Renewable Energy Group Q3 Earnings Forecast
- Background of Renewable Energy Group.
- Forecast for Q3 and Q4 earnings, and discuss some assumptions and results.
- Some commentary on REGI's convertible bonds.
- Some comments on U.S. biofuel policy.
Renewable Energy Group (NASDAQ: REGI) is the largest producer of biodiesel in the U.S., having grown through a series of acquisitions. It now owns over 500 million gallons of nameplate biodiesel production capacity.
Beyond production growth, REGI has made many investments over the years to diversify its production technologies, and therefore has the ability to process multiple feedstocks at many locations. This enables REGI to select the local feedstock for which it obtains the highest production margin. Biodiesel feedstock options include soybean oil, used cooking oil, corn oil and other animal and vegetable fats. Some byproduct feedstocks like used cooking oil and distillers corn oil obtain premium carbon credit values which can greatly improve production margins in low-carbon mandated markets like California.
As a co-founder a biodiesel company in 2006, I worked in the industry for a decade. Having initially raised capital through a friends and family round, I helped grow a niche biofuel company into a multi-million dollar enterprise operating throughout the East Coast. As a result, I probably know more about the biodiesel industry than I wish I did. The most notable thing about the industry is its absolute co-dependence upon government subsidies and government policy. As a result of this co-dependence, it is often difficult for a biodiesel producer to plan for the future, raise capital, and meet investor expectations. REGI deserves a lot of credit for weathering the myriad of policy storms that have surrounded the industry.
For example, the biodiesel Blender’s Tax Credit (“BTC”) is an on-again, off-again $1/gal credit that the blender of biodiesel can receive or use to offset other tax obligations. This credit was allowed to lapse at the beginning of 2012, 2014, 2015 and 2017. In each of these years, REGI and other biodiesel producers were forced to operate with near-zero production margins, with the hope and expectation that the BTC would be renewed retroactively. The graph below highlights in red the periods in which the BTC was not in effect. The non-highlighted years show when the BTC was current. The year 2017 has been unique for REGI in that its share price rose throughout the year while the BTC was not in force. This might suggest that investors are fully expecting the BTC to be installed retroactively, and that is my expectation as well.
The blue line in the graph above “Estimated SME Gross Margins,” is a generic calculation of the margins from making biodiesel from soybean oil ("SME" is soy methyl ester). The simple formula assumes a total $1.50/gal incentive premium for biodiesel (either from RINs and/or the BTC). As such, the formula is: NYMEX Diesel Price – 7.5 * soybean oil price + $1.50/gal.
Actual biodiesel production margins would be plant-specific and based upon many factors, including feedstock prices and regional incentives. In any case, the "estimated SME gross margin" line has correlation with REGI stock prices.
Forecast Earnings For Q3 and Q4 2017
For Q3 2017, I have forecast that REGI will beat its average analyst estimates for EPS, both on GAAP and an adjusted basis. There are some special items that might enable REGI GAAP earnings to significantly beat the analyst forecasts, which I discuss below.Discussion of Assumptions & Results
I have forecast GAAP earnings to be near $0.38 per share, which includes $0.44 per share in special items: 1) $9mm in non-cash earnings for REGI’s convertible debt adjustment, and 2) $7.8mm in proceeds from REGI’s business interruption claim from a Geismar outage. It is possible that REGI could rally on the release of earnings if they achieve my forecast targets.
REGI may not report a non-cash positive adjustment for its convertible debt obligation for Q3. In my understanding, since the Q3 ending stock price of $12.15 is lower than end of Q2 stock price of $12.95, the implied call option in the convertible bonds has reduced in value and therefore would reduce the book value of the obligation. I discuss the convertible bond in greater detail below.
Generic biodiesel production margins have improved throughout the year (depicted by the blue line in the graph above), and if margins remain at this level, then REGI could also beat the current 4th quarter earnings estimates.
For full-year 2017, REGI could end up with very bullish financial metrics if the BTC is renewed retroactively. With a retroactive BTC, REGI could finish 2017 with a trailing twelve month P/E ratio (adjusted) under 3.0.
While many investors will focus on the P/E ratio, I consider REGI to be more appropriately valued on the basis of its EBITDA and specifically its Enterprise Value / EBITDA ratio. I am forecasting REGI’s EV/EBITDA ratio to be near 6.0 for Q3 and – depending upon the outcome of the BTC – as low as 2.0 by the time Q4 earnings are reported.
