FutureFuel Looks Undervalued, But Mind The Volatility

| About: FutureFuel Corp. (FF)
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For most of the past decade, investors have been badly burned by energy-tech and bio-whatever. In many cases, investors bought into bad business models that were built more on hype than sound economic principles. Yet, throughout that time, ethanol and biodiesel use has continued to grow and the U.S. government has continued to encourage (and in many cases, mandate) increased use of these fuels.

That leaves the very small FutureFuel (NYSE:FF) as an interesting, albeit very risky, stock to consider. Not only does FutureFuel have a real biodiesel plant up and running, but it uses a different feedstock than most if its competitors. FutureFuel also has a specialty chemical business that not only offsets some of the volatility of the biodiesel business, but also offers growth prospects in its own right.

Biodiesel With A Little Twist

As of the U.S. Energy Information Administration's latest report, there are 2.1 billion gallons of biodiesel capacity in the U.S., up just 4% since the start of 2010. Over that same time period, production has grown from 27 million gallons a month to about 87 million gallons. So it's not as though biodiesel is a brand new thing on the U.S. fuel scene.

How FutureFuel approaches biodiesel is a bit different, though. While about three-quarters of biodiesel producers (including Archer Daniels Midland (NYSE:ADM)) use low free fatty acid (LFFA) feedstocks like soybean oil, FutureFuel has focused on using high free fatty acid (HFFA) feedstocks like white grease and yellow grease.

While LFFA-based biodiesel is usually easier to produce, it's also generally more expensive to produce given the price of soybean oil (even if many LFFA producers use soybean oil that is unfit for human use). At a minimum, I'd argue this makes FutureFuel a less risky play than names like Amyris (NASDAQ:AMRS), Gevo (NASDAQ:GEVO), and Solazyme (SZYM) where there is still execution risk to the production processes.

While sourcing rendered animal fats does put FutureFuel theoretically into some competition with Darling (NYSE:DAR) (which has its own high free fatty acid biodiesel project with Valero (NYSE:VLO)), there's plenty to go around, and FutureFuel is pretty flexible in terms of the feedstock(s) it can use. Soybean oil prices have eased off some from their summer 2012 highs, but still remain elevated on a historical level, making HFFA-based biodiesel still relatively attractive.

The Rundown On RINs

The U.S. government has a pretty dismal record of intervening (or, depending upon your point of view, interfering) in markets. Almost despite itself, though, the government hit on a decent idea with biofuels in the renewable identification number (RIN) concept.

As part of the 2005 Energy Policy Act, the EPA can set annual quotas compelling the use of a certain amount of biofuels blended into fuels for passenger and commercial vehicles. To ensure compliance, the EPA came with the concept of RINs, basically serial numbers that attach to batches of biofuel and can be used to show compliance with the quotas.

RINs can also be "detached" and sold separately from batches of biofuel, allowing companies to basically buy compliance with fuel blending rules, but also offsetting the higher cost of biofuels. As Forbes referred to it, RINs are in some ways a "self-adjusting" subsidy that responds to production (as seen in the fact that ethanol RINs go for a few pennies per gallon, while biodiesel RINs have gone for a dollar or more per gallon).

Unfortunately, there have been multiple cases of fraud and the EPA fines can be so punishingly high (and with a 7-year window to prosecute) that blenders increasingly won't touch RINs from smaller producers. That has hammered the RIN market (with prices down almost two-thirds since 2011) and introduced quite a bit of uncertainty - not at all helpful for a smaller producer like FutureFuel.

Specialty Chemicals Holds Potential

While biodiesel may be the sizzle for the FutureFuel story, specialty chemicals are still the steak. Specialty chemicals produce close to half of the company's revenue, and not only does this business produce considerably higher gross margins, but those margins are also more reliable.

A sizable percentage of FutureFuel's chemicals revenue (and overall corporate revenue) comes from selling a bleach activator to Procter & Gamble (NYSE:PG) - it's the little blue flecks in powdered Tide detergent. The company also produces an herbicide product for Arysta. Unfortunately, both of these businesses are likely to be in decline - the bleach activator sales hurt by ongoing consumer swapping away from powdered detergents and the herbicide business hurt by foreign competition and FutureFuel's desire to exit this low-margin business.

