America boasts the world's largest ethanol production footprint in the world -- and it's not even close. The commodity is also mired in a prolonged slump. The last time ethanol prices topped $2 per gallon was December 2014. Before that, they hadn't dipped below $1.50 per gallon since June 2005. The average monthly price through the first five months of 2019 was only $1.15 per gallon.
There's a complicated set of factors influencing the price of the fuel additive, ranging from a swollen national inventory to near-zero prices of federal credits attached to each gallon of production. The consequences are far simpler, however: Ethanol producers such as Green Plains (NASDAQ: GPRE) are treading water and accumulating red ink. With shares trading at just half of book value, should investors consider the ethanol stock a buy?
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A rough start to the turnaround
Green Plains entered 2018 with ample diversification from volatile ethanol markets. It owned Fleischmann's Vinegar, which allowed it to use some of its capacity for higher margin food-grade ethanol markets (vinegar is manufactured by fermenting ethanol). It owned cattle feedlot operations, which allowed it to directly upgrade corn byproducts from the ethanol manufacturing process and sell meat products. It also generated a strong income stream from its logistics partnership, Green Plains Partners LP, which acts as the ethanol equivalent of an oil and gas midstream business. The plan was to drop down certain assets to the partnership to capitalize on booming ethanol exports.
Despite generating $36 million in net income in 2018 from diverse operations, management grew frustrated by the limitations of the company's balance sheet. Over half a billion dollars in debt resulted in interest expenses of $101 million last year, up from just $40 million in 2015, and constrained the company's operating flexibility.
That's why Green Plains divested its vinegar business and a handful of ethanol manufacturing facilities to pay off a $500 million secured-term loan in the final weeks of 2018. The idea was to scale down, invest in production efficiency, and refocus the business on ethanol and protein markets (through cattle feedlots and protein byproducts).
Unfortunately, almost every external factor has worked against the strategy. In the first quarter of 2019, Green Plains reported that its cattle feedlot business, now the core of the food and ingredients segment, coughed up an operating loss of $1.4 million. The vinegar business and higher prices per head of cattle had delivered a $12.6 million operating profit in the year-ago period. Meanwhile, a smaller ethanol production footprint meant the revenue streams from the agribusiness and energy services segment shrank, along with the partnership. The two segments combined to deliver an operating profit of $17.8 million, a 20% decline from the prior-year period. Worse, planned collaborations for building ethanol export infrastructure have fizzled.
The strategy for the ethanol segment backfired, too. Management decided to curtail production from its smaller fleet to better navigate poor market fundamentals in Q1 2019, but running facilities at reduced utilization rates increased operating losses. The ethanol segment coughed up an operating loss of $44 million in Q1 2019, much worse than the $27 million operating loss in the year-ago period.
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Questionable decisions are eroding trust
Making matters worse, external factors aren't entirely to blame for the business's recent woes.
Investors were right to have some doubts about management's vision when the turnaround strategy was first announced, but it was at least possible to believe that the goal of debt reduction might prove worth the cost of selling the high-margin vinegar subsidiary.
Management's recent decisions, however, have brought those doubts back into focus. In mid-June Green Plains announced it was suspending its dividend to save approximately $20 million per year. It was the right decision for the long-term viability of the business, but that argument was immediately diluted by a second announcement the same day: The ethanol producer announced it would issue $105 million in debt to repay $58 million in older debt and repurchase $40 million in shares. The few million dollars remaining after deducting fees would be invested in efficiency upgrades.
In other words, the company finally positioned itself to have tens of millions of dollars in cash to invest in much-needed technology upgrades at its facilities and drive long-term value for shareholders, but management decided that the money would be better used buying back stock. Shares are cheap, but they're cheap because Wall Street sees little value in operations. Repurchasing cheap shares doesn't fix that.
These actions make it easy to question if management is serious about delivering the needed efficiency upgrades as quickly as possible. For instance, Green Plains has teased a bolt-on technology for years that could create corn protein byproducts with higher-value amino acid compositions, allowing the products to be sold into premium animal feed or aquaculture markets. It's expected to add $0.10 per gallon to ethanol margins, which would amount to $110 million annually across the company's fleet. But it will be installed at just one of 13 ethanol manufacturing facilities by the end of this year. Accelerating that deployment seems like it would've been a better use of $40 million.
A lack of priorities is proving costly
Things aren't going great for Green Plains. Shares have lost 43% since the end of April, and are trading below $10 apiece for the first time since early 2013. And the recent turnaround strategy has started off on the wrong foot, thanks to awful market fundamentals and some clumsy decisions by management. Could better days be ahead?
Perhaps. Green Plains recently tapped the engineering firm ICM to execute its production efficiency goals. The collaboration could reduce segment operating expenses by up to $0.24 per gallon in the next 18 months. Then again, investor trust in management isn't very high right now, and $0.24 per gallon seems almost too good to be true.
Investors should avoid this ethanol stock until operations are indisputably heading in a better direction.
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