- Renewable Energy Group, Inc. (REGI) equity has not yet priced in the likely impact of the impending December 31, 2013 expiration of the Blenders' Tax Credit, which we estimate to have contributed 77% and 104% of Adjusted EBITDA in 2012 and in the 9ME 9/30/2013, respectively. Upon expiration of this subsidy in 2.5 weeks' time, we believe REGI's margins will be wiped out and that it will operate at a significant loss. The expiration of the Blenders' Tax Credit is not without precedence. The BTC was also not renewed throughout 2010. According to REGI, "The absence of and uncertainty around the blenders' tax credit during most of 2010 materially curtailed demand for biodiesel and our ability to cost effectively produce and sell biodiesel, resulting in our idling production at several of our facilities during that period." In 2012, REGI generated $39m of Adjusted EBITDA, relative to $107m in the 9ME 9/30/2013.
- From period to period, REGI does not discuss the specifics pertaining to the size of its Blenders' Tax Credit (BTC) benefit anywhere in its financial filings; and, it aggregates revenues from all types of incentives into a single line item, “Biodiesel Government Incentives,” obscuring the significance of BTC revenues. We believe this has prevented investors from ascertaining the impact of the tax credit on REGI’s financial state, resulting in a steep disconnect between intrinsic value and trading levels.
- REGI’s share price also dislodged from the realities reflected by the D4 RIN price, which is down ~40% in 2013 – indicating substantially weakened biodiesel demand – while REGI’s share price is up 75%. We believe most investors are not tracking the D4 RIN price.
- US Renewable Group (USRG) – which is headed by Jonathan Koch, a former REGI board member – was a longtime shareholder and the second-largest shareholder in REGI as of a few months ago. Over the course of June and July, USRG liquidated over 3 million shares for total proceeds of approximately $43M, and on many days accounted for ~20% of average volume, indicating an urgent exit.
We believe based on a confluence of factors that REGI's EBITDA will decline precipitously in 2014, to levels last seen in 2012, another period in which the Blenders' Tax Credit was not renewed. We believe the equity is highly overvalued at current levels, with an intrinsic value of $4.70/share, ~55% below current trading levels.
Renewable Energy Group, Inc. is a low-cost producer of biodiesel; through a series of acquisitions and production capacity builds it has grown to become the largest biodiesel producer in the United States based on gallons produced. As of September 30, 2013, it owned 8 active biodiesel production facilities with an aggregate production capacity of 257m gallons per year. In 2012 and the 9ME 9/30/13, it sold 188m and 186m gallons of biodiesel, respectively, including 25m and 30mm, respectively, of which it purchased from third parties and resold.
>99% of REGI's revenues are generated as a result of biodiesel revenues; we estimate that in the 9ME 9/30/12, biodiesel revenues were split 88%/12% between Biodiesel Sales and Biodiesel Government Incentives, respectively.
Blenders' Tax Credit: 100% of EBITDA, Expires on Jan 1, 2014
The biodiesel industry has been substantially aided by federal tax incentives. Because biodiesel has historically been more expensive to produce than diesel fuel, the biodiesel industry has depended on governmental incentives that have effectively brought the price of biodiesel more in line with the price of diesel fuel to the end user. These incentives have supported a market for biodiesel that might not exist without the incentives.
- REGI S4/A filed on 11/23/2009 (Risk Factors)
Any repeal, expiration, non-renewal, substantial modification or waiver of the renewable fuels mandate or Federal or state incentive programs could reduce the demand for biodiesel and result in our inability to produce and sell biodiesel profitably.
- REGI 10-K for 2011
The biodiesel industry - including public companies REGI and Future Fuel (FF) - is dependent on governmental programs and incentives that support the biodiesel market. The most significant tax incentive program is the federal Blenders' Tax Credit (BTC), which we believe makes up 90-95% of REGI's Biodiesel Government Incentives revenue. It is set to expire at the end of December 2013. We believe that because the company does not customarily disclose the dollar value of the BTC in its financial filings, which would enable investors to gauge its significance on the company's financial state, the impact of the expiration on REGI's financials has not been widely recognized and is not reflected in today's market price.
