Description

Conclusion: We recommend going long Apollo Resources (AOOR), as you get to own 67% of Earth Biofuels (EBOF), one of the premiere biodiesel producers/refiners, at a 45% discount to its public market value, as well as of AOOR’s remaining assets (oil/natural gas reserves and pipelines) for free. Alternatively you can choose to put on the spread, and play for the negative stub value, as 1) education of this anomaly and realization that the spread is near its widest levels in history, as well as a 2) possible reverse merger between EBOF and AOOR (mgmt is willing to consider this) may provide the necessary catalysts.

We believe the dislocation exists because of 1) confusion over AOOR’s ownership amount, 2) skepticism over EBOF’s valuation and, 3) little knowledge of AOOR’s remaining asset mix. Each of these three issues is addressed below.

1. AOOR’s Ownership in EBOF: AOOR owns 128.7mm share of EBOF (67% of the 192.884mm shares outstanding)

This ownership amount is not entirely obvious and requires a walk through the filings of both companies to become comfortable.
- 9/13/05 - A subsidiary of Meadows Springs Inc. (MWDS) acquired AOOR’s stake in Earth Biofuels in exchange for 21.45mm shares of stock (88.09% of the Company).
- 11/14/05 - Meadow Springs engaged in a reverse merger, in which its subsidiary with the Earth Biofuels interest collapsed into the parent. The pro forma entity was named Earth Biofuels (new ticker EBOF) and underwent a 6-1 stock split.
- 5/22/06 - The fully diluted share count for EBOF stands at 192.884mm, of which 128.7mm (6 * the original 21.45mm shares) is owned by AOOR.

2. Justifying EBOF’s Valuation: EBOF is trading at 19x ’07 production/refining EPS (see detail on biodiesel industry below to gain comfort with the growth potential to justify the multiple). We would argue that EBOF is trading at a defendable valuation especially considering that their capacity is coming on line much sooner than that of other alternative energy players which are trading at much richer valuations (i.e., PEIX @ 150x ’07 EPS and currently producing any fuel).

EBOF will have 38mm gallons / year (mmgy) of biodiesel production capacity by year end (according to management guidance, a 4mmgy plant in Meridian, MS, 10mmgy plant in Durant, OK, 14mmgy plant in Houston, TX and another 10mmgy plant in Greenville, MS).

For each 10mmgy plant that EBOF produces, they expect to do $27mm in annual revenue with a 20% NI margin or $5.2mm of NI annually. On a base case, that would give you annual production revenue of $102mm or $20.5mm in Net Income ($0.11 in plant production EPS).

In addition to bio-diesel production, EBOF is engaged in a JV with Shell Oil to blend the company’s B20 fuel at their 52 hub locations. The company takes in $3-5mm in revenue per month from blending and clears $250k in profit. That adds another $3mm in Net Inc to EBOF, or $.02 of EPS in refining capacity.

Therefore, EBOF is trading at 19x ’07 production/refining EPS of $.13.

3. Justifying AOOR’s Stub Asset Valuation: Excluding its stake in EBOF, AOOR owns 180k barrels of oil, 1bln cf of natural gas, LNG production facilities with 35 contracted customers (85k gallons / day), 2 fully operational drill rigs (sold on 5/19 in exchnge for 13.7mm restricted shares of Siam Imports, Inc.) and 2.6k miles of pipeline offset against ~$10mm in net borrowings. Our estimate of this stub asset value is $12.3mm (or $22.3mm - $10mm of liabilities, see below). This translates to ~$.07/share of value versus the -$.45/share or -$75mm of value the market is currently ascribing.


Oil and Natural Gas Production – Assuming $20/barrel for the proven oil reserves and $2.50/mmcf for the natural gas reserves (both discounts to comparable transactions in the Midwest / Four Corners region), you get $6.1mm of gross asset value.

Background: AOOR began its expanded business focus in oil and natural gas production through the acquisition of BC&D. BC&D is a small exploration and production company consisting of 151 wells located in the Four Corners area of New Mexico. Many of these wells are in need of remedial work or equipment repair. The Company has estimates of proved reserves totaling 28,156 barrels of oil (currently $70/barrel) associated with the BC&D fields. The company’s other oil and natural gas acquisition production operation, Mountain States, is located in the Four Corners area of New Mexico, Arizona and Utah, consisting of 50 wells. The company has 184,467 barrels of oil in proved reserves and 1,059 million cubic feet of proved natural gas reserves (currently $6.30/mmbtu) associated with the Mountain States fields.

Transportation of Oil and Natural Gas – With a 20% discount to the straight-line estimate of the pipeline assets using their precedent transaction below, you arrive at ~$7.9mm of gross asset value.

