Pacific Ethanol: 'We've Only Just Begun'

Mar.31.14 | About: Pacific Ethanol, (PEIX)

Summary

The ethanol industry is maturing, and the troughs of the cycle should now be profitable.

Global demand is ramping, and China likely coming online could explode international demand.

Investors will do a double take when they realize what Pacific Ethanol will earn this year.

Pacific Ethanol (NASDAQ:PEIX) has recently had a large up-move, but this article will discuss why I think the stock has a lot further to go. Before I get into the specific upside drivers, I think it's important to understand some things about the ethanol industry and Pacific Ethanol in particular to understand why I think this rally has only just begun.

The ethanol industry is young. Domestic ethanol production capacity has gone from 900 million gallons in 1990 to 1.63 billion gallons in 2000 and 13.9 billion gallons in 2011. Ethanol's share of gasoline supply has gone from 1% in 2000 to 10% in 2010. MTBE, an oxygenate which was at one time used to help improve air quality and reduce carbon emissions, was banned in most states after it was found to be polluting the groundwater. Out of the need to replace MTBE and a need to wean ourselves from foreign oil, ethanol began being used as a mainstream component of overall gasoline consumption. The race to build out ethanol capacity was uneven, and the companies carried heavy debt burdens, were dependent on subsidies, and thus, often hurt by the vagaries of a commodities cycle, often finding themselves with insufficient cash to hedge their inputs or production. Initially, large capex requirements and low ethanol volumes made for a tough environment. As the industry ramped up by 2008, much like most industries, it began to struggle under the tough economic conditions brought about by the crash and the fallout in 2009. To add insult to injury, severe droughts in the Midwest, which started in 2010 just as the economy began to recover, wreaked havoc on the input component of corn. Heavy debt loads and economics that don't work with non-hedged input of $6-$8 dollar corn took these nascent companies within a whisker of their financial lives, and in some cases, into bankruptcy.

Starting in 2013, as the droughts subsided, corn prices began to drop, and late in the year, challenged the $4 area before bouncing back to the $5 area recently. The USDA is predicting that the price of corn will retreat to $3.30 for the 2015-2016 marketing year and for it to remain depressed in their ten-year outlook. To learn more, you can click on the following link:

http://www.agriculture.com/news/business/usda-projects-330-cn_5-ar41892

The major inputs of ethanol are corn and, to a much lesser extent, natural gas. As described above, and because of increased global plantings and inventories of corn, the price backdrop has structurally started to benefit ethanol producers, and this benefit should increase over time. As far as natural gas is concerned, the US is blessed with an abundant supply, which is supported by stable strip prices as far as the eye can see. An extremely cold winter this year, which spiked demand and constrained supplies, still couldn't generate prices anywhere near those achieved in past cycle highs due to the market perception that there is an unlimited supply once the winter cold recedes. A combination of structurally glutted corn and natural gas in the long-term outlook sets a very favorable input cost backdrop for ethanol producers for years to come.

Recently, a combination of lower corn prices, retreating natural gas prices from winter peaks, spiking ethanol prices from growing international demand and bottlenecks of railcars unable to deliver ethanol to the coasts have created a very strong operating environment for ethanol producers. Pacific Ethanol, long plagued by huge debt loads and difficulty with procuring necessary corn feedstock efficiently in times of scarcity, is now benefiting from its west coast location. An environment where ethanol prices spike and input costs remain subdued, as well as a large cash infusion from 7.5 million warrants struck at $7.50/share will allow Pacific Ethanol to pay off most, if not all of its debt in the next couple of quarters. Rather than focus on how much PEIX can make in these peak times, I find it more interesting to think about what it can make in a more normalized environment of $4-$5 corn, $4 natural gas, and $1.6-$1.85 ethanol prices. Let's look at what PEIX did in Q4 w/ $1.86 average ethanol prices, $4+ nat gas prices, and $4.50 corn prices. It earned $0.54 cents per share. The reason that is important is because it is very likely that a similar backdrop, if not materially better, will persist for many years to come for the above-listed reasons for corn and natural gas prices to fall even further than they were. Couple this favorable input cost backdrop with rising international demand for ethanol and constrained production supply, and it becomes clear that Q4 was the beginning of things to come. Note that front-month ethanol prices closed at $3.25 on Friday, up a staggering 75% from the Q4 average. The earnings leverage on those prices will be equally eye-popping.

