Analysis Of Renewable Energy Group's Purchase Of Syntroleum

| About: Renewable Energy (REGI)

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Back in August I wrote about who might be interested in buying Syntroleum (NASDAQ:SYNM). Number 3 on the list was Renewable Energy Group (NASDAQ:REGI).

3) Renewable Energy Group may be a buyer. REGI doesn't have any renewable diesel plants, so this would help REGI diversify its portfolio of plants. Access to SYNM's technology would open the door for REGI to retool/rebuild its plants to higher margin renewable diesel plants if they are near essential infrastructure especially a reliable hydrogen source. As the table above demonstrates the SYNM process can add value to REGI's net margins, a benefit that gets magnified in the colder months when the spread between SYNM's "blended" fuel and FAME biodiesel widen. REGI has over 250 million gallons of capacity, so the licensing fees to SYNM and the marginal benefits to REGI could be substantial. Additionally, REGI knows the EPA's RVO for biomass-based diesel has its limits, and may be near a peak. If REGI wants to continue being a major player in the RFS2 game, it needs to find a way to make cellulosic biofuels. Teaming up with SYNM would allow them to do that. REGI may be SYNM's needed source for a plant long as TSN agrees.

Just recently, REGI announced that it will be purchacing basically all of SYNM's assets.

Renewable Energy Group, Inc. and Syntroleum Corporation announced today that they have entered into an asset purchase agreement pursuant to which REG would acquire substantially all of the assets of Syntroleum Corporation, and assume substantially all of the material liabilities of Syntroleum.

The terms of the agreement are:

The terms of the transaction call for Syntroleum to receive 3,796,000 shares of REG common stock (subject to reduction in the event that the aggregate market value of the REG common stock to be issued would exceed $49 million or if the cash transferred to REG is less than $3.2 million)...assuming that the cash reserve is sufficient to discharge Syntroleum's obligations and expenses, which would result in Syntroleum stockholders receiving 0.3809 shares of REG common stock for each outstanding share of Syntroleum common stock (subject to reduction in the event that the aggregate market value of the REG common stock to be issued would exceed $49 million or if the cash transferred to REG is less than $3.2 million)...The asset sale is expected to close in the first quarter of 2014, subject to satisfaction or waiver of the closing conditions.

Analysis Fundamental:

3.8 million shares represents about 10% of REGI which has 36.45 million shares outstanding, and a float of 29 million. It is unclear from the press releases if REGI plans to issue new shares to purchase SYNM. SYNM currently has a market cap of $34 million and a maximum buyout value of $49 million. REGI currently has a market cap of $387 million. The current market cap of SYNM is less that 10% of REGI.

REGI recently reported that it made $48.9 million adj EBITDA for Q3 2014, or $1.43/share. To reach that amount they sold 77 million gallons, so they made about $0.62/gal in adj EBITDA.

We generated adjusted EBITDA of $48.9 million in the quarter, this translates into $1.43 per share.

SYNM recently reported in Q2 2013 that they had margins of over $1.00/gal.

With the new catalyst in place and our weighted average net cash margins are now over $1 a gallon.

SYNM confirmed similar margins in Q3 2013. At 85% production the Dynamic Fuels plant would have produced about 20 million gallons over the period referenced.

We estimate the plant would have generated cash flow of approximately $20 million since July 1, 2013, through October 2013.

The key point being that SYNM will essentially represent 10% of REGI shares post purchase. REGI's capacity will increase from 257 million gallons to 257 + 37.5 = 294.5 million gallons, or an increase of 15%. REGI is spending 10% to expand capacity by 15%. More importantly, gallons from that new 15% will have a higher margin than what REGI currently produces. Put that all together and whether or not REGI issues new shares, the SYNM purchase should boost EPS...if they can get the plant to run as advertised.

Running the numbers and assuming 100% production (something that has yet to happen but is likely possible with the resources and expertise REGI has) and $1.00 EBITDA margins would add $37.5 million EBITDA on 3.8 million shares or about $10/share on an annual basis, or $2.50/share on a quarterly basis. As noted above, REGI's current EBITDA/share was $1.43 for Q3 2014. SYNM's shares provide a 57% boost in EBITDA/share, which should provide about a 6% boost to the overall EBITDA/share or REGI.

Currently REGI is trading at $10.63/share, 0.3809 shares are valued at $4.05. SYNM is currently trading at $3.42/share or a 15% discount to the current buyout offer price. The maximum REGI will pay for SYNM is $49 million, which puts the max price of SYNM at $4.91/share. That max price will be reached when/if REGI reaches $12.90/share before the final merger date. SYNM is currently trading 30% below the max buyout price.

