Pacific Ethanol PEIX S W
May 11, 2006 - 12:28pm EST by
2006 2007
Price: 44.10 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,950 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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Pacific Ethanol (PEIX) is wildly overvalued, and the catalysts to reverse this occur in under two months. It may go up from here before it goes down, but I would be very surprised if the stock were not meaningfully lower in mid-June.

As you probably know, ethanol is an alternative fuel derived from organic products, usually corn. Whether it even has a positive energy balance (i.e., if it provides more energy than it consumes in its manufacture) is still open to debate, but there are significant political interests aligned behind its development, and so its future is bright. Ethanol production should increase from around 4 billion gallons in 2005 to 7.5 billion by 2012, as ethanol displaces both MTBE as an oxygenate (octane provider for gasoline) and grows in popularity as an alternative fuel.

There aren’t too many ways to invest in ethanol today unless you are an agricultural cooperative building a plant next to your cornfields. The only real pure play, in fact, is PEIX, which is planning on building five ethanol plants on the West Coast over the next three years. As such, investor excitement has driven the stock from $10 before Bush’s state of the union address to around $44 today, giving it a market capitalization of around $2 billion (44m shares outstanding including the Cascade preferred), with negative earnings and no revenues from ethanol manufacturing—all revenues are from very low margin marketing. This will reverse by the end of June, when the second- and third-largest ethanol producers, Aventine and Verasun, have their IPOs.

The company does not yet have permits to build all of its plants (nor any significant revenues to speak of), but let’s assume they get them. Then they will build out their 200 million gallons of capacity over the next few years, and by 2009 will have an enterprise value of around $2.3 billion (current enterprise value plus anticipated capital expenditures), or roughly $11/gallon of capacity. Given that there are no competitive advantages or barriers to entry, and that many cooperatives are building plants as a way to market their agricultural products (i.e., they have a lower return hurdle than a competitive enterprise), it seems aggressive to value this company at nine times replacement cost. That having been said, it is a little nebulous to think of this in terms of TEV/capacity, as the company could announce more capacity going forward. Of course, so can everyone else (note ADM’s 275m gallon announcement a few days ago, and Aventine’s 220m gallon announcement in April), which is why ultimately this will be a commoditized business.

In addition, there are potential risks to building plants in California that could make plants there a very bad investment indeed. The first is that the California environmental agency doesn’t want ethanol in its fuel, claiming that its evaporative properties actually exacerbate pollution issues, not alleviate them. For now, there is no substitute (as MBTE has been banned), but other oxygenates (such as isooctane) could displace ethanol demand over the next few years. The second is that it is inherently more expensive to bring in corn from the Midwest (to feed the plants) than bring in ethanol, given the mass differences. Rail congestion could alter this arbitrage temporarily, but over time the plants will be at a cost disadvantage versus Midwest plants. The third is that imports can easily make it to California over the water. Imports are currently blocked by a large import duty, but this tariff can be circumvented through the Caribbean Trade Initiative (as Cargill is doing), and if Brazilian domestic demand ever cools, California is most at risk for that supply. The fourth is that in California, regulatory risk should generally be viewed as higher than in other states.

Contrast this with another company, Aventine Renewable Energy (Verasun has filed its S-1 also). Aventine was a former cooperative that was bought by Morgan Stanley Capital Partners and IPO’d in a 144 transaction a few months ago. They own a wet mill in Illinois and a dry mill in Nebraska as well as the largest ethanol marketing business in the country. The wet mill, which is half of their production, is inherently a lower cost asset than dry mills (significantly higher capital costs mean that no new wet mills will likely be built). The dry mill, as it is still 20% owned by farmers, sources its corn at a 15% discount to the prevailing market.

At current ethanol prices, Aventine trades at around 10x earnings and an enterprise value of $1.7 billion. I think Aventine is clearly superior, so while I am not sure how much it is “worth”, I know it is a higher value than PEIX. It generates (substantial) current earnings, has a much better asset base (from a cost and geographical perspective), has the countries largest ethanol marketing division and yet trades at a discount. On current capacity it trades at $9/gallon, but on announced capacity it is half that.

You can only buy Aventine through the Friedman Billings portal system, but it is liquid, and the pair trade is interesting. The short I believe is equally or more interesting at this point though. Aventine will do an IPO and be publicly traded by late June, with Verasun coming a week or so later. When the market has two legitimate, money-earning companies to use as ethanol proxies, PEIX should quickly deflate. Insider selling has been rampant, and while Bill Gates’ Cascade Investments is a large shareholder, they bought a preferred with an $8 strike price and asset protection—hardly a vote of confidence. The company recently announced that they were locked up on 60% of their holdings through April 2007, but I wouldn’t be surprised to see them sell the remaining 40% sooner than that.


IPOs of Verasun and Aventine in mid to late June
Continued insider sales, including by Gates/Cascade
Some sort of technical reversal (if you're into that kind of thing)
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