Biofuels Companies Are Attractive M&A Targets; Syntroleum Attracts Multiple Suitors

| About: Syntroleum Corporation (SYNM)
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(Editor's Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

Earlier this week I wrote an article titled "Why Big Oil Should Embrace RFS2 and Biofuels." I detailed the thesis that the ironic outcome of the EPS's efforts to create a biofuels industry was likely going to drive "Big Oil" to buy up the independent biofuels companies in order to minimize the impact of the RFS2 regulations.

That being said, these regulations may have accidentally stumbled upon a way to make biofuels a reality and be funded by "Big Oil" in a relatively non-punitive and less-divisive and confrontational manner. Right now, as the regulations stand, "Big Oil" is forced to fund the development of their competition. A commercially viable solution, however, is for "Big Oil" to be the ones that benefit from these regulations. Nothing is stopping "Big Oil" from simply buying up these biofuels plants and paying themselves the cost of the RINs.

Well, it looks like it took less than a week for that theory to be proven valid. Just today Syntroleum (NASDAQ:SYNM), after a heart stopping trading halt, announced that they have had multiple, and I stress multiple, unsolicited and I stress unsolicited, inquiries about possible purchase of the firm and/or some of its assets.

On July 17, 2013, Syntroleum announced that its Board of Directors has retained Piper Jaffray & Co. for the purpose of evaluating strategic alternatives to enhance shareholder value. This action was prompted by the receipt of unsolicited offers from third parties with respect to a potential sale of (1) the company, (2) its assets, (3) its intellectual property or a combination thereof.

The fact that there have been multiple unsolicited offers during a time when SYNM is involved in a patent dispute with Neste (OTCPK:NTOIF) pretty much supports my belief that SYNM is significantly undervalued, and it is pretty easy to demonstrate why.

SYNM's main asset is a 50% ownership in a joint venture with Tyson (NYSE:TSN) called Dynamic Fuels. The situation is very similar to Valero's (NYSE:VLO) joint venture with Darling International (NYSE:DAR) called Diamond Diesel. The Dynamic Fuels plant is a 75 million gallon per year renewable diesel plant that uses animal fat and vegetable oil to make a fuel blend of 5% LPG, 7% Naphtha and 88% drop-in ultra low sulfur diesel or ULSD. SYNM does not get renewable identification numbers, or RINs, for LPG, but they do get RINs for their naphtha and ULSD. They get 1.7x a D5 RIN for their naphtha and 1.7x a D4 RIN for their ULSD. That means at full production SYNM's 50% ownership of Dynamic Fuels represents 37.5 million "blended" gallons and 56.1 million D4 RINs and 4.5 million D5 RINs.

75 0.5 37.5 Blend Gallons
37.5 0.88 33.0 ULSD Gallons
37.5 0.07 2.6 Naphtha Gallons
37.5 0.05 1.9 LPG Gallons
37.5 0.88 1.7 56.1 D4 RINs
37.5 0.07 1.7 4.5 D5 RINs
37.5 0.05 0 0.0
Total 60.6 RINs

Right now D4 RINs trade for $1.03 after trading above $1.40 earlier this week. Using current market prices, the SYNM RINs alone are worth over $60 million/year. SYNM has a capitalization of only $56 million. Less than 1 year's RIN production is worth more than the entire company at current RIN market prices. That is why I believe SYNM is grossly undervalued, especially considering that RINs are likely to go higher, not lower unless some regulatory changes are made.

