Description

Investment Summary

FutureFuel Corporation (FF) is a producer of custom chemicals and biodiesel. I believe FF is a compelling short for three reasons:

1)       Certain governmental policies (which have since expired) have caused the biodiesel business’ profitability to increase wildly over the last 18 months. Current spreads imply that the business will revert back to break-even this quarter, while the street seems to believe these elevated earnings are sustainable longer term.

2)       FutureFuel’s method of allocating fixed costs based on revenues causes their chemicals segment to appear to be more profitable (and growing faster) than it actually is, since biodiesel revenues have increased over 400%. This will become more apparent as the biodiesel segment revenue declines in the future due to the decline in biodiesel per gallon selling prices after the expiration of the blender’s tax credit and lower volumes since the company was running the facility at maximum capacity to take advantage of the windfall profits.

3)       The chemicals business faces some potential structural issues as well, with close to half of its revenue coming from products in terminal decline.

The lack of sellside coverage and institutional ownership in this stock (and lack of a publicized short case, unlike peers Neste Oil and Renewable Fuel Group) cause many of these issues to be overlooked. At today’s prices, I see about 25% downside.

Company Overview

FutureFuel Corp (FF) was originally a SPAC that IPO’d in 2006. Within three months, the company reached an agreement to acquire a chemical plant located in Batesville, Arkansas from Eastman Chemical for $75 million plus contingent payments based on biodiesel sales over the next two years. The plant was constructed in the 1970’s to produce photographic chemicals for Eastman Kodak’s photography business, but as that business declined the plant’s operations shifted to synthesis of fine chemicals and organic chemical intermediaries. The Batesville plant began producing biodiesel a year before Eastman’s sale of the business.

See below for the last few years of earnings:

Biodiesel Subsidy Background

Biodiesel production is heavily dependent on government subsidies to maintain profitability. These subsidies come through the form of: 1) RINs and 2) tax credits.

1)       A RIN (renewable identification number) is a vehicle created by the federal government to ensure compliance with their Renewable Fuel Standard (RFS) program. The RFS requires refiners to accumulate a certain amount of RINs annually in order to ensure that a sufficient amount of renewable fuel is being blended into our fuel supply. Biodiesel “D4” RINs have the broadest usage. They can be used to fulfill the specific “D4” biomass diesel requirement, the broader “D5” advanced fuel mandate, or the total renewal fuel “D6” requirement. 1.5 D4 RINs are created for every gallon of pure B100 biodiesel that is blended into the fuel supply at certain concentrations. The blender can either use the RINs to satisfy their own renewable fuel obligation or sell their RINs on the open market.

2)       A $1 tax credit was awarded to the blender per gallon of biodiesel blended. The tax credit was first used to offset taxable income but becomes a direct payment to the extent your tax credit exceeds income taxes. This tax credit expired 12/31/13.

While FF typically does not blend its biodiesel, based on my conversations with the company, I understand that FF captured the “lion’s share” of the economics of both subsidies.

Recent Developments that have Changed Biodiesel Profitability

-          RIN Pricing: In early 2013, the EPA released their proposal for the 2013 RFS. This RFS required 16.55 billion gallons of total renewable fuels to be blended into the fuel supply, an increase from 2012’s 15.2 billion gallons. Due to the lack of growth in the US’ gasoline consumption and the fact that most cars can’t run on fuel that is blended with greater than 10% ethanol, refiners were unable to meet these requirements internally and were forced to buy up RINs on the open market to avoid fines associated with noncompliance. Since this increase in demand affected the broadest “D6” RINs, pricing of D4, D5, and D6 RINs pricing rose dramatically, as the price of D6 RINs act as a floor for the price of D4 and D5 RINs:

As you can see, RIN pricing has decreased dramatically from its 2013 highs.

-          $1 Tax Credit: The $1/gallon tax credit has had a bumpy history. The credit was originally established in 2004 with a scheduled expiration of 2006. A slightly modified version was passed which extended the credit through 12/31/09. It was allowed to expire but in December 2010 was reinstated retroactive to 1/1/10 and extended through 12/31/11. Again, the tax credit expired but in January of 2013 was reinstated retroactive to 1/1/12 and extended through 12/31/13. This tax credit was allowed to expire without a renewal at the end of 2013. While there is an extender’s bill currently in Congress that may bring back the blender’s tax credit, it seems unlikely such a bill would be passed prior to the November elections, given the Republican’s desire to pass a more sweeping tax reform rather than continue to extend old credits.

