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Pacific Ethanol, Inc. (NASDAQ:PEIX)

F3Q08 Earnings Call

November 10, 2008 9:00 am PT

Executives

Gregory Pettit – Hill & Knowlton

William L. Jones – Chairman of the Board

Neil M. Koehler – President Chief Executive Officer, Director

Joseph W. Hansen – Chief Financial Officer

Analysts

Joseph Gomes - Oppenheimer & Co.

Analyst for Jinming Liu - Ardour Capital

Pavel Molchanov - Raymond James & Associates

Ian Horowitz - Soleil Securities

Operator

Good day ladies and gentlemen and welcome to the Pacific Ethanol Incorporated third quarter 2008 earnings conference call. My name is Michelle and I will be your coordinator today. At this time all participants are in listen only mode. We will be facilitating a question and answer period toward the end of today’s conference.

(Operator Instructions) As a reminder this conference is being recorded for replay purposes. I would now like to turn the call over to your host or today, Mr. Gregory Pettit with Hill & Knowlton.

Gregory Pettit

Welcome to the Pacific Ethanol third quarter conference call. Before we get started this morning, I would like to point out that there are slides to accompany this call available for downloading from the company’s homepage which is www.pacificethanol.net. Also, this call will be available for replay both telephonically and audio webcast replay within two hours of the conclusion of this call. Replays will be available for the next 15 days.

For some Safe Harbor language with the exception of historical information, the manners discussed on this call are forward-looking statements that involve a number of risks and uncertainties.

The actual future results of Pacific Ethanol could differ from those statements. Factors that can cause or contribute such differences include but are not limited to the ability of Pacific Ethanol to obtain additional debt of equity financing including additional working capital financing or failing new sources of financing, the ability of Pacific Ethanol to reschedule or restructure its indebtedness, the ability of Pacific Ethanol to successfully capitalize on its internal growth initiative, the ability of Pacific Ethanol to operate its plants at their planned production capacities, the price of ethanol relative to the price of corn and other inputs and the price of ethanol relative to the price of gasoline and the factors contained in the risk factors section of Pacific Ethanol’s Form 10K filed with the Securities & Exchange Commission on March 27, 2008 and the risk factors section of Pacific Ethanol’s Form 10Q for the quarterly period ending September 30, 2008 to be filed with the Securities & Exchange Commission.

Now I would like to turn the call over to the President and CEO, Neil Koehler.

Neil M. Koehler

Welcome everyone to Pacific Ethanol’s investor call to discuss our financial results for the third quarter and year-to-date period ending September 20, 2008. I am joined today by Joe Hansen, our Chief Financial Officer. I will make a few opening remarks followed by Joe walking us through the numbers. After closing comments on the market environment, Joe and I will be available for Q&A.

For the third quarter we achieved net sales of $184 Million dollars. An increase of 56% compared to $118.1 Million dollars in the third quarter of 2007. In the third quarter of 2008 we sold 65 million gallons a 30% increase compared to the 50 million gallons in the third quarter of 2007. We recorded a net loss available to common shareholders of $55.7 Million or $0.98 per share.

This amount includes a non cash impairment charge of $26.6 million associated with suspension of our Imperial Valley project. Our operating results were negatively impacted by high corn prices coupled with rapidly falling ethanol prices that resulted in negative gross margins in our business. We also incurred expenses related to the startup of our Stockton, California facility in the quarter.

While we made the considered and we believe prudent decision not to take forward hedge positions in corn during the quarter, we were consistently grinding higher priced corn into both falling corn and ethanol commodity markets. Since we bring corn into our facilities in unit trains from the Midwest, we have up to a month’s volume of corn purchased either at or in transit to our plants. Conversely, we hold relatively minimal ethanol inventories since our ethanol is sold primarily in local markets around our plants.

In a market like today where corn and ethanol prices are correlated this further compresses margins in a falling corn market but benefits us in a rising corn market assuming minimal hedged positions. We sold slightly fewer gallons in the third quarter compared to the second quarter. Our produced gallon volumes were slightly higher but we sold fewer third party gallons.