56.1 1.03 57.8
4.5 1.025 4.6
Total 62.4

In addition to the RINs, SYNM also acts as a "blender" so it keeps the full $1 of the "blender's tax credit" for each gallon of ULSD it produces and a portion of the $1 tax credit for its naphtha. The tax credit for the ULSD alone is $33 million/year, or over 1/2 SYNM's capitalization. Additionally, the tax credit is renewed annually and may not exist permanently. SYNM would benefit from having the tax credit expire because the RINs would adjust accordingly, and they have a 1.7x to 1.5x advantage to biodiesel, so they would most likely see their margins increase by more than $1. That is because biodiesel makes up the bulk of the D4 RINs and therefore the markets price them off of biodiesel. Renewable diesel makes up a relatively small part of the RFS2 mandate. Because RIN prices are likely to increase if the tax credit fails to be re-instated at the end of 2013, the RIN "tax" to "Big Oil" will be even higher, providing an even greater incentive for "Big-Oil" to pay up for firms that produce RINs. Basically a "Big Oil" firm buying a RIN producing firm is simply good risk management, it is almost like buying insurance against a tax increase.

The other aspect is the operating margin. SYNM uses 7.6/lbs of yellow grease per "blended" gallon. Right now a "blended" gallon sells for about $2.81

% Blend Capture Price Wt Val
ULSD 0.88 0.98 $ 3.04 $ 2.62
Naphtha 0.07 0.96 $ 2.28 $ 0.15
LPG 0.05 0.79 $ 0.94 $ 0.04
Total $ 2.81

Yellow grease sells for $34.50/lb and delivery is about $0.04/lb, so the cost of feedstock is around $2.93/gal.

Feedstock 7.6 $ 0.345 $ 2.62
Transport 7.6 $ 0.040 $ 0.30
Total $ 2.93

SYNM also has operating expenses of $0.55/gal at full production, so excluding the RINs and tax credit, the SYNM process loses about $0.67/gal.

Blend $ 2.81
Feedstock $ 2.93
OPEX $ 0.55
Net Margin $ (0.67)

The tax credit for the 88% of the blend that is ULSD more than compensates for the $0.67/gal loss from operations, so SYNM is able to keep all the value of the RINs and a large part of the tax credit. From a profit center perspective, SYNM isn't in the renewable diesel business, it's in the RIN and tax credit business. The renewable diesel business is a money loser, but provides an ends to a means, that being the RINs. "Big Oil" however doesn't really care about the biodiesel, they want the RINs, and that is what makes SYNM valuable. If my theory is correct, SYNM won't be the only firm where "Big Oil" comes knocking, assuming of course that "Big Oil" is the one knocking on SYNM's door right now that triggered the press release.

SYNM produces a "drop-in" renewable diesel that, unlike ethanol, doesn't face the risk of a "blend-wall" situation. SYNM's ULSD is a market demand driven product, that "Big Oil" has no problem blending and/or selling. The benefit SYNM offers "Big Oil" over ethanol is that the fuel it produces can be sold at a premium to ethanol, doesn't have blending issues and provides more RINs per gallon. This is another reason I would expect "Big Oil" to pay up to purchase firms like SYNM. "Big Oil" can either build a refinery and produce an ULSD from petroleum, make a small margin and pay the RIN tax, or they can buy a firm like SYNM and produce an ULSD that also comes with a $1 tax credit and 1.7x D4 RINs attached. Unless I've overlooked something, the decision seems pretty cut and dry.

Additionally, SYNM claims that the Dynamic Fuels plant can run up to 120% of the boiler plate value, so if true, all those above numbers can be multiplied by 1.2. It is important to note however that SYNM has not been able to get the Dynamic Fuels plant to run at full capacity for an extended period of time. If they do sell the Dynamic Fuels plant, something that may take extensive legal work, contract revisions and board and shareholder approval, I would expect them to sell it contingent upon proving its ability to produce at full capacity in order to maximize its value. Waiting to sell until the settlement of the NTOIF.PK lawsuit would also likely greatly enhance its value. The fact that multiple firms are considering SYNM now, before the restart, implies to me they are either not concerned with the production difficulties and lawsuit, or they are trying to buy SYNM on the cheap. With the markets the way they are, I doubt the latter is the reasoning. I would expect that the potential buyers have examined the production issues and legal issues and have concluded that they are still interested.

