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I've just finished poring over everything I could get my hands on about Nutracea (NTRZ.OB) and I am incredibly impressed with this company. In particular, I think that CEO Brad Edson really knows what he is doing. He gives some of the most detailed and informative conference calls I've ever heard.

I'm going to draw from a number of sources and give you the basic file on NTRZ, and then create my own earnings estimates and do some valuation analysis. I wish I could give you all of my notes regarding the company, but they are probably too long to keep your attention. I highly encourage individual investors to go beyond the information listed here in order to understand NTRZ's Stage I and II plant structure, pricing, etc. In particular, the following PDF file, a presentation given by the CEO in September, contains a wealth of excellent information.

Profile

NutraCea, a health science company, engages in the development and distribution of stabilized rice bran and rice bran-based products for the consumer food and animal feed sectors. Nutracea's patent protected, proprietary technology allows it to stabilize rice bran, the most nutricious part of the rice kernel. (Before NTRZ, rice bran was a virtually worthless byproduct of the rice milling process. It remains very inexpensive, as it has few applications without NTRZ's technology.) It then sells this stabilized rice bran [SRB] for both human and animal consumption. Its products include food supplements and medical foods for humans and animals. Its customers include General Mills (GIS), Purina, Archer Daniels Midland (ADM), and several other Fortune 500 companies, as well as foreign governments in the developing world.

Market

NTRZ is the only company in the world that has the ability to create SRB. Based on the fact that 70% of the world consumes rice as their number one source of grains, the potential market is enormous. At present, NTRZ is predicted to have a capacity to create 70k tons of SRB in 2007. Current world rice production is about 60 million metric tons, so obviously, NTRZ has just begun to scratch the surface of this market.

Furthermore, NTRZ has been capacity constrained and operating at 100% capacity since 2005. They are pursuing an aggressive expansion program in order to meet the demand for SRB, which in the words of the CEO, "exceeds our production capacity many times over." NTRZ can basically sell all it can produce, and because the technology is proprietary, they have no competition.

2006 Year in Review

NTRZ has yet to report FY2006 earnings, but there is enough visibility to make estimates here. It is clear that 2006 has been an incredible year for NTRZ. They have recorded their first quarter of profitability in Q2, and will report their first full year of profitability. Based on my estimates, NTRZ should announce revenues of approximately $6.5 million for Q4, and a net income of approximately 0.02 cents per share. Full year revenues should exceed 19 million, an increase of about 300% on 2005. Meanwhile, earnings should come in at 0.03 cents per share, representing NTRZ's first year of profitability in its history.

More importantly, NTRZ has completed significant capacity expansion in 2006. They completed the expansion of their Dillon, MT plant in September of 2006, which should add some $10.8 million to revenues annually. They are also scheduled to begin production at their new plant in Louisiana in January 2007. This new plant should add another $12 million to revenues annually.

2007 Outlook

NTRZ continues to engage in expansion projects in order to meet the overwhelming demand for its products. They plan to complete another plant in the U.S. which should add $32 million in revenue annually. They are also looking at the construction of a European plant with capacity for 40k tons of SRB, or revenues of at least $16 million (assuming no stage II production).

2008 Outlook

The company has stated their desire to maximize production capability in the U.S. with 7 plants. These plants will likely be completed in 2008, giving the company a potential for greater than $150 million (possibly $250) in revenue in 2008.

Beyond

As the U.S. and Europe only represent 1.8% of global rice production, there remain significant expansion opportunities in Asia, Latin America, and Africa. This would also be likely to have a beneficial impact on margins, both through lower production costs and decreased transportation costs relating to international food programs. Potential for revenues to exceed $1 billion by 2011.

Balance sheet

No debt, approximately $15 million in cash by end of FY2006.

Shares outstanding: at present 83 million, with a fully diluted share count of 150 million. Current float of 65 million.

Financing expansion

In the most recent CC, the CEO mentioned that the company was exploring the best ways to finance their rapid expansion in 2007 and beyond. In particular, he noted that the recent financial performance of the company had opened up new avenues of financing (ie debt financing). Traditionally, NTRZ has used equity dilution as a way of financing new projects. I believe that NTRZ will annouce in Q1 2007 that they will be financing further expansion through debt, and will likely get a revolving credit line of $25 to $50 million. Current cost of building a stage I plant is $3 million, and a stage II plant costs $7 million. Therefore, taking on $50 million in debt could allow the company to maximize capacity in the US (there is not enough rice production in the US for further expansion). Moreover, this investment will be repayed in less than a year.

Biggest risk going forward

As far as NTRZ goes, the risks are fairly limited because of the patents that protect NTRZ's process. However, there is a risk of further dilution in order to finance expansion. While this would not be necessarily bad, I believe that it is no longer necessary, because the company's balance sheet and operating performance should allow them access to debt financing.

