With ethanol margins weak and rising uncertainty around industry protective import tariffs, tax benefits and the implementation of e-15 rules, it seems prudent to consider the future of Rex's (REX) investment in the Levelland-Hockley LLC (LH) plant. I believe the plant is losing money currently and, while its certainly possible LH will fix its issues or restructure its loan with GE Capital, a temporary or possibly permanent closing of the plant seems a real possibility. While any actions such as these could pose a "headlines risk" for REX shares, I believe the impact on REX's earnings, corporate cash & tax assets and, ultimately, its stock price, would actually be modestly positive.
Background on Levelland-Hockley Plant
Rex owns 56% of the LH plant, which it consolidates on its balance sheet as $17.1 million net assets (Rex's proportional assets are therefore $9.6 million). Rex also holds a $5 million convertible secured promissory note from LH and a $4 million line of credit. LH has a term loan with GE Capital that stood at $33.9 million on October 31, 2010. Importantly, this term loan is non-recourse to Rex, with the liability ending at LH.
Located near Lubbock, TX, LH is the only plant Rex has invested in that is outside of the corn belt. It is also Rex's only sub-100 million gallon per year (gpy) capacity plant investment, with name plate capacity at 55 gpy. These factors create substantial barriers to profitability in that the smaller plants are by nature less efficient (reduced economies of scale) and using corn as feedstock is expensive in Texas due to shipping costs. These headwinds were supposed to be offset by higher prices for ethanol and distillers grains, state tax credits and the use of locally grown sorghum in lieu of corn. However, this has not worked out as planned.
From the beginning, the LH plant has run into trouble. The state of Texas pulled funding for the tax credits LH expected to receive for production even before the plant went on line, costing the company a little over $3 million per year in forecasted income. While the plant does appear to have garnered higher prices for its ethanol and co-products, this has not usually offset higher feedstock costs. LH had difficulty getting local farmers to grow enough sorghum to support year-round operations and has had to ship in significantly more corn as feedstock annually than it originally planned. This problem has been exacerbated recently with skyrocketing cotton prices as we believe many local farmers are switching to this more profitable crop.
Potential LH shutdown impact on Rex's assets and profits. Because LH had been operating unprofitably (yet covering cash costs), taking it out of Rex's P&L would be accretive by, I estimate, $0.15 to 2010 results. More importantly, it would prevent LH from becoming a bigger loss in future quarters if margins deteriorate further.
From a balance sheet perspective, its more difficult to quantify the impact given the value LH would receive in a distressed sale is uncertain. However, any losses would be non-cash to Rex and could actually add to Rex's cash balances. This is important as I believe REX shares are largely valued based on its cash (including near-cash tax assets) and real estate value, with the market assigning virtually no value to its ethanol assets.
Valuation: Closing LH could actually help Rex shares. So what would Rex's shares be worth if LH were to shut down and liquidate? Based on recent valuation work I have done, the market value of Rex's assets before liquidating LH is about $23 per share. This consists of cash and tax assets of $10/share, real estate at $4/share and $9/share in ethanol assets. Of the $9/share in ethanol assets, LH composes only $2/share. Rex would also accrue tax assets of approximately $5.5 million (about $0.50/share), assuming a tax recovery of about 30% on a full $19 million loss. These tax assets would obviously be smaller and cash gains higher if the company can recovery any of its investment.
WIth REX currently trading at $13.50, the stock is trading below the value of its cash, tax assets and real estate value. The market doesn't seem to apply any value to the ethanol assets. So, while the hypothetical LH plant closure could pose some short term headline risk, it would seem unlikely to cause any real long term damage to the stock value or price. In fact, the increase cash and tax assets could actually be a net positive for the stock over time.
Under a more traditional P/E valuation, REX is trading at about 9x 2010 estimated EPS (assuming EPS of about $0.50 for fourth quarter 2010). Without LH in the operating results, I believe EPS would be more like $1.65. Applying the same P/E and the stock should be trading closer to $15 without LH. I believe the market value of the assets is a better framework that shows how undervalued REX shares are, but even using a P/E valuation, the closing of LH, should it occur, should not be viewed negatively.