investors on. If you look at this graphic, we have about another 11 or 12 plants that we're in process of trying to put in place, at different locations, that we hope that would move to $16.5 million higher. For now, the ones that are running, we think that we can get them up and running to about $16.5 a quarter.
We get to page 22. As we get questions on, okay, where does that show up on Gallagher's financial statements? If you look at page 22, I've just shown you the previous page where it comes down to $16.5. It is very difficult to trace this information through our financial statements. Here's what you can know. None of these results flow through our brokerage or risk management segments. All of the results are captured in the corporate segment. Following it through a traditional P&L in the corporate segment is very difficult, we've been providing what we call our shortcut table in our earnings release, 10-Qs, and our supplement, where these clean energy investment results can be quickly found.
You can see on the right side, we've shown you that in the corporate segment, we provide you a shortcut table, and one line on there will capture all the clean energy investment activity, and you'll see the $16.5. Ultimately, that's what you should see showing up per quarter. On an annual basis, if we can get that up and running at that level times four, you'd see it down in the annual amount. Again, this is over the near term. We think it's going to take us the rest of this year to get to those running rates at least, at least you can see graphically where you can find it in the financial statements here. Turning to page 23, I admit that 23-26 is a little difficult to follow.
This may take some further study after this call, let me take you through what we're trying to do here. When you recognize the income from these projects, the tax accounting rules govern how we recognize this income. On an annual basis, it's fairly easy to understand, but on a quarterly basis, you can get some extreme volatility based on when you produce these investment returns and receive the tax credit, and also based on the seasonality of a company. On page 23 here, we just took a simple example. This is not Gallagher, but we said if you look in the yellow column, if a company makes $300 million, they're going to pay $120 million in tax, and they've got a 40% tax rate. These clean energy investments in the green section would show that it costs us pre-tax money to generate the returns.
You'll see that it comes down to the $66 million there. For the year, you would just derive a new annual expected tax rate. That's what we do at the beginning of the year. We kind of sit back to say, what's going to happen with the tax rate? Again, this isn't Gallagher. It's just a simplified model. Turning to page 24, 25, and 26 show you what happens on a quarterly basis. Let me just take you through page 24. If all these plants would run only in the first quarter, you can see here that in the first quarter, you'd have. If you assume that you have $60 million of pre-tax of regular core earnings, $16 million of losses, $75 million of tax benefit, you get down to a point. That's what's produced. Look at the green line.
It says $75 million of tax credits are produced during the quarter. When you come down to kind of the pink line, on a GAAP basis, we would only be allowed to recognize $11.7 million worth of tax credits in that quarter. We would have to spread them out for the rest of the year. You can see over in the right column, there's $75.6 million of credits, so that by the end of the year, we've recognized all the credits we've produced, but we have to spread those over the future earnings of the company on a quarterly basis. You can see at the bottom, you get to an effective tax rate per quarter, but the net earnings for the company in this case, in this simplified illustration, will be $38.1 million. Hold that in your mind.
When you turn to pages 25 and 26, you can see in the green section, if we produce clean coal and credits equally throughout the year, your income is dramatically different. Look at the purple oval at the bottom. If we produce all the credits in the first quarter, we'd have $38.1 million of income for a total illustrative company. If we do it equally throughout the year, we'd recognize $48.5 million in the first quarter. In the fourth quarter, page 26 says, if we produce it all in the fourth quarter, it's a dramatically different number. Whenever these are produced, it produces a different answer. In addition, any seasonality in our earnings would cause volatility.
The punchline in all this is that when we provide guidance to you, we're going to do our best efforts to pick a number on what we think will be for the quarter, but there can be volatility around that guess when we're providing information to you for your models. That's a long bit of information on those four pieces. It's very confusing. I'm sure that you're going to have some questions. Call me afterwards if it's unclear to you. Page 27 is kind of the punchline on the cash, what Pat teed up for you at the beginning of his remarks. The cash that we generate from these clean energy investments is intended to be used. First of all, there's a limited period of time that we're going to get them. The tax credits expire in 2019 and 2021.
We're going to use that cash to further buy brokers and risk managers. We may also use it to buy our shares, but the cash flows that are generated from these investments are not intended to directly impact our dividend. As we redeploy it into core earnings, it will influence dividends, but it's not intended to directly fuel the dividend. Page 28 just shows you what happens. If, for instance, we can take $16.5 a quarter, earn that all year, we create $66 million a year of additional cash flows from the company. If we deploy that into buying brokers and risk management, and we just assume a seven multiple on this page, it says that we could buy about $9.5 million a year of EBITDAC or $7.5 million after-tax cash from additional brokerage and risk management.