Background: With the acquisition OGC, Apollo acquired approximately 2,600 miles of pipeline segments and related easements and rights-of-way in south central in Oklahoma, Texas, Kansas and Indiana, the great majority of which is currently idle. They plan to utilize the OGC pipeline assets to gather natural gas, develop gas production in adjoining areas along the pipelines, and develop other opportunities within certain segments of the approximately 2,600 miles of right-of-ways. These lines can service existing natural gas producing regions within the State of Oklahoma, including the Woodford Shale in south-central Oklahoma and the coal seam gas play in the Cherokee Basin, located in northeastern Oklahoma. On March 1, 2006, the Company executed an asset purchase and sale agreement with Northeast Shelf Energy, LLC to sell approximately 33 miles of these pipeline sections for $125,000. Pursuant to the agreement the Company maintains rights to the right-of-way along this section of pipeline to install and operate another pipeline within the easements.

Fully Operational Drill Rigs– Recently sold for a controlling interest in Siam, we can assume that the rigs went for something close to market value (if not more given that a premium is justified for the illiquid consideration). We received guidance of $15k day rates for each rig, so assuming 1) 95% utilization (industry norm), 2) 20% EBITDA margins (well below the industry to be conservative and considering the overhead is spread on a smaller asset base), and 3) a 4x EBITDA multiple (huge discount to larger peers in the 6-7x range), you get $8.3mm of gross asset value.


LNG Sales and Production- There is some positive value here given the 35 customer contracts and production facility, but we will exclude this to offer even more conservatism to the rest of the valuation.

In December of 2005, Apollo added the production, distribution and sale of LNG to its line of businesses through its acquisition of ALT and Arizona LNG. These subsidiaries allow AOOR to produce and distribute LNG; a fuel that is often cleaner-burning than coal, gasoline or diesel. ALT has about 35 customers most of whom are on contract to buy a set number of gallons of LNG, each month, for not less than one year. A small number of LNG sales are made by ALT through mobile fueling stations. These fueling stations are equipment that ALT has leased. ALT has several long-running and high-volume customers primarily, located around Los Angeles, California; a region of dense population without an ample infrastructure of natural gas pipelines as found in comparable population concentrations elsewhere in the United States. Arizona LNG operates a natural-gas liquefaction plant in Topock, Arizona. Daily output for this plant is about eighty-five-thousand gallons of LNG – made from a daily input of about 7,000 MCF of conventional natural gas. ALT purchases this LNG from Arizona LNG for distribution to its customers. AOOR’s per-month LNG sales are equal to over two-million gallons. About nine in ten of these gallons are made by Arizona LNG at the Topock, Arizona plant. The residual is purchased by ALT on the open market. The number of gallons sold each month is stable and is expected to continue based on annual contracts for the foreseeable future.


Bio-Diesel Industry Background (Appendix)
By way of background to the bio-diesel industry, on August 8, 2005, President Bush signed the EPAct of 2005, further encouraging energy compliance through incentives and reducing the nation’s dependence on imported petroleum. The act included offering credits for the purchase of hybrid vehicles and a 30% credit to fueling stations for the cost of installing alternative fuel vehicle (AFV) refueling equipment, resulting in increased access to the general public through retail pumps throughout the country.

Today, B20 (bio-diesel fuel containing at least 80% petroleum diesel fuel and 20% bio-diesel) is the most common and fastest growing bio-diesel blend in the United States, because the overall emission benefits outweigh conventional diesel as an alternative fuel. While diesel engines are about 30% more efficient than gasoline engines, bio-diesel further enhances the advantages of diesel by reducing emissions of hydrocarbons by 20% and carbon monoxide and particulate emissions by 12%. Additionally, bio-diesel reduces vehicle sulfur emissions on average by 20%, plus bio-diesel is nontoxic and biodegradable.

In Europe, diesels account for 40% of the passenger car market. In the U.S., more than 600 filling stations currently make bio-diesel available to the public, and 1,500 petroleum distributors carry it nationwide. Hundreds of U.S. fleets, representing over 25,000 vehicles for commercial, government, military, utility, municipalities and transit use, currently run on bio-diesel blends nationwide. Bio-diesel blends are also used increasingly in the farming, mining and marine industries, as well as in heating oil and electrical generation applications.

In 2005, US bio-diesel production exceeded 75mmg compared to 67bln gallons of diesel fuel that were consumed in the US. By 2010, which is also coincidentally the year in which most analysts feel the US will begin to approach the optimal 10% ethanol blend for gasoline, US bio-diesel production could exceed 2bln gallons versus the DoE estimated 76bln gallons of total US diesel consumption. That would only equate to a 2.6% bio-diesel blend.

Bio-Diesel Production Economics
- Revenue: B100 Sale Price = $2.74/gal
- Costs:
Feedstock (soy/canola) = 1.87/gal
Methanol = .11/gal
Catalyst = .02/gal
Total = 2.00/gal

- Gross Margin = .74.cal
- Processing Ops = .22/gal
- Net Margin before Tax Credits = $.52/gal

- Credits:
CCC Credit (8.5mm gal cap) = .60/gal
Fed Producer Inc Tax Cr = .10/gal
State Producer Inc Tax Cr = .20/gal
Total = .90/gal

- Net Margin after Tax Credits = 1.42/gal











EBIT Breakdown (base case)

Catalyst