Introduction

I generally shy away from industries that are highly dependent on government regulation.  However, the more I learned about Renewable Energy Group’s expanding business model, especially as it continues to diversify away from government regulation, the more comfortable I became with the company.

Company Overview

Renewable Energy Group, Inc (REGI) is the largest producer of biodiesel in the US with a national logistics and distribution network.  With its flexible use of feedstock, REGI has become the low cost US producer of biodiesel.  The company began as a producer of “green” household cleaning products, but has since seen significant growth from its involvement with the biodiesel industry.  Over the years the company has gained an expertise in acquiring, constructing and retrofitting refining plants, sourcing feedstock, optimizing production facilities, marketing, selling and distributing its products. 

Industry Overview

Biodiesel is a low carbon, renewable alternative to petroleum-based diesel fuel and is most often blended with petroleum-based diesel to meet the Renewable Fuel Standards (RFS) set by the EPA.  It is created through a refining process that uses agriculture oils (edible, inedible and used cooking oil), grease and animal fats as feedstock, and is functionally identical to petroleum-based diesel.  Pure biodiesel (B100) will have CO2 and hydrocarbon emissions that are up to 80% and 60% less than petroleum-based diesel emissions respectively.  The Biodiesel industry has evolved because of the government’s RFS, which require that transportation fuel sold in the US contain a minimum amount of renewable fuel.  Each year the EPA sets its Renewable Volume Obligations (RVO) for ethanol, biodiesel and biomass specifying the minimum amount of renewable fuels that are required to be blended each year.  For 2014, 1.28 billion gallons of biodiesel are required to be blended with petroleum-based diesel to satisfy the government’s requirements.  That number has nearly doubled from the 0.65 billion gallons required in 2010. 

The government carefully monitors the amount of biofuels being blended each year by issuing Renewable Identification Numbers (RIN) for every gallon of biofuel created.  These RINs have a value which is embedded in the price of a gallon of biodiesel and can be used to offset tax liabilities of the company that blends the biofuel with petroleum fuels.  The cost of a gallon of biodiesel, which is often at the same price or higher than petroleum-based diesel, is highly influenced by the price of oil, soybean oil (the most common feedstock), the number of gallons of biodiesel produced, and the embedded cost of the RINs (which can be bought and sold in a secondary market).  To make the biodiesel market viable, states and the federal government provide additional tax incentives to biodiesel producers and blenders.

The biodiesel industry is highly fragmented with nearly 1/3 of total production coming from 3/4 of the refiners, with a handful of the top producers controlling much of the market share.  Most independent biodiesel producers are smaller regional players with 1 or 2 refineries generating less than 20 million gallons per year.  Renewable Energy Group, an independent producer, is the largest producer with over 257 million gallons of biodiesel capacity per year (~20% of RFS market share) competing directly with larger conglomerates like:  Cargil, ADM, Louis Dreyfus Commodities and AGP.

Competitive Edge

Being the largest biodiesel refiner has provided Renewable Energy Group with significant competitive advantages over many of its competitors.  Feedstock represents 80-90% of the cost to produce biofuels.  REGI’s production size, multiple refineries and strong relationships with feedstock suppliers provides a competitive edge in price negotiation, especially when they are able to “fill-in” for higher amounts when needed.  Additionally, REGI’s refining plants have been constructed or retrofitted to provide the flexibility to refine a variety of feedstocks; 83% of their production comes from animal fats, white and yellow grease, used cooking oils, and inedible corn oils.  Soybean oil is the most expensive source of feedstock and while used by the majority of biodiesel refiners, it only represents 17% of Renewable Energy Group’s feedstock (mostly used during the colder winter months because it has a low cloud point – the point at which biodiesel gels).  This flexibility in sourcing the lowest cost feedstock gives REGI and advantage in the industry, which amounted to $0.60/gallon in 2013. 

But REGI’s strong relationship is not just with its suppliers; it is also considered one of the top brands within the industry and has a strong relationship with both retail customers and distributors.  Through its 27 terminals, storage at its 8 refining plant and multiple distributors, Renewable Energy Group have created a national distribution and logistics footprint delivering biodiesel, ultra-low sulfur diesel and heating oil into 43 states, 4 provinces in Canada and 1 state in Mexico.  Recently, REGI announced that it would leverage its North Eastern terminals system and its brand to sell petroleum-based heating oil and diesel.  This is not a departure from biodiesel but a more competitive service to offer its client base while providing additional opportunities to blend more biodiesel.

The company is currently in the process of adding 150 million gallons/year of new capacity through 4 new/expanded refining plants which should be operational by the end of 2015.  In early June of 2014, REGI purchased a 75 million gallon/year renewable diesel refiner in Geismar, Louisiana, bringing its current nameplate capacity to over 330 million gallons.

Scarce Resource

Renewable Energy Group operates in a niche segment within the renewable biofuels industry.  The Biodiesel industry is still in its early stages.  However, limited demand, margin pressures (caused by tax incentive uncertainty), competition, and high start up costs have provided a barrier to entry for new companies entering the market.  REGI has grown-up along side the biodiesel industry and being one of the first entrants has provided the company with economies of scale to become the low cost producer, a clear leader in the overall market share, and the ability to create a strong logistics and distribution network.  As REGI continues to grow within the industry, both organically and through acquisitions, its choice of refining sites reflects the expanding regional growth in specific areas, along with its desire to remain close to its feedstock suppliers. 