Every year, if we generate $66 million of free cash, we can go out and buy another $9 million of EBITDA or $7 million cash. Page 29 is a compounding of that effect. If we generate $66 million a year for the next 10 years, and you go out and buy brokers with it, and that compounds, and use the cash from those brokers and risk managers to buy other ones, it produces about $1.1 billion of additional free cash flows for the company as a result of this. Page 29 is nothing more than a compounding effect, you can see here why we believe that these cash flows off of these investments can be fairly exciting for Gallagher.
We believe this will continue to fuel our successful M&A activity that we've been doing for 20 years, and it allows us to continue to go out and build out our franchise around the world. That's the excitement on it. Pages 30 to 45 are what can go wrong. There are lots of risks in these type of investments, I want to spend a few minutes making sure you focus on this. We have spent a significant amount of time on our 10-K laying out all the risks, what I want to do is just flip through it. What can go wrong? Page 31, we get a lot of questions. If the IRS ultimately determines that they're not in favor of this program, or Congress repeals the tax credits, there's not a lot we can do about that.
In the meantime, we protect ourselves by getting private letter rulings and making sure that we maintain a close ear to the Washington scene. This is an important piece of legislation for energy policy in the U.S. We believe that Congress has seen this right, that coal is an important part of our future, and these laws, we believe, have a likelihood of surviving, but there's no guarantee. If they reduce the tax rate, we would just further sell off portions of our projects to others to reduce our ownership percentage to thereby reduce the number of credits that we'd recognize. There is a phase-out in this if coal prices get too high, turning to page 32. If coal prices rise too much, then the tax credits would no longer be available to us. On page 33, we put together a trend of what's happened in the past.
You can see on page 33, the punchline on page 33 is that we're still well within. There's no phase-out risk at this point in the near term. We estimated what we think was going to happen in 2012 a couple of weeks ago. Yesterday, they came out with the regulations, and there is no phase-out for 2012. You can spend some time reading this page 33 on your own, but we'll publish this information for you in our Q's so you know what the phase-out's going to be, or what we think it is per year. At this point, there is no risk for phase-out in 2012. On 33, we took the history, and we just used Excel's linear trend line capability and set up the trends of coal price inflation and phase-out inflation continued.
You might see a phase-out in one scenario in 2042, in another scenario in 2030. This whole program expires in 2021, so at this point, the projection would indicate there's not a risk of phase-out. Clearly, if historical trends don't repeat, the phase-out could come sooner than that. At this point, the historical trends would indicate we're not at risk during this program at this point. On page 35, there's other risk. Because we don't control these plants, we are at risk that our other partners could make decisions that are different than what we believe is in our best interest. We also have partners that operate these plants, that may fail to run the operations the way they need to.
We've been working with these folks for a long time, and we think that their interests are aligned with us, and we think that they're good solid partners, but it's still a risk it could happen. Page 36. Anytime you're running a manufacturing operation, there are a lot of operational risks. Inputs may not be available. The plants could be idled because the utility decides to do something else. There's disruptions in the supply chain. There could be labor strikes. There can be weather issues. Anything that you can think of when it comes to operating a manufacturing facility, there are those risks that face this. If they happen, then it obviously impairs some of our cash flows for a short or a longer period of time. Page 37. There's a lot of questions that happen. What is the likelihood demand of coal?
We do run the risk that some of these facilities will want to displace coal with natural gas. They could choose to shut down their utilities. Excuse me, shut down these plants. These plants are portable. We can move them to other utilities. If we have a utility that shuts down, we would pull them out of the housing and connections. That would probably cause a write-off of $2 million-$4 million, and we'd move the plant into a different location, hopefully at a utility that will continue to burn it. Page 38 is a graphic where we show here that it's projected through 2035 that the U.S. demand for coal actually may rise slightly, as total need for electricity increases, coal in this graphic looks like it will be a viable part of the U.S. energy source for a long period of time.
Page 39 shows you they've been burning about 1 billion tons of coal in the U.S. per year for U.S. electrical generation for a long time, and if that happens for the next 10 years, we should be in pretty good shape there. Page 40 provides a laundry list. There's a lot of popular press written right now about coal versus natural gas. You can read through this. Basically, natural gas has its issues also. It's not as an efficient fuel, from what we can tell, as coal. Again, we believe that coal is going to be here as a part of the U.S. energy need through the end of these programs. On page 41, I talk about if a utility stops burning the coal, we can move the Section 45 plant. I've already talked about that.
Obviously, page 42, ChemMod is an intellectual property, and there are risks that are always faced to company on intellectual property. We could have somebody come in and claim we have patents on these. ChemMod has patents on its technologies, but that doesn't mean somebody couldn't sue us for them. Although I think that we've got a pretty solid case on them. Page 43, there are a lot of things that can go wrong when it comes to environmental products and product liability. You just need to be aware that we don't believe that the ChemMod solutions produces an environmental problem. In fact, we think it improves the ash dramatically. Somebody could come in and claim otherwise on that. We also have a risk that key personnel, there are five folks that spend a lot of time at Gallagher working on this.