While we continued to expand our customer base and increased business with existing customers and broadened our sales region, we also took the position of not renewing some business where we concluded the pricing terms were not acceptable. We also operated our plants at approximately 10% below designed capacity. This was both in response to poor margins and an effort to conserve working capital.

With the successful startup of our Stockton plant in the quarter we are proud to have achieved our long-standing goal of owning 220 million gallons of annual ethanol operating capacity by the end of 2008. The plant successfully completed its performance test confirming annual production capacity of 60 million gallons which allowed us to complete the financing of the facility. Our Stockton plant is now providing ethanol and wet distillers grains to local markets to meet the growing demand for both products in California.

As we have now completed this construction phase of our business we will focus on being an efficient operator. We are lowering our SG&A as we focus on production and marketing and eliminate costs related to construction. We continue to focus on better yields, lower energy use, new distribution facilities and new technologies to position us for medium and advanced bio-fuels requirements of the Renewable Fuels Standard.

With that I would like to now turn it over to Joe to run through the financial details of our first quarter 2008 results.

Joseph W. Hansen

Slide 2 has a list of the items we will cover. On slide 3 we summarized the income statement. Our net sales increased to $184 million in Q3 2008 from $118.1 million in Q3 2007, a 56% year-over-year increase. Year-to-date our net sales increased to $543.5 million from $331.1 million in the first nine months of 2007 or an increase of 64%.

Going to slide 4. We show our net sales in gallons sold. We sold 65 million gallons of ethanol in Q3 2008, up 30% from 50 million gallons in Q3 2007 but down 3% over the prior quarter. For the first nine months of the year we sold 191 million gallons of ethanol, up 44% from 132.8 million gallons in the first nine months of 2007.

Our third party purchases and marketing activity represented 49% of our gallons sold in the third quarter and 54% of our gallons sold on a year-to-date basis. Going forward we expect that our marketing volume will continue to represent a significant portion of our total ethanol sales.

Going to slide 5. We recorded a gross loss of $20.3 million in the third quarter of 2008 compared to a gross profit of $4.8 million in the third quarter of 2007. In the third quarter we experienced negative crush margins at our production facilities, noncash charges including an inventory valuation adjustment and a relatively low co-product return.

Our gross loss includes a lower of cost to market inventory valuation adjustment of $5.6 million reflecting a markdown in the value of our ending ethanol and corn inventories as commodity prices continued to fall at the end of the quarter. In addition, our gross loss also includes a $1.7 million adjustment related to derivative positions and a $6.9 million of depreciation expense. Our commodity derivative loss of $1.7 million for the quarter is comprised of derivative gains of $1 million related to hedge positions that were settled during the quarter and $2.7 million of unrealized mark-to-market losses on open positions that will settle in future periods.

For the first nine months of 2008 we had a gross loss of $4.2 million or -0.8% as a percentage of sales compared to gross profit of $13.2 million or 9.4% as a percentage of sales in the first nine months of 2007. Our year-to-date results include the $5.6 million inventory valuation adjustment just discussed, unrealized derivative losses of $4.5 million and $17 million of depreciation expense.

Returning to slide 3. Our SG&A fell as a percentage of sales but increased by $0.8 million in the third quarter of 2008 over the same period last year primarily due to an increase in payroll, noncash compensation and bad debt reserves. Year-to-date our SG&A was slightly higher in absolute dollars versus the first nine months of 2007 but also fell significantly as a percentage of sales. We expect our SG&A expenses to continue to decrease on a per gallon and percentage basis relative to sales.

In the third quarter we recorded a non cash impairment charge of $26.6 million related to our Imperial project to write down the value of capital previously invested in the project. As you may recall, we suspended construction of our Imperial project last year due to unfavorable market conditions. Since the production margin environment has remained very challenging, we are recording an impairment charge related to these assets as we do not intend to resume construction in the near term.