REGI operates a life sciences R&D division which has been a drag on company earnings. REGI has at least one high profile partnership in this R&D operation with Exxon Mobil (XOM). While there certainly seems to be value in this research, in my view REGI could unlock value by selling this division and/or spinning it off. The Life Sciences division might obtain more value as a biotech research operation that is close to commercialization. Some of the synergies between REGI and Life Sciences could be monetized in a spin-off (e.g. byproducts of REGI plants could be contracted to the new company). REGI has said that it is nearing the end of its “strategic review” for this division.
Note on REGI Convertible Bonds
REGI issued convertible bonds in mid-2016 which have introduced several complications to the valuation of REGI shares. First, under REGI’s current shareholder agreements, the bond conversion liability must be marked to market at the end of each quarter, and this has introduced extreme variability in REGI earnings as these non-cash charges adjust from quarter to quarter. Perhaps institutional investors can see past this noise, but even the sell-side analysts who cover REGI stock continue to ask questions about it (as in the last earnings call).
Second, this convertible bond carries warrants that I have modeled as equivalent to a long-term call option with a $14/share strike price. While REGI has expressed its desire to settle these call options with cash if and when the warrants are exercised, there is dilution risk to current REGI shareholders particularly as the stock price increases towards and above $14/share. In my understanding, there are currently 14.1 million warrants in the convertible debt instrument and 38.7 million shares of REGI stock. The warrants if fully exercised therefore could represent 27% of the total shares. If REGI were to cash settle these warrants and the stock were at $14/share, I calculate the cash value of these warrants to be over $60 million.
The presence of these warrants make me less likely to renew a long position. REGI has made an announcement for a shareholder vote in December to enable the issuance of new shares under a potential bond conversion. The benefit of voting yes would be the elimination of earnings variability with respect to these bonds; nevertheless, the risk of equity dilution (and or significant cash outlay) would remain.
Additional Notes on Biodiesel Policy
Biodiesel policy and incentives are a multi-layered puzzle that might be difficult for the typical retail investor to follow. There is federal policy and incentives, individual state policies and incentives, and international trade rules and import tariffs. I will briefly touch on a few of these. Overall, my view is that the policy climate is in general favorable for biodiesel producers. Nevertheless, policy is always a wild card and it seems that Washington, DC politics are a fractious as ever.
Biodiesel firms unfortunately have to depend upon a fickle, unpopular, and apparently unprincipled U.S. legislature for a continual renewal of the BTC. In past years (including 2012, 2014 and 2015), the biodiesel blender’s credit was extended retroactively. While one might consider the current year retroactive extension of the BTC to be a fait accompli, it is indeed harrowing for biodiesel companies that so much of their firm value is dependent upon the stroke of a legislator’s pen. There has been a lot of talk about a production tax credit, which in theory makes more sense, but unfortunately politics doesn’t tend to deal in logic.
The BTC has historically been passed together along with literally hundreds of other federal tax credits in the “tax extender’s package” in an annual end-of-year lobbyist boondoggle. One of the best things for biodiesel policy is that it gets to “tag along” with so many other individual and industrial tax incentives. As a result, other lobbyists tend to fight indirectly for the BTC, and the tax extender can tends to get kicked down the road.
Separately, The EPA in September had issued guidance in that they would modify some pieces of the Renewable Fuel Standard (“RFS”) that governs the mandates and mechanisms for blending biofuels. The biofuel industry breathed a sigh of relief when in mid-October, the EPA back-tracked and indicated that they would not make big modifications to the RFS. The EPA is scheduled to issue its annual final rule for 2018 biofuel mandates by November 30 th. The RFS will likely continue to be a political football.
If the “swamp” in Washington is indeed being drained (don’t hold your breath), then I could envision a scenario where the BTC would eventually lapse, just as the ethanol blender’s credit lapsed several years ago. I believe that the biodiesel industry could and should survive without the BTC, particularly with clear RFS mandates and other sensible policies (such as imports of biodiesel not qualifying for RINs). Since the Commerce Department is planning to tax imported biofuels, this could eventually become a quid pro quo for biodiesel: “we give you U.S. market protection, but you lose your tax credit (maybe with a sunset period).” But, again, politics doesn’t deal well in logic.
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Disclaimer and Notes
All charts above were taken from Trading View unless otherwise indicated, and all tables were created by Viking Analytics unless otherwise indicated.
This article was written for information purposes, and is not a recommendation to buy or sell any securities. All my articles are subject to the disclaimer found here.
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