Given the increased value of RINs, as well as the looming expiration of the $1 tax credit, biodiesel producers put the “pedal to the metal” and pumped as much biodiesel through their plants as possible to take advantage of the incredibly attractive economics. This is apparent in FF’s financials, where the biodiesel segment gross profit has increased from 8.6mm in 2012 to 38mm LTM and over 48mm in Q4 ’13.

Recently however, the EPA released their preliminary draft for next year’s RFS. This preliminary proposal (which historically has proven to be a good indication of the finalized standard) calls for the total RFS to decline back to 15.2 bn gallons, with the biodiesel component remaining flat at 1.28 bn gallons. This has had a dramatic effect on the price of RINs, with pricing declining precipitously in Q4 ’13. This, in combination with the expiration of the blender’s tax credit has reduced the economics of biodiesel production to roughly break-even. To give you a sense of the decline in profitability, Neste Oil publishes a chart which shows the reference margins for US biodiesel production using soybean oil (a higher cost feedstock than what FutureFuel uses, but generally indicative of the overall profitability of the industry):

The University of Iowa publishes an excel spreadsheet that shows their calculation of biodiesel profitability based on a typical soybean oil biodiesel facility:

Further, while FF does not provide guidance, competitor REGI announced Q2 and Q3 guidance during its Q1 ’14 results call in May:

-          Q2 '14 gallons sold of 65-75mm with adjusted EBITDA of -$2.5mm to $7.5mm

-          Q3 '14 gallons sold of 70 - 80mm with adjusted EBITDA of -$10mm to $10mm

This guidance assumes that the spreads realized at the time of the guidance remain constant. These figures compare to Q4 ’13 adjusted EBITDA of $36mm and gallons sold of 72.8mm (REGI full year adjusted EBITDA in 2013 was $148mm). I believe REGI’s results and guidance are a good indication of economics of FF’s biodiesel business since most of REGI’s facilities use similar feedstocks to FF.

Chemicals Segment / Structural Issues with Key Products

The chemicals segment has historically been a relatively stable business with long term contracts and large customers. Currently the business is running at very close to full capacity utilization. The vast majority of the business is custom manufacturing where FF creates the product based on their customer’s recipe.  It is typically a business that competes with their customer’s internal production capabilities—FF wins if it has a geographic, feedstock, or chemistry advantage. The business is challenged as its two main products, which represent close to half of the chemicals revenue are in structural decline.

-          Bleach Activator: The largest, representing about 35% of chemicals revenue, is a bleach activator that is used by Proctor & Gamble in its powdered Tide detergents (the “blue speck”). Powdered detergent is in secular decline. As the market continues to move to liquid detergents, revenues from this product have declined at an 11% CAGR over the last 3 years. The revenue decline is somewhat offset by the terms of their contract which allow them to earn a higher $ profit / unit as volumes decline. However, longer term this business seems challenged / likely to go away eventually.

-          Herbicide: The second major product is a proprietary herbicide manufactured for Arysta Life Sciences, representing ~12% of chemicals revenue. The “recipe” has recently gone off patent and the product has seen generic competition. Revenue for the product line has declined 31% year-over-year and FF has exercised its option to terminate the contract, although they are still selling to Arysta on a day-to-day basis as they look to restrike a new contract. FF is looking to supply the product to other players in the space but is in the early stages of evaluating this opportunity.

These headwinds, combined with the fact that the facility is running at close to full capacity, make it seem unlikely that chemicals profitability will grow materially in the future.

Fixed Cost Allocation Method Creates Misconception of Growth in Chemicals Profits

The chemicals segment has appeared to be growing earnings very significantly over the last few years. However, most of this perceived growth has been driven by the company’s method of allocating fixed costs and a few one-time items. FutureFuel reports segment level gross profit for both its chemicals and biodiesel businesses. These segment level figures include an allocation of plant level fixed costs. General corporate overhead (which runs at about $10mm/yr) is a “below the line” item such that total segment gross profit – corporate overhead = consolidated EBIT. According to the 10K “Cost of goods sold is allocated to the chemicals and biofuels business segments based on equipment and resource usage for most conversion costs and based on revenues for most other costs.” Based on conversations with the company, my understanding is that about $15mm of annual plant level fixed cost is allocated based on revenue.