We recorded a net loss of $54.9 million in Q3 2008 compared to a net loss of $4.8 million in Q3 2007 primarily due to the swing in gross profit and noncash impairment charge discussed earlier. Year-to-date we have a net loss of $98.3 million compared to net income of $0.3 million during the same period last year. Recall that our year-to-date results include noncash charges totaling $65.2 million including a $38.6 million goodwill impairment charge related to the value of Front Range Energy and a $26.6 million impairment related to the suspended Imperial project.

After deducting preferred stock dividends of $0.8 million, our net loss available to common shareholders is $55.7 million for Q3 2008 or $0.98 per share. Year-to-date our net loss available to common shareholders is $102.4 million or $2.14 per share of which $65.2 million or $1.36 per share respectively is related to the goodwill and Imperial impairment adjustments.

Going to slide 6. EBITDA was -$18.5 million for the quarter compared to a -$1.4 million in Q3 2007. For the first nine months of the year EBITDA was -$6.8 million compared to a +$6.9 million for the first nine months of 2007. The swing in EBITDA in both periods is due to significantly increased volatility in commodity markets, negative margins from ethanol production and a $5.6 million inventory valuation adjustment.

On slide 7, we summarize our commodity price performance. Our production gallons increased significantly in Q3 2008 versus the same period last year due to the addition of production from our Magic Valley and Stockton plants while third party sales were down slightly. Our average selling price of ethanol was $2.45 per gallon during the quarter, up 16% from $2.11 in the same quarter a year ago but down 4% from $2.55 in Q2 2008. Year-to-date our average sales price was $2.43 per gallon, up 9% from $2.22 per gallon in the same period last year.

During the third quarter our delivered cost of corn was $6.99 per bushel, up 54% from $4.54 per bushel in Q3 2007 and also up 4% from our Q2 2008 delivered cost of $6.73. Our corn basis averaged $0.71, up $0.04 from a year ago due to higher freight costs but down slightly from $0.75 in the prior quarter due to falling fuel surcharges.

In the third quarter our CBOT equivalent corn cost was $6.28 per bushel compared to the average CBOT market price of $5.78 during the quarter. Though we did not have any material commodity hedge positions going into the third quarter, our CBOT equivalent corn price was $0.50 per bushel higher than the market due to corn inventory positions at our plants and the normal timing lag from when unit trains of corn were priced upon shipment to the arrival and processing of corn into ethanol.

Due to these factors our ethanol pricing lagged our corn pricing by approximately one month which significantly hurt production margins in the third quarter given the unprecedented volatility and rapid decline in market prices of both corn and ethanol.

Year-to-date our delivered corn cost has averaged $6.48 per bushel, up 55% from $4.19 per bushel in the same period a year ago. Our basis averaged $0.73 in the first nine months of the year versus $0.64 last year.

Our co-product return was a disappointing 21.6% in the third quarter. This metric continued to of fixed price pressured by significantly higher corn prices during the quarter and as we indicated in our prior call, a relatively high ratio of fixed price sales contract that were in place through the third quarter of this year. Our co-product return at Q3 2008 is down from 25.3% in Q3 2007 and in line with the 21.7% realized in the previous quarter. Year-to-date we realized a co-product return of 22.6%, down from 25.6% in the same period last year.

The net impact of the corn, ethanol and co-product metric results in a weak production commodity margin of $0.35 per gallon for the quarter. The production margin is down significantly from $0.99 per gallon in Q3 2007 and $0.49 per gallon in the prior quarter. Year-to-date our production commodity margin averaged $0.54 per gallon versus $1.18 per gallon in the same period last year.

At quarter end we had forward fixed price ethanol sales contracts with a dollar value of $27.3 million as well as 81.5 million gallons of forward indexed based ethanol sales. Our forward corn purchase commitments consist of $18.5 million in fixed price contracts as well as 6.4 million bushels of forward indexed based purchase contracts. Additional details of our purchase and sales commitments are available in the 10Q in the commitments footnote to the financial statements.