We believe that they've been here for many decades, and we think that we've got ways of keeping them here at the company. There is a risk that we could have key personnel depart from the company. In the last 35 minutes, I've pushed through these 44 slides. We come to a frequently asked questions section. At this point, I'd like to just open up the call. The key takeaways on this, investments that create cash that we can turn around and buy brokers and risk managers with, lots of excitement, lots of possibilities, but lots of risks. With that, operator, if we could open it up to calls, we'll move into the question and answer portion of the call.
Thank you. The call is now open for questions. If you have a question, please pick up your handset and press star one on your telephone at this time. If you're on a speakerphone, please disable that function prior to pressing star one to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing star two. Again, that's star one for questions. Our first question is coming from Daniel Farrell of Sterne Agee. Please state your question.
Hi. Thank you and good morning. Appreciate all the detail you've given on this.
Good morning, Dan.
I think you mentioned that a number of plants that the ChemMod technology is being used in plants which you don't own or burners that you don't own. Is there an estimate of cash that you could get from that? Because I think right now you're giving us an estimate of just the plants which you own a piece of.
Dan, the answer to that question is, it's a little early right now for us to make a pick on that. We've told you early on that we think that maybe ultimately ChemMod could be burning
Being used at 150 million to 200 million tons a year. You can see there's a royalty rate in there. It's a little unsafe to extrapolate, purely taking 150 million to 200 million times the royalty rate on a pre-tax basis of about $0.50 a ton. I would be careful on that because there are a lot of operational vagaries. We do believe that ultimately, our 29 plants and the other's 33 plants, if there's 60 plants out there owning 15%-20% of the market, we think there could be some nice cash flows. ChemMod as a company is required to distribute all but 90 days working capital to its partners. The cash that would come into ChemMod would be distributed to Gallagher and the other partners as long as it can meet its 90-day working capital needs.
Okay. Can you just talk about if a plant decides to switch to gas or some other fuel other than coal, are there hurdles in doing that? Is there a cost? Is it difficult? Is it easy for them? I'm just trying to think if one becomes more attractive, is it fairly easy for them to switch that?
Well, it depends on the plant. I think that some plants have a fairly easy switchover and low cost. Other plants, it would be more cost and structure. One of the things for everybody to realize, every plant in the U.S. has a different personality around the world. The plants, the way they're built, the way they're constructed, the materials, the configuration of their equipment, all of these plants are different. That, in a sense, provides a great opportunity for us, but also it's one of those things that it causes us to have to waffle on this answer, Dan. I can't give you a generalized answer for that. Some, it's going to be pretty easy for them to swap over, and others, it's not going to be.
We believe that our utility partners that choose to put in a clean coal plant and use the ChemMod solution are those partners that think that coal is probably a viable solution for that plant for something other than the short term. We think that by us, if there's 600 different types of utility boilers out there around the country, and there's only 60 of these plants between us and our partners, putting these plants in a spot where a utility believes that they're going to run this for a long time seems like a logical choice.
Okay. Thank you very much.
Thanks, Dan.
Our next question is coming from Mark Hughes of SunTrust Robinson Humphrey. Please state your question.
Thank you. Good morning. When would we expect to hear any updates about these additional facilities that you're pursuing? Then can you say anything about international? Are you pursuing international opportunities? Is there an appetite for this kind of technology?
Good morning, Mark, thanks for your questions. Our intention is to provide an update on where we are with respect to rolling out other plants during our quarterly conference calls. The next time you'll hear from us is in about three weeks, we'll give you an update on where we are with those other plants. What we told you in January is we have a good pipeline for them, we're working hard to find host utilities for those other plants. We're not changing any of that in this call. This call is not meant to update that guidance. I'll do that in three weeks and give you a status report on that.
In terms of what's the potential for the international market, the strategic direction set for ChemMod over the last two years has been to work closely with any U.S. developers that wanted to create Section 45 clean energy plants. Next, ChemMod will start spending its efforts toward the end of this year on trying to find a pure mercury solution location, a location that wants to use ChemMod purely for mercury control. As for international, we have had some discussions with folks internationally, but I would say those are extremely premature. Gallagher acts as the manager of the domestic company, but we don't act as the manager of the international company. We only own 20% of the international ChemMod company, whereas we own 42% of the U.S. company. I do believe there is a need for mercury control internationally. The Chinese have a significant interest in it.
I think that mercury control is something that will be necessary internationally. We're just not spending the efforts on it at this point.
You didn't change your financial guidance as part of this call, did you?
No, there was no update in our financial guidance at this point.
Yep. Thank you.
The only thing we did is we took, if you go to page 22, I think that's the right page. We just took our fourth quarter press release, and it's on page 21, and just put it in tabular form rather than you going through the words in the press release.
Thank you.
Thanks, Mark.
