- By Jeffrey Alton & Bill Feingold
Convertible Bond Summary
The new REGI convertible bond appeared at least a few percentage points cheap at issue, even with fairly cautious inputs driven by the company’s small size and the market’s unfamiliarity with the name. With a set of cookie-cutter inputs (600 over, 35% vol), the bonds modeled about 3% cheap, but that cheapness vanished as soon as the bonds began to trade. Still, there is plenty of “play” in the assumptions. The options are not particularly liquid or long-dated, but they trade with implied volatilities in the high 40s. Even kicking the volatility assumption up to 40 leaves a couple of points of cheapness in the current price.
Despite the post-issue richening, the bond has the optics of an old-school convertible, and there’s much to be said for that. A five-year piece of paper with a yield exceeding 2.5% and a conversion premium in the mid-30s feels the way a convertible should. Some quick upside/downside calculations suggest this bond is likely to deliver the kind of two-thirds upside/one-third downside we used to expect in most of our deals. These days, though, this is a rarity, and it adds to the appeal of the REGI convertible.
-Low cost producer with the ability to use its balance sheet to grow
-Expected clarification of government incentives in the second half 2014 could act as stock catalyst
-Expanding into new businesses for long-term growth
A Low Cost Supplier……
Renewable Energy Group, Inc. (REGI) is a biodiesel production company operating in the United States. The company’s business model is a low cost producer of biodiesel by retrofitting existing production plants with the capability to refine multiple feedstocks, using the lowest cost mix of feedstock in any given time period. The company’s main product, biodiesel, can be used as a replacement for petroleum based heating oil. Because biodiesel is made from renewable-based feedstock, it is considered more eco-friendly than petroleum-based diesel. The US government has enacted incentives to promote the production of bio-based fuels which are beneficial to REGI.
The biodiesel industry is fragmented with many individually owned refineries built to refine primarily soybeans into biodiesel. However, increases in the price of soybeans over recent years have made these refineries uncompetitive in times of industry disruption. REGI has purchased several of these uncompetitive refineries and upgraded them to refine lower cost feedstocks in addition to soybeans. In 2013, 83% of REGI’s feedstock was lower cost inedible corn oil (derived from ethanol production), used cooking oil and inedible animal fats with the remaining 17% vegetable oils. REGI currently operates 9 refineries with a total nameplate production capacity of just over 270 million gallons annually.
REGI had annual revenues of $1.5 billion in 2013, up 48% over 2012, and first quarter 2014 revenue of $219 million, down 17% from 2013 Q1. The decrease in Q1 revenue was primarily based on the suspension of the Blenders Tax Credit discussed further below. Adjusted EBITDA in 2013 was $148.4 million, up 54% over 2012 and $1.9 million in Q1 2014, down 91% from Q1 2013. Net income for Q1 2014 was a loss of $0.06 per share, down from a profit of $1.11 in Q1 2013, primarily because of the suspension of the Blenders Tax Credit as well as cold winter weather decreasing general economic activity, higher feedstock prices and lower selling prices partially resulting from a drawdown in existing biodiesel inventory levels by customers.
Dependent on Government Subsidies, which have currently lapsed……
Despite being a low cost provider of biodiesel, REGI is still not capable of competing with petroleum-based diesel on the open market. To encourage the development of the biodiesel industry, which indirectly benefits farmers, the US Government had instituted two main incentive programs: the Blenders Tax Credit and the Renewable Fuel Standard (RFS2).
The Blenders Tax Credit
The Blenders Tax Credit pays $1 per gallon federal excise tax credit or a cash refund to the first blender of biodiesel with at least 0.1% petroleum-based diesel fuel. This tax credit became effective in 2005 and has lapsed twice before being retroactively reinstated. The Blenders Tax Credit lapsed for a third time on December 31, 2013 and Congress is currently debating renewal once again.
Renewable Fuel Standard
The RFS2 program outlines required volume obligations, or RVO, of different biofuels to be included in the nations fuel supply on an annual basis. RFS2 has been instrumental in increasing ethanol production from 3.9 billion gallons in 2005 to 14 billion gallons in 2011. Biodiesel production has also grown, reaching 1 billion gallons in 2011.
However, the EPA has suspended the originally mandated RVO for 2014 and is currently reconsidering the volume amounts based on two factors.