Referring to the balance sheet on slide 8. Our consolidated cash balance of $33.6 million including restricted cash was down slightly from total cash of $35 million at the end of the second quarter. We used cash during the quarter primarily to support operating losses and working capital needs at our production facilities and to fund construction of the Stockton project.

At the end of the quarter approximately $13.4 million was remaining to be spent on the Stockton project to pay final construction invoices. Of this amount approximately $10 million came from availability under our construction loan facility and restricted cash on hand for construction. The balance of $3.4 million was additional equity that was contributed from our unrestricted cash.

In the third quarter we completed our construction program and achieved our goal of 220 million gallons of installed production capacity. Our Stockton facility successfully completed performance testing at the end of the quarter and in October we made a final $24.2 million draw from our debt facility that was a return of our previously invested equity in the project. After funding required debt service reserves and the payment of final construction invoices, $15.7 million became available to the parent for working capital.

Going to slide 9. We show our operating facilities consisting of Madera, Columbia, Magic Valley, Stockton and our 42% ownership interest in Front Range Energy. In the third quarter we reduced our operating rate at some of our production facilities below their designed capacity. As we have previously stated we will continue to adjust our production levels according to market conditions.

That concludes the summary of the financial results for Q3. I’d like to turn it back to Neil for further comments and the Q&A.

Neil M. Koehler

The market environment in the ethanol business continues to be very challenging. While demand continues to grow, ethanol supply has increased approximately 50% year-over-year. While the physical market is actually reasonably well balanced with total US inventory holding constant at around 22 days, the supply has grown faster than minimum levels of lending required by the Renewable Fuels Standard which has resulted in pricing power favoring the buyers. In 2009 we believe there will be a shift in this dynamic as 1.5 billion gallons of new minimum demand will be required and new capacity coming on line will be 1 billion gallons or less.

With the strains on ethanol margins resulting in some existing capacity currently being off line and new capacity in the industry being delayed, we expect supply/demand balances to tighten considerably over the next 12 months. We will certainly need new capacity to be built to meet the Renewable Fuels requirements in 2011 if not before. Margins will have to improve to not only provide a better business environment for existing capacity to operate but also to attract investment in needed new production.

The new Obama Administration we believe will continue to support the rapid growth of the bio-fuels industry. In fact, in its campaign platform President-Elect Obama called for an increase of the Renewable Fuels Standard to 60 billion gallons by 2030 from the 36 billion gallons currently required by 2022. Combining continued policy support for the rapid growth of the ethanol industry with the significant value that ethanol delivers to the transportation fuel supply should result in a much healthier ethanol industry as we move through 2009.

Low carbon fuel standards will be the next wave of policy support interaction for the growth of our industry. California is pioneering this effort and will be finalizing the rules early next year to implement Governor Schwarzenegger’s executive order calling for a 10% reduction in the carbon intensity of fuels by 2020. We believe California’s program will be the model for a national low carbon fuel standard which was also a policy goal in President-Elect Obama’s campaign platform.

Expanded ethanol use remains the quickest most cost-effective way to achieve meaningful CO2 reductions from fuels. Our business strategy of building energy efficient plants that use 30% less processed energy than typical Midwest plants by avoiding drying our co-product distiller grains gives us a distinct competitive advantage in the low carbon fuel regulatory environment. While average US ethanol reduces the life cycle of CO2 emissions by roughly 25%, the ethanol that Pacific Ethanol produces reduces CO2 emissions by over 40%. We will be able to monetize this advantage as state and national low carbon fuel regulations are implemented.

The Renewable Fuels Standard requirement for advanced bio-fuels combined with low carbon fuel standards will also provide strong impetice for the rapid growth of cellulose ethanol. We continue to develop our strategy to be an industry leader in this area. Our geographical position and initiatives supported by our collaboration with BioGasol of Denmark and the Department of Energy are moving us toward an integration of cellulose technology into our current corn ethanol production platform.