Our next question is coming from Ray Iardella of Macquarie. Please state your question.
Thanks, good morning, guys. Just a couple quick questions. First, I guess you had described that the investments you made in ChemMod and I guess $1 million of cash currently. Is the right way to think about it is you've received $12.3 million of cash to date in the investment?
No, we're saying that we have not recovered. If you look at it this way, we've recovered $1 million thus far of our $13 million investment.
Got it. We can expect about $12.3 million of cash by mid-2013. That's the right way to think about it, I guess?
Well, the way we get to that number is on page 21.
We say that on a quarterly after-tax basis, ChemMod, we think ultimately could be generating, in the near term, about $2.5 million of cash per quarter for us.
Okay, thanks. That's very helpful. As far as insurance costs, I guess they were broken out in sort of the expense line for the ChemMod royalties. Is there any insurance costs that are in relation to the actual production in the plants?
There are costs that the LLCs buy. There is insurance that the LLCs do buy to cover the plants. There are costs of operating the plant that include insurance.
Okay.
We buy property insurance and liability insurance on the actual plants.
Okay. That's helpful. Just lastly, on sort of seasonality of when coal is burned and when we can expect the pre-tax earnings. Is there any way to think about that? Once you get to the run rate, is there more coal burned in one particular quarter?
Well, listen, I think that during the air conditioning season, electricity is primarily used for cooling, not necessarily heating.
A lot of these plants are in southern states or in Midwest states that they burn a lot of coal in the summer. Not only do you have the seasonality of production, you've got the seasonality of Gallagher's earnings. Those two in combination do cause quarterly swings, I'll put it that way.
Okay, great. Thanks.
Thanks, Ray.
Our next question is coming from Jay Cohen of Merrill Lynch. Please state your question.
Yes, thank you, and thanks for doing this call. You're talking about the kind of cash these both plants will generate, and obviously the money you get from the ChemMod. I know you've looked at ways of monetizing that. Why doesn't that work? Why can't you essentially sell the patents and sell these plants now? You get a bit of a discount, but why is the discount so big?
Jay, good morning, and thanks for your question. I think that there's two different pieces you have to look at, is that in effect, we do sell off about 51% of the plants, remember? We do get our ownership level down to in the 40s someplace when we own the plant. In effect, we're doing that by selling that. Anybody that buys into a plant wants to do this on a pay-as-you-go basis. They would pay a lump sum up front for their 49% or 51% ownership, but the discount is pretty steep for all the risks that I've described between pages 30 and 44. I guess the question would be for you is, what would you pay us up front for an uncertain cash flow, right? That's on the plants.
When it comes to ChemMod, I have said that we do believe that ChemMod, the recipe, that we will go through an exercise with our partners to find out whether we want to continue to hold ChemMod as a partnership or whether there's a strategic buyer for it or a financial buyer for that recipe card. That's something, but the strategy of the ChemMod partners was first develop as many of the clean coal plants as we could, get them qualified before December 31st, 2011, continue to roll that out, get them up and running, and then step back and find out what's the next best step for ChemMod. We talk about that on page 50 in the Q&A, or the frequently asked questions here. Yeah, there is a next step for ChemMod, and one of those things could be selling it off.
Yeah. Certainly seen some patent sales recently in the technology area that have gotten healthy prices, but obviously this is a different business.
Yeah, I think the entire environmental control area and coal does produce significant opportunities for us, but you have to demonstrate that your technology works. That's the reason why we're doing this. Remember, this is actually what the government wanted to happen. Congress had the forethought to say that if you can subsidize private investment to make coal a better fuel for America, then this is exactly what we had to do. We had to commercialize this technology, then it's time to sell it.
You use Congress and forethought in the same sentence.
Yeah, I know.
which you typically don't hear very often. One last question. You mentioned the ash that's produced, and it can be used in concrete. In that ash, obviously, is some toxic stuff, and now it's potentially toxic stuff that's in concrete. I know it's all solidified and all, is there a longer-term environmental issue if someone starts to drill into this concrete? Does it release a lot of this toxic stuff?
It becomes benign, and it's only released if it's over 3,000 degrees. There's only one or two things that we know that goes over 3,000 degrees that's uncontrolled. That's a nuclear explosion, I don't think we'll worry about the mercury coming out of the concrete if that happens. We found in testing that it just doesn't release unless you heat it up over 3,000 degrees. There's a ceramic bond around it. The chemistry is very well-proven. Drilling into the concrete would not produce that. It is a viable replacement for Portland cement that can make concrete stronger. Our tests have proven that the concrete's better. You're taking an ash that may have been disposed of with a cost. That's another benefit to the utility for using this.
We believe that it makes their ash better, and we've proven that it makes their ash better, you can turn it into concrete.
Interesting. That's great. Thank you.
As a reminder, ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. Our next question is coming from Arash Soleimani of Stifel Nicolaus. Please state your question.
