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Syntroleum (NASDAQ:SYNM) just released earnings, and the $1.15 EPS for a stock that trades at $4.00 appears to be a phenomenal earnings report. The first thing investors should ask however is how does a firm generate such earnings when its main asset, the Dynamic Fuels plant, hasn't been producing since late October of last year?

Syntroleum's net income was $11.0 million or $1.15 per share for the three months ended March 31, 2013, compared to a net loss of $1.9 million or $0.20 per share for the corresponding period in 2012.

Q4 2012 was an awful quarter for biofuels due to the tax credit debate creating uncertainty. This uncertainty resulted in negative margins for many firms, as the RIN prices fell in anticipation of the bill's passage. During that time SYNM had its plant in standby mode for much of the quarter. That helped minimize its Q4 loss. The bill eventually passed, so had SYNM produced more during that quarter its tax credit would have been larger, but the passage of the bill was uncertain during the quarter, and the economics at the time did not justify production. In this earnings report, SYNM discusses both Q4 2012 and Q1 2013 because of the material impact of the tax credit.

For Dynamic Fuels' quarter ended December 31, 2011, we reported a loss from Dynamic Fuels of $830 thousand.

The actual company of SYNM had a loss of $2 million,or about -$0.20 EPS.

For the quarter ended March 31, 2013, the Company reported an operating loss of $2.0 million resulting from total revenues of $899 thousand and operating expenses of $2.9 million.

The actual company of SYNM isn't normally what is important however. What is important is the 50/50 joint venture with Tyson (NYSE:TSN) called Dynamic Fuels that matters most to SYNM investors. The Dynamic Fuels plant produces a "drop-in" ultra low sulfur diesel and jet fuel from various feedstocks like waste vegetable oils. SYNM has been having problems getting it to run consistently, and the plant has been on standby since last October.

Equity in earnings of Dynamic Fuels for the quarter ended March 31, 2013 is $6.7 million which includes $12.6 million in gains representing our portion of the retroactive reinstatement of the $1 tax credit for 2012, partially offset by $5.9 million in losses resulting from our share of Dynamic Fuels' operating results for its first quarter ended December 31, 2012.

That part needs some deciphering. SYNM received $9 million in a tax credit refund, and Dynamic Fuels will receive $7.2 million in a tax credit refund. SYNM uses equity accounting for the Dynamic Fuels plant, so it records 1/2 of the Dynamic Fuels tax credit as its own. $9m + $3.6m = $12.8m. $12.8m - $5.9m = $6.9m gain. SYNM reported a $6.7m gain. That accounts for about $0.67 of the $1.15 EPS.

Income from Discontinued Operations for the quarter ended March 31, 2013 includes $5.8 million in proceeds from the sale of our nominal two b/d pilot plant in Tulsa, Oklahoma and $603 thousand from the previously accrued asset retirement obligations.

$5.8 + $0.6 = $6.4m, or about $0.64 of the $1.15 EPS.

Put them all together and you get $0.67 + $0.64 -$0.20 = $1.11. SYNM reports $1.15 EPS.

On its surface that appears to be a very solid number, but the problem is none of those earnings were generated from operations in 2013. They come from either the 2012 tax credit or the liquidation of a two barrel/day pilot plant.

From the 10-Q, we get some more information. In my opinion, the most important news provided is a partial explanation and clarification as to why the plant has not been running and remains in standby mode.

Planned turnaround operations commenced on October 25, 2012 and were completed on December 10, 2012 at which time the plant was placed in standby mode as Dynamic Fuels monitored economic conditions to determine the appropriate time to resume operations. The plant continues to be in standby mode. While the economic conditions have improved in 2013, Syntroleum and Tyson continue to monitor the long term economic conditions conducive for plant restart. During the first quarter Syntroleum and Tyson each made an additional $4 million working capital loans and invested an additional $1.7 million in the form of an equity contribution. Working capital requirements for restart of the facility are estimated to be approximately $20 million.

