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BIOF Biofuel Energy Corp Significantly Undervalued Short Thesis is Wrong

August 27, 2014 | About:

This article is response to a article written by New Capital on Seeking Alpha on the July 21, 2014 titled, "BioFuel Energy – Day Traders Pushed The Price Above Reasonable Limits."

The writer of that article has taken a short position in BIOF and argues that there are a number of reasons why he thinks the price of Biofuel Corp is to high and that he thinks insiders are selling 49% of their equity stake JBGL. I show below that a number of his points are in fact incorrect and that BIOF, actually represents a very interesting long investment opportunity. (I hold a long position in BIOF)

A quick background, Biofuel Energy is a failed ethanol producer that completely exited ethanol business in Nov 2013 and remained a shell company with $10.7m in net cash and $179m in federal NOLs (expiring in 2028). In order to utilize NOLs, a company's main shareholder Greenlight Capital (35.4%) and Jim Brickman (founder of JBGL) have proposed a reverse merger with JBGL Capital – unlisted residential property developer that is owned and controlled by the same Greenlight Capital and Brickman.

First, the New Capital states that "Insiders are selling out, so should you". This in incorrect. Yes, insiders are reducing their stake in the company but to nowhere near the extent that the New Capital claims which he says is 49% of their JBGL stake.

In fact what is really happening is that insiders are swapping their JBGL equity for debt and equity, in the new entity. David Einhorn (Trades, Portfolio) currently holds 2.2 million shares in BIOF and is the majority shareholder in JBGL. Post the reverse merger Einhorn will essentially swap his stake in JBGL for BIOF debt and equity. As the capital structure of the new entity will change Mr. Einhorn will swap a part of his JBGL equity for $150million of high yield debt in the new entity. Hence Mr. Einhorn will continue to own a part the JBGL Enterprise, but in part will do so by being invested higher up in the capital structure. Clearly Mr. Einhorn must still believe that the JBGL enterprise is a good investment for him to hold the company's debt.

Additionally through the rights offering, Mr. Einhorn will purchase 1.76 million shares for a consideration of $8.76 million of BIOF stock. In addition Mr. Einhorn and Mr. Brickman will swap part of their equity in JBGL for equity in BIOF by receiving 11.14 million shares as part of the equity issuance. What New Capital has failed to mention is that this portion of share will equate to a dollar consideration of $69.28 million meaning that for this part the insiders will be receiving their shares at a price of $6.23 per share a premium to the rights offering price. This shows that the insiders are willing to swap part of their JBGL equity for a higher price than that being offered through the rights issue. Clearly this shows that both Mr Einhorn and Mr Brickman think that the BIOF shares are worth more than 6.23 per share post transaction.

Since the cash portion of the transaction will be $205 million not $220 million as New Capital states it means that in fact the insiders will only be selling a portion of their JBGL equity being $55m ($205 million cash portion of transaction less $150 million debt =$55m) This equates to only 20% of the transaction value not 49% as the short seller mentions. It is not uncommon for insiders to take some chips off the table when they take a company public, and 20% is hardly a huge amount.

What this all means is that Greenlight Capital and Mr. Brickman will still own roughly 80% of the Enterprise Value post consummation of the acquisition. To me this hardly looks like insiders are trying abandon ship and in fact shows that they are willing to continue to hold a large stake in the enterprise.

Additionally Daniel Loeb (Trades, Portfolio) of Third Point, one of the best investment firms out there, and a current owner of BIOF shares is not a shareholder of JBGL and hence will definitely not be a seller. In fact third point will be increasing its stake in the company by taking up its full subscription rights and has also agreed to fully exercise its oversubscription privileges and purchase all of the available shares not otherwise sold in the rights offering. This is something that New Capital conveniently did not mention. Furthermore Third Point will receive priority over all other holders in the allocation of shares available to fulfil oversubscription requests. Clearly we can see that Third Point is a keen buyer of BIOF and will be increasing its stake in the company from 1m shares to 5.2m shares, an increase of over 420%.

As a side note both Greenlight and Third Point purchased BIOF shares back in 2007 at price that I estimate ranged between $9-11. ( See their respective fillings) Hence they must believe that the shell company alone and its tax assets are worth considerably more then $9-11.

Next the New Capital mentions that the "share count will increase fivefold." This is not really a sensible statement to make without mentioning the fact that right now BIOF is just a shell company but post issuance of the new shares, will own a company with rapidly increasing future earnings 50% in FY15 as well as quality management and land assets. Hence it makes perfect sense to issue new shares if it means that in return the shareholders will take ownership of a quality asset.

So the question really becomes what is BIOF worth post the transaction? Given JBGL's historical performance and strong expected earnings growth I view the company as a growth stock. (I do not agree with New Capitals negative view of the housing market). Hence I believe the best and simplest way to value the company is to apply a PE multiple to future earnings.

To do this I first look at the companies' Pro Forma financial statements in order to estimate earnings per share (EPS). I make some adjustments to Pro Forma FY13 earnings (based on S1 doc) to estimate FY14 and FY15 EPS. By taking FY13 net income of $4.7m and adding back the BIOF salaries expense (which I think will be eliminated once the companies merge) of $8.1m plus and the selling, general and administrative expense of $1.63m I come up with adjusted net income of $14.43m for the new entity. (this number is very similar to if we were to take the net income of JBGL for FY13 equal to $32m, subtract $15million in new debt interest payments and $3m in taxes) I then divide $14.43m by 31.4m in shares to come up with a new entity eps of 46 cents. I use the companies eps growth projections of 5% in 2014 and 50% in 2015 to come up with eps of 48 cents and 72 cents per share for 2014 and 2015 respectively.

With the forward 2015 PE on the S&P500 currently at 14.86 I argue that the new JBGL should trade at a premium to the general market due to its strong earnings growth profile (50% expected EPS growth in 2015). I also argue that this premium is warranted due the fact that David Einhorn (Trades, Portfolio) has a very strong investment track record and will be guiding the company in its capital allocation. Additionally, to date, management has done a wonderful job of growing the business. With a significant equity stake in the new BIOF, management will have every incentive to push for further growth. This in turn should translate to increased shareholder value. Hence I apply a PE multiple of 17 to FY15 EPS of 72 cents which brings the post transaction valuation of BIOF shares to $12.24 per share.

Investors who purchase the equity at current prices (last $10.95) and participate in the rights offering can create the new entity shares for $6.84 per share. (10.95 + 2.2245*5). This would mean that investors would be entering the investment at a significant discount to the $12.24 post transaction valuation.

Furthermore, given that David Einhorn (Trades, Portfolio) has an excellent investing track record and a investing style that seems to follow a lot of Warren Buffett's principals, he may in fact turn BIOF into a mini Berkshire Hathaway, using it to make future acquisitions. Given his investment track record such action if taken could provide significant upside to BIOF shareholders(think of early Berkshire Hathaway shareholders that invested 30 years ago and the returns they achieved), which is currently not being priced into the shares.

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