REGI’s recent acquisition of LS9, a development stage company, will help the company increase its ability to refine new feedstocks, and reduce the production cost of biodiesel.  It is estimated that development of alternative feedstock as well as continued optimization of its refining process could reduce Renewable Energy Group’s production costs by as much as 35%.  LS9’s focus and expansion into the growing segment of renewable chemicals and lubricants will also help REGI become a fully integrated biodiesel and renewable chemical platform, with opportunities to expand into paints & coatings, manufacturing lubricants, health and beauty, home products, and the plastic industries.  Additionally, the movement into renewable chemicals will also allow REGI to de-emphasize its dependency on the volatile biodiesel market while moving into the more stable and higher margin chemical market.

Government Regulation & Incentives

There are a number of government regulations and tax incentives that have an impact on the biodiesel industry.  In 2010, the diesel Renewable Fuel Standards (RFS) was established.  Each year the EPA sets the blending Renewable Volume Obligations (RVO) for diesel fuel, setting the minimum amount of gallons that are required to be blended with petroleum-based diesel.  In 2010 that amount was 650 million gallons.  In 2013 & 2014, the RVO was set at 1.28 billion gallons (RVO targets were not raised in 2014 which surprised the market).  In addition to the government regulation, companies like REGI are incentivized to produce and sell biodiesel through state and federal tax incentives.  The Renewable Identification Number (RIN) and the Blender Tax Credit (BTC) are two federal incentives that were created to both monitor production and blending within the biodiesel market, as well as make the biodiesel market viable until it matures and is able to survive on its own. 

At the end of 2013, the BTC expired and its future remains uncertain as the government plays politics ahead of the November 2014 midterm elections.  This would not be the first time the BTC has expired only to be reinstated retroactively (2 times in the past 5 years).  The government’s mismanagement of the BTC has allowed companies to “game” the system, acquiring excess biodiesel in 2013 in order to receive the BTC before it expired, with the objective of using the excess biodiesel in 2014.  This year-to-year ambiguity that surrounds the BTC has created a nascent market place that is uncertain and very volatile, putting smaller industry players at a significant disadvantage.  Without the added benefit of the BTC and the lack of increase to the RVO, demand for biodiesel has declined, putting pressure on biodiesel producers and their margins (especially those producers that use soybean oil as feedstock).  As margins decline, smaller players will be forced to shut production.  A survey conducted by the National Biodiesel Board in April of 2014 found that nearly 80% of US biodiesel producers have scaled back production with more than 50% of the producers idling production at a plant.

Valuation

In order to value REGI, one needs to access the company first without the benefit of the Government’s BTC, and then evaluate how the company would look with the BTC reinstated.  The 1^st quarter of 2014 saw revenue at $219 million on 47 million gallons sold and an ASP/gallon of $3.54.  On a quarter to quarter comparison, revenues were down 17%, ASP down 20% and gallons sold were 22% higher but coming in at the lower end of guidance.  The elimination of the BTC definitely had a large impact on Q1 financials, but it is important to remember that Q1 was unseasonably cold, especially in the North Eastern and Mid Western portions of the US.  Freezing temperatures decrease the demand for biodiesel, as biodiesel will gel (cloud point) at higher temperatures than petroleum-based diesel.  Additionally, REGI processes higher levels of soybean oil in Q1 because soybean oil has the lowest cloud point of any of its feedstock.  These factors negatively impacted margins pushing gross margins down into the 5% range.  Going forward, and using 2012 as a template (2012 was the most recent year without the BTC – only to be reinstated retroactively in early 2013), my expectations are that the next three quarters will see higher demand leading to higher margins and an annual free cash flow of $35 - $40 million.  At current prices, this equates to the stock trading at nearly 12x 2014’s FCF, which includes all of the current headwinds and uncertainty impacting the industry being priced into the stock.  Without the BTC, I think REGI is worth about $16/share which is equal to a little over 16x my 2014 FCF expectations.  If the BTC were to be reinstated either currently or retroactively, than Renewable Energy Group could easily generate over $90 million in free cash flow and be worth $38 - $40/share.

Additional upside potential can also be achieved as REGI’s expands into the renewable chemical market, which will help the company not only de-emphasize its dependency on the biodiesel market, but also help it supplement its revenue with higher profit margins.  Of course, this will not happen overnight, so it is helpful that Renewable Energy Group’s balance sheet contains over $3.50/share of cash which will provide some downside protection as investors need to remain patient.

Summary

The government’s regulation and tax incentives to the biodiesel industry were meant to provide stability and support to a burgeoning industry.  However, never missing an opportunity to make a bad decision even worse, Congress has decided to play politics creating uncertainty and economic turmoil for the companies it wishes to support.  This has forced many companies within the biodiesel industry to reduce, idle or shutter their production.  In the short-run, the BTC expiration is obviously bad for the industry as a whole, but in the long-run Renewable Energy Group will benefit as it will help rationalize the industry.  For the patient investor, Renewable Energy Group’s robust balance sheet (~$3.50/share in cash) provides some downside protection, and as the industry continues to consolidate, REGI will have the ability to purchase assets at very distressed levels.

Renewable Energy Group is a tale of two margins.  The current depressed margins, stemming from the BTC uncertainty, disappointment in lack of biodiesel RVO growth, oversupply in 2013 that needs to be worked off, and healthier margins if and when these headwinds abate.  The current stock price reflects the uncertainty surrounding the industry.  But even if these headwinds were to remain for the foreseeable future, the price of REGI stock still provides upside potential with limited downside risk.  Renewable Energy Group is also a tale of two companies:  A company that is interconnected to the biodiesel industry and, as such is dependent on the government regulations and tax incentives for growth; and a company, through acquisitions and organic growth, which has levered its core competency to expand into the ancillary renewable chemicals industry.

• Reinstallment or reactivation of the BTC
• Increase in the RVO for 2014 or beyond
• Further consolidation within the biodiesel industry
• Leveraging Renewable Energy Group's LS9 acquisition to reduce production costs and expand into the higher margin business of renewable chemicals