I published an instablog post way back in early February highlighting how the economic conditions had substantially improved, and have been scratching my head ever since trying to figure out why the Dynamic Fuels plant was not running. Others wrote about positive developments as well. Just recently Renewable Energy Group (NASDAQ:REGI) reported earnings pretty much validating that the economics are profitable. So investors were justified in their confusion as to the status of the plant. With the 10-Q report we now have the answer, and the $20 million start-up cost, $10 million of which SYNM would need to fund, suddenly makes everything come into focus. I would imagine much of that $20 million will be feedstock, but in order to justify risking such a large sum of money it may be following the "discretion is the better part of valor" approach. The Dynamic Fuels plant is also scheduled for a recycle pump replacement in the near future, so that may also play into its calculus.

This caution however may not be justified. 2013 is not 2012; in fact, as far as the tax credit goes, it is just the opposite. Last year the tax credit was up for reinstatement, and when it passed, it was applied retroactively to 2012 production after the fact. The uncertainty last year created havoc and confusion in the market, and literally forced firms to either shut down based upon current market conditions or gamble on the passage of the bill. Last year, SYNM made the logical decision to stop production based on conditions that existed in the market at the time. The retroactive tax credit then passed after the New Year which instantly made the unprofitable market conditions profitable...after the fact. It is extremely difficult to manage a business when its success or failure depends upon a bill passing congress.

The problem with these tax credit provisions is that they are supposed to incentivize steel in the ground but in the end incentivize no such thing.

Why? Projects that need the credit to be viable can't get 15-year financing on a one-year extender. Lenders zero the credits out because they know the loan must be safe even if the credit sunsets long before the loan does.

The problem this year with the tax credit is just the opposite from 2012. In 2012 firms had to gamble as to whether or not the bill would pass. Those firms that continued to produce in Q4 2012 were rewarded for taking that risk because the tax credit passed, but had the tax credit not passed, those firms that did produce would have had nothing to compensate them for their losses. Last year, as speculation about the tax credit was discounted by the markets, the price of RINs fell. This year however the RINs have already discounted the fact that the tax credit passed. Theoretically D4 RIN prices are $1.00/1.5 = $0.67 below where they would be without the $1.00 tax credit ceterus paribus. The 1.5 denominator is the RIN multiplier for biodiesel. What that means is that this year when the markets begin to discount the fate of the tax credit, they will discount its removal. That should result in higher RIN prices, not lower RIN prices like 2012 ceteras paribus. The tax credit economics are the exact opposite of 2012.

Other favorable economic developments are that soybean oil based biodiesel (SME) has had relatively tight margins, and SME makes up the majority of biodiesel production. The tight SME margins combined with the financial difficulties created by the tax credit issue making firms more cautious has resulted in 2013 biodiesel production lagging the EPA target. It has also helped contain the supply of RINs. RIN integrity programs, as well as the establishment of a RIN trading market should help stamp out fraud, reduce uncertainty and support RIN prices. Alternative feedstocks like yellow and choice white grease have seen stable or falling prices, and new feedstock types like inedible corn oil help lower the price and increase the price elasticity of feedstock. Fuel prices themselves have been relatively high as well, so the economics are pretty compelling today, and should continue into the future. If my theory about the tax credit is correct, combined with the lagging production, these strong economics should result in a surge in production late in the year as firms rush to capitalize on the profitable environment. This surge of production will depress the price of RINs ceteras paribus, but unlike 2012 where conditions went from profitable to unprofitable, 2013 should see thing go from profitable to less profitable. The regulatory mechanism isn't in place this year to drive the margin into negative territory. That doesn't mean negative margins can't develop, it just means that this year it is unlikely to develop due to the tax issue. SYNM also has plenty of cash, as does Dynamic Fuels.

