Not Yet (Rentech Inc.)

December 10, 2009

The trouble with getting in on the ground floor of a new technology is that you never know how tall the building is going to be. Too many investors confuse technological brilliance with competitiveness, and a typical example of that is Rentech Inc.

On the whole I’ve never been too excited about technology for its own sake, and when I read a company profile that talks about improving chip interface architecture my eyes start to glaze over, which I think is a reasonable defense mechanism for an investor because there is a difference between knowing what a company literally does and knowing why they’re good at it (and more importantly whether their competitors might not become better at it). However, I was all excited about RYN and its black liquor processing, so it occurs to me that I like technology just fine, but not computers.

Bagasse_dsc08999Rentech has a patented and proprietary method for turning synthetic gas (a mixture of carbon monoxide and hydrogen) into hydrocarbons usable for fuel, and synthetic gas apparently can be manufactured from ordinary waste. From the company’s overview in their SEC filings, they seem to make much ado of the fact that synthetic gas comes from urban and rural garbage, sugar cane refuse and other biomass, which gives them green credentials and also qualifies them for a grant from the Department of Energy  (unlike USEC which refines uranium using proven technology that actually is competitive and only wanted a loan guarantee but that is another story…). However, according to that same filing they have found that fossil fuels such as coal or petroleum refuse is more technologically complicated but seems to work better.

They have constructed a demonstration plant, and have made several attempts to demonstrate commercial viability, without success. Their primary source of funding has been issuing their own stock at a discount to whoever will buy it, which is not good for the shareholders but since the firm is not stable enough to sustain debt financing, there isn’t much else they can do. It explains why a company with a market cap of $300 million is selling at less than $2 a share right now. I don’t normally pay too much attention to a company’s price per share, but that is certainly anomalous. This year, they acquired, presumably using the proceeds of new issuance, an equity interest in a company that makes their feedstock out of cellulose, and acquired another that creates feedstock out of biomass, but it is not clear to me whether their main issue in commercialization is a sufficiently cheap source of feedstock or inefficiency in their own refining process.

cargillfertilizerCuriously, though, the company also owns a profitable segment: they use natural gas to produce nitrogen fertilizer. This Cinderella of a subsidiary supplies the operating needs of the company and also occasionally allows them to turn a profit (like last quarter, although it was the seasonal peak for demand of ammonia fertilizer). In fact, in 2008 if you neglect R & D expenditures, they turned a profit. According to Damodaran, research and development should be treated as a capital expenditure, rather than a flat expense, because it is not all money thrown away. In 2009 to date, Rentech have ratcheted down their R & D, but it seems to me that by acquiring these two new synthetic gas producers they have simply bought their research instead of doing it in-house.

So, this makes me wonder if we should turn it around; instead of a fuel refiner with a fertilizer segment slaving away to keep the firm afloat, perhaps we should look at Rentech as a fertilizer company with a parasitic fuel refinery. The refinery itself contributed $50 million year to date to operating earnings so far in 2009 (even after their supply contracts required them to pay an above-market price for natural gas, which the firm recorded as a loss), and $33 million last year. After $8 million year to date in interest, that leaves $42 million in pretax earnings, which would normally translate to $28 million in post-tax earnings but the firm is stuffed full of net operating loss carryforwards. With the firm’s market cap of only $330 million, that’s a P/E ratio of less than 8, which is good, right?

No. Unfortunately a parasite cannot be ignored, and given last year’s performance the nitrogen segment’s profits might be unsustainably good this year. I have been thinking of “real options” analysis, which is an attempt by finance professors to discover the next new thing, applying option valuation techniques to a company’s choices in its business plan. It may be said that we hold a profitable fertilizer company and hold an option on the future profitability of its refinery, but given the $60 million in R & D last year, and the $16.5 million plus acquisitions this year, it seems like this option has a high premium and seems constantly to be expiring and needing to be re-bought. And, of course, “we” the investor do not hold the option; the company management does and they seem to be very attached to it.  And, of course, there is their ongoing equity issuance, which dilutes ownership of the entire company, not just the refinery side.

Of course, if this refinery pays off the company should do very well by it, but I don’t know at what price per barrel of oil they will become competitive or whether that price has gone down or up in the last few years. If I had that information (perhaps the company could do something useful and commission a study that would actually figure this out), I would feel better if the price were something I could see happening in the near future.

But as things stand, I think a wise fructivore should take a pass. Buying into exciting new technology cheaply is always enticing, but better to wait for the technology to pass the “new” phase and into the “workable” phase.

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