Investing in ethanol stocks: The Wall Street rock star

Greg Guenthner - Mon 26 Jun, 2006

...Investing in ethanol stocks...the pin-stripped hucksters at Wall and Broad have been dressing up lots of ethanol companies as hot new IPOs to sell to an adoring public...

 
 
- Ethanol is a rock star on Wall Street, and every brokerage firm knows it. That's why the pin-stripped hucksters at Wall and Broad have been dressing up lots of ethanol companies as hot new IPOs to sell to an adoring public.

- Ethanol's long-term growth prospects are very real, of course. This bio-fuel seems certain to capture a growing share of the liquid fuels market. But even so, ethanol may have become a bit too popular with investors...for the time-being.

- That's why every brokerage firm on Wall Street is trying to sell ethanol-focused companies to the public – looking to grab the easy money while it's still available?

Investing in ethanol stocks: Frothy and speculative

- Ethanol will be one of several alternative fuel sources that will help break the country's petroleum habit. A growing variety of other alternative fuels – like biodiesel, liquefied natural gas and gasified coal – will also play a growing role. But in the here and now, ethanol stocks have become a bit frothy and speculative.

- The recent crop of ethanol IPO's will certainly produce some winners. But others will stumble badly. Quality is key. On top of the ethanol heap is Archer Daniels Midland (NYSE: ADM), with a 30% share of the domestic ethanol market. The company's stock has a market cap of nearly $26 billion and sells for about 20 times estimated earnings.

- The second-largest ethanol producer in the US, VeraSun Energy (NYSE: VSE), debuted on Wall Street last week. The IPO raised enough money for VeraSun to skip over the world of small-caps, posting a market cap today of more than $1.9 billion.

- In fact, VeraSun's shares were up 30% on its first day of trading last week. (The IPO was at $23 per share, a little more than expected.) And after topping out at more than $30 a share, VeraSun finished Friday's trading at $24.97. The stock sells for about 31 times estimated 2006 earnings.

Investing in ethanol stocks: Serious growth

- And now that its bank account is brimming, the company is readying itself for some serious growth. The proceeds from VeraSun's IPO will go to more than double its ethanol production by 2008 to 560 million gallons. (Right now, VeraSun produces 230 million gallons of ethanol a year - 5% of total US production.)

- Given VeraSun's breakneck growth plans, we would not be surprised to see additional stock offerings in the future – an event that sometimes weighs on the price of a stock.

- The next two ethanol-company IPOs standing in the queue are Hawkeye Holdings and Aventine Renewable Energy Holdings, the latter of which has a very close relationship with VeraSun, which could cause problems for VeraSun down the road.

- "Aventine Renewable Energy buys virtually all of the ethanol VeraSun produces," reports Robert Walberg in a column Street Patrol. "Recognizing the potential conflict of interest that creates, especially as Aventine starts to increase its own production of ethanol, VeraSun has informed Aventine that the distribution deal will end in March 2007."

- So it looks like VeraSun will be shopping for a new distributor fairly soon. And if the company can't find a way to get its product to the consumer, there could be some delay to all of the growth the company has been talking about.

Investing in ethanol stocks: A good deal?

- Aventine – which Walberg compares to Pacific Ethanol (Nasdaq: PEIX), another small-cap ethanol company – has announced plans to offer 7.75 million shares at a range of $37 to $41 per share.

- But even this deal isn't all it's cracked up to be. Company insiders are selling 1.4 million shares on the offering, or about 20% of the total IPO. Heavy insider selling into an IPO is not uncommon, but it is always unwelcome. The public buyers would rather be buying alongside the insiders, not FROM the insiders.

- As a rule of thumb, it is rarely a good idea to buy whatever Wall Street is eagerly selling. So now that ethanol-company IPOs are pouring into the market, investors should regard these newly minted stocks with a healthy dose of skepticism.

- Ethanol's long-term prospects may be very strong, but many of these new IPOs will subject investors to sizeable short-term risks. Proceed with caution...


Regards,

Greg Guenthner
for The Daily Reckoning

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