Description

Overview

FutureFuel Corp. (FTFL) is a closely held, generally unknown, and effectively privately-trading specialty chemicals and biodiesel producer that represents a deep value opportunity.  On conservative valuation, shares offer 20% return and 64% in our upside scenario, which excludes difficult to quantify additional optionality.  We are unaware of any other management team in the alternative-fuels industry that has created shareholder value since the sector bubble peak in 2006-2007, suggesting exceptional skill.  Management also exhibits a strong pattern of "owner-like" behavior.

This opportunity exists because FTFL is still mostly held by the shareholders of the original SPAC deal (including management and insiders), and is run to maximize the intrinsic value of the business rather than share price, i.e. no roadshows, PR, or analyst coverage or efforts to improve liquidity and/or share price.  As more and more investors find FTFL on their value screens and study this business, the investor base will broaden and valuation will continue to converge with the peers.  This process is evident in recent months as volume picked up, bid/ask narrowed, and liquidity improved.  In addition to these factors driving gradual appreciation, idiosyncratic catalysts are described below.

FTFL was a SPAC deal launched in July 2006.  Shortly thereafter, FTFL acquired the wholly-owned subsidiary of Eastman Chemical Company, Eastman SE, Inc. (EMN) -- a chemical manufacturer which recently began biodiesel production.  The facilities are located on ~2K acres near Batesville Arkansas with ~500 acres taken up by production facilities and infrastructure.  The staff consists of approximately 500 non-union FTEs.  The facility manufactures diversified chemical and bio-based products consisting of biofuels and specialty chemical products.  In May 2009, biofuels production capacity was expanded to 60 million gallons of biodiesel per year (MMgy) via a new continuous processing line.  The facility is multi-feedstock, processing high free fatty acid/low cost inputs.  While competitors generally claim similar capability, our DD indicates scientific expertise and equipment capabilities of the industry tend to fall short of these claims.

Capital Structure

(2009 10-K, 000's)

Shares of common stock - 28,573

SPAC warrants (6.00 strike price, 7/12/2010 expiration) - 19,293

Equity compensation plans' options, warrants, and rights (6.41 weighted-average exercise price) - 423

Share price (last trade, 3/26/2010) - 6.80

On 3/12/2010 FTFL announced $.20/share special dividend payable on 3/23/2010.  While a number of outcomes are possible, according to the filings the large holders appear to be fully-exercising their WTs  to take advantage of the dividend given the short remaining life of the WTs.  I assume full exercise of SPAC and equity compensation plan warrants:

Valuation

Chemicals Business

The chemicals segment manufactures products for specific customers and produces multi-customer specialty chemicals.  It is a stable business with operating metrics that have improved since it was acquired from EMN as assets received more focus and overhead was reduced:

The most important single product produced by FTFL is a bleach activator sold to Procter & Gamble under a multi-year supply agreement that was renewed in April 2008.  This product composed $73,466K of 2009 revenue.  The next largest sales contributor is a proprietary herbicide and intermediates manufactured for Arysta LifeScience North America Corporation providing $31,587K of 2009 sales.  The two largest customers represented approximately 53% of 2009 revenues.  We understand that the bleach activator has been manufactured for P&G for an extended period and, as it is no longer a growth vehicle, it is un-economic for P&G to attempt to develop in-house production capabilities.  Such efforts were (unsuccessfully) made by P&G earlier in the product's history.

There are significant barriers to entry for competitors in the form of technological and manufacturing capability.  This moat is illustrated by the inability of P&G to move the bleach activator manufacturing in-house, for instance.  R&D is stable and there is no evidence of harvesting of the business (R&D skimping) since acquisition -- just the opposite.  The replacement cost of the facilities in North America also represents a formidable barrier to entry (visit http://maps.google.com/maps?q=35.719315,+-91.522508 - and - http://www.futurefuelcorporation.com for some views)

EMN (the former facility owner) has traded in the EV/Sales range of 0.4-1.3 over the past 10 years with the average of 0.9.  The valuation has never fallen below 0.7 outside of the Q4 2008 - Q1 2009 market lows.  The EV/EBITDA multiple for EMN has been unstable over the past 10 years due to poor profitability in the 2002-2004 timeframe but has generally varied in the 2.8-10.0 with the average around 7.0 and never dropping below 5.0 outside of the Q4 2008 - Q1 2009 market lows.  Meanwhile, the FactSet Specialty Chemicals industry aggregate has traded with the EV/Sales range of 0.8-1.5 over the past 10 years with the average of 1.2.  The EV/EBITDA range during the period has been 6.5-12.2 with the average of 9.0.  The index consists of 38 members with the median market cap of approximately $700 million.  Restricting this group to companies <$1billion MktCap (to match FTFL) yields 24 companies with the median MktCap of $380 million, EV/Sales of 1.0, and EV/EBITDA of 11.1.

