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Thesis: Vertex Energy (VTNR.OB) is priced inefficiently due to its micro-cap size, majority ownership stake held by insiders, relatively obscure listing on the pink sheets, and the complexity of its related party financial arrangements.

Catalyst: The upcoming purchase by VTNR of its related party upstream aggregator, related party transport partner, and downstream related party refining partner will eliminate the related party complexity discount and incrementally widen the universe of potential investors due to increased market cap. Further, the resulting vertically integrated re-refiner will be more attractive to potential third party acquirers. My expected value estimate is a 44% rise in stock price from recent levels due to value unlocked in this transaction.

The Business:

There is no value-add in describing the business myself so in the company's own words from the 2011 10-K filing, "We are an environmental services company that recycles industrial waste streams and off-specification commercial chemical products. We manage the transport, storage and delivery of the aggregated feedstock and product streams to end users. Our Company operates in two divisions.

Black Oil Division

Our Black Oil division… aggregates and sells used motor oil. We have a network of approximately 50 suppliers that collect used oil... We purchase the used oil from collectors and manage the logistics of transport, storage and delivery to our customers.

Refining and Marketing Division

Our Refining and Marketing division… aggregates used motor oil, petroleum distillates, transmix and other off-specification chemical products… We have toll-based processing agreements… in place with Cedar Marine Terminal and KMTEX, Ltd… to re-refine these feedstock streams… into various end products that we specify. Cedar Marine Terminal is a related party and uses a proprietary Thermal Chemical Extraction Process ("TCEP") technology to re-refine used oil into marine fuel cutterstock and a higher-value feedstock for further processing. KMTEX uses industry standard processing technologies to re-refine our feedstocks…We sell all of our re-refined products directly to end-customers or to processing facilities for further refinement."

Drivers and Risks of the Business:

VTNR is exposed to changes in the prices of the various petroleum products that it purchases and ultimately re-refines (through third parties) for later sale. The company does mitigate the risk of fluctuations in these prices by making contractual purchase and sale agreements that ensure specified minimum volumes from both upstream and downstream partners and allows the company to capture the spread between the contractually guaranteed prices. As not all purchases and sales are contractually guaranteed ahead of execution there does remain some risk in re-valuation of inventory due to market forces. This risk was realized in Q2 2012 when a rapid decline in commodity prices temporarily squeezed margins. Importantly, this squeeze was due to the rapid decline which caused carried inventory to devalue, but is generally not sensitive to the actual price level for oil, be it high or low. VTNR is also exposed to environmental liability risk given the hazardous materials in which they deal. While there are several larger players in this industry, the industry remains highly fragmented and no player has a dominant role in either aggregation of used oils or in re-refining volume. Basically, this is a simple business with consistent demand for its re-refined petroleum end products.

A Look at the Financials and Comparable Valuations:

VTNR is in good financial health with a clean balance sheet, no long-term debt, and approximately 22% of market cap in net cash. Revenues have grown rapidly since the 2008 formation of the current Vertex Energy; 2009 - 2010 growth of 48%, 2010 - 2011 growth of 90%. Margins are in the mid-single digits which is consistent with the industry. Data from Yahoo Finance.

The closest comparables of which I am aware are publicly traded Heritage-Crystal Clear (NASDAQ:HCCI) and privately held (but IPO plan announced) Safety-Kleen. Both are significantly larger than VTNR and also have additional business lines that are within the same broadly defined industry. While Safety-Kleen remains privately held it did file for IPO both in 2008 and again this year. While this year's filing does not offer clues to valuation, the 2008 filing put the market cap at approximately 930 mm with an enterprise value of approximately 1.2 Billion. Financials included in that 2008 filing put revenue at 1.23 Billion, EBITDA at roughly 132 mm, and Net Income at approximately 40 mm to 50 mm. In the comparison below I applied multiple compression to the 2008 Safety-Kleen IPO valuation in-line with broader market multiple compression experienced since that time.

As apparent in the table below, VTNR is cheap in both relative and absolute terms. While some discount is merited by its micro-cap size, this discount should be mitigated by its pristine balance sheet and rapid growth.

 

VTNR

Heritage Crystal Clear

Safety Kleen (at Proposed IPO Value)

Recent Price

$1.80

$19.28

N/A

P/E TTM

5.61

16.8 (normalized)

Btwn 18 and 23 in '08 - applying multiple compression - would now be btwn 11.5 and 15

EV/EBITDA TTM

5.13

7.5 on '13 est.

