The Short Case For BioFuel Energy

| About: BioFuel Energy (BIOF)
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Executive Summary:

Corn ethanol producer BioFuel Energy's share price is down only 6% YTD despite its failure to raise sufficient cash to settle a default by one of its operating subsidiaries. The company was granted a grace period by its lenders but the deadline passed on July 30 without any resolution. BioFuel Energy is now attempting to raise sufficient cash via the sale of one or both of its two corn ethanol facilities. While the company's balance sheet at the end of Q2 2013 reports a Price/Book ratio of 0.5, recent sale prices of used corn ethanol facilities suggest that the company actually has negative shareholder equity in the event that both facilities are sold. The company's share price has up to 78% downside following resolution of the sale(s), which will likely occur this year.

BioFuel Energy Corporation (NASDAQ:BIOF) owns and operates two corn ethanol facilities with a combined production capacity of 230 million gallons per year [MGY]. Both facilities are located in the Midwest, one in Wood River, Nebraska and one in Fairmont, Minnesota. The company has significantly underperformed most of its peers as well as the S&P 500 YTD (see figure).

BIOF Chart

BIOF data by YCharts

From a different perspective, however, it is impressive that BioFuel Energy's share price has held up as well as it has. In September 2012, when the Midwest drought was at its peak, the company idled its Minnesota plant; this was followed by large layoffs at the facility in February 2013 and the announcement that it would remain idled until at least the following autumn. This decision could not have come at a worse time, as the corn ethanol crush spread (which reflects the difference between ethanol's market price and the cost of corn feedstock) turned positive for the first time since May 2012 less than a month later (see figure).

Source: CARD (2013)

Worse news came in late March when BioFuel Energy announced that it was exploring "strategic alternatives" related to a default by one of its operating subsidiaries. The subsidiary's arrears totaled $8.2 million at the end of 2012, which was nearly equal to the company's total cash on hand at the time. This amount grew to $17.6 million by the end of Q2 2013. Furthermore, the company's current ratio had fallen from 2.35 at the beginning of 2012 to 0.2 a year later, greatly restricting its ability to repay its subsidiary's debt. Instead its lenders granted it a grace period until July 30, 2013, to negotiate the sale of one or both of its corn ethanol facilities.

Any hopes that BioFuel Energy would be able to take advantage of an improving corn ethanol production environment to either generate or raise enough cash to settle its subsidiary's default were eliminated during the interim when the company reported its Q1 and Q2 2013 earnings. While the idling of its Minnesota facility has staunched some of its losses, causing it to report much-improved YoY net income, EPS, and EBITDA numbers in Q2 2013 despite lower YoY revenue (see table), the company continued to bleed cash with -$8.7 million in net income in the first half of 2013 alone. Worse, these losses occurred even as its peers began to rapidly recover from the effects of the drought. The company's book value has reflected these challenges, declining by 50% since the start of 2012 and 20% YTD. Despite all of this, however, BioFuel Energy's share price has only lost 6% since the beginning of the year.

BioFuel Energy financials

Q2 2013 Q1 2013 Q4 2012 Q3 2012 Q2 2012
Revenue ($MM) 91.0 89.0 84.9 116.1 122.8
Gross Profit ($MM) -2.3 -1.9 -7.8 -8.0 -8.3
Net Income ($MM) -4.1 -4.6 -10.0 -9.8 -10.6
Diluted EPS ($) -0.77 -0.87 -1.89 -1.88 -2.05
EBITDA ($MM) -5.4 3.6 -2.5 -10.1 -10.7

Source: Morningstar

The comeback story argument

Investors love a good comeback story and, based on its own history, BioFuel Energy appears to have many of the makings of one. This is not the company's first trip to the brink, as it found itself in a similar situation at the end of 2008. The combination of raging public controversy over corn ethanol production and the fallout from the 2008 financial crisis conspired to drive the company's share price down more than 97% from its post-IPO peak in just over a year. Its balance sheet rapidly deteriorated and its current ratio plunged from 1.6 to 0.18 in a single quarter. It reported a cash reserve of only $6.1 million at the end of 2009, or less than half of its reserve at the end of Q2 2013.