As a shareholder I personally hope SYNM sells its share of Dynamic Fuels. I've always thought SYNM should be the McDonald's (NYSE:MCD) of renewable diesel, Coal-to-Liquids (CTL) and Gas-to-Liquids (GTL), where it doesn't own the plants, it franchises/licenses the technology, and lets others take the risks and make the capital expenditures. When SYNM started the Dynamic Fuels plant it was a small cap stock in the Russell 2000, now it is a micro-cap stock that just recently got added to the Russell Micro-cap index. The Dynamic Fuels venture has been a huge drain on the cash, focus and energy of SYNM, and has diverted it away from its Fischer-Tropsch foundation. Natural gas and coal are far more abundant and elastic than yellow grease, and offers far greater scalability and potential.

SYNM basically has no long-term debt, plenty of cash and sells just over book value, so the market is basically giving little or no value to the technology. From the above analysis, I doubt that that condition will persist. SYNM is a micro-cap stock with very little if any Wall Street coverage. After Friday's halt in trading, I doubt that SYNM is still a secret. I imagine Wall Street will use a variety of methods to value SYNM.

1) Discounted cash flow (DCF): SYNM can make $60 million per year just for their RINs. SYNM would basically pay for itself in a single year using a discount rate of 10%. Clearly using the DCF method SYNM is extremely undervalued unless the plant is only expected to last for 1 year.

2) Multiple of earnings (P/E): SYNM has 8.7 million shares outstanding. Using just the RINs again, $60/8.7=$6.90/share. SYNM only trades for $6.40/share. Apply a 10 P/E to just the RIN earnings and SYNM is a $69 stock. Clearly SYNM is deeply undervalued using the multiple of earnings approach.

3) EPA regulatory costs: "Big Oil" will simply analyze the cost per gallon to meet the EPA regulations, multiply that by 37.5 million, discount those costs back to the present, and that will be the value assigned to SYNM. The value of SYNM to "Big Oil" is simply equal to the discounted value of the regulatory benefits it generates. I would imagine this value would be close to the DCF calculation above.

4) Comparisons to like firms: Renewable Energy Group (NASDAQ:REGI) has a market capitalization of $431 million and around 255 million gallon capacity, so investors are paying $431/255=$1.69/gallon. Using that metric SYNM would have a market capitalization of 37.5x1.69=63. SYNM has 8.7 million shares outstanding so the price would be 63/8.7=$7.29/share. SYNM however produces a higher margin per gallon than REGI, and produces a superior product. SYNM also has a portfolio of Fischer-Tropsch patents, so unlike REGI, SYNM can easily venture into CTL and GTL. Because of those reasons, I would expect SYNM to sell at a premium to REGI. Additionally because REGI is totally focused on biodiesel, it is less diversified and has much greater political risk if changes are made to RFS2.

5) Replacement: Dynamic Fuels has cost about $200 to build and get running. It was originally expected to cost around $135 million. Dynamic Fuels however is built, and a single year of regulatory costs is substantial. Firms evaluating either buying SYNM or building their own plant would value SYNM based upon the regulatory costs incurred during the building of the new plant (which can take years), the learning curve costs involved and the cost of the actual plant. If a plant takes two years to build, the regulatory costs of waiting would be $60 million x 2 to the firm just for the RINs. SYNM has a current market cap of under 1 year's RIN production equivalent. Clearly from that perspective the firm would be much better buying SYNM, the payback starts immediately and it minimizes the opportunity costs. Time is money, and with RINs over $1 time is getting expensive.

6) Enterprise Value: To save time and also provide more details, I'll reference fellow Seeking Alpha author Thomas Hor's article Renewable Energy Group And Syntroleum: Alpha Generation And Intelligent Way To Hedge RIN Risk Of Independent Refiners. He puts an enterprise value for SYNM around $11.0/share. Note: this quote references an article written before SYNM's 10-1 reverse split, so the $1.10 is really $11.00.

Given the industry dynamics and improving unit economics, REGI and SYNM are undervalued. Applying industry comparable multiples to conservative production volumes and margins, REGI should be trading at $22/share, approximately 250% premium to today's share price of $8.87. Using a similar valuation method, SYNM should be trading at $1.10/share, approximately 280% premium to today's share price at $0.40/share.

