Hazelton Capital Partners: Risk vs. Volatility; REGI Bull CaseVW Staff
Hazelton Capital Partners letter to investors for the second quarter ended June 30, 2015.
Hazelton Capital Partners, LLC (the “Fund”) declined 7.5% from April 1, 2015 through June 30, 2015, declined 7.75% year-to-date, and has returned 79% since its inception in August 2009. By comparison, the S&P 500 gained 0.3% in the same quarter, increased 1.2% year-to-date and has returned 127.5% since the Fund’s inception.
Hazelton Capital Partners Performance – The Quarter in Review
Hazelton Capital Partners ended the 2nd quarter with a portfolio of 18 equity positions and a cash level equivalent to 15% of assets under management. The Fund’s top five portfolio holdings, which are equal to 36% of the Fund’s net assets, are: Western Digital, DreamWorks Animation, Apple, Renewable Energy Group and Cisco Systems. Throughout the first five months of the year, Hazelton Capital Partners vacillated between slightly up to slightly down on the year. In June, there was a downturn in the portfolio, lead by a decline in a number of our holdings, including Western Digital, which accounted for half of our YTD decline.
Hazelton Capital Partners - Risk vs. Volatility
In the financial media, "risk" and "volatility" are often used interchangeably to describe the movement of a company's stock price. A company with a volatile stock price is often considered to be a risky investment, unless the price of the stock steadily increases, and then it is considered a growth stock. Hazelton Capital Partners defines risk as the exposure to danger, harm or loss, while volatility is simply a mathematical equation that measures the change of an asset's price over a period of time. Risk and volatility have nothing in common. The key ingredient behind volatility is uncertainty; it harnesses the emotional power of fear and greed, leading to a myopic and short-term reaction (overreaction). The greater and longer the uncertainty persists, the more a stock price will vacillate. In most cases, these knee-jerk responses to buy or sell shares completely ignores the fundamental and future intrinsic value of a company.
Instead of fighting it out in the scrum, Hazelton Capital Partners chooses to stand outside the chaos and wait for a stock price to provide a buying or selling opportunity. Hazelton Capital Partners is vigilant with our investments, consistently searching for changes in their long-term intrinsic value and stands ready to remove a company from the portfolio when necessary.
Hazelton Capital Partners - Renewable Energy Group (REGI) Current Holding
Renewable Energy Group, Inc (REGI) is the largest producer of biodiesel in the United States. With its flexible use of feedstock and national logistics and distribution network, REGI has become the low cost US producer of biodiesel. The company has grown its refining capabilities from 12 million gallons in 1996 to its current nameplate level of over 330 million gallons, representing approximately 25% of domestic biodiesel production. Through construction and acquisition, REGI has gained an expertise in retrofitting and optimizing production facilities, sourcing feedstock, marketing, selling and distributing its products. With the recent acquisition LS9, Renewable Energy Group plans to leverage its infrastructure, sourcing, and production facilities and expand into commercial grade specialty chemicals using bio-based feedstock.
The US biodiesel industry is highly fragmented with 75% of the refiners producing only 33% of total production. Of the top biodiesel producers, Renewable Energy Group is the only independent refiner and competes with agricultural processors like Cargil, ADM, Louis Dreyfus Commodities and AGP. Biodiesel's refining process uses a variety of agriculture oils (edible, inedible and used cooking oil), grease and animal fat as feedstock and is functionally identical to petroleum-based diesel fuel. However, pure biodiesel (B100) emits CO2 and hydrocarbon levels that are up to 80% and 60% less than its petroleum counterpart. Reduction in greenhouse gases from biodiesel and other bio-based fuels did not go unnoticed by the EPA (Environmental Protection Agency), and as a result, the agency established the RFS (Renewable Fuel Standard) program. The program requires transportation fuel sold in the United States to contain a minimum amount of bio-based fuels. Each year, the EPA sets its RVO (Renewable Volume Obligations) target for the amount of bio-based fuels to be blended with petroleum fuel. For 2015, 1.7 billion gallons of biodiesel is required to be blended to satisfy the government’s requirements. That number increases by 100 million gallons a year over the next two years, hitting 1.9 billion gallons by 2017, nearly tripling the 650 million gallons required in 2010.
To monitor the amount of biofuels being blended each year, the US government issues Renewable Identification Numbers (RINs) for every gallon of biofuel created. These RINs have a value which are embedded in the price of a gallon of biodiesel and can be used to offset tax liabilities of the company that either produces or blends the biofuel. The cost of a gallon of biodiesel is approximately the same as petroleum diesel once you strip out the cost of RINs and other embedded incentives. Besides the price of oil, biodiesels prices are also influenced by the price of soybean oil (the most common feedstock), RFS production levels, and the spot price for RINs. In addition to the RIN program, the Federal Government also incentivizes production of biodiesel with the Blenders Tax Credit (BTC). Established in 2005, the BTC provides a tax credit of $1.00/gallon to either a producer or blender of B100 biodiesel. In December of 2013, the BTC expired and its fate remained uncertain until it was retroactively reinstated in the last weeks of December 2014. Currently, the US Senate is working on a tax extenders package that would reinstate the $1.00/gallon biodiesel blenders tax credit.