BioFuel Energy managed to stay afloat long enough for operating conditions to recover, however, and by the end of 2011 it had managed to triple its cash reserve and increase its current ratio to 2.4. Those investors who purchased at the bottom were handsomely rewarded as the company's share price increased by more than 1000% in less than a year (see figure). What was perhaps most impressive about this price increase is that the company's income statement wasn't necessarily impressive at the time. While it didn't lose as much money in 2009 as it had in 2008, it still reported a net income of -$13.6 million and an EPS of -$11.4 for the year. It did report a positive EBITDA of $23.3 million as well, but the company was hardly profitable.

BIOF Current Ratio Chart

BIOF Current Ratio data by YCharts

One reason that BioFuel Energy's share price has held up so well in 2013 could be that investors are drawing a number of parallels between its current condition and that of 2008-09. The parallels are certainly there to make. In both instances, the company was battered by negative operating conditions and, given its small size, its balance sheet incurred significant damage as a result. Investors who were long its shares witnessed large paper losses on their holdings as well. The corn ethanol industry is very volatile given its reliance on a combination of weather, energy prices, and government policy, however, and those investors who added shares in late 2008 and early 2009 when the company's prospects were at their worst did incredibly well. Given that the company is in a slightly better position now with regard to cash reserves, current ratio, and EBITDA than it was at the end of 2008, what's to prevent investors from experiencing yet another major gain?

This time is different

The above parallels aside, a number of factors will prevent BioFuel Energy from staging another comeback. The first factor is its incredibly poor financial position. While the company's cash position is larger now than it was at the end of 2008, its total current assets are actually 18% lower than they were then. This challenge is further compounded by the fact that the company's reported current liabilities at the end of Q2 2013 were nearly 5x the number reported at the end of 2008, which is why the company's current ratio has fallen so low. So while the company has more cash now than it did back then, its ability to service its current liabilities is much worse than it was then.

Second, BioFuel Energy needs to sell at least one of its ethanol facilities very quickly if it has any hope of moving forward as a going concern. To do so at a time when the crush spread is more favorable than it has been in more than a year is to greatly limit its ability to generate future profits. At the end of 2008, BioFuel Energy had just finished constructing 230 MGY in corn ethanol production capacity, and it utilized this capacity to drive net income and EBITDA in 2009. Now, however, it is in a position that will effectively prevent it from repeating that feat. While revenue from one facility is better than no revenue at all, any facility sale will greatly limit the company's ability to generate more than a fraction of its past net income in the future.

Third, the above assumption that BioFuel Energy will be able to retain one of its two facilities is by no means assured. In 2008, corn ethanol production was still several billion gallons shy of both the blend wall (as the point at which the U.S. transportation fuel network can't handle additional ethanol is known) and its ultimate volumetric mandate under the revised Renewable Fuel Standard [RFS2]. Today the blend wall is just around the corner due to lower-than-expected gasoline consumption and the Environmental Protection Agency [EPA] may reduce the 2014 and 2015 corn ethanol mandates to reflect this limit. Even if it doesn't, corn ethanol producers are unlikely to benefit much from the mandate in the future as any subsidies under it will need to be passed to consumers to incentivize consumption of higher ethanol blends. This unique situation has put significant pressure on the prices of corn ethanol facilities. Recent sales of Midwestern corn ethanol facilities have ranged from $0.32/gal of installed capacity to $0.03/gal (see table).

Facility State Sale price ($MM) Capacity [MGY] Sales price ($/gal capacity)
Utica Energy WI 16 50 0.32
NEDAK NE 15 50 0.30
New Energy IN 2.5 100 0.03
Purified Renewable MN 2 25 0.08

While BioFuel Energy's facilities are quite large and less than a decade old, it is entirely possible that it will need to sell both to raise the necessary funds to settle its subsidiary's default. In addition to the 100 MGY facility sold in Indiana for a mere $2.5 million, a "used new" 110 MGY facility in Pennsylvania was recently sold for only $9.4 million. BioFuel Energy will need to receive at least $0.15/gal installed capacity for a 115 MGY facility (i.e., an amount equal to the amount of its subsidiary's arrears at the end of Q2) if it is to retain even one of its facilities. As the above table shows, this is possible but by no means likely. The company reported as much in its Q2 earnings statement, saying that:

The Company also announced that the grace period provided under its previously disclosed Lender Agreement, dated April 11, 2013, expired on July 30, 2013. The Company has received indications of interest from several parties with respect to one or both of the Company's ethanol plants, but no third party has offered to acquire one or both of the plants on terms that would result in meaningful residual proceeds accruing to the Company.