Hi. Just a quick follow-up question. On the $16.5 per quarter, I think that should go through 2019, right? That drops off in 2020, I think, to about $11.75. Can you just remind me what causes that drop off in 2020?
Good question. These qualified plants have a 10-year useful life from the date of they're placed in service.
Right.
For our 2009-era plants, they will produce investment streams through 2019, and our 2011-era plants that we built will produce through 2021. That's the reason why.
Okay, thanks. I think Mark was asking this earlier, but basically in terms of the additional plants that you wanted to deploy, I think there were the additional 11. What year should we expect to see a potential pop from those? Or is that just very uncertain at this point?
It's like any sales process. You get a lot of interest on the front, and you percolate them down. There are a lot of issues with respect to getting these plants placed in service. They're all placed in service, but get them at a host utility. There's a lot of engineering that has to go on. There's environmental permitting that has to go on. There's a lot of contracting. These things take a while to get into their final resting home. We're working hard on it. I can't give you any update right now. I'll do that in a few weeks. It just takes a while for these things to get finally up and running to their full capacity.
Okay. That's fair enough.
Yeah.
All right. Thank you.
Our next question is coming from Yaron Kinar of Deutsche Bank. Please state your question.
Good morning. Thanks for a very informative presentation. Can we talk a little bit about the capacity for the refined coal plants? What is the average capacity for one of those per year?
Well, the capacity of a plant is different than the volume burned by the utility. I'll just make this up. Let's say that we actually have made three different sizes of plants by and large. If you take one plant that could maybe run 5 million tons a year, and you put on a conveyor that's only running 1 million tons a year, clearly that's the constraint in what the plant can do. These plants do have the capacity to generate or to produce a significant amount of coal. The likelihood of us putting them into a utility that can use their full capacity is remote. The plants have the ability to produce more than what the utility would actually burn.
Okay.
There's a wide degree. We have one plant that's running on 100,000-ton conveyor belt at this point. It has the capacity to do 2 million tons.
Okay. If I look at the 2009 versus 2011 era plant, it seems like you're getting more in net earnings from the 2011 era plants. Does that just mean that you have more favorable contracts with larger utilities that you're partnering with for the 2011 plants?
Yes.
Okay.
One of the things to know that we are about the process of trying to redeploy some of the 2009 era plants to larger conveyor belt locations.
Okay. When you talk about the 100 to 140 million tons per year of coal consumption, possibly moving up to 150 to 200, does that also include the Gallagher plants, or is that for the non-Gallagher plants alone?
The 100 to 140 is the non-Gallagher.
The 150-200 would include the Gallagher plants, but not at full capacity.
Okay. I guess what I'm trying to get at is what additional upside there is. I realize there's only so much you can say without just putting a finger up and guessing. Is there any way to think about that, how much additional revenues or net earnings that you could be making there?
Well, ChemMod has a substantial opportunity to increase the amount of its earnings. If we can get to 150 million-200 million tons a year, and we're making a $0.50 royalty off of it, you can see that there's substantial earnings capacity of ChemMod. There's a lot of ifs in that. I just want to make sure there's a lot of things that can go wrong, you can do the math on that and then take it times 42%, and then take it times 60% for the tax effect on it. You can see that ChemMod could be a nice stream of royalty income for Gallagher and its partners during this program.
Okay. Then if some of your competitors actually do increase their coal consumption or help with coal consumption, I'm assuming that. Is that coming from plants that are already in service, or are those plants that they are kind of similar to maybe the two 2009 era plants that you have and the few other 2011 era plants that are currently sitting idle? Would those be plants that come into operation over the next year or two? If so, does that mean that you're facing some stiff competition to find homes for these idle plants?
We believe that the other licensees of ChemMod might be further along in locating host utilities with their 33 plants than we are with our remaining 11 or 12. I don't see the other 33 being highly competitive with us, but that could happen. There could be some situations. Generally, this is a small group of people. We know them very well. They're a customer of ours, so we support them. As Gallagher manages ChemMod, we're supporting the other licensees. We want them to be equally successful of us, and truthfully, the market is plenty big enough that they can find locations, and we can find locations.
Okay. One final question, if I may. Are there any costs associated with disassembling a plant other than the write-off? If so, is that something that's borne by Gallagher or by the partners, or how should we think about that?
If we have to decommission the connections and housing of a currently installed plant, there are costs associated. It costs us $4 million to build the conveyors and that. It probably costs us $1 million to tear it down.
Okay.
It's de minimis compared to what the earnings capacity of a plant. If a utility stopped burning coal, it is a very easy decision to rip the machinery out and move it to a different location. If you've got to write off a little bit of your carrying value. Remember, if we get a plant up and running in a location, we recover all of our capital costs in about two to three months of running that plant. Cash, there is a high incentive. There's a high payback. These plants produce so much income that putting them in place, if they run for three or four months, you get your cash back out of it. We have a big incentive to move them to another location, and the write-off pales in comparison to the opportunity.
Oh, okay. At the end of time, let's say the end of 2019, the end of 2021, I'm assuming you also have to disassemble these plants. I'm just trying to think in terms of cash flows.
Well, let me tell you. The answer would be, if that's the case, we actually believe that these plants have the potential to be toggled over to pure mercury control. We think these plants are legitimate environmental improvement plants. These are not plants that are purely operating in order to harvest a tax credit. That is not what these are. These improve the environment, the chemical works, we're very hopeful that at the end of 10 years, that the addition rates will slightly change, or the utility will continue to run this for mercury control.
Even if we had to pay $1 million a plant in 10 years, it's a pretty small number when you really come down to it, because I don't think it'd really cost us $1 million to decommission it, and we don't think all of them are going to decommission it.
Okay. Thank you very much.
Sure. Thank you.
Our next question is coming from Mark Dwelle of RBC Capital Markets. Please state your question.
Yeah, good morning. I have several questions. Let me start off by thanking you for doing this. I think it's something that's probably pretty long overdue. Let me just start by posing a statement. Is the message, the reason that we're doing this is that this is something that's going to be with us for a long time, so we might as well get used to understanding it and kind of watching it go through the P&L over the next decade or so?
Yes.
Okay.
We think so. We hope so.
Okay.
We hope it's with us a long time.
The second question, you've talked about the income that these plants generate. I want to clarify something on that. Do the plants actually generate income, or do they only generate income because there's a tax credit associated with it? Said differently, if the tax credit were to go away, which I'm not saying it would, but if it were to, would these plants lose money?
If we didn't change the charges to the utility, if we had no ability to go back to the utility and charge for pure environmental control, then yes, they would. We wouldn't run them.
Right. If another administration were to say, "This is a subsidy that we don't wish to support," the most likely outcome would be decommissioning.
Correct. That's it. That's one of the risks. That's the first one that we hit on page 31, was if the IRS cries foul on this, or if Congress changes its mind with respect to this subsidy, then there's a high likelihood that the cash flows that are generated from this would disappear.
Okay. In that vein, that's how this investment resembles all of the prior in the sequence of various tax credit-driven investments. It's why it ultimately can make sense for Gallagher, because you have such a strong operating earnings stream related to your real business that you're always going to be, or you would most likely be in a position to utilize tax credits on a long-term basis.
Correct. You've hit it right on the head.
Okay. A slightly different numbers question. On pages 13 and 14, you had outlined the $13 million or so that you have into ChemMod, and then the $31 million or so that you have in the plants. Is that the right way to think of it, is just using kind of shoebox accounting? You've got $45 million in the shoebox, regardless of how it appears on the balance sheet. There's $45 million in the shoebox, and the cash flows from the tax credits when they begin to flow, would first offset that run.
Yes, with one slight asterisk on it. All right? We've got $45 million in the shoebox. In 2009 and 2010, the 2009-era plant actually generated for us over $10 million of after-tax profits, or about $10 million of after-tax profits. If you think about the $45 million, we've recovered already $10 million from running the plants in 2010. Interestingly, I believe that most of our investment for 2011-era plants, we depreciated already 100% in 2011 because all capital expenditures were afforded a 100% depreciation deduction in 2011 as a result of one of the stimulus bills. Yeah, $45 million of cash went out, but we've got $10 million of it back already, by paying less taxes in 2010. We also depreciated them.
The shoebox had some money coming back into it because of production and everything. I don't have it right here in front of me, but my gut guess on this is that maybe net-net out on all this, we've got something like $22 million, something like that, $25 million.
Okay.
Probably $25 million-$30 million is probably closer to the number.
Okay. That's helpful. Obviously, if things go as you hope, that comes back pretty quick.
Yeah, I'd like to have it, by the end of this year, everything recovered. You're playing on house money a little bit.
Okay. I guess the last question I would pose, it kind of goes along those same lines as the one Jay Cohen asked earlier about why not sell it. What would be the one message that you would tell to investors as to sort of why you should pay Gallagher and the valuation of Gallagher for absorbing this risk and pursuing this cash flow stream, rather than just take the heavy discount and stop having conference calls about coal?
I think that with more time, I think that the discount factor becomes less. Remember, commercializing ChemMod was a very important aspect of developing these plants. I think that with time, you might have a very good argument, but at this point, we believe the discount is just too steep. We think that there's more shareholder value to be created by harvesting the cash flows over time than there is to take a one-time hit right now, or one-time opportunity right now.
Okay. Thanks for the answers. Thanks for the call.
All right. Thanks for your questions.
Our next question is coming from Justin Moorer with Lord Abbett. Please state your question.
Morning, guys.
Morning, Justin.