Based on opaque and disparate disclosures over several quarters' time, we estimate that this tax credit made up 77% of REGI's EBITDA in 2012 and ~100% of EBITDA in the 9ME 9/30/2013. When the subsidy expires, in 2.5 weeks, we believe REGI's margins will be wiped out and that it will operate at a significant loss; the absence of the BTC will also likely hurt the demand for biodiesel, as exhibited in past periods it was not renewed.
Dependency on the Blenders' Tax Credit Obscured With Opaque Disclosures
From period to period, REGI does not discuss the specifics pertaining to the size of its BTC benefit anywhere in its financial filings; and, it aggregates revenues from all types of incentives into a single line item - "Biodiesel Government Incentives," which is a component of Biodiesel Revenue, obscuring the significance of BTC revenues. Due to special circumstance, however, the company disclosed a limited amount of information in its 2012 10-K.
The Blenders' Tax Credit was allowed to expire on December 31, 2011, and was not reinstated throughout 2012. On January 2, 2013, however, President Obama signed into law the American Taxpayer Relief Act of 2012, which reinstated the federal biodiesel Blenders' Tax Credit for 2013 and retroactively reinstated the credit for 2012. In its 2012 10-K, REGI estimated the net benefit it would recognize in 1H 2013 that related to its 2012 operating performance and results, and included these estimates in a table detailing Adjusted EBITDA, as if the credit were in effect for 2012; it showed a 2012 net benefit from the Blenders' Tax Credit of $57.7m, or 60% of EBITDA (refer to table below). Based on our analysis of opaque disclosures in subsequent quarterly filings, however, indicate the benefit was ~77% of EBITDA.
In its Q2 10-Q, REGI disclosed a reclassification of an expense that in Q1 was booked as COGS, reversing it and booking it instead as a reduction in Biodiesel Revenue. It's described the $69.5m expense as the "Blenders' Tax Credit amount refunded to customers," with no elaboration.
"During the second quarter of 2013, we revised the presentation of biodiesel government incentives revenue and biodiesel cost of goods sold from amounts previously reported in the first quarter of 2013 to reflect the Blenders' Tax Credit amount refunded to customers of $69.5 million as a reduction of biodiesel government incentives revenue versus biodiesel cost of goods sold."
Then in its Q3 10-Q, it again reclassified the charge, this time reversing the charge booked in Q2 against the Biodiesel Revenue line item and booking it instead as a reduction of Biodiesel Government Incentives. This time the company elaborated on the nature of the expense; it was a nonrecurring charge against the retroactive BTC benefit. Per the Revenue Recognition section of the filing,
"While in general the Company has not historically offered sales incentives to customers, the uncertainty around the reinstatement of the federal blenders' tax credit led to the introduction of such an incentive during 2012. Specifically, during 2012 the Company negotiated contracts with certain customers to allow such customers to share in the value of federal blenders tax payments if the law were to be reinstated. The federal Blenders' Tax Credit was reinstated on January 2, 2013 and the Company recognized $69,534 of cash payments owed to customers as a reduction of Biodiesel sales revenue. Before 2012, the Company did not have similar contracts and none of its sales subsequent to December 31, 2012 contain such provisions."
Its disclosure indicates that in a normal operating environment, this would have been booked as a BTC benefit to revenue. In order to assess the significance of the BTC to REGI's financials, then, we would add the value of this figure ($69.5) to the $57.75m benefit already booked; in such a case, REGI should have booked a total benefit of $127.3m in 2012 as the result of the tax credit. This number is corroborated by REGI's Q1'10Q disclosure regarding its change in Accounts Receivable account:
"$127.9 of the accounts receivable increase relates to the retroactive 2012 Blenders' Tax Credit passed into law on January 2, 2013"
Adjusting for the $69.5m addition, 2012 EBITDA would have been reported to be $166.05m. The BTC would have made up 77% of 2012 EBITDA.
