I accidentally walked into a buzz saw a few weeks back when I wrote an article about book value analysis. Apparently, book value analysis is orthodoxy when it comes to shareholders of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). Personally, I have zero interest in Berkshire, and have very little interest in book value or deep value analysis. I have an extensive background in finance and economics, but I almost always rely upon my economics understanding when making investment decisions. Never in my studies of economics have I studied book value as a true measure of value. In economics, you are always taught to use market values, and that the value of an asset is the sum of its discounted future cash flows. Unless the assets are mark to market, the book value of a company can totally misrepresent the true value of a company, in fact two identical companies that use different depreciation schedules will have different book values.
The classic example is the buggy whip maker. You could have been the Solyndra of its day, a high-tech automated efficient buggy whip maker with the most expensive and modern equipment in the world, and that wouldn't have meant diddly squat once Henry Ford fired up his assembly line. I'm pretty sure Solyndra had a real impressive balance sheet as well. Here you can see President Obama touring one of its factories. Pretty impressive, but worthless, stuff. Personally, I'm shocked that video is still up on the White House website ... bet it won't be up much longer.
What inspired this article however wasn't my articles on BRK.A, it was an article written about a stock that I quasi-own, Renewable Energy Group (NASDAQ:REGI). I say "quasi" because I own Syntroleum (NASDAQ:SYNM), which is being purchased by REGI in a stock swap, and I also own calls on REGI. The article was extremely well written, in fact it was selected as a Seeking Alpha "Pro" article. I complemented the author on his thorough analysis and highly detailed article. The problem is, while the article was exceptionally well written, its correct conclusion was partially based upon faulty valuation analysis.
The title of the article was Renewable Energy Group, Inc.: A Textbook Dollar Bill For Fifty Cents, Maybe Less, and it was very bullish of REGI. I should be jumping for joy that someone wrote a bullish argument about a stock that I own, and I am. I appreciate the article, but I disagree with some of the analysis. Relying on balance sheet analysis is largely useless when dealing with "green economy" stocks. Solyndra's book value was irrelevant as are the balance sheets of countless other bankrupt "green economy" stocks. Free market principles and traditional accounting measures mean very little when dealing with "green economy" stocks.
The reason for this is very simple - the "green economy" is a government manufactured economy completely dependent upon government subsidies, tax breaks, loans, tariffs and regulations. Once the government support is gone, so is the industry, no matter how impressive a balance sheet the company has. The "green economy" doesn't generate earnings, it receives incentives. Huge difference. Earnings are the result of consumers voluntarily exchanging their incomes for goods and services that they value greater than the dollars they are holding. It is a completely voluntary, market driven effort to increase the utility/well being of an individual. If I value a pizza more than the $10 in my pocket, I voluntarily engage in an exchange, if I don't, I don't. Government incentives are the result of the ever-changing and unpredictable political process, and are largely removed from market forces. When political support ended for future wind projects, the projects simply vanished into thin air. That kind of do-or-die, sudden-death risk should not be ignored by investors, regardless of their political beliefs.
Investors in wind-generated power nearly abandoned ship when Congress let the tax credits for wind projects expire, a new report says.
Installations of new U.S. wind projects fell 93 percent last year. A Navigant Research report says wind power installations had increased to a record high of 13,100 in 2012, according to the Houston Chronicle.
This belief/fact does not go over well with "green economy" enthusiasts, and they have even written articles about how wrong my views are.
What I can criticize is Robert Wagner's articles regarding the crash of the 'green economy.' Wagner focused more on debunking global warming. There is literally zero economic analysis of solar power to be found in his writing. Specifically, Wagner made a very broad claim that was not supported by any source.
"We know that the vast majority of the 'green economy' is completely dependent upon government support, and are far from being commercially viable."
The problem I have with my critics is simply that they are wrong. The article above never even mentioned that SolarCity's (NASDAQ:SCTY) success is largely due to a 30% Federal Tax credit. And even the author admits he can't figure out the accounting.
This company's value is notoriously difficult to estimate, because all capital investment is funneled towards a recurring revenue stream in the future. We don't know precisely what SolarCity's costs are, and the nature of their accounting (by necessity) is convoluted.
