KiOR: Production Issues Are Expected. Investors Need To Be Patient And Understand The Risks

| About: KiOR, Inc. (KIOR)

In KiOR's (NASDAQ:KIOR) first quarter conference call KiOR Treasurer Max Kirkorian made the following statement:

I would like to remind everyone that statements will be made during this call that are not historical facts in our forward-looking statements. These statements about the company's future expectations, plans and prospects include statements regarding the following: the predicted timing of and cost related to production from and generation of revenues at the company's Columbus facility; the company's plan to build its next commercial facility in Natchez, Mississippi; the company's plans to obtain additional debt and/or equity financing; government policy making in relation to renewable fuels; and other statements containing the words believes, anticipates, plans, expects, intends and similar expressions.

These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. The company cautions that a number of important factors could cause our actual future results and other future circumstances to differ materially from those expressed in any such forward-looking statements. These important factors and other factors that could potentially affect the company's financial results are described in the section called Risk Factors and the company's most recent annual report on Form 10-K for the fiscal year ended December 31, 2012, and the company's other quarterly filings with the SEC, which are available through the Investor Relations section of KiOR website at or on the SEC's website at

The company may change its intentions, beliefs or expectations at any time and without notice based upon any changes in such factors in the company's assumptions or otherwise. The company undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after today or to reflect the occurrence of unanticipated events. Therefore, you should not rely on these forward-looking statements as representing the company's views as of any date subsequent to today, May 9, 2013.

KiOR's CEO Fred Cannon then went on to say:

Looking now to our expectations for production in the second quarter. We are poised to build on positive momentum in the first quarter...Consistent with our previous guidance, we expect that total fuel production during the second quarter will range between 300,000 and 500,000 gallons, keeping us on track to fall within our projected production range of 3 million to 5 million gallons for 2013.

Having been an investor in Syntroleum (NASDAQ:SYNM) since it opened its Dynamic Fuels plant, I have more experience than I would like to admit about the trials and tribulations of getting a first and one of a kind revolutionary plant up and running. If creating a new fuel that can replace petroleum in a commercially viable manner was easy, it would have already been done. Investors simply can not, nor should they expect the path to be smooth. There will be bumps, setbacks and many disappointments. Companies like KiOR are trying to change the world. It is attempting to revolutionize the entire energy industry and if it succeeds, one day the world will no longer be dependent upon petroleum. KiOR's process, if it can succeed, will be able to make America energy independent. KiOR represents to me all that is good about our capitalistic system; it is a company with its heart in the right place that is using our beautiful economic system to make the world a better place.

I was therefore extremely disappointed, but not surprised, to see a class action law firm file a class action lawsuit against KiOR because it recently missed production estimates.

Pomerantz Grossman Hufford Dahlstrom & Gross LLP has filed a class action lawsuit against Kior, Inc. ("Kior" or the "Company") (KIOR) and certain of its officers. The class action, filed in United States District Court, Southern District of Texas, and docketed under 13-cv-2443, is on behalf of a class consisting of all persons or entities who purchased or otherwise acquired securities of Kior between August 14, 2012 and August 7, 2013 both dates inclusive (the "Class Period"). This class action seeks to recover damages against the Company and certain of its officers and directors as a result of alleged violations of the federal securities laws pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder...The Complaint alleges that throughout the Class Period, Defendants made false and/or misleading statements, as well as failed to disclose material adverse facts about the Company's business, operations, and prospects. Specifically, Defendants made false and/or misleading statements and/or failed to disclose that: (1) the Company was not on track to produce commercially meaningful quantities of biofuel at the Columbus facility in the amounts projected by management; (2) the Company lacked adequate internal and financial controls over its calculation and forecasting of production levels at the Columbus facility; and (3) as a result of the foregoing, the Company's statements were materially false and misleading at all relevant times... On August 8, 2013, the Company disclosed to investors that it had only shipped 75,000 gallons of biofuel during the second quarter of 2013 - far below the 300,000-500,000 gallons Defendant Cannon had promised investors less than three months before. On this news, Kior shares fell $2.12 per share or over 44%, over the course of the next six trading sessions, from a close of $4.76 per share on August 7, 2013 to a close of $2.62 per share on August 15, 2013.

