A Close Look At Pacific Ethanol (PEIX)

| About: Pacific Ethanol, (PEIX)

[Background: For background on the ethanol sector, please read this and this.]

Himanshu Pandya from at FinancialNirvana.com has done a nice job on following Pacific Ethanol, and I would recommend reading his posts. In particular he has pointed out that some of the speculation is likely due to a Bill Gates factor, which, along with some financing, may be in jeopardy.

Story: Pacific Ethanol (Nasdaq: PEIX) is building a refinery in California for corn based ethanol production in the heart of the California agricultural and dairy land (the biggest agricultural and dairy producer in the country). The refinery is supposed to come on line in Q4 2006, and there are plans for 4 more subsequent refineries. As there is unlikely to be any increased ethanol demand in California (see background above), the supply capacity they are bringing online must be able to disrupt the current out-of-state supply and/or undercut the current prices. They are one of the biggest distributors of that alternate supply in the state, and that is their main business right now.

Byproducts of corn based ethanol production include Wet Distillers Grain [WAG], a dairy feed, and CO2, which they plan on capturing and selling to the beverage industry. The CO2 recapture is nice PR, but probably financially irrelevant. The WAG will likely help recoup some of the raw cost of their corn, although I don't have a good handle on estimating that, and they don't provide any financially relevant information. I can attest to the fact that their plant will be centrally located in one of the biggest agricultural centers in the country, particularly for dairy. For ADM, corn represents about 30% of the cost of ethanol, which right now has a spot price around $2.50/gal. So, we would like to see them recoup about $0.75 in WAG per gallon of ethanol produced. To figure that, we need the selling price of WAG, and mass of WAG/gallon of ethanol produced. We don't know either of those, so the advantage gained by their byproduct processing is unknown, and may be irrelevant.

From their prospectus:

PEI California [the refinery subsidiary] has, to date, not conducted any significant business operations other than the acquisition of real property located in Madera County on which we are constructing our first ethanol production facility.

That leaves open the possibility that all they have done is purchase the land, and construction hasn't even started, but that fear seems to be unfounded. It's a 35M gal/year plan. However, apparently they do not yet have all the necessary operational and construction permits (including water discharge) for the Madera plant (prospectus, pg. 14), which is supposed to start operations by the end of the year. Based on that alone, as well as what one would assume are recent pictures of the plant, I doubt the plant will begin operations this year.

[Update: The plant progress photos shown by the construction contractor are out of date, and more recent photos can be seen in a slide show on the lower left of the Pacific Ethanol website. Those photos show that the plant is further along, and that there might be a chance at it opening by late 2006. In that same slide show is the only place that I have found two other key bits of information: from the annual ca. 12.5M bushels of corn, they expect to produce 35M gallons of ethanol, 290K tons of WDG, and 100K tons of CO2.]

Company: They have a complex corporate history - they used to be Accessity Corp, which as far as I can tell had absolutely nothing - medial billing recovery?, auto repair management? - to do with their current business, and was small and a money loser. Accessity was reincorporated as Pacific Ethanol. The have 3 remaining sub-entities, one that does ethanol marketing, one building the Madera plant, and one holding warrants and options on other land for future plants. The pro-forma results for their combined entities shows a slight increase in revenue Y/Y, from $83M for FY 2004, to annualized $100M ($75M for 9 months) in 2005, with a gross margin of ca. 3%, but losses after operating costs.

Some meat: they estimate 12.5M bushels/year of corn needed to operate their plant (prospectus, pg 15). Let's assume that allows for their maximum capacity of 12.7B gal/year of ethanol, which would give ca. 1000 gal of ethanol/bushel of corn. The CBOT says the ratio should be more like 2.6. With the CBOT's numbers, they have production capacity of 32.5M gal of ethanol/year (12.5Mx2.6). At a $2.50 spot price, that gives them $81M annual revenue, and at a corn bushel spot price of $2.40 that gives them a potential annual gross profit of $51M ($81M-$2.40x12.5M).

On the other hand, Barron's, in my background above, estimated corn is 30% of ethanol cost for ADM. which is consistent with the 2.6 factor between corn bushels and ethanol gallons with the price for a bushel of corn and a gallon of ethanol approximately equal. But the CBOT estimates corn cost is more like 70% of ethanol production cost, which would be in line with current corn prices and $1.30/gal for ethanol - it's historic average ($1.3x2.6/$2.4 = 0.7). So, if the increased ethanol production helps to moderate ethanol prices by increasing supply, their potential annual gross revenue could reduce to $12M. I would guess that they would have at least $12M in operating expenses for the plant.

You would think that as part of a prospectus, or at least on their web site, they would somewhere make the case for the financial viability of their ethanol plant. Their current ethanol trading business, even at record ethanol prices, is a loser, so the company's prospects depend on that plant. I've tried to get some handle on the possible economics of the plant. It doesn't look to me like they will lose money on it, but estimating the upside gives a wide range, and they provide no real guidance.

Stock: In order to complete their first ethanol plant, they just raised $34M, and will require an additional $60M, neither of which are assured. In March 2005, a significant private placement of stock was used to raise $21M for the company. For that private placement, the stock was valued between $3 and $5/share. Current PEIX quotes are about 8 times higher. The latest private placement in Nov 2005 was for $8/share.

Let's take the best case possible: they make $51M gross revenue, and have no operating costs so that it all drops to thebottome line. After their ca. $5M (that's a 9-month loss, but were' trying to be generous here) loss from current operations that leaves them $46M. With 28M shares outstanding, that gives them projected EPS of $1.64. At a current share price of 28, that gives them a projected P/E of 17. That's perfectly reasonable. What if they have trouble completing the plant? What if ethanol goes back to $1.50/gal? What if they have $20M in plant operating expenses, and we annualize their current losses? That gives them projected earnings of $22M, for a projected EPS of $0.79, and a projected P/E of 36, for a company that may only be profitable in 2008.

At $10, where their price was in January, this gamble might have been worth it, but at current prices they seem uncompelling. More gambling than investing. Pass at current prices. I doubt their plant is coming on line in 2006, so there will likely be better buying opportunities in the future.

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