This is from the SolarCity website.
The economics of solar power have never been better. As more people have gone solar, the price of solar panels has come down. The federal tax credit covers 30% of the solar system cost, and in some states there are additional local and utility rebates to offset retail price.
In this video CNBC's Hank Greenberg also raises questions about SCTY's accounting. He uses the term "complicated and opaque" and "made-up metric" that should be red-flags for everyone. Also, be sure to pay attention to the comments about tax incentives. Watching that video I had a flashback to the "new metrics" of the Dotcom Bubble. I personally am shocked at how cavalier some analysts are about certain risks.
What I've learned from my writings is that some groups of investors simply choose to ignore some very, very important facts and risks. Investors do so at their own peril. People just seem to be willing to allow their personal and political beliefs cloud their judgment.
Back to REGI. The problem with applying traditional financial analysis to "green economy" stocks is that the "green economy" is an artificial economy where free market principles and traditional financial analysis don't really apply. The author correctly points out that REGI is very cheap.
This report has argued that the common stock of Renewable Energy Group, Inc. is selling at a substantial discount to intrinsic value...Put simply, REG is priced like it is at risk of liquidating, when in reality it is poised to continue to thrive.
The questions investors should be asking themselves is:
1) How can the market be so wrong on its valuation of REGI?
2) Is there something that I am missing?
The chances of the market being wrong are basically nil, and arguing with the markets can be very costly. The market can afford to stay "wrong" with regards to valuation a lot longer than most investors can remain solvent. There is a reason people often call deep value stocks value "traps."
The markets are properly valuing REGI and its extreme cheapness is warranted. REGI has extreme volatility and uncertainty in its earnings. Two years ago, while it was producing without a "blenders tax credit" or BTC, its earnings were awful, and the stock lagged. Then the BTC got reinstated in early 2013 and made retroactive to 2012 and suddenly, with a stroke of a pen, it had outstanding earnings for 2012 and 2013, and the stock exploded. The BTC was then rumored to not get reinstated for 2014, which it didn't, and the stock then gave back much of its gains.
Understanding REGI and other "green economy" stocks isn't rocket science, and balance sheet analysis isn't much use. Unless the balance sheet can predict the outcome of a Congressional vote or EPA decision the balance sheet is the worst financial report to analyze. Net margins on biodiesel, which is what REGI produces, are effectively $0.00/gal, and that margin includes 1.5x a D4 RIN, which currently trades around $0.63. Yes, REGI does have an advantage in that it can use lower cost feedstocks, and its net margin is likely to be above $0.00/gal, but its margin isn't above the approximately $1.00 RIN value embedded in each gallon. Lose the RIN value and REGI is most likely losing $0.50 to $1.00 per gallon of biodiesel it produces. The book value of a set of assets that generate negative margins is effectively scrap metal prices.
The lines of the balance sheet that are important are cash, current assets, current liabilities and working capital. Because of the on-again-off-again subsidies and EPA proposals, revisions and final rules offered the insane, overlapping, confusing system that currently exists, creating a feast or famine market. One year margins will be extraordinary, and the next, they are non-existent. This is a huge advantage to larger companies like REGI that can afford to gamble on a BTC being reinstated. They can afford to produce at low or no margins, while other smaller firms can't take that risk.
Even so, it is a high risk game for REGI, and betting wrong just once likely means game over. REGI has working capital of around $250 million and production capacity of around 250 million gallons per year. The loss of the BTC took gross margins down from well over $1/gal to basically break even. The RINs are supposed to adjust for the loss of the BTC, but the oversupply from 2013 has kept D4 RIN prices relatively low, as has uncertainty about the EPA's final decision on the biodiesel volume mandate or RVO. If for some reason the EPA's Renewable Fuels Standard 2 or RFS2 program gets halted, biodiesel margins could fall by another $1.00/gal. Under that situation, REGI would only have one year's worth of cash to burn, and if nothing was done to reinstate the BTC or RFS2, and feedstock prices didn't adjust to make margins positive, the biodiesel industry for all intents and purposes would be extinct. The book value of a plant that produces a product with a negative margin is meaningless.
