|Shares Out. (in M):||23||P/E||0||0|
|Market Cap (in $M):||161||P/FCF||0||0|
|Net Debt (in $M):||107||EBIT||0||0|
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As markets try to find a bottom following a severe market dislocation, common investment wisdom is usually to begin to accumulate investments of only the highest quality, stability, and predictability. We will be upfront and say this is not one of those recommendations.
We are recommending a long position in GPRE. GPRE has been previously written up in 2017, and about a year ago in 2019, and we suggest that you check out those write ups for further background and to understand the company’s transformation. We believe the story over the past year has continued to change meaningfully, while at the same time recently the stock price has come down, yielding a stellar entry point for an investor truly focused on the long-term transformation of this company to a high value ag producer.
We divide the relevant background info into four sections:
1) Company overview
2) Current capital projects for high protein feed and cost reduction measures
3) Recent share price dislocation
4) The ethanol environment
Green Plains is primarily an ethanol company, taking corn and refining it into ethanol for use as an additive in motor vehicle gasoline. The company was started and IPO’d in 2004, with the IPO proceeds used to construct its first ethanol plant in Iowa. The plant construction coincided with the passing of The Renewable Fuel Standards Program (RFS) in 2006, which mandated a slow increase of biofuels blending into motor gasoline over a 10 year period to 10% of the fuel supply. Over time, GPRE had built or acquired additional ethanol plants. In 2016, it went on an acquisition spree buying three ethanol plants and a vinegar operation with leverage, and ended 2017 with 17 ethanol plants and ~$587mm in net term debt (excluding working capital financing, which was 3.8x trailing EBITDA). At the start of 2018, the company had 1.4bn gallons per year (gpy) of ethanol capacity, or ~8.5% domestic market share. In addition to the vinegar operation, the company has a share in a cattle feeding JV, an agricultural storage/trading operation, as well as has ~50% ownership in a publicly traded MLP consisting of ethanol transportation assets adjacent to GPRE’s ethanol plants.
In May 2018, after a challenging 12 months in the ethanol industry, we believe management realized their platform was unsustainable - high leverage and costs while selling a commodity product. Their previous thesis of rolling up and rationalizing the ethanol industry had failed. At the same time, they saw an avenue to high-grade the value of DDGs into a specialty product while at the same time reduce costs. So the company announced a Portfolio Optimization Plan that was subsequently completed in 2019.
GPRE sold assets, payed down debt, and reduced operating costs. In October 2018, the company announced the sale of its vinegar operation (bought at a 9-10x multiple, sold for a double digit multiple) as well as the sale of three ethanol plants, or ~20% of the Company’s capacity. In 2019 the company also sold its interest in an ethanol termainl, and a 49% interest in its cattel feeding operation for $105mm. GPRE took most of the $780mm of proceeds from these sales to repay its $500mm term loan and kept the rest of it as cash on the balance sheet. The company also reduced controllable expenses in 2018 by $19mm, versus an originally announced $10-15mm target. By luck or otherwise, the ethanol industry has remained extremely challenging, and GPRE has survived.
At 12/31/19, the company had 1.1bn gpy capacity, or ~7% market share. The company had $245mm of converts outstanding (due 2022 and 2024) and $270mm of cash. The company also had $132mm of non-recourse debt for its MLP (ticker: GPP), and $188mm of working capital financing.
High Protein and Low Cost Upgrades
Over the past 6 months, as GPRE wrapped up its Portfolio Optimization Plan, it has shifted to what it calls a Total Transformation Plan. Management has made it very clear that they are shifting from a commodity ethanol producer to a value-added ag player - and they are attempting to do so as fast as possible. To do this, they intend to 1) reduce costs to become a top quartile producer and 2) invest in high protein feeds.
