Friday, December 07, 2007

Alice's Pool of Tears

Over a year ago in my August 22, 2006 post entitled “Adventures in Wonderland,” I panned the ethanol industry through an Alice in Wonderland theme. I posited that ethanol producers using corn could feel the pinch of rising input prices, falling like Alice into a Pool of Tears.

Since corn prices have just about doubled in the last year and profit margins are trimmed thin, it seems my concerns about ethanol as a viable business might have had more foundation that most thought at the time my post appeared.

VeraSun Energy Corp. (VSE: NYSE) has reported profits, but is struggling against declining profit margins. Rising corn prices (feedstock), high cost of fuel to power the production process (natural gas) and distribution bottlenecks are all trending against the company. Profit margins dropped to 10.6% in the September 2007 quarter compared to the mid 30’s in 2006.

VeraSun recently made an overture toward one of its neighbors, Minnesota-based
U.S. BioEnergy Corp. (USBE: Nasdaq). It is an all-stock deal that will make the VeraSun-BioEnergy combination the largest ethanol producer in the U.S. with 1.6 billion gallons coming on-line by the end of 2008. That will put the current king of the corn squeezins’, privately-held Poet LLC (formerly Broin Companies), in a close second with 1.1 billion gallons in production capacity.

Since U.S. BioEnergy is also profitable, the deal should be accretive for VeraSun. Wall Street seems to like the deal. VSE shares have gained approximately 30% off historic lows following the late November 2007 announcement.

My question is whether industry consolidation is enough to solve the business model issues that are inherent in the ethanol business model. Ethanol production is localized at every level. This means that economies of scale are not likely to have that great an impact on costs.

Don’t believe me? Drive by an ethanol production facility - trucks are usually lined up out to the highway. These are just ordinary trucks that drive over from a nearby a farm or farmers’ cooperative to the ethanol plant. It will not make any difference that VeraSun following its combination with U.S. BioEnergy will have so much more production capacity. There are no larger trucks around to deliver larger volumes of corn more economically. This means there are not likely to be any sourcing arrangements that will aggregate local corn supplies at lower costs for the larger company.

On the sales side of the ethanol producers’ dilemma, transportation is also the issue. Since the highly corrosive ethanol cannot be sent down the maze of oil and gas pipelines that lace the country’s interior, ethanol must be sent by truck or rail tankers. Rail is better than truck, but still an expensive means of connecting to the gas distributors that mix the ethanol with petroleum gas.

My concern is that consolidation is not likely to deliver any economies of scale for sales and distribution either. Aggregating the production under corporate umbrella, combining negotiation forces, uniting behind a single brand name - none of that has much of an impact on distribution arrangements that begin at the local ethanol plant and move down the same channels regardless of the name on the letterhead.

Consolidation may save VeraSun and U.S. BioEnergy some dollars at the operating level, but I do not see it as a life preserver. Consequently, even at recent low prices none of the corn-based ethanol producers looks compelling.

Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

No comments: