Green plains a strategic shift amid continued low margins – green plains inc. (nasdaq gpre) seeking alpha gas density formula

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Last February I wrote about how the share price of ethanol producer Green Plains, Inc. ( GPRE) was continuing to drift lower as investors tired of waiting for higher production margins to return. Margins have held steady at close to zero since then but investor optimism has made a rapid comeback in recent weeks (see figure).

Several factors have contributed to this rebound, although the company’s Q1 earnings, in which diluted EPS missed the consensus by a wide margin while coming in negative, was not one of them. Rather, macroeconomic factors have led investors to expect higher margins this summer and last year‘s tax reform has forced the company to adopt a new strategy.

Analysts had not expected an attractive Q1 earnings report given that the price of ethanol steadily lost ground compared to the price of gasoline between January and April even as corn prices moved higher on poor Midwestern weather conditions (see figure). Even the consensus diluted EPS estimate of -$0.30 ended up being optimistic, however, as the actual result came in at -$0.60 (compared to -$0.09 in Q1 2017). Revenue came in at $1 billion, or almost 13% higher YoY. EBITDA came in positive at $23.1 million, although this still represented a substantial decline from $43.8 million over the same period.

The company’s returns were hurt by a consolidated crush spread of $0.05/gallon that made last year‘s Q1 figure of $0.12/gallon attractive by comparison. This in turn contributed to a reduced production rate of 280.4 million gallons in the latest quarter, down 14% YoY. Revenue only increased because of cattle feedlots that Green Plains acquired in 2017 and increased sales of natural gas. The ethanol segment’s EBITDA fell by almost $21 million YoY as a result, more than offsetting modest gains to the agribusiness/energy and food/ingredients segments’ EBITDAs. A shifting outlook

The response of the company’s share price to the Q1 earnings report’s release is even more interesting in light of the industry’s current operating conditions. The industry crush spread briefly rallied at the beginning of May but has subsequently moved back toward zero (see figure). There are two explanations for the continued lack of even modest production margins.

First, as already mentioned, corn prices have steadily increased throughout 2018 to date due to concerns over corn planting conditions in the Midwest. While these concerns have abated somewhat amid a planting rush in recent weeks, prices have remained high as farmers have continued to plant more soybeans in place of corn.

The second explanation is that the price of ethanol has completely shed its historical price premium on an energy-equivalent basis to gasoline as it approaches a 4-year low (see figure). This development is preventing corn ethanol producers from benefiting from gasoline prices that are at 4-year highs in real terms (see next figure).

Whereas gasoline prices have increased by 21% over the last three months, the price of ethanol has actually declined over the same period. Even the price of natural gas, which comprises a smaller contribution to production margins, has increased over the last three months. Very little has gone right for ethanol producers this spring, especially large ones such as Green Plains.

Two other developments, then, help to explain the recent rally in the company’s share price. The first is the expectation that production margins will eventually catch up to the rising gasoline price as the summer driving season moves into high gear, running ethanol inventories down. This is indeed happening already as ending stocks have fallen from their March highs to a 2-year seasonal low (see figure), and inventories should decline further based on expected near-record gasoline demand this year. Barring a sharp increase in corn prices such as occurred during the poor harvest of 2012, ethanol production margins will move higher this summer.

The second development is specific to Green Plains, although the company’s investors should also be disappointed by it even as it contributes to a higher share price in the short term. The company’s Q1 earnings report announced the undertaking of a major strategic shift:

On May 7, 2018, Green Plains announced it will divest assets that do not support the company’s strategic focus on the production of high-protein feed ingredients and ethanol exports to significantly reduce or eliminate the company’s term debt and invest in high-protein process technology at certain ethanol facilities.

This is a very notable development given that the company has spent the last few years rapidly expanding its balance sheet via acquisitions that have been heavily-funded by long-term debt (see figure). One consequence of this is that its interest expense has nearly tripled over the last five years, outstripping the increases to long-term debt and gross PP&E over the same period. This has occurred even as the company’s trailing return on assets has fallen sharply due to the low production margins that have largely prevailed since fuel prices collapsed in late 2014 (see next figure).

At the time of the acquisitions, which made Green Plains one of America’s largest ethanol producers with 1.5 billion gallons of annual production capacity, the company’s strategy was to take advantage of low interest rates and depressed market conditions to build a large footprint in preparation for a return to higher margins.

That this hasn’t happened in 2018 is due in large part to the battle over the biofuels blending mandate that has raged in Washington D.C. since President Donald Trump’s election victory and injected a great deal of uncertainty into the ethanol market (one result of which has been ethanol’s discount to gasoline on an energy-equivalent basis).

Further complicating matters for Green Plains was last year’s legislative federal tax reform package, which limits interest deductions to 30% of EBITDA until 2022, at which point the limitation further increases to 30% of EBIT. The company’s shift in strategy has taken on a new urgency when viewed from this perspective: In 2017, for example, its interest expense was equal to just over half of EBITDA and well more than all of EBIT (see figure). President and CEO Todd Becker was open about the company’s new need to reduce its interest expenses in the Q1 earnings call, stating that:

The new tax plan enacted at the end of 2017 proved favorable to our last year’s results. But commodity processing companies like ours carry[ing] significant debt balances have a negative tax implication. As we reduce our overall debt level as part of the portfolio optimization program, we believe we are taking steps to take advantage of tax law change that will be very beneficial in the long run to our shareholders. In addition and even maybe more important, the reduction of the corporate tax rates makes it an opportune time to sell assets and pay less in taxes versus even last year.