SYNM however is most likely worth more than the above calculations would suggest because all but the enterprise value calculations are based upon just the RINs and/or renewable diesel production. SYNM has additional value in its Fischer-Tropsch patents. With the GTL and CTL economics where they are, the opportunities are enormous. If SYNM follows the licensing business model, the possibilities are literally limitless. SYNM could license its CTL technology to firms wanting to build a CTL plant, SYNM could license its GTL technology to firms wanting to build a GTL plant and it can license its "Synfining" technology to firms like REGI, allowing it to boost its margin per gallon for a nominal fee. Unlike the Dynamic Fuels plant model where SYNM sank a disproportionate amount of its capital into a single plant in an attempt to take a big slice out of a small pie, the licensing model would allow it to take a smaller slice out of a much larger pie with essentially no capital at risk.

One fly in the ointment of all this analysis is that SYNM has outstanding warrants, options and restricted stock with a weighted exercise price of $29.96. Many of those are held or have been exercised by TSN, so TSN also has an incentive for SYNM to get top dollar for anything they do.

Weighted average exercise prices of options, warrants and restricted stock excluded $29.96

Options, warrants and restricted stock excluded (in thousands) 1,937

Tyson agreed under the terms of the Warrant Agreement to provide credit support for the entire $100 million Bond issue for which we issued Tyson warrants, which they have exercised, to purchase 800,000 shares of our common stock for $0.10 per share. This debt funding is in addition to the equity contributions provided by each member.

Unfortunately SYNM didn't name the suitors, nor did it mention who it recently signed a memorandum of understanding with regarding a possible GTL joint venture, but the usual suspects would be "Big Oil," Natural Gas and Coal firms, REGI or even TSN. VLO is already pursuing this business model, and the cost benefit calculation for REGI would be pretty simple. The benefit of superior products and margins would be weighed against the costs of upgrading its existing multi-feedstock plants. REGI has a history of buying up struggling biodiesel firms, and a purchase of SYNM would allow it to diversity into the renewable diesel market. It would also likely enhance its value if "Big Oil" comes knocking at its door, which I expect they eventually will.

One long-shot would be Rentech (NYSEMKT:RTK). The largest increases in the RFS2 going forward in both percentage and volume terms is cellulosic biofuels. While RTK has recently put its alternative energy efforts on hold, it still owns the technology, and more importantly, it has recently purchased wood processing facilities, and signed contracts with utilities to provide them wood pellets to fuel their plants.

The contract establishes a strategic relationship with Drax, which plans to invest approximately U.S. $1 billion through 2017 to transform the largest coal-fired power station in the U.K. into an electricity generator fuelled predominantly by sustainable biomass. With the conversion of three of six generating units from coal to biomass, Drax is expected to demand approximately seven million metric tons of pellets per year by 2017.

Wood is a feedstock for cellulosic biofuels and RTK has technology to produce syngas from it, as well as the technology to refine syngas into fuel. Converting the wood to cellulosic renewable diesel would allow RTK to capture some of the cellulosic RINs. Both SYNM and RTK utilize the Fischer-Tropsch processes, so there would be synergies in that area. RTK also has the capital and has been seeking ways to increase its return on its cash holdings. A cellulosic renewable diesel plant based upon Fischer-Tropsch technology may be something it is considering, and SYNM already has the experience with plant construction, operations and knowledge gathered from a very difficult learning curve.

All this analysis of course assumes that any contract or agreement can be amended. TSN would need to be involved in any negotiations regarding Dynamic Fuels, but TSN may also be one of the Suitors. TSN is on the hook for a $100 million "Go-Zone" loan, and it may simply want to be in total charge. TSN could buy SYNM's 1/2 of the Dynamic Fuels plant and then license SYNM's "Synfining" technology. REGI is most likely the largest buyer of yellow grease in the biofuels industry, so the market that SYNM and TSN hoped to create with Dynamic Fuels was created organically by the market with the emergence of multiple feedstock biodiesel firms. TSN benefits mostly from higher feedstock prices, so that goal has already been accomplished while the Dynamic Fuels plant has sat idle.