Near term catalysts

I believe that there are several near to medium term catalysts operating here. In the near term, 2006 earnings and, more importantly, 2007 guidance could send the stock much higher. Additionally, an announcement that further expansion will be debt financed and non-dilutive would be well received on the street, and should boost shares.

Announcing the beginning of construction on a European plant, which may come in Q1 2007, would also help. Moreover, the expected move to either the AMEX or Nasdaq, which I anticipate happening in Q2 or Q3 of 2007, provides more momentum.

Over the longer term, the company has economic momentum due to rising corn and wheat costs. As the CEO said in the last CC, the cost of rice bran has not risen because of its wide availability and the fact that it is not generally usable (except by Nutracea). Because rice bran has superior nutrition qualities, demand should continue to rise as it becomes a more cost effective substitute for other grains in animal and human food.

My earnings estimates

First, some general comments. According to the most recent CC, gross margins should remain at or above current levels. I have used 50% as a basis for calculating gross margins going forward.

For 2007, the CEO has estimated that revenues should fall in the range of 50-70 million. I am going to create upper and lower bound estimates going forward through 2011, and then do some PEG analysis on NTRZ to determine an appropriate price. My lower estimate for 2008 is based on already planned capacity expansions. For 2009 and beyond, the estimates are based on the potential of the general market.

Based on the CEO's comments in the Q3 CC that SG&A expenses will probably increase by a few million in 2007, I have estimated them at 7.5 million, which represents a $2.5 million increase over 2006. This allows us to make a conservation estimate for net income. From 2008 onwards, I have assumed 12% annual growth in SG&A.

Finally, NTRZ has approximately $40 million in tax loss carry forward, so will not begin to pay taxes until 2008. In 2008, I have estimated that only $10 million in income will be taxable. For all taxable income, I estimated a sustained tax rate of 35%. I have assumed a 5% annual increase in share count. All estimates are in millions. Here is my lower bound for estimates:

kelly chart 1

Remember, this is a bare minimum lower bound estimate going forward. Now I will propose an upper bound. SG&A and shares outstanding have remained the same, so only revenues and tax expense has really changed. The upper bound is:

kelly chart 2

To come up with a fair value estimate for the stock I will use the midpoint of the lower and uppper bound, and then find an estimated combined annual growth rate. This will allow me to use PEG (price earnings to growth) analysis, and come up with a fair value for the stock.

Using the midpoint of the two bounds, I find that 2011 earnings are best estimated to be at $1.93 per share, and 2007 earnings at 27 cents per share. Using the CAGR formula, I can find an annual growth rate for the company. Here, I have used 1.93 as the end value, 0.27 as the beginning value, and 5 years as the time period. This yields a CAGR of 48%.

Now, using PEG analysis, I can calculated a fair value for the stock. Assuming that fair value is a PEG of 1, then at a 48 percent growth rate, the company has a fair value of $12.96 (48 x 0.27 = 12.96). Therefore, I believe the company is radically undervalued here.

Obviously, because these estimates are so far in the future, I don't expect the company to jump to $12 right away. It will have to continue to deliver solid results to reach these levels. However, as the company is currently able to sell all it can produce, I have faith that the company will continue to deliver solid growth, and eventually, the street will have to take notice. Even if the company fails to hit even the midpoint of my range, it still has significant room to move higher.

Near term valuation

It is worth noting that the company also appears cheap according to 2007 estimates. According to my lower bound, the company is only trading at 13.5 times 2007 earnings. If the company manages to reach to my upper bound earnings for 2007, it is trading at less than 8 times earnings. Both multiples are incredibly cheap for a company giving 100+% revenue growth year over year.

Summary

I believe NTRZ represents one of those rare opportunities to invest in a secular growth story while it is still on the ground floor. NTRZ has just become profitable, and still has not garnered the attention of the street. While there are a few institutions playing down here (as evidenced by the 100k+ share transactions), the stock remains underfollowed.

Going forward, it is clear that NTRZ is going to have a huge return on investment in building more capacity. Their Stage I plants cost only $3 million to construct, and contribute about $7.5 million in gross profit annually. The figure is even better for Stage II plants.

In addition, NTRZ is the only company in the world that has figured out the process behind making SRB. They have patents protecting their process, which forms a moat around the business. This helps with earnings visibility, and it means that we can count on NTRZ to deliver growth up to the point where demand and supply reach an equilibrium. As the CEO stated in the most recent conference call, it is clear that we are nowhere near that level at the moment.

All in all, I think that the odds weigh in my favor at current prices, and that NTRZ has the potential for huge growth in the next several years. I intend to make this one of my core holdings, at least until the value of this company is fully recognized.

Disclosure: Author is long NTRZ.

NTRZ 1-yr chart:

NTRZ

Source: NutraCea: A Radically Undervalued Smallcap Stock