Cost Reduction Plan - Project 24
Ethanol producers grind corn, and convert the starches/sugars through a fermentation and distillation process to ethanol alcohol. What’s left over after this process is corn oil (used in biodiesel) and dried distillers grains (a basic animal feed). However, technological processes differ, and the ethanol industry is split into two technology trees - ICM, and everyone else (for GPRE the processes are Vogelbusch and Delta T). ICM is considered the gold standard as far as operating costs, yields and process reliability. Out of 13 plants, GPRE has 5 ICM technology plants, and 8 others.
In early 2019, GPRE announced “Project 24” - an initiative where the company hired ICM, inc, the company that created the gold standard ethanol process, to examine its non-ICM plants and find ways to reduce costs. The projects identified included recycling and reduction of gas/heat costs (the main costs within ethanol production outside of corn inputs), as well as other improvements to processes, yields and reliability. GPRE estimates at a cost of 10 cents per gallon, it brings their platform down to 24 cents per gallon on opex and each project has a <1 year payback. For their entire portfolio, that’s a cost of about $60mm for a return of $80mm in EBITDA within a year.
GPRE completed its first upgrade in in January, and by the end of Q1 they will have 2-3 additional plants completed. After that, they will complete one plant a month and be done with all 8 plants by Q3, at which time they see their entire operating platform operating at or below 24 cents per gallon - a top quartile cost position in the industry, allowing them to run continuously at 90%+ without losing money. Running continuously benefits their protein feed strategy, discussed below.
The company has exclusivity of this technology/know how from ICM for one year after their final plant upgrade (until late 2021). While we fully expect this to be copied and competed away, we think producers first have to survive to that point and in the meantime, GPRE’s cash generation and head start allows them to move to their main goal of high protein upgrades.
High Protein Upgrades
This is the crux of GPRE’s transformation plan, and an area where we have done extensive channel checks. GPRE has identified a certain mechanical technology - called the Fluid Quip MSC Protein Recovery System - to take its dried distillers grains (DDGs) and split it into standard DDGs, and high protein DDGs. Standard DDGs have 20-30% protein content, while high protein contains a stream of DDGs at 50%+ protein content. It is also important to note here that all protein is not created equal - the process allows for mechanical and biological optimization of the amino acid profile of the high protein to optimize its value as an animal feed as per customer demand.
This is a new technology with the first plant starting up in 2H 2018 at competitor Flint Hill Resources’ plant in Fairmount, NE. Our checks indicate that process has been in good operation for over a year, and some of the early kinks/learnings have been ironed out of the process by Fluid Quip. Flint Hills has announced a second plant in Shell Rock, Iowa and should announce more shortly. GPRE announced the technology upgrade at one of their best performing plants in Shenandoah, Iowa which is starting up now. And finally a fourth startup in spring 2020 is expected in Cherokee, Iowa at an independent plant.
GPRE has indicated that installation of this technology at each plant will cost $30-40mm (30-50 cents per gallon). And in return, create a product with 50% protein where they receive a ~12-16 cents per gallon uplift in earnings. For their first plant at Shenandoah at 82mm gpy, that’s $11-12mm of incremental EBITDA for a $35mm investment, or a 3-4 year pre-tax payback. According to our conversations with those familiar with existing Fluid Quip installations, it cost Flint Hills ~$55mm to install the system (on a 120mm gpy plant, or 45 cents per gallon) and they received “high-teens or better returns” at start, which have only been increasing since the project start up in 2018.
Beyond the initial uplift from the project, we believe this upgrade has two unique factors: A deep and huge market, and the ability to push protein content on an exponential pricing curve. GPRE has indicated that they already have effectively signed offtake agreements for 100% of the capacity of Shenandoah’s high protein feed, months before the unit even started up. A bit more than half of the feed should go to a “pet food raw material” manufacturer, while the remaining is likely going to an aquaculture producer abroad. Our conversations indicate that the economics of this product are simple - it’s a better nutrition profile for the same amount of mass. This makes it highly applicable to animal, poultry, fish and pet feeds. GPRE indicates that world demand for protein is growing at 8mm tons per year, while if the entire US ethanol industry instituted this technology it would create about 8mm tons of feed, or one year worth of demand.
