Description

Previously known as Pacific Ethanol, but never before written up on VIC under its new name, Alto Ingredients offers a timely opportunity to invest in a small-cap whose numbers are in the process of inflecting higher after a disastrous 2022.  The stock has begun to recover some of its lost ground, but I believe there is substantial stranded value within the company that is likely to be unlocked in the near future via a recently begun activist campaign.  This is unfolding in real time against what appears to be a much improved industry backdrop that should become clear when the company reports this coming Monday after the close, serving as an additional near-term catalyst for the stock.

On June 29th, Raper Capital published a letter to the board of directors calling on them to engage in a sales process immediately to take advantage of several fortuitous and perhaps temporary industry circumstances.  The logic of the letter is strong and the entire letter can be found here.

This thesis/write-up is organized as follows:

1. The commodity ethanol market appears to have bottomed after a terrible 2022.
   1. Crush margins / corn basis appear to have recovered
   2. The real fuel outlook has improved as the EPA recently granted a waiver allowing 15% blending of ethanol into gasoline
2. Inflation Reduction Act and the Carbon Capture Sequestration & Cogeneration opportunity
   1. Extremely valuable subsidies are suddenly on the table for ALTO and serve as extremely low-hanging fruit whose value alone covers the entire enterprise at less than 5x EBITDA assuming the existing operating business is worth nothing.
3. Valuation scenarios
4. Risks

GPRE – the dominant player in this industry, has been written up a few times (including by me in 2019).  GPRE remains the larger and higher quality company, but a number of moving parts make ALTO more attractive at the moment as an investment that offers investors a bit more torque.

For the uninitiated, ALTO – at its core – is a company that transforms grain into high-margin components used in a wide variety of consumer and commercial products.  Historically, the bulk of ALTO’s operations have been related to the production of fuel-grade ethanol.  The production of fuel-grade ethanol is a less attractive, price-oriented business focused on commodity products.  As a result, ALTO is in the process of repositioning its business to be able to extract a better protein yield from their ethanol, which will allow ALTO to focus on expanding the production and sale of specialty alcohols and essential ingredients – all higher-margin, less cyclical products.  ALTO’s specialty alcohols find their way into a wide variety of consumer products, which the company divides into three key markets:

Health, Home & Beauty: mouthwash, cosmetics, pharmaceuticals, hand sanitizers, disinfectants, cleaners, etc. 

Food & Beverage: alcoholic beverages, flavor extracts, vinegar, corn germ, CO2

Essential Ingredients: dried yeast, animal feed, pet foods

With a production capacity of 140 million gallons of specialty alcohol (40% of its total capacity), ALTO is currently the largest producer of specialty alcohols in the US.

ALTO’s production of fuel-grade ethanol constitutes its Renewable Fuels market, where ALTO’s products are used as transportation fuel and distillers corn oil is used as a biodiesel feedstock. 

Taking a page out of GPRE’s playbook (literally – they basically copied GPRE’s deck), ALTO has embarked on a multi-year path of repositioning the company as a producer of higher-margin, value-added products.  It plans to increase high-margin sales and grow EBITDA by optimizing its asset base and reducing its carbon footprint.  Expanding production of higher margin products (corn oil, neutral grain spirit, yeast), implementing various efficiency initiatives (corn storage, natgas pipeline, equipment upgrades), and carbon capture utilization and sequestration/cogeneration will produce a series of incremental boosts to EBITDA over the next three years with staggered timing, but overall are expected to yield an incremental $65m EBITDA by 2025 and $125m EBITDA by 2026.  The details of all individual capital projects and their contribution are laid out in ALTO’s investor presentation, but are summarized below:

For equity generalists such as myself, it’s easy to get lost in this industry’s endless jargon and takes some time to get fully up to speed on all the metrics and moving parts.  Polonius said a lot of stupid things in Hamlet, but he was right about brevity, so I shall try to heed his advice.  I’m happy to address anything in more detail in the comments section.

     1. The commodity ethanol market appears to have bottomed

The ethanol market in the US is a strange beast, full of subsidies, farmer interests at odds with consumer interests, political meddling, and extreme volatility.  The industry suffers from a perpetual state of oversupply, and to make matters worse, the majority of ethanol produced is used to blend into gasoline, making this a cyclical commodity business, exposed to the whims of gasoline demand and regulatory ping-pong games.

In 2020/2021, ethanol prices remained high due primarily to elevated gasoline demand (COVID road trip fever) and elevated demand for hand sanitizer, resulting in ALTO reporting $67m and $77m in EBITDA, respectively.  In 2022, EBITDA swung violently to negative $10m, driven by spikes in the input costs for ethanol (corn and natural gas), and a rapidly declining crush margin down from ~$1.25/gallon at the beginning of the year to ~-0.40/gallon in a matter of weeks.  ALTO’s average corn basis cost alone increased 64% in 2022, resulting in a $37m hit to EBITDA, nearly half of the previous year’s total.

