OGIB BULLETIN # 143 DECEMBER 3 2013
PACIFIC ETHANOL – PEIX-NASD
COMPANY ANALYSIS
Of course, there is a good reason why PEIX has such a low valuation and such huge leverage—they’ve gone bankrupt once and management has to prove themselves to the Market. I’ll get into a bit of detail on that.
But my investment is based on the idea that their troubles are behind them; the industry’s troubles are behind it, and Q4 2013-Q4 2014 has the potential to be profitable for PEIX it could easily get some multiple expansion to 5-8x PE, which would result in a multiple of the current stock price.
QUICK FACTS
| Trading Symbols: | PEIX-Nasdaq |
| Shares Issued: | 16 million—FULLY DILUTED=24.5 million |
| Share Price: | $3.76 |
| 2014 Projected EPS : | $1.16-$4.64 |
| Market Cap: | $60.1 million |
| Net Debt: | $109 million |
| Enterprise Value (EV): | $169.1million |
POSITIVES
– four fully built and functional ethanol plants
– debt/liquidity issues resolved now
– ZERO analyst coverage by sell-side stockbroker firms
– underfollowed by institutions because of low market cap
– profit margins soaring now with huge 2013 corn crop
– trading at a tiny price to earnings ratio
– trading at a fraction of the replacement cost of ethanol plants
NEGATIVES
– leverage and exposure to corn prices works both ways
– previous bankruptcy filing will keep many investors away
– some remaining dilution from restructuring is still to come
– the company still carries a significant amount of debt
WHAT IS ETHANOL
Pacific Ethanol takes a feedstock (corn) and turns it into ethanol. Two ethanol by-products—distillers grain and corn oil—can also be produced.
Ethanol plants use natural gas, chemicals and enzymes to turn corn into ethanol.
First, smash the corn and put it into a tank. Mixed with water and enzymes and then heat—this turns the corn starch into a sugar.
The mixture is then moved into a fermentation tank and mixed with yeast and chemicals/antibiotics (to control bacteria).
This new gooey mess is fermented for half a week at a high temperature, and then distilled to separate out the ethanol.
The two major costs are corn (by far the biggest) and natural gas. Some simple math shows just how much the price of corn affects the all-in cost for producing ethanol.
THE SIMPLE MATH
Each gallon of ethanol requires roughly .35 bushels of corn; conversely a bushel of corn makes 2.85 gallons of ethanol. If corn was priced at $4.25 per bushel (roughly where it is today–) that would mean the cost of corn in each gallon of ethanol produced is $1.49. Ethanol sells for $2.50/gallon now.
Natural gas is the second largest non-fixed cost. With $3.50-$4.00/mcf natural gas prices, each gallon of ethanol would have a natural gas input cost of something like $0.14 to $0.16 per gallon.
You can figure out the economics of ethanol quite easily too, using all the same math. At $4.25/bushel corn—you can go to Bloomberg and get the daily corn price per bushel (here’s the link: http://www.bloomberg.com/
Then multiply it by 0.35 to get a gallon of ethanol cost ($1.49/g) and add 15 cents for natgas—we’re now at $1.64/g—and you get a pretty rough but accurate cost for ethanol. The NASDAQ publishes a daily ethanol price per gallon—here’s the link: http://www.nasdaq.com/markets/
THE ETHANOL MARKET
I just explained the simple economics of ethanol. The most important thing I want investors to understand is that ethanol is NOT subsidized; it is a real market with real economics—like I just showed.
Investors get confused when they hear that the US government mandates a certain amount of ethanol be mixed in with gasoline—it’s called the RFS, or Renewable Fuels Standard.
I’m agnostic on ethanol mandates; my job is to make money whatever the rules are. It does raise some big emotions in the Excited States of America though.
The RFS says US refineries must use 13 billion gallons of ethanol next year, or use ethanol credits, called RINs, to make up the difference. RINs are Renewable Identification Numbers—one for each gallon of ethanol ever made.
There was a lot of RINs around for years because ethanol was so economic to use, nobody used RINs. Then when corn prices spiked in 2012 because of the drought, ethanol wasn’t economic, and everybody wanted to use RINs. RINs went from 2 cents to $1.50 a gallon in 2013 as a result. But now that ethanol is once again very economic, RIN prices have fallen back a lot, and the reduced RFS ethanol mandate for 2014 has made them fall back even more.