SYNM has a large amount of net operating losses or NOLs, but the way the laws are written, I doubt they will be much benefit to REGI.

Analysis Strategic:

In my opinion, REGI's purchase of SYNM will be a transformative event for REGI. Currently REGI is essentially 100% captive to one of the highest risk fuel products in existence, biodiesel. Biodiesel is essentially a 100% government manufactured industry, that is completely dependent upon government subsidies and support...and the government/EPA just blinked. The EPA just proposed biomass-based diesel production quotas for 2014 that are unchanged from 2013, and advanced biofuels, cellulosic biofuels and ethanol all got cut. The EPA has effectively capped the US biodiesel industry at 1.28 billion gallons + maybe 20%. REGI's 257 million gallons represents 1/5th of the entire EPA quota/renewable volume obligation or RVO. With capacity of over 2 billion gallons already in existence, biodiesel is a zero-growth industry.

Without SYNM, REGI is essentially a 100% un-diversified energy company totally dependent upon an inferior product that demands substantial government support just to exist. A single stroke of a pen can eliminate essentially the entire biodiesel industry. One more record cold winter that forces people to look behind the curtain of the "science" behind global warming, and that may become a real possibility.

The purchase of SYNM transforms REGI from a company trapped in a no growth government manufactured industry that has very powerful enemies, into a diversified energy producer focused on the fuels of the future. I've always believed companies like SYNM and KiOR (KIOR) offer the real solution to America's energy independence. Unfortunately wind, solar and ethanol have been the focus on the Nation's energy policy, and companies offering the real solutions have been ignored. REGI finally provides the capital SYNM has needed to fully implement its technology and realize the potential of its patents.

With the purchase of SYNM, REGI cannot only survive but grow with the EPA's RFS2. While it looks like the EPA is abandoning the first phase of the RFS2, that being the fuels based upon food as a feedstock, they still appear committed to the second phase, that being fuels made from non-food cellulose. While ethanol is running into the blend wall limitation, and is effectively being capped at current levels of production along with biodiesel, cellulosic biofuels are slated to go from essentially zero gallons today to 16 billion gallons by 2022. The real future of renewable fuels lies with cellulose, not oil-based biodiesel.

SYNM's Fischer-Tropsch (FT) technology allows REGI to enter into the infant cellulosic fuels industry. With this technology REGI can take yard clippings, timber waste, sewage, paper garbage and other sources of carbon, gasify them, and turn them into cellulosic fuels. That isn't fantasy, the FT process has been in use since the 1930s.

SYNM's current bio-synfining process creates a renewable diesel that takes the same feedstocks as REGI currently uses, but converts them into higher margin "drop-in" fuels that are indistinguishable from petroleum based fuels. SYNM's renewable diesel doesn't require a government mandated RVO to create a demand, the demand is the existing demand for fuel. If REGI is smart, they will start liquidating their old technology biodiesel facilities and use the capital raised to expand the production of future technology renewable diesel. The drop-in fuel produced by the SYNM's bio-synfining process will also help REGI's earnings during the cold months when FAME sells at a discount to SME.

With the SYNM purchase, REGI can abandon the EPA and RFS2 all together if they want. The FT process allows REGI to get into gas-to-liquids or GTL, coal-to-liquids or CTL and other non-renewable energy ventures. They of course may want to change their name if they do, or create a subsidiary named synthetic fuels or something like that, or just keep the Dynamic Fuels name if they can.

The SYNM purchase opens the entire world up to REGI. Right now REGI is trapped in a 1.28 billion gallon domestic drum, without much hope of growth or reach. With SYNM they can pursue ventures across the globe. SYNM has an extensive Rolodex of contacts having dealt with companies in China, Mazda, the US Navy and other major oil and gas producers. Prior to the buyout announcement, SYNM had signed a MOU to pursue a GTL plant.

One of the developing growth opportunities is stranded gas and flare gas. With SYNM's technology REGI can go after GTL opportunities in the newly discovered gas and oil fields in America. The EPA is planning to regulate flare gas in 2015, so once again, SYNM allows REGI the opportunity to stay ahead of the regulatory curve instead of getting run over by it. Velocys (VLS.L), another FT company, is already making headway in that industry.

EPA will begin imposing new emissions control requirements on natural gas wells that are developed using hydraulic fracturing (commonly called "fracking") under final regulations adopted last month. New hydraulically fractured wells, and older wells that are refractured, must immediately employ emissions combustion (flaring) technology, and must be fitted with emissions capturing devices, known as "green completion" technology, by 2015.

