Recommendation:

I recommend shorting Vertex Energy (ticker VTNR).  The Company has recently doubled down on the used motor oil collection and re-refining business, and the market has cheered this “transformative acquisition,” taking VTNR’s enterprise value from $85 million to nearly $300 million (despite the acquisitions totaling $65 million in size).

With the very recent opening of Chevron’s new motor oil refining facility however, North American lubricant capacity just grew 10% in an industry where consumption is stagnant at best.  With the lubricant market likely to be oversupplied over the next 2-3 years, VTNR’s margins are likely to fall short of aggressive management targets.

The market cap is pretty small for VTNR, but trading volume is decent (>$3 million per day on average), short interest is moderate (8% of float), and the cost to borrow isn’t excessive (<4% in my experience).

Company Description:
Historically, VTNR has primarily been a collector and aggregator of used motor oil (UMO) and other petroleum by-products, with some re-refining capabilities as well.  Legacy VTNR consists of 3 segments:

• Black Oil (55% of 2013 revenue, 15% of operating income)
  • Collects and purchases used oil from automotive service shops, manufacturing facilities, etc.
  • Owns fleet of 13 collection vehicles, 7 transportation trucks, and 90 aboveground storage tanks
  • Also aggregates used oil from network of 50 suppliers operating similar collection businesses to VTNR’s
  • Either re-refines the UMO into marine fuel cutterstock (owns facility with up to 30 million gallons of annual UMO capacity) or sells the UMO to other third party refiner

• Refining and Marketing (34% of 2013 revenue, 43% of operating income)
  • Aggregates diverse mix of feedstocks including UMO, petroleum distillates, transmix and other off-specification chemical products
  • Feedstock streams purchased from pipeline operators, refineries, etc, and are also transferred from Black Oil division
  • Has a toll-based processing agreement in place with third party (KMTEX, Ltd) whereby third party re-refines the feedstock streams into various end products that VTNR then sells to customers

• Recovery (11% of 2013 revenue, 42% of operating income)
  • Using fleet of 8 trucks and heavy equipment, provides industrial dismantling, demolition, decommissioning, investment recovery, and marine salvage services in industrial facilities

Over the past year, legacy VTNR collected 11 million gallons of UMO itself and aggregated another 35 million gallons of UMO from third party collectors.  Legacy VTNR generated LTM 3/31/14 revenue of $175 million, adjusted EBITDA of $7.9 million, and adjusted EBIT of $5.4 million.  Until March of 2014, legacy VTNR traded at a sub-$100 million enterprise value.

On March 19, 2014, VTNR announced an agreement to acquire Omega Holdings, a UMO re-refiner.  The assets VTNR is acquiring include two UMO re-refineries, one in Louisiana that produces vacuum gas oil (an intermediate product that can be used as a feedstock to produce a number of other petroleum products) and another that produces base lubricant (the main component of motor oil).  Omega Holdings generated 2013 revenue of $185 million.

The Omega acquisition occurs over two separate closings: the first closing (in which the Louisiana facility was transferred) occurred in May, while the second closing (for the Nevada facility) is scheduled to occur in the third quarter.  The total purchase price was approximately $48 million at the time of the acquisition announcement ($30.75 million in cash, 2 million shares of VTNR stock valued at $7.5 million at the time, and the assumption of $9.7 million of capital leases and other liabilities).

In addition, at the end of July, VTNR announced a letter of intent to purchase Heartland Group, which owns a re-refinery in Ohio, for $16.5 million, subject to further due diligence on VTNR’s part.  Financials for Heartland Group haven’t been disclosed.

The Omega and Heartland acquisitions more than double VTNR’s revenue and expand the company’s presence further down the UMO recycling value chain.  Legacy VTNR primarily focused on UMO collection and aggregation and had capacity to re-refine up to 30 million gallons of UMO on its own.  After the Omega and Heartland acquisitions, VTNR will have re-refining capacity for an estimated 140 million gallons of UMO, producing marine fuel cutterstock, vacuum gas oil, and recycled base lubricant.  Strategically, VTNR will likely become much more dependent on third party suppliers of UMO now, as its own re-refining input needs are much greater than its internal collection capabilities.

Both the Street and the market view these acquisitions as “transformative.”  The day before the announcement of the Omega Holdings acquisition, VTNR traded at $3.82, representing an $80 million market cap and $85 enterprise value.  Today, the stock trades at $8.67; pro forma for the equity and debt issuance associated with the acquisitions, this represents ~$250 in million market cap and ~$290 million in enterprise value.   In other words, as a result of 2 announced acquisitions totaling $65 million in size, the market has increased VTNR’s enterprise value by more than $200 million.

