Renewable Energy Group: Heavy Fuel (NASDAQ:REGI)


Certain food-based biofuels like biodiesel have always been a bad idea. Others like corn ethanol have served a useful purpose and essentially are obsoleting themselves.

– Vinod Khosla

Biodiesel producer Renewable Energy Group (REGI) has appreciated 276% in the last one year. Analysts are bullish on the stock over the long term. On September 1, 2020, when the stock was hovering at around $33, Credit Suisse initiated coverage with an Outperform rating and a price target of $51. The firm estimated that REGI was the biggest biodiesel producer in the U.S. and had considerable flexibility and rich experience, and was therefore a potential JV partner or an acquisition candidate. On the same day, Truist Securities initiated coverage on the stock with a Buy rating and a price target of $70.

The stock price is running on such heavy fuel that it has already crossed above Credit Suisse’s target price and is flying towards Truist’s. In a space of just one month!

REGI closed at $55.70 as of October 2, 2020. Here’s my take on whether it is investable at this price.

1. The Biodiesel Market

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Image Source: EIA

COVID-19 has caused a sharp fall in motor gasoline’s demand, and therefore, the U.S. Energy Information Administration (EIA) estimates that biodiesel’s production will be about 110,000 barrels/day in 2020. This number is 2% lower than 2019’s production. On the profit front, biodiesel producers are currently making a margin of about $0.42/gallon.

In Q2 2020, REGI produced 132 million gallons of biodiesel and ended up selling 183 million gallons by drawing from inventories. It earned revenues of $546 million, a decent number considering that we are passing through very adverse economic times.

The Environmental Protection Agency (EPA) has drafted a proposal to increase the biofuel mixed by refiners from 20.09 billion gallons in 2020 to 20.17 billion gallons in 2021. So, REGI is estimated to report a slight increase in 2021 revenues based on its current production capacities.

REGI has recently signed a deal with Hunt & Sons that enables it to sell REG Ultra Clean fuel in Northern California. The company is also expanding into the downstream market and plans to deliver products directly to its customers. New initiatives such as these will keep increasing revenues over the long term, and growth can take off once the virus is contained.

2. Climate Change: The X Factor

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Image Source: My tweet based on a report on green stocks on The Lead-lag Report

Asset managers, led by BNP Paribas and PIMCO, believe that climate risks are increasing. Even most of us are saying the same thing.

Therefore, it’s a no-brainer that local and global investors will continue to chase environment-friendly stocks. That’s what has been happening to REGI. Even the options chain data suggest that high open interest has built up for the October 2020 $55 put option. It implies that investors are expecting the stock to rise some more in October 2020.

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Image Source: NASDAQ

3. Risks

a.) REGI’s business runs on thin margins, and therefore, the company needs to generate very heavy volumes to turn in profits that can make shareholders happy. Its profitability is also dependent on government incentives.

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Image Source: REGI’s Income Statement

In Q2 2020, REGI clocked biodiesel sales of $451 million and earned government incentives worth $94 million. The company’s cost of operations was $521 million, leaving it with a poor gross profit margin of around 5%.

In Q2 2019, a non-COVID-19 quarter, REGI incurred a gross loss of $27 million because it received just $530,000 in government incentives.

REGI’s business is very volume- and incentive-dependent. Therefore, it would do REGI bulls a lot of good if they were to closely track Low Sulfur Diesel (LSD) prices and volumes generated by the company. Also, investors must track changes in federal and state tax incentives, and EPA’s Renewable Fuel Standard (RFS2), a federal law that mandates the minimum renewable fuel mix in transportation fuels.

b.) About 13% of REGI’s H1 2020 revenues were from one client – Pilot Travel Centers, which owns a chain of truck stops in the U.S. and Canada. Though fuel demand is down, the logistics business is doing okay because of the boom in e-commerce. Cold chain logistics too are likely to boom when the vaccine transportation begins. Generating 13% of revenue from one client does not seem to be a big risk for REGI, but I just brought it to your notice.

c.) Biodiesel is considered inferior to renewable diesel. The petroleum industry allows 100% renewable diesel to pass through the storage used for petroleum diesel. Renewable diesel enjoys a higher price premium and also earns more RINs (Renewable Identification Number) per gallon than biodiesel.

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Image Source: REGI’s Q2 2020 SEC Disclosures

REGI is working on a large-scale expansion of renewable diesel operations at its Louisiana facility. If the plan is actioned, the company will have to incur heavy capital expenditure by financing it with debt.

d.) REGI’s Forward P/E ratio (GAAP) is estimated at 16.24% versus the sector median of 7.90%, making it expensive at current prices.

e.) The company makes biodiesel from food products (raw vegetable oils). If food shortages occur or if prices shoot up, biodiesel producers can feel the policy heat.

Summing Up

REGI’s thin margins, dependence on government incentives, an unexciting 2021, and a possible expansion into renewable diesel make it an unattractive investment from a fundamentals point of view. Bulls can argue that the company helps the environment, but ultimately, everything boils down to numbers. I am apprehensive about the long-term prospects of generating fuel from food.

However, backed by analyst upgrades and investor fancy, the stock is flying up the charts as if it were powered by heavy fuel. So, to me, REGI is more of a trading bet. I would watch it on the charts and trade it based on price action and my favorite indicators. But I wouldn’t invest in it.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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