Beware the Allure of Ethanol Investing

I am a fan of ethanol. The addition of corn ethanol to our US fuel supply chain has had a significant impact in keeping gasoline prices way lower than they otherwise would have been, and has paid for the subsidies many times over. But that has not translated to gains for ethanol stocks, which are down on the order of 50% over the last year according to the Camino Energy index, and it won’t change anytime soon.

As the bellwether US ethanol pureplays are finally down to earth, and my predictions have come to pass. Two years ago ahead of Verasun’s (NYSE:VSE) IPO, I blogged an analysis saying I thought Verasun should trade in the $3 to $8 range, depending on the margin, PE, and growth assumptions. The bankers and the market thought I was nuts, treating VSE and Aventine (NYSE:AVR) which listed near the same time as technology style growth stocks. The company listed at several times my target range, and then traded way up from there. But as I had predicted, the margin pressures from a range of commodity price movements and the relatively low barriers to entry for capacity additions came to bear. But the fall is probably not over.

I stated then and reiterate now that ethanol companies are basically small refiners with potentially worse economics. And refiners traditionally trade at single digit PEs, and single digit PE. Worse, refiners don’t always do well when commodity prices rise or their markets grow fast, as the spreads they make their margin on are often affected as much by relative capacity contraints as the raw commodity prices themselves. In fact, fast moving commodity prices in either direction in either refined products or feedstocks can sometimes bode ill for refining profits, depending on what’s happening in capacity.

VSE now trades under $5. Right in the middle of range I predicted it should. And the PEs for VSE and AVR are finally down in the range close to the independent refiners group I follow, Valero (VLO), Sunoco (SUN), and Tesoro (TSO). BUT. And there is a but. The TEV/EBITDA multiples for VSE and AVR, which are way down, are still 2-3x those of the refiners, and the PEG ratios are still richer as well. This likely means more room to fall, or at least languish.

The next wave of venture backed ethanol companies, mostly cellulosic, are beginning to break ground on pilot plants, and given the penchant for certain ethanol crazed venture investors to IPO deals when windows open, it is likely we will see some of these soon. And it is likely that they will be sold to the market the same way, as high growth stocks based on great technology and macro conditions justifying stratospheric PEs on unsustainable margins. Then they’ll hit their first commodity cycle, the margins will compress, the bloom will come off the rose, the multiples will come down, and the investors who bought and held post IPO will get crushed.

We’ve seen it before and we’ll see it again. Try not to get caught this time.

Neal Dikeman is a founding partner at Jane Capital Partners LLC, a boutique merchant bank advising strategic investors and startups in cleantech. He is the founding CEO of Carbonflow, founding contributor of Cleantech Blog, a Contributing Editor to Alt Energy Stocks, Chairman of Cleantech.org, and a blogger for CNET’s Greentech blog.

3 replies
  1. luis
    luis says:

    Very interesting.If the economics don't work, recycling and sustainable efforts won't either. Check http://LivePaths.com a blog about innovative entrepreneurs that make money selling recycled items, provide green services or help us reduce our dependency on non renewable resources. These include some very cool Green online ventures, great new technologies, startups and investments opportunities.

  2. James Arthur
    James Arthur says:

    CleanTech Biofuels Addresses Rising Global Food Costs and Sustainable Waste to Energy Cellulosic Ethanol Technology SolutionsCEO of CleanTech Biofuels, Inc., Edward Hennessey, commented: “As ethanol production from food crops has exploded in recent years, there are increasing concerns over the amount of arable land once used for food production being displaced for energy crops. Additionally, concerns have been raised regarding the energy and pollution balance of other methods of ethanol production. Consequently our business model which leverages the existing infrastructure for municipal solid waste collection and disposal to collect biomass at a low or negative feedstock cost is beginning to receive the recognition we feel it deserves.”Hennessey further stated: “We believe that we will achieve profitability quickly relative to other cellulosic ethanol producers who must develop their infrastructure to collect and transport more expensive feedstocks such as switchgrass, wood waste, or corn stover. Moreover, biomass derived from garbage should not be subject to increases in commodity prices that plague producers currently manufacturing ethanol from corn.”Aurora Venture Communications Group is now featuring an online webcast audio interview with Mr. Michael Kime, COO of CleanTech Biofuels, Inc., who also Co-Wrote and Co-Produced the award winning feature documentary, “Can Mr. Smith Get to Washington Anymore”. The interview covers a range of topics including Mr. Kime’s personal insights into the conflux of environmental and political forces that are driving the market and the media’s interest in waste-to-energy technology. The interview can be found online at: http://www.avcg.net/CLTH.

  3. David J. Phillips
    David J. Phillips says:

    My analysis suggests the pain is just beginning over at AVR:"Given likely increases in net interest obligations (borrowings needed for timely completion of facility expansions) combined with narrower commodity spreads (falling ethanol prices combined with rising corn costs), does anyone expect the liquidity outlook at Aventine to improve come 2009?"http://industry.bnet.com/energy/2008/06/20/how-golden-is-aventine-renewable-energy%e2%80%99s-future/ My Best,David J PhillipsContributing Energy AnalystCNET/BNET

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