The following summarizes the average comparable valuations:

These comparables yield the following valuations for the chemicals business:

Ignoring the outliers, valuation in the $3.0/share - $6.0/share seems reasonable for FTFL's chemicals business.  I arbitrarily use $4.0/share as the P50 value (slightly below the average).

Biofuels Business

[GK4] Plant management began biodiesel production in 2005, leveraging scientific expertise and existing manufacturing capacity to pursue growth.  The biofuels segment currently produces biodiesel.  FTFL has fuel blending capacity and sells biodiesel blends.  The company has constructed storage infrastructure to take advantage of feedstock price volatility.  In March 2009 the company purchased a granary in central Arkansas and may use it in future expansion projects.  FTFL is one of 36 producers that as of YE 2009 achieved BQ-9000 certification (out of a total of 176 producers registered with the EPA).  The company employs 75 degreed professionals, including 19 chemists and 10 PhDs -- a source of significant edge when it comes to processing low-grade feedstock, meeting quality requirements, and maximizing efficiency and by-product value.  Production capacity is approximately 60MMgy.  There is no significant customer concentration.

The Biodiesel market is highly competitive and plagued by large overcapacity.  In 2009 there was over 2.5 billion Gy of biodiesel production capacity in the United States.  It is estimated that only 0.5 billion gallons were actually produced in 2009.  FTFL produced approximately 20 million gallons, or 4% of the total.

Unlike competitors that generally claim multi-feedstock capability, FTFL's technical expertise enables a truly feedstock-flexible process.  The company procures a broad range of feedstock including pork, chicken and beef fat.  Soybean oil is typically the highest-cost feedstock available.  On-site storage allows for pre-purchasing of feedstock when attractive margins can be locked in the animal tallow market vs. the heating oil/diesel market.

Tallow generally represents the lowest-cost broadly-available biodiesel feedstock for facilities with multi-feedstock capabilities, so I will focus on edible tallow.  Weekly pricing is available from USDA and industry sources.  Transportation costs are: $.01 - .02/lb.  Approximately 7.5 lbs. of oil/fat are required to produce a gallon of biodiesel.  Non-feedstock costs are roughly an additional $.50/gallon.  Biodiesel sells at a similar price as NYMEX #2 heating oil but receives $1.0/gallon blender's tax credit.  This credit expired at YE 2009.  While the House and Senate have passed bills to renew the credit for 2010, they must agree on a common text to send to the President, which is unlikely to happen until April, after the recess.  It is safe to assume that the credit will be renewed and will be retroactively effective to 1/1/2010.  Over the past two years, spot margins have ranged from the happy days of Q4 2008 at >$0.80/gal when few competitors could get trade financing (let alone the working capital), to the mess of Q4 2009 at <-$0.50/gal as newly-available liquidity from the re-emerged gravy train of easy equity funding and banks' reluctance to rock the boat gave many producers the opportunity compete-away margins.  In Q1 2010 margins have recovered to positive territory and now oscillate near zero..  Competitors' sensitivity to the availability of capital causes historical profitability to be strongly counter-cyclical, making a strong biodiesel player a good hedge against a double-dip scenario (this is easy to see by tracking the tallow price or the tallow/diesel ratio).

FTFL's biofuels segment produces significant revenues and helps with the fixed cost absorption.  In spite of the industry overcapacity and generally poor margins, it has been consistently profitable over the past two years once the scale and storage infrastructure were built-out allowing the company to lock in positive margins when the spread between oil/fats and diesel markets is attractive.  As both commodities are volatile and competitors tend to lack developed infrastructure, FTFL's storage capacity significantly boosts profitability:

This segment is difficult to value given terrible industry fundamentals.  One option is to use normalized margins:  As FTFL is the best run business we have seen in the biofuels sector (where our work was otherwise on the short side), it captured positive margins in 2009 when those could be locked-in.  I estimate that in 2009 FTFL produced approximately 20 million gallons and thus enjoyed gross margins of approximately $0.07/gallon.  This occurred in a year with 0% average spot margins and competitors' seemingly getting a free ride from creditors.  In the earlier analysis of the chemicals business, I assigned all of the corporate, D&A, and interest expenses to that segment when calculating segment EBITDA.  So for simplicity I will equate biodiesel's gross margin to the segment EBITDA.  Given that spot margins exceed $0.10/gallon over a broader period -- I believe this is a reasonable normalized gross margin -- at current commodity prices and at full capacity the segment would generate approximately $180 million in revenue and $6 million in EBITDA.  At 5x EV/EBITDA (long-term average for refiners), the normalized valuation would be approximately $.60/share.