I'll leave it to the reader to decide if the law firm's press release statement is consistent with the facts:

KiOR's CEO Fred Canon: "we expect that total fuel production during the second quarter will range between 300,000 and 500,000 gallons"

Pomerantz Grossman Hufford Dahlstrom & Gross LLP press release:
"Defendant Cannon had promised investors less than three months before."

Personally I have a problem with words like "expect" being twisted into "promised," but then again, these lawyers aren't out trying to revolutionize the energy industry and make the world a better and safer place to live. Investors can at least take comfort in that KiOR and not the lawyers are actually doing something to solve our energy problem.

Another comment the law firm apparently failed to read is:

While we expect shipments to pick up going forward, shutdowns will continue to be par for the course until the facility fully stabilizes, so shipments can be expected to be sporadic.

If I were KiOR, I would take the above quotes and file a counter claim against the law firm. I'm pretty sure a jury of elementary school children could catch the misleading statement made by the lawyers, and children know that if the teachers tells them they will be going outside to play for recess and it starts to rain, that the plans will change. I think it would be nice to see KiOR hold the lawyers to the same standards they hold everyone else to.

These were the alternatives that the Congress and the president sought to create with the legislation that created RFS2. And these are the alternatives that everyone can agree are in our nation's best interest. We at KiOR are starting to make those alternatives a reality at commercial scale in Columbus. And we appreciate your continued interest and support as we do.

Why KiOR Investors Shouldn't Worry:

Assuming a judge will throw out the lawsuit, investors in KiOR have a lot to be excited about. No other industry I know of has an EPA designed regulatory mechanism that is intended to guarantee profits sizable enough to not only attract capital, but to attract capital in amounts necessary to rapidly expand capacity. To a free market economist like myself that hates governments picking winners and losers, the EPA's Renewable Identification Number or RIN system is pretty impressive. The EPA's administration of the program, however, risks making a well designed program a failure, which is KiOR's greatest risk. KiOR only exists because of the EPA's Renewable Fuels Standard 2 or RFS2 program, and the EPA's manufactured crisis called the ethanol "blend wall" is a threat to the entire program:

KiOR was born in the same year that the Renewable Fuel Standard was revised by Congress and signed into law as RFS2. Quite a lot has happened since then. First, and foremost, the production of cellulosic fuel which had only been a glimmer of hope in the eyes of many

Why investors should be excited about KiOR is that the 2013 RFS2 quota for cellulosic biofuels is effectively 0 gallons, but the 2014 mandate is 1.75 billion gallons. To get from 0 to 1.75 billion gallons in a little more than a year will require a whole lot of construction and production expansion in the next year. Assuming that the EPA doesn't grant a cellulosic waiver in 2014 like it has in the past, that should make D3 cellulosic RINs very valuable.

If things work as designed, the D3 RINs should allow firms like KiOR to make enough money to not only produce using existing capacity, but to expand to reach the target quota. A case study in how much RINs can move in price are this year's D6 ethanol RINs. At one point they had increased over 2,700% from the start of the year. If the EPA sticks to its guns and enforces the 2014 D3 cellulosic quota, I would imagine a D3 RIN will be one of 2014 best investments. One of the added benefits of a D3 RIN over a D6 RIN is that a D3 RIN requirement must be satisfied by a cellulosic biofuel. D3 RINs and cellulosic biofuels don't have to fear supply coming from other biofuels like ethanol and its D6 RINs do. Back in 2010 the EPA granted cellulosic waivers and they cost $1.58, which may give a clue as to what a D3 RIN may start trading at.

The three big risks I see to KiOR are 1) the EPA continuing to grant D3 cellulosic waivers 2) KiOR costs and 3) Cash flow/cash burn.

If the EPA continues to grant D3 waivers, this industry will never get off the ground. There is simply too much uncertainty created, and the costs are too great. Companies rely on the revenues from the D3 RINs to survive. Waivers totally defeat the entire purpose and design of the RIN system. If the EPA continues to grant waivers, KiOR should hire the law firm currently suing it for misleading forward guidance and sue the EPA -- they change forward guidance all the time. And while they are at it, have the lawyers look into the global warming "science" backing the RFS2. I'm still recovering from my childhood trauma caused by fears of the coming ice age.

