Quarterly Update After Earnings Part IV: Vertex Energy $VTNR

Nothing could be finer than buying a refiner

Welcome to Part IV of the quarterly earnings call update, this final installment with regards to Vertex Energy (VTNR).  

In every investment that goes against me by more than just everyday market volatility, I try to figure out where I went wrong to prevent making the same mistake twice.  The big red flag that I should have seen with VTNR was their prioritizing renewable diesel over traditional refining while their term loan had an interest rate of SOFR + 10.25%.  When a business is paying 16%, their only priority should be getting to profitability, paying down debt, and refinancing at a lower rate.  If VTNR had focused on streamlining their traditional refining first, they would be in a much different position today.  

Vertex Energy (VTNR), when I met with management in February there were three options to get out from under their debt burden, and management preferred them in the following order:  The first option was to sell a portion of the Mobile refinery to a joint venture partner, Bank of America was chosen to handle the process.  The second option would be to sell the legacy used motor oil recycling business in Louisiana, preferably if they could get $200 million for it based on the Ohio comparison, but the market for renewables is currently weak.  And the third would be to refinance their debt and bootstrap their way out of this mess.  

It appears that the JV process may have failed.  I say may have failed because VTNR recently acquired two new loans, one for $15 million and one for $20 million.  With the $15 million loan there were warrants issued to the lender that resulted in 0.5% dilution at a strike price above the current share price.  With the $20 million loan there were warrants issued to the lender that resulted in 2.5% dilution at a strike price of $0.01.  If this second transaction is indicative of their current financial stress, then that is a huge problem as it indicates that the dilution needed to bring VTNR to profitability will mostly wipe out shareholders.  

Have you ever watched Shark Tank and thought that the dilution was large for the money offered?  Well, for a strategic partner, it is worth it.  How much value is added when Lori Griner puts your product on QVC?  Maybe she deserves her 30% for $50,000?  If the 2.5% dilution warrants were because VTNR felt that the lender was a strategic partner, then the dilution would not be indicative of the path forward, and while the lender is anonymous, I have heard rumors about who it is.  

The new $20 million loan included a requirement to bring on board a restructuring officer, Seth Bullock, details below.  It also temporarily relaxed certain leverage requirements which might indicate that VTNR is in the process of refinancing the whole term loan as in option 3.  The CFO believed in February that with execution risk off the table after bringing the refinery into operation, lenders would offer closer to 10% - 12% instead of the current 16%.  Due to the negative net income, I have my doubts that refinancing would be as low as 10%, but perhaps if they did an asset secured loan, their 1,500 acre parcel on a deepwater port at current prices would be $75,000,000 of collateral, give or take, not including plant and equipment.

https://www.alvarezandmarsal.com/our-people/seth-bullock

So assuming VTNR can either refinance, do a joint venture, or some combination of the two, how far away is profitability?  First, the current net income looks worse than it is.  VTNR originally bought a lot of renewable diesel feedstock at the peak of the cycle and has been running down their inventory.  Those barrels were produced at a loss, but that loss was baked into the cake when the inventory was purchased.  Releasing that inventory created some positive cash flow, but negative net income.  Going forward, only the traditional refining will be contributing, and in the first six months of 2024, conventional refining contributed $30 million of EBITDA.  When compared to the $67 million of annual interest expense, there is still a problem, but a somewhat manageable one.

The conversion of the hydrocracker to conventional fuels and the startup of the Texas tower should all happen in Q3 of 2024, with Q4 of 2024 showing us what kind of efficiency the refinery is capable of with the new upgrades.  My best guess of what the Texas tower will do to the bottom line is about $7 million per quarter as efficiency gains should be about three percentage points more of high value product over low value product.  I have no guess as to how many percentage points gain of efficiency the hydrocracker can provide.  But even just with the Texas tower and the closure of the renewable diesel, that would put 2025 EBITDA for the first time more than enough to cover interest expense.

The Texas Tower:

Par Pacific (PARR) has a production yield of 73% compared to VTNR’s 64%, just as an indication of what is technologically possible with capex.  Every percentage point increase in efficiency gained should result in just a bit over $2 million quarterly.  An increase to 73% efficiency would add $80 million of net income a year, give or take.

Also, VTNR has slowly been getting control over the wholesaler’s margins that were contractually tied up with Shell for several years after the acquisition.  The first product to come out of lockup was bunker fuel, the picture below is the new vertical that VTNR created by bypassing the wholesaler and delivering bunker fuel directly to nearby ports.  In the last six months this new vertical contributed $3.5 million in EBITDA.

Bunker Fuel Delivery:

The aviation fuel contract rolled off, and VTNR signed an offtake agreement on April 1st of 2024.  I have no estimate as to how much this new vertical should be for VTNR.  I would be really punting to say $5 to $10 million annually.  The big change will happen around Q2 of 2025 when the gasoline and diesel come out of contract and VTNR can manage the truck ramp business.  This is estimated to generate “dozens of millions” of EBITDA per year for VTNR.

So between the new verticals and the efficiency gains, VTNR’s traditional refinery in its final form can cover interest expense and pay down debt.  That final form would be $60 million EBITDA run rate currently, $20 to $40 million from efficiency gains, $7 million from bunker fuel, maybe $5 to $10 million from aviation fuel, and $25 to $35 million from the gas and diesel truck ramp.  That would be $127 to $152 EBITDA run rate starting in Q3 of 2025.  The only big problem is the money to be spent in Q3 of 2024 before the transition to being cash flow positive in Q4 2024, and how much dilution will be required to borrow new money and refinance the old debt.  

If VTNR could even refinance $100 million in a ten year asset backed loan against the refinery at 9%, and $100 million unsecured at 12%, interest expense would drop by $11 million annually.  That would bring the current $67 million annual interest expense down to $56 million.  Boot strapping themselves out of this situation doesn’t seem so farfetched, but the risks of further dilution into Q3 and Q4 of this year are very real.

As a rule of thumb, I don’t invest in companies with imminent dilution.  But in this instance, the hidden asset in the truck ramp, and the aligned incentives of having a founder CEO with 7% ownership in the business make me somewhat confident that dilution will be the bare minimum required to bring VTNR into Q2 of 2025 where their fortunes should improve.  Of course there is always the dreaded widowmaker, the crack spread.  A collapse in the highly cyclical refining margins could put huge pressure on VTNR, and surviving through that downturn with such an upside-down balance sheet would result in massive dilution, or the refinery being handed over to the lenders.  It’s a race against time to see how much balance sheet improvement VTNR can execute before the next major crack spread bear market.