We adjusted REGI's Q1'2013 Biodiesel Government Incentives line item based on this information, enabling us to estimate the BTC's impact on YTD 2013 EBITDA. Based on our analysis, ~104% of Adjusted EBITDA is the direct result of this government subsidy, and in its absence, REGI would be operating at a significant loss. This Tax Credit is set to expire in two weeks at the end of December 2013.
The decline of REGI's business in the absence of this subsidy has precedence. The BTC was also not renewed throughout 2010. Per the 2011 10-K:
"The absence of and uncertainty around the blenders' tax credit during most of 2010 materially curtailed demand for biodiesel and our ability to cost effectively produce and sell biodiesel, resulting in our idling production at several of our facilities during that period."
And per the 2010 10-K:
"If Congress decides to eliminate or reduce the blenders' credit, non-RFS2 related demand for our product could be significantly reduced and/or the price we are able to charge for our product could be significantly reduced without a corresponding reduction in the price of feedstock, in either case, harming revenues and profitability."
So not only does the absence of the BTC impact REGI's bottom-line, it also impacts the demand for biodiesel because it is split by producers of biodiesel such as REGI and blenders (REGI's customers), such a Pilot Travel Centers LLC. Blenders are less incentivized to blend biodiesel since they longer benefit from the tax credit, thus reducing overall demand for biodiesel.
If the market had already baked in this impending storm, we believe REGI's share price would be trading substantially lower. At current trading levels, we are left to believe investors have not yet fully appreciated the significance of the Blenders' Tax Credit on REGI's financial state.
RFS Mandate Reduction and the Collapse of RIN Prices
REGI's share price appears significantly disconnected from its realities as represented by the D4 RIN price, which is down ~40% in 2013, as REGI's share price is up 75%. Because of this, we believe most REGI investors are not following the trend in D4 RIN price, which poses another very significant risk to REGI's share price. The D4 RIN price is reflecting waning market demand for biodiesel.
RINs are a product of the Renewable Fuel Standard (RFS), the most important government program supporting the biodiesel industry, enacted by Congress in the Energy Independence and Security Act of 2007. The RFS requires that a specific amount of renewable fuel be used annually in motor vehicle fuel nationwide. In 2010, RFS began requiring that a certain percentage of the diesel fuel consumed in the United States be made from renewable sources. The RFS requirements for 2011, 2012, and 2013 were set at 800m, 1B, and 1.28B gallons, respectively. RFS has created demand for biodiesel, REGI's core product, which has been used to satisfy the vast majority of the RFS requirements. The program forces petroleum refiners and fuel importers ("Obligated Parties") to demonstrate compliance with its standards.
As a part of the EPA efforts to track renewable fuel production and compliance with the renewable fuel standard, it created a system - the renewable identification number, or RIN. The EPA created the renewable identification number, or RIN, system to track renewable fuel production and compliance with the renewable fuel standard. EPA registered producers of renewable fuel may generate RINs for each gallon of renewable fuel they produce. In the case of biodiesel, 1.5 biomass-based diesel RINs may be generated for each gallon of biodiesel produced. Most renewable fuel, including biodiesel, is then sold with its associated RINs attached.
RINs are ultimately used by Obligated Parties to demonstrate compliance with the RFS2. Obligated Parties must obtain and retire the required number of RINs to satisfy their RVO during a particular compliance period. An Obligated Party can obtain RINs by buying renewable fuels with RINs attached, buying RINs that have been separated, or producing renewable fuels themselves.
