Value Gaps Of All Value Gaps - A Tale Of 2 Ethanol Companies

Jul.29.14 | About: Pacific Ethanol, (PEIX)

Summary

A massive valuation gap between GPRE and PEIX should resolve itself with a strong rally in PEIX.

Ethanol metrics substantially improved in Q2 and should remain robust for two to three more quarters.

There is asymmetric risk/reward to the upside for PEIX.

To lessen risk, a short GPRE/long PEIX strategy can be employed.

Great Plains Renewables (NASDAQ:GPRE) will report Q2 earnings later today. They will undoubtedly be good as ethanol margins were stellar as corn and natural gas (two of the main cost inputs for making ethanol) imploded, while ethanol drifted slight lower during the quarter. On balance, these margins appear to be in place for the balance of 2014 and possibly into Q2 2015.

GPRE is slated to earn approximately $3.25 per share in calendar 2014. At its current price of $40, that is a P/E of slightly over 12. They also have over 600 million of debt. How does this compare to other ethanol companies of similar stature? The short answer is there is only one public comparable, Pacific Ethanol (NASDAQ:PEIX).

Pacific Ethanol has minimal analyst coverage, but for 2014 has an estimate earnings target of $3.15. (They earned $1.24 in Q1 but had a non-cash charge related to their outstanding warrants due to the huge run-up in their stock price.) Since mid-2013 they have reduced their debt from over 100 million to $31 million, which they would love to pay off. However, due to provisions in that debt that call for making whole interest payments, that likely cannot happen.

Both companies are very well-managed ethanol producers using a variety of input feedstock. Also, both companies benefit from the increased margins that have been prevalent in the ethanol refining business for the past two to three quarters.

So, the question becomes: Why does GPRE trade at $40 and carry a 12.5 P/E and PEIX trades at $18 and carries a P/E of only 6? Clearly some misconception exists between investors perceptions of these two companies. This will most likely change after both companies report their quarterly earnings. The valuation gap cannot persist at this magnitude, in my opinion, as I haven't seen one this wide in my 30 years of trading in these markets. Either GPRE will drop substantially (not likely, given the ethanol margins for the next two to three quarters) or PEIX will have to rise substantially. This is the most likely scenario.

Given that Q3 margins will be better than Q2 for ethanol producers and that Q4 may be even slightly better than Q3, it is hard to fathom that PEIX cannot attain a price near to or north of $30. PEIX has a number of qualities that should make it trade at a premium to GPRE:

  • It is based on the West Coast and serves a market untapped by others.
  • They have a subsidiary, Kinergy, which markets ethanol for PEIX as well as other suppliers, and can serve as their marketing arm to export ethanol to Asia when and if that becomes possible.
  • They do not hedge their corn costs and so can benefit more in times of corn surpluses (very likely this year and next).
  • They have a sound management team that has guided this company from near death to its current stature.

PEIX reports their earnings on Wednesday, July 30, and although there will likely be a much smaller non-cash charge for their outstanding warrants as the stock is slightly higher than when they reported Q1, the earnings should clearly be good. They should beat expectations, and the metrics moving forward should provide a tailwind for the next two to three quarters. Given a 20% discount to GPRE, which I don't feel is warranted, that would propel PEIX to the low $30s, still keeping its P/E under 10 -- too low, in my opinion.

Pacific Ethanol should be owned, either as a singular investment or, to lessen risk, as a pair with a half position short in GPRE against it.

Disclosure: The author is long PEIX, GPRE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.