The Long Shot: An Emerging Biofuel Play

 | Jul 18, 2011 | 10:55 AM EDT
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RealMoney's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.


The last year has been the start of what I am calling "Biofuels 2.0," as the wreckage of the ethanol bubble gives way to a second generation of biofuel names that use more interesting technologies beyond simply distilling corn mash. In the last year, we saw the public debuts of Codexis, Amyris, Gevo, Solazyme, and KiOR . These companies all sport some variation on what they do (produce enzymes or oils for others to build and operate refineries), what they will produce (ethanol, oil, jet fuels, etc.), and who they have as partners and customers.


These names join the existing league of Biofuel 1.0 names that survived the shakeout, including Green Plains , FutureFuel , BioFuel Energy , Pacific Ethanol , and Syntroleum . One element the new crop does have in common is that they all face challenging valuations and development-stage revenue. While all are promising results, in their own way, the combined market-cap of $5 billion compares against 2012 revenue forecasts of only $695 million.


Along these lines, I have uncovered another emerging biofuel play that combines cutting edge technology, a unique business model, and the happy circumstance of being nearly undiscovered, and, therefore undervalued. AE Biofuels is a Silicon Valley-based ethanol producer with these unique attributes, and the stock could possibly be a home-run investment if the company continues to execute on its business plan. Be forewarned: The company is small, with an enterprise value of $50 million (a $20 million market cap with $30 million in debt.) However, it is beyond the development stage, with an operating plant and a significant revenue stream turning on as we speak.


The first unique element of AE Biofuels' story is its business model. To grow, the company is leasing ethanol refineries rather than building them from scratch, thus reducing its capital needs and time to market. There are plenty of stranded plants from the 1.0 boom to fuel this approach for years. The company leases a refinery or creates a joint venture with the owners, then installs its processing technology. This removes steps from the distillation process and broadens the usable feedstocks beyond just corn (to cellulosic, for example). The company operates the modified plant, sells the ethanol to the open market, and splits the cash flow with the refinery owner. On a plant that might cost $100 million to $200 million to build "greenfield," AEBF can use this "brownfield" strategy to get into production for only a few million dollars. Its first leased plant near Modesto, Calif., started producing in the second quarter, and it is on track to produce 55 million gallons of ethanol per year. This means the company is already set to generate $150 million of revenue in the next 12 months -- at current ethanol prices. (With ethanol costs lower than current gasoline prices, the government tax credit can disappear and not affect the positive economics of the business now.)


The key differentiator for AE Biofuels is its enzyme technology, which consolidates several of the fermentation steps. This also enables AEBF to process any number of feedstocks, such as corn cobs, sugar cane bagasse, wood, etc. The company just announced its acquisition of Zymetis, which further strengthens this advantage. Zymetis is a spin-out from research done at the University of Maryland, and the company owns genomic patents on certain Chesapeake Bay microbes that they identified, which convert cellulosic feedstock (such as saltwater grasses) into sugars. Zymetis' technology will further enhance the process step reductions AEBF can put in place when leasing new refineries.


AE BioFuels can also redirect its production to other specialty chemicals rather than only ethanol. The company's early history is checkered, because it built a biodiesel plant in India as its first foray into production, but ended up stymied by conflicting Indian laws, which are preventing the normal subsidies that would make the plant economically viable. The company is redirecting production from ethanol to other chemicals for the pharmaceutical industry, and expects to generate tens of millions of dollars from product sales in India in the next year.


So, in contrast to the Biofuel 2.0 universe, AE Biofuels has 100 employees, an owned plant in India ramping chemical production for the pharmaceutical industry, and a leased plant in California producing 55 million gallons/year of ethanol. The company has visibility on $200 million of revenue in the next 12 months, yet trades at a $20 million market cap. The management team is very strong: CEO Eric A. McAfee was the founder of Pacific Ethanol, and has a strong track record of entrepreneurial success. The management team understands the liquidity issues and such surrounding its status as a micro-cap stock, but I fully expect them to progress by raising additional capital, issuing more shares, and garnering coverage from leading investment banks and analysts.


So let's hit the risks, because there are always some. RealMoney is always wary of analyzing pink-sheet stocks, because 80% of them are going nowhere, are frauds, are shells, etc. But some are real companies with great prospects. AEBF is micro-cap and pink-sheet stock, so it should be considered extremely speculative right now; it would only be appropriate for a small percentage of an investor's high-risk allocation. Most funds will need to wait for an uplist, more volume and a higher price before getting involved. But as the company ramps revenue, becomes profitable, and attains more liquidity with a follow on and uplisting (hopefully), its valuation could improve to reflect its growing financial strength and solid prospects.


Other risks include the potential that the Zymetis microbes will not attain commercial efficacy, ethanol prices could collapse, gasoline prices could collapse (recreating the need for subsidies), or that an insufficient number of ethanol refineries will be available at economic lease rates. The company's specialty chemical strategy for the plant in India -- and Modesto and others as well -- could also falter. AEBF faces the same daunting risks faced by other biofuel names, but with the positives of a solid and experienced management team and revenue flow.


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