At the same time, FutureFuel has been seeing double-digit growth outside of these two major customers, and growing this business holds meaningful revenue and margin potential. As companies as varied as PPG (NYSE:PPG), Albemarle (NYSE:ALB), and Ashland (NYSE:ASH) have come to appreciate, special chemicals can be lucrative and adding more customers/products should enable FutureFuel to better leverage its existing infrastructure (to say nothing of the incremental revenue).

At a minimum, I would think that the company could explore adding to its glycerin refining capabilities; glycerin is a byproduct of the biodiesel refining process and highly-refined glycerin is used in food, pharmaceuticals, and many other higher-value applications.

Plenty Of Risks Remain

While both the biodiesel and specialty chemicals businesses at FutureFuel hold promise, there's quite a bit of risk here as well.

For starters, investors need only look at companies like Valero or the refining segments of Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) to see how volatile even "regular" refining businesses can be, nevermind the carnage of past failures in biofuels production. With the volatility in the RIN market and the agricultural markets, it's easy to imagine that FutureFuel will always be facing highly variable prices and input costs.

While specialty chemicals may be less volatile, that's only a relative basis. While good specialty chemical businesses can produce consistent revenue growth and solid returns on capital, plenty see pronounced cyclical volatility and struggle to deliver even high single-digit returns on capital.

Then there are some company-specific risks to consider. The CEO of FutureFuel has a background in investment banking and asset management, while the chairman's background is more in midstream petroleum transportation rather than refining. Likewise, the COO of the company has a background in packaging distribution, not refining. None of this is to say that the management team can't run the company successfully (and they own a considerable amount of stock), but it's a risk nonetheless.

It's also worth noting that there's minimal institutional support and involvement here. Yahoo! Finance lists just 22% institutional ownership, and only one sell-side analyst follows the stock. Likewise, the holder's list isn't really a who's who at this point - well-regarded Royce owns a little bit, but if FutureFuel is a gem, it's largely a hidden gem today.

Last and not least, capital allocation may be a risk as well. The company announced a special dividend of $1.20 per share, or about $50 million. Given the opportunities for consolidation in biodiesel refining and specialty chemicals, I have to ask if that money wouldn't have been better used in M&A than returned to shareholders as a one-time dividend. At a minimum, I find it hard to believe that a company with less than $400 million in revenue and $100 million in EBITDA can no longer find value-additive investment opportunities for surplus capital.

The Bottom Line

Offsetting these risks are what I see to be significant business opportunities and an undemanding valuation.

Refining is a business with razor-thin margins that tends to reward scale; with about 75% of biodiesel refinery capacity made up of players with less than 20 million gallons of capacity (FutureFuel is near 45 million gallons in capacity), I think an industry shake-out could be on the way that should be supportive of prices and margins down the road. What's more, while I expect to see significant soybean plantings next year, I believe turning food into fuel is not tenable for the long term, and I think FutureFuel's use of "waste fat" is not a trivial point. Likewise, while I see near-term risks of volume declines in specialty chemicals, I think this is a very "buildable" business over time.

Cash flow modeling for a company like FutureFuel is tricky almost to the point of futility, given that companies like this rarely produce numbers that fit a smooth curve. Even so, if FutureFuel can grow revenue at a compound rate of about 5% and produce a free cash flow margin of 9% or so (very high for a refiner, but not unreasonable for specialty chemicals), cash flow could grow by about 6% a year and the stock would be worth about $15. Drop the free cash flow margin to 6% and the target falls to $11.

Backing up the free cash flow target, an EBITDA analysis suggests that the shares are undervalued. Using a blended forward EV/EBTIDA multiple of 6.5x (specialty chemicals often trade at multiples of 6x to 8x, while refiners can go from 5x to 6x) and an estimate of $70 million for 2013, fair value would be around $14.50.

Given that FutureFuel has been free cash flow positive for every year but one so far as a public company and has ample avenues for growth, I'm favorably inclined towards the stock at this price. Making matters better, it's still under-followed and presumably off many investors' radar screens, and that could offer some tailwinds if the company continues to execute its long-term plan.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.