TODAY’S STUDY: A BUY IN BIODIESEL

Renewable Energy Group Has 150%+ Upside On Higher Capacity And The Blend Wall

Tristan R. Brown, August 2, 2013 (Seeking Alpha)

Summary

Renewable Energy Group (REGI) is one of the rare success stories in the U.S. biofuel sector at present. Of the four producers of biodiesel and/or renewable diesel to have gone public in recent years, it is the only one that is currently trading above its IPO price (see figure). Its performance in 2013 has been especially notable, as the company's shares have increased in value by 167% YTD.

REGI at a glance

REGI operates eight biodiesel facilities with a combined annual nameplate capacity of 257 million gallons. Of these, three are located in Iowa, two are located in Illinois and Texas each, and one is located in Minnesota. The company is constructing four more facilities with a combined annual nameplate capacity of 150 million gallons in Georgia, Kansas, Louisiana, and New Mexico. When completed, these facilities will bring REGI's annual production capacity to 407 million gallons, cementing its status as the largest biodiesel producer in the U.S.

Like the rest of the biofuels industry, REGI ran consecutive quarterly losses in the second half of 2012 as drought conditions caused feedstock prices to increase sharply (see table), reducing profits. Revenues also fell in Q4 2012 due to a combination of lower biodiesel prices and fulfillment of the biomass-based diesel volumetric mandate for the year, although this may have improved QoQ net income due to the poor operating margins that existed at the time. Both revenues and profits rebounded to new highs in Q1 and Q2 2013 due to a 30% increase in the biomass-based diesel volumetric mandate, higher diesel prices, a tripling of biomass-based diesel [D4] RIN prices, and the retroactive renewal of the biodiesel blenders' credit from 2012 through 2013.

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REGI and the RFS2

Foremost among the factors contributing to REGI's success is the company's participation in the revised Renewable Fuel Standard [RFS2]. The RFS2 mandates the blending and consumption of annual volumes of different categories of biofuels. It provides a financial incentive for the production of the biofuels required to meet these mandates in the form of Renewable Identification Numbers [RIN]. RINs are tradable compliance commodities that are attached to each gallon of biofuel as it is produced and detached as each gallon is blended with petroleum-based fuels for retail. Refiners, termed "obligated blenders" under the mandate, are required by the RFS2 to blend a specific volume of biofuel (the "Renewable Volume Obligation," or RVO) that is determined by their respective market shares of domestic transportation fuel sales. These refiners must submit a sufficient number of RINs to the EPA at the end of each year to demonstrate that they have blended or sold volumes equal to their RVOs for the year. Each RIN is equal to one gallon of ethanol-equivalent on an energy basis.

RINs resemble carbon credits under a cap-and-trade scheme in that they can be bought and sold. A refiner that has not blended or sold enough gallons of biofuel to meet its RVO can purchase the balance from a refiner holding excess RINs. The RINs thus have a market price that operates as a function of the difference between the attached biofuel's market price and feedstock cost. Other things being equal, RIN prices increase when feedstock prices increase and decrease when biofuel market prices increase (with petroleum prices serving as a proxy). Biofuel producers, as the only parties capable of generating new RINs via biofuel production, are thus assured of receiving sufficient value via RINs to incentivize enough production to meet the mandate. To prevent biofuel producers from receiving windfall profits, however, RIN prices fall to zero when biofuel production exceeds the mandate.

Four nested biofuel categories exist under the RFS2 (see figure). The first is the "total renewable fuel" category, which encompasses the other three categories. It is thus the largest category by volume until 2022 and primarily consists of corn ethanol, which is capped at 15 billion gallons per year (BGY) under the RFS2. The second is the "advanced biofuels" category, which encompasses the final two categories: biomass-based diesel and cellulosic biofuel. The advanced biofuel category volume is greater than the combined biomass-based diesel and cellulosic biofuel categories, and the difference is primarily met via sugarcane ethanol imported from Brazil. The biomass-based diesel category covers lipid-based biodiesel and renewable diesel and is the category in which REGI has primarily participated in to date.

