Exactly like my reactions after 2018 third quarter results for Vertex Energy (VTNR), I was first disappointed, then, ultimately, optimistic, when the company reported 2018 fourth quarter and full-year results on March 6, 2019.
Vertex Energy is a UMO (used motor oil) re-refiner which means it takes UMO as feedstock to produce "viable commodity products". The United States generates approximately 1.3 billion gallons of used motor oil annually. Approximately half is burned by industrial companies as a fuel source. Of the remaining half, it's estimated Americans improperly dispose of 200 million gallons. The remainder is re-refined. Vertex acquires its feedstock by buying used motor oil from third-party suppliers and by self-collecting through its own local street collections. Domestically, it is the second largest processor and re-refiner of used motor oil with an annual processing capacity of over 115 million gallons.
In the summer of 2014, Vertex Energy's shares were trading over $10 - at the same time, crude oil prices were more than $100 per barrel. In the next nine months, crude oil prices would be cut in half. For Vertex, it was an inopportune time for crude oil prices to fall as dramatically as they did. The company owed over $40 million and faced a maturity date of less than one year for approximately 25% or $10 million. To its credit, Vertex persevered and successfully cleaned up its balance sheet throughout 2015 and 2016. In 2017, just as it tried to focus on becoming profitable, Hurricanes Harvey and Irma hit. There was a significant impact on Vertex' business operations. Feedstock supply was limited from third parties and the price for #6 fuel oil, Vertex Energy's feedstock, was priced at a premium. With higher operating costs, profitability eluded the company. It expected things to finally look up in 2018.
Revenue in 2018 did increase 24% to $180.7 million, compared to $145.5 million in 2017. In part, the revenue improvement is a reflection of the 25% capacity increase since 2016 at Vertex' Louisiana (Marrero) and Ohio (Heartland) facilities. Prices on Vertex' finished products also increased, on average by 30% year-over-year.
But, in the fourth quarter of 2018, oil prices suddenly dropped again. Vertex was not isolated from the impact and profitability eluded it once again.
For the year, the gross profit margin improved from 15% in 2017 to 16% in 2018. Vertex generated a 38% increase in gross profit from $21.3 million in 2017 to $29.4 million in 2018. And, still, there was a net loss of $8 million for the year which equated to a $0.23 loss per share. This was the first point in the fourth quarter report that sparked initial disappointment.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) tallied $8 million in 2018. The increase in cash flow allowed Vertex Energy to pay down $1 million of the long-term debt it had rebuilt in the year. When 2017 ended, the company's long-term debt obligation was $15.15 million. It increased to $16.7 million by September 30, 2018. At year-end 2018, Vertex Energy owed $15.7 million.
Throughout the last half of 2018, maturity dates were a frustrating focal point. Initially, management had expected to conclude a private capital transaction to fund unfinished projects by summer's end. The capital was also intended to repay a portion against existing obligations.
Further, we do expect to recover some of the capital invested in the projects to this point back into our balance sheet." (emphasis added)
During the early November 2018 earnings call, Vertex still seemed confident in securing the funding.
We currently anticipate entering into a transaction by the end of 2018 in order to raise capital for our Heartland and Myrtle Grove facilities."
Vertex Energy has several maturity dates looming in 2020. It is required to redeem its Series B Preferred Stock and Series B1 Preferred Stock on June 24, 2020. The liquidation and redemption value of these stocks is now $27.2 million. As well, both its Encina Business Credit agreement and revolving credit agreement mature in February 2020. As of December 31, 2018, Vertex owed $19.1 on the two agreements - $15.3 million under the Encina agreement and $3.8 million under the revolving agreement.
Although 2019 is well underway, the transaction has still not closed. This is the second point which led to initial disappointment when first perusing the fourth quarter report. But, management's tone on the subject has definitely changed.
