Green Plains Renewable Energy is a growing agricultural commodity company and the 4^th largest ethanol producer in North America.  It is trading at a dramatic discount to fair value largely as a result of last summer’s once-in-a-generation drought that drove the price of corn to record highs.  Despite this massive headwind, GPRE’s ethanol division was profitable for the year. In a “normal” corn harvest, (expected in 2013), the company should generate approximately $125 million of annual ethanol EBITDA, while its non-ethanol divisions generate $65m on a recurring basis. Subtracting out the company’s modest capex requirements, low taxes (due to long-term depreciation) and corporate overhead results in a a levered free cash flow yield of approximately 30% on today’s market value of $326 million, and an EV/2014 EBITDA of 3.2x.   Using a modest 6.0 multiple results in a $26 share price in 2014.

One can also look at GPRE from an asset value perspective.  Transactions of similar quality ethanol plants, including two within the past year highlighted in the appendix, have consistently sold for $1.20-1.30 per gallon.  If one were to place this value on the GPRE ethanol plants, and give NO additional consideration for the $65m of additional annual EBITDA, the company’s shares would be worth $24.

While the ethanol market is volatile,  GPRE has demonstrated that even in the worst case scenario (e.g. 2012), it will not lose money on its ethanol production, due to the company’s low-cost position in the production curve as well as its ability to hedge effectively to lock in pockets of profit opportunity.  During the last two years (including this drought period), it has paid down significant debt, repurchased roughly 30% of its shares and opportunistically sold non-core assets at good prices.  Its shares are poised for a material rise when the market gains confidence that the new crop is not a repeat of the extremely low-probability event that occurred last year.  The commodities futures markets are already reflecting this, as ethanol EBITDA margins based on Q4 2013 corn, gas, and ethanol prices are roughly at pre-drought levels (15-20 cents per gallon)

Valuation Summary

 *Not including $47m 2012 EBITDA gain and $50m residual corn revolver debt from 2012 sale of grain silos

GPRE Segment Profiles

EBITDA by Segment ($m)

 (1) Excludes $47m associated with sale of division assets

Ethanol Production

GPRE is the 4^th largest ethanol producer in the U.S., with capacity to produce up to 740m gallons per year.  Its portfolio of modern, efficient large-scale plants, located in strong corn production areas and in good proximity to railways allows it to produce these gallons at a lower cost than most of its competitors.  The plants use 265 million bushels of corn annually and in addition to ethanol, produce and sell roughly 2.1 million tons of distillers grain, a byproduct of the production process used as a feed supplement and included in the profits of the division.  

Corn Oil

GPRE has fitted all of its plants with equipment to produce low-grade corn oil, generated by essentially ‘squeezing’ distillers grains.  It is used as a feedstock for U.S. biodiesel producers and secondarily as a food source for cattle, pigs and chickens.  It is a close substitute for “choice white grease”, and trades with proximity to this product.  Corn oil constitutes approximately 12% of the feedstock used by U.S. biodiesel producers but is growing, as it is a cheaper source of feedstock than alternatives (soy and canola oil) and generates greater output.  Demand for this product will be further enhanced in 2013 as a result of the increased federally mandated biodiesel market as part of RFS II legislation.  According to one very material biodiesel producer “we are using all the corn oil that we can get our hands on”.

The EBITDA contribution from corn oil is material.  GPRE can produce roughly .23 lbs of corn oil for every gallon of ethanol.  At 40 cents per lb this generates $65 million of revenues and $35 million of annual EBITDA for GPRE.

Marketing and Distribution

This segment includes several initiatives: 

• GPRE sells ethanol for other producers and earns roughly a 1% commission, generating a marginal amount of profit.
• Blendstar, a wholly owned subsidiary, operates nine ethanol blending facilities across the US.
• GPRE opened a new storage and blending terminal in Alabama in Dec 2012 which should generate $5m of annual EBITDA
• A railcar subleasing program whereby GPRE leases a surplus portion of its railcar fleet to North Dakota oil drillers who are short on tanker cars.  This initiative is expected to generate roughly $15m of EBITDA in 2013, though it will likely then trail off as the tanker car shortage eases.

Agribusiness

In December 2012, GPRE sold the vast majority of its grain storage business to The Andersons, for $135 million.  Leftover are a few minor grain elevators that generate a small amount of income.  The company plans to opportunistically rebuild this division with storage assets located near its ethanol facilities.

Other

Over the last two years, GPRE has been developing an initiative to utilize excess CO2 from its ethanol plants towards the production of algae, which can be used in food, personal care, and nutraceutical applications, amongst others.  No value is currently ascribed to this effort.

2012 Drought

The USDA describes the 2012 U.S. drought as, “the most severe and extensive drought in at least 25 years”.  Eighty percent of agricultural land experienced difficulty, which “made the 2012 drought more extensive than any since the 1950s”.  Corn was severely affected.  Initial expectations at planting time suggested corn yields averaging a record 166 bushels per acre; by the end of the season the forecast was just 122 bushels per acre, the lowest since 1995.  This resulted in U.S. 2012 corn production of 10.7 billion bushels, down sharply from the early-season projections of 14.8 billion.  Ending stocks for 2012/13 were roughly 647 million bushels, the lowest since 1995/96.  All of this resulted in record high corn prices throughout 2012.