Chemicals peers are poor comparables for valuation as they enjoy far better fundamentals.  Public biofuels producers (the few survivors) suffer from similar challenges of overcapacity and negative spot margins but appear to enjoy valuations that are hard to justify (in excess of replacement costs and 1x EV/Revenue for the small group I track).  They are short candidates and hence poor comparables as well (though they present pair-trade opportunities).  The oil refining and marketing industry faces similar issues and remains near cyclical low valuation, so I will use it as a comparable (using the same FactSet industry groupings as with chemicals):

Using 2009 results and the above comparables the valuations for the biofuels segment are:

$0.50/share seems to be a reasonable P50 valuation for the segment.  The significant upside to this valuation is at full capacity or, in the case of margin expansion, driven by industry rationalization:  At a 60MMgy run-rate at the above profitability the comparables valuation would yield ~$1.50/share.  Spot margins around $.20 (likely needed by the industry to earn cost of capital) would support a normalized valuation of ~$1.20/share.  When the industry was in distress in H2 2008, margins spiked to ~$0.80/gal, so a double-dip presents a delicious source of profitability upside:

Transactions in the private market have recently occurred near replacement cost (>=$1.00GPY) yielding private-market valuation ~$1.25/share for this segment.

Management

The 10-K and the web contain detailed information on Paul A. Novelly (chairman of the board) and Lee E. Mikles (CEO) as well as Mr. Novelly's Apex Oil Company.  The management team has significant insider ownership with Mr. Novelly owning 36.7% of the fully-diluted shares and Mr. Mikles 4.8% at year-end 2009.  The insiders have been aggressive purchasers in the late-2008 environment around $5.00/share.

Top officers do not take salaries and have been compensated entirely via option awards over the past two years.  In general, management compensation appears very subdued and strongly aligned with shareholder interests.

In the absence of attractive acquisitions and expansion opportunities, the company has consistently returned cash to shareholders in the form of special dividends:

....and warrant repurchases: "FutureFuel did repurchase and cancel 1,642,300 of its warrants for an aggregate purchase price of $799"

Managements' discipline speaks for itself:  From the top of the alternative fuels bubble, when most of the comparables that we used in pair-trades against FTFL experienced bankruptcy or devastating share price declines, the total return for FTFL SPAC units (using the current intrinsic value of the warrants) was 10%.

The track-record of shareholder-friendly actions and conservative re-investment make this one of the best-run businesses we have seen.

Cash

The company has $3.66 of estimated pro-forma net cash per share.  Given the track record of value creation by management, the history of shareholder-friendly actions, significant insider ownership, and extreme restraint in deploying cash, we believe no discount should be applied to the cash balance.  In fact, cash has significant option value if industry rationalization occurs, banks liquidate non-performing biofuels assets, and/or the economy double dips.

Fair Value

Combining the above valuations:

The base case EV of ~$217MM passes the smell test given historical annual EBITDA of $30-40MM and operating cash flow of $25-35MM.

Catalyst Timeframe and Expected Return

The main catalyst for the convergence of FTFL's valuation to that of its peers is a broader discovery of the company by investors.  As with spin-offs, bankruptcy emergences, and de-mutualizations, FTFL's limited history as a public company, small investor base, and lack of analyst coverage leave it overlooked.  Studies show that that such investments become familiar to the investment community and their valuations converge to those of peers generating alpha over a few years.  For instance, the excess return of spin-offs is well-researched, with outperformance starting in the second year of trading history and continuing for one to two years. FTFL's history as a public company and evidence of improving liquidity suggest a similar convergence to the peer group over one to two years, yielding base-case annualized excess return of 10-20% with upside annualized excess return of 28-64%, excluding difficult to quantify upside.

Legislation passed in 2010 expanded the Renewable Fuels Standard (RFS) which, for the first time, provided for a renewable component in U.S. diesel fuel.  RFS2 requires the use of 0.5 billion gallons of Biomass-based Diesel in 2009, increasing to 1 billion gallons in 2012.  With 2.5 billion gy of theoretical capacity in 2009, the industry appears oversupplied with no hope of a supply squeeze.  But with the limited operational history and questionable product quality of most producers (only 20% have achieved BQ-9000 certification) and the widespread biodiesel quality issues, over the next two years margin expansion for the few high quality manufacturers capable of delivering "safe" product is possible.

The timeframe for industry rationalization is harder to estimate.  Banks and investors have kept most of the industry in operation, even financing capacity expansions in spite of a multi-year record of value destruction and continually worsening industry fundamentals.  While we do not have a framework for putting an upper bound on the time this generosity persists, FTFL's margin expansion in a reversion to the environment of late-2008 will provide a valuable fundamental hedge to long portfolios.

Management consistently returns excess cash to shareholders.  The current rate of approximately $1.00/year (15%) is similar to the rate at which the company has built cash.  In light of this evidence, we believe that in the current environment - devoid of attractive acquisition opportunities or incentives for expansion - excess cash from warrant exercises will be returned to shareholders in the next year.

Catalyst

Catalysts

• Broader discovery by investors of the company and analyst coverage driving convergence of valuation to that of the specialty chemicals peer group or to the speculative valuations of biofuels peers.
• Margin expansion in the biodiesel business driven by mandates (given that most biodiesel producers can't ship product to spec), commodity price volatility, or industry rationalization as investors/creditors fold.
• Accretive use of cash on distressed assets in a double-dip / disorderly rationalization / panic scenarios.
• Return of excess cash to shareholders.
• Buyout.