We think that time is on our side as far as trying to close something on terms. Our financials are improving every day. And, so, we are well within our comfort level and timing for that capital. We will bring some capital in. But, we're being very thoughtful about the terms and how that gets done. And, so, I can say we're pretty close. I think it's more in our hands at the moment as to the timing of how we execute that."
Looking Forward Into 2019
Besides portraying a renewed control over its recapitalization plans, Vertex Energy's enthusiasm about 2019, in general, was palpable. The 2018 fourth quarter reset was temporary. My initial disappointments quickly turned to revived optimism.
Recently we have seen pricing and spreads reset going into the new year and we anticipate 2019 financial results to improve over 2018."
The company shared its Heartland refinery was "pretty much in a sold-out position for 2019". Regarding its base oil business, it shared that first quarter business was already "way ahead of projections". In August 2016, Vertex Energy announced it had assumed "marketing, sales, and logistical duties" in the United States for Group III base oils for Dutch firm Penthol. Group III base oils are purer. Their consumption is expected to grow at a faster pace than the consumption of Group I base oils. The automotive industry is increasing its demand for Group III, or higher-purity, base oils. New car models and new engines are expected to drive demand for full synthetic oils. Though not actually synthetics, Group III base oils are substitutes for current synthetics in formulations requiring high oxidation resistance, wide temperature range viscometrics, and low volatility. The formulations must be approved individually. As approvals are received, Vertex Energy anticipates 10% growth year-over-year for at least the next decade. The sales of Group III base oils should also generate higher margins.
Vertex also estimated the impact from IMO 2020 had "already started". The IMO 2020 Rule refers to the International Maritime Organization's global regulation to be enacted on January 1, 2020. It updates the limit for sulphur content in marine fuel. The limit is to be lowered from 3.5% mass/mass (m/m) to 0.5%. The intent of the regulation is to lower sulphur oxide emissions in order to protect the environment and human health. It's been calculated that just 15 of the largest ships in the world emit more sulphur oxide than the total of all of the world's cars. Many industry analysts estimated the impact of IMO 2020 would be akin to the financial crisis of 2008.
IMO 2020 will be one of the most disruptive changes to ever affect the refining and shipping industries with a global impact in excess of $1 trillion over five years and implications for all sectors in the energy space as well as many other industries."
The only hint of hesitancy the company expressed about the new year was related to its street collection volume growth. Street collection is the segment of Vertex Energy's business where it gathers used motor oil from local generators. In 2015, Vertex Energy was paying generators $1.00 per gallon for UMO. Vertex led the industry migration from a pay-for-collection model to a charge-for-collection model. The industry now vacillates between the two models depending on market conditions. In either model, though, the profit margin on collected volume far exceeds the profit margin on purchased UMO from third-party suppliers. In 2018, Vertex collected 30 million gallons of the 103 million gallons of UMO and other by-product feedstock it re-refined. This compares to collections of approximately 20 million gallons in 2016 and approximately 26 million gallons in 2017.
In February 2016, Vertex Energy even advertised its hunt for small collections businesses. Its ability to acquire additional collection routes and expand existing routes organically is a fundamental game changer. But, Vertex wasn't willing to forecast a collections target for 2019 - yet. It, instead, pointed to its track record.
"We have had a sustainable growth rate, compounded annual growth rate since 2013 of 23%, so we anticipate continuing that course because we've got control over our operations and we're able to build out at that pace."
Capital for additional acquisitions should not be an obstacle. Regarding cash flow, the $8 million in 2018 was just a start.
We anticipate 2019 to be a marked improvement over 2018. And, we see a lot of tailwind with IMO going into 2020."
In the first two months of 2019, Vertex is already experiencing upside. Yet, it projects a continuing climb.
The back half should speak louder than the front half."
On December 21, 2018, the H.R. 1733 bill was signed into law. The goal of this legislation is to:
increase responsible collection of used oil,
inform the public of sustainable reuse options for used oil, and
develop a coordinated Federal strategy to promote sustainable reuse of used motor oil both at the Federal level as well as among the general public.