International ethanol demand is expected to outstrip supply for as far as the eye can see. Anyone interested in this needs to read the following link:

http://www.unece.lsu.edu/biofuels/documents/2013Mar/bf13_04.pdf‎

What's interesting to note here is that China making a 5% ethanol blend is not even included in this analysis. In a recent "thegreenenergyreport" interview with noted energy investor Chen Lin, he talks about this in great detail. What I like most about it, besides the fact Chen is a fellow Princetonian, is his logic that China will be forced to blend 5% ethanol into their gas to help with their declared battle on air pollution. He believes that if China does this, it would collapse the traditional discount of ethanol to gasoline. Historically, ethanol has traded at a discount because of its lower energy content, but perhaps the benefit of cleaner air attributes and scarce supply are about to change that. A link to the entire interview can be found here:

http://www.theenergyreport.com/pub/na/fight-chinas-smog-with-ethanol-says-chen-lin

On the Rex conference call, Stuart Rose said the following in response to a question regarding China/ethanol/air pollution and the 5% blend:

"I was just in Brazil and Brazil has probably more crowded highways than China but because they use so much ethanol, there is not near to air pollution problem that China has. Okay I'm not the Chinese government but I think it will be smart if they did introduce something like that but I have no knowledge if that's imminent... I just think it would be smart on their behalf to do it. In terms of exports, China is a new market, while the biggest for exports is Canada. But China is starting and we'll see what happens, that could be -- if that really happened where they introduced the 5% level that would be fantastic."

Much has been made of whether the EPA will be at 13 or 13.8 billion gallons for their ethanol mandate. What most have failed to embrace is that global demand has grown to over 800 million barrels. International demand is rising, and will strain supplies for years to come. If the EPA does, in fact, soften their stance on the 13 billion and goes back to the 13.8 billion gallon number, it is possible this could create supply problems in the not-too-distant future. If China moves forward with implementation, then we have a whole different ballgame.

Getting back to PEIX, there have been several different well-written articles on Seeking Alpha about its earnings power for 2014. I would like to point out a couple of additional things. Since those articles were written, ethanol prices have exploded. Interestingly, not just the front-month contracts, but the out-months as well. Near-record low inventories of ethanol due to strong international demand and domestic logistical issues with railcars have come at the worst time for consumers and the best time for producers as we come into the maintenance period for plants ahead of the summer driving season that typically draws down storage. The only response available to the markets is to take price to a point where supply is rationed. This means profit margins, which were already rising sharply at the time of the last articles, has literally exploded. Note that there will be an extra 7.5 million shares in the fully diluted share calculation for 2014, as the $7.50 warrants are in the money at the current stock price. This will dilute EPS, but raise a very large slug of cash ($56.25 million), which it can use to pay off more than half its debt load. Free cash flow will pay off the balance, by my calculations, sometime later in the year (perhaps as early as late Q3 early Q4) given the current margin structure. In short order, if it so chooses, PEIX will be debt-free, which will save them $10-15 million per year in interest expense or ($0.50-$0.75 per share), and they will be in a position to buy back stock and/or implement a dividend. Yes, that is correct. Pacific Ethanol, a company plagued by debt (and even bankruptcy) in the past, will be debt-free going into a secular backdrop of lower inputs and international demand that will challenge supply for the foreseeable future. If I were to run-rate the current vertical margin backdrop, I can easily get to $10 in EPS for 2014. However, even simply using the current futures strip for 2014, I forecast something in the realm of $6-$8/share being very possible using the same mechanics the previous articles used. For reference, the lone sell-side estimate is for $2.20 in EPS in 2014. I don't think that is appropriate to run-rate the last couple of weeks, as I'm sure at some point margins will contract in this highly volatile industry, but I think it will take quite a bit of time to rebuild the ethanol inventories. The Sidoti analyst recently raised her estimates nearly four-fold for REX in 2014, from $2+ to $8+. Obviously, it's exciting to guess just how high the numbers will go for PEIX after Q1 (I think Q1 EPS will probably be somewhere around $1, as the majority of the vertical move in margins and ASPs having come only in the last month of the quarter, and as mentioned, the warrants are now in the money, so the fully diluted share count will rise by almost 50%. The problem is figuring out how long the current environment lasts, and what the tail-end of the trough earnings picture looks like. But consider this: What if the Russian/Ukraine situation resolves itself, and corn retreats back towards the $4 level and begins to move toward the USDA forecast? My view is ethanol will not collapse even if corn and natural gas do, for the reasons listed above. It could make the explosive margins that we have seen in the past month even stronger.

How do we value a stock that could make $1.50-$2.00 in a trough environment (no debt and better backdrop of supply/demand dynamics) and $6-$10 if margins remain elevated or improve? I think it is appropriate, as in most highly cyclical industries, to take the average earnings for the cycle and apply a below-market multiple to reflect the volatility. Using a conservative average cycle earnings of $4, and applying a 10x multiple on it (a discount to peers like GPRE at 13x), we can easily see how this is a $40 stock. Markets always overshoot, and I have no idea how long this potentially secular shift in making ethanol at extremely profitable margins will last. However, if PEIX executes and some of the aforementioned catalysts come to fruition (first and foremost being a move by China to blend 5% ethanol), the upside will be greater still. I think this rally in PEIX has only just begun.

Disclosure: I am long PEIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long PEIX, and intend to trade it actively as price dictates.