Renewable Energy Group In Q2: Happy Days Are Here Again
- Biomass-based diesel producer Renewable Energy Group saw its share price set a new all-time high after it posted strong Q2 earnings.
- While the earnings beat the consensus estimates on both lines, they were especially notable for the fact that they were based on a great operating environment rather than policy support.
- The Q2 report showed that Renewable Energy Group is very capable of generating solid profits even without the blender's tax credit and high Renewable Identification Number prices.
- Management's outlook suggests that the Q2 result will not be a one-time event despite a lack of support from the White House for the U.S. biofuels mandate.
Biomass-based diesel producer Renewable Energy Group (REGI) reported Q2 earnings this week that beat the consensus estimates on both lines. More importantly, the company managed to notch one of its strongest quarterly performances of the last several years during a quarter in which the biodiesel sector received relatively little federal policy support. It has taken longer than the company's investors would have liked, and the going has been anything but smooth, but Renewable Energy Group's Q2 earnings showed that it is able to break out of the rut that it has been in since late 2013. Not surprisingly, investors have responded to the news by sending its share price above $20 for the first time ever (see figure). Last month, I wrote that the Q2 report would do much to show whether Renewable Energy Group's "recent performance is a sign of sustained strength rather than a temporary fluke." The answer now appears to be the former.
The Q2 earnings report can be a bit confusing at first glance due to the retroactive extension of the biodiesel blender's credit [BTC] by Congress earlier this year for 2017. In other words, in early 2018, Congress retroactively provided the refundable tax credit of $1/gallon to biomass-based diesel producers, but only for fuel produced during the previous year. This has greatly skewed Renewable Energy Group's recent earnings reports, first because it was recorded on the Q1 2018 earnings and second because the YoY comparisons for Q2 2018 now show its impact in the prior-year quarter. When reading the Q2 earnings report, it is important to remember that the 2017 vs. 2018 comparison is not on a like basis, as the tax credit is not reflected in the 2018 numbers but could appear in them in subsequent earnings reports. The comparison will change again if Congress retroactively extends the tax credit for 2018, as it has done in the last several years.
Ignoring the tax credit's impact, then, Renewable Energy Group experienced a much stronger operating environment across the board in Q2 2018 than in either Q1 2018 or Q2 2017. Its sales volume increased by 7.3% YoY to 171,943 gallons despite having fewer renewable diesel (as opposed to biodiesel, although both fuels fall under the umbrella of "biomass-based diesel") gallons to sell due to earlier planned downtime at its Geismar renewable diesel facility. Q2 production of biomass-based diesel rose by 5.9% over the same period to 124.4 million gallons as the company's previous acquisitions came into play.
The production growth came at an ideal time for the company. Diesel fuel prices have rallied strongly since last August (see figure) and, while the price of biomass-based diesel has not kept pace, Renewable Energy Group's average sales price in Q2 improved by 8.7% YoY to $3.11/gallon. Taken together, these improvements contributed to an 8.4% YoY increase to consolidated revenue that in turn caused adjusted EBITDA to more than double (excluding the impact of the tax credit) over the same period to $42.3 million. (This result declined by 47% YoY if the tax credit is included but, as mentioned earlier, such a comparison does not reflect the tax credit's lengthy history of being retroactively extended by Congress.) Adjusted EPS for the quarter rose to $0.56, beating the consensus by $0.10.
The revenue result would have been higher but for the aforementioned reduction in government benefits. Renewable Identification Number [RIN] prices under the U.S. biofuels mandate have fallen sharply in 2018 as the White House has taken steps to weaken the mandate, and Renewable Energy Group's RIN sales fell by 61% YoY to $26.2 million as a result. Revenue from biomass-based diesel sales rose by 20% YoY in Q2, providing investors with an indication of what would be possible under a more robust blending mandate. The effect of the weaker mandate was partially offset by the company's sale of biomass-based diesel under the West Coast's Low Carbon Fuel Standard, in which credit values reached $185/metric ton of CO2 during the most recent quarter.
Management's comments during the subsequent earnings call were as upbeat about the company's operating outlook as it was about the Q2 performance. Last month, I highlighted commodity prices as one of the most important factors to watch for in the Q2 earnings report. Management attributed its better-than-expected earnings in part to the presence of lower soybean prices during the quarter that in turn pushed other lipids prices down. While soybean prices rebounded a bit in July (see figure), President and CEO Randy Howard indicated during the earnings call that Renewable Energy Group's use of flexible lipid feedstocks will help it keep its feedstock costs down over the rest of the year even if soybean prices continue to rally:
In addition, you know so far this year and we are projecting you know certainly later in the fall that cattle slaughter rates are at record levels. I mean they're just all a lot more feedstock than that we thought coming into this year and we and the market are benefiting from that.
I also highlighted the policy outlook as being a second factor that investors should watch for in the Q2 earnings. While the lower RIN price has worked against Renewable Energy Group, Mr. Howard said that he expected the blender's tax credit to be reinstated for 2018 by a lame-duck Congress after November's midterm elections, an event for which a strong precedent exists. Notably, though, management provided a strong EBITDA forecast for the rest of the year based on conditions at the end of July (i.e., under the current policy environment). Diesel fuel consumption in the U.S. continues to be strong and Mr. Howard projected fuel sales of up to 190 million gallons in Q3 alone (compared to 172 million gallons in Q2). This would, in turn, result in an EBITDA in Q3 of up to $50 million without any additional policy support. The retroactive extension of the tax credit would push this number as high as $110 million, with any rebound to RIN prices coming on top of that result. The worst that management is forecasting for Q3, then, is a repeat of Q2's excellent performance.
There is one note of caution for investors to be aware of. Renewable Energy Group's forward EV/EBITDA ratio was trading well above its trailing ratio even before the post-earnings share price rally (see figure). While the current investor enthusiasm is easily justified by the Q2 results, Renewable Energy Group operates in a very volatile sector and its share price has historically made large swings in both directions as a result. I would not recommend that investors initiate long positions in the company without a margin of safety in the form of undervalued shares, if only because its share price reflects its current operating environment. Buying now would be to bet on the White House strengthening the biofuels mandate and/or Congress retroactively extending the blender's tax credit for 2018 and, while arguments can be made in favor of both developments occurring, they are also highly uncertain.
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