9.00

Cash Net of Debt Per Share

$0.39

$1.40

N/A

P/E TTM Excluding Net Cash

4.39

15.5

N/A

Return on Equity TTM

55%

14%

Est. 22% - 28%

Market Cap

19.23 mm

351 mm

934.5 mm

Enterprise Value

15.16 mm

322 mm

Approx. 1,200 mm

Revenue Growth 2 Yr Avg

69%

25%

Unknown

Table data from SEC filings linked above and Yahoo Finance.

So VTNR is Cheap, Let's Analyze the Catalyst:

VTNR conducts much of its business with related parties controlled by VTNR CEO Benjamin P. Cowart. These parties, which will be merged with VTNR upon completion of the recently announced acquisition agreement, are Vertex Recovery and Subsidiaries (which aggregates used oil products), CrossRoad Carriers (which transports oil products), and Cedar Marine Terminal (CMT, which re-refines the feedstock using VTNR's licensed proprietary process, and which acts as a storage point for onward marine or overland transport). All related parties are majority owned by VTNR CEO Cowart. Upon completion of the transaction VTNR will be a vertically integrated feedstock aggregator, transporter, re-refiner, and supplier of value-added petroleum products. In principle this sounds like a positive. Given the nature of the related party transaction though one must question whether this transaction is in the best interest of VTNR shareholders writ large or is most beneficial to insiders, who are the ultimate seller of these related party operations. Most central to that issue is the valuation of the purchase - what revenue and profit stream will VTNR realize from the purchase and at what price?

As noted in the most recent 8-K filing, buyer and seller (substantially the same entity for practical purposes) have agreed that the purchased entities (controlled by Mr. Cowart) will receive earn-out payments dependent upon reaching EBITDA targets in addition to the agreed upon purchase price of $14.8 million cash and assumed debt, plus 4,545,455 shares of restricted common stock, plus $1.7 million for real estate included. The EBITDA targets for earn out payments (@$2.23 million per year) are $10.75 million at year one, $12 million at year two, and $13.5 million at year three. Given that CEO Cowart engineered the deal and its terms, and stands to benefit from the earn-out targets, it seems likely he expects to reach these targets which would indicate an accretion of more than $7 mm of EBITDA in year one. As the related parties produced $6 mm of EBITDA in FY 2011, this target does not seem unreasonable given the growth trajectory of the Vertex group of companies (including the related parties) in the last several years. Furthermore, during the Q2 earnings conference call Mr. Cowert confirmed the acquisition target produced 3 mm in operating profit in the first half of 2012.

Under the terms of the deal VTNR will pay a total consideration of about $24.5 mm (at recent stock prices) to acquire a revenue stream which we can infer by the earn-out EBITDA targets is expected to add approximately 7 to 8 mm in EBITDA to the combined company earnings. At a total price of $24.5 mm VTNR is purchasing the related parties at approximately 3x EBITDA. This appears reasonable. While the price tag rises if earn-out targets are met, the deal appears to be a good use of capital as the EBITDA payback period will most likely be within 3 years. Further, it allows management to make near-term use of approximately $40 mm in existing Net Operating Loss carry-forwards.

Further, the acquisition documents indicate management intends to finance some or all of the non-stock portion of the purchase with debt. This appears to be a good decision given historically low borrowing rates and as an alternative to further diluting equity at these low multiple stock prices.

Financial Outcome of the Transaction:

For the purposes of analysis I assume VTNR finances 15 mm of the purchase price and achieves 10.75 mm in combined EBITDA at completion of year one, triggering the first earn-out payment. To be conservative I also assumed Net Operating Losses applied in near term years only match the earn-out payments which are $2.23m. The below analysis also accounts for the dilutive effect of partially funding the purchase with stock. One point that I do not account for in estimated financials is the acquisition of significant hard assets in the deal. Currently the company employs an asset light model and contracts for use of hard assets necessary in the course of its business. Upon closing of this transaction VTNR will likely have a greatly reduced Return on Equity, increased CAPEX requirements, but also significantly increased depreciation expense.

Pre and Post Combination Selected Financials

Pre-Merger VTNR

Post Merger VTNR Yr 1

Notes

EBITDA TTM

2.96 mm

10.75 mm (mgmt incentive target)

Management target is 10.75 mm for earn out payment

Net Income TTM

4.56 mm

10.75 mm (mgmt incentive target)

Assuming earn out of 2.23 mm and an equal amount of net operating loss

Diluted Share Count

14,204,958

18,750,413

 

Diluted EPS TTM

$0.321

$0.573

 

Cash Net of Debt

4.18 mm

N/A

 

Long-Term Debt

N/A

15 mm

 

Expected Value Analysis:

Using the above expected financial result of the transaction as a starting point I constructed four cases to account for the variety of potential outcomes. In calculating the expected investment value below I used the average of the P/E and EV/EBITDA method for each case.