As one can see, the rapid growth in biodiesel revenue has had the effect of shifting close to $7mm of fixed cost burden from the chemicals segment to the biodiesel segment:

Chemicals profitability is further skewed by a one-time contract termination payment paid to the company in 2013 and the effect of LIFO liquidations (dipping into LIFO reserves). Assuming 50% of the LIFO liquidations related to the chemicals business and 50% to the biodiesel business, you can see that chemical segment profits have been roughly flat over the last 3 years:

Substantial Net Cash Position

FutureFuel has close to 30% of its market cap in net cash. The company has kept this large amount of cash on the balance sheet for a long time as the company looks to acquire a higher cost soybean oil biodiesel plant and convert it to low cost HFFA feedstock. The company claims that there is some proprietary know-how in completing this conversion and since they have the experience and expertise in already doing it, they think they can convert a new facility much faster and cheaper than they did the first time. Given the recent dynamics in the biodiesel marketplace, FF has not found any attractive acquisition opportunities, although their president thinks that this year’s correction in the marketplace could provide significant opportunity. I don’t fully understand the company’s capital allocation strategy, as they have paid special dividends in addition to their regular dividend each of the past 3 years (including $1.20/share in 2012), yet have sold $37mm in stock through an at-the-market offering from 2/2011 to 2/2013 (with the majority occurring at the beginning of 2013).

Valuation

The biofuels segment earned $38mm in gross profit in the LTM period. Last quarter they earned $0.5mm. In the last 6 years, this segment has only earned greater than $10mm in gross profit in one year and on average earned about $4.5mm. In 2011, the segment earned $19mm, as the $1 tax credit was in effect (and not retroactively so), such that pricing in the market reflected the tax credit, even though FF was typically not the blender. Likewise, the RFS increased from 650mm gallons of biodiesel to 800mm and it appears as though the industry had shut down a decent amount of capacity in the ‘08/09 timeframe:

Given the excess capacity in the industry (in the first 10 months of 2013 the market has already produced more than the amount the 2014 RFS calls for), low RIN pricing and lack of clarity around the tax credit, I think $10mm of gross profit (similar to what the business did in 2012 adjusting for the overburdening of fixed costs) is a very optimistic assumption for 2014 and wouldn’t be surprised if the segment earned nothing. Note that Wedbush, the only sellside firm that covers FF, assumes this segment does over $20mm in 2014 and $36mm in 2015. Taking the $10mm of gross profit and burdening it with 25% of the corporate overhead, I get to $7.5mm of EBIT. At 10x this is worth $75mm. Taking another approach, if you comp the business out to REGI on a trailing EBIT basis, it is worth about $70mm. One could make the argument that REGI is worth a higher multiple than FF due to the multiple non-income producing assets they have. If you comp the business out to REGI on an EV / capacity basis, you get a similar figure as well.

Given the very high capacity utilization and headwinds with key products, the chemicals business seems to be a no-growth earner at best. The lack of special sauce in this business leaves them largely at the mercy of their customers. $56.4mm of adjusted pre-fixed cost gross profit, less $12mm of real segment level fixed costs and 75% of the corporate overhead, gets me to $37mm in normalized EBIT. At 8x EBIT this business is worth $300mm.

Putting it all together and adding in the $212mm of net cash, FF is worth about $580mm or $13.40/share.

Looking at it another way, I have the company earning $0.67 on a normalized basis excluding interest income on the cash. Net of the cash, enterprise value is $12.00. So company is trading at 18x normalized earnings.

Risks

The EPA could come out with a materially higher 2014 RFS once the final ruling comes out. This seems unlikely given the backlash from the refining community about the 2013 debacle. Blender’s tax credit could be reinstated near the end of the year and lead to somewhat better biodiesel economics.

The company deploys balance sheet cash to buy a business at attractive multiple. They have been very patient with the cash and got a great deal on the Batesville plant from Eastman.

The company is setting up processes to allow them to refine and sell the glycerin waste product that is created during the biodiesel manufacturing process. This could be a more material driver of biodiesel profits than I expect.

Catalyst