Summary
- GPRE's shares have fallen by 53% since September as gasoline prices have collapsed.
- GPRE's forward P/E ratio is less than half of its 5-year historical average.
- Rebounding RIN prices will insulate GPRE's earnings from gasoline price volatility.
- A return to the 5-year average P/E ratio would cause shares to double from their current price.
Executive Summary
Falling petroleum prices have caused independent corn ethanol producer GPRE's shares to lose more than half of their value in the last four months, resulting in a forward P/E that is less than half of its 5-year average. This bearish sentiment is based on the faulty assumption that the company's near-term profitability is correlated with the price of gasoline. A recent announcement by the EPA and rebounding RIN prices are offsetting low gasoline prices, however, and investors can expect GPRE's shares to double when sentiment rebounds on continued strong earnings reports.
Long-term investors in independent corn ethanol producer Green Plains Inc.(NASDAQ:GPRE) were undoubtedly happy to change their calendars and say goodbye to a rather brutal Q4 2014. The company's shares vastly outperformed the S&P 500 in the first three quarters of the year, rising from $19.02 on 2014's first trading day to $45.75 by early September, its highest recorded share price since it began ethanol production in late 2007. This rapid increase came on the back of a strong ethanol crush spread (see figure) that enabled GPRE to handily beat EPS expectations in Q4 2013 and Q1 2014 despite reporting underwhelming revenue numbers. While its Q2 numbers missed expectations on both lines, its diluted EPS of $0.82 was still strong (Q2 2013 EPS was $0.19) and the company reported another EPS beat for Q3 2014. Despite these numbers and sustained strength in the crush spread, GPRE's shares have shed 53% of their value since early September 2014, wiping out most of the strong gains achieved earlier in the year.
Source: CARD (2014). Black line represents 90-day moving average.
GPRE at a glance
GPRE operates 12 ethanol facilities in the Midwest U.S. with a combined annual capacity of roughly 1 billion gallons. In addition to ethanol it also produces large quantities of dried distillers grains and solubles (DDGS) and corn oil, while one of its Iowa facilities also produces microalgal oils for conversion to nutraceuticals. The company has rapidly expanded since beginning operations at a single facility in 2007, and in 2013 it took advantage of the industry slump that followed the 2012 drought to purchase its most recent three facilities. These capital investments placed the company in a strong position to take advantage of 2014's strong crush spread and it did just that, recording strong financial growth across the board for the year (see table).
GPRE Financials
| Q3 2014 | Q2 2014 | Q1 2014 | Q4 2013 | Q3 2013 | |
| Total revenue ($MM) | 834 | 838 | 734 | 713 | 758 |
| Gross profit ($MM) | 98 | 78 | 101 | 72 | 41 |
| Net income ($MM) | 42 | 32 | 43 | 25 | 9 |
| Diluted EPS ($) | 1.03 | 0.82 | 1.04 | 0.60 | 0.28 |
| EBITDA ($MM) | 91 | 75 | 94 | 64 | 37 |
Source: Morningstar
The company's strong earnings in FY 2014 were also driven by strong profitability measures that, by all accounts, were the best in its existence (see table).
| TTM | FY 2013 | FY 2012 | FY 2011 | |
| Net margin (%) | 4.58 | 1.43 | 0.34 | 1.08 |
| ROA (%) | 9.25 | 3.01 | 0.85 | 2.70 |
| ROE (%) | 22.04 | 8.38 | 2.37 | 7.74 |
| ROIC (%) | 13.11 | 5.21 | 3.15 | 5.31 |
GPRE also strengthened its balance sheet in FY 2014 following its capital investments the previous year. Total cash doubled between Q1 2014 and Q3 2014 to $401 million and now represents 24% of total assets. Current liabilities fell from $431 million to $370 million over the same period and now represent 40% of total liabilities. The company's current ratio of 2.12 is its highest since it began producing ethanol and its D/E ratio of 0.59 is its lowest.