Corn ethanol producers have contributed the greatest volume of biofuel under the RFS2. The size of the corn ethanol market is expected to run into a ceiling known as the "blend wall" at some point in 2013, however, due to an unwillingness among consumers to purchase ethanol in blends with gasoline of greater than 10% by volume (E10). The ethanol blend wall is expected to be reached when ethanol consumption reaches 13.4 billion gallons, which is short of the 13.8 billion gallons that corn ethanol had been expected to contribute to the RFS2 this year. Recognition that the blend wall was about to be reached caused refiners to snap up RINs at the beginning of the year. Corn ethanol (D6) RINs soared from $0.04 in January, a level that they had yet to rise above up until that time, to a peak of $1.45 in July (see figure). While D4 RINs began the year at approximately $0.50, they closely tracked D6 RINs on the way up due to the nested nature of the categories, which allows fuels in the biomass-based diesel category to alternatively qualify for advanced biofuel [D5] or D6 RINs. As a producer of D4 RINs, REGI greatly benefited from the high RIN prices. In its Q2 conference call it reported an average RIN closing price of $0.94 for Q2, during which it also sold 69.2 million gallons of biodiesel.

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The biodiesel blenders' tax credit

The Congressional deal that averted the fiscal cliff at the beginning of 2013 included a retroactive renewal of the Biodiesel Mixture Excise Tax Credit, otherwise known as the biodiesel blenders' credit. It is a refundable tax credit worth $1 for every gallon of biodiesel that is blended with petroleum-based diesel prior to retail. The legislation retroactively renewed it for 2012 and it continues until the end of 2013. REGI recognized a net benefit of $57.4 million in Q1 2013 from the retroactive portion of the credit, which contributed to the 95% increase to cash and cash equivalents that it reported in Q2 2013. This in turn contributed to the company's strengthened balance sheet and current ratio at the end of Q2 (see figure).

Improving margins

REGI also witnessed stronger soybean crush spreads in Q1 and Q2 2013 as soybean oil prices fell relative to diesel prices (see figure). This represented a complete shift from the summer of 2012, when the drought narrowed the gap between the two prices.

Future growth potential

As mentioned above, the arrival of the ethanol blend wall has resulted in a maximum consumption volume of ethanol in 2013 that is 400 million gallons short of the 13.8 BGY mandate for the total renewable fuel category. This difference increases to 1.2 billion gallons in 2014 and 1.9 billion gallons in 2015 due to annual increases in the volumetric mandate and the expected decline in gasoline consumption resulting from increases to engine fuel economy. While a number of options are available for making up the difference, biomass-based diesel production is in the best position to do so over the next two years. Biodiesel does not face the same blend wall ceiling as ethanol, as its production is equivalent to just 2.3% of diesel consumption (based on 2013 biofuel production and EIA estimated diesel consumption for the same year) while U.S. engine warranties permit biodiesel blends of at least 5 vol%. U.S. biodiesel production as of the end of June is on track to reach 1.27 billion gallons in 2013 out of the 1.28 billion gallon volumetric mandate. This is equal to only 58.6% [pdf] of U.S. biodiesel production capacity as of May 2013 according to the Energy Information Administration [EIA], resulting in 900 million gallons of unused capacity. Another estimate byBiodiesel Magazine calculated 3.3 billion gallons of U.S. capacity (both existing and under construction) in 2012, although no reason is given by the latter for its higher figure relative to the EIA's calculation.

Each gallon of biodiesel produced under the RFS2 generates 1.5 RINs due to the difference in energy content between a gallon of biodiesel and a gallon of ethanol. The blend wall-induced ethanol production shortfall means that the difference could be met by 267 million gallons, 800 million gallons, and 1267 million gallons of biodiesel in 2013, 2014, and 2015, respectively. Sufficient biodiesel capacity exists at present to both meet the biomass-based diesel volumetric mandate and make up for the corn ethanol shortfall until 2015. Furthermore, given new capacity such as the 150 MGY currently under construction by REGI, there is a very good chance that biodiesel could meet the 2015 shortfall as well.

These numbers are conservative in that they assume that the annual volumetric mandate for the biomass-based diesel category doesn't increase in the future. The RFS2 permits the Environmental Protection Agency (EPA) to determine the volumetric mandate for the category each year based on capacity and production trends; in 2013, for example, the EPA increased the category's volume by nearly 30%. Given the continued success of the biomass-based category and the 60% reduction in greenhouse gas emissions attributed to qualifying biofuels under it, there is a strong possibility that the EPA will further increase the size of the category in the future.

The above figures also exclude the portion of the advanced biofuels mandate attributed to sugarcane ethanol, which reaches 1.5 billion gallons in 2015. Sugarcane ethanol is limited by the same U.S. blend wall as corn ethanol, so an additional 1 billion gallons of biodiesel would be needed to meet the advanced biofuels volumetric mandate by that year as well. Even if we assume that the biomass-based diesel category remains unchanged from its 2013 level, 2.3 billion gallons of additionalbiodiesel production would be required by 2015 to meet the total renewable fuel, advanced biofuel, and biomass-based diesel categories. (At this level the supply of domestic feedstock becomes the major limiting factor; assuming that 7.5 pounds of lipids are required to yield 1 gallon of biodiesel, then 27 billion pounds of lipid feedstocks would be required by 2015 to meet all three volumetric mandates. In 2010-2011 the USDA estimated the total U.S. supply of lipid feedstocks to equal33.1 billion pounds.) Assuming that the RFS2 remains in its current form through 2015, U.S. biodiesel production will need to increase by 176% in two years to eliminate the biofuel shortfall created by the blend wall.

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Future RIN prices

D4 RIN prices have remained high even as biodiesel production has remained on pace to meet its 2013 mandate and the crush spread has improved because it may be needed to meet the total renewable fuel and advanced biofuel mandates as well. The previous D4 RIN price of $0.50 was insufficient to encourage this additional production and its current price will therefore remain high until sufficient production begins to come online. This is an immense benefit to companies with stronger balance sheets such as REGI, as the RINs will effectively subsidize purchases of existing capacity and construction of new capacity by increasing until the transaction becomes economical. RIN prices also serve to insulate producers such as REGI from petroleum and feedstock volatility by increasing in response to deteriorating product margins.

Risks

At present the missing ethanol gallons under the RFS2 are most likely to be replaced by increased biodiesel production. There are two alternative scenarios that could occur, however, and the occurrence of either would reduce the opportunity for growth in the biodiesel market. The first alternative scenario is that the blend wall is overcome via increased consumption of higher ethanol-blend fuels, such as E15 and E85, by consumers, thereby increasing the blend wall volume by a corresponding amount. For several years economists and policymakers considered this to be the most likely scenario for a number of reasons outlined here. Consumer opposition to higher ethanol blends specifically and fuel ethanol in general was not anticipated but has occurred, resulting in very low rates of E15 and E85 consumption. One reason that D6 RIN prices have increased as much as they have is because the RINs for that category now serve to subsidize ethanol consumption rather than production; this despite a significant improvement in ethanol production margins since 2012. The high D6 RIN prices are necessary to incentivize consumers to increase consumption of E15 and E85 via lower ethanol prices. It is possible that D6 RIN prices will remain high enough for this to occur at the level necessary to significantly increase the blend wall volume, although such a situation to be probable. Consumers will require evidence that any discount to ethanol relative to gasoline on an energy basis is more or less permanent before switching fuels (especially to E85, which only runs in modified vehicles), and enough extra biodiesel capacity will have most likely come online to reduce D6 RIN prices before this occurs.

