A Mixed Outlook In The Green Plains, Inc. Q2 Earnings Report

Summary

• Green Plains, Inc. reported Q2 earnings this week that were substantially better than analysts expected despite resulting in a negative net income.
• The company's recently announced strategic shift toward more streamlined operations found some support as its cattle-feeding operations drove Q2 EBITDA.
• Not surprisingly, Green Plains announced a large expansion of its cattle-feeding operations just before the Q2 earnings report was released.
• Management was not nearly as upbeat about the ethanol export and domestic policy outlooks, however, and this sentiment was reflected in the Q2 data.
• The company's share price continues to be quite exposed to events in Washington D.C. to the detriment of its shareholders in recent months.

Investors wanting to know just how underwhelming operating conditions were for ethanol producers in Q2 need look no further than the most recent earnings report from Green Plains, Inc. (NASDAQ:GPRE). The ethanol and agricultural commodities producer managed to beat the analyst consensus by a substantial margin on robust YoY revenue growth en route to its strongest diluted EPS result in any quarter since Q4 2016. Its share price, which has been beaten down in recent months (see figure), staged a nice rally in response. Despite all of this, however, the EPS result still came in as a loss at -$0.02 in the quarter that is usually the strongest of the year for the broader ethanol sector.

GPRE data by YCharts

The company's share price began to struggle after management announced in the Q1 earnings report the start of a major strategic shift away from its circa-2015 diversification efforts in favor of a more streamlined focus on ethanol exports and high-protein feed ingredients. As I wrote at the time, management's decision was rational in the wake of last year's tax reform legislation and the stubborn presence of low ethanol operating margins, the latter of which has persisted despite the last year's large gasoline price rally. Investors were understandably disappointed, however, since the shift meant a reversal of the growth strategy that had contributed to its previous share price rally in 2016.

Any questions from investors about whether or not Green Plains intended to maintain its new export-and-protein strategy at a time when America's trade relations with many of the world's largest importers of U.S. ethanol have sharply deteriorated were answered shortly before the earnings report's release. On July 31, Green Plains announced that it was purchasing two cattle-feeding operations from Bartlett Cattle Company for approximately $16 million, excluding working capital (The working capital requirements will be financed via a $75 million increase to the company's senior secured revolving credit facility to $500 million). The acquisition has increased the company's feeding capacity by nearly 50% to 355,000 head.

While cattle prices remain below their 2014-15 highs, they are currently well above the average prices that prevailed in the two decades prior to 2014. Corn prices, on the other hand, are trading near decade lows. Viewed from the perspective of the S&P feeder cattle and corn indices, a substantial divergence has occurred over the last several years in favor of the former (see figure). Put another way, a low corn price and high cattle price benefits cattle-feeding operations in the same manner that a low corn price and high ethanol price benefits ethanol producers. More important from the perspective of Green Plains is the fact that it produces cattle feed from corn in the form of DDGS as an inherent part of the corn ethanol production process, so an expansion of its cattle-feeding operations is closely aligned with the ethanol business that it knows so well.

^SG4G data by YCharts

The Q2 earnings report contained early indications that the company's strategic shift is already paying off due to this dynamic. The food and ingredients segment, which handles the feed cattle operations, achieved a record Q2 EBITDA of $19 million, more than that of the ethanol production ($3.4 million) and agribusiness/energy services ($12.8 million) segments put together. While all of the segments recorded impressive YoY EBITDA increases on higher volumes, the fact that the food and ingredients segment was such an important contributor to the total EBITDA of $41.8 million even before the Bartlett acquisition does much to explain management's enthusiasm in the Q2 earnings call for the transaction, about which CEO and President Todd Becker had the following to say:

Over those last four years we've averaged over $60 a head on margins for all the cattle that we've fed and brought to market and we've consistently been able to achieve those type of numbers, some quarters are 25 and some quarters are 100, but in general we've always been able to achieve a return on our capital better than we see in the ethanol business. I would say the growth that we announced yesterday by acquiring the Bartlett Cattle Company which we're very excited about.

The Q2 earnings report was also cause for some investor concern, however. Management's April announcement that its strategic shift included a focus on ethanol exports could not have been timed worse, not that management could have know, given that the White House began escalating trade tensions with major ethanol importers such as China, Canada, and Mexico shortly afterward. While it is too early to specifically attribute a recent decline in U.S. ethanol exports (see figure) to rising trade tensions, the fact remains that exports are unlikely to be the pressure relief valve that U.S. producers would hope for at a time of low operating margins and weakening domestic demand. This is already being reflected in the Q2 data, with Green Plains reporting a 29 million gallon YoY increase to its individual export volume that fell well short of offsetting a 60 million gallon YoY decrease to its domestic ethanol sales volume. Mr. Becker made a point during the earnings call of showing just how damaging reduced exports would be by noting that many of America's most important trade partners will need to import hundreds of millions of gallons of ethanol annually apiece just to comply with their own internal blending mandates:

