The ethanol industry once held great promise to reduce the US dependency on foreign oil. It still does, though the rosy outlook has been clouded by the economic realities of competition. While government subsidies have had their desired affect, a still fragmented industry is faced with higher cost of capital that has forced participants to be more creative in how they fund expansion. Robert Sherwood reports.
Annual consumption of ethanol in the US has increased by 2bn gallons to 6.5bn since the US government introduced favourable legislation in 2005 in an effort to induce production. Demand is expected to increase further with the implementation of standardised blends for the fuel additive, with a stated target of producing 36bn gallons by 2022. It was this promise that drove enthusiasm for a wave of initial public offerings in the summer of 2006.
VeraSun Energy, the second-largest producer behind Archer Daniels Midland, had little trouble attracting interest to its US$419m IPO in June 2006. Morgan Stanley and Lehman Brothers were able to increase both the size and targeted pricing, from 17.25m shares at US$18–$20 to 18.25m shares at US$21–$22, before pricing at US$23. The shares gained 30% to close first-day trading at US$30.
“Ethanol companies are hard to value because most are mostly green-field operators,” noted one investment banker. In other words, they are early stage companies that are valued upon profitability far into the future. A major element in evaluating that potential profitability, aside from prices of corn, oil and ethanol itself, is the future capacity of individual operators.
The relevant valuation metric was, and still is, enterprise value to forward production. Based on proposed production of 340m gallons in 2007, VeraSun initially was valued at US$4.81 per gallon. With ethanol prices at record-high levels, the rationale was to raise as much capital as quickly as possible, to achieve the highest valuation.
Aventine Renewable Fuels took advantage of the phenomena by providing investors what essentially amounted to a call option on future production through a US$389.5m IPO, also in June 2006. The results were even more impressive. Banc of America, Friedman Billings Ramsey and Goldman Sachs placed 9.1m shares at US$43, versus targeted 8.1m share offering at US$39–$41.
The offering valued Aventine at an enterprise value of US$8.10 per gallon based on 206.5m gallons of production by the end of 2007. The company offered the potential to more than triple that production to 756.5m gallons by 2009 through the construction of new facilities and by entering into non-binding agreements. Metalmark Capital, a private-equity firm founded by former principals of Morgan Stanley, took advantage of the rising valuations by purchasing a 40% stake for US$260m (US$13 per share) in a December 2005 private placement.
Thomas H Lee, another private-equity firm, attempted to exploit a similar private-to-public arbitrage by purchasing an 80% stake in Hawkeye Holdings in May 2006 for US$736m, only US$390m in equity and the remainder funded with debt. Three weeks later, the private-equity firm filed to take the company public in an offering that would value its new investment at US$893.8m, more than double its initial equity investment.
By the time Hawkeye hit the road in September 2006, however, the economics of ethanol had softened dramatically. Credit Suisse, Morgan Stanley and Banc of America were targeting a valuation of US$4.03 per gallon, which was far above spot-market prices for the commodity. After peaking at US$3.92 in June 2006, spot prices plunged to US$2.04 by September and currently stand at US$1.83.
The rationale for the run-up of ethanol prices was only partially attributable to higher demand. Technical factors, specifically the phasing out of MTBE, a fuel additive that ethanol replaced, and an underdeveloped infrastructure gave ethanol producers leverage to set prices. The price of corn, the primary feedstock, also spiked above US$4, its highest level since the mid-1990s, as farmers were unprepared to meet the new demand.
Prior to 2005, when President George Bush spearheaded ratification of the US Energy Policy Act of 2005 that provided the industry with incentives, ethanol was a low-growth fuel alternative. With subsidies of US$0.51/gallon and tariffs on imports, the legislation made it a high-growth priority seemingly overnight. Ethanol production has increased 58% since Bush’s State of the Union Address in 2005.
The short-term technical factors that caused ethanol prices to rise have been removed; the costs of production have not abated, and producers have been squeezed in the process. The net result is that companies are no longer getting credit for production. Public-market valuations based on 2008 production range from US$0.38 per gallon for BioFuel Energy, the most recent company to go public, to US$2.89 for Pacific Ethanol.
