Earnings Surprise On Deck For Pacific Ethanol?

| About: Pacific Ethanol, (PEIX)
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Summary

Fundamental catalysts remain as corn prices continue to drop and ethanol prices remain strong.

A vast reduction in debt load during the first quarter has led to reduced interest expense going forward.

The re-opening of its Madera ethanol plant will provide increased sales volumes over the first quarter.

Fair value adjustments to outstanding warrants led to a disappointing reported earnings number in Q1 for the company.

It's been quite a roller coaster ride for investors in Pacific Ethanol (NASDAQ:PEIX) over the last 14 months as the company narrowly avoided falling back into bankruptcy in 2013 only to enjoy the current operating environment presenting some of the best ethanol crush margins in recent history. Owners of the stock endured a 15:1 reverse split in May of 2013 and a low share price of $2.43 in November before the tides turned and the company was saved by a large drop in corn prices, as shown below.

US Corn Farm Price Received Chart

US Corn Farm Price Received data by YCharts

This trend of low input costs has continued into the second half of 2014 as corn futures have declined to prices not seen since the middle of 2010.

Corn Futures Chart from http://finviz.com/

In addition to the decreasing corn prices, ethanol futures have remained strong.

Ethanol Futures

According to page 20 of the most recent 10-Q, Pacific Ethanol was receiving a substantial premium to the CBOT price because of its location on the west coast:

Ethanol prices in the Western United States have typically been $0.20 per gallon higher than in the Midwest due to the freight costs of delivering ethanol from Midwest production facilities. From October 2013 through April 2014, however, ethanol prices in the Western United States have averaged $0.40 per gallon higher than ethanol prices in the Midwest due to rail logistics challenges and weather conditions which constrained the flow of ethanol and co-products from the Midwest to the markets in which we operate.

This combination of continued strength in ethanol prices coupled with lower corn prices should bode well for margins in the quarter.

Debt Reduction

Pacific has drastically reduced its outstanding debt over the last several quarters as margins have improved and the company has returned to positive cash flows. According to page 19 of the company's most recent investor presentation, the Pacific has reduced outstanding debt by over $50M since the end of 2013.

According to the company conference call following Q1 earnings, this should result in at least a $2.4M savings in the second quarter.

Interest expense was $4.4 million, compared to $3.5 million in the first quarter of 2013. The comparative increase is attributable to acceleration of unamortized debt discount associated with the prepayment of our senior unsecured notes.

Going forward, we expect our interest expense not to exceed $2 million a quarter based on current debt balances.

In addition to the previously mentioned $50M reduction, on June 10th the company announced an additional reduction of plant debt to a total of $20.5M outstanding. While this occurred late in the quarter and will have a negligible effect on the second quarter, it is expected to lower the annualized interest expense by about $2M and should be a boost to second half of 2014 earnings.

Production Boost

As if there wasn't enough good news already, the company will also be reporting increased production in the second quarter as its Madera facility was put back into production.

During the May 1 earnings call, President and CEO Neil Koehler stated:

Yesterday, we commenced production of ethanol at our Madera plant. We are very excited to achieve this important milestone of again operating all of our production facilities, which collectively have 200 million gallons of total annual production capacity. We are pleased with the significant progress we have made in the last few years to establish a solid business foundation from which to continue the company's growth.

We expect our Madera plant to reach full capacity within the next several weeks. This shift from a plant with a net cash burns and now on operating plant with an analyzed production capacity of 40 million gallons add significant value to our entire operation at current margin levels.

Assuming the Madera plant reached full production around the 3rd week of May, this re-opened facility should add roughly 4.6 million gallons in sales for the second quarter. This provides a roughly 11.5% increase in potential production gallons sold quarter over quarter.

Warrant Adjustments

The market seemed to be confused with non-cash adjustments in earnings due to the mark to market effect of outstanding warrants in the first quarter. This accounting charge was actually do a positive event for the company, an increasing share price. As the share price increased from $7.04 to $15.58 during the first quarter, the fair value of outstanding warrants increased significantly from $8.215M to $32.679M, as was detailed by Oil and Gas Investments Bulletin's article "Here's What Happens When You Only Read The Headline".

This accounting adjustment is further explained on page 20 of the 10-Q (highlights made by me):

From 2010 through 2013, we issued in various financing transactions warrants to purchase shares of our common stock. The warrants were initially recorded at their fair values, which are adjusted quarterly, generally resulting in non-cash expenses or income if the market price of our common stock increases or decreases, respectively, during the period. Due to the substantial increase in the market price of our common stock in the first quarter of 2014 and because the exercise prices of these warrants were, as of March 31, 2014, well below the market price of our common stock, the fair values of the warrants and the related non-cash expenses were significantly higher in the first quarter of 2014 than in prior quarterly periods, which resulted in an unusually large non-cash expense for the quarter. These fair value adjustments will continue in future periods until all of our warrants are exercised or expire. These adjustments will generally reduce our net income or increase our net loss if the market price of our common stock increases on a quarter over quarter basis. Conversely, the adjustments will generally increase our net income or reduce our net loss if the market price of our common stock declines on a quarter over quarter basis.

The "good" news for investors is that the share price of Pacific Ethanol decreased slightly during the quarter, from $15.58 to $15.29. This decreased share price will adjust down the fair values of the outstanding warrants and will result in a slight increase in reported net income for the quarter.

While these adjustments are non-cash and have no material impact to the company's operations, they did seem to have a big impact on the share price following the release of Q1 earnings, as the stock dropped on the news and fell by about 30% in the following week before rebounding and setting new 52 week highs going into tomorrow's earnings release.

Upcoming Earnings

The company is scheduled to release earnings after the close on July 30th. With very limited analyst coverage, Yahoo Finance is currently showing an estimate of $0.65 for the quarter, with Businessweek showing $0.83.

Below is the Financial Summary from the company's current investor presentation, showing $1.34 in adjusted net income for the first quarter.

PEIX Net Income

With the catalysts I've listed above, I don't believe the company will report a number any lower than this for the second quarter.

With falling corn prices and stable ethanol prices, lower interest expenses, 10%+ higher production, and the absence of non-cash adjustments due to changes in warrant valuations, I expect at least $1.50 per share in earnings for the quarter. With analyst expectations much lower, there could be a nice upside in shares on the earnings release.

Assuming similar margins in the second half of the year, the company could achieve annual earnings in the $5-$6 per share range. With the stock currently trading at $18.50, there appears to be the potential for significant upside. Applying a conservative 8 PE multiple for a cyclical company and using the mid-point of $5.50 could lead to an end of year share price of $44, providing the potential for a double over the next 6 months.

Conclusion

As I stated in the opening, investing in Pacific Ethanol is not for the faint of heart and its definitely not what I would consider a sleep-well-at-night stock. However, with the company recovering from near bankruptcy and now enjoying excellent market conditions, there appears to plenty of upside remaining in the stock. With the outlook for a bumper corn crop and instability in Europe and the Middle East keeping crude oil prices elevated, strong fundamentals should remain in the second half of the year.

Disclosure: The author is long PEIX, GPRE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a Civil Engineer by trade and am not a professional investment adviser or financial analyst. This article is not an endorsement for the stocks mentioned. Please perform your own due diligence before you decide to trade any securities or other products.