Bad Case

Post Combination Valuation at 6mm EBITDA, 8mm Net Income due to NOLs.

Projected Stock Price

Projected % Return

P/E TTM of 4

$1.71

-5%

EV/EBITDA TTM of 3

$0.16

-91%

Average

$0.94

-48%

Resulting Market Valuations

Method

P/E

EV/EBITDA

Market Cap

32 mm

3 mm

Enterprise Value

47 mm

18 mm

For the bad case I assumed a decline of 33% from FY 2011 combined EBITDA. This outcome could reflect any number of operational and macro-environment headwinds.

Weak Case

Post Combination Valuation at Current VTNR Multiples

Projected Stock Price

Projected % Return

P/E TTM of 5.61

$3.22

66%

EV/EBITDA TTM of 5.13

$2.14

19%

Average

$2.68

49%

Resulting Market Valuations

Method

P/E

EV/EBITDA

Market Cap

60 mm

40 mm

Enterprise Value

75 mm

55 mm

This case assumes VTNR remains at current multiples which are historically low for VTNR.

Base Case

Post Combination Valuation at FY 2011 VTNR Multiples

Projected Stock Price

Projected % Return

P/E TTM of 6.5

$3.72

107%

EV/EBITDA TTM of 5.5

$2.35

31%

Average

$3.04

69%

Resulting Market Valuations

Method

P/E

EV/EBITDA

Market Cap

70 mm

44 mm

Enterprise Value

85 mm

59 mm

This case assumes VTNR equity returns to what were roughly average multiples for VTNR in FY 2011.

High Case

Post Combination Valuation at Safety Kleen Multiples

Projected Stock Price

Projected % Return

P/E TTM of 11 (low end)

$6.30

250%

EV/EBITDA TTM of 9

$4.36

142%

Average

$5.33

196%

Resulting Market Valuations

Method

P/E

EV/EBITDA

Market Cap

118 mm

82 mm

Enterprise Value

133 mm

97 mm

The high case assumes multiple expansion to match one of the largest players in the industry, Safety Kleen. While Safety Kleen should command a premium based on scale, VTNR's rapid growth may command a similar multiple. In-fact, a P/E of 11 in this case is less than half my guesstimate of medium term growth of 25% per year.

I calculated expected value based on 5% probability of a zero case which assumes VTNR goes to zero, 25% probability of the bad case, 30% probability of the weak case, 25% probability of the base case, and 15% probability of the best case. The resultant expected value is a stock price of $2.60 which equates to a 44% return from recent levels.

Risks/How The Deal Could Go Bad: There are a number of un-quantifiable risks to an investment in VTNR.

  • Merger Integration Risk - There is always the possibility that merging companies are unable to integrate cultures, processes, and infrastructure efficiently. This risk appears to be very minimal in the case of VTNR as some or all of the target companies already work from the same office space as VTNR and are majority owned by the VTNR CEO.
  • Lack of Corporate Governance - CEO Cowart has majority ownership and control of VTNR and all related parties. Shareholders have little recourse if he decides to act contrary to their interests. This is mitigated by the benefit to Mr. Cowart of a rising VTNR stock price given his large ownership stake.
  • Excessive Dilution/Poor Capital Allocation - VTNR has a history of granting options in fairly large volume to insiders. Below is a table representing fully diluted share count growth over time. The transaction currently at hand appears to be good capital allocation and justifiable dilution given the immediately accretive effect on EBITDA and Net Income and the reasonable valuation of the deal.

Fully Diluted Shares Outstanding

Post Combination

18,750,413

Current

14,204,958

Year End 2011

14,775,339

Year End 2010

14,128,864

Year End 2009

7,453,958

  • Customer Concentration - As of year end 2011 VTNR had one customer which accounted for 49% of Revenues and 44% of receivables. It is possible this "customer" was, in fact, a related party but I could not confirm that theory.

Bottom Line: VTNR is undervalued relative to its current operations and even more so relative to the operations of the soon to be combined group of related companies. Vertex expects the transaction to close in September. Given the minimal integration risk in this case I believe purchasing pre-transaction makes the most sense. The October 2012 earnings release will likely act as an additional catalyst in that the immediately beneficial nature of the transaction will be apparent.

Source: Vertex Energy: Event-Driven Price Appreciation Coming In September