Just a couple follow-ups. I guess I'm trying to understand, with the hundreds of million dollars that the utilities are spending on scrubbers, this seems like a de minimis kind of cost to them. Why wouldn't the utilities be doing this themselves? Obviously, you guys, like you said, you've commercially developed ChemMod and want the kind of cash flow and income stream that comes off of that. Why wouldn't the utilities spend the $5 million bucks to kind of build their own hoppers, if you will, to which then you guys would be just selling the chemical and the process for a royalty stream?
Interesting. In order to encourage development, the IRS actually doesn't allow the utility to own a significant portion of these plants. It has to be done by a third-party developer. I think the utilities, in some cases, some of them do own a piece of the projects. In some cases, they just take a discount on their coal, or we pay them rent. They participate in this profit pool in a different way, but they're actually prohibited by law from owning a significant portion of these plants.
Got it.
That's the reason why.
Relative to what's a contractual, if there is such a thing, with the utility, and to the questions about tear down if you had to remove the equipment or whatever. Are these 10-year contracts with the utilities? How many of these, say, just roughly, are public companies, large utilities versus co-ops or muni utilities? Just give us some flavor, maybe, of the makeup of the customer base you guys have.
I think that Well, let me answer the question in two pieces. They have long-term commitments to us to use the clean coal, but there are outs in any situation that would allow them to get out if their strategy changes, they decide not to burn coal. We believe that we have a long-term customer there. As any contract, there are outs if their strategy and direction changes. In terms of the composition of the owners, yes, there are several of our customers that are public companies. There are several licensees of the ChemMod that are co-ops. I'm just talking about ChemMod engineering. I would say that the utilities participating in this environmental improvement exercise, cover the gamut of utilities. Some are public, some are private, and I don't have a split out of how much of the volume would flow to each of those.
I think that we're finding interest from everyone.
Got you. What's the gating mechanism? You mentioned the 11 to 12 other plants you have waiting to be put into service. What's the gating mechanism for those? What are you guys waiting on for those to be placed into service?
I think that first, is one, they want to see how our current plants are operating. The first thing, you have to demonstrate the technology. The next thing is they've got to go through permitting in the state that they're in, and then there's the contracts that have to be drafted. I would say that the real hurdle is getting environmental permitting in that state. Obviously we'd like to do utilities that have already had state approval on it, and then they just have to make sure that the chemistry reacts to their boiler properly, and then they have to see what the costs are going to be. Engineering takes time. Really, the critical path is probably permitting by the state. That's the biggest uncontrollable.
Yep. I don't know if it's different based on the different ones waiting to be placed in, have you spent the $1 million plus the $4 million in each of those cases, or some kind of part way and some all the way or?
We've spent the $1 million for each of the 12 that we haven't spent the remaining $4 million, nor have we recovered anything from our partners.
Got it. Okay. Last question. In terms of the reconciliation to kind of the current run rate of tonnage, you said $66 million is kind of the bottom-line impact. You talked about potentially this 150 million-200 million ton opportunity, what are you guys currently running between the plants that you own, kind of directly in the $1.91 that you're generating versus the license fees, the $0.11?
Several different questions in there, here's the thing. The volumes that we're currently running are currently lower than what we ultimately think that they can run.
Okay.
All right? We're working on operational tweaking on that. Our previous guidance that we've given, that we're not changing, that I'll just repeat, I'm not updating, is that there's lots of operational tweaking. There's a lot of a startup mode that's going on. There's a ramp-up in 2012 before we reach the ultimate run rate. It'll be tough going over the next nine months with our partners to get these things all sorted out. I don't have definitive numbers for you on that yet, and I don't have insights from our partners yet on exactly where they are in terms of their optimization efforts.
Got it. Okay. Thanks very much, guys. Appreciate it.
Thank you.
Once again, if you would like to ask a question, please press star one on your telephone keypad. Our next question is coming from Keith Walsh of Citigroup. Please state your question.
Hey, everybody. Good morning.
Good morning, Keith.
Just, Doug, real quick, I think you've kind of answered these in a couple different ways, thinking of the 18 of the 29 plants you've got up and running, are the earnings estimates you have on those based on those plants operating at full capacity, half capacity? What rate are they currently running at? I've got a follow-up.
What I want to do is make sure we refer back to page 21. On there, we believe when those plants run based on what we think the demand for the utility would be, those are the numbers that we're projecting. Clearly, those plants could produce more coal because they're bigger machines than what the utilities are using. Remember, the constraining factor is how much is the utility going to burn, and that's what our best guess is on page 21, is assuming that we get them up and running, with all the operational bugs worked out, their coal comes in, they don't displace, we don't have problems. We think that these things can run based on what those utilities have typically done in the past years to produce this type of income stream for us on 21.
Okay. That's not full capacity, but you think it's enough capacity to meet demand, is what you're saying?
