Tuesday, August 01, 2006

Growth Investing :: Recapitulation Part III

In the first and second parts of this series on growth investing we looked at two elements that are hallmarks of a successful growth company.

  1. The ability to grow turnover (sales generated by each unit of operating assets)
  2. The ability to earn excess economic profits.

Using just these two ideas we can see that the ethanol industry is not populated by growth companies. Many companies in the industry are experiencing rapid sales and profit growth. Yet they are not real growth companies creating long term value. A rising tide is lifting all boats, but none of the boats is getting bigger

The first reason is that a pure play ethanol producer [Pacific Ethanol (PEIX) Aventine Renewable Energy (AVR), VeraSun Energy Corp.(VSE) etc] cannot grow total asset turnover. The business model for an ethanol company is that you put X units of carbohydrates in, and get Y units of ethanol out. There is no way to increase the efficiency of this process. It is physically limited by the ability of yeast to ferment glucose into alcohol.

Distillation and fermentation technologies have been under development since 700 AD. It is reasonable to assume that no distiller has proprietary technology which gives it a lasting competitive advantage over other producers.

If you want to get more ethanol, you will have to invest in larger facilities. These companies cannot growth revenues without additional capital expenditure, and that increase is always proportional to the investment. None of these companies can increase the return on operating assets over time. They will never see the rewards of growth on growth.

Growth on growth what growth investing is really about, the ability to invest/reinvest at an increasing rate of return. Imagine a savings account earning 5%. Now imagine another savings account earning 5%, but with the interest rate rising each year. Clearly the second account is better, and will outearn the first account.

Because ethanol is fungible (a fancy way of saying that ethanol from one company is interchangeable with ethanol from another), ethanol distillers operate in a competitive market. Every supplier is the same, and the sale goes to the lowest bidder. You can’t raise prices in such a market. Over time the ethanol market will settle into an equilibrium in which no excess economic profits are earned.

The combination of an inability to increase return on operating assets and eventual maturation into a competitive market without pricing power, means that companies in the ethanol sector will not accomplish real excess growth.

2 Comments:

At August 03, 2006 2:02 PM, Anonymous Anonymous said...

Your conclusion might be correct, if there was no way to increase the yield of ethanol from the fermentation process, as you suggest. However, yields have improved steadily from the 1980's. The use of other feedstocks also offers potential for yield improvement.

You're correct about fungibility -- my ethanol looks a lot like your ethanol. But yield ? It's going to get even better. Life, as Michael Crichton suggests with dinosaurs, finds a way.

 
At August 03, 2006 10:22 PM, Blogger Market Participant said...

I'm not so optimistic as you are. Other than using sugercane, the pure starch from corn is pretty much the perfect substrate.

Yeast techologies have petty much topped out. Every company can eventually come up with its own strain of ninja yeast. However ultimately you end up being limited by the reaction kinetics.

 

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