Finally, BioFuel Energy will need to make drastic and rapid improvements to its profit margin if it is to survive for more than a few months with a single facility. Its profit margins have remained negative even as those of its peers have moved into positive territory on the back of a much-improved corn ethanol crush spread (see figure). It is extremely unlikely that the crush spread will ever return to its pre-2008 highs, and the inability by a producer to achieve a positive profit margin in today's environment effectively dooms it to an eventual bankruptcy in light of the shrinking market size created by the blend wall.

BIOF Profit Margin Quarterly Chart

BIOF Profit Margin Quarterly data by YCharts

The bankruptcy option

Given BioFuel Energy's precarious position, this raises the question of how investors would fare under a bankruptcy. The company is currently trading at a mere 0.5 price/book ratio, raising the prospect of a positive return for new investors even in the event of a bankruptcy or buyout. I do not consider the stated P/B ratio to be accurate, however, due to the difference between the value of the company's two corn ethanol facilities on its balance sheet and that of similar facilities on the market. At the end of Q2 2013, the company reported owning gross PP&E valued at $327 million, or $197.3 million after accumulated depreciation. While it doesn't report how this value is distributed, the company reported a gross PP&E of $314.6 million at the end of 2008, the same year in which it reported spending a combined $319 million on the construction of its Minnesota and Nebraska facilities. This suggests that the vast majority of the company's current net PP&E is attributed to the two facilities.

Based on the aforementioned corn ethanol facility sales, a sale price for BioFuel Energy in terms of installed capacity of $0.32/gal (the upper end of those reported in the table above) would translate into a total sale price of $74 million for the company's combined capacity of 230 MGY. This is much lower than the company's reported net PP&E at the end of Q2 2013 of $197.3 million. Reducing the company's total assets of $239.7 million by the difference between its net PP&E and the above combined sale price:

  • $197.3 million net PP&E - $74 million facilities sales = $123.3 million PP&E difference

reduces the revised total assets figure to $116.4 million:

  • $239.7 million reported total assets - $123.3 million PP&E difference = $116.4 million revised total assets

This revised total assets figure is less than the company's short-term debt of $170.7 million, let alone its total liabilities of $191.8 million. A bankruptcy sale at a price similar to that seen for other Midwestern corn ethanol facilities would therefore result in negative shareholder equity. Looked at another way, the company would need to receive a sale price of $0.56/gal installed capacity for its 230 MGY in combined capacity, or $128.8 million, just to raise enough cash to equal its short-term debt:

  • $197.3 million net PP&E - $128.8 million facilities sales = $68.5 million PP&E difference
  • $239.7 million reported total assets - $68.5 million PP&E difference = $171.2 million revised total assets

While a company with a stronger balance sheet could hold out in hopes of waiting for an improved corn ethanol outlook, however, unlikely that may be, BioFuel Energy does not have that luxury; indeed, its grace period expired three weeks ago. BioFuel Energy would need to receive a much higher price for its two facilities in a bankruptcy sale than have been seen in other recent bankruptcy sales if its shareholders are to see positive equity in such an event.

