This Value Stock Just Secured a Major Regulatory Approval

Image source: Getty Images.

The nation's fourth-largest ethanol producer just received some excellent news: The U.S. Environmental Protection Agency approved the use of a new process at its Stockton, California, manufacturing facility that allows the production of high-value cellulosic ethanol. Yes, that type of ethanol. The kind that has been infamously promised to be "five years away" for the last 10 years. It's finally here.

Pacific Ethanol (ALTO 0.52%) won't be producing much of it right away -- just 1 million gallons per year at Stockton -- but if the new process is rolled out across the company's entire 515 million gallon fleet, then investors could enjoy up to $15 million in additional (and nearly) cost-free revenue per year. To put that into perspective, the company realized net income of $5 million in the most recent quarter and has realized a net loss of $8 million for the first half of 2016.

The milestone puts Pacific Ethanol in some great company. Now, the United States will have three major cellulosic ethanol producers including POET, the nation's second-largest producer, and DuPont (NYSE:DD). The latter began production at a 30 million gallon per year facility in October 2015. While not a staggering volume, DuPont is hoping to use the facility to demonstrate its technology prowess ahead of additional investments and licensing. In contrast to building new, specialty production facilities, Pacific Ethanol's approach allows it to retrofit its existing fleet -- a low-cost advantage.

Why the extra revenue, and why is it (nearly) cost-free?

All ethanol sales are accompanied by renewable identification numbers, or RINs, that allow the EPA to track production and blending activities over the course of the year. To incentivize the production of renewable fuels, RINs have a value attached to them that varies depending on market conditions. Before 2013 these credits rarely traded above several cents per gallon, but the arrival of day traders selling RINs on the open market before being submitted to the EPA (seriously) has resulted in more volatility in recent years. As a result, first-generation ethanol, or that made from corn sugar, currently generates RINs valued at $0.86 per gallon -- relatively high. In other words, Pacific Ethanol receives $0.86 per gallon in addition to the selling price of ethanol.

Each gallon of cellulosic ethanol, however, is much more valuable, generating between $1 and $1.50 depending on certain regulatory factors. The higher price of cellulosic ethanol RINs stems from the desire of the EPA to foster a budding market for next-generation renewable fuels. The process utilized by Pacific Ethanol will generate D3 RINs, which implies cellulosic ethanol co-produced with traditional ethanol, although the exact amounts in the combination are unknown.  (It's important to note that these advanced RINs are not heavily traded on the open market because nationwide production volumes of next-generation renewable fuels are still low, totaling just 1 million gallons in the first quarter of 2016. POET and DuPont own a lion's share of current production.)

In other words, Pacific Ethanol will generate between $1 million and $1.5 million annually from the RINs attached to its cellulosic ethanol production at Stockton in addition to the selling price of ethanol. If rolled out across the company's 515 million gallon fleet, that amounts to nearly $15 million in revenue from RINs alone. But it gets better.

Pacific Ethanol will also receive federal subsidies under the Second Generation Biofuel Producer Tax Credit and subsidies from the state of California in the form of carbon credits under its Low Carbon Fuel Standard. It's too early to tally up exact figures, and management was mum on the details, but it could amount to over $20 million per year in extra revenue. There is, however, a slight catch.

Pacific Ethanol doesn't own the new process

A company called Edeniq pioneered the cellulosic ethanol-generating process, called Pathway. It's a simple, bolt-on process that can be easily applied to traditional ethanol manufacturing facilities to allow the side-by-side production of traditional ethanol from corn sugar and cellulosic ethanol from corn oil or corn fiber kernel, which are common byproducts. Pathway also boosts overall ethanol yield up to 7%, which can create additional value for producers.

This isn't a major deal for investors; process technologies are often licensed and cross-licensed within manufacturing industries. But it does mean Pacific Ethanol has to pay Edeniq to access the technology. The latter maintains that a 120 million gallon per year ethanol facility could generate up to an additional $10 million in revenue, resulting in a payback period of one year. Whether or not the pair can optimize the process at Stockton to approach that level of value creation remains to be seen, but the 40 million gallon per year facility in Madera, California, is next up to be retrofitted.

What does it mean for investors?

Despite enjoying a great year-to-date stock price run of 33%, Pacific Ethanol trades at just 66% of book value. The value stock does have a large amount of debt payments coming due soon from a recent (and massive) acquisition, but assuming the debt can be repaid and/or restructured, investors may not be on the hook for the amount of risk currently priced into shares. Either way, improving the profitability of its manufacturing fleet, rather than needing to build expensive new facilities as DuPont is committed to do, will go a long way to making debt payments more manageable -- and the new Edeniq Pathway technology is an excellent step in that direction.