As of March 31, 2013, we had $14,935,000 in cash and cash equivalents and current liabilities of $1,476,000. On April 12, 2013 Syntroleum received $8,986,000 in refunds from the IRS related to the reinstatement of the $1 tax credit retroactive to 2012 resulting in total cash of approximately $23,921,000...Dynamic Fuels will receive approximately $7,200,000 for the 2012 reinstatement of the $1 tax credit. We expect that we will fund additional short-term working capital needs of Dynamic Fuels through working capital loans in 2013.

One concern is that the partners disagreed as to what constituted sound "economic conditions" and what should be required to restart the plant. From the 10-Q it appears that both partners are still behind the plant and willing to continue funding it...for now.

During the first quarter Syntroleum and Tyson each made an additional $4 million working capital loans and invested an additional $1.7 million in the form of an equity contribution.

It also appears that SYNM has contingency plans as to future funding sources if they are needed.

If we are unable to generate funds from operations, our need to obtain funds through financing activities will be increased.

SYNM just recently implemented a reverse split, which may facilitate raising capital in the future if needed, but that most likely would not be the way preferred by shareholders. SYNM does have assets that possibly could be used as collateral for a loan if needed, namely patents, deferred revenues and their equity in the Dynamic Fuels plant.

This is from SYNM's 10-Q back in 2010.

We expect to obtain additional funding through debt or equity financing, joint ventures,
license agreements and various other financing arrangements. If we obtain additional funds by issuing equity securities, dilution to stockholders may occur. In addition, preferred stock could be issued in the future without stockholder approval, and the terms of our
preferred stock could include dividend, liquidation, conversion, voting and other rights that are more favorable than the rights of the holders of our common stock. There can be no assurance as to the availability or terms upon which such financing and capital might
be available.

Another interesting point from the 2010 10-Q is:

As of September 30, 2010, our total estimate of exposure to loss as a result of our relationships with this entity was approximately $35.1 million which represents our equity investment in this entity.

This is what the current 10-Q states:

We have contributed cash in the amount of $45,220,000 to the capital of Dynamic Fuels
since inception and have remaining working capital loans to Dynamic Fuels of $8,963,000.

That may help explain the caution in using more cash.

SYNM also made a supportive, but cautionary note.

Although management remains positive about the future of Dynamic Fuels our entire investment could be subject to loss.

I found similar language in their previous reports so that wording isn't new, but it is important. This is from a 2012 Q-10.

Although management remains positive about the future of Dynamic Fuels, if Dynamic Fuels fails to achieve profitability, our entire investment could be subject to loss.

One thing that might help alleviate investor anxiety after such a statement would be an increase in insider buying. If the plant is going to fail, I doubt the insiders will be buying shares. If they do buy, however, that may be a vote of confidence from the management that things are improving. Insider buying however is far from an exact science, so it should only be used as a possible clue as to the firm's prospects. It should be considered one dot in a broader mosaic.

SYNM has a conference call scheduled for Wednesday, May 8, 2013, at 10:00 a.m. Central time. Key issues investors should listen for are:

1) SYNM has been in an ongoing legal battle with a foreign competitor Neste. How this issue is progressing will likely be discussed, and may have an impact on the stock price. If you are interested in more information on this issue I have an instablog posting covering it as well. SYNM recently filed a counter suit against Neste in Singapore.

2) SYNM has been in discussions to build a gas-to-liquid plant, and recently sold a demonstration unit to Sasol. Any progress here may help the stock.

3) SYNM has an insulating product called "phase change material." It is a pretty interesting concept and uses an endo/exotermic reaction in insulation which uses the same physics principle that orange farmers use when they spray oranges in advance of a freeze. Any progress on this issue may be beneficial to the stock.

4) Dynamic Fuels recently installed new feedstock processing units and has plans to replace a recycle pump later this year. How the new equipment is working (when it is running) and details on the recycle pump and any impact on the shut-down may be important.

5) What constitutes the positive economic conditions that would support restart?

6) What are the current estimated margins for their process using market values for feedstock, fuel, RINs and including the tax credit. I'm currently showing estimated margins of over $1.00/gallon if they were running at full capacity.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I am long SYNM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Deciphering Syntroleum's Earnings