The short case

In light of these figures, it is unlikely that BioFuel Energy's share price will remain at its current levels for very long. The report of a sale price for both of the company's facilities that is substantially below their respective net PP&E values would likely prove to be the catalyst for a much lower share price. Just how low would depend on the actual sale price and volume, but the aforementioned $0.32/gal installed capacity figure would result in negative shareholder equity and, at most, a share price of zero. The sale of both facilities for anything less than $0.56/gal installed capacity would result in negative shareholder equity and, by eliminating the company as a going concern, also result in a share price of zero. In reality, the share price is unlikely to fall all of the way but we can estimate a price target based on the company's brush with illiquidity at the end of 2008, when it held only $12.3 million in cash. In that year, its P/B ratio fell to 0.1. The same P/B ratio today would require the company's book value (and share price) to fall by 78%:

  • $47.9 million book value at end of Q2 2013 x 0.1 P/B ratio = $4.8 million market capitalization
  • $4.8 million new market capitalization = 78% of current market capitalization of $21.7 million

I expect the share price to begin declining as soon as the sale price for the two facilities is announced. This could occur in a matter of weeks given that the deadline for BioFuel Energy's grace period has already been reached. Alternatively, should a sale not occur and the company prove unable to raise the necessary cash through alternative means, then I would expect the share price to begin declining when this failure is announced and the inevitable bankruptcy rumors begin.

Caveats

As outlined above, there is a high probability that BioFuel Energy investors would be wiped out in the event of a near-term bankruptcy. With that said, the company is a micro-cap stock with a market capitalization of $22 million. As such, it presents a number of risks that investors initiating a short position in the company should be aware of.

First, micro-cap stock prices tend to be prone to more volatility than their larger brethren. BioFuel Energy, for example, has a beta of 3.14. The company's share price has experienced multiple movements of +/- 50% in a matter of days in the last year alone.

Second, $22 million is mere pocket change for large contrarian investors and companies. While I do not consider BioFuel Energy to be a buyout target due to the nature of the RFS2 at present (blenders represent a far more attractive opportunity due to their ability to generate tradable Renewable Identification Numbers under the RFS2), I cannot entirely discount the possibility that a larger investor won't take advantage of BioFuel Energy's low P/B ratio to expand its corn ethanol capacity.

An example of these risks was illustrated by BioFuel Energy itself in 2010, when David Einhorn's hedge fund Greenlight Capital built up a 40% stake in the company. BioFuel Energy's share price jumped 35% on the day that the stake was announced and ultimately more than doubled during the three weeks surrounding the announcement. Such volatility is unique to micro-caps such as BioFuel Energy.

BioFuel Energy could also experience a short squeeze in the future. The company currently has a short ratio of 10.5, which is several times higher than the basic materials sector. Short squeezes are particularly likely to occur in companies such as BioFuel Energy with low market capitalizations and high volatility.

Finally, the fact that a sale of BioFuel Energy's two corn ethanol facilities at recent used facility prices would result in negative shareholder equity does not necessarily mean that the company's share price will revert to zero. The facts that BioFuel Energy's subsidiary is in technical default and the company's grace period from its lenders has expired make it very likely that it will either be forced to sell one or both of its facilities at current prices or enter bankruptcy. However, a higher-than-expected facility sale price or the granting of another bridge loan from a third party would extend the company's life expectancy. There is a slim possibility in both scenarios that the company would survive long enough to strengthen its balance sheet, although I consider even this to be unlikely given the strong headwinds facing the corn ethanol industry as a whole.

Conclusion

BioFuel Energy's future existence as a going concern requires it to both rapidly find a seller for at least one of its two corn ethanol facilities and earn a very high price on the transaction. At present, it is three weeks overdue on the original grace period extended by its lenders to make such a sale and, based on recent transactions for used corn ethanol facilities in the Midwest, it is unlikely to make enough cash from a sale to continue as a going concern. Indeed, the company would likely have negative shareholder equity were the facilities sold at current used facility prices. The company represents an asymmetrical short opportunity due to the immediacy of its cash requirement and the current low value of corn ethanol facilities on the market. In conclusion, I refer to BioFuel Energy's most recent 10Q filing:

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern; however, the default of our Operating Subsidiaries under the Senior Debt Facility, the cessation of operations at the Fairmont ethanol facility, and our limited liquidity all raise substantial doubt about the Company's ability to do so.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in BIOF over 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.

Additional disclosure: All figures used in this article are based on public documents. I am not an investment professional and investors should consult with their financial analyst or broker prior to acting upon any information contained in this article. Finally, nothing in this article should be construed as legal advice in any way.