Michelle, at this time please open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Joseph Gomes - Oppenheimer & Co.

Joseph Gomes - Oppenheimer & Co.

I was wondering if you guys might be able to give me the amount of DDG sales in the quarter and what your average price was?

Neil M. Koehler

We don’t actually break those out but you can certainly back into it if you look at our co-product return. From a modeling standpoint you can probably work with the co-product return number based upon our corn; a pretty typical amount of distillers grain versus the corn used.

Joseph Gomes - Oppenheimer & Co.

I’ll also ask my typical question on the [Pursuit Dynamics]. Anything new going on there?

Neil M. Koehler

We’re still working very diligently with Pursuit Dynamics. The status there we believe that it is going to result in meaningful yield improvements. Some of the operating issues that we ran into when we were putting it into commercial operations required us to work with Pursuit Dynamics to really reconfigure and expand the equipment so that we can have the units more integrated and be able to clean it off line while we continue to operate. So it’s essentially putting in an additional unit that is currently being constructed. We hope by the end of the year or early next to have that new equipment installed and continue with the testing regime.

Joseph Gomes - Oppenheimer & Co.

On the liquidity issue if I was doing some quick back-of-the-envelope calculations correctly, with the final drawdown on the debt facility it sounded like in October you had roughly $36 million worth of cash left over for use of working capital purposes. Is that somewhat in the ballpark?

Neil M. Koehler

We don’t give forward guidance on exactly where we were but you can see from the end of the quarter that the cash on the balance sheet was a bit over $30 million and it was actually roughly the same as it had been the prior quarter and subsequent to that we did get the additional return of the equity that Joe talked about.

Joseph Gomes - Oppenheimer & Co.

On the SG&A I know you mentioned it would be going down on a per gallon basis and on a percentage of revenue basis, but on an actual dollar basis it has been coming down. Is this level today or in the third quarter a good level to be modeling or do you still think there’s more to ring out in that?

Joseph W. Hansen

There’s probably a little bit more to ring out in that. The SG&A was impacted by our Stockton facility, bringing it on line and also we’ve got a number of initiatives currently in place to reduce SG&A. So I think you’re going to see a reduced SG&A number in the future but I really can’t comment on what that number would be.

Operator

Our next question comes from Analyst for Jinming Liu - Ardour Capital.

Analyst for Jinming Liu - Ardour Capital

In terms of your marketing business you talk about it as being a more increased percentage of your total ethanol sales. Can you shed some light on that? Do you anticipate buying more ethanol in the fourth quarter or how are you finding the market in terms of getting hold of it and reselling it?

Neil M. Koehler

It currently represents about 50%. Actually that proportion was down slightly from the prior quarter so we’re very responsive to market dynamics and opportunities. We are seeing good growth in the demand for ethanol in our market, specifically as California moves from a 5.7% to a 10% blend over the next 12 months. We will certainly evaluate opportunities to grow our marketing business along with our production.

Analyst for Jinming Liu - Ardour Capital

Prices have continued to sort of pull back in fourth quarter. Is it fair to assume that we could see some more inventory write-downs in the coming quarter?

Joseph W. Hansen

We don’t want to comment on the future quarters but it’s solely going to be dependent on where the commodity markets go. It’s highly uncertain and you’re just going to have to watch the commodity markets.

Neil M. Koehler

It all depends on your assumption on where ethanol prices will be at the end of December, and that’s awfully hard to call given the current volatility of all commodity markets.

Operator

Our next question comes from Pavel Molchanov - Raymond James & Associates.

Pavel Molchanov - Raymond James & Associates

On your liquidity do you still have a $30 million loan payment that’s due in the first half of ’09?

Joseph W. Hansen

Yes, that is true. Our strategic partner Lyles and we are talking with Lyles currently and have been talking with them throughout both the third quarter and like I indicated currently about possible restructuring.

Pavel Molchanov - Raymond James & Associates

If you do need to make the prepayment, can you talk about some of the options for raising that cash?