In addition, for GPRE, the goal is not to stay at 50% protein. At 48-50%, the feed is priced at a $50-100 premium to Soymeal (currently $300 per ton, which itself is priced about double the price of low-value DDGs). GPRE has signed an exclusive agreement with Novozymes to take the 50% protein feed and use biological/enzymatic processes to increase protein content even more. One former Biology PhD we talked to in the industry indicated this was very possible, and it is just a matter of time. GPRE currently indicates a 5 year plan to push protein, and climb up the non-linear price curve over the next 1-5 years, where adding 10% more protein content triples the price of your product.
Finally, we believe GPRE (and Flint Hills) are committed building an oligopolistic, defensible position in this new industry. We have heard each of them say they talk to the other and there is some knowledge sharing between projects. The industry is well versed in creating commoditized products, and they are working hard to avoid this outcome for high protein DDGs. At an investment of $30mm+ per unit, they see it as unlikely for marginal players in this industry to be able to invest in this in the near term (more on the industry below). In fact, we heard that GPRE purchased some product from Flint Hills before their plant has started up, to start to deliver to their own customers.
For GPRE, they estimate a $350-450mm investment if they institute this across their 13 ethanol plants, with returns of $150mm in EBITDA. The company is exploring project based financing to fund this expansion since they are able to sign offtake agreements for the product prior to start up. We expect to see additional announcements around this from GPRE over the next year.
Recent Share Price Dislocation
As mentioned in our intro, we believe currently shares are priced at an exceptional long-term risk reward opportunity.
In the current market environment, we believe that GPRE is being treated more like a levered, oil-related entity similar to shale E&P players (who very well may be facing bankruptcy) after oil prices have crashed. We believe this is a symptom of GPRE screening poorly combined with the challenging upcoming environment that ethanol producers will face (which GPRE will survive).
Despite being a biofuel producer which is correlated with oil (and instead more tied to corn), GPRE shows up as a member of the SPDR S&P Oil and Gas Exploration and Production ETF (XOP) And within this index, GPRE clearly screens poorly - based on Bloomberg, GPRE has $486mm of net debt, on forward EBITDA estimates of $48mm, or over 10x “leverage”. We believe computer programs and investors “shot first” in frenzied days of selling and currently there is no bid for shares due to uncertainty. As a comparison, GPRE is down 74% YTD, while XOP is down 67% YTD, and CRAK (Oil Refining ETF) is down 50%. YTD.
This is not to say that the share price decline is not warranted for the short term, given the impact of COVID-19 on the world economy. The Ethanol industry demand picture has three parts - statutory blending, discretionary blending, and export demand. Export demand will be down, while estimates currently are for near-term gas demand to be down 15-20%+, and follow on effects of COVID quarantines are currently unknown. And discretionary blending will also have a headwind.
We spoke to the company and although margins are negative, they still see ethanol trading at a level where refiners continue to blend. Gas (RBOB) is currently trading at 60-70 cents, while ethanol net of RIN values (renewable credits given to the blender when they blend ethanol) are at 70-80 cents - currently at a 10-20 cent premium to gasoline. While ethanol usually trades at a discount to gasoline, ethanol would need to be at a 40-50 cent premium to gasoline for an extended period of time to incentivize full switches for refiners over to MTBE.
While things are going to be challenging for the next few months or quarters, we believe the industry has finally arrived at maximum pain. Ethanol margins are currently -25 cents per gallon, inventories are high, and losses are large enough where complete shut downs make sense. There are already reports trickling in of ethanol plants halting corn bids, a precursor to halting operations. Industry observers are also saying that this time some of these shutdowns will be permanent or semi-permanent, as most facilities are funded with debt.
We believe as a top producer in the industry GPRE has the cash position to survive. We go through below why we believe that. At the same time there are a few potential upsides to the industry going forward which would benefit any players that emerge from this downturn, as the industry comes forward with lower production levels and more rationality.
