Why Renewable Energy Group is a Buy

Maxxwell A.R. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is no secret that the fuel industry goes hand-in-hand with low margins, but that doesn’t mean investing opportunities don’t exist. After all, low margins never stopped anyone from investing in supermarket companies such as Whole Foods Market (NASDAQ: WFM) with its whopping 3.85% profit margin over the last year.

Now what if those low margins were coupled with an industry that was reliant on a combination of government tax credits and mandates? Before you call off further research let’s consider the example of biodiesel producer Renewable Energy Group (NASDAQ: REGI). Here are the company’s 2Q12 highlights:

  • 43 million gallons produced, up 30% yoy
  • 54 million gallons sold, up 63% yoy
  • $272 million revenue, up 39% yoy
  • $87.1 million in cash, up 16% from 1Q12
  • $20 million operating income, down 12% yoy
  • $14 million net income, compared to net loss yoy
  • New distribution terminals in NM, OH, CA

Growth realization, not potential

You won’t see it just by looking at the numbers above, but REG is just beginning to hit its stride. The company has a current production capacity of 212 million gallons per year (mmgy) with another 135 mmgy under construction. Furthermore, REG is building an impressive distribution network along the country’s most important transportation hubs. Through the first six months of 2012 REG produced 82 million gallons of biodiesel, which made up approximately 15-17% of the total biodiesel produced in the United States.

By contrast, FutureFuel Corp. (NYSE: FF) has a current capacity of just 59 mmgy and can only distribute its products by rail or barge out of its Arkansas facilities. The company does have a more impressive suite of specialty chemicals and pays a 3.82% dividend, but it really doesn’t compete with REG in biodiesel. Archer Daniels Midland (NYSE: ADM) has a production capacity that exceeds 450 mmgy, but an overwhelming majority is sold outside of the United States. Therefore, ADM won’t be included in my analysis. Take a look:

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Revenue TTM</strong></p> </td> <td> <p><strong>Cash 2Q12</strong></p> </td> <td> <p><strong>Book Value</strong></p> </td> </tr> <tr> <td> <p>FutureFuel</p> </td> <td> <p>$368.89 million</p> </td> <td> <p>$112.03 million</p> </td> <td> <p>$7.08 per share</p> </td> </tr> <tr> <td> <p>REG</p> </td> <td> <p>$983.46 million</p> </td> <td> <p>$87.05 million</p> </td> <td> <p>$10.88 per share</p> </td> </tr> </tbody> </table>


I know what you’re thinking: “Of course REG has more revenue. They get tons of help from the government to sell all of that biodiesel!”  Not so fast. Consider the following table:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>2Q11</strong></p> </td> <td> <p><strong>2Q12</strong></p> </td> </tr> <tr> <td> <p><strong>Average selling price</strong></p> </td> <td> <p>$5.91 per gallon</p> </td> <td> <p>$5.03 per gallon</p> </td> </tr> <tr> <td> <p><strong>Government incentives</strong></p> </td> <td> <p>$11.93 million</p> </td> <td> <p>$815,000</p> </td> </tr> <tr> <td> <p><strong>Biodiesel sold</strong></p> </td> <td> <p>33.30 mmg</p> </td> <td> <p>54.24 mmg</p> </td> </tr> <tr> <td> <p><strong>Biodiesel sales</strong></p> </td> <td> <p>$196.31 million</p> </td> <td> <p>$271.93 million</p> </td> </tr> </tbody> </table>


Losing an important tax credit resulted in a 15% slide in selling prices. However, the company’s impressive growth has made it less reliant on government incentives as it replaced subsidies with increased volume and facility acquisitions. The company is on pace to produce over 164 mmg of biodiesel this year, which would represent about 78% of total capacity and 16% of total domestic biodiesel production. Unfortunately, producers may cut production due to some uncertainty ahead.

Biodiesel and RFS2

Thanks to the amended Renewable Fuels Standard (RFS2), the United States must consume 1 billion gallons of biodiesel in 2012 - up from 800 million gallons in 2011. The good news is that we are well on our way to exceed that number. The bad news is that targets for 2013 have yet to be released. With the impending fiscal cliff and presidential election, which features a candidate who wants to spend less on renewable energy, there is no way of knowing how or if RFS2 will be affected.

<img src="/media/images/user_6293/usbiodieselproductionconsumption_large.png" />

Political bickering led to a temporary loss of an important biodiesel tax credit in 2010, which forced 52 of the nation’s 170 biodiesel facilities to close. I would argue that the industry – and economy as a whole - is stronger now than it was in 2010. For one, REG has made a push to switch from the expensive and relatively volatile feedstock of soy oil (primary feedstock for biodiesel) to waste oils, fats, and greases. Over 80% of its current capacity comes from waste feedstocks, while all of the 135 mmgy under construction will be capable of using waste feedstocks.

In the end I don’t have a crystal ball and thus cannot predict the outcome of a (potentially) similar scenario in the next year. REG CEO Dan Oh had this to say about RFS2:

“RFS2 is fundamental to our industry. It took a long time to get in place. What we do need is more predictable guidance, especially in the known growth requirements in RFS2, otherwise we see a slowdown in buying behavior.”

Foolish bottom line

According to Biofuels Digest, The National Biodiesel Board is pushing for annual increases of 200-300 million gallons per year, which would put the 2013 mandate at 1.2 billion gallons and the 2014 mandate at 1.4 billion gallons. Assuming REG has all of the currently planned facilities in operation by the end of next year (350 mmgy) the company would account for 25% of the total domestic biodiesel production in 2014. In that scenario, an average selling price of $4.29 per gallon (a 15% reduction from current selling prices – just to be cautious) would give REG $1.5 billion in revenue.

REG is in the midst of solid growth via production increases, strategic acquisitions, and distribution expansion. The more the company grows, the more it will be able to insulate itself from further reductions in government incentives. As such an important domestic producer, the government mandates actually benefit REG by creating a market for the company’s products. With a book value of $10.88 per share – a 97.8% premium to $5.50 per share – the company is significantly undervalued. I believe REG is a solid long-term investment around $5.00 per share and will look to buy shares by the end of the year.

Did you enjoy this article? Follow me on Twitter to keep up with my future posts on energy, sustainable chemicals, and biopharmaceuticals @BlacknGoldFool.

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