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The second alternative scenario is that either Congress or the EPA adjusts the total renewable fuel volumetric mandate down to match the blend wall volume. It is unlikely that the EPA will do this since it attributes a 20% reduction to GHG emissions for corn ethanol relative to fossil fuels but a 60% reduction for biodiesel; given the agency's goal of reducing the GHG emissions of the transportation sector, it would likely approve of the replacement of corn ethanol production by biodiesel production in furtherance of it. Congress, on the other hand, recentlyheld hearings on the subject of RFS2 reforms and several members have expressed a desire to depress RIN prices. While the motivation exists, Congress has passed a total of 15 bills so far in 2013, five of which were commemorative or related to disaster relief. The earliest that a new Congress will be sworn in is January 2015, so it is unlikely that any RFS2 reforms will occur prior to that date. The worst-case scenario for REGI, a full repeal of the RFS2, is extremely unlikely given that several GOP representatives have stated that they don't have the votes in the House (let alone the Senate) to pass such legislation.

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The Bottom Line

REGI is in a strong position as the country's largest biodiesel producer to take advantage of the increased production that will be required in the next 42 months to meet the RFS2 volumetric mandates. In addition to the 257 MGY in existing capacity that it owns, the company is in the process of building another 150 MGY in new capacity. Furthermore, REGI took advantage of the weak market conditions that followed the 2012 drought to increase its capacity by purchasing idled facilities as well. It received excellent deals on these purchases, paying approximately $0.20/gal of capacity for its Atlanta and New Boston facilities and $0.53/gal of capacity for its Mason City facility. Furthermore, the company nearly doubled its cash and short-term investments in Q2 2013 and is now sitting on reserves of $95.5 million. Stronger performance in the biodiesel sector suggests that REGI will no longer be able to purchase idled capacity for $0.53/gal of capacity (let alone $0.20/gal) in the future. Even if we assume a price of $0.75/gal of capacity, however, the company could purchase idled capacity with cash and still have $15 million in cash remaining, plus $77 million in net accounts receivable.

The operating conditions for biodiesel producers are very favorable at the moment and, thanks to continued strong government support, can be expected to remain so in the future. The retroactive blenders' tax credit for 2012 improved REGI's balance sheet, enabling it to purchase new capacity without resorting to the issuance of new shares. While the tax credit only lasts until the end of 2013, the manner in which RIN prices operate ensure that its expiration will have minimal impact on biodiesel producers, as RIN prices will increase in value to counteract its expiration. The RIN prices will also insulate it from price shocks and remain at current levels or higher until a category of biofuel achieves sufficient production to meet the total renewable fuel, advanced biofuel, and biomass-based diesel volumetric mandates between now and 2015. Finally, the fact that D4 and D6 RIN prices have remained very close in value limits the downside to REGI, as the gap between the volumes of ethanol permitted by the blend wall and required by the RFS2 will keep RIN prices high even in the event of unexpected overproduction of biomass-based diesel.

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REGI's share price at the time of writing of 15.62, which is 9.8x its TTM EPS of 1.6, 5.5x its estimated 2013 EPS of 2.83, and 11.2x its estimated 2014 EPS of 1.4. I believe that its estimated 2014 EPS is far too low based on the catalysts described above, however. By comparison, REGI reported an EPS of 1.49 in 2011 on revenues of only $824 million. The estimated 2014 EPS is 38% lower than the estimated 2013 EPS even though the estimated revenue for the same is only 6% lower ($1.37 billion in 2013 versus $1.29 billion in 2014), suggesting that analysts anticipate REGI's net income to fall to $63.4 million in 2014. This amount is even less than the company reported in the first half of 2013. While the biodiesel blenders' credit will have expired by then, I do not expect this to materially impact the company's returns due to the way in which RINs operate. (The retroactive renewal of the tax credit was a different situation since it occurred after RIN prices were determined for the same year and therefore had no impact on them.)