To value REGI and other "green energy" stocks the key metrics/issues to follow are:
1) The capacity of the plant.
2) The margin made on each gallon.
3) The EPA's RVO for renewable fuels and specifically renewable diesel. Progressive fuels mentioned in its daily commentary that the EPA hinted that the proposed 1.28 billion gallon RVO will become final. That will likely keep D4 RINs relatively low.
4) Progress on the reinstatement of the BTC or similar incentives.
5) Working capital.
Looking forward, analyzing the above metrics and issues one can begin to build expectations for REGI and other similar "green energy stocks."
Right now ethanol margins are at or near records. With low corn prices and confusion about the prospects of a "blend wall" hitting in 2014, investors are paying top dollar for ethanol plants. Companies like Green Plains Renewable (NASDAQ:GPRE) has an above market P/E of 25 and a forward P/E of 15. D6 ethanol RINs, supply bottlenecks, weather issues, cheap corn, a Brazilian drought and the fear of a "blend wall" have all converged to drive ethanol producers higher. Just recently David Einhorn's Green Light Capital proposed to spend $275 million for the 65% of BioFuel Energy (NASDAQ:BIOF) it didn't already own. BIOF is a 2 plant 220 million gallon per year ethanol producer. That values the plants at $275/0.65 = $423 million or about $2.00/gal at full capacity. GPRE has a market cap of $953 million and production capacity of about 1 billion gallons per year, or about $1.00/gal at full capacity. Personally, unless David has plans to upgrade BIOF's plants to 2nd generation biofuels, I bet this will be a big loser of a purchase. The EPA's RFS2 is designed to replace corn based ethanol as a biofuel, and resistance growing in Congress.
[Editor's Note: Since this article was published, new information has emerged, that the author has asked us to link to here.]
Biodiesel however isn't ethanol. Ethanol economics stand on their own right now, even if the D6 RINs disappear. Biodiesel isn't a fortune. Biodiesel's market is a small fraction of the ethanol market, and its cost structure and quality/acceptance isn't even close to being profitable/demanded without government assistance. Flexible feedstock plants may have a chance at survival as long as the feedstock prices adjust to their highest and best use price, and their highest and best use is biodiesel. The transition would almost certainly be ugly however as the loss of the BTC is proving to be.
Looking forward there are four major events that will almost certainly move REGI and other green energy stocks.
1) The EPA will issue final RFS2 rules and RVOs for 2014. If the final RVO for biodiesel if over 1.28 billion gallons, or the RVO for advanced biofuels is over 2.2 billion gallons, or the total renewable fuels RVO is over 15.21 billion gallons, I would expect green energy stocks to rally. The date of the final decision is unknown, but 2013's final rules were issued in August 2013.
2) Congress will decide on the tax extenders. This may or may not happen in 2014. The 2012 tax extender was passed in early 2013 and made retroactive. Reinstatement will certainly boost biodiesel firms, and even more so if it is made retroactive. At full production that would mean REGI would be given a tax credit for around $125 million for 2014 assuming REGI negotiated a 50/50 split with the blenders.
3) If ethanol hits the blendwall and sends D6, D5 and D4 RINs well above $1 as they did in 2013, green energy stocks should rally strongly. A bad EPA ruling or a decrease in fuel consumption could trigger the blend wall.
4) A landslide election in November 2014 and especially in 2016 could spell disaster for the "green economy." If Republicans first hold the House and take the Senate in 2014 and then take the White House in 2016, investors would be wise to sell "green economy" stocks and invest in traditional, reliable, proven, safe, self-sufficient old school energy companies and new-technology fracking companies. In my opinion the "green economy" has very little chance of surviving a Republican landslide election. The EPA is almost certain to have its powers curtailed, global warming/climate change will join the coming ice age of the 1970s, and production of efficient proven and reliable fuel sources will become the focus of US energy policy.
Bottom line for investors is that to value green energy/economy stocks they should put away the balance sheets, turn off CNBC and turn on C-SPAN. Politics is what gives the "green economy" its real value. One bad vote and the book value disappears.
Disclaimer: This article is not an investment recommendation or solicitation. 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. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.
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.
Additional disclosure: I own calls on REGI
Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.