VeraSun - Analysis of an Upcoming Ethanol IPO, or Ethanol Fuel Over Heated?

The Nasdaq and the US stock exchanges are not dead for cleantech IPO filings, despite the emergence of the AIM exchange in London as the place to list for cleantech, energy tech and environmental companies. (Process diagram from VeraSun website).

We've had four cleantech filings in the US this year so far, in solar, water, and 2 in ethanol.

• Ascent Solar Technologies, Inc.
• Aventine Renewable Energy Holdings, Inc.
• Basin Water, Inc.
• VeraSun Energy Corporation

One of the most talked about is VeraSun Energy Corporation (NYSE: VSE Proposed), an ethanol play. VeraSun filed for a $150 mm IPO on March 30. They have since upped the filing to $300 mm, however over a third of the shares are selling shareholders, so unfortunately not all of that cash is going into the business. Morgan Stanley & Lehman Brothers are the lead underwriters. With $236 mm in revenues and $29. 9 mm in EBITDA in 2005, the company claims to be the 2nd largest ethanol producer in the US. VeraSun has two plants operating, Aurora, SD, a 120 mm g/yr plant, and Fort Dodge, IA, a 110 mm g/yr plant that started in late 2005. They are in construction on another 110 mm g/yr plant in Charles City, IA, and plan to build two more with the proceeds from the IPO. They are targeting 560 mm g/yr by 2008.

Their process, like most, is a corn fermentation/distallation process. They use a dry milling process, with natural gas as the fuel source and they claim on their website 2.8 gallons of ethanol + 18 lbs of distillers grain per bushel of corn.

Process summary from VeraSun's prospectus:

1. "In the dry-mill ethanol process, the corn kernels are first ground into a flour, or “meal,” and mixed with water in cookers to form a slurry, called “mash.”
2. In the cooking system, the action of heat liquefies the starch in the corn and enzymes are added to break down the starch to fermentable sugars.
3. The cooked mash is then cooled and pumped to the fermenters where yeast is added. The action of the yeast converts the sugars in the mash into ethanol.
4. The fermented mash is pumped to the distillation system where the ethanol is separated from the non-fermentable solids (the stillage), and water is removed to concentrate the ethanol to a strength of 190-proof (95% ethanol).
5. The ethanol is further concentrated in a molecular sieve dehydrator to a strength of 200-proof (99+% ethanol), to produce fuel-grade ethanol which is then denatured (rendered unfit for human consumption) with gasoline and transferred to storage tanks.
6. The stillage from the distillation system is sent through a centrifuge that separates the coarse grain from the solubles. The solubles are then concentrated in an evaporator system. The resulting material, condensed distillers solubles or “syrup,” is mixed with the coarse grain from the centrifuge and then dried to produce dried distillers grains with solubles, a high quality, nutritious livestock feed. Some of the distillers grains may bypass the final drying stage and be sold as wet distillers grains with solubles."

They are also selling a branded E85 fuel called VE85 in the Midwest, and have partnered with Ford, as well as GM as part of its Live Green Go Yellow marketing campaign, to promote ethanol fuels. Interesting though it is, the VE85 product accounts for well less than 1/2 a percent of current revenues.

Another tidbit, Aventine, another ethanol company which has also filed to go public this year, is the marketer/buyer of most of VeraSun's ethanol production, despite being a competitor producing ethanol from its own plants. VeraSun has stated its intentions to go direct in 2007.

I did a back of the envelope analysis of the numbers to get an idea of what valuation made sense and how the IPO might do. Currently, the company issued bonds to build its new Charles City facility, and at $210 mm in debt, is levered a serious 9.5x Debt/EBITDA until the new facilities come on line (2005 numbers). EBITDA and Gross Margins were both down in 2005 compared to previous year, about half driven by squeezed margins in part from higher average natural gas prices, and in part from increasing SG&A from the expansions. The high current leverage has kept net income at a breakeven level for 2005 (though it rebounded nicely for the first quarter 2006, due to increases in average ethanol price and a drop in average corn cost).

By my back of the envelope calculation from the SEC filings, 2006, based on a full year's operations from both facilities, an 85% capacity factor, $1.80/ gallon in revenues (ethanol + distiller's grain), and $0.25-35/gal in EBITDA (in line with their range the last 2 years, though lower than 1Q06), would likely be between $350 mm in revenues and $49 - $68 mm in EBITDA, bringing leverage down to a more manageable 3-4.5x Debt/EBITDA range. And in 2007/2008, a target of at $520 mm revenue, $72-$101 mm in EBITDA, on an annualized pro forma basis for the Charles City plant coming on line (estimated as 3Q 07). Pro forma for the in planning Welcome and NW Iowa plants, the numbers would be $856 mm revenues, $119-$167 mm in EBITDA.

I have not had a chance to delve into the hedging strategies. And keep in mind that those are good EBITDA margins for a refiner, and I'd expect them to get beaten down into the high single digits to low double digits like the oil industry as the industry matures. Keep in mind also that last year the company made the vast majority of its gross margin in just 1 quarter out of 4. So expect some volatility. Though if the company can maintain the per gallon EBITDA margins they managed in 1Q06, they should have quite a bump above my estimates.

Now to valuation. I then went and did a quick and dirty valuation based on this analysis. The 12/31/05 book value /share is $3.05. So we can start there.

A quick estimate of Yr 3 Net Income, using the assumptions above, a 32 year average depreciation on assets at $1,250/ 1,000 gallons/ year installed cost x rated capacity, requirement of another $115 mm in debt to complete the build out with a 10% average interest rate, and a 39% tax rate, got a net income of between $40 and $70 mm in Yr 3.

The current valuation multiples for oil & gas refining companies are 11x EPS and 5.5x EBITDA. Using those numbers with no discount, I calculated a 2009 estimated value range after VeraSun is fully built up, and discounted that back at a 10% WACC to get a post-IPO valuation that ranged between $281 and $568 mm in equity valuation. After subtracting the $150 mm IPO raise (done before they announced their increase), that leaves a per share range of c. $2.77-$8.82, depending on whether you believe the $0.25/gallon EBITDA margins or the $0.35 ones. The current pricing is expected in the $18-20 range. Well above what my analysis could get to, even assuming aggressive long-term operating margins, unless we assumed valuation multiples a lot higher than a typical refinery or process plant would receive. I'll be particularly interested in what operating margin assumptions and what P/E the first analyst reports are forecasting. Given how hot the ethanol sector is right now, I'd expect this float to go out at the high end of the range, and probably trade well, but at the end of the day, it is a refiner, not a tech company, so be careful.

Neal Dikeman is the founder of Cleantechblog.com and Cleantech.org, and a partner at Jane Capital Partners, a boutique merchant bank focused on energy technologies. Find the original version of this article and other information on ethanol on www.Cleantechblog.com.

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