Can Renewable Energy Group Afford Share Buybacks?

When Congress passed the latest budget deal to fund the federal government, it agreed to extend a slew of tax credits for renewable energy technologies. The single biggest winner may have been biodiesel, for which the lapsed federal biodiesel excise tax credit (BTC) was retroactively reinstated to the first day of 2018 and extended to the end of 2022. The subsidy essentially provides a $1 per gallon tax credit to biomass-based diesel producers. 

That means Renewable Energy Group (REGI), the nation's largest biodiesel manufacturer, will earn a windfall of over $500 million sometime in early 2020 for production from the last two years. The business could earn an additional $1 billion in subsidies during the three-year extension period spanning 2020 to 2022. News of the BTC's revival sent shares of the renewable energy stock soaring.

What will the renewable fuels leader do with its newfound surge in cash flow? CEO Cynthia Warner recently told investors that the company will accelerate its expansion strategy and look to deliver value to shareholders through various means, including share repurchases. Can the money-losing business actually afford share buybacks? 

Image source: Getty Images.

Repurchasing shares amounts to short-term thinking

How can a $1 billion company due to receive over $500 million in the first quarter of 2020, and an additional $1 billion or more in subsidies over the next three years, not be able to afford a share repurchase program? It needs to make a monumental change to its business first.

In the first nine months of 2019, Renewable Energy Group reported a gross loss of $15.5 million and an operating loss of $104 million. The company sold 547 million gallons of biomass-based diesel in that span, a year-over-year increase of 12%, and still couldn't generate a profit in the absence of federal subsidies. 

Investors can argue that biomass-based diesel displaces dirtier fossil fuels, or that it's better for air quality in urban environments, and they might be right. However, without a sustainable system in place to value those environmental benefits, the reality is that shareholders have been exposed to significant uncertainty in recent years thanks to Renewable Energy Group's dependence on the subsidy.

The business has done a remarkable job expanding into retail sales, building a nationwide distribution network, increasing sales of renewable heating fuels in the Northeast, and making continued improvements to production efficiency across its manufacturing fleet. Despite the progress, the rising costs of biomass inputs and falling average selling price of diesel fuel have historically been too volatile to fully mitigate. That suggests biodiesel may never be profitable year-round without government subsidies.

While the BTC has been extended through the end of 2022, there's no guarantee the subsidy will be extended beyond that. In fact, lawmakers considered phasing it out completely in recent budget negotiations.

That's why Renewable Energy Group must take advantage of the BTC's temporary revival and build a business that's not dependent on tax credits. To do that, management must go all-in on the future: renewable diesel. Turns out, the future is kind of expensive, but very much worth it.

Image source: Getty Images.

Biodiesel today, renewable diesel tomorrow

Both biodiesel and renewable diesel are biomass-based diesel fuels, which means they're manufactured from feedstocks such as fats, non-edible agricultural oils, and greases. They both qualify for the BTC and both generate renewable identification numbers (RINs), which are separate credits that can be sold and traded to offset manufacturing costs.

Unlike biodiesel, renewable diesel is chemically similar to petroleum-based diesel. That allows the next-generation renewable fuel to be blended more seamlessly with petrol and to utilize existing petroleum infrastructure, which allows it to be used year-round in more markets. It sells for a premium to and generates more RINs than biodiesel. It's also an ideal fit for new low-sulfur diesel requirements for international shipping.

Although both renewable fuels are exposed to the same pricing volatility of biomass feedstocks, renewable diesel is typically produced at a much larger scale, which lowers the per-unit costs of production. That can make all the difference in the low-margin, commodity-driven market for biomass-based diesel fuels.

Consider that the average size of an American biodiesel production facility in Renewable Energy Group's fleet is 51 million gallons per year (mmgy). The recently shuttered New Boston facility churned out only 17 mmgy. 

Now consider that the company's lone renewable diesel facility, located in Geismar, Louisiana, sports an effective capacity of over 112 mmgpy. The asset was responsible for over half of the company's total adjusted EBITDA in 2018, but represented just 20% of total production capacity. 

What's more, while the Geismar facility is the company's largest manufacturing asset by volume, it's actually quite small relative to the competitive landscape. 

Data source: SEC filings.

Renewable Energy Group had been waiting for the BTC to be retroactively reinstated before expanding its renewable diesel footprint. With that milestone behind it, the business can finalize plans for a large-scale expansion of the Louisiana facility. The details of the expansion are not public.

Similarly, Renewable Energy Group had been exploring a renewable diesel joint venture with Phillips 66 (PSX -0.26%). Initial proposals called for building a 250 mmgy renewable diesel facility adjacent to a Phillips 66 petroleum refinery in Washington state by 2021, which would provide easy access to utilities (further lowering manufacturing costs), blending, and end markets.

End markets are especially important for renewable diesel. The California Low Carbon Fuel Standard (LCFS) mandates that transportation fuels used throughout the state achieve 10% and 20% lower carbon emissions by 2020 and 2030, respectively, relative to 2010 levels. It provides a generous subsidy trading program for low-carbon transportation fuels. In fact, biomass-based diesel fuels are the lowest-carbon (and therefore the most valuable) fuels in the program -- lower carbon (and more valuable) than electric vehicles. 

However, most biodiesel is manufactured in the Midwest, which explains why renewable diesel facilities based on the West Coast or in Asia have provided the majority of the biomass-based diesel mandated by the LCFS. That underscores the geographic and economic importance of finalizing the joint venture with Phillips 66. Doubling the size of the Geismar facility would help, too. 

Even in that upbeat scenario, the business would rely on low-margin, money-losing biodiesel for half of its production in 2023. Is that acceptable to shareholders with a long-term mindset, or can the business scale its renewable diesel footprint even more beyond publicly known plans?

Renewable Energy Group ended September 2019 with $115 million in term debt, which will likely be a priority to pay off with the new windfall. After funding two large-scale renewable diesel expansions, how much money would be left for share buybacks -- and would that be a responsible use of cash? Investors will know more details soon enough, but ideally management will maintain its long-term mindset and avoid giving in to the short-term whims of Wall Street.