Historically speaking, renewable-fuels companies have been downright awful investments for individual investors. That changed in 2018. Renewable diesel and biodiesel are finally creating sustainable businesses. Now, only ethanol remains a challenging investment among renewable fuels.
Indeed, domestic ethanol markets are in crisis, with the average ethanol selling price last year hitting its lowest level since 2002. That was three years before the federal government created a market for the fuel by mandating that it be blended into the nation's gasoline supply. This largely explains why shares of leading ethanol manufacturer Green Plains (NASDAQ:GPRE) lost more than 22% of their value in 2018. It has recently been trading in the $13 per share range for the first time since late 2013.
Green Plains may be down on its luck, but it drastically overhauled operations just before the end of 2018. Management thinks those moves will provide it with some much-needed breathing room in 2019 -- and they might be right. Here are three things to watch for regarding Green Plains and the renewable energy business in the year ahead.
1. Are profits coming?
Last year, the commodity-linked company was carrying so much debt that its interest expense alone was enough to tip it into the red each quarter. In the first nine months of 2018, Green Plains paid $67.5 million in interest and posted a net loss of $37.6 million.
Management had had enough. They embarked on a strategic reshuffling of the business, divesting it of a handful of ethanol manufacturing facilities and its high-margin vinegar business (the world's largest). Then, in December, they used the net proceeds to fully repay all of the company's term loans. The leaner Green Plains won't be handicapped by interest payments in 2019. That alone might be enough to turn it into a profitable business.
There are three main items to consider in the profitability calculus: Green Plains will save approximately $90 million per year in interest expense (a good thing); it will reduce losses from its ethanol segment by operating a smaller fleet of production facilities (a good thing in the current market environment); and it has forfeited a healthy portion of the $45 million in annual operating income that its food and ingredients segment used to generate by selling its vinegar business. The last item wasn't ideal, but the divestiture saved it more by allowing it to retire its debts. The sum of those factors could result in earnings per share (EPS) of around $1.00 in 2019, compared to its loss per share of $0.94 in the first nine months of 2018.
2. Can protein deliver an operating margin boost?
Slimming down wasn't the only focus of management's strategic overhaul. Green Plains is also going all-in on increasing its production of protein products to boost margins. Most ethanol production facilities in the United States rely on a process called dry milling, which is less capital intensive than the alternatives. Dry milling also creates an animal feed product called dried distillers grains with solubles (DDGS) that significantly improves the financial profile of ethanol production.
Of course, in recent years it has been clear that the revenues from selling DDGS aren't enough to make up for weak fundamentals in the ethanol market. Green Plains thinks it has found a long-term solution in the form of a new bolt-on process technology that's capable of creating animal feed byproducts with higher protein contents. These high-protein products would sell at a premium compared to DDGS, including in new markets such as aquaculture, and boost ethanol margins by at least $0.10 per gallon, according to the company.
That would create a significant windfall considering Green Plains owned 1.5 billion gallons of annual production capacity before its asset divestitures. This upgrading technology is largely unproven at commercial scale, however, and will take time to roll out across the company's operations.
3. Will the United States address its ethanol glut?
While Green Plains is repositioning itself to deliver profitable operations in any market environment, the most sustainable benefit to its business would come from Uncle Sam addressing some of the underlying problems in the ethanol market. There's some low-hanging fruit Washington could pick in that regard.
Last year, the United States set a new annual record for ethanol exports -- by the end of October. The nation was on pace to export around 1.5 billion gallons of fuel, or just under 10% of total production capacity, marking the third consecutive year exports topped 1 billion gallons. This figures to be a great long-term trend, but it hasn't provided much relief to producers in recent years. The federal government could enact policies to encourage or incentivize even more ethanol exports.
Another long-term improvement for the ethanol industry could come from Washington revisiting the Renewable Fuel Standard (RFS). After all, the 16 billion gallon-per-year ethanol industry is still playing by rules established for when it was in its infancy. The policy structure creates too much uncertainty, which is tanking subsidy prices and ethanol selling prices alike. If the government simplified the incentive structure and enforced other parts of the standard (for example, it could stop allowing multibillion-dollar oil refiners to take "financial hardship" exemptions from blending requirements), that might force less efficient producers out of the market. Or, it might simply provide producers with more confidence to plan for the future.
Additionally -- though this policy shift would be a long shot for approval under the current administration -- the Environmental Protection Agency had previously given a green light to the idea of increasing the volume of ethanol blended into gasoline nationally from the current 10% to 15%. This change is based on findings that the higher proportion caused no harm to automobile engines. Even an increase to 11% would instantly create an additional 1.4 billion gallons in domestic demand, helping to ease the supply glut. Considering that, the industry might want to stop drawing a hard line at a 15% blending level, and come to a sensible compromise.
Ethanol is in the gutter, but this business may find a way out
Last year's strategic overhaul might be enough to allow Green Plains to operate at minimal profitability. The next phase of the overhaul calls for increasing production of high-protein products, although it's unclear precisely how much that will benefit the bottom line. The bolt-on technology is unproven at commercial scale and has yet to be implemented across the company's fleet. Meanwhile, a reevaluation of U.S. ethanol policy is long overdue.
Taken together, I think these factors suggest that investors should wait to see management's full-year 2019 expectations before making a decision on Green Plains stock. And that's at the very least. Depending on the level of profitability (or not), investors may want to wait until the high-protein strategy begins to deliver results. That said, the high-reward potential of Green Plains stock will keep it near the top of my watch list this year.