Neil M. Koehler

That would be conjecture on our part at this point but obviously it would depend upon where margins were and what kind of cash was being generated by operations, and we obviously have options and access to debt and equity markets as well.

Pavel Molchanov - Raymond James & Associates

In the third quarter it seems like third party sales kind of dropped off a little bit. Can you tell us what you’re seeing in terms of production from some of the smaller private producers?

Neil M. Koehler

It’s probably inappropriate for us to comment on partners that we work with but certainly you’ve seen general industry reports on how some production has come off line and some has been reduced. So certainly we’re seeing that across the industry. Our own reduction on third party sales was also a function of not only our own production increasing but really our taking a fairly disciplined approach to the market.

We were walking away from business that we thought was inappropriately priced. It’s part of what we’re able to do with the marketing and the production business is that we can calibrate our sales and how much we buy versus how much we produce depending upon our view of the market.

Pavel Molchanov - Raymond James & Associates

I know you haven’t historically given marketing margins but have you seen any noticeable change in marketing margins let’s say in the last two or three months?

Neil M. Koehler

No. So many of our deals we take a pretty low risk view and we have marketing agreements that are based upon a fixed margin so typically they don’t change all that much. Certainly and you can see it from our inventory write-down, when you are purchasing product and selling into a falling market we do end up taking a hit on inventory as the market goes down and conversely pick that up when the markets go up.

Operator

Our next question comes from Ian Horowitz - Soleil Securities.

Ian Horowitz - Soleil Securities

Joe, I think you made a comment on the distillers grain side that you had a high ratio of fixed price contracts for the third quarter. Have those anniversaried or sunsetted or are we to expect another fourth quarter with a significant volume still remaining under these fixed contracts?

Joseph W. Hansen

We normally don’t comment on what’s going to happen in the fourth quarter but traditionally these fixed price contracts are renewed, they’re called [caught] contracts, in the late third quarter or early fourth quarter. I really don’t want to comment on what we’re going to be doing in 2009. Maybe I’ll just leave my comments on that unless Neil’s got something further to add.

Neil M. Koehler

The only thing I would add is that Joe’s correct and there’s still some of that contracting we’ve done. Obviously it’s reset at different values of corn but just as we’ve been fairly close in on our going out and taking forward positions on corn and ethanol, we’ve tended to try to match up our distillers grain sales as well. We also are seeing a response on the part of the feeders. The dairies and the feedlots are taking a similar view. So there’s less long-term contracting that’s going on in that business as well. It’s more weighted to contracts that are shorter term and often indexed to corn prices.

Ian Horowitz - Soleil Securities

Joe, can you just run down the noncash charges for the quarter again? You have an inventory adjustment of $5.6, a net derivative loss of $1.7, and I understand the Imperial one as well. Were there any others that I missed?

Joseph W. Hansen

There would be $0.7 million of noncash compensation.

Neil M. Koehler

Do you remember what the depreciation was? Had we provided that?

Joseph W. Hansen

$7 million. $6.9 million depreciation and there was also [gap] reserve of about $300,000. I think that would catch all of it.

Neil M. Koehler

And then you’ve got the $26.6 million impairment.

Operator

Our next question comes from Joseph Gomes - Oppenheimer & Co.

Joseph Gomes - Oppenheimer & Co.

Just following up on what Ian said. On the co-products do you guys think you can get back to that mid-20 co-product return level?

Neil M. Koehler

It is our effort to increase the value of all the products we sell so it is our effort to move than number up. Without offering guidance on that we do see some indications in the market that we’re going to be able to improve some value.

Operator

That does conclude the question and answer session. I’ll now turn it back to management for closing remarks.

Neil M. Koehler

Thank you all for participating on the call. We appreciate your interest and support and look forward to speaking to you next quarter.

Operator

Ladies and Gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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Source: Pacific Ethanol, Inc. F3Q08 (Qtr End 9/30/08) Earnings Call Transcript
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