I mean basically there is a 10% mandate by 2020 [in China] and we don't think internally they can meet that and they will need to import U.S. gallons to do that. We were expecting 200 to 400 million potential gallons which would change the whole economics of this industry and we continue to tell the trade reps and the administration of what the impact of this trade war is on the ethanol industry not just agriculture. If we had that, it would be a very different market today. And we would be in a very different situation and discussion today. So, we need one of these markets to hit, you know whether it's Japan opening up in 2019, we believe it's 100 to 200 million gallon market in 2019, whether it's Mexico starting small, it's a longer-term gain, but Mexico potentially could start to open up.

The final negative to come out of the company's Q2 earnings was the lack of optimism from management regarding the outlook for the U.S. biofuels mandate. While President Donald Trump has made multiple declarations of his strong support for the mandate in the past, his administration has taken strong steps to weaken it and thereby reduce domestic demand for ethanol. Mr. Becker indicated that the refining sector, which has strongly lobbied the White House to weaken the mandate, has little incentive to negotiate with the ethanol lobby now that it has largely achieved its goals. Meanwhile, the White House's response to concern in the Corn Belt over trade tensions and the blending mandate has been to provide temporary relief spending. As Mr. Becker put it in the earnings call:

I think we've given up everything so far from the side of what the refineries have gotten and we really have gotten nothing in return, and that's a – that's is really where the rubber is going to meet the road, as the administration realizing that, if you really want to make a big pitch to agriculture during this trade war, [increased ethanol blending] is the answer and it's not necessarily the need to spend $12 billion on subsidies.

Of the three important factors for Green Plains, Inc. that I identified prior to the Q2 earnings report's release, then, only one - the strategic shift - was a substantial contributor to the most recent quarter's earnings given the food and ingredients segment's strong performance. The company's ethanol exports did grow strongly during the quarter but still fell well short of offsetting the impact of reduced domestic demand even as the trade outlook has worsened. Meanwhile, management's comments during the earnings call reflected the pessimism that has prevailed in the Corn Belt in recent months over the outlook for the U.S. biofuels mandate. While the company's operating conditions did improve in the most recent quarter compared to Q2 2017, this week's earnings report did little to assuage investors' concerns over its operating outlook.

Analyst’s Disclosure: I/we 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.

Comments

[ComputerBlue]

Gpre overpaid for shoddy plants instead of investing in their best plants for less $/gal. They now want to operate flat out with plants that have been under capitalized and aren’t as efficient as their competitors.

[FuriousA]

Agreed. It amazes me that this company has pulled 2 complete 180s in a matter of months.

#1 -- They've gone from being a debt-financed accumulator of "cheap" ethanol assets to a distressed seller of "undervalued" ethanol assets in order to reduce debt rapidly.

#2 -- They've gone from being the responsible swing producer to support ethanol market fundamentals to now running flat out almost regardless.

What's even more embarrassing is that the analysts seem confused. One doesn't understand the switch from ethanol asset accumulator to ethanol asset seller. Here is his clue: interest expense = $22m vs EBITDA = $42m.

Another analyst isn't sure why they are expanding cattle if they are trying to reduce debt? Well because what they are trying to do is reduce debt relative to EBITDA, not just reduce debt you simpleton. If they can increase EBITDA enough, then it could be worth increasing debt to do so. But what they've concluded (and recent history has proven them out) is that increasing debt for ethanol EBITDA is what has led them to the sunken place and it is cattle (and food) that will now lead them out.

In just the 3-4 years I have spent following this company, I've never followed one so vulnerable or exposed to government regulation. Without doing anything wrong (like an oil spill), this company's fundamental rationale for existing (RFS) has been called into question, its capital structure has been up-ended (thanks to tax reform's limitation on interest expense), and its increasingly critical export markets have been thrown into disarray (thanks to getting tough on trade).

So that's three strikes and counting. I'm sure there's a giant opportunity here, but I think I'll wait until I see what these coming liquidations look like. Based on what the company has signaled, it would seem that each dollar raised from selling ethanol assets should be plowed first into any EBITDA-rich and accretive cattle-feeding or other food expansions, and failing that, used to reduce term debt.

So that begs the question of who is buying ethanol assets in a big way right now? I don't feel like there is an opportunistic short-term play here for existing players, as much as a long-tern foot in the door for China or Brazil. It makes a lot of sense for them to be opportunistic buyers esp as their currencies keep weakening vs the USD, In addition, there hasn't been this much capacity up for sale in a long time. My guess is that China is about to buy a lot of market share.

[Tristan R. Brown]

Thanks for commenting.