Clearing Confusion About Nova Biosource Fuels

| About: Nova Biosource (NBF)

Nova Biosource Fuels (NBF) is an odd duck. It’s nearly a start-up with no biodiesel sales revenue through most of 2007. But it could be selling nearly $200 million worth of biodiesel at some point in the third quarter of this year. Moreover, far from the condition of most start ups, it has a remarkably wide and deep management team - most with many years if not decades of experience with top petroleum and chemical companies.

It produces a commodity product – biodiesel fuel – but not like others do. Instead of petroleum or food inputs, it uses proprietary processes to process a wide variety of feedstocks, including low-cost, high-free-fatty-acid matter such as fish oil or dead animal remains. Its technology has been vetted and pronounced superior to all others for biodiesel production by top ranked engineering and financial firms, but it has yet to be fully proven in operations.

NBF’s profit margin depends on government tax credits for biodiesel that could expire in two years, but which industry insiders expect to be renewed for the foreseeable future in the new farm legislation being finalized in Congress.

This muddy picture of a startup company with great promise wrapped in multiple layers of uncertainty partly accounts for NBF’s relatively modest $300 million total market cap based on a $2.35 per share stock price. Another cause is the immaturity of the industry in which it participates. You might say the biodiesel industry is just now emerging from the swamp and that industry participants come in many flavors – some not all that tasty. So it is not surprising that some investors may be confused about either the biodiesel industry or NBF’s position within it.

What is so intriguing about NBF, on the other hand, is that in only six or eight months from now, virtually all these uncertainties may be resolved. My research and analysis suggests a strong likelihood for positive resolutions. If that comes to pass, there is good reason to expect that the NBF market cap will accelerate rapidly. The resolution will come out the the operations of NBF’s three plants.

Last week I toured the company’s new 60 million gallon per year Seneca, IL refinery. It was an impressive performance by the company on many levels. For one, the visitors included a rather large group of well grounded fund managers and sell-siders – a total of about 40 analysts. For another, the pedigree of the Seneca facility makes a lot of sense. Seneca is the fourth and by far the largest biodiesel plant that NBF has constructed. But in a way it was the easiest to build. The first plant was rated at10 million gallons per year capacity. Then two 20 mg/y plants were built, all three for ownership and operation by other companies. That made for an inherently difficult construction process since two separate management teams were involved in the construction. More importantly, both the 10 and the first 20 mg/y plants were struggles because NBF had never previously constructed a plant of such a size. Thus, each component was a first-time design that had never before been produced or connected into the whole. The Seneca plant, however, is simply three lines of the now-proven out 20 mg/y variety. Having previously suffered the pains of “from scratch” plant construction, management was able to get the Seneca plant up and running from start of construction to product out the door in just about twelve months because all the specs had been written and proven out in the field previously.

Most impressive is the fact that the people and the corporate partners that NBF has brought together to produce Seneca have strong and deep backgrounds. The corporate partners and suppliers have names like Mueller, Con Agra, and Emerson. Newly recruited managers come from years at Dupont, Texaco and other leading companies. The resumes of NBF’s top people appear on their website, along with a great amount of additional background information.

The Seneca plant seems like a logistical dream. It is fitted with both truck and rail loading and off loading facilities and it sits next to the Illinois River, which feeds into the Mississippi for possible future barge transport. If NBF decides to sell its product in Europe, where diesel prices are quite elevated compared with the U.S., it would probably want to ship by barge. In terms of feedstock, there is an estimated 130 mg/y worth of animal feedstock within a fifty mile radius of the Seneca plant.

An additional benefit of the Seneca plant is that it uses less than 40% of the land on which it sits. NBF already has in inventory the hardware to build two additional 20 mg/y production lines. Thus, it would be relatively easy to expand the Seneca plant substantially.

Full production is within sight at all NBF owned plants. Seneca will begin accepting feedstock within weeks, will produce biodiesel within the next couple of months and is scheduled to operate at capacity and with a full variety of feedstocks early in Q3 of 2008. Of the three plants that NBF built previously for third parties, two are now part of NBF’s operations. The 10 mg/y plant has been bought by NBF. It is producing biodiesel but was not initially constructed to handle a full range of feedstocks, so it will soon be upgraded and should be processing a full range of feedstocks in the second half of 2008. One of the 20 mg/y plants is now a joint venture in which NBF has bought the rights to 50% of the plant’s output. It began operations in Q4 of 2007 and is moving toward but has not yet achieved full feedstock processing. Thus, NBF is now producing biodiesel in two plants but has yet to prove out the full capability of its technology.

NBF recently finalized bank financing for roughly 60% of the cost of the Seneca plant. Its credit capacity will be substantially enhanced by having a successful operating history in the rear view mirror. For that matter, so will its ability to raise additional equity. The company has stated an objective of reaching 420 to 600 million gallons per year biodiesel production capacity by 2010. Such expansion objectives will become more credible as the successful operation of its existing plants increase its financing capabilities.

What are the risks? The principal risk is that the patented NBF processes fail to be capable of smoothly processing the full range of feedstocks that NBF claims is possible. The price of feedstock constitutes nearly 80% of production costs, so the ability to process low cost, high free fatty acid feedstocks is critical to the NBF business model. Moreover, acquisition of very low cost feedstock often requires the ability to act and take possession quickly. Thus a key to the NBF strategy is being able to use a wide variety of feedstocks in combination at a plant like Seneca that has three production lines that may need to process a combination of feedstocks simultaneously in order to be efficient.