- Refiners successfully made the argument that gasoline consumption in the US is dropping and the 2014 RVO would push ethanol concentrations in gasoline beyond 10%, harming the engines in older cars. This is commonly referred to as the “blend wall”
- Environmentalists made the case that using food such as corn for fuel is a mis-allocation of resources in a world where some humans still live in poverty and do not have enough food to eat.
2013 RVO requirements were 16.55 billion gallons, including 1.28 billion gallons from biodiesel. Before the EPA began to reconsider the RVO under the RFS2 program, renewable fuel required volumes were expected to increase to 36 billion gallons by 2022, with an increasing share devoted to feedstocks other than corn starch such as biomass-based diesel substitutes and cellulosic biofuel.
In late 2013, the EPA proposed reduced RVO numbers for 2014 summarized in the following chart. It is important to note that each fuel can be substituted for the RVOs in the lower fuel category. For example, biodiesel can be used to satisfy the RVO in the Advanced biofuel and Renewable fuel categories.
The EPA has submitted the proposed RVO standards to the Office of Management and Budget for their review, so it is likely that the numbers for 2014 will be finalized in the next 30 to 60 days.
Fuel definitions are:
Renewable fuel is a fuel other than an ether produced from biomass and used to reduce fossil fuel based transportation fuel. This is the catch-all category for biofuel. Any excess production from other categories can be used to meet the Renewable fuel requirements.
Advanced biofuel is renewable fuel derived from biomass, other than starch or sugar, with a lifecycle GHG emission 50% less than the petroleum baseline.
Biomass-based diesel is renewable fuel derived from non-petroleum feedstock such as animal or municipal wastes with a lifecycle GHG emission 50% less than the petroleum baseline. Acceptable feedstock pathways include 1) soybean oil and other virgin plant oils or 2) waste grease, waste oils, tallow, chicken fat, or non-food grade corn oil.
Cellulosic biofuel is renewable fuel derived from cellulose, hemicellulose or lignin biomass with a lifecycle GHG emissions 60% less than the petroleum baseline. Cellulosic biofuel production capacity is currently very limited.
But can the government make it more complicated? Yes, of course…..
How do all these different types of fuels get tracked through the US fuel system? The answer is Renewable Identification Numbers (RIN). RINs are certificates that are generated as the renewable fuel is produced and then become standalone certificates when the renewable fuel is blended with petroleum into a transportation fuel or otherwise sold at the end of the supply chain. For example, 1.5 RINs are issued for each gallon of agri-biodiesel produced. When the agri-biodiesel is sold by the refiner, the RIN is transferred along with the physical biodiesel to the buyer. At the front-end of the supply chain, the RIN must continue to be transferred with the physical biodiesel. However, at the end of the supply chain where the obligated party sits, the physical biodiesel may be sold to the ultimate consumer, but the obligated party retains the RIN. At that point, the RIN can be kept by the obligated party to show RVO compliance in the current year or next year, or the RIN can be traded to other obligated parties. RINs are subject to a 20% rollover cap from one year to the next and RINs expire after two years.
This system attempts to introduce market forces to the extent that increases in the production of renewable fuels would theoretically decrease the price of RINs. Also advanced biofuel RINs are typically worth more than general renewable fuel RINs because they count toward multiple categories.
The RIN system also allows fuel producers to skip purchasing renewable fuel directly, but to simply purchase RINs in the open market to satisfy their RVO.
The interaction of RINs and the biodiesel Blenders Tax Credit is somewhat counter-intuitive. If the Blenders Tax Credit is not reinstated, the price of RINs would be expected to rise to entice producers to produce enough biodiesel to satisfy the RVO. However, without the RVO standards, the bio-based fuels industry would collapse.
The catalysts for Growth….
Renewable Energy Growth has three main growth avenues.
- In the short-term, the potential retroactive reinstatement of the Blenders Tax Credit and finalizing the ROV standards would prove to be a windfall for REGI.
- Over the medium term, soybean prices provide cover for additional acquisitions and Growth
- Over the longer term, REGI has begun acquiring technology to develop additional bio-based products such as bio-chemicals and cellulosic fuels.
Reinstating the Blenders Tax Credit and Finalizing the ROV Standards
Debate in Washington continues regarding the reinstatement of the Blenders Tax Credit as supporters press their case. For example, reinstatement was included in the Hire More Heroes Act of 2014, which passed the House and Senate Finance Committee, but is now bogged down on the floor of the Senate. Because 2014 is an election year, there is some speculation that the Blenders Tax Credit will only be seriously considered after the November elections.
