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Investors Brake for Ethanol
By Will Swarts Published: November 21, 2006
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§Pacific Ethanol (PEIX)
Share price as of Monday's close: $17.49
Share price now: $18.56
Percent change: 6.1%
Volume: 3.5 million shares, daily average 1.7 million
The News
Shares of Pacific Ethanol (PEIX: 18.72, +1.23, +7.0%) were firing on all cylinders Tuesday after the company swung to a third-quarter profit, surprising Wall Street analysts who expected the alternative-energy company to report a loss.
Pacific Ethanol said late Monday it earned seven cents a share for the quarter, driven by increased sales from its ethanol-brokering operations. Analysts expected the Fresno, Calif., company to lose three cents a share, the same amount it lost in the year-ago third quarter.
While the results were welcome, management said the earnings surprise reflected an ethanol market in flux. Sales volume climbed to 23.1 million gallons for the quarter, a 43% increase from the same period a year ago, and prices accelerated even more quickly. Pacific Ethanol sold the corn-derived fuel at $2.45 a gallon, a 49% jump from a year earlier. The difference allowed the company to quadruple its gross profit from the third quarter of 2005. Gross margin hit 12.2%, up from 6.2% a year ago. Revenues were $61.1 million, a 131% increase from last year.
"The increase in gross profit margin and the increase in total gross profit are generally reflective of advantageous buying and selling during a period of rapidly increasing market prices," the company said in its earnings release. "Future gross profit margins from marketing operations can vary widely, based upon, among other things, the size and timing of the company's net long or short positions during its various contract periods and the volatility of the market price of ethanol."
Paul Resnik, an analyst with Dutton Associates, an issuer-paid research firm based in Northern California, says the company put the results in the right context. California uses 900 million gallons annually, about 25% of total national ethanol consumption, and Pacific's proximity to the market gives it a clear advantage, he says.
"Twelve percent margins are not sustainable," he says. "They understand that, and they said, 'This is very nice.' This is better than a sharp stick in the eye, but it's not relevant."
The Analysis
Ethanol is the leading alternative fuel used in the U.S., but it's not because the market has made its decision freely. The agribusiness lobby, described by ethanol critics as a more powerful political force than the National Rifle Association, has powered federal and state incentives to boost its use as a fuel additive, providing tax breaks and subsidies to producers and distributors.
Politics shape and support the alternative-energy market, as evidenced by last summer's passage of the federal Energy Policy Act, designed to boost nonpetroleum fuel use. That's working out to the advantage of Pacific, which is the largest West Coast-based marketer of ethanol through its Kinergy Marketing subsidiary.
Location hasn't hurt Pacific, says Brian Niemiec, an analyst at Susquehanna Financial Group.
"Their main driving point is that they're California-based and they have access to some markets that not everyone is able to touch," he says. "When [investors] love the stock, that's why they love it."
In July, California Gov. Arnold Schwarzenegger issued a state bioenergy plan to boost alternative-fuel use and production, a development followed by the opening of Pacific's first ethanol production plant. The Madera, Calif., facility, outside of Fresno, is the first of five planned by the company and is slated to produce 35 million gallons a year. A plant in Boardman, Ore., in the sparsely populated eastern part of the state, is under construction. Only 5% of the ethanol used in California is produced in-state.
Even with the cost of shipping corn from the Midwest, making its own fuel should help Pacific capitalize on state-mandated ethanol usage regulations, says Mark Manley, an analyst at Ardour Capital Management, a New York full-service brokerage concentrating on energy companies.
"To be honest, somebody in the position of Pacific Ethanol is almost ideally suited to move into production," he says. "They understand the marketplace and how to hedge on demand side and the product side, they have established customer relationships in place and they have a captive marketing unit. They also have had first-mover advantage in California."
Pacific is the rare moneymaker in a start-up phase, says Resnik. The company has $161 million cash in its coffers, part of which can be used for developing production. When its plants are online, it should be able to support its contention that it's cheaper to ship grain west than to move liquid fuel more than 1,000 miles to its larger markets.
The Bottom Line
Alternative energy is the investment of the future, and skeptics think it always will be. It's a headline-driven sector and is vulnerable to changes in the price of corn and fluctuations in shipping rates — not to mention the cost and availability of traditional fuels. Consider that Pacific Ethanol's stock has lost more than half its value since it peaked in May, when unleaded gasoline was selling for more than $3 a gallon. As prices at the pump came down so too did Pacific's shares.
Susquehanna Financial's Niemiec says ethanol in particular isn't an especially economical fuel, but it's got lots of political heft behind it.
Matthew Hartwig, a spokesman for the Renewable Fuels Association, a national trade association for the U.S. ethanol industry, says federal legislative backing is pretty evenly distributed, and that the recent Democratic triumphs in Congress likely won't alter the pace or direction of government support.
"It really didn't change things," he says of the Democrats' rise in the legislative branch. "The momentum that we have seen behind renewable fuels, and ethanol in particular, will certainly continue with whoever is in charge. This is an issue that isn't decided on party lines."
For investors who accept that the free market isn't powering major developments in the sector, ethanol probably enjoys the most stable political backing among alternative fuels, and Pacific is in most respects particularly well-positioned, Manley says.
"I would counsel investors to find the best of breed," he says. "I'd say, find the lowest-cost producer, and Pacific Ethanol is that."
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