The purchase of SYNM greatly reduces the systemic risk profile of REGI. REGI goes from being a high-risk undiversified biodiesel firm beholden to the whims of government regulations and ever-changing subsidies, to a diversified synthetic energy and specialty chemicals company. With the SYNM patents REGI can broaden out into building materials and clothing made with SYNM's phase change material or PCM. Bottom line, REGI will no longer be a one trick pony doing yesterday's tricks in a circus that is losing market share. REGI will become a three-ring circus focused on all the latest attractions. With a greatly lowered systemic risk profile, REGI should justify a higher stock price ceteras paribus.

Flys in the ointment:

1) Shareholders and TSN still have a say. Either one of these parties can still vote against the merger. If that happens, SYNM is in real trouble because they would owe REGI $5 million for exiting the deal. SYNM would no longer have the cash to start the plant even if they wanted to.

If the Syntroleum stockholders vote against the REG transaction, Syntroleum will be free to accept another offer. The termination fee in the transaction is $5 million, which is payable in certain circumstances as described in the asset purchase agreement.

2) I was surprised that REGI was able to get SYNM for so cheap. As noted above, SYNM's fuel has a margin of over $1/gal, and SYNM controls 37.5 million gallons. A multiple of 1 seems awfully cheap. How many investments that large can pay for themselves in 1 to 1.5 years? That being said, SYNM mentioned over the summer that "multiple" buyers were examining SYNM. REGI has done the due diligence, made comments about the confidence they have in the operational ability of the facility and has given the markets a price that they can analyze. REGI, by showing their hand and signaling confidence in the Dynamic Fuels plant, just made it a whole lot easier for another bidder to emerge. REGI is known for being an expert vulture capitalist that feeds off distressed but valuable assets, buying them for pennies on the dollar. REGI wouldn't be buying them if they didn't see value in the SYNM assets, and other firms understand that.

"Combining Syntroleum's renewable and synthetic fuel technologies with REG's expertise in biodiesel production, sales, marketing and logistics should be a positive outcome for investors in both companies," said Renewable Energy Group, Inc. President and Chief Executive Officer Daniel J. Oh. "This will help us grow our advanced biofuel business, enhance our intellectual property portfolio, expand our geographic footprint and launch REG into new customer segments."

"Syntroleum and its 50%-owned subsidiary Dynamic Fuels represent an attractive entry path for REG into renewable diesel," Oh continued. "They have invested substantial resources in their Bio-Synfining technology, which enables the economical conversion of lipid-based biomass into diesel and jet fuel. Their technology and products complement our core biodiesel business."

3) SYNM is still engaged in multiple lawsuits with Neste. So far SYNM has won all the major issues in the US lawsuit, and moving ahead with their suit AGAINST Neste in the Singapore case. The fact that REGI made an offer before the final verdict gives me some confidence that my original analysis, skeptical of the lawsuit, will be justified. That being said, while I've always thought REGI was the best fit for a buyer, I've always thought Neste would be the most likely buyer. By buying SYNM, Neste could make all the lawsuits go away, and gain a production facility here in the US. Currently Neste exports renewable diesel to the US. Now that REGI is buying SYNM, there will be far more resources available to go after Neste. A verdict in favor of SYNM could cost Neste far more than $50 million, so why risk it?

In conclusion, REGI's purchase may be a game changer for both REGI and SYNM shareholders. Because of SYNM's lack of resources and apparently dysfunctional relationship with their 50/50 partner Tyson Foods (NYSE:TSN), SYNM was simply in a race against the clock before they ran out of cash. SYNM simply had to find a way out of the Dynamic Fuels situation or go bankrupt. Their only hope was to get the plant running and past attempts to make that happen failed, or find a new source of capital. With a cash burn rate of over $1 million a month, a cash commitment of $10 million required to get the plant running again and a cash balance of $14.2 million, SYNM simply ran out of time. The REGI merger however allows for the opportunity that the value of SYNM's patents will finally be recognized. What has been holding SYNM back is its lack of capital. REGI has plenty of capital, and the needed expertise and operational experience to make that happen. In my opinion, SYNM shareholders will be better served with a REGI/SYNM merger than keeping SYNM a standalone company. Unless another buyer emerges, or a new source of capital develops, cash burn has simply forced SYNM's hand. Fortunately, falling into REGI's hands appears to offer a bright future for current SYNM shareholders.

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.