This Renewable Energy Company's Impatience Could Cost Long-Term Investors

Just a few short years ago, management at Green Plains (GPRE 6.67%) embarked on an ambitious diversification strategy to stabilize the bottom line of its commodity-driven business. It was easy for investors to follow the rationale: the company is one of the world's largest ethanol producers in the world -- and ethanol has become synonymous with low-margin sales and uncertainty, at least in recent years.

Management executed nearly flawlessly by focusing on vertical integration. In a span of just 18 months Green Plains became the world's largest producer of food-grade vinegar (manufactured from ethanol) and the United States' fourth-largest owner of cattle feedlots (reliant on byproducts from the ethanol manufacturing process). In 2017 these two businesses were responsible for 13% of total revenue, 26% of total segment EBITDA, and 86% of operating income. By the end of 2018, though, the vinegar business could be could be sold off. Wait, what? 

It's true. Management has grown frustrated that Wall Street isn't properly valuing the company (Green Plains has lost 25% of its market value in three years), so it's embarking on a new "Portfolio Optimization" strategy that could jettison part of the food and ingredients segment and some of its 17 ethanol facilities. It could be a risky and impatient move based on short-term thinking -- and one that could cost long-term investors.

Image source: Getty Images.

Portfolio optimization or impatience?

To be fair, Wall Street certainly isn't giving Green Plains a fair shake. The company ended the first quarter of 2018 with shareholders' equity of $929 million, but only boasts a market valuation of $675 million. In other words, for shares to trade at exactly book value the stock price would need to climb 38%. 

That's a healthy premium, but management thinks it should be even higher. Much higher. In a recent investor presentation, management claims that the company's nearly 1.5 billion gallons of annual ethanol production capacity is valued at just $0.22 per gallon, when it should be closer to $1.00 per gallon. That alone would value Green Plains at $1.9 billion, and that's before arguing that the higher-margin businesses are likely undervalued, too. 

Unfortunately, the math is a little difficult to justify. Green Plains' ethanol segment delivered $40 million in EBITDA last year, so valuing the ethanol assets at $1 per gallon would amount to a valuation of over 37 times EBITDA. It would weigh in at a still-hefty 15 times EBITDA using profit totals from 2015 or 2016. 

The problem is that management's unrealistic expectation for the value of Green Plains' ethanol segment is the driving force behind the new portfolio optimization strategy, which has three main goals to create shareholder value as quickly as possible:

• Refocus the business: align operations around ethanol exports (an important growth opportunity) and high-protein animal feed production (created during the ethanol manufacturing process).

• Divest non-core assets: sell off businesses that don't align with the "exports and protein" focus.

• Reduce term debt: use proceeds to significantly reduce or eliminate the roughly $770 million in long-term debt.

Central to the portfolio optimization strategy is a huge bet on a new high-protein manufacturing process. The system is expected to upgrade low-value distillers grains (currently sold as animal feed) into high-margin, high-protein animal and aquaculture feed. According to Green Plains, that could lift ethanol margins by $0.10 per gallon. While some production facilities are expected to be sold during the optimization process, achieving those gains would have boosted the ethanol segment's annual profits by $125 million last year. 

But Green Plains has yet to finalize a license for the bolt-on technology or fully implement it at any production facilities. Moreover, past adoption of novel process technologies to boost ethanol production margins have not been enough to overcome the industry's volatility over the years, despite rising production volumes. And the competitive dynamics of the high-protein animal and aquaculture feed industry are rapidly changing, which could erode future margins.

That said, betting on the new bolt-on technology isn't necessarily a bad move in the long-term, but it seems premature to go all-in at this stage. Investors might struggle to understand why those efforts need to be coupled with divesting the vinegar business, which was only acquired in October 2016. After all, the food and ingredients segment was the best pound-for-pound performer in Green Plains' portfolio last year -- and it didn't even have a full year of operations, as multiple acquisitions were made in the first half of 2017. 

Source: SEC filings.

Since the results from the food and ingredients segment aren't broken down between vinegar and cattle, it's difficult to gauge individual contributions from each business, but management is keen to keep its cattle business as it fits with the latter half of the "export and protein" strategy. That's fair enough, and perhaps the vinegar business simply wasn't a good fit.

But management's plan to divest the vinegar business and use the proceeds to pay down a significant portion of the term debt -- no minor detail considering the company paid $90 million in interest in 2017 -- might be a little unrealistic. Green Plains acquired the business for $250 million in 2016, but had $770 million in long-term debt at the end of the first quarter of 2018. Even if it's sold for a significant premium, the potential asset sale seems unlikely to eliminate the debt by itself. Unloading an ethanol facility or two won't fetch much, either. They're grossly undervalued, remember?

Put another way, when the dust settles, it's possible that Green Plains will have sold off a valuable high-margin business and still be stuck with a significant level of debt. And that's before knowing whether or not the new high-protein manufacturing process will pan out.

Image source: Getty Images.

Management shouldn't risk long-term potential for near-term milestones

The portfolio optimization strategy loses some firepower by including plans to sell the vinegar business. Sure, debt has weighed down Green Plains recently, but that's primarily due to sustained weakness in the ethanol segment. If the high-protein focus delivers the promised $0.10 per gallon margin boost over time, then selling the vinegar business will have been unnecessary. Worse, if the export and protein strategy doesn't overcome ethanol industry volatility, then management will have some regrets about selling the high-margin vinegar business.

There seem to be better ways to tackle the debt, as Green Plains isn't exactly in a precarious financial position. It ended March with $240 million in cash and cash equivalents. It has an active $100 million share repurchase program. It pays a dividend yielding 2.8%. It has a bold plan to boost the margins of its underperforming ethanol production segment within a few years. If management wanted to, then it could find $770 million in extra cash spread out over a two or three year period. Unfortunately, short-term thinking has taken over -- and that impatience could prove costly.