David Jackson The Green Investor

My last column looked at the case for ethanol, and concluded that every one of the three leading types of ethanol by source (corn, sugar, and bio-waste) has advantages and challenges.

This time, I'm going to look in more detail at two ethanol stocks: small cap Pacific Ethanol and large cap Cosan.

A Small Cap Play on Corn Ethanol

Pacific Ethanol, Inc. (PEIX) produces and markets corn-based ethanol primarily in the western United States. It owns ethanol production facilities near the point of consumption in California, Colorado, and Oregon, believing that this will give it a competitive advantage as the cost of transporting ethanol is higher than the cost of transporting corn.

Corn-based ethanol was the darling of investors through mid-2006, and Pacific Ethanol rode that enthusiasm to a peak of $42 a share. Now, with the stock trading between $5 and $6, the company has a market cap of not much more than $200 million.

Pacific Ethanol COO John Miller outlined the company's strategy on a conference call with analysts: "Our strategy consists of growing our market share and keeping our total sales well ahead of our production volume. Then we add low-cost production capacity in locations where we believe we have a sustainable economic advantage."

Corn Up, Ethanol Down

Adding production capacity doesn't seem to be a problem. Pacific Ethanol says it's on track to expand its annual production capacity to 220 million gallons this year and 420 million gallons in 2010. PEIX booked 2006 revenues of $226 million, and that should jump to over $450 million for 2007 when final results are reported.

The company's challenge lies in the "sustainable economic advantage" part of its strategy. Sure, producing ethanol close to where it's consumed reduces transport costs. But Pacific Ethanol, like other companies that produce ethanol from corn, is facing more serious economic challenges: Its profit margins are caught in the vise of rising corn prices and falling ethanol prices.

On the conference call I quoted from above, for example, the company described how its cost of corn rose 7 percent between the second and third quarters of 2007 (from $4.23 per bushel to $4.54), while the price it received for the ethanol it produced fell on concerns of a supply glut.

Pacific Ethanol is upbeat about future demand for ethanol: "We continue to believe that the economic and environmental imperatives will drive new demand for ethanol steadily towards 10 percent ethanol volume in all U.S. gasoline over the next several years. We were also encouraged by recent comments from Energy Secretary Bodman that the country needs to move towards higher level blends between 12 percent and 20 percent by volume to help address the severe energy challenges ahead." Dramatically higher demand would likely boost the price of ethanol.

True Believers Only

But the stock is hard to value. Analyst consensus is that Pacific Ethanol will lose $0.07 this year on over $700 million in revenue. It's hard to project how profitable the company will be in future years, since so much depends on government policy (including subsidies for ethanol) and the future price of corn.

If you're a believer in corn-based ethanol, and think that government policy will drive huge increases in ethanol consumption and corn prices will fall, PEIX is likely a buy now. The time to buy stocks is before the good news hits, when sentiment is negative.

However, if you share the concerns about corn-based ethanol outlined in my last column, or doubt whether government policy will promote corn-based ethanol, or think that high corn prices may rise further, Pacific Ethanol is a risky bet.

Rising to the Challenge

Perhaps in recognition of the challenges facing corn-based ethanol, Pacific Ethanol is moving into cellulosic ethanol. Along with two partners, it received a matching grant of $24.32 million from the U.S. Department of Energy to build the first cellulosic ethanol plant in the northwestern United States. The plant will produce ethanol from wheat straw, wood chips, and corn stover.

But before you get too excited about PEIX's expansion into cellulosic ethanol, remember that the cellulosic ethanol production technology for the new plant was developed by BioGasol ApS, not Pacific Ethanol. Also, the plant won't be completed until the fourth quarter of 2009.

If you want to research PEIX in more depth, start with unfiltered information straight from the source: the most recent transcript of the company's conference call with analysts. You'll be able to read the company's own description of its business, the short-term challenges it faces, and the issues that concern the analysts who follow the stock.

A Large Cap Play on Sugar and Sugar-Based Ethanol

Brazil-based Cosan Group is the largest grower and processor of sugarcane in the world, the largest ethanol producer in Brazil (and the second largest in the world), and the largest sugar producer in Brazil (and one of the three largest sugar producers in the world).

Last April, Cosan created a new parent company listed on the New York Stock Exchange with a superior level of corporate governance and compliance with Sarbanes Oxley, and also SEC supervision. That company, Cosan Ltd. (CZZ), has a market cap of $2.9 billion and had 2007 revenues of $1.68 billion.

The company operates 17 mills, 2 refineries, 2 port facilities, and numerous warehouses. These facilities are located in the southern-central region of Brazil, which is one of the world's most productive sugarcane regions.

Trends and Questions

Cosan identifies four trends in its favor:

• Increasing global demand for ethanol.

• Increasing global sugar market opportunities, as demand for sugar rises in developing countries and developed markets gradually drop their price protections.

• Further consolidation of sugar producers in Brazil.

• Strong future demand for alternative energy in Brazil.

A key question for investors in Cosan: Is this stock more leveraged to sugar or to ethanol?

A Sweet Rebound

After a tough 2007, during which excessive global output led to a collapse, the price of sugar is now rising. Surpluses are shrinking, and production capacity is being taken offline where it's uneconomical. Agricultural commodity prices are generally rising, and hedge funds perceive sugar as a particularly undervalued commodity.

Gary Dorsch, one of the smartest commentators on global investing, says, "Fund managers are pouring billions of dollars into commodities across the board, as a hedge against the explosive growth of the world's money supply, competitive currency devaluations, and the negative interest rates engineered by central banks. To the chagrin of central bankers, much of new money pumped into the global markets is also going into commodities, instead of the stock market."

Yet even with rising sugar prices, Cosan is focused on profiting from ethanol rather than from sugar. Cosan purchases 40 percent of the sugarcane that it uses to produce ethanol and sugar from third-party sugarcane growers, so Cosan would suffer from a rise in sugarcane prices.

Remember that ethanol production from sugarcane has higher energy efficiency than ethanol produced from other feedstocks. Ethanol from sugarcane has an energy output/input ratio of 8.3 versus 1.9 for sugar beets, 1.3 to 1.8 for corn, and 1.2 for wheat. And sugarcane has the highest ethanol productivity per hectare among currently commercially viable renewable fuel feedstocks.

Bouncing Back, for Now

In its October earnings call, Cosan indicated that it's using its "maximum capacity to produce ethanol," as it believes that "ethanol prices vis-a-vis sugar prices will be more attractive to us in this inter-season."

Bear Stearns analyst Marc McCarthy argues that "Cosan, having bounced from its lows, is unmatched in size, liquidity, management strength, and corporate structure." Cosan's stock has risen from a 52-week low in November of $9.53 to about $14.50. The stock now has a trailing P/E of about 18.

What could go wrong? Like other agricultural producers, Cosan is exposed to weather and other environmental risks. Sugar demand should grow as developing countries become wealthier, but in developed countries artificial sweeteners may reduce demand for sugar. Moreover, despite the fact that it trades on the NYSE, Cosan is a Brazilian company. In the past, investors in Brazil have worried about political and economic stability and risk of devaluation. (Much of Cosan's revenue is billed in Brazilian currency, so a devaluation of the real would hit the dollar-denominated stock.)

If you want to research Cosan further, here are two must-read sources: The prospectus for Cosan's NYSE listing describes its business in detail and is a great primer on sugar and sugar-based ethanol. And the transcript of Cosan's most recent conference call provides an update on the company's business and strategy, and a Q-and-A session with analysts.