Description

Bio-Extraction Inc. (BXI CN)

Note all figures are in Canadian dollars (1.02 to the USD)

COMPANY DESCRIPTION AND INVESTMENT THESIS

Traditionally canola seeds have been processed to produce canola oil and meal. The naturally occurring protein in canola seeds has traditionally been destroyed by the high temperature process used to extract oil (100 - 140 degrees Celsius). BXI has a patented solvent and process that works at lower temperatures (60 degrees Celsius) so that they can extract the same amount of oil as the traditional process but also extract protein which was previously destroyed (the BioExx process produces less meal than the traditional process but meal is low value while the protein is very high value).

The economics of being able to produce a high quality protein from canola seeds when previously it wasn't possible are immense as per the table below:

Management and employees are heavily compensated with stock options (accounted for in my diluted share price calculation) - so basically they become rich after years of working hard on mediocre pay only if the company's product succeeds.

VALUATION

The valuation methodology involves modeling out the cash flows of the Saskatoon plant that is expected to start producing proteins in April 2010 and assume that other plants they build will have similar cost structures on a per ton basis. These cash flows less corporate expenses will give us the free cash flow generation for this business. I assume a 30 year life for each plant and no terminal value for the business. For product mix I assume management is able to realize their goal of producing oil, meal and protein isolates as per their six month ramp up schedule.

Before we get too deep into valuation let's do some basic math:

• At $800 of gross margin per ton of canola seed processed and 120K ton capacity in the two announced plants you have total gross margin of $96m per year
• $6m of corporate expenses and a 35% tax rate gives us $58.5m a year. 10x this gives you a stock price of $3.42 price.

The problem with valuation is that it is dependent on how many individual plants they set up. Currently management's plan is to build 760,000 metric tons of capacity by 2014 with one new plant being built each year. If that really is the case then the stock is worth over 15 dollars assuming each plant has a 10% discount rate and between now and October 2010 I apply a 30% discount rate.

I don't expect the market to look as far ahead as 2014, instead I expect the market to look about 12 months into the future when the Saskatoon plant will have fully ramped up by October 2010 after having started to produce proteins in April  2010. The North Dakota plant will be near completion by then and people will feel good that this is a business that works and the market will give them credit for the plant that is producing, the plant that is nearly built and a newly announced plant. The NPV of the company with three plants will give you a share price of $4.86.

LIQUIDITY

In terms of liquidity, the three month daily average volume is about 475,000 shares so you could potentially own $600,000 of this stock before worrying about liquidity. The stock closed yesterday at $1.88.

CATALYSTS

• In April 2010 - they should start producing protein isolates
• October 2010 - protein production yields should have ramped up by now
• March 2011 - reports 4Q numbers which will be the first near run-rate quarter for the Saskatoon plant; this will make their value proposition very clear to investors

RISKS

The reason I think that this is the time to get in is because most of the major risks that this company would face have passed.

• Risk that technology doesn't work outside the lab- this risk has passed because in 2Q 2009 they used the Saskatoon plant to do a full scale pilot protein extraction; the government of Canada gave them their seal of approval with a $2.95 million zero interest 5 year loan on September 25, 2009 (plus the Canadian agri minister held a press conference there on that day). Based on third party analysis of their scientific papers and tests of the protein produced in that plant I think the risk is of delays in production rather than absence of production. 
• Competitors enter and drive down margins -
  • Burcon is the only other company that has a proven technology (since 2004) to extract protein concentrates and isolates from canola seeds but despite their partnership with ADM they have not announced any plans to build a plant; instead there have been persistent reports that their technology is too complicated and expensive for commercial scale production
  • Margins can decrease in one of two ways - 1) price of canola seeds rise due to this additional use of canola - in 2008 the world produced 38.5 million metric tons of canola seeds so the upper end of production of 760,000 tons that BioExx is targeting by 2014 is less than 2% of present canola production. 2) price of proteins fall - this is also going to take a long time to happen because the 760,000 tons of seeds will at most generate 136 million kilograms of isolate proteins which translates to 114 grams a year for each of the ~1.2 billion people who live in OECD countries
• Product acceptance - they already have a 10 year contract to sell all the canola oil and meal produced in their Saskatoon plant to Sunora and Shafer respectively. Their proteins have been tested by third parties (good reviews) and they have an agreement with Helm AG (a German company with 2008 revenues of EURO 9.1 billion) to provide all three classes of proteins to animal and human food and beverage makers
• Product contamination - they have received GRAS (Generally Accepted As Safe) certification to sell the oil currently being produced from the plant to the human market; also over the summer of 2009 when there was a salmonella scare at some Canadian canola meal producers BioExx's facility was totally clean
• Delays in launching the protein products - this is a distinct possibility. They have already suffered delays in installing and running machinery. Given their small size they don't have much clout in getting equipment delivered on time. A few months delay in launching the product will not seriously affect the investment thesis.

APPENDIX

What is canola?

Canola was developed through conventional plant breeding from rapeseed, an oilseed plant already used in ancient civilization. Selective breeding to develop a variety of rapeseed low in uric acid and it was named canola, from Canadian oil, low acid.

Canola oil has been claimed to promote good health due to its very low saturated fat and high monounsaturated fat content, and beneficial omega-3 fatty acid profile. The Canola Council of Canada states that it is completely safe and is the "healthiest" of all commonly used cooking oils. It has well established heart health benefits and is recognized by many health professional organizations including the American Dietetic Association, and American Heart Association, among others. Canola oil has been authorized a qualified health claim from the US Food and Drug Administration based on its ability to reduce the risk of coronary heart disease due to its unsaturated fat content.

Canola is potentially a great source of protein with the protein efficiency ratio of canola based protein concentrates being nearly comparable to animal based proteins.

Catalyst