ALTO - Alto Ingredients: Poor Execution In A Favorable Market Environment - Avoid

2023-11-07 11:15:20 ET

Summary

• On Tuesday, shares of renewable fuel and specialty alcohol producer Alto Ingredients, Inc. plummeted by more than 50% after a surprise Q3 earnings miss.
• According to management, major unscheduled downtime impacted production volumes and the company's hedging strategy thus causing a shift to lower margin products.
• In addition, the company is experiencing weaker demand in its higher-margin specialty alcohol segment.
• Estimated construction costs for a key profitability enhancement project have increased by 70% thus resulting in the requirement to raise additional capital and delay the implementation timeline.
• Given poor execution, weak near-term prospects, and increased uncertainties regarding the company's ambitious long-term profitability enhancement roadmap, investors should avoid Alto Ingredients' shares for the time being.

Note:

I have covered Alto Ingredients, Inc. ( ALTO ) previously, so investors should view this as an update to my earlier articles on the company.

After marking a new 52-week high going into the company's Q3 earnings release on Monday, shares of renewable fuel and specialty alcohol producer Alto Ingredients cratered by more than 50% as results came in well short of expectations.

While revenues were slightly ahead of consensus estimates , earnings per share of -$0.05 missed analyst expectations of $0.09 by a mile.

Please note that things have changed, as just four weeks ago, a fellow contributor projected the company to beat expectations " by at least 100%, if not 200% " due to highly favorable crush margins during the quarter.

However, Alto Ingredients largely failed to capitalize on the most favorable market conditions in recent years, as outlined in the press release :

Our third quarter results reflect the contribution from stronger ethanol crush margins partially offset by the impact of unusually high unscheduled downtime that lowered our anticipated production volumes and shifted our mix toward lower margin products.

On the conference call , CFO Rob Olander provided additional color on the issues experienced by the company (emphasis added by author):

Corn basis levels increased by $0.31 compared to Q2 2023, illustrating a sharp increase sequentially and by $0.03 compared to Q3 2022, demonstrating a similar supply and demand profile as last year.

In addition (...) we incurred significant increases in unexpected repair and maintenance costs. The associated downtime reduced anticipated production volumes . This adversely impacted our hedging strategy to lock in favorable market crush spreads, which resulted in derivative losses of $3.7 million and shifted our product mix to more wet ingredients that carry lower margins .

Year-to-date, our specialty alcohol sales were impacted by lower consumer demand . We are working with our customers to roll a portion of the 2023 contracted volume commitments into 2024 .

As such, sales and profitability were lower than expected for the third quarter. Additionally, we incurred higher feasibility and legal costs associated with our strategic capital projects .

The weakness in the higher-margin specialty alcohol business is particularly disappointing, as the company executed on a strategic realignment to focus on this segment a couple of years ago.

Adding insult to injury, estimated costs for developing primary yeast production have increased by 70%. Moreover, the anticipated construction period has been increased by 50% to 27 months:

The issues with one of the company's most ambitious profitability enhancement projects have caused management to push out previously stated Adjusted EBITDA expansion goals:

Based on these findings, changing capital requirements, and current capital market conditions, we have extended our EBITDA expansion goals by six to twelve months. We continue to evaluate various funding alternatives with potential financing partners and will prioritize projects with the greatest return on investment within an appropriate time frame.

Please note that Alto Ingredients will now require additional capital to execute on its more ambitious projects like primary yeast and carbon capture.

Given the need for additional funding in combination with the company's less-than-stellar execution, I wouldn't bet on the new timelines for Adjusted EBITDA expansion being met.

In fact, I wouldn't be surprised to see some of the company's projects being delayed indefinitely or even cancelled entirely going forward as access to affordable capital is likely to remain constrained for the time being.

But the bad news doesn't stop here. On the conference call, management outlined a number of issues potentially impacting Q4 (emphasis added by author):

First, during Q4, customer commitments are not solely based on market demand, rather they are reflective of buyers managing their fuel-grade inventory balances with the goal of minimizing inventory levels by year-end.

Second, winter buying patterns tend to start the day after Thanksgiving and typically demonstrate a deep decline in volumes from Q3 .

Third, with an intention to take advantage of higher crush margins in Q3, we postponed our planned winter facility outages until October .

Fourth, as we fill our fixed priced specialty alcohol sales booked for the entirety of 2024, we are also building our hedge portfolio. The derivatives we used to preserve the margin on these sales don't qualify for hedge accounting treatment, and the quarterly results can be materially impacted by mark-to-market unrealized gains and/or losses depending on commodity price swings .

In combination with lower crush margins, I would expect the company's results to fall well short of current consensus expectations again:

Moreover, the decision to delay scheduled maintenance at the company's wet mill from August 2023 to April 2024 is likely to impact Q2 results next year.

However, Alto Ingredients still generated approximately $16 million of free cash flow during the quarter thus resulting in sequentially improved liquidity and debt levels:

Bottom Line

Despite a highly favorable market environment, Alto Ingredients delivered disappointing third quarter results and indirectly warned investors of a weak Q4.

Adding insult to injury, the company is facing substantial cost increases in one of its key capital expansion projects thus resulting in the requirement to secure additional financing and push-out previously communicated Adjusted EBITDA expansion targets.

Considering the operational missteps and need to raise additional capital, the Board of Directors should likely consider putting the company or at least some of its key assets up for sale, very much as requested by activist investor Jeremy Raper in his letter to the Chairman in late June.

Given poor execution, weak near-term prospects and increased uncertainties regarding the company's ambitious long-term profitability enhancement roadmap, investors should avoid Alto Ingredients' shares for the time being.

However, considering the massive selloff in the shares, I have decided to abstain from assigning an outright " Sell " rating for now.

Risk Factors

Following Tuesday's 50%+ selloff in Alto Ingredients, Inc. shares, activist investors are likely to put more pressure on the Board of Directors to consider strategic alternatives, including major asset sales. The initiation of a strategic review clearly has the potential to provide a boost to the stock price.

In addition, ethanol crush margins tend to be volatile. Any sustained margin increase from current levels would greatly benefit the company's earnings and cash flows.

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