KiOR's costs are far from being commercially viable, but that is what is expected in the early stages of development. The RIN system is designed to afford infant industries some protection and ensure profitability until they can walk on their own two feet. That is a legitimate function of government, the spirit of which is captured in Article 1 Section 8 of the US Constitution, and why as a free market economist I support this program... as long as it is eventually ended once the goals are reached and the industry can stand on its own two feet.

KiOR's costs, however, will have to come down quickly. Once the D3 RINs do start trading and values can be placed on them, they are almost certain to attract attention... as they are designed to do. The whole purpose of the RIN system is to attract capital, and capital is attracted to profits. RINs in essence are capital magnets, strengthened by the coercive power of the EPA and Federal Government. Ethanol went from 9 billion gallons in 2008 to 13.8 billion gallons today using the RIN mechanism, and biodiesel went from basically 0 to 1.28 billion gallons today, so the RIN mechanism has been proven successful.

Cash flow/cash burn is greatly compounded by the EPA waivers. Without the revenues for the D3 RINs the cash flow issue is greatly compounded. The entire RIN mechanism was designed to ensure enough cash to generate profits large enough to produce and expand an industry. Without RIN revenues, KiOR may have to turn to other forms of financing.

The problem KiOR faces is that once the D3 RINs start trading and attracting capital, the capital it attracts may be for plants that have a far better and less expensive process. The Fischer-Tropsch (FT) process can be used to turn cellulose into biofuels, and that process has been in use for over 90 years in commercial processes of one form or another. KiOR may be the first and biggest now, but that doesn't mean new competition won't develop. The 2014 quota is 1.75 billion gallons, sizable enough to likely outstrip capacity, so D3 RIN prices should remain high... as long as the EPA doesn't grant a waiver. But over time new capacity will develop, and as new capacity comes on line, the supply of D3 RINs will increase, and their prices will fall. KiOR is therefore in a race against time. KiOR has to get its costs down fast enough to remain profitable when the time comes that D3 RIN prices start to fall.

I don't want this article to sound too bullish. I'm bullish on the D3 RIN mechanism creating a cellulosic biofuel industry. KiOR may not survive, even with the EPA's support of this industry. KiOR is having production issues, and its process is extremely expensive relative to other biofuels. Even a $1.58 D3 RIN wouldn't make the company profitable at its current cost structure. KiOR must get its costs down, or it will risk other firms capturing all the D3 revenues. The advantage KiOR has is that there aren't any other plants currently generating D3 RINs of any scale. Through June, only 73,271 D3 RINs have been generated, and it appears to be from cellulosic ethanol, not diesel. As more capacity comes on line, however, that is sure to change. The ideal situation for KiOR would be for the EPA to stop granting cellulosic waivers and have the cellulosic fuel capacity to grow, but not at a rate adequate enough to meet the quota, thus creating a D3 shortage situation. That would be the best economic conditions for KiOR, and with a 1.75 billion gallon quota for 2014, and only 73,271 RIN being produced through June, that situation is highly likely. The EPA would then face a situation where it would likely have to grant a waiver for the shortfall or adjust the quota, but that wouldn't be expected until late in the year when enough data was available to make the decision. Until the EPA decision, if one is needed, the D3 RINs should have been priced as if the quota was intact and there would be no waiver. If that happens, the cellulosic biofuels industry should have a profitable 2014, and if KiOR is able to produce at lower costs, it too should profit.

In conclusion, investors in companies like KiOR should not have any expectations whatsoever that getting a first and one of a kind plant up and running will be smooth and efficient. They should expect many setbacks and disappointments. One only needs to study the SYNM case study to know what to expect. Investing in new unproven technology like KiOR's is highly risky, and requires the ability to tolerate high volatility. KiOR investors shouldn't be focused on the quarterly ups and downs, but instead should focus on how the EPA is managing the RFS2 D3 Cellulosic RIN quota, how fast KiOR can get its costs down and the supply of D3 RINs produced verses the quota. KiOR is in on the ground floor of the cellulosic biofuels industry that has a quota that goes from effectively 0 gallons today to 16 billion gallons in 2022. KiOR has plenty of time to get the bugs worked out... but it must get the bugs worked out before other capacity comes on line. The way the RIN mechanism is designed has KiOR in a race against the clock... and apparently the lawyers as well.

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.