REGI reported net income of $69.5 million in the first half of 2013 on the sale of 108.2 million gallons of biodiesel and the relevant co-products, or $0.64/gal. By the beginning of 2014 the company's three most recent acquisitions should have finished renovations and begun operations, bringing its annual capacity up to at least 257 million gallons. This figure could be higher if its current construction is completed by then or it uses its cash reserves to purchase additional existing capacity in 2013. If we conservatively estimate that these facilities achieve production equal to 90% of their nameplate capacity, then REGI can be expected to produce and sell 231 million gallons of biodiesel in 2014. As mentioned before, RIN prices will remain at their current levels (or higher) until the growing gap between the RFS2 volumetric mandate and the ethanol blend wall is met; I do not expect the operating environment that prevailed in the first half of 2013 to have changed by 2014 given the tripling of this volume gap that is expected to occur during that time. REGI should generate a net income of $147.8 million in 2014 as a result ($0.64/gal x 231 million gallons). This figure in turn would result in a 2014 EPS of $4.11 which, based on a continued P/E ratio of 9.8x, suggests a price of $40.28 per share by the end of 2014, or 164% above current levels.

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Current valuations suggest that the market expects the expiration of the biodiesel blenders' credit and/or lower future RIN values to cut into REGI's net income in 2014 even as annual revenue remains near its 2013 high. The market has misjudged the magnitude of the impact that the volume gap will have on RIN prices through the end of 2014, as it is unlikely to be resolved soon. The catalyst for REGI's share price to move above its current level will be continued high RIN prices through the end of 2013. Much as surging RIN prices in the beginning of 2013 prompted a 167% rise YTD, recognition that they are remaining high going into 2014 will spur an additional increase to the company's share price as investors realize that the current estimates for that year underestimate net income. Given growing demand for biodiesel in the U.S. under the RFS2 and the high value that the program's RINs provide biodiesel producers for each gallon produced, there is limited downside to this investment so long as the mandate remains in place. Even were high D4 RIN prices to cause overproduction in the biomass-based diesel category, REGI would still be able to take advantage of similar prices for D6 RINs.

While there are a number of scenarios in which biodiesel doesn't allow for three of the four volumetric mandates to be met, I consider these scenarios to be unlikely for the reasons outlined above. Furthermore, REGI would continue to have upside were either ethanol to overcome the E10 blend wall or Congress to reform the RFS2 in a way that reduced but did not eliminate the volumetric mandates. In the first scenario the EPA would still be responsible for setting future biomass-based diesel volumetric mandates and, given the category's continued success and attractive carbon footprint, it would be unlikely to set this below feasible production in a given year. Similarly, Congress would be unlikely to take any steps that limited biodiesel production in a meaningful way, particularly in light of the fact that the retroactive renewal of the biodiesel blenders' credit was required just six months ago to avert the fiscal cliff. In both scenarios REGI would be assured of a continued market for its biodiesel production, although it would not be able to take advantage of high D6 RIN prices in the event that D4 RIN prices fell in response to unexpected overproduction in the biomass-based diesel category.

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Conclusion

The market is assuming that REGI's strong performance in the first half of 2013 will turn out to be an aberration resulting from a short-term increase in government financial support. This is reflected in a much lower estimated EPS in 2014 relative to 2013. Given the circumstances surrounding the major increase in RIN prices that has occurred over the last six months, the current level of financial support will most likely remain strong through at least 2014. Accounting for higher-than-estimated net income in 2014 resulting from this continued support suggests a target share price of $40.28 by that year, or an increase of 164% over its current price. Finally, the nature of the RFS2 insulates REGI's net income from deteriorating operating conditions, thus limiting the company's downside risk so long as it remains in place. While it is possible either that the RFS2 is reformed by Congress or the EPA in a way that reduces the current level of government support, or that ethanol manages to overcome its blend wall, neither scenario is probable.

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