SYNM's higher margin product would allow for higher feedstock prices based upon the theory of highest and best use. TSN's ownership of Dynamic Fuels and license agreement with SYNM would allow TSN to approach REGI and other biodiesel plants about upgrading existing plants from biodiesel to renewable diesel. As more and more firms upgrade to renewable diesel, the higher margins would likely result in yellow grease being bid up to reflect the greater profit potential. This would be a win win win situation for SYNM, TSN and the entire biodiesel industry. SYNM's license would apply to far more gallons than just the 75 million theoretically able to be produced by Dynamic Fuels, TSN has a mechanism to drive feedstock prices higher in a market and anti-trust friendly manner and REGI and other biodiesel firms would be able to produce a higher margin, higher quality drop-in renewable diesel.

Another potential suitor could be NTOIF.PK. If you can't beat them, buy them. NTOIF.PK and SYNM have been embroiled in patent disputes, and recent findings have worked against NTOIF.PK. SYNM also has a lawsuit pending against NTOIF.PK in Singapore. NTOIF.PK buying SYNM would put an end to all the wasteful legal battles, and give NTOIF.PK rapid access to the US market.

Brainstorming and discussing this issue with others, I was able to compile some talking points:

1) If this company is being sold, it will be sold at a premium to the price before the sell-off

2) The recent sell-off is unjustified and most likely due to rumors of the plant not starting.

3) The rumors were right. But they were right for the wrong reason (problems with the plant). A likely and plausible argument is that the plant is in standby because of the pending sale.

The key message is that SYNM appears to be ready and able to run if it chooses, but because of the recent positive developments it is taking its time and weighing its options. The fact that SYNM has attracted multiple suitors without solicitation is evidence that at least some firms may consider SYNM as undervalued and/or of having valuable technology and services. With margins where they currently are, a simple spreadsheet calculation will validate that view.

I've always thought SYNM was an undiscovered gem, a diamond in the rough so to speak ... if they can get the Dynamic Fuels plant to run. Now with multiple suitors, that belief seems to be vindicated. With the recent regulatory turmoil in the RIN market, SYNM should be negotiating from a position of strength. With RIN prices near a peak, the Dynamic Fuels plant should be a peak value. Additionally SYNM has installed the new catalyst at the Dynamic Fuels plant, and all systems appear go if they choose to restart the plant. SYNM seems to be in the ideal negotiating position, and should be in no hurry to sign any deal unless it can get top dollar. With net margins estimated to be over $1.00/gal well above break-even and a break-even production level estimated to be below 20%, the risks of restart are greatly reduced. SYNM can take its time negotiating and attempt to attract additional suitors while it waits.

In conclusion, as I pointed out in the article "Why Big Oil Should Embrace RFS2 and Biofuels" I would expect all independent biofuels companies to become targets, the regulatory cost are simply too high making the economics so compelling. In addition to SYNM, I would expect "Big Oil" to show interest in REGI, KiOR (NASDAQ:KIOR), Biox (OTC:BXIOF), RTK and ethanol companies like Pacific Ethanol (NASDAQ:PEIX). I would imagine that any company that can help reduce the regulatory burden would be a possible target. If a company can save $1/gal in regulatory expenses by spending less than that on biofuels capacity, I would expect them to do so. That creates a sellers' market for biofuels, and because of that SYNM should be negotiating from a position of strength. SYNM's technology, higher quality product and higher margins should make her a dance-hall favorite, and keep her dance card full. Considering the music has just started and SYNM has multiple requests already, by the end of the night, she should have plenty of offers to consider. As the old song goes, "my mama told me you better shop around... don't try to get yourself a bargain son, don't be sold on the very first one, pretty girls come a dime a dozen."

Disclosure: I am long SYNM. 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.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.