June 18, 2019 - 11:36pm EST by
2019 2020
Price: 15.21 EPS 0 0
Shares Out. (in M): 38 P/E 0 0
Market Cap (in $M): 572 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 572 TEV/EBIT 0 0

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I recommend entering a long position for Renewable Energy Group (ticker REGI); today's closing price is $15.21/share.

Last year tugger85 wrote an excellent piece about REGI; the share price has since risen from $13 to $32 and has now fallen back to about $15 (actually it felt back to $13.6 then climbed back to $15.21 today due to a new development about BTC, to be discussed below). I believe this is a great entry point because the valuation is very compelling and there is a high likelihood catalyst in the near future (which, if happens as predicted, will move up the share price by at least 40% immediately).

industry background
REGI is the largest biodiesel producer in North America. Last year it sold 649M gallons of fuel and generated revenues of $2.4B (~25% market share). The company started as a producer of "green" household cleaning products and has grown into a big player in the biodiesel industry. Due to its scale and flexible use of feedstock, REGI has became the low cost producer. Most biodiesel is produced by small mom and pop shops using soybean oil while REGI is mainly using animal fat as input which has significantly lower cost.

Biodiesel is a low carbon, renewable alternative to petroleum based diesel. Pure biodiesel B100 will have CO2 and hydrocarbon emissions that are up to 80% and 60% less than petroleum based diesel emissions respectively. Making diesel from biomass is not economically competitive without government subsidy and this whole industry was created by the Renewable Fuel Standards (RFS). The RFS is a federal program that requires transportation fuel sold in the US to contain a minimum volume of renewable fuels. It's volume requirement for biodiesel by year is the following (see this wiki page ):
2014    1.63B    (billion gallons)
2015     1.73B
2016      1.9B
2017      2.0B
2018      2.1B
2019       2.1B
2020      2.43B
and this number is projected to grow going forward.

The biodiesel industry is complicated because it has two forms of government subsidies instead of one. The first form is Renewable Identification Number (RIN); which is a serial number assigned to a batch of biofuel. Refiners can either purchase biofuel to blend or purchase RIN to satisfy its blending volume requirement. RFS volume requirement + RIN is enough to create a well functioning market to distribute blending cost among refiners; but the industry has another form of subsidy called biodiesel tax credit (BTC) which gives the producer $1 for each gallon produced.

dynamics of the industry
If there is no BTC, things would be much simpler (and we will not have this opportunity to make money). In that case RIN price will drive supply/demand into balance: if there is not enough biodiesel to satisfy RFS volume requirement, RIN price will be higher to activate more (high cost) production capacity; if there is too much biodiesel then RIN price will be lower to reduce some (high cost) production. Overall a low cost producer like REGI would make money consistently (making at least the cost spread) in such an environment.

The situation is similar if BTC is always active because in that case people will simply shift their cost calculation by $1/gallon. It's the uncertainty of BTC that is causing the problem. Namely, there are three cases for each given year:
(A): year begin have BTC.
(B): year begin no BTC, year end BTC retroactively granted.
(C): year begin no BTC, year end BTC not retroactively granted.
Case (A) is simple because people will just take BTC into their cost consideration. In case (B), things will be equivalent to (A) if everyone is expecting BTC; things will be better than (A) if not everyone is expecting BTC; so overall (B) should be no worse than (A). Since the introduction of RFS, BTC has been granted every single year, either at the beginning of the year or retroactively at year end:
2005 current
2006 current
2007 retroactive
2008 retroactive
2009 current
2010 retroactive
2011 current
2012 retroactive
2013 current
2014 retroactive
2015 retroactive
2016 current
2017 retroactive
2018 ??? no BTC at year start, will it be retroactively granted???

So I think most players are expecting BTC if it's not instated at the beginning of the year and (B) should be roughly equivalent to (A). The bad scenario is (C) (because people will set price as if there is BTC; so they will lose money without BTC) which has never happened before and I think it's not unlikely to happen in the near future. There is another possibility:
(D): year begin have no BTC and people don’t expect it to be retroactively granted (for example, if some bill passes explicitly saying that BTC will be inactive for certain period).
If (C) happens then we might move into (D) which is strictly better than all other cases because in that scenario everyone will set price assuming no BTC so any BTC change will be pure upside. In fact, the industry is lobbying very hard trying to get 5 years forward BTC certainty: either have BTC every year for the next 5 years or no BTC for sure for the next 5 years; REGI is a supporter of this lobbying effort; from our analysis you can see why BTC certainty is good for REGI. I think 5 years BTC certainty is very unlikely because politicians usually don’t want to give up their bargaining chips.

