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Cash is King in the Ethanol Business

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Find the Levers That Create Value in Your Ethanol Business

 

Like investors in any business, investors in ethanol plants seek a return on their investment. Whether returns take the form of short term dividends or long term capital gains, the ability to deliver returns to shareholders is based on the ability of the business to drive cash flows to shareholders over time. Since the value of your business is based on your ability to drive cash flow, it is important to understand the levers that generate cash flow in your business as well as how you might improve that potential going forward.

 

The ability of a business to drive cash flow is a function of: 1) the Product Margins it earns (net revenue less cost of goods sold) which is based on its markets and logistics and defines a company's potential to deliver profits; and 2) Operating Efficiency, which defines the efficiency with which the business can convert that profit potential into cash at the bottom line.

 

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a commonly used measure for the cash generating potential of a business. While EBITDA is not exactly the same as 'cash flow' in the purest sense of the term, it is useful because it reflects the primary cash drivers of the business: product margins earned and the operating efficiency of the plant, and is comparatively easy to measure.

 

In addition, since it is fairly commonly defined and used, the metric can also be useful in comparing the performance characteristics of your business with others in order to assess your competitive position in the industry. This can be an important perspective in any commodity driven business, perhaps even more so in one that has a limited market capacity (i.e., the blend wall).

 

Like many commodity driven sectors, ethanol plant performance has demonstrated a cyclical and volatile history. The following chart illustrates the earnings volatility of ethanol plants over time.

 

Chart1

 Source: Internal research and simulation models (thru Q1 2014)

 

Note the repeating pattern of the business cycle (peak to trough). With industry capacity at or above blend wall constraints today and with many efficient operations investing in expanded capacity, less efficient operations are vulnerable to displacement when margins are at the low end of the cycle.

 

Perhaps given the fairly standard process designs across the industry and the maturity level of the commodity markets involved, one might not expect a great deal of variance in performance from one plant to another. The fact is performance and therefore value vary widely from plant to plant in the ethanol industry.

 

Chart2

 Source: Internal plant performance monitoring

 

The chart above presents a distribution of three year average EBITDA's for a number of plants that Ascendant monitors in the ethanol industry as part of a performance monitoring program. All are Midwestern plants located with reasonably competitive access to feedstocks and markets. Yet note the variance in performance: ranging from an average of 4 cents gallon to more than 30 cents per gallon and everywhere in between.

 

To relate this discussion to shareholder value, let's start by agreeing that a plant generating higher cash flow is worth more to shareholders than another that generates less. To illustrate, we can use a common industry metric to start with and define the value of a firm to be 5 times a company's three year average EBITDA. While the multiple (5) is the same for each company, the average EBITDA varies quite a bit as we have seen, and that can make a big difference to owners and investors.

 

Following this simple example, the value of a 60 million gallon ethanol plant generating an average EBITDA of $18 million (i.e., $0.30/gallon) is $90 million ($18 x 5). While the value of a similarly sized plant generating the industry average EBITDA of $12 million ($0.20/gallon) would be $60 million ($12 x 5). That variance in performance represents a $30 million difference in the value to the business owners – a 50% increase in value over the average.

 

The ability of a plant to drive cash flow and value reflects the unique characteristics of each individual business. Some are strong in the ethanol markets, others are positioned to derive greater value from distillers grains, corn oil or CO2. Some consistently deliver superior operational efficiency while others dilute their profit potential through high energy costs, poor conversion factors or higher costs. Still others might be positioned to procure corn at a lower cost. Each operator must seek to understand, define and optimize its own unique set of competitive advantages as levers to improved performance.

 

Of course no one metric represents a magic recipe for success. To be sure there is more to defining business value and future success than just measuring and comparing EBITDAs. The important message here is that you do have control over the levers that effect cash flow and that cash flow ultimately drives shareholder value. By better understanding your cash flow levers and potential as well as where you stack up on the industry 'competitive curve', the more control you will have over your company's future value and viability.

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