RINs have become a significant portion of the value of a gallon of biodiesel, and the rise in RIN price was a primary driver of REGI's 2013 profitability. The rise of RIN prices, driven by the ethanol mandate, was well documented throughout the media, which had positive impact on biodiesel. However, RIN prices began to fall dramatically in Q3 and Q4 as the EPA released a "bombshell" November 15, 2013, proposing no increase in biodiesel mandate of 1.28 billion gallons for 2014 and 2015. Most experts and market participants expected an increase to as high as 1.9 billion gallons for 2014 and beyond. Craig Irwin, analyst at Wedbush Securities, articulated this market consensus expectation as early as 2Q13:
"Dan, as we look out at 2014, some of the numbers we understand NBB might be talking about, it could be as high as maybe 1.8 or 1.9 billion gallons. If you are going to stay in the range of 15% to 25%, sort of suggest that there is a lot of the potential for being at the lower end of the range with big numbers like that being tossed around, how would you prioritize your opportunity for investments to meet a large RVO like that?
The EPA proposal clearly disappointed, evident in the biodiesel RIN prices subsequently collapsing.
Biomass-based RINs can be viewed as a mechanism that reflects present and future demand for biodiesel. As such, we view RINs as a leading indicator of the health of the biodiesel market. High RIN prices suggest tight supply-demand fundamentals; low RIN prices suggest low demand or an oversupplied market. Because RINs are generated for every gallon of biodiesel produced, as is the Blenders' Tax Credit, RIN economics are shared between the blender and REGI. With RINs hovering close to $0.20/gal, we expect further drag on REGI's profit margins.
At the moment there is a significant disconnect between D4 RIN price and REGI's valuation. Year-to-date, D4 RIN prices are down ~40% and yet REGI's share price is up 75%. We believe the disconnect results from most investors not following what the D4 RIN is indicating. As investors become aware of its precipitous decline, we believe REGI's share price is at further risk of substantial decline, in reflection of market demand. (We should note that we believe the RIN prices will begin to rebound in 2Q14, in normal seasonal pattern, as increases are needed to ensure enough marginal production to meet the RFS mandate.)
(The comment period for the RFS proposal, ending January 28, 2014, allows for industry participants to put in their "two cents" on the proposal. Gary Haer VP of Sales and Bruce Lutes, General Manager of REGI recently provided their testimony at a recent EPA hearing. However, through our channel checks, it is highly unlikely that we will see any significant changes to the current proposal. Market prices of RIN means industry watchers also share our view.)
Industry Characterized by Overcapacity
The National Biodiesel Board (here) is one of the sector's leading industry and lobbyist groups (annual spending history here), and throughout 2013, was advocating to increase the mandate to nearly 2 billion gallons per year. Their argument was simple: the industry is fully capable of producing at a 2 billion gallon per year run rate and will create jobs and, as such, the EPA should increase the 2014 mandate to nearly 2 billion gallons.
The industry has the ability to and frequently overproduces relative to the EPA's mandates. This year's projected volume is expected to exceed 1.7 billion gallons of biodiesel, 33% more than the 2013 mandate. The charts below displays monthly production (which includes imports into the US), annualized, (in order to be able to compare to the annual mandates) relative to the 2013 biomass-based diesel mandate of 1.28B gallons. The data behind the charts can be obtained directly from the EPA EMTS website.
Since the third quarter of 2013, the industry has produced biodiesel at 100% of its capacity, an annualized runrate exceeding the actual mandate. Industry insiders will tell investors that the recent increase in production is due to expiration of the tax credit, resulting in blenders pulling in demand from 2014 into 2013 to obtain the $1 Tax Credit. This is great for the short term, but what happens in the first half of 2014, which is already seasonally weak? There will be a high likelihood that in the first quarter of 2014, prices for biodiesel will collapse as demand sharply falls. We believe poor biodiesel economics will continue for an extended period of time due to the flat year-over-year mandate and low RIN prices. As a result, there is a high likelihood that REGI will reduce production, or even shut plants in light of the new market environment.
Economics 101 suggests that in any market characterized by overcapacity, prices will fall and profit margins will be razor thin as the marginal biodiesel producer will produce just to capture a last sliver of profit. Investors should be aware that the US biodiesel market will likely have overcapacity as a structural problem for the next two years.