Despite this massive headwind, GPRE was able to achieve breakeven, if not better, EBITDA every quarter in its ethanol division due to a combination of low cost production, hedging strategies, and vertical integration.  Prior to the drought, GPRE generated an average EBITDA of 18 cents per gallon on its ethanol production (over the period 2009-2011), achieving profitability in each and every quarter.

*Excludes any allocation of the annual $23m of corporate expense

Current Futures Curve

The 2013 corn-planting season is again expected to be one of the largest on record.  On February 22^nd the USDA forecasted planted acreage at 96.5 million.  Private projections are even larger.  The USDA also projects corn yields of 163.6 bushels per acre assuming “normal” weather conditions.  This implies a record corn crop of 14.5 billion bushels  (To date the weather has cooperated although this is certainly something to closely monitor.)  If the forecasts are correct, corn prices will drop significantly relative to last year, and ethanol EBITDA/gallon should improve dramatically. 

The futures curves for corn, ethanol, and natural gas can be used to estimate the expected future profitability per gallon of ethanol.  These values shift considerably from week-to-week, depending on changes in the market dynamics for each commodity.  Based on current levels, it is expected that ethanol margins for GPRE will be in the 5-10 cent per gallon range for Q2 and Q3, and then return to historic profitability levels when the new corn crop is harvested in the fall.  Company management has confirmed these margin levels.

Prices as of Feb 25, 2013

The futures market provides the company with an opportunity to lock in ethanol margins for upcoming quarters.  They do this by securing future delivery of corn and natural gas at or around futures market prices, and correspondingly locking in future sales of ethanol at or around the prevailing futures market price.  This process helps to smooth out earnings and in times of negative movement can provide GPRE with a substantial advantage over competitors’ results.  For example, during the planting season in 2012 (but before the drought) GPRE locked in ethanol EBITDA/gallon levels of $0.20 for the fourth quarter of the year for a material portion of its output (more than half).  It should be noted that this year, the company has not yet been able to do this for Q4 as farmers have been somewhat unwilling to sell forward corn in volume.  However, this is likely to change as the crop outlook becomes more clear.

Debt and Use of Capital

Much confusion arises regarding GPRE’s debt levels.  It is important to break these down into several main pieces, in order to realize that this does not represent a material risk to the company.

• Plant-level debt ($400m): Incurred during the construction of the ethanol plants, each plant has a specific term loan and a smaller revolver to cover working capital needs (mainly corn).  Both loans are non-recourse to the parent, meaning that a problem at one plant would not impact the others.  The loans amortize quarterly, and system-wide, account for $400m, or $.54 per gallon.  This is now comfortably below the threshold at which agricultural lenders will provide debt for ethanol production assets.  Company management has stated that they may look to transfer this to a more traditional, non-amortizing note.  If successful, this would add roughly $40m per annum to the company’s discretionary free cash flow.

• Agribusiness debt:  ($105) This debt is a revolving working capital loan made to purchase grain (mainly corn) for GPRE’s agribusiness unit.  Since this division generates very small margins, the debt levels here had historically been disproportionately large vs profits.  However, there is little to no risk associated with this debt, as it is fully secured by the grain assets. Currently on the books is $50 million of debt that is a residual loan left over from its recently divested agribusiness assets.  (Essentially, GPRE elected to sell the grain silos but keep ownership of the corn.)  This debt amount should not be included in calculating enterprise value, as it supports strategic excess inventory which will dissipate as it is used in Q1.

• Corporate level ($157): This includes a note payable of $27 million that will be paid in early 2013 (proceeds had been used to repurchase shares from a large holder) and a moderate-interest convertible note of $90m that is due in 2015 (callable in 2013), and a $39m asset based senior revolver.

The company has used its capital recently towards activities that should be viewed favorably by shareholders.  This includes material plant debt paydown ($110m in 2011-12) and significant share buybacks (30% of all shares outstanding).  Further, the company accepted a 2012 offer from the Andersons for its grain silo business for the simple reason that “the price was right”.

Key Risks

There are many variables that ultimately impact the profitability of ethanol producers.  Some of the more notable risks include:

• Oil Industry Lobbying Efforts: The oil industry seeks to protect its interests and ethanol is a direct competitor.  Lobbying takes many forms including efforts to change/eliminate RFS II, media coverage regarding the perceived negative effects of ethanol on automobiles or of corn supply scarcity on other industries, etc. (“food vs fuel”).  These headline risks could certainly impact the stock price.    

• RFS II Changes: Given that the RFS II requirements of 13.8 billion gallons of ethanol of production are likely greater than the e10 blend wall levels of 13.5 billion gallons (10% of the 135 billion gallons of gasoline used for fuel), it is possible that changes to RFS II will be made. 