The case against GPRE
It is unusual for a company's shares to lose more than half of their value even as it is in the process of generating its best-ever annual earnings report. This indicates that the market is front-running an expected earnings downturn and, in GPRE's case, the cause of this anticipated downturn is the recent collapse in the price of petroleum. It is interesting to note that both GPRE's shares and the price of gasoline have fallen by almost identical percentages from their 2014 highs. Fuel ethanol is a lower-value alternative to gasoline and, as such, its price is strongly affected by gasoline's. It is understandable for investors to be bearish on GPRE at a time when a Forbes headline states that petroleum could sink to $20/bbl sooner rather than later. Furthermore, the U.S. ethanol industry was roiled last October after Brazil approved the creation of a tax credit for its cane ethanol exports, prompting concerns of increased competition for U.S. corn ethanol producers within their home market.
GPRE's main obstacle, however, is the U.S. Environmental Protection Agency's [EPA] November 2013 proposal to reduce corn ethanol's share of the revised Renewable Fuel Standard [RFS2] mandate in 2014 from 14.4 billion gallons to 13.01 billion gallons. This proposal was prompted by concerns that ethanol consumption, which is currently limited to 10 vol% blends with gasoline in unmodified vehicles (the EPA permits 15 vol% blends but these are discouraged by both automakers and fuel retailers and have achieved minimal market penetration as a result), will be unable to achieve its mandated blending levels due to falling U.S. gasoline consumption. The market's realization that this so-called blend wall had been reached in 2013 caused the price of Renewable Identification Numbers [RIN], as the RFS2's variable subsidy component is known, to jump in price from $0.04 at the beginning of the year to $1.45 the following July. This prompted a major lobbying effort from the refiners tasked with absorbing the costs of RINs (unlike most subsidies, RIN expenses are borne by refiners rather than taxpayers) that ultimately resulted in the EPA's November proposal and subsequent collapse in RIN prices. Faced with a declining domestic market size due to the blend wall, a lack of regulatory support, and falling gasoline prices, the argument can be made that GPRE is unlikely in 2015 to repeat its strong earnings performance from 2014.
Future EPS estimates have fallen over the last 90 days as bearish sentiment has weighed on analysts. The consensus for Q4 2014 has fallen from $1.08 to $1.01. The Q1 2015 consensus has fallen from $1.08 to $1.04. The biggest reduction has been for FY 2015, however, which has been reduced from $3.89 to $3.66. In this latter case the biggest reduction (from $3.85 to $3.66) did not occur until after GPRE's share price had already fallen by half, suggesting that the market has been frontrunning estimates rather than vice versa.
Why you should buy GPRE
While the argument against investing in GPRE makes some valid points, the argument for doing so is more convincing. In November 2014 the EPA announced that it was "significantly delaying" the release of its final rulemaking on its November 2013 proposal due to the "significant comment and controversy" that it had caused. The following month saw RIN prices, which had remained relatively stable throughout the year, begin to rapidly escalate in value (see figure). This price increase has coincided with the fall in gasoline prices and indicates that, for the first time since their implementation, RIN prices are now operating to subsidize ethanol production (as opposed to just ethanol blending, as was the case during 2013's price increase). Corn ethanol's contribution to the RFS2 is estimated to have reached 14.2 billion gallons in 2014, well above the reduced volume found in the EPA's 2013 proposal, suggesting that the market no longer expects the agency to limit ethanol to the volume permitted by the 10 vol% blend wall (RIN prices only have value so long as they are needed to meet but not exceed the RFS2's volumes).
Source: EcoEngineers (2015).
The combination of high RIN prices and global demand for U.S. ethanol exports has caused ethanol's price premium over gasoline to reach a 6-year high. Concerns that this premium will discourage ethanol demand are overblown due to the way in which RINs subsidize ethanol production. Each RIN is created when the gallon of ethanol to which it is automatically attached is produced. It is not detached and made available for separate trading until that gallon is blended with gasoline for retail, so every gallon of qualifying ethanol that is traded prior to blending captures the RIN price as well as its own value as fuel. It should come as no surprise then that the rise in ethanol's price premium relative to gasoline that has occurred since last November has coincided with the increase in RIN prices. In fact, if we subtract the D6 RIN price from the ethanol price (as represented by the daily nearby futures price in Chicago plus Iowa basis), we see that RINs were necessary for ethanol and gasoline prices to achieve a rough parity on an energy-equivalent basis for most of 2014 (see figure). In other words, without RINs ethanol would have traded at a discount to gasoline for much of the year. Continued high RIN prices will therefore prevent the ethanol price premium from dampening domestic demand since ethanol blenders will be provided with a de factorebate at the point of blending in the form of detached RINs. Strong exports in the future will only serve to keep RIN prices high (other things being equal) by decreasing the volume that contributes to the mandated volumes under the RFS2.
