Commodity, low-tech businesses usually lack investment fizz, unless that business is somehow tethered to the Utopian world of alternative energy.
One tethered energy source, ethanol, is responsible for more fizz than any other thanks to politicians left and right, environmentalists and sundry rent seekers chatting it up as the most expedient solution to the putative energy-independence conundrum.
The chat is backed by more than rhetoric: it’s backed by legislative muscle. The Energy Policy Act of 2005 requires that at least 4 billion gallons of ethanol and biodiesel be used in 2006, increasing up to at least 7.5 billion gallons in 2012, with an annual increase of approximately 700 million gallons each year. More recent legislation passed by the Senate (but not the House) amps ethanol usage to 8.5 billion gallons in 2008 and 13 billion gallons in 2012.
What’s more, the legislation is heavily slanted in favor of the home team. Imported ethanol is subject to two duties: (1) a 2.5% ad valorem tax and (2) a tariff of $0.54 a gallon, rendering imports uncompetitive.
Citing the potential boon from more favorable energy-policy iterations, influential Lehman Brothers analyst Mansi Singhal on August 30 scribed a research note upgrading ethanol producers VeraSun Energy Corp. (NYSE: VSE) and Aventine Renewable Energy Holdings Inc. (NYSE: AVR) to "overweight" from "equal weight” while upgrading the entire sector to "positive" from "neutral.” (For a related story, see Aventine Renewable Energy Holdings: Beyond a Fad.)
Other analysts are less sanguine, expressing concern that increased capacity means increased pricing pressure and margin squeezes down the road. On that front, Bank of America analyst Eric Brown recently predicted that the "relentless supply" of new ethanol production will lead to a 70% contraction in margins by 2009.
Even less sanguine are the free-market economists who believe ethanol economics are fiction. The sector can’t exist at industrial levels without subsidies and tariffs; therefore, it exists at the whim of elected officials.
Political intervention invariably produces unintended consequences, to be sure. Corn prices have nearly doubled this year, soft-drink manufacturers have struggled to buy corn and corn syrup and environmentalists have fretted over new stresses on America’s farmland. All have powerful lobbyists with access to Congress’s ear and could stymie future pro-ethanol legislation.
That said, a complete 180 is unlikely. Alternative energy supporters have the wind at their back. The ethanol market thrives and money is being made, though who will continue to make money as competition, output and unintended consequences multiply is anyone’s guess. For that reason, investors might consider ethanol exposure with less of a California-gold-rush tack and more of an established-diversified-company one.
One company fitting the established-diversified mold is MGP Ingredients (Nasdaq: MGPI), a $225-million market-cap based in Atchison, Kan., that tempers its ethanol exposure with specialty and commodity wheat proteins and starches.
Alcohol production constitutes 66% of MGP’s total revenue, though only 54% of that is derived from ethanol production. This rest is derived from food-grade alcohol, primarily grain neutral spirits and gin, and food-grade industrial alcohol that’s used in food ingredients (vinegar and food flavorings), personal care products (hair sprays and deodorants), cleaning solutions, biocides, insecticides, fungicides, and pharmaceuticals.
MGP’s other business, ingredients (33% of revenue), is composed of specialty wheat starches and specialty wheat proteins, wheat starches, vital wheat gluten, and mill feeds. The products are used primarily as food additives for human and animal consumption.
The output is prosaic, to be sure, but demand is growing and operations are profitable. On the former, revenue for fiscal-year 2007 (ended July 1, 2007) advanced 14.1% to $368.0 million from $322.5 million in the prior year. On the latter, EPS grew 26.5% to $1.05, from $0.83 in 2006.
First Call expects MGP to continue growing profitably. Revenue is estimated to push ahead to $426.6 million in 2008 and $453.8 in 2009, with EPS rising to $1.14 and $1.47, respectively.
Of course, the news hasn’t all been good (but then no worthwhile investment is without distractions). Margin and earnings growth have been hobbled by increasing corn, wheat, and energy prices. MPG’s corn cost was 75.9% higher in 2007 compared with 2006, while energy costs have risen progressively higher since 2003.
Higher costs and lower expectations have flattened the fizz of ethanol producers in recent months. Many pure-play issues have seen their share price halved, while others have been dinged for their ethanol association, including MGP, whose stock has lost 36.1% of its value in the past 52 weeks.
The sell-off is likely overdone and presents an opportunity for value investors. Unlike many of its competitors, MGP is no Johnny-come-lately. The company has been successfully navigating the choppy agriculture waters for 65 years. At a recent price of $14 and change, MGP’s stock sports a forward 12-month P/E of 12.7, which is at the low end of its historical range; a 2% dividend yield; a current ratio above two; and a conservatively funded capital structure (long-term debt is only 7.7% of capitalization).
More important, long-term MGP shareholders have historically fared favorably compared with those of its publicly held competitors, including the much larger Archer Daniels Midland Company (NYSE: ADM). Direct comparison between MGP and the self-anointed “supermarket to the world” over the past 10- and five-year periods shows MGP investors have realized a higher return on their investment (albeit with a higher standard deviation.)
Of course, past isn’t always prologue, but MGP’s current discounted stock price and its history of managing volatile commodity costs suggest patient investors could be positioned for another favorable 10-year run.