Money and Investing Thoughts

VeraSun Energy (VSE: 0.00 N/A N/A) President and CFO Danny Herron presented at the William Blair 28th Annual Growth Stock Conference 2 weeks ago. I listened to the replay, checked out the slide show and took some notes. The presentation was very upbeat, as they usually are. This is a company that has gone from a couple of plants to the nations leading ethanol producer in the space of about 3 years. I was most interested in the comments concerning the ethanol market in general and the specific growth and profitability prospects for VSE.

First, some notes on ethanol production overall:

• Every gallon currently being produced (9.4 billion gallons anual capacity) is being used to blend with gasoline. There is no excess capacity or inventory of ethanol.
• Gasoline blenders are reformulating their gas to require ethanol blending. This reduces the overall cost of the gas and increases the blender’s profits.
• In 2007, for the first time since 1977, oil imports from the Middle East decreased. This is due to the use of 6.5 billion gallons of ethanol, replacing 228 million barrels of (not) imported oil.
• Ethanol plants currently being built or planned will top out at 12 billion gallons per year production. No new plants have been proposed for the last 2 years, so additional capacity is a minimum of 2 years out.
• Note: Brazil could export to the U.S. at most 500 million gallons per year of sugar ethanol, they too would need a couple of years to get new plants built.

Positive notes on VeraSun (VSE: 0.00 N/A N/A) specifically:

• Overhead cost is down to 5¢ per gallon. All of their plants are identical (and still under warranty) reducing training costs and allowing personal to be easily transferred.
• Next profit stream: Corn oil extraction from distillers grains (DDG). They will be able to extract 175 lb. of oil from each ton of DDG. Oil extraction will add $20 million EBITA per plant. The resulting, dryer, DDG is of higher quality than soybean meal, which currently costs twice as much as DDG. First plant with oil extraction coming fall 2008.
• The merger with U.S. BioEnergy will yield synergistic savings of $80 to $160 million per year by the end of 2009.

My belief is that ethanol blended into gasoline of at least 10% will be the standard for U.S. gasoline and in fact is about 2/3 of the way there. VeraSun as the largest, best managed of the ethanol companies will stay profitable and grow their revenues and profits. I also think the market has no clue on the future profitability of VSE. The analyst estimates for 2008 earnings (courtesy of Yahoo Finance) range from -26¢ to +61¢ per share and we are half way through the year. VeraSun does not buy corn at the CBOT market rate and they do not sell ethanol at the spot rates. Most ethanol is sold to blenders at a contract price that is related to the cost of gasoline, and we know what gas prices have been doing.

Many of the factors that will help VeraSun’s profitability will not kick in until late 2008 and into 2009 so there may be no rush to buy the stock even if you think they will do better in the next 2-3 years. However, a positive earnings release in the next couple of weeks could make hindsight of $4 VSE stock seem very attractive.

Note: I have a long position in VSE.

As I sit here writing this (Friday morning) the stock market is trying to hold even on some positive personal income numbers. The last few weeks have been very hard on stocks in general. So, is this the great bear market of the new century or a short terms set back and positive growth will eventually drive stocks higher? First, let us see what some of the market averages have done since recent peaks:

• Dow Jones Industrial Average: Down 12.2% since peaking just above 13,000 in mid May.
• NASDAQ Composite: Down 8.8% since an early June peak.
• S&P 500: Down 9.7% since May 19.

Interesting that most of the major indexes peaked on May 19, but the NASDAQ was off a little on May 19 and reached a higher close on June 5. Now a couple of ETF’s of high interest sectors:

• Energy Select Sector SPDR: (XLE: 74.02 0.00 0.00%): Up 29.8% since low on January 22, but off 4% since May 20 peak.
• Financial Select Sector SPDR: (XLF: 14.66 0.00 0.00%): Current price is down 29.4% since Feb 1 peak and down 24% since recent recovery peaking on May 2.

In spite of all of the tea leaf reading and parsing of arcane government data, there are (IMO) just two factors driving the market downward. First, is the strong inflationary factor in industrial commodities with oil leading the way. Raw materials and transport for most manufactured goods are going up and high gas prices are a serious negative on consumer sentiment. Second, the forced mark-to-market and subsequent write downs of huge amount of debt instruments held by the financial institutions has caused a virtual collapse of the stock prices of all businesses that rely on lending and credit, no matter the credit worthiness of the business or collateral.

At some point in time both of these trends will correct. If the world economy is truly slowing, energy demand will slacken and prices will fall. Oil prices have doubled in the last year and emerging economies and developed economy consumers are starting to take steps to reduce their energy costs.

Although there is some true crap out their in the finance securities that have fallen so much in value, there is a bunch that has been marked down 20, 30, 40% and will at some point pay off close to par values. Because this paper is currently treated the same as radioactive waste, I am sure astute investors are buying or holding these securities and anticipating the day when their patience is rewarded.

At this point my stock holdings are off something similar to the 10% the market averages are down. Yesterday I think every stock in my tracked portfolios was down except for Silver Wheaton (SLW: 36.11 0.00 0.00%). Fear currently drives the market, so I am going to hold my positions, collect a few dividends, and wait for earnings season to start at the end of July into August. At that time, we should see that many companies are doing fine and the current fears are a little misplaced.

