January 23, 2019 - 4:26pm EST by
2019 2020
Price: 1.20 EPS 0 0
Shares Out. (in M): 45 P/E nm nm
Market Cap (in $M): 54 P/FCF nm nm
Net Debt (in $M): 180 EBIT -25 -40
TEV ($): 234 TEV/EBIT nm nm

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Pacific Ethanol is one of the last 5 major ethanol players still standing (the others are ADM, Valero, Green Plains Renewable Energy and Poet/Broin).

This idea is admittedly not for the 'stable business, compounding' crew, and is quite speculative.

The ethanol business has been covered in other posts on this forum, so rather than rehash those economics, suffice it to say it is a very tough business owing to the fact that all of its inputs and outputs are highly volatile commodities (inputs: corn, natural gas; outputs: ethanol, distillers grains/animal feed).

Pacific Ethanol is an interesting investment idea for just a few key reasons:

1) The enterprise value represents a significant discount to where ethanol plants have traded in the past 12 months;

2) Ethanol prices are at multi-decade lows currently, owing to both China's withdrawal from trade in 2018 and record high production levels. These factors caused ethanol inventories to build to record levels domestically. I believe these issues go away when a trade agreement is announced, which I think is likely at some point in 2019. Further, the Trump administration recently pushed for allowing E15 blends year round, which has the potential to increase domestic ethanol demand 50%. Note that the economics of using E15 is currently so favorable (owing to the steep discount ethanol trades at relative to gasoline) that several major gas stations are now expanding their rollout of the product.

3) Much of the company's debt is at the asset level, and the company could simply bankrupt individual assets without forcing impairment to the corporate equity (which is what the company did in 2009).


Enterprise Value vs Asset Value

In October 2018, Green Plains Renewable Energy sold 280mm gallons of ethanol production for $300mm to Valero, representing about $1.07/gallon of production capacity.

Pacific Ethanol has about 565mm gallons of ethanol production (after adjusting for their 74% ownership of their Aurora plants).

At PEIX's current enterprise value of $235mm, the business is trading at about 40 cents per gallon of production capacity, a steep discount to recently traded asset values and an even steeper discount to replacement cost ($1.25-$1.50/gallon).

Just for illustrative purposes, the table below shows what PEIX share price would be at 60 cents, 80 cents and $1 per gallon:

Value / Gallon $0.60 $0.80 $1.00
Enterprise Value $340mm $450mm $565mm
Share Price $3.55/sh $10.00/sh $12.50/sh

Clearly, the stock is cheap based on comps and replacement value. Granted, many of their plants are smaller scale (60mm gallons of production vs 100mm gallons) and located west of the corn belt, increasing their basis cost for corn, but even at significant discounts there is still meaningful share price upside.


Ethanol Prices, Trade Dispute & Political Overview

Admittedly this is the riskiest part of the thesis, and I don't proclaim to have any special political acumen. What I will cover, however, is some of the stats behind the ethanol export market as well as review China's ethanol consumption ambitions. I'll further frame this in light of how much ethanol they're likely to buy if the trade dispute is resolved.

Currently, the United States produces about 16bn gallons of ethanol per year (source: EIA), versus domestic demand of around 14.3bn gallons (10% of US gasoline demand). The remainder is sold into the export market (largest importers are Brazil, which uses a 30% ethanol blend vs our 10%, Canada and India). 

With the China trade dispute, an extra 100-200mm gallons of ethanol per year have no place to go, and domestic production has continued to inch upwards owing to plant improvements and modest capacity expansions. 

All this said, there is no reason the US can't easily switch to an E15 blend at any time, and the depressed ethanol prices have taken a serious toll on the farm belt. Recently, the Trump administration approved E15 use year round:

And several gas stations are starting to aggressively roll it out:

On the China front, China has stated it intends to also reach a 10% ethanol blend by 2020 (which they will almost certainly fall short of):

A 10% ethanol blend in China would necessitate at least 5 billion gallons of ethanol, and they currently only produce 1 billion gallons. They have a further 2 billion gallons worth of production capacity under construction, leaving a 2 billion gallon shortfall.

Apparently China recently offered the United States a trade deal to increase purchases from the US by $1tn over the next 6 years, or about $160-170bn more per year. I think much higher ethanol purchases would clearly fit in to this plan, and it would also help solve Trump's domestic political quagmire he has with the farmbelt, as farmers have been hit the hardest from the trade dispute (China was a massive buyer of our soybeans).

Asset-level Debt

Despite the company's high leverage, $125 million of the debt is at the asset level of their ICP and Pekin plants. The company may choose to individually bankrupt these assets to preserve cash (which is similar to what the company did in 2009). 



This is a high-risk, high-reward situation with significant upside potential if ethanol prices recover. Despite the terrible market conditions, the company managed to produce positive "adjusted EBITDA" in the third quarter of 2018 and burned less than $10mm of cash in the quarter. 



I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Trade dispute resolution

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