Even though demand for biodiesel continues to grow, refining biodiesel remains a challenging business. The ongoing uncertainty surrounding whether Congress will renew the BTC along with the EPA's nearly 2 year delay in updating their RVO targets (the new targets were just announced May 31, 2015) have lead to volatile biodiesel prices and margin pressure. This uncertainty and price volatility actually create an opportunity for REGI. Being the largest domestic biodiesel refiner, Renewable Energy Group has significant competitive advantages over many of its competitors. With feedstock representing 80-90% of production costs, REGI's multiple refineries, production size and its ability to "fill-in" for higher amounts when needed provides the company with the ability to reduce production costs. Additionally, REGI’s refining plants have been constructed or retrofitted to provide the flexibility to refine a variety of feedstocks; 83% of REGI's feedstock comes from animal fats, white and yellow grease, used cooking oils, and inedible corn oils. Soybean oil is the most common and expensive feedstock and is used by the majority of biodiesel refiners, especially refiners that are also agricultural processors (Cargil, ADM, Louis Dreyfus Commodities and AGP). This flexibility in sourcing provided REGI with a $0.25/gallon advantage over competitors in 2014. As the market continues to consolidate, it is expected that REGI will expand its footprint, acquiring strategic properties at distressed levels.
Renewable Energy Group's recent acquisition of LS9, a R&D company focused on development of renewable chemicals, is expected to create cheaper feedstocks, reducing the production cost of biodiesel. It is estimated that development of alternative feedstock, as well as continued optimization of its refining process, could reduce Renewable Energy Group’s production costs by as much as 35%. LS9 will also allow REGI to expand into the growing segment of renewable commercial grade chemicals and lubricants used in paints & coatings, manufacturing lubricants, health and beauty, home products, and the plastics industry. Additionally, the movement into renewable chemicals will also allow REGI to deemphasize its dependency on the volatile biodiesel market while moving into the more stable and higher margin chemical market.
Renewable Energy Group is a tale of two companies: A company that has matured along side the often volatile biodiesel industry, emerging as its progressive leader; and a company, through recent acquisitions and organic growth that is expanding into the complementary and stable renewable chemicals industry. REGI's current stock price reflects the continued uncertainty surrounding government incentives. But even if these headwinds were to remain for the foreseeable future, the price of REGI stock still provides upside potential with limited downside risk.
Critics of the biodiesel industry are quick to point out that without government programs like the RFS, RINs, and the Blenders Tax Credit, most of the biodiesel refiners would be hard pressed to turn a profit. One of the main reasons why the government is supportive of the biodiesel industry is because it solves three problems: Reduces US dependency on fossil fuels, provides an opportunity to recycle agricultural and animal fat waste, while helping to reduce greenhouse gases. It is also important to point out that the US Government also provided loans and tax incentives to the solar industry over the past decade. In 2006, the US produced 6,000 Mwh of electricity from solar energy; today, it is estimated that the US has 20 Gwh (20,000 Mwh) of capacity from solar which is now a viable energy source. More telling is that the cost of an unsubsidized kilowatt hour produced from a solar cell has fallen to around $0.13 vs. $0.12 from coal. Solar energy produces less than 1% of total electricity used in the US, and it will never unseat coal, natural gas, nuclear or even wind's production levels. However, without the support of the US government, solar energy would never have grown into a practical and clean energy source.
Hazelton Capital Partners - Xerox (XRX) 76.8% Gain
In 1972, comedian George Carlin had a routine called: "Seven Words You Can Never Say on Television." You can use your imagination (or Google) as to what those seven words were. Five of the seven words were "four" letter words. When I was growing up, the term "four" letter words were those words considered offensive and never to be used in public. Investing has its own list of "four" letter words that should never be used to describe an investment: "Pray," "Wish," "Want," "Love," and the most dangerous of all: "Hope." Whenever an investor finds himself using one of these words to describe an investment thesis, he should immediately take notice and reevaluate.
Xerox is a symbol of a bygone era when copiers were cutting edge technology and ruled the business world. The same technology that brought the copier into the office soon ushered in the networked printer. However, the demand for networked printing was short-lived as technology, once again, disrupted the printing industry by providing electronic documents that could be created, edited, shared, distributed and read without ever printing a single page. Except for specialty and industrial sales, Xerox copier revenues have been in steady decline. Xerox does not profit from the initial sale of the copier; its profits come from the financing, servicing and supply contracts that are attached to each sale. Finance, service and supply contracts are structured as multi-year contracts that provide both recurring and predictable revenues. In fact, nearly 80% of Xerox's total revenues are recurring. Copier related services account for approximately 30% of recurring sales with the remaining revenue generated by Document & Business Process Outsourcing (BPO).
In early 2010, XRX purchased Affiliated Computer Services (ACS) for $6.4 billion. ACS specialized in BPO for a growing number of commercial, government and non-profit organizations. These companies were looking to cut expenses by contracting out their human resource, finance, and accounting responsibilities. Even though XRX had an established BPO operation, the merger between the two companies had very little overlap. In fact, it seemed very synergistic as Xerox had the brand and strong customer relationships world-wide, while ACS brought the infrastructure and operating expertise to the table. Xerox financed the deal by issuing approximately 500 million shares of stock, diluting its current share holders. Even though Xerox laid out plans to use future cash flows to repurchase shares and increase their dividend, share holders did not react favorably to the dilution. By July 2010, the stock had fallen 30% from its April high.
Hazelton Capital Partners began investment in Xerox starting in mid summer of 2010 and continued to add to the position opportunistically over the subsequent years. Our investment thesis did not rely on a reversal in the copier market, but rather a steady generation of cash and improved margins from the company's acquisition of ACS. At the existing share price, as long as management fulfilled its promise to repurchase shares and increase dividends, and did not do something stupid along the way, the value of Xerox would be meaningfully higher than where we were purchasing it.