Increased Competition from Low-Cost Producers Argentina and Indonesia
On November 20, 2013, the European Union (EU) imposed five-year anti-dumping tariffs on Argentina and Indonesia biodiesel for levies up to 25% beginning November 28, 2013. Because the levies on Argentina and Indonesia are so high, reports indicate that biodiesel exports to the EU will fall substantially and be redirected. Guess where some of this excess biodiesel is heading? The US.
Argentina, one of the world's largest producers of biodiesel, is expected to double its year-over-year exports to the US in the fourth quarter 2013 here. In 2014, Argentina is expected to generate 2.6 billion liters (680 million gallons) of biodiesel, and export close to half its production at 1.2 billion liters (300 million gallons). Argentina's reported nameplate capacity for biodiesel production is 5.2 billion liters (1.38 billion gallons). Today, Argentina is running at 40% to 50% production capacity because of anti-dumping issues with the EU. Exports of biodiesel from Argentina to the EU fell 50% after the European Commission opened its investigation.
Indonesia is in a similar position, as most of its production is exported. More than half of its production is for the export market. Internal consumption is not great enough to absorb the excess capacity. A lot of the biodiesel was going into Europe, but we expect some of those exports to be redirected to the US.
Biodiesel Veteran & Former REGI Board Member Sold >50% of His Holdings
US Renewable Group (USRG) - which is headed by Jonathan Koch, a former REGI board member - was the second largest shareholder in REGI as of a few months ago. According to its website, USRG is a leading renewable energy focused investment firm with over $750 million of assets under management.
Since mid-2013 through early 4Q13, USRG has sold shares at a rabid pace, liquidating over 3 million for total proceeds of approximately $43M. This represents approximately 8% of the total shares outstanding. More alarming was that USRG, on many days, sold at a pace of 19% of the average traded share volume, indicating a sense of urgency to get out. USRG was an investor with REGI before it became a public company. Koch and USRG were in the front seat at REGI when the Blenders' Tax Credit was allowed to expire in 2012, witnessing first hand its impact on REGI's stock price, which traded below $5. Mr. Koch's fiduciary duties are to his investors at USRG; but, we believe frequently selling at 19% of daily volume, which can adversely impact the share price. We view this as a red flag. USRG has liquidated their original common position and the remaining 1.5 million shares are common shares that have been converted from their preferred holdings.
Target Valuation and Conclusion
We believe REGI's production output and its profitability will contract as the culmination of the expiration of the Blenders' Tax Credit, fall in RINs prices, structural industry overcapacity, and elevated risks from foreign exports. We believe REGI's EBITDA is likely to decline substantially, to levels they traded at in 2012 - a corollary period, when the Blenders' Tax Credit was allowed to expire. Our target price is around $4.71 for 2014, a 56% decrease from current levels.
Government Programs Favoring Biodiesel Production and Use
The biodiesel industry benefits from numerous federal and state government programs, the most important of which is RFS2.
Renewable Fuel Standard
On July 1, 2010, RFS2's biomass-based diesel requirement became effective, requiring for the first time that a certain percentage of the diesel fuel consumed in the United States be made from renewable sources. The biomass-based diesel requirement can be satisfied by two primary fuels, biodiesel and renewable diesel. Historically, Renewable diesel has not been available in the United States in significant commercial quantities and thus, biodiesel has satisfied the vast majority of the RFS2 biomass-based diesel requirement.
