Long-Term Planning Mitigates Risks from Prolonged Downturns

Advisors provide guidance and tools to achieve more sound financial footing.
By Frank Baumgardt | May 15, 2015

Ethanol plants are exposed to market forces over which they have little control, such as the price of commodities (ethanol, the cost of corn and natural gas), transportation rates for feedstock, and government support policies (e.g., potential changes to the RFS). Any commodity-based business is subject to sudden and prolonged market disruption, as recently experienced when the drop in oil prices put pressure on ethanol prices. In this economic environment, how can a plant stay profitable?
When best laid plans fail and plants encounter financial difficulties, an experienced financial advisor who has worked with ethanol companies and other stakeholders and interested parties, such as lenders and investors, can prove to be indispensable. There are several strategies to mitigate the risks being faced in the current environment and lessons learned on ways to improve the financial position of ethanol plants and ensure the long-term viability of their operations.

The ethanol industry had a record-setting year in 2014, with generous crush margins leading to high profitability for many plants. These high margins evaporated, however, toward the end of 2014 as falling crude oil prices resulted in lower gasoline prices that in turn pressured ethanol prices, as illustrated in the accompanying chart. With little economic incentive to increase ethanol blending beyond the regulatory minimum and limited demand from the export market, ethanol producers continue to face industry overcapacity and challenging market conditions into 2015.

FTI Consulting has significant experience working with ethanol plants that faced financial distress in recent years and would like to share some lessons learned to help the industry weather the current unfavorable conditions and avoid the fate of companies such as Bionol Clearfield LLC, a 110 MMgy ethanol plant completed in 2010 at a cost of $270 million, which was idled in 2011 as the ethanol buyer breached its contract. The plant was sold in bankruptcy in 2012 for only $9 million.

External factors largely determine the profitability of an ethanol plant. When crush margins come under pressure, as they are now, plant managers have the option to reduce production, including idling facilities, to mitigate operating losses. However, depending upon the length of time a plant faces unfavorable conditions, financial reserves may be depleted before markets improve. For a plant with debt in its capital structure, idling production does not alter the debt amortization or interest schedule, which can lead to liquidity issues, covenant breaches or missed debt payments.  If not addressed through a planned response to these challenges, the timetable and options available diminish and the company potentially loses control.

Avoiding Financial Distress
Leverage (financing a plant with debt) can increase the profitability of a plant by providing a relatively cheap source of money, but it also increases the risk to a plant’s viability when operating results deteriorate. Reducing the amount of debt will reduce the risk of financial distress, as a plant is relieved from the cash constraints of a strict debt payment schedule. Having access to sufficient reserves to meet debt obligations during prolonged periods of negative margins is another option to mitigate the default risk. These options require long-term planning which is not a luxury that many possess if already under financial distress. There are other measures that can be taken in advance that may be effective short-term solutions.

Conducting a financial analysis of the operating costs relative to sales prices will provide management with meaningful guidance for the business operations. The goal of this exercise is to determine the breakeven point of the plant’s profitability, which is driven by various factors, many of which are unique to each plant. In cases where operating economics have deteriorated beyond the breakeven point, a plant can reduce output or idle the plant entirely in order to reduce cash burn and stabilize the overall financial health of the operation. The break-even analysis is similar to a crush margin analysis but should include the cost of raw materials and the sale prices for all products, not just ethanol. A review of existing contracts and opportunities to hedge certain price risks also should be included in the analysis. Given the continued fluctuation of commodity prices driving an ethanol business’ profitability, companies should review and refresh their breakeven analysis on a periodic basis.

If an ethanol plant faces difficulties meeting its debt obligations, prompt intervention can significantly improve the outlook for the facility. Interested parties benefit if there is a way to keep a plant in business rather than face the cost and uncertainty of bankruptcy. Dealing with financial distress is a new situation for most ethanol producers who, while experts at converting corn into ethanol and DDGS, are not typically as experienced in navigating day-to-day interactions with lenders that may be required in times of financial adversity. An outside advisor who focuses on financial restructuring will analyze the maturity profile of the existing debt and its alignment with forecast cash flows and asset mix to develop alternative capital structures and refinancing options that meet the needs of the business and lenders for the particular operating environment. Involving an outside party that specializes in distressed situations and has the experience to navigate this process can provide significant value, such as assisting with forecasting cash flows; implementing cash preservation strategies; and identifying, planning and executing on strategic options that preserve the business while demonstrating to lenders that collateral value is being maximized through solutions that avoid bankruptcy. The core of the financial advisor’s work should include analyzing all business aspects of the ethanol plant, recommending change where needed based on biofuels industry knowledge and situation-specific considerations, and presenting that information to lenders in a manner that will foster cooperation.

While an ethanol producer may be reluctant to share information in periods of distressed financial conditions, navigating lender debt work out processes requires carefully orchestrated communication of facts, as well as information supporting the preferred way forward for the company. There is a balance between communicating the situation and providing sufficient visibility to allow creditors and investors to make informed decisions. For example, if inventory management can be improved and the corresponding value is demonstrated in refined economic models, lenders may realize that their exposure is mitigated by amending existing loan covenants. One aspect of the role of a third-party advisor is similar to that of a translator:  The advisor speaks the same language as the lenders, which allows the advisor to present the information from the ethanol plant in a format that is easily understood by the lenders, ultimately facilitating resolution of the situation in as positive and constructive a manner as is available.

When to Seek Help
Financial difficulties become harder to resolve the longer they linger. Once debt covenants have been breached, many options are off the table. An analogy that rings true comes from experience skiing in my home state of Colorado: If I’m wondering whether I’m going too fast, then I’m probably going too fast. Accordingly, if you think your operation might be headed for financial distress, it is likely a good time to have an initial conversation with experts in that field to see what can be done. While it may be counterintuitive to spend money on advisors when confronting a cash crunch, the ultimate payoff can be significant.

Author: Frank Baumgardt
Senior Director, Corporate Finance, Clean Technology
FTI Consulting Inc.