Source: CARD (2014). Gasoline-eq. basis.
This is not to say that RIN prices will necessarily remain high in the future. What they will do, however, is insulate GPRE from low gasoline and/or high corn prices. Furthermore, they will continue to do so as long as U.S. ethanol consumption remains below corn ethanol's share of the RFS2, a scenario that seems increasingly likely in light of the EPA's continued inaction. Until the EPA says otherwise corn ethanol's contribution to the mandate in 2015 is capped at 15 billion gallons, or 800 million gallons above its expected 2014 contribution. Total U.S. annual corn ethanol capacity, including facilities under construction, is 15.05 billion gallons. Assuming that some of this is exported, these figures suggest that U.S. corn ethanol and imported cane ethanol have room to co-exist under the RFS2.
The long case
GPRE's current share price of $21.44 is equal to:
- 6.23x its TTM diluted EPS of $3.44
- 5.50x its FY 2014 estimated diluted EPS of $3.90
- 5.86x its FY 2015 estimated diluted EPS of $3.66
This contrasts with the company's 5-year average P/E ratio of 12.6x. The forward FY 2015 P/E would represent its lowest TTM P/E ratio since it began producing ethanol. In FY 2010 GPRE's P/E fell to 7.6x as it reported diluted EPS of only $1.51 and EBITDA of $130 million, making its current valuation very low by comparison. A return to its 5-year average P/E ratio in 2015 would equal:
- 12.6 X $3.66 FY 2015 EPS = $46.12/share
or an increase of 115% over its current share price. Even a return to its FY 2010 P/E would equal:
- 7.6 X $3.66 FY 2015 EPS = $27.82/share
or an increase of 30% over its current share price. Assuming such a low P/E ratio in light of the strength of its balance sheet and its recent record profitability is conservative and must be based on an expectation that GPRE's earnings reports in 2015 will rapidly deteriorate due to falling petroleum prices. As pointed out above, however, the recent increase in RIN prices will insulate the company's earnings regardless of how far petroleum prices end up falling. Fair or not, the RFS2 transfers the risk of inexpensive petroleum from biofuel producers to refiners and, given the EPA's recent indecision on its proposed rulemaking, this transfer will continue to operate in 2015. Given GPRE's ability to make future capital investments and its insulation from petroleum price volatility, I expect the company's final FY 2015 EPS to be closer to the earlier consensus estimate of $3.89 than to the current consensus estimate of $3.66. Recent RIN prices have kept ethanol prices not just high relative to gasoline but close to the 2014 average of $3.18/gallon gasoline-eq. (see figure). Similarly, corn ethanol's return over production costs as calculated by the Center for Agricultural and Rural Development [CARD] have remained close to their 2014 average. A fall in EPS shouldn't be expected so long as this return remains stable.
Source: CARD (2014).
Catalysts
GPRE has two catalysts on its horizon that will potentially allow its investors to recognize strong gains. The first is a delay by the EPA in announcing the mandated volumes under the RFS2 for 2015. As discussed above, the agency has yet to announce the volumes for 2014 and the market has assumed in the meantime that the original volumes as laid out by the mandate's host legislation stand, resulting in the recent inverse relationship between petroleum and RIN prices. The original volumes for 2015 are even higher than 2014's and represent all of U.S. corn ethanol production capacity, even assuming that none is exported. The EPA has a robust track record of issuing its final rulemaking on RFS2 volumes late in the affected year, meaning that the 2015 rulemaking may not be released until Q3 or Q4 2015. A lack of final rulemaking such as was seen in 2014 will result in continued strong earnings reports from GPRE as RINs continue to offset low petroleum prices. EPS beats for Q1 and/or Q2 2015 are the first potential catalyst for significant share price appreciation.