I have a couple of positive topics I am interested in writing about today or over the next few days. However, the severe negativity surrounding the stock and real estate markets and now consumer confidence makes writing positive stories feel Pollyannaish. In my opinion, irrationality abounds, first entire sectors of the market were being driven down, now it appears that entire stock markets in most countries are feeding on the fear of a massive global economic slowdown. Yet oil prices keep going up as though a massive global economic slowdown would not reduce energy consumption! At this point, I am going th throw out a few random thoughts and get back to more specific topics later.

First, I do truly get entertained with the comments on articles concerning bad economic news. MarketWatch allows comments, and the disaster whiners (DW’s) just love a negative story. You got to wonder if any of them ever owned or will own a stock, mutual fund or home. My favorites are the ones predicting a multi-decade economic disaster. If you really believe that why are you even reading financial news?

On bubbles:

• Tulips were a investment bubble. (If you do not understand the reference, stay away from investing)
• Japanese stocks were an investment bubble.
• The Dot.com stocks were a investment bubble.
• Housing prices were a bubble.
• Fertilizer is not a bubble and prices and stocks will keep rising at 100% per year for at least 5 more years!

I find the stocks I own to be better values now than when I bought them, so at this point I see no option besides sitting tight. The up coming earnings reports should reveal whether these companies are truly in a slow down scenario (which I doubt) or the market has over reacted and many companies are still doing fine in regards to revenues and profits (my hope and belief).

Finally my favorite reason, or maybe its a pair of reasons, the markets are “collapsing” is either the mismanagement of 8 years of Republican leadership or the pending election of a Democrat President and his desires to raise taxes. So it is both the Republicans and the Democrats fault! I guess there really is no hope.

The power and the glory | Economist.com

I found some interesting reading over the weekend, and much of it was directed towards the renewable energy. The longish article (read it all) linked above hypothesized the next boom in investments will be in the energy field, specifically renewables. I found the short history of economic booms to be revealing and I will attempt to give a quick outline here.

The modern industrial age was driven by the increasing availability and use of different energy sources. Coal to power factories and trains, oil increased the efficiency of ship, trains and gave us the personal mobility of cars and trucks. Electricity allowed us to light and power our homes and business efficiently. Natural gas provided a clean, inexpensive source of electricity and heat.

These low cost energy sources lead to the recent technological booms: Computing in the 1980′s and the Internet in the 1990′s. Now, however, the rising cost of energy has become a cost too big to ignore and threatens global economic growth.

The point of the article is we will see a boom in renewable energy to compare with the economic booms of the past. They make a very good point on how huge the prospects for future energy needs are:

A prize beyond the dreams of avarice

The market for energy is huge. At present, the world’s population consumes about 15 terawatts of power. (A terawatt is 1,000 gigawatts, and a gigawatt is the capacity of the largest sort of coal-fired power station.) That translates into a business worth $6 trillion a year—about a tenth of the world’s economic output—according to John Doerr, a venture capitalist who is heavily involved in the industry. And by 2050, power consumption is likely to have risen to 30 terawatts.

My interest and research into renewable energy started in earnest about a year ago, and I believe this industry is still in a very early stage. The initial investing excitement has passed for sector, but the true breakthroughs are still ahead of us. In comparison, the largest oil ETF (XLE: 74.02 0.00 0.00%) has $5.5 billion in assets, the largest renewable energy ETF, (PBW: 6.15 0.00 0.00%) has $1.6 billion. Of the stocks in the respective indexes, the median market cap in XLE is $48 billion, for PBW it is $3.7 billion, putting the value of renewable stocks at a fraction of the oil companies.

I believe we do not yet know where the true renewable energy breakthroughs will come. I am referring to those technologies that will let us replace a significant portion of our carbon based energy, as the Internet has replaced the TV and newspaper as sources of news. As an investor, I currently would go with an ETF like the PowerShares Global Clean Energy Fund (PBD: 9.68 0.00 0.00%). This will be a boom that takes decades to fulfil it’s destiny.

Citigroup Pans Ethanol… On Flooding (VSE, BIOF, ADM)

The ethanol industry just keeps getting hammered by bad news. The news yesterday that Citigroup was downgrading the stocks is just another example (linked above). Yesterday I wrote about news I have received concerning the corn crop in Iowa and Minnesota and there is more flooding news today. The stocks downgraded by Citi took big hits, down at least 10%. BIOF lost a quarter of it’s value.

Today corn prices sit just north of $7 per bushel, a big jump from the $6 price that has been prevalent through the spring. However spot ethanol is pushing $2.70, up from $2.30 a couple of weeks ago, keeping the crush spread in positive territory. A $1.00 increase (or decrease) in corn price requires about a 35¢ change in ethanol prices to maintain the same gross profit margin.

The one item in the analyst (David Driscoll) report that I find especially interesting is his contention that up to 5 billion gallons of ethanol production could drop off the market in the next few months. I find this highly unlikely for several reasons. First, I assume he means annualized production, since the entire ethanol industry only produces about 850 million gallons per month. Second, 5 billion gallons is about 50% of the total annual ethanol capacity and the producers are currently having no problem selling every gallon they produce. Finally, the combination of clean air mandates and pricing advantage is pushing the country to 10% ethanol for all gas. Currently ethanol accounts for 7% of all the gas sold in the country and that amount is not going to drop.

The bottom line (my hypothesis) is that ethanol prices will rise and fall with corn prices to maintain some level of profitability for ethanol production. However, I do not believe that the market will realize this anytime soon and on-going bad crop news (I do not see any positive news this year for corn) will continue to hurt the ethanol stocks or at least prevent serious price gains.

Note: I have a long position in VSE.