I estimate the pro-forma combined capital structure for VTNR as of 3/31/14 as follows:

• Cash of $9 million
  • 3/31/14 actual cash on hand of $5 million, plus $17 million from recent private placement of shares, plus $31 million in incremental new debt recently issued, less $31 million cash paid for Omega and $17 million cash paid for Heartland, plus $4 million in cash from the assumed eventual exercise of 1.9 million in-the-money options at avg strike price of $1.87

• Debt of $48 million
  • Consists of new $40 million 9% term loan and $8 million of “assumed capital leases and other liabilities” associated with Omega acquisition

• Share count of 28.7 million
  • 21.3 million shares outstanding as of 3/31/14, plus 1.3 million from assumed conversion of preferred stock, plus 2.2 million shares from recent private placement, plus 1.9 shares from the assumed eventual exercise of in-the-money options, plus 2 million shares issued as part of Omega acquisition

Lubricant Refining 101:

The motor oil used to lubricate engines and machinery is composed of base lubricant combined with various additives. “Virgin” base lubricant is produced from refining crude oil.  Base lubricant can be characterized into several groups, including the following:

• Group I
• Group II
• Group III
• Groups IV and V

Group I base lubricants are easier/cheaper to refine (and therefore usually cost less), but they contain more compounds which can diminish performance.  Group II and III base lubricants are more difficult/expensive to refine but are also more desirable.  Groups IV and V are typically used for higher performance niche applications and are produced in lower quantities.  While there remains significant existing capacity to produce Group I base lubricants, most new refining capacity tends to be designed for production of Group II and III base lubricants.

Currently, there are 14 refineries in North America producing virgin Group I, II, or III base lubricant.  These base lubricant refineries are all attached to larger petroleum refineries.  The larger petroleum refineries produce, among many other things, an intermediate product called vacuum gas oil (VGO).  A refiner can then choose to run the VGO through further refining to produce things like diesel fuel, jet fuel, etc., or, if that refiner has base lubricant capability, it can use VGO to produce base lubricant.

In addition to refineries that produce virgin base lubricant, there are also “re-refineries” that take used motor oil (UMO) as a feedstock to produce recycled base lubricant (or just VGO in some cases).  Approximately 1.4 billion gallons of UMO are generated each year in the U.S., of which approximately 1.0 billion gallons are collected (with the remainder being lost due to improper management and disposal).  About 60% of the 1.0 billion gallons of collected UMO are used as fuel for asphalt plants, steel mills, and other energy users.  The remaining 40% is processed by re-refiners.  For every 100 gallons of UMO processed, a re-refiner can typically generate 50-75 gallons of recycled base lubricant, depending on the technology used.  Re-refiners procure UMO either by setting up their own route networks to purchase and collect UMO from automotive service centers and the like or by paying third party UMO aggregators (of which there are many).

Currently, there are at least 11 base lubricant re-refineries in North American; these re-refineries use over 400 million gallons of UMO annually to produce 225-250 million gallons of base lubricant and/or VGO.

An expansion in lubricant refining margins in 2010-2012 led to a wave of new supply that is still coming on:

The chief determinant of a base lubricant refinery or re-refinery’s profitability is the spread between the cost of feedstock and the price of base lubricant.  For virgin base lubricant refineries, the feedstock is crude oil/VGO.  For re-refineries, the feedstock is UMO.  Typically, the cost of crude is a decent proxy for the cost of UMO (as the main use of UMO is as an industrial fuel source, it is a substitute for other oil-based products).  For most of the 1990s and 2000s, there was very little base lubricant capacity built, largely because the spread between crude/UMO and base lubricant didn’t justify new construction.  In 2010-2012 however, the spread widened considerably:

 
Source: “The Challenges of Re-Refining, Again”, ILMA Magazine, February 2014

What triggered the historically wide base lubricant refining margins in 2010-2012?  Not surprisingly, multiple factors contributed, including:

• An extremely tight lubricant inventory situation at the end of 2010/beginning of 2011:

         
          Source: Energy Information Administration data

For all of 2009 and much of 2010, many U.S. lubricant refiners were operating at lower than normal utilization levels.  As demand began strengthening in 2010 (recovery from 2008-2009 recession), production levels did not ramp up as quickly.  While U.S. lubricant demand grew 11% in 2010, production grew 9% (according to EIA data).  And by the end of 2010, lubricant stocks were at historical lows.