One of the problems is that there are very few barriers to entry. Once ground has been broken on a facility, it takes anywhere from 12 to 18 months to reach full production. There are now 119 active ethanol refineries producing 6.5bn gallons annually, according to the Renewable Fuels Association. The trade group tracks an additional 6.6bn that will come on-line in 2008.
“More than two thirds of projects under construction are being funded by co-ops, private equity and individual investors,” said Friedman Billings Ramsey analyst Eitan Bernstein.
Searching for alternatives
The biggest hurdle is the economics – ethanol prices are 50% below peak levels, while corn prices are down just 25% from last year. Hesitant to sell stock at depressed valuations, public companies have been forced to seek alternative strategies to fund expansion.
Instead of selling stock at current prices of US$13.61, 40.8% below the IPO level, VeraSun turned to the debt markets in May for US$450m. Together with its stock and project financing, the company used proceeds from the offering to acquire rival ASAlliances Biofuels. The acquisition is expected to increase its capacity to 1bn gallons by the end of 2008.
“It should, almost always, be cheaper to build a plant than to purchase one,” says Raymond James & Associates analyst Pavel Molchanov. The ASAlliances acquisition suggests that the cost of acquiring production is getting closer to production costs.
The US$725m purchase, which was funded with US$200m in stock, US$250m in cash and US$275m in project financing, implies an enterprise value of US$2.20 per gallon. “This is a unique opportunity to acquire immediate production and revenue at a cost similar to that of building new facilities,” said VeraSun CEO Don Endres.
Recent unrest in the credit markets has made debt a prohibitively more expensive option. VeraSun’s 9.375% notes trade at 90, a spread of Treasuries plus 645bp, about 200bp wider than when they were issued. The Aventine 10% notes, which were issued in March, can be had for 93, a spread of 660bp over Treasuries.
Panda Ethanol was recently forced to postpone a planned US$140m convertible bond sale. Management cited constrained access to equity and credit as a reason for the manoeuvre. “Along with ethanol firms’ vulnerability to falling prices and margins, additional tighter credit terms may have the cumulative effect of undermining new capacity builds,” suggests Lehman Brothers’ oil-markets analyst Michael Waldron.
BioFuel Energy took a slightly different tack leading up to its US$99.75m IPO in June 2007 by forging a strategic relationship with Cargill, the world’s largest producer of corn. Cargill would procure corn, handle the marketing and logistics, and provide risk-management services. The market did not buy in.
JPMorgan, Citi and AG Edwards placed 5.25m shares at US$10.50, below a US$13–$14 indicative range that was reduced from US$16–$18. The offering, which valued the company at US$2.13 per gallon, originally was sized at 9.5m shares. BioFuel Energy’s principal financial backers, Greenlight Capital and Third Point Funds, made up for the funding shortfall by purchasing 4.25m shares in a concurrent private placement at the IPO price.
A global phenomena
The economic difficulties of ethanol production are not limited to the United States. The industry in Brazil, the second-largest producer of ethanol behind the US and the largest exporter, is also contending with flagging prices for both ethanol and sugar, the primary feedstock.
Cosan, the world’s second-largest producer, struggled with a recent US$1.05bn equity sale through Cosan Ltd, a new listing vehicle domiciled in Bermuda. Originally targeted at as much as US$2bn, the offering was hindered in part by questions over corporate governance. Credit Suisse, Goldman Sachs and JPMorgan ran the books on the mid-August placement.
Majority shareholders exchanged their 51% stake in Cosan SA, which is listed on the Bovespa, into the super-voting shares of the new entity. The arrangement enabled the company to sell stock and allow majority shareholders to retain control. Cosan Ltd, the new listing vehicle, is prohibited from directly competing with Cosan SA in Brazil.
The arrangement protects the interests of Cosan SA shareholders by eliminating the possibility of the operating company purchasing weaker assets, contended ECM officials. “Would anyone want them to buy a corn-based ethanol company in the US?” asked one banker at the time.
Ultimately, the governance of individual countries may need to change. The latest amendment to the Bush administration’s Renewable Fuels Standard indicates seeks to generate 36bn gallons of renewable fuel by 2022. “It would be impossible for the US to grow that much corn,” said a banker. “If other technologies proved as uneconomical as corn-based ethanol, then The US would have to relax existing tariffs on Brazilian ethanol.”