Vertex Should Improve After Awful Q2, Given Valuation Support

Summary

• There are a lot of reasons to be skeptical on Vertex after a dire Q2 showing.
• However, these are basically commodity refining assets and I think a $16/share valuation is fair (range $5/share-$55/share).
• There is some downside in the worst case with more management issues or very tight spreads, but equally it seems that the shares could broadly double without heroic assumptions.
• RBOB spread futures and limited new supply suggest that U.S. refiners may enjoy comfortable margins for some time. The market doesn't seem to want to believe this, but the evidence is there.

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Vertex (NASDAQ:VTNR) is a hated company. Q2 results were an almost unmitigated disaster. The CEO has sold stock. The company ultimately gave up perhaps $90M of value with its hedging strategy. They reduced Q3 guidance last month. Short interest is running at over 30%. However, in valuation terms there may be an opportunity for those willing to bear various risks and management's credibility issues.

Q2 results were so bad, that Q3 results may offer some signs of encouragement and the company's renewable diesel plans could be a source of further upside in 2023. Importantly, crack spread futures do suggest that the company may be able to maintain an attractive profit stream into 2025 and beyond.

It's worth jumping to the valuation first as that underpins the investment case.

Valuation

Asset	Value	Notes
Value of Mobile refinery	$1,243M	10 x $125M net income (normalized $10/barrel margin with $4/barrel of costs), 95% utilization, 20% tax rate
Super-normal refinery profits in Q3 and Q4	$65M	estimate $33M in Q3 (inc. +$13M inventory gain) and $48M in Q4 (hedges roll off) (after tax)
Legacy Assets	$140M	Value of Safety-Kleen prospective purchase
Biodiesel Conversion	$153M	14,000 bpd, $0.75/gallon, 95% utilization
Current net debt less offsetting inventory	-$98M	debt including inventory financing less $201M inventory and $98M cash
Remaining capex to complete biodiesel plant	-$120M	estimated cost
Assuming working capital spend to ramp up biodiesel plant	-$50M	rough estimate
Resulting equity value	$1,549	sum of the above
Benefit for convertible debt conversion	$1,594	+$45M net value of converts
Resulting valuation per share (inc. convertible dilution)	$16.30	97.8M shares outstanding (inc. convertible dilution)

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Range of Sensitivities on Mobile Refinery

Since the refinery matters so much, here are some sensitivities to the multiple and spreads (all values assumed convertibles are dilutive, which is punitive at prices below $15/share)

	5x PE	10x PE	15x PE
$5 spread barrel ($4 costs)	$4.65	$5.71	$6.77
$10 spread/barrel ($4 costs)	$9.95	$16.31	$22.67
$20 spread/barrel ($4 costs)	$20.55	$37.51	$54.47

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Thus, downside is clearly possible if spreads do revert to long-term averages or worse. Still, the futures market and the trends in terms of lack of new capacity and the disrupted European energy market suggest profits may stay high for a few years. If not, where is the incremental capacity that would typically bring down prices?

Q2 Results Were Awful

To say Vertex Energy's Q2 results were a train wreck would be unfair to train wrecks. The company reassuringly guided to robust results after the transformational acquisition of Shell's (SHEL) refinery, then management (the CEO and a director) sold material amounts of stock, then results were well below guidance. Management lost money on hedges and spreads. All this against a less attractive version of the crack spread (2/1/1 vs. 3/2/1).

Crack Spreads Remain Favorable

The main asset on my valuation numbers above is the Shell refinery. Yes, the company has legacy assets and a conversion project, but the refinery is the main variable driving my valuation numbers.

It is therefore important that RBOB crack spread futures are trading in a $13-$27 range (per barrel) through to 2025, with the fluctuations mainly due to seasonality. Note that these spreads have limited correlated to Mobile's spreads (given diesel, jet fuel production etc.), but they give an indication of market direction.

There are no plans to add refining capacity in the U.S. in fact, refineries are being shut down or converted to green fuels. Therefore, refineries may remain attractive assets for some time if the futures curve is robust, which seems a fair assumption.

A Great Deal

Also, as much as management failed to deliver on expectations for Q2, I believe they did a great job buying the Mobile refinery. After inventory spending the total cost (before any biodiesel work) is perhaps $300M and yet it's fairly easy to arrive at a valuation 3x-4x that number. Yes, some of that value is due to the Ukraine war, but not all.

Q3 and Q4 Results May Be Robust

Q3 results may improve on Q2 numbers. Obviously, take that with a pinch of salt given reduced guidance and management's track record here. However, +$13M of inventory sales missing from Q2 should land in Q3 and the company's hedging situation may improve perhaps by +$20M. Then if the underlying profit is down to perhaps $20M based on higher costs, tighter spreads and lower volumes, the company may report around $53M of EBITDA pretty easily. Then in Q4 if the company is back to market rates as hedges roll off $100M of EBITDA may be possible.

Risks

• It could be argued that management has limited credibility at this point. Q2 numbers were a disaster, bearing no real link to guidance issued a few months before. Even the explanation of Q2 numbers was somewhat confusing. Q3 guidance has been reduced.
• The parameters of the Mobile refinery aren't that well understood after a single quarter of reporting. It's possible the refinery itself has fundamental issues, which I currently attribute more to poor hedging and contracting issues, but there could be more fundamental issues in play.
• It's quite possible that the start of the biodiesel project is delayed. Recent covenant changes (see 8-K 9/30/22) pushed the true start date back from end of February to end of April. Unclear if this is cautious legal wording or an incremental change in the project timeline.
• This is a commodity asset and unfavorable price swings could wipe out the equity value, for example if crack spreads return to lower historical levels from history.
• The CEO continues to sell stock. He, and his family, still hold a lot of stock, perhaps ~$80M of value, but the recent ongoing sales as recently as September are a concern, even though I can imagine the CEO does want a little more diversification given the stock's considerable volatility.
• Q2 results were extremely complex given the incorporation of a major new asset (the Mobile refinery) and associated working capital swings, the financing for the acquisition and multiple hedging and forward contracting impacts. This makes estimation of future quarterly results challenging.
• Short interest is high. Some of this may be convertible debt hedging, but may also suggest a strong bear case in this name.

Catalysts

• Q3 results expected in early November
• Q4 results will show underlying refinery performance without hedging impact
• Biodiesel production expected in early 2023
• Crack spreads remaining higher than historical norms for an extended period, at least the next 2-3 years

Conclusion

This is a tough investment to get to rock-solid conviction on given the Q2 results and all the questions they generate. I expect management to continue to underperform and be a distraction to the underlying value of the business.

Still, I believe Q3 results will be a lot more in-line with expectations than Q2, and Q4 may surprise markets as hedges roll off and management has line of sight to a biodiesel start date. There are other renewable energy assets with less hair on them that are definitely also worth considering e.g., CLMT if you're ok with a K-1. But Vertex is likely cheap at these levels and the current discount may fade over the coming year.

It's also noteworthy, perhaps, that in writing this, I have been tempted to bring down numbers, generally be conservative and caveat everything given how bad Q2 was. If others feel this in the market (and I suspect they do) then if management can just deliver a 'normal' Q3 and Q4 there's an implicit discount here, that may fade over time.

Disclosure: I/we have a beneficial long position in the shares of VTNR either through stock ownership, options, or other derivatives. 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.