Technology experts who have studied it believe NBF’s approach should succeed in that capability. But it has yet to be proven out in long or even short term experience. NBF is like a young, apparently talented baseball team in spring training. There is likely to be a learning curve during the playing season as the team comes together and figures out how to play the opposition (the various feedstocks). There is every reason to think they will succeed but until they actually put up a series of wins, it is a matter of faith.

A second risk is that the federal $1 per gallon tax credit for biodiesel may not be renewed. Analysts who have followed the progress of the matter in Congress are highly confident that it will. Also worth noting is that at least one NBF director is extremely well connected in Washington. But this risk is enhanced because the biodiesel industry is very young, is not of uniform quality, and may not be as well coordinated on a political level as it should be. On the other hand, letting the tax credit lapse this year would virtually kill the biodiesel industry; it seems highly unlikely that Congress will want to cause the death of a promising green producer of alternatives to Middle Eastern oil as the next election approaches, especially after just establishing ambitious mandates for biofuels that include biodiesel. That gives me a fair degree of comfort on the subject.

Finally, there are some uncertainties surrounding the sale of biodiesel. Management sees no problem selling its production at the wholesale “rack” rate. But biodiesel has some qualitative differences from petro-diesel that currently preclude it from pipeline distribution. There are questions of how much biodiesel distributors will want to blend into their product, and the answer may ultimately depend on truckers’ acceptance. Biodiesel is not as efficient as petro-diesel for long haul operators. On the other hand, it is more efficient in stop and go local traffic. Eventually, drivers may be able to dial the mixture of bio- and petro-diesel they want, but that is some time off. Again, the immaturity of the industry may lead to some delays in acceptance. On the other hand, increasingly robust state mandates and financial incentives for using biodiesel – 31 states now have them - are becoming increasingly prevalent. It seems unlikely there will be a sales risk. But, like the other questions, one will feel more comfortable after seeing the system work as management expects.

One positive future development is baked in: the trend toward more U.S. diesel powered cars. With the advent of ULSD (Ultra Low Sulfer Diesel) that was mandated by Congress and became effective a couple of years ago, the pollution and performance problems of diesel powered cars in the U.S. has disappeared. The use of diesel vs. gasoline in the U.S. is certain to increase markedly. Not only does diesel perform better than gasoline, but it also gets about 20% better miles per gallon.

Interestingly, the amount of diesel that can be refined from a barrel of crude oil is fixed, so refineries cannot produce more diesel and less gasoline from a given barrel of crude if the demand ratio changes. The U. S. currently exports diesel fuel, but with increased U.S. diesel demand exports will need to be reduced and possibly imports will be required. Higher diesel prices may result as the demand for diesel and biodiesel becomes far more robust in the next few years.

In addition to the likely increase in future diesel demand that will help NBF, there is also a high likelihood that the price of crude oil will increase over time. NBF earnings are leveraged to the oil price because a higher oil price will be translated directly into a higher price of diesel fuel and therefore biodiesel. A higher price for biodiesel has a leveraged impact on the profits of NBF. If the price of crude increases by 50% over the next few years, say, which is a slower rate of growth than has occurred over the past three years, that change could cause the earnings of NBF to double or triple, possibly, depending on changes in the price of feedstocks that are far more indirectly related to crude oil prices. Of course that works both ways; if you believe oil prices are likely to decline you should not own NBF or any company tied to the price of crude.

The most significant aspect of NBF’s possible benefit from higher crude prices is that it offsets the risk that the $1 per gallon tax credit for biodiesel may expire in the future. The likelihood that the subsidy will expire increases as the price of crude increases – but so too does the profitability of NBF’s operations. So in a sense, higher crude prices become an alternative profit source (and probably a larger one) than the tax credit. If the price of oil does not increase, the biodiesel subsidy is probably secure for a long time.

An interesting analog to Nova Biosource is a Chinese company, Gushon (NYSE:GU). It produces and sells in China about $100 million of biodiesel and earns about $40 million pre tax. The company projects a doubling of its operations within a short time based on financing obtained from a public offering of its shares in New York late last year with Merrill as the chief underwriter. The economics of the biodiesel business in China may be quite different from those in the U.S. and therefore far more difficult for a U.S. investor to evaluate. So I would not be an owner of GU. (As my wise brother-in-law once said, “I have plenty of ways to lose money with American stocks; I don’t need to go overseas.”) Nonetheless it is interesting that the market cap accorded by U.S. investors to GU is now nearly $1 billion.

What is the bottom line for NBF stock? If and when the company produces and sells 80 million gallons per year of biodiesel, the total rated capacity of its three plants, for roughly $200 million, it could earn $1.25 per gallon – of which the tax credit makes up $1.00. $100 million of earnings equates to about $0.65 per share pre-tax. NBF could be generating those numbers by some point in the second half of 2008. Equally important, once the uncertainties discussed above are resolved, NBF could well expand production and therefore grow earnings in future years at relatively predictable rates. NBF has targeted a capacity of 420 - 600 million barrels per year globally by 2010. The chief remaining uncertainty after production and sales uncertainties are reduced will be the availability and cost of financing for expansion. But that task should also become easier as the company’s successful operating history gets longer. It thus does not take a lot of imagination to foresee NBF as a company with a total market value in the billions of dollars within a few years, compared with the current $300 million TMV.

On the other hand, if the uncertainties discussed above are resolved negatively, there could be little value to the company at all. In short, NBF is as close as I get to doing venture capital. Only investors with an appetite for that sort of risk profile should become owners of Nova Biosource Fuels, Inc.

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