A funny thing happened on the way to a reduced ethanol mandate: ethanol prices and margins increased—which is not what the Market expected. Because of the high pitched rhetoric between ethanol and oil producers over the RFS, investors can forget there is a real market for ethanol not based on subsidies. Since the RFS has been reduced, corn prices have stayed at $4ish/bushel while gasoline and ethanol prices have gone up—taking PEIX and GPRE margins with them!
Contrary to what you read on the web, ethanol is not a political commodity. It’s a market based commodity–and it makes economic sense for refiners to use it.
A supporting factor for 2014 ethanol should be higher US net exports. There’s a large ethanol market globally, and the US imported a lot of ethanol when corn prices spiked. Now, in Q4 2013, the US is a big net exporter and I expect that to continue through 2014. Corn is so cheap now that the US is the global low cost supplier—and net exports could rival 2011’s 1.1 billion gallon record. You can see in the chart below how ethanol imports soared along with corn prices as the US mid-west drought hit in June 2012.
In 2013 there was a record or near-record corn crop in the US—over 93 million acres planted and a yield of close to 155 bushels per acre—one of the highest ever. That drove down corn prices, making ethanol a lot more profitable—and started a new wave of exports that should continue into 2014.
Here’s an ironic positive to the PEIX story—because they have just refinanced their debt and equity, they don’t have a lot of cash on hand. They literally cannot afford to hedge their production. That costs about 10% down for the amount you want to hedge. PEIX doesn’t have it.
Not that they would want to—the spot market is where the Big Margins are now. But they are running the business completely opposite to GPRE, who hedge out every gallon they produce usually, and only recently started doing more spot sales. That is actually a lucky irony, and should make them buckets of extra money the next 2-3 quarters.
SECONDARY PRODUCTS BESIDES ETHANOL
Like GPRE, Pacific Ethanol also sells distillers grain and corn oil which are two add-ons / by-products from ethanol production.
Distiller’s grains are sold to cattle farmers (both dairy and beef) as a high protein feed supplement. Using feed that has a 20-30% distiller grain content helps cattle put on weight and increase milk production. It also reduces the cost of feeding the animals.
In order to sell corn oil an ethanol producer first needs to install corn oil extraction equipment. That’s usually a $3 million cost, with payback in less than a year.
At this point PEIX has its Magic Valley Idaho plant equipped to extract corn oil. They have (or is about) to commence corn oil production at the Stockton plant as well.
The costs involved in adding corn oil separation are minimal so this is a very high margin by-product for ethanol producers like Pacific Ethanol.
The corn oil production won’t make or break the company, but it is a nice bit of incremental income. A typical ethanol plant would produce roughly .15 pounds of corn oil per gallon of ethanol that is produced. Pacific Ethanol estimates that corn oil sales at their Magic Valley plant will create up to $4.5 million of operating income annually.
The corn oil produced is not suitable for human consumption, so it is used as a soybean oil substitute.
PEIX also makes a little bit of money through its own marketing subsidiary.
Through Kinergy Marketing, PEIX markets (sells) ethanol, distillers’ grains and corn oil for other producers.
Marketing third party ethanol and by-products is not a high margin business, but it keeps their fingers in a lot of pies, it helps solidify their market presence and it pays for the overhead.
Now, just quickly I’ll explain that the Magic Valley Idaho plant is increasing profits by an extra 10% because of a great deal cut by management. PEIX management was able to secure a huge supply of sugar—which can be a partial substitute for corn in the ethanol process—from the US government at crazy low prices—4 cents then 2 cents a pound, in two separate purchases.
They’re running 15% sugar now, and increasing profits by a full 10%! The reason they’re not running it 100% is because if you run ALL sugar with your corn in your ethanol process, you can’t make corn oil or grains—and they have customers in the feedstock business they are committed to. And, CEO Koehler told me it that there’s no guarantee they could keep getting that ridiculously cheap sugar year after year.
PEIX has actually done an intriguing job of sourcing out-of-the-box sugar sources, like old wine from California. It doesn’t really amount to much (except for the sugar!) but it shows they’re thinking.
in Part II on Tuesday, I’ll get into the nitty-gritty business, explaining to my subscribers at the time that the ethanol business has been unbelievably volatile, and it just about killed PEIX. But of course, that was our opportunity….And I touch on some ideas around valuation and economics.