The Ethanol Industry
We don’t need to sugar coat the ethanol industry - many previous hopes of the industry reaching supply and demand balance in the past proved to be short lived and production always ticked higher. GPRE and the industry will certainly lose money in 2020. However at its current share price, GPRE is pricing in the worst of the worst (as if it is near bankruptcy) while there are certain things on the horizon which could improve things very quickly.
The ethanol industry has been in a multi-year down turn driven by over-capacity, as well as regulatory hits by the Trump Administration. In addition, a 70% import tariff levied by China in 2018 in retaliation to a trade war reduced export demand to one of the largest ethanol export markets in the world. In its current state, the U.S. ethanol industry has approximately 16.5 billion gpy of nameplate capacity. Domestic blending demand falls around 14bn gpy, and export demand at 1.5bn gpy, leaving about 1bn gpy of oversupply in the industry.
The industry has stubbornly survived the last 2-3 years of a downturn, and operating rates have not come down meaningfully. We believe this is because the lower 50% of the industry are plants owned by farm cooperatives - co-ops that were started to buy corn from local farmers. Those co-ops are willing to fund cash losses through debt or equity, knowing farmers are getting payments from government assistance programs. We also believe the hopes of a China trade deal also kept production high, leading to high inventories to start this year as producers anticipated immediate China buys.
There are a number of developments of the past year that COULD help the ethanol industry from here:
1) Small Refinery Waivers - At its start, the Trump administration (specifically the EPA), was extremely “oil friendly”. The EPA used a “financial hardship” rule to grant exemptions to small refineries for biofuel quotas, without clearly defining what financial hardship was. The fight in congress has been fierce, however in January there was a court ruling that set a precedent to strike down some of the excessive waivers. The EPA in 2019 also committed to re-allocate at least a portion of waived gallons to reduce demand losses. The fight is ongoing, but it seems the oil industry got clear favoritism in the past and now that is more balanced.
2) Chinese Export Demand - Ethanol was heavily rumored to be part of the trade deal signed in January. It’s a product that China actually needs, as specific provinces in China have already mandated E10 requirements (to reduce pollution), and domestic Chinese capacity and corn stocks are not adequate. GPRE still believes China will take hundreds of millions of gallons of ethanol in the back half of the year. We’ve spoken to one expert on the ground in China, and he’s noted for the refineries, the economics of blending U.S. ethanol is favorable even at 20-30% tariff levels and they will do it (Tariffs are currently 70%, however there have been reports that companies can start to apply for waivers as of March). The expert believed that China could take up to 250-500mm gallons near-term, which would put a 25-50% dent in the current level of oversupply.
3) Year Round E15 - In 2019, the Trump Administration approved rules to allow for year round blending of up to 15% ethanol in gasoline (currently mandated at 10%). Economically, when ethanol is at a discount to gas, retailers are happy to offer lower prices to consumers. Oil refiners, however, don’t prefer to substitute more. What ultimately drives the industry is lower prices for E15 blends and uptake of that by consumers. However the infrastructure and labeling of pumps is required to dispense the gas. The USDA has recently approved a new $100mm program to help retailers install pump upgrades across the country. E15 stations are expected to grow from 2000 to 3000 (out of 150k total in the USA) and should be a steady source of demand growth for ethanol and will be for years to come.
We’ll stress again that this write up is not a call on the ethanol industry - but instead we’re just outlining how it COULD have some upside from here and how GPRE will be a different company in a few years, and one that is insulated from the volatility in ethanol economics and regulation.
We can approach valuation in a few ways. First, where the stock is at currently - at approximately $4 per share, we estimate GPRE’s ethanol assets are priced extremely low at 15 cents per gallon capacity.
This number can vary if you value other income streams for GPRE differently, or if you add in working capital debt - but the band remains the same with a valuation that is nearly zero cents per gallon.
