Why Cereplast Is a Short-Term Sell

| About: Cereplast, Inc. (CERPQ)

Cereplast (CERP) develops and makes resin that is used to produce biodegradable plastic that requires little to no petroleum, as opposed to conventional plastic. Naturally, biodegradable plastic is rising in use because as oil becomes scarce, alternatives become desirable. However, Cereplast has been losing money every quarter, and I see no signs of this abating for the next several years.

Cereplast has shown amazing revenue growth in the most recent few quarters, especially last quarter. Total revenue for Q1 2011 was $7.2 million, which beat the company's entire 2010 revenue of $6.3 million. Despite the amazing quarter, gross profit margin was only 9.7% in Q1 2011, as compared to 17.3% gross margin for the 2010 year.

In Q1 2011, over 65% of Cereplast's revenue came from sustainable resin. This large percentage of sustainable resin sales is unlikely to continue. Historically, sustainable resin only made up 30% of Cereplast's revenue and the other 70% of its revenue comes from compostable resin. If sustainable resin only represented 30% of sales in Q1, then total revenues would have only been $3.6 million, or half of what the company had.

The differences between the two types of resin are: Compostable resin is a 100% compostable substitute for petroleum plastics. It's used for single-use disposables and packaging like cups, straws, cutlery, and bags. Sustainable resin replaces most of the petroleum resin used in conventional plastics like plastic chairs, consumer goods and electronics, and construction.

Cereplast's CEO Frederic Scheer said in the Q1 2011 conference call:

If the price of oil goes to $120 or more, Cereplast's revenues from sustainable resin would shoot through the roof...

As long as oil is over the price of $100, then there is price parity between the price of sustainable bio-based plastic and traditional petroleum based plastic.

Because of this price parity, and the recent spurt in oil prices, the interest level of large plastic manufacturers in the U.S. has increased. On the other hand, if oil drops much below $100, like to the $90-$95 it's at today, this will greatly decrease Cereplast's sustainable resin business. Plastic manufacturers in the EU and U.S., especially in the U.S., are mainly motivated by profits and not so much by what's best for the environment.

Cereplast is building a second plant in Italy. Since 85% of its revenues come from the EU, this will reduce transportation costs and create efficiencies. Also, Italy just recently enacted a ban on petroleum based plastic bags, so Cereplast will contribute to its soon-to-be-booming biodegradable plastic bag production. From what I've researched, the biodegrable plastics business is the kind of business that's often "winner take all." Cereplast is quickly expanding to get a jump on the competition. However, it may have been too hasty because of its jump in revenues in the first quarter. The initial investment alone for the new plant will cost between €10 million to €12 million. Cereplast predicts the first stage of production for its Italy plant will happen in late 2012.

Cereplast had a $1.8 million net loss or $0.12 per share in Q1 2011 as compared to a $1.7 million net loss in Q1 2010 or $0.17 per share. Cereplast's CFO, Heather Sheehan, said that gross margins will gradually improve throughout the year and the company expects it to be over 20% by the end of the year 2011.

Management has said that in order to break even, Cereplast would have to have annual revenues of between $30 - $35 million. Its guidance for 2011 is between $28-$34 million. By my calculations, if Cereplast hits its guidance, it will still have a loss for the year.

For example, let's say that Cereplast's revenue for 2011 totals $34 million, the top of its range. That's another $27 million for the year. Now let's estimate its gross margin for the rest of the year averages 15%, then that makes a gross profit of $4 million for the last three quarters. Then we can assume SG&A and R&D expenses are conservatively about $2 million per quarter, so $4M - ($2M*3) equals a loss of $2 million for the remaining three quarters, for a total loss of $3.8 million for the year, and that doesn't even include interest expense.

The company just took on a large amount of convertible debt. At a 7% interest rate, it will cost Cereplast $12.5M x .07 = $875,000 for the next year.

Furthermore, I don't believe Cereplast will even reach its predicted revenues of $28-$34 million this year. I have spoken with Cereplast's investor relations and they give no specifics of how the company came to its guidance of $28-$34 million. They just said it is from "scenario probabilities." They don't say what percentage will be compostables and what will be sustainables. When I tried to get down to specifics, they didn't give me much. They ended up basically saying that people who invest in Cereplast don't do it because of specifics, they invest because they see the value and potential of bio-based plastics, and Cereplast is a pure play on this. So therefore, it's a good investment. I have witnessed this attitude in Cereplast's conference calls as well. Management keeps things simple for investors and dances around inquisitive questions. You get the impression that Cereplast's management have a lot of knowledge behind the scenes that they don't want to talk about for some reason. I guess it's because they don't want to confuse people.

Some 85% of Cereplast's revenues come from the EU. Right now, the so-called PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are at risk of going bankrupt. Paying off debt is much more important to those countries at the moment than doing what's best for the environment. A country like Italy, which is burdened with debt, can't afford to give Cereplast too many subsidies and tax breaks to fund its plant. This is not good because Cereplast expects government support for its plant. Even the EU countries doing well like Germany and France aren't going to want to spend too much tax dollars on environmental products because their economies are also affected by the PIIGS contagion. All those EU countries will have to make spending cuts, and usually "green" spending is among the first that gets cut.

In my opinion, the convertible loan terms are a bad deal for Cereplast shareholders, but a great deal for the lenders. The deal was $12.5 million in 7% senior convertible notes due June 1, 2016. The notes are convertible into common stock at 172 shares per $1000 of notes, which comes out to about $5.80 per share. If the company does well, and all the notes are converted, that would dilute the shares by 2.15 million shares, or 13.6% of the outstanding shares. Since the notes are senior, all the bondholders have to worry about is if Cereplast goes bankrupt, which probably won't happen because it will be able to issue more common stock. So basically the bondholders have no risk and are getting a nice 7% return. But if Cereplast manages to knock it out of the park, they don't get left out. The fact that the terms are so favorable to the bondholders means bankruptcy must be a material risk for the company. In general, bond purchasers are allowed access to more information than shareholders are. I can guarantee that they know a lot more about the interworkings of the company than shareholders are privy to.

There is also a good chance that Cereplast will do another share dilution in the next year or two, because it will need more funds for the Italy plant. If the company issues more debt, it will probably have to do so at too high of a rate, definitely above 7%. That's because the debt would be junior to this recent debt offering. Therefore, it would be more prudent to do a share offering.

Mr. Scheer said:

There seems to be a new era developing in India. As of April 2011, India has placed a ban on the sale and storage of plastic bags. The market for bioplastic in India has the potential to be five times that of Italy.

What does all this mean for the stock? It's hard to tell because we don't know how much competition Cereplast has in places like Italy, other countries in the EU, and India.

San Francisco has banned petro-based plastic bags since 2007, how much of that market has Cereplast taken? How much revenue does Cereplast get for each plastic bag sold that it helped to produce?

These are all questions that shareholders will not get to know, and can only guess.

If the company continues to gain market share and increase revenues to become profitable, I think this could be a good investment if your time horizon is 5-10 years. However, most investors don't want to wait that long. At this point, I'd start buying at around $3.00 a share. This is mainly because of all the uncertainty in this sector, and it's hard to measure Cereplast's present and future success.

Disclosure: I am short CERP.