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3 stocks to ride ethanol's rise
It's no secret ethanol is being hailed as a fuel of the future, or that ethanol stocks are overpriced. Here's a better way to play the trend.
By Jim Jubak
Think about this next time you fill up your car with $3 gas: Everybody is talking about the need for alternative energy, whether it's ethanol from corn or switch grass, solar, wind, nuclear, coal to liquid, or bio-diesel. So why aren't there more alternative energy stocks for an investor to buy?
If you're looking for a pure play on an alternative energy -- whether it's solar or ethanol -- then the pickings are pretty slim. Subtract the overpriced, the over-hyped and the illiquid stocks, and there doesn't seem to be much left.
Let me use the ethanol sector to explain exactly why this is so and to suggest why the best alternative energy stocks to buy aren't the overpriced pure plays but companies that have substantial exposure to new energy alternatives and solid existing businesses. I'll end this column with three ethanol picks -- stocks that I recommended in my regular Wednesday morning appearance on CNBC's Morning Call.
High-priced corn
Investing in ethanol ought to be a no-brainer. President Bush brings it up just about every time he talks about a national strategy for reducing the U.S. dependence on oil. The technology works -- and works now. The economics work -- ethanol is cheaper than gasoline. And the raw material -- corn at this stage of the technology -- is in abundant supply.
And it's not that you can't find obvious ethanol plays on the stock market. Ethanol stocks trading at 52-week highs and with plenty of momentum include MGP Ingredients (MGPI, news, msgs), a producer of food-grade and fuel-grade alcohol; and Pacific Ethanol (PEIX, news, msgs), a startup with plans to build five ethanol plants on the West Coast.
It's just that most of these ethanol pure plays are too expensive.
How expensive?
MGP Ingredients, with $300 million in sales in the last 12 months, trades at a price-to-earnings ratio of 62. Pacific Ethanol has $88 million in sales in the last 12 months, but with no earnings, the shares don't have a price-to-earnings ratio.
Related news and commentary on MSN Money
In both these cases, I think an investor is paying a premium price to get a hot pure play in a sector where there are relatively few names to buy.
Contrast that pricing with that for a company with a dose of ethanol blended into another business.
Archer Daniels Midland (ADM, news, msgs), the world's largest corn processor, is also the country's largest producer of ethanol, with a 25% market share in the United States. It plans to add a second plant, producing 275 million gallons of ethanol this year.
But that leading position in ethanol is just a small part of Archer Daniels' business. Sales for the company's bio-products group, which includes ethanol sales, were just $105 million for the most recent quarter. That's up 7% for the quarter but represents just 1% of Archer-Daniels' $9.1 billion in sales for the quarter.
The stock has historically traded at a price-to-earnings ratio between 13 and 33, with an average of 17. At the May 2 closing price, investors were paying 25 times trailing 12-month earnings per share. That's above the historical average for the stock but reasonable in the over-heated world of pure-play ethanol valuations because that fast growing business is blended with the company's existing businesses.
Too many ifs
I'm emphasizing price because, as exciting as the future of ethanol companies may be, they all face huge uncertainties. Considering those uncertainties, I'm not that keen on paying a high price-to-earnings multiple for these shares today.
Part of the appeal of ethanol depends on the Bush administration's energy policies, and these policies haven't been especially consistent. For example, while promoting ethanol in his speeches, the president has also asked for waivers this summer that would let areas with critical fuel shortages delay their switch to reformulated gasoline with higher ethanol content. Presumably that would reduce ethanol demand and ethanol prices.
While producing ethanol from corn, which Archer-Daniels does, is a proven technology, the long-term direction of ethanol technology is very, very fluid. Ethanol production in the United States is projected to expand to 6.5 billion gallons in 2007 from 3.9 billion gallons in 2005. But beyond 2007, corn-based ethanol will face increasing competition from ethanol made from plant cellulose. According to a study by the Stanford Washington Research Group, production of ethanol from corn will top out at around 14 billion gallons. (Annual U.S. gasoline use is about 140 billion gallons.)
Iogen, a private company and the early name in cellulose-based ethanol thanks to a blue ribbon investor group that includes Goldman Sachs (GD, news, msgs), expects to start producing plant-based ethanol by 2009. Iogen is projecting a cost of 90 cents a gallon when its plants are in full production. Right now it costs about $1.10 to produce a gallon of corn-based ethanol, according to the U.S. Department of Agriculture. Thanks to the lower cost of plant cellulose versus corn, plant-based ethanol could have a permanent cost advantage.
Some of these ethanol companies are still busy raising capital for new plants. Pacific Ethanol, for example, in November 2005 raised $84 million to pay for part of the construction of its five planned ethanol plants in an issue of convertible preferred stock. This kind of capital raising, essential as it is, dilutes the holdings of current shareholders by reducing the percentage of the company they own. And that will make the price-to-earnings ratio even higher -- when the company finally does have some earnings.
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