We can then compare this 15 cent implied value per gallon to other metrics to:
· It costs $1.50 to $2.00 per gallon to build a new ethanol plant
· Prior to the last few years, ethanol plants had earned 10-20 cents per gallon for long stretches of time
· In bankruptcy over the past few years, we have seen assets trade at 30-50cent per gallon. Most recently, on March 3rd Pacific Ethanol (PEIX) sold its majority interest in a 145mm gpy ethanol plant to its co-op partner - valuing the plant in total at ~50 cents per gallon
· Prior to the ethanol downturn, reliable assets traded at $1 per gallon. And in 2018, GPRE themselves sold 3 plants at ~70 cents per gallon
A slightly more reasonable valuation on the base business at 50 cents per gallon yields an upside price fully diluted at $15 per share:
And over a longer-term period, we believe you have to look at the net value of the high protein and cost reduction initiatives. If we continue to value ethanol assets at 50 cents per gallon, while GPRE adds $230mm of EBITDA at a 5-7x refiner multiple, we can add an additional $14-24 per share to our diluted base case valuation over 4 years putting the share price at $31-40 vs. $4 today.
If GPRE assets were valued at their most recent transactions from late 2018 of ~70cents per gallon, that adds $5 to our share price. And at replacement cost of $1.75 a gallon, that’s an extra $25-30 per share to value.
The bottom line is the market is currently ascribing nearly zero economic value to GPRE’s ethanol assets, OR it’s high protein upgrade/cost reduction initiative. We think it’s also interesting to add the interplay between those two factors - for the high protein initiative and cost reduction upgrade to have zero value would imply that the entire industry must make these upgrades and compete away the profit pool. However, that means that there is economic value to ethanol assets that should be higher than zero.
Downside, Upside and Liquidity
As far as the downside, we first start with liquidity in the current environment. The company has no debt maturities until 2022, and $270mm of cash and a revolver with $290mm of capacity. Approximately $110mm of cash is required for the remaining growth and maintenance capex projects this year. Additional protein projects are expected to be project financed at the asset level. That leaves GPRE with approximately $160mm of cash liquidity and $290mm of revolver capacity. So if the stock is priced as if it will go bankrupt (like unrelated shale E&P players, in the XOP), this is incorrect.
At the moment, crush margins in 2020 are looking very similar to 2019 (negative through the year except Q4) - where GPRE burned $27mm of CFFO in 2019. Even if they burn $50mm of cash, the company has enough liquidity to make it through 2 years of a continued downturn in the industry, or at least make it through the point where their capital projects add cash or even self-fund.
We also believe if shares stayed low enough, it is possible that oil refiners have interest in ethanol assets. GPRE’s plant sales in 2018 were to Valero, who saw value in integrating ethanol production into its gasoline blending after a tough year for ethanol producers. Since blending is government mandated, refiners have a clear incentive to own ethanol at the right price. If we saw vertical consolidation like this in the 30-50 cent per gallon range, that would translate to roughly $10-15 per share for GPRE, before consideration of any value from the protein initiative.
And as far as an upside or bull case, we can split up the value of protein at their various contribution levels, and the value of ethanol assets at various valuations per gallon.
The above table is illustrative - we can choose to value protein at different levels and also if we want to include the value of ethanol. In 5 years, if we believe all ethanol profits are competed away to zero, GPRE is still a $237-406mm EBITDA company (at the 53-56% protein levels targeted) and net of all costs/debt, at 7x EBITDA the company could be worth as much as $50 per share. If at that point ethanol were to be valued at 50cents a gallon (and nothing else for other income streams), it is an incremental $13 per share.
1) Continued meager ethanol industry conditions, leading to higher cash burn and a liquidity problem. If gasoline demand remains tepid, while China does not engage sometime in 2020 or 2021, while production remains high, the industry will continue to have 500mm-1bn gallons of excess overcapacity.
2) Failure of the cost reduction or protein initiatives - these are new processes, and delays or assumption changes are possible.3) Regulatory changes around the RFS removing the 10% ethanol mandate - this is a continued fight for years between Big Oil and Big Corn. Democrats have historically been more Big Corn friendly, while Republicans are Big Oil friendly. The tide can and has shifted in the past.
China returns to buying U.S. ethanol exports, normalized fuel demand post-COVID, Protein upgrades enhance earnings power
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