The last and original federal study on the benefits of re-refining was conducted in 2006. Many technological advances have been made since then. Shareholders of Vertex can expect the company to remain committed to maintaining a foothold at the forefront of its industry. The company should reap the benefits of this renewed domestic focus.
We believe that increasing consumer and industrial awareness of the environmental impact of improperly disposing used oil may drive additional market growth."
According to the Environmental Protection Agency, re-refining used oil now takes only about one-third the energy of refining crude oil to lubricant quality. Also, it only takes one gallon of used oil, compared to 42 gallons of crude oil, to produce 2-½ quarts of new, high-quality lubricating oil.
The growing demand for higher-purity oils will ultimately result in higher-quality used motor oil. This means the feedstock to Vertex Energy will continue to improve as higher-purity oils are adopted. It should further broaden the gap between producing higher-purity base oils from UMO as compared to production from crude oil.
A common valuation method for oil and gas refiners is the price per flowing barrel or the enterprise value to daily production ratio (EV/BOE/D). Converting Vertex' production capacity of 115 million gallons to a daily production rate equates to 7,000 barrels of oil equivalent per day. Leading refiners are valued at an EV/BOE/D ratio above 17,500. Thus, if Vertex Energy were valued similarly, its enterprise value would near $122.5 million, approximately 25% greater than its current EV of $98 million.
In such a valuation model, there are two primary factors able to influence Vertex Energy's result - the production capacity and the debt obligations. And, indeed, when Vertex elects to conclude its private capital transaction, not only should its debt obligations decrease, funding for its unfinished projects will be available. These projects will further increase production capacity.
Founder and CEO, Mr. Ben Cowart elaborated on the projects in an interview with the Houston Business Journal in early 2018. In summary, Vertex Energy needed approximately $87 million to fund three unfinished projects at Myrtle Grove and Houston in Texas and at Columbus, Ohio.
The Columbus project at the Heartland facility would focus on infrastructure to produce higher-purity base oil products.
Myrtle Grove is currently idled and costing Vertex approximately $1 million annually in carrying costs. The site includes over 40 acres of leased land. Re-refining infrastructure includes a process area, loading and unloading areas, a lab and a control room as well as offices and maintenance buildings. Vertex owns and leases refining equipment located at the site. The lease costs approximately $650,000 annually and does not expire until May 2022. Of the $87 million need identified, Myrtle Grove was estimated to need more than half.
However, it is probably unlikely Vertex Energy, nor any re-refiner, will ever be valued akin to a "leading" refiner. It is pertinent to recognize higher-purity base oils and IMO 2020-compliant marine fuel should command higher margins. As the majority of its production shifts to these products, it could be argued Vertex Energy shouldn't be valued simply as a refiner anyway.
Rather, it would be more reasonable if the market valued Vertex Energy based on product sales and the associated growth potential. Considering the current price-to-sales ratio is just 0.30, it is easy to see the possibility for share price appreciation. And, yet, both steps, re-refining its balance sheet (pun intended) and securing its growth potential, continue to hinge on the private capital funding.
When Vertex Energy reported third quarter results in November, the market was in turmoil. The status of the private capital transaction seemed to be out of Vertex' hands. Vertex' debt obligations had crept higher. Its profitability target was in jeopardy. Caution, rightfully, prevailed.
But, enough has changed now. Closing the private capital transaction is up to Vertex. Debt has decreased. Profitability is back in sight. Potential investors would be wise to consider building a long-term position.
My investment club typically allows a company three years before we judge its performance against our expectations. Vertex Energy has been on our troubled list and we need to consider averaging down. The winds of change have blown away the hesitancy and carried in an air of optimism. It's an opportune time to restart the clock on Vertex Energy.
Disclosure: I am/we are long VTNR. 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: I belong to an investment club that owns shares in VTNR.