The biomass-based diesel requirement is one of four separate renewable fuel requirements under RFS2. The RFS2 requirements are based on two primary categories and two subcategories. The two primary categories are conventional renewable fuel, which is intended to be satisfied by corn ethanol, and advanced biofuel, which is defined as a biofuel that reduces lifecycle greenhouse gas emissions by at least 50% compared to the petroleum-based fuel the biofuel is replacing. The advanced biofuel category has two subcategories, cellulosic biofuel, which is intended to be satisfied by newly developed cellulosic biofuels, such as ethanol made from woody biomass, and biomass-based diesel, which is intended to be satisfied by biodiesel and renewable diesel. RFS2's total advanced biofuel requirement is larger than the combined cellulosic fuel and biomass-based diesel requirements, thus requiring the use of additional volumes of advanced biofuels.
The RFS2 volume requirements apply to petroleum refiners and petroleum fuel importers in the 48 contiguous states and Hawaii, who are defined as "Obligated Parties" in the RFS2 regulations, and requires these Obligated Parties to incorporate into their petroleum-based fuel a certain percentage of renewable fuel or purchase credits in the form of RINs from those who do. An Obligated Party's RVO is based on the volume of petroleum-based fuel they produce or import. The largest United States petroleum companies, such as Valero, Phillips 66, Exxon Mobil, British Petroleum, Chevron and Shell, represent the majority of the total RVOs, with the remainder made up of smaller refiners and importers.
Renewable Identification Numbers
The EPA created the renewable identification number, or RIN, system to track renewable fuel production and compliance with the renewable fuel standard. EPA registered producers of renewable fuel may generate RINs for each gallon of renewable fuel they produce. In the case of biodiesel, 1.5 biomass-based diesel RINs may be generated for each gallon of biodiesel produced. Most renewable fuel, including biodiesel, is then sold with its associated RINs attached. Under the RFS2 regulations, the RINs may also be separated from the gallons of renewable fuel and once separated they may be sold as a separate commodity. RINs are ultimately used by Obligated Parties to demonstrate compliance with the RFS2. Obligated Parties must obtain and retire the required number of RINs to satisfy their RVO during a particular compliance period. An Obligated Party can obtain RINs by buying renewable fuels with RINs attached, buying RINs that have been separated, or producing renewable fuels themselves. All RIN activity under RFS2 must be entered into the EPA's moderated transaction system, which tracks RIN generation, transfer and retirement. RINs are retired when used for compliance with the RFS2 requirements.
The value of RINs is significant to the price of biodiesel. In July 2010, when RFS2 became effective, biomass-based diesel RINs began trading at approximately $0.55 per RIN. By the end of 2010, the 2010 biomass-based diesel RIN value had become increasingly significant to the price of biodiesel, contributing approximately $1.11, or 26% of the average The Jacobsen B100 Upper Midwest spot price of a gallon of biodiesel. As of December 31, 2011, RINs contributed approximately $1.83, or 38% of the average The Jacobsen B100 Upper Midwest spot price of a gallon of biodiesel. During 2012, the value of RINs, as reported by OPIS, have contributed to the average B100 spot price of a gallon of biodiesel, as reported by The Jacobsen, and range from a low of $0.63 per gallon, or 24%, in October to a high of $2.39, or 50%, per gallon in January. There was a sharp decline in RIN prices during third quarter 2012 that carried through the end of the year. During this period, RIN pricing declined from $1.17 per RIN at June 30, 2012 to $0.64 per RIN at December 31, 2012, as reported by OPIS, which contributed to the decline in price of biodiesel.
Blenders' Tax Credit
The Blenders' Tax Credit provides a $1.00 per gallon excise tax credit to the first blender of biodiesel with at least 0.1% petroleum-based diesel fuel. The Blenders' Tax Credit can then be credited against such blenders' federal excise tax liability or the blender can obtain a cash refund from the United States Treasury for the value of the credit. The blenders' tax credit became effective January 1, 2005 and then lapsed January 1, 2010 before being reinstated retroactively on December 17, 2010. The Blenders' Tax Credit again expired as of December 31, 2011 and on January 2, 2013, it was again reinstated retroactively for 2012 and prospectively for December 31, 2013. The Blenders' Tax Credit is set to expire again on December 31, 2013 and it is uncertain whether it will be extended.