• Brazilian Imports:  Brazil has historically been the largest exporter of ethanol into the US (made of sugarcane, not corn) However, recent legislative initiatives in Brazil have increased the ethanol blend mandate, and are expected to put a damper on future exports to the US. 

• Change in corn oil supply/demand: Any shortfall in demand for corn oil is certainly a risk, however RFS II calls for an increase in the use of biodiesel in 2013 and as a feedstock, corn oil’s more attractive price should provide a tailwind to demand.

• Extreme weather: While the drought of 2012 was widely characterized as a once-in-a-generation event, this does not preclude similar or less devastating adverse weather developments for the upcoming crop year.

• Reduction in fuel consumption: The US has been steadily reducing its fuel consumption for the past several years (although early 2013 data has shown an increase).  This continued trend will lower the demand for ethanol as a fuel blend.

APPENDIX

Ethanol Basics 

The U.S. uses approximately 135 billion gallons of gasoline each year.  Ethanol is a substitute for gasoline and in the U.S. it is made from corn, with each bushel producing approximately 2.8 gallons of ethanol.  The U.S. produced 13.3 billion gallons of ethanol in 2012, or roughly 10% of fuel demand, consistent with the E10 blend wall.

The supply/demand, pricing, and profitability of ethanol production in the U.S. is a complicated subject that is affected by many variables, many with their own complicated dynamics.  We will not attempt to address all of these in this report, but they include:

• RBOB/Ethanol Price Spread: Ethanol has consistently traded at a significant discount to RBOB fuel stock (50 cents to $1.00 per gallon).  Even in the back half of 2012 with severe drought and dramatically escalated corn prices, this differential averaged roughly 40 cents.  This translates into direct increased profit for fuel blenders for every gallon of ethanol mixed vs gasoline.

• Oxygenate requirement: In order to meet federal and state emissions regulations, gasoline must be blended with a oxygenate.  Since the banning of MBTE in 2006, ethanol has been the most cost effective additive by a wide margin.

• Octane requirement:  The US gasoline market sets minimum octane ratings for the nation’s fuel supply.  Ethanol, with an octane rating of 113, is blended with gasoline to improve the rating of the overall mix.  Currently, the majority of oil-based feedstock is refined into CBOB, which has an octane rating of 84, below the minimum threshold.  Thus, material ethanol blending is required to meet regulations. 

• Renewable Fuel Standard (RFS II): The federal government has set a required target for corn-based ethanol usage that has increased annually since 2006.  In 2012 this level was 13.2 gallons.  In 2013 it will increase to 13.8 gallons.  It will max out in 2015 at 15.0 billion gallons

• E10/E15 Blend Wall: The EPA imposed blend cap of 10% ethanol per gallon of gasoline known as e10 is gradually being altered to the 15% level (e15).    This will take time, as the required retail infrastructure is built and automakers become comfortable with the demonstrated lack of negative ‘side effects’.  It is possible, and perhaps likely, that the RFS levels in place for 2013 and 2014 will exceed the ability of blenders to use the fuel.  In the short-term, the government has resolved this issue via a system of tradeable credits known as RINs. 

• Import/Export Market: U.S. ethanol exports in 2011 and 2012 of 1.2 billion gallons and 725 million gallons, respectively, exceeded imports of 174 million gallons and 533 million gallons.  In certain periods of the year, imports exceeded imports.  Imports are almost entirely from Brazil, while exports go largely to Canada.  A rise in imports could negatively impact prices.

• Plant Construction Costs: Large-scale U.S. corn ethanol plants will never again be built given the build cost of over $2.00 per gallon, and the fact that the most profitable ethanol plants average 20 cents of EBITDA per gallon of ethanol produced.  Financing a plant would be impossible to obtain; existing plants were built during a period of high government subsidies.

• Transportation Fuel Demand: miles driven in the U.S. peaked in 2007 and has been declining steadily since then as the fuel economy of vehicles steadily improves and high gas prices dampens demand.

• Commodity Costs: corn and natural gas are the two major inputs used to produce ethanol; pricing and availability are a function of their own supply/demand dynamics.

Transactions

Over the past few years, there have been several comparable ethanol plant transactions that clearly set a market price for these assets.  This has continued even in the 2012 ‘drought era’.  This includes the following:

The natural buyers in this market are the top 3 producers (POET, ADM, Valero) as well as other integrated fuel companies such as Flint Hills (a Koch Brothers entity) who recognize the value that these asset will bring to their fuel supply chain.

It should be noted that these transactions are for assets comparable to those of GPRE – large scale, well situated near a deep corn base, constructed by the top tier design firm (Fagen/ICM), and able to accommodate unit trains via a direct rail link.  Investors have likely been confused by transaction prices for assets that do not have these characteristics and which are consequently in a distressed state.  Given their highly disadvantaged position on the cost curve, the value of these assets is materially less than those of GPRE plants.