In 2023, these headwinds seem to have reversed.  The crush margin has steadily increased throughout the year and is now firmly in positive territory, while natural gas has faltered.  Additionally, in Q1 ALTO reported their average corn basis was 0.46, down from a brutal 1.01 in Q4 of last year.  As an added kicker, elevated natural gas prices and negative crush margins forced ALTO to hot-idle some of their western capacity, sending their capacity utilization down from 86% in 2022 to 70% in Q1 2023.  Now that these cost headwinds have reversed, I expect at least some increase in utilization for 2023.  An increase in utilization coupled with a decrease in average corn basis will have an outsize impact on EBITDA.

Finally, the EPA has recently granted a waiver allowing 15% blending of ethanol into gasoline, providing an incremental boost for ethanol demand for the year.

     2. Inflation Reduction Act and the Carbon Capture Sequestration & Cogeneration opportunity

Embedded in the Inflation Reduction Act is something the industry calls Carbon Capture Sequestration & Cogeneration.  This simply refers to the government’s offer to pay ethanol producers for saving and storing the CO2 that is naturally produced during the ethanol production process.  The simple idea is that if the CO2 is properly stored, it will not return to the earth’s atmosphere, a good thing in the fight against climate change. 

This is something of a jackpot for ethanol producers because the production of CO2 does not require any additional costs on their part (CO2 is a natural by-product of ethanol production).  Of course, there are costs associated with separating and storing the CO2 in order to meet the standards set forth by the government, but the subsidies are doubtless a giant, low-risk windfall for the industry that is only recently becoming better understood.  Indeed, six weeks ago GRPE held an event they called the “Inflation Reduction Act Teach-In” help investors better understand the opportunity here.  I don’t believe the market fully understands what this means for ALTO.

Under the IRA, there are two primary subsidies available to ALTO’s largest production facilities (Pekin Campus): the 45Z provision and the Low Carbon Fuel Standard credit (LCSF).

In short, the 45Z provision offers 2c/gallon for every point below 50 on the Carbon Intensity score of a production facility.

Assuming ALTO’s Pekin production facility is at a typical 60 point score of Carbon Intensity, the 35 point reduction that carbon sequestration and cogeneration offers would bring the Pekin facility down to a Carbon Intensity score of 25, or 25 points below the subsidy threshold.  There is scant guidance on the fixed and variable costs associated with meeting the government’s standards to earn the subsidy, but Raper Capital’s letter to the board suggests the combined costs are on the order of $40m.

In sum, this subsidy yields in incremental $115m in revenue and ~$75m in EBITDA.

The LCSF subsidy is more difficult to model.  Raper Capital suggests it could be worth $55m in incremental EBITDA, but I leave it out for the sake of extreme conservatism.

     3. Valuation Scenarios

The varying quality of ALTO’s production facilities demands a SOTP valuation.  The western facilities, Magic Valley and Columbia together represent 100m gallons of capacity, or ~28% of total.  Recent transactions of similar facilities have taken place at prices ranging from 40 cents - $1.00/gallon.  Raper Capital values these assets at 40 cents/gallon, but these precedent transactions all pre-date the Inflation Reduction Act and its valuable subsidies.  As a result, I think something like 60 cents/gallon is quite conservative.

The Pekin facility (~72% of ALTO’s capacity) represents the bulk of value and contains all the optionality.  It’s important to note that the Pekin campus is really three individual production facilities, one of which is engaged in “wet milling,” a process that produces a higher-protein, higher-value product.  This particular facility, then, should fetch a higher value than the other two “dry milling” facilities.  Unfortunately, there are no recent comparable transactions to indicate value here, but on GPRE’s Q4 call, the CEO was asked about asset values in the industry and indicated that they are seeing assets trade for close to replacement value.  I’m not sure what replacement value is for the Pekin campus (I have heard rumblings of $2.5+/gallon), and they were $2+/gallon 15 years ago.  This number also obviously pre-dates the IRA subsidy.  Putting it all together:

Note that this valuation ascribes zero value to the company’s ~$118m in working capital.

     4. Risks

Barring an exogenous shock that sends crush margins falling and cost inputs soaring again, the primary risk here is that ALTO fails to transform itself successfully.  Even GPRE has fallen far behind schedule, and Raper Capital’s letter argues that the company lacks the liquidity and management lacks the know-how to move forward with this multi-year plan independently.  I am still waiting to connect with management on the point of liquidity, and do not have a strong view either way on this particular point.  Not to say Raper is wrong, but I would fully expect an activist to make this argument when advocating for a near-term sale, particularly when so many larger industry players would be able to crystallize the latent subsidy value more quickly and easily.  Nevertheless, there’s certainly logic to this argument.

Management has certainly not covered itself in glory for the way it has run the company over the past decade, and to the extent that the board ignores a call to action from shareholders, it could gradually destroy the value of the subsidies within the IRA given that they are not given in perpetuity.  So management is certainly a risk here, but this risk is mitigated by the fact that well north of twice the company’s shares outstanding have traded hands so far this year, and the shareholder base is almost certainly eager for management to take the shortest, easiest route to value creation.

Catalyst

- Earnings on 8/7

- Activism