The second potential catalyst is a rebound in petroleum prices. I will not attempt to predict the timing or magnitude of such a rebound as doing so is a fool's game (as the unexpected recent collapse has shown) and is outside of my skillset. I will say that petroleum prices are very volatile, however, and unlikely to remain low for an extended period of time given growing demand from China and India, which together represent roughly 1/3 of the world's population but have only a small fraction of the per capita auto ownership of the developed world. While, other things being equal, rebounding petroleum prices will be offset by falling RIN prices the ethanol market's recent bearish sentiment will turn positive when (not if) petroleum prices rebound. The company's TTM P/E ratio remained above 12.0 for the first three quarters of 2014 and didn't fall below that level until the price of WTI crude fell below $90/bbl (see figure). A return to that TTM P/E would cause GPRE's shares to double from their current price on the basis of analyst estimates for FY 2015 EPS.
Source: YCharts (2015).
Risks
The biggest risk to this investment thesis is unexpected regulatory action by the EPA. The agency's recent announcement that it is delaying its final rulemaking on its proposal for the 2014 RFS2 volumes due to the "comments and controversy" that it caused indicates that it is now considering volumes that exceed those permitted by the 10 vol% blend wall. While unprecedented, however, it is possible that the EPA's final rulemaking will adopt its November 2013 proposal by making the 10 vol% blend wall permanent, in which case current ethanol blending will exceed the mandate and RIN prices will collapse as they will no longer be needed to incentivize additional production/blending. This scenario can be expected to negatively affect GPRE's earnings in the event that both demand for U.S. ethanol exports collapses and petroleum prices remain low. I expect the simultaneous appearance of all three conditions to be improbable, however, and the company can repeat its strong earnings performance without support from RINs in the event that petroleum prices rebound. It is worth noting that its share price doubled in Q1 2014 due to the strong crush spread despite the recent release of the EPA's proposal to make the 10 vol% blend wall permanent.
GPRE investors could see some downside in the unlikely event that the EPA does ultimately finalize its November 2013 proposal, although this would be limited due to the current low valuation of the company's shares. A return to its 5-year average P/E ratio at its current share price would require a FY 2015 EPS of $1.70:
- $21.44/12.6 = $1.70 FY 2015 EPS
This is well below even the lowest analyst EPS estimate of $2.69 for FY 2015. However, we can use the company's FY 2013 earnings as a rough approximation of the valuation that would result from such an EPA decision. RIN prices in that year primarily benefited blenders rather than producers and corn ethanol's average return over operating costs was $0.30/gal lower in FY 2013 than in FY 2014, approximately the amount that D6 RINs would need to fall to return to the level seen prior to the EPA's delay announcement. GPRE reported a diluted EPS of $1.26 for FY 2013. The same EPS in FY 2015 combined with a return to its 5-year average P/E ratio of 12.6 would result in a share price of $15.88:
- 12.6 X $1.26 FY 2015 EPS = $15.88
or a 26% fall from its current price. While not insignificant, this scenario is greatly outweighed both in magnitude and probability by the scenario in which the EPA increases the 2014 and 2015 RFS2 volumes above those presented in its November 2013 proposal.
Conclusion
The market is assuming that GPRE's earnings for Q4 2014 and FY 2015 will fall well under expectations due to the collapse in the prices of petroleum and gasoline. This sentiment is based on the faulty assumption that gasoline prices are the primary driver of corn ethanol's profitability. While true in the past, the recent resurgence of RIN prices in response to falling petroleum prices and the EPA's decision to delay its final RFS2 rulemaking for 2014 ensure that GPRE will be insulated from petroleum price volatility. Furthermore, the company has used its strong earnings from the past year to further bolster its balance sheet by increasing cash and reducing short-term debt. The company's forward P/E ratios are at historical lows and do not reflect its current financial position and potential earnings. A return to its historical average P/E ratio as sentiment recovers would cause GPRE's share price to double, making the company an important addition to any investor's portfolio.
Author's Note: I inadvertently used GPRE's former name "Green Plains Renewable Energy" in place of its new name "Green Plains Inc." when submitting this article. The article was updated shortly after publication to correct the error. I apologize for any confusion this may have caused.
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