REGI valuation
Let's first consider REGI's normalized EBITDA when there is BTC; i.e. the (A), (B) cases above. REGI's EBITDA/gallon is about $0.45 for the five year period 2012 - 2017 and last year 2018 is higher. Assume REGI has volume >= 600M gallons going forward; it's annual EBITDA would be >= 600M * 0.45 = 270M. The current market capitalization is $572M which is about 2.12x EBITDA. If (C) happens then REGI will break even or lose a small amount of money in that year; but as discussed above; this likely is good for REGI’s long term prospect. In any case, if we assume the probability of (C) is <= 20% and REGI is worth >= 4x EBITDA with BTC then the multiple should be at least (1 - 20%) x 4 = 3.2 compare with the current multiple of 2.1. So the share price is significantly undervalued from this perspective. Using average per gallon EBITDA margin calculated over the past 5 years should be on the conservative side because: (1): RFS biodiesel volume requirement was increasing every year; it has been increased to 2.43B from 2.1B in 2020; this is expected to grow at 7% CAGR going forward (the CAGR from 2014 to 2020 is about 6.9%); so demand is growing; (2): US passed a biodiesel antidumping duty bill which eliminates more than 500M gallons of foreign supply from Argentine and Indonesia completely; (3): REGI is expanding production capacity to capture a large share of the market.

REGI will receive $237M (about $6.3/share, about 40% of the current price) if BTC is retroactively instated for 2018. I will argue below that this is likely to happen in the near future. But before doing that, let’s analyze the downside scenario and the trading situation. The news about retroactively instating BTC for 2018 came out yesterday after market close and the price today moved from $14.31 to $15.21; 1 - 14.31/15.21 = 6%. So if BTC 2018 ended up missing the share price will drop back somewhere around the pre-news level; let’s say it’s about 10%. If we get BTC 2018 then the share price will move up by at least +40% $6.3/share ($6.3 from BTC; it’s possible that 2019 BTC is also included in the bill; also having 2018 BTC retroactively instated increases investors’ estimate of future BTC probability). Suppose the probability of getting retroactive 2018 BTC is p, then the break even point is: p*(+40%) + (1-p)*(-10%) = 0; p = 20%. Based on historical data I think p is significantly higher than 20%. Also I will argue below that likely we will get retroactive 2018 BTC very quickly.

Some other minor items:

(1): Book value per share is $18.96 so the current share price is about 80% of book value.

(2): the CEO Warner Cynthia bought 4000 shares at $14.16 yesterday; after this purchase her total holding is 62578 shares worth about $900K.

BTC situation
Yesterday house committee on ways and means proposed a bill "Taxpayer certainty and disaster tax relief act of 2019"; which contains the BTC extension in Subtitle C Section 121: Biodiesel and renewable diesel. The draft version does not specify whether this is only for some specific years or for certain number of years going forward; but in any case, the 2018 lapsed BTC will definitely be reinstated if this bill passes.

If you look at the senate/house voting procedure you will realize that this bill is very likely to pass. First of all, without one party controlling president/senate/house all three, it’s very difficult to pass a single item bill. This is especially true for special interest things like BTC. That’s why the market didn’t care a bit when Republican senator Chuck Grassley introduced a bill including 2018 BTC; also there was another BTC bill introduced by a Democratic congressman Abby Finkenauer from Iowa Based on senate/congressman voting history over the past many years we know there is bipartisan support to BTC; but these two bills are very unlikely to pass. To pass something like BTC, you need to patch it to the government spending bill, or a bill containing many other special interest items so that senators and congressmen have incentive to motion the bill; otherwise the bill will just sit there collecting dust (don’t be fooled by the list of cosponsors; having a large number of cosponsors means nothing; what counts is whether the few key players have incentives to move the bill forward).

The house committee on ways and means bill is likely to pass and retroactively instate BTC because:
(1): Democrats controls the house and this bill is led by a Democrat congressman Richard Neal (he is the chairman of the house ways and means committee) so he wants to vote this bill. There will be some back and force bargaining but this bill will get voted and it will pass the house.
(2): After this bill passes house, it will be sent to senate committee on Finance. Republicans controls the senate and this committee is chaired by…… Chuck Grassley from Iowa. If you remember from above, Chuck Grassley introduced another bill containing the BTC item earlier this year. If you check his history, Chuck Grassley is the most ardent supporter of BTC. So house democrats know that if this bill does not have BTC it will never be voted in the senate. Therefore, the final version passed to senate will definitely have the BTC item.
(3): BTC has bipartisan support. Trump needs support from farmers. So if a bill containing BTC actually get voted it will pass both house and senate and pass Trump. As discussed, the house committee on ways and means bill will get voted in the house; and when passed to the senate finance committee it will also get voted because the finance committee chairman Chuck Grassley wants to pass the BTC stuff (a lot of other Republican senators also have incentives to pass this bill); and Trump will definitely ok this bill.
(4): House will discuss this bill on Thursday this week so things will play out very quickly.

(1): the current valuation is compelling with limited downside.
(2): with high probability the “Taxpayer certainty and disaster tax relief act of 2019” bill will pass in the near future and retroactively instate BTC for 2018 which will move REGI up by more than 40%.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


passing the "Taxpayer certainty and diaster tax relief act of 2019" bill retroactively instate BTC (Biodiesel Tax Credit) for 2018, which will be at least +40% for the current share price

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