• Overseas base lubricant capacity cuts in 2010 and 2011 that led to an increase in export demand:

          
           Sources: LubeReport.com, EIA

In 2010 and 2011, overseas base lubricant refining capacity actually shrunk, as old Group I refineries were shut down.  This led to an increase in demand for exports of base lubricant from North America (an area already experiencing tight supplies).

The widening of lubricant refining margins in 2010-2012 dramatically changed the economics of the industry.  Not surprisingly, industry participants responded by launching a number of new projects during this period.  Rightlanedriver noted the increase in re-refining capacity in his excellent write-up on HCCI back in May of 2012.

At the beginning of 2010, I estimate that North American re-refineries were processing ~325-350 million  gallons of UMO annually to produce ~200 million gallons of base lubricant and/or VGO.  Since then, re-refining capacity has increased 35%.  Projects representing a further 30% increase are currently under construction.  And projects representing yet another 30% increase are on hiatus; should re-refining margins show signs of improvement, it’s likely these projects would be resumed.

Sources: LubeReport.com, company press releases and filings

Of course, re-refining (now totaling ~275 million gallons of annual base lubricant capacity) only represents about 10% of total North American lubricant supply, however.  So the bigger driver of both refining and re-refining spreads is what is happening to virgin lubricant supply.  Both internationally and in the U.S., total lubricant supply has been ticking up since the 2012 margin peak:

Sources: LubeReport.com, Lubes N Greases Magazine, EIA data

Moreover, the domestic market is just about to absorb a big chunk of new capacity:  Earlier this summer, Chevron completed its $1.4 billion base lubricant refinery in Pascagoula, Mississippi.  With capacity of 25 thousand barrels per day of Group II base lubricant, this new plant represents a 10% increase in total North American capacity (the Chevron plant is not reflected in the chart above).

The opening of the Chevron facility represents the largest increase to North American lubricant capacity in well over a decade.  Here’s what some industry observers have to say about it:

Heritage Crystal-Clean CEO, 2/21/14 earnings call:
“We see the market pretty plentiful here with the start-up for Chevron.  And so we don’t see any relief on the pricing for this year and could be for the next couple of years…..Over the longer term, we’ve seen these cycles before.  It’s not the first time that a major facility has put in place the first time, I would say, parallel to what we’ve seen here is – into mid to late 1990s and that cycle lasted a couple of years.  So if we’re going to be a couple years here or more than that, it’s pretty hard to forecast.”

Gabriella Wheeler, U.S. Base Oil Price Report 8/6/14 (LubeReport.com):
“There has been little evidence in the market of any direct impact of the fresh introduction of API Group II oils from the new Chevron plant in Pascagoula, Miss., which was heard to be running well and reliably….Nevertheless, other producers have been concerned for quite some time about the pressure that the additional product might place on domestic supply levels and pricing.  Sources have already reported some competitive pricing movements in the spot market, and this trend is expected to become even more pronounced in coming weeks.  At the moment, the Group II segment appears to be fairly snug given the extended turnaround at the Excel Paralubes base oils plant in Westlake, La., which started in late June and was anticipated to last until the end of August.  The unit can produce 22,200 barrels per day of Group II oils….But there are reports that the plant may be restarted earlier than anticipated…..This is likely to occur around the same time that demand slows down at the end of summer.”

Demand growth is unlikely to save this industry from an oversupply situation:

For some industries, a sudden 10% increase in capacity might be easily absorbed by increased demand.  But motor oil is an industry where consumption is stagnant, at least domestically.  The number of vehicle miles driven in the U.S. is still below 2007 levels, and new cars require fewer oil changes than past models.  As a result, U.S. motor oil consumption is currently 15% below levels from a decade ago:

Source: EIA data

VTNR management’s target objectives look aggressive:

VTNR is difficult to model going forward, as its pending acquisitions more than double its revenue yet we have only partial data on the margins and cash flows of the acquired assets.  In a May investor presentation, VTNR management did provide its “target objectives” for the company after the Omega acquisition is completed:

If we assume a 15x P/E multiple for this company, then VTNR would be worth $9-$13 per share under management’s “current pricing” scenario and $15-$19 per share under an “improved pricing” scenario.  I am highly skeptical of these forecasts for the following reasons, however:

• Management is factoring in significant top-line synergies with little rationale behind them:
  • Over the LTM period, VTNR’s legacy operations generated revenue of $176 million.  In 2013, Omega assets VTNR is acquiring generated revenue of approximately $185 million.  So the combined pro forma VTNR generated ~$360 million of revenue over the past year.  VTNR’s “current pricing” objectives assume revenue will grow between 20% and 40% from current levels.
  • When discussing “synergy potential,” management notes that it expects to “reduce UMO costs” and “garner higher VGO prices.”  Given that VGO is a highly fungible commodity with daily prices quoted on Bloomberg, I doubt that they can improve VGO pricing.  And given that VTNR will only be internally collecting a small percentage of its UMO needs for the acquired re-refineries, VTNR will be highly dependent on third party UMO suppliers, which if anything is likely to drive VTNR’s UMO costs higher.

• Management’s “current pricing” EBITDA margin objectives of 8.5%-10% are very aggressive:
  • The LTM adjusted EBITDA margin for VTNR’s legacy operations is 4.5%.
  • The 2013 EBITDA margin for the bigger of the two Omega re-refineries being acquired was 2.8%.
    • In mid-July, VTNR released an 8-K with financials for the Louisiana re-refinery being acquired in the Omega acquisition (the Louisiana re-refinery is the bigger of the two re-refineries in the Omega deal and represents about 75% of Omega’s revenue).  The 8-K revealed that the Louisiana facility generated an EBITDA margin of just 2.8% in 2013.  Additionally, the 8-K provided 2013 pro forma financials assuming the combination of legacy VTNR and the Louisiana re-refinery, and the combined pro forma adjusted EBITDA margin was 3.7%.

• I expect base lubricant re-refining margins to worsen from current levels because of looming oversupply

My rough back-of-the envelope assumptions for VTNR are as follows:

• Pro forma revenue of $450 million
  • I’m simplistically taking the $360 million in LTM combined revenue for Omega and VTNR, assuming another $60 million from the Heartland acquisition, and another $30 million in revenue synergies (even though I don’t know what the revenue synergies would really be here

• Pro forma EBITDA margins of 5%
  • I think this is very generous to VTNR, as it assumes improvement from historical levels for VTNR and Omega, despite the fact that I expect weakening prices in the base lubricant market will be a drag on margins.

• Pro forma D&A at 2% of revenue

• Interest expense of $4 million
  • Pro forma for the acquisitions, VTNR has $48 million of debt outstanding, most of which carries a 9% interest rate.

• Pro forma tax rate of 37.5%
  • Note that VTNR currently has $31 million in NOLs, so they are unlikely to be cash taxpayers over the next couple years.

Under these assumptions, VTNR would be generating EBIT of $13.5 million, fully-taxed net income of ~$6 million, and EPS of ~$0.20 (pro forma diluted share count of approximately 29 million).  As I mentioned above, VTNR also has $31 million in NOLs, so figure $0.35 per share in value for those.  Under any realistic multiple, I think it’s difficult to justify VTNR’s current stock price and enterprise value under that scenario.

Risks:

• With the Omega and Heartland acquisitions, VTNR is likely adding re-refining capacity at below replacement cost; if I’m wrong about base lubricant re-refining margins weakening over the next couple years, then VTNR has positioned itself well.
  • New re-refining capacity built in recent years has cost from $1.00 to $3.00 per gallon of UMO input capacity.  With its Omega and Heartland acquisitions, VTNR is adding 110 million gallons of UMO input capacity at a cost of ~$65 million (~$0.60 per gallon).  That said, 60 million gallons of the 110 million gallons of added capacity is for a re-refinery that produces vacuum gas oil instead of base lubricant, and such a facility costs substantially less on a per gallon basis than a full base lubricant re-refinery.  Still, even if we assume that VGO capacity is half the cost of lubricant capacity, then VTNR is still adding capacity at a cost per gallon below the low end of the recent range for new construction.

• The UMO collection and re-refining industry has seen a healthy amount of M&A over the past few years, so a buyout is a risk on this one.
  • Over the last couple years, there have been seven notable deals in the space (including the two recent VTNR deals):

                   
                    Sources: Company filings, LubeReport.com, Googled news articles

• Decrease in base lubricant prices and margins from current levels (LubeReport.com’s weekly base oil price report is a good way to track this).
• Future earnings releases showing revenues and margins below management targets.