A reinstatement would have a positive effect as it did in Q1 2013 when the Blenders Tax Credit was reinstated retroactively to cover 2012. Upon payment, REGI realized revenue of approximately $57.4 million on total revenues of $264.4 million for that quarter, a significant windfall that could be repeated if the Blenders Tax Credit is once again retroactively reinstated in Q1 2015.
Conversely in the short-term, the expectation that the Blenders Tax Credit will be reinstated retroactively can have a negative effect on margins. Biodiesel prices may actually drop by the expected tax credit, but the tax credit is paid in the future creating a cash flow crunch. This was the case in the second half of 2012 when the market correctly anticipated retroactive reinstatement in 2013. However, this short term period of negative margins proved advantageous for REGI as several smaller biodiesel producers suspended production, providing acquisition targets for REGI. Once the Blenders Tax Credit was ultimately paid, margins for the entire 2012 period were rebooked as positive.
Switching gears to the RVO standards - the current proposed flat biodiesel number has temporarily depressed biodiesel purchases as the 2013 RIN overhang gets absorbed by the market. However, any upside surprise to the proposed EPA biodiesel RVO of 1.28 billion gallons would result in a tailwind for REGI.
Soybean Prices Provide Cover for Additional Acquisitions and Growth
Soybeans remain the major feedstock for biodiesel production and as such, result in a higher RIN price to encourage biodiesel production. As mentioned, 83% of REGI’s feedstock in 2013 was lower cost inedible corn oil (derived from ethanol production), used cooking oil and inedible animal fats. By upgrading acquired plants to use other low-cost feedstocks, REGI has developed a model to take maximum advantage of the ROV/RIN system. In other words, RINs are priced at soybean feedstock levels, but REGI produces with lower priced animal fats, etc. Disruption and downturns in the industry will continue to provide opportunities for REGI to use their superior business model and balance sheet to purchase and upgrade smaller producer facilities.
Most recently, REGI acquired Syntroleum which owns a 75 million gallon per year biorefinery in Louisiana. Syntroleum was 50% owned by Tyson Foods and was designed to refine low grade chicken fat into renewable biodiesel. The plant has been idled since the industry downturn in 2012, with the partners unable to agree on restart terms. The plant provides REGI the opportunity to use its manufacturing expertise and stronger balance sheet to make the plant profitable, without adding additional capacity to the market.
Bio-Based Chemical Acquisition
In early 2014, REGI acquired LS9 which is developing microbes capable of producing renewable chemicals. Prior to being bought by REGI, LS9 had raised a total of $75 million from well know venture capitalist firms such as Khosla Ventures and Blackrock.
Similar to REGI’s biodiesel multi-feedstock platform, LS9 is developing one-step microbe pathways to bio-based chemicals which can use a variety of feedstocks including conventional cane and corn sugars, cellulosic sugars and crude glycerin from biodiesel production. Obviously using crude glycerin from biodiesel production offers synergies with REGI’s current refineries.
Bio-based chemicals which can compete with traditional petroleum-based chemicals in price and performance are a growing market as the chemical industry becomes increasingly sustainable. While the LS9 acquisition will continue to be developmental in nature for the foreseeable future, it is REGI’s first step in creating a new bio-chemical platform.
Investors should be pleased going forward….
While REGI common stock has been as high as 16 over the last year, its price dipped below $10 on the disappointing first quarter results and the recent convertible bond issue.
With both potential short-term and long-term catalysts available, investors may have become overly focused on the current period of political disruption and lower operating margins. Resolving the Blenders Tax Credit and ROV issues in 2014 coupled with REGI’s expanding production could provide a catalyst back to the higher 2013 stock prices as history repeats itself.
The following chart from the Iowa State University’s Center for Agricultural and Rural Development, which tracks biodiesel profitability, shows that periods of underperformance, typically arising from incentive expiration, are often followed by periods of high profitability as the incentives are reinstated retroactively.
The sections in red are industry operating profitability and indicate that the biodiesel industry is currently experiencing a period of lower profitability, but as has happened in the past, margins are likely to rebound strongly when incentives are reinstated. Thus, the recent drop in REGI’s stock price provides investors who believe that incentives will be reinstated with a reasonable investment entry point to participate in the future growth of the company.
However, even if the Blenders Tax Credit is not reinstated, the RFS2 alone can support profitable biofuel production for low cost producers like REGI over the long haul. Upon any announcement that the Blenders Tax Credit will not be reinstated, supply would likely fall and RIN pricing should begin to adjust to allow REGI to expand their margins once again.