I think it's what a utility would tell us they're intending on running, including their shutdowns, including their seasonality. If we don't have a hot summer, they'll fall short of those estimates. If we have a super hot summer, maybe they'll run them some more. It's what the utility expects to run in terms of clean coal.
To the 150 to 200 million ton number that you cited, that's annual, I'm assuming. What kind of capacity usage are you assuming in that number?
It's a guess based on what the other licensees have told us and kind of a look at what we think that our plants might ultimately be producing. As these plants actually run, over the next year, I'll be able to refine that number much better.
The last question, I appreciate your comment earlier about the current discount to monetize is too great, but I guess my only concern would be how much time are you and Pat spending on this right now, as far as the way to think about shareholder value?
Keith, this is Pat. You can tell from this presentation that my time in this is about nothing.
Keith, I have to admit, over the last six months, I've probably spent a day a week on it. I think that it's important to generate if we really believe we can get these things up and running, I think a day a week of my time is probably good effort in order to create this type of cash flow to the company. Going forward, the team that does this is highly experienced in it, and I would say that my efforts would come down dramatically on that.
Just last question, I'm sorry if this is probably repetitive, but just really simply, what is this currently running at now as far as cash flow benefit to Gallagher in your estimates, and what do you think the opportunity could be?
Well, I'd like to save the answer to that question for three weeks from now. The last guidance that we gave was in our February 1st conference call at the year-end. What we said there in that call is that the guidance given at that time was that this would cause the corporate segment to be about break-even in the first quarter, maybe make $0.02 in the second quarter, maybe take the corporate segment to $0.04 of earnings in the third, and $0.06 in the fourth. Again, as you can see from pages 23-26, there is some volatility around the word about there. That's the last guidance we've given, and I will update that in three weeks.
Okay, great. Thanks a lot, guys.
Thanks, Keith.
Our next question is from Raymond Iardella of Macquarie. Please state your question.
Yeah. I just have one follow-up question. I guess on slide 16, I guess you guys broke out $1.04 from the ownership interest and then $1.02 as the developer. I'm just curious, sort of, what's the difference between the two?
Well, probably nothing. I think that just tried to give a difference and why does our ownership percentage not exactly track with the amount of profits that are realized by the partnerships. If all of our financial partners would've been in with us since day one to develop the plant, then you would see an exact split of the profits exactly in accordance with their ownership percentages. Because we developed the plant and took the risk to develop it, place it in service, find the host utility, secure the long-term contracts, go through the effort, Gallagher participates slightly more in terms of the profits than just a financial partner would.
Okay.
That's the only thing we're saying there.
Okay. Even though that's a 49% interest, I guess, in the LLC, you might receive a greater percentage of the profits. That's the way to think about it?
Yeah, the reason why is because the financial investors pay us for their investment partially upfront and partially over time.
Got it. Okay. Thanks for the color.
Thanks, Ray.
Once again, ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. Our next question is coming from John Campbell of Stephens. Please state your question.
Hey, guys. Good morning. It's John Campbell in for Brett Huff.
Morning, John.
Morning. We appreciate you guys putting this slide deck and call together. It's been very helpful. Most of my questions have been covered, but just wanted to go for one last two-part question here. Just trying to better understand the risk. As you guys attempt to qualify for the tax break, you mentioned that you have to prove through the laboratory test that you can reduce, I think it was mercury by 40% and nitrogen oxide by 20%. Can you talk a little bit about the success rate or maybe just hit rate at which ChemMod achieves this mark? Are we talking 99.99%, or is there some variability in risk in there?
We have never had a laboratory test, that I'm aware of, that we didn't achieve these results.
Okay, that's helpful. Last part of the question, it's kind of hard to predict actions from Capitol Hill, but are there any concerns that they might push those limits higher? I think it was the 40-20 mark that you mentioned. If so, if you guys can just maybe talk a little bit about how much ChemMod currently exceeds that 40-20 mark.
The ChemMod solution has reduced mercury well into the 90s. I think that if Capitol Hill pushes it higher, I think that makes ChemMod even a more viable solution. I believe that by just putting in a little bit more of the chemical, you end up with higher reduction rates. It's not the science in there to get the numbers to move higher is. We have a lot of experience with that.
Okay, great.
Now, the real question is, if Capitol Hill does that, are they going to encourage more plants to be built, too?
Right.
Which we'd be okay with.
Absolutely. Okay, that's helpful. Thank you.
Gentlemen, I'm showing there are no further questions at this time.
All right. Thank you everybody for listening. We hope that this has provide more transparency into our clean energy investments and what the cash can be used for. It's a very exciting time for us. There are a lot of risks associated with doing this. We'd like to keep you updated on a quarterly basis, but we thank you all for taking an hour and a half to let us take you through it, and hopefully this has been a nice educational process for you. Thanks everyone, and have a good day.
This does conclude today's conference call. You may disconnect your lines at this time.