Why I Didn't Short KiOR
Ed. note: This piece was first published on Robert Rapier”s R-Squared Energy Blog.
In a recent column on the metric of “success” in Cleantech, I wrote that the measure of success that will matter to most people is whether the company sells energy at an affordable price:
I simply don’t think that the fact that one can talk up a company and then IPO it at a profit is the proper metric for success. Some of those companies that have been IPO’d are grossly overvalued. Many of them won’t be around for long. (In fact, I wrestled hard this week with a decision to short one of them; I ultimately decided not to – but not because I don’t think the company is grossly overvalued). So is a company that is IPO’d, makes initial investors some money, and then ultimately goes bankrupt without producing energy a success? Not for the general public it isn’t. Those “successes” do not help wean us off of oil.
The company that I considered grossly overvalued and thought about shorting was KiOR, a company that Vinod Khosla IPO’d earlier this year. Some people already knew this, because they wrote to me and asked. In fact, at least one venture capital firm called me a month ago and asked which company I thought was so overvalued. When I wrote that article, KiOR sported a market capitalization of right at $2 billion. Between the time I wrote that article and now, one analyst downgraded KiOR, the National Academy of Sciences released a report suggesting that KiOR will have a tough time competing against projected oil prices, and KiOR’s market cap has been shaved by 25%.
There are three questions I would like to answer about KiOR that touch on areas of due diligence and investing (both of which I will be talking about at this year’s ASPO Conference). First, why did I feel that the company was so overvalued? Second, why didn’t I short the company myself? And third, why didn’t I name them in my essay?
There were a couple of reasons that I considered KiOR to be grossly overvalued. The first comes from a comparison to competing companies. KiOR aspires to convert woody biomass into fuel. There are a number of companies – some publicly traded, some not – that are doing the same thing. Take a company like Ensyn. They have been doing the wood to pyrolysis oil route for more than 20 years, and have operated a 75 dry ton per day facility for the past four years (which I actually visited a couple of years ago). They are in a joint venture with UOP called Envergent Technologies to produce transportation fuel from pyrolysis oil. UOP is the gold standard for upgrading many types of oil, and thus they are a very credible partner in this venture. So I see Envergent being far ahead of KiOR at this stage as far as actually demonstrating they can convert wood into fuel.
Then I look at a company like Rentech. Their approach is different; they are gasifying biomass and then converting it into fuels. In fact, Rentech’s product is transportation fuel while KiOR’s will still need to be converted in a refinery. Rentech is run by people with a great deal of gasification experience. (Full disclosure, Rentech’s CTO and Executive Vice President was my manager at ConocoPhillips (COP), Harold Wright). At COP Harold oversaw the construction of a 400 barrel per day gas-to-liquids (GTL) facility that started up ran successfully. Rentech reported a profit in the latest quarter (albeit due to a fertilizer plant they own), owns two unique gasification technologies, operates the only integrated GTL facility in the United States (demonstration scale at 400 gallons per day) and has several projects in their pipeline. If you ask me which company – KiOR or Rentech – is more likely to be producing fuel 10 years from now my answer would be Rentech. Their market cap? $200 million, a tenth that of KiOR’s (Update: Rentech has risen to $250 million over the past week).
Finally, look at the product. KiOR is trying to produce a commodity, and they do not have a significant (if any) advantage over competitors. Should they ultimately be successful, their profit margins will be at best in line with those of other energy companies. While oil companies get a lot of press for having huge earnings, that’s not because they have huge profit margins. They have small profit margins but operate at enormous scale. Even if KiOR’s wildest projections prove true, they are going to be a tiny fraction of the scale of an integrated oil company, and therefore their small profit margin is going to translate into a small profit (again, at best) and a price to earnings ratio in line with that of an oil company (generally mid to high single digits). KiOR has been priced for explosive growth, but I can’t see them producing enough revenue to fuel explosive growth.
Why Not Short It Myself?
I wasn’t kidding when I wrote that I wrestled with this decision. Over the years, there have been a number of companies that I believed were overvalued, and potentially destined to go out of business (not suggesting the latter for KiOR). In 2006, I wrote about a company called Pacific Ethanol (PEIX). I was convinced that they too were grossly overvalued for reasons I spelled out in that article. Their market cap when I wrote that article was around $500 million after briefly exceeding $1 billion. I took some heat from people who insisted that I didn’t understand the big picture, and since people like Bill Gates were investing in them that I was an idiot for suggesting they were overvalued.
Three months after I wrote that article, Pacific Ethanol’s valuation was down 40%. Today’s market cap on PEIX is under $8 million (down more than 98% from when I wrote the article), and they have been through a Chapter 11 bankruptcy since then. After the stock had plummeted, I heard from a brokerage who told me they had advised their clients to short the stock, partially on the basis of my article. So, I had some regrets over failing to take action based on my analysis. I helped others make money, but I earned nothing even though I was exactly right on my assessment.
Another case is Xethanol, where I also made $0 despite being exactly right on my assessment. Xethanol went bankrupt, as I thought they would. Dallas Mavericks owner Mark Cuban made some money, but again I didn’t act on my own convictions. (Mark Cuban did offer me free Mavs tickets for my assessment – but I was never able to take him up on that offer).
So along comes KiOR. I told a colleague recently that if there was one thing I was certain about, it was that KiOR is not a $2 billion company. My expectation was that the value would be shaved by at least $1 billion. So I started looking into shorting it, and then I remembered why I don’t short stocks.
Shorting isn’t like just buying a stock. If I am convinced that a company is undervalued (as was the case with PBR in 2008), then I can buy it and just wait. But you can’t do that with shorting. I could be correct that within three years the share price of KiOR is a fraction of its current value – and yet still lose my shirt. There are two reasons for this. The first is that I have to borrow shares in order to short them, and I have to pay interest on what I borrowed. I checked, and I would be paying something like 9% interest while I waited for the share price to fall. So I need to be right not only on the direction, but on the timing. If the fall comes later rather than sooner, that 9% interest will eat into my return.
But the second reason is more problematic. Even a completely worthless company (again, not saying that about KiOR) can be bid up to ridiculous values. Consider once more Pacific Ethanol’s $1 billion market cap. Had I shorted them on the way up – say at $200 million – my position would have been wiped out as the market cap rocketed to over $1 billion before plummeting. So you have to be right not only on the direction and timing, but you have to hope that exuberant investors don’t bid the price up before the fall. When I am buying – as long as I am not doing so on margin – a short-term price drop doesn’t hurt me. When shorting, a short-term price spike can wipe you out.
Had I been able to simply make a bet that the value of KiOR would be lower than $2 billion in two years, I would have done that. But to my knowledge there is no investment vehicle that works like that.
But a final reason for not shorting is that it compromises my ability to write about the company. That’s not exactly a deal-breaker; after all I can short and tell people why I shorted. But then anything I write about KiOR after that would be viewed with suspicion. I would have a vested interest, and therefore some people would dismiss my arguments by simply saying “Yeah, but he shorted the stock. What do you expect him to say?”
I do have investments in the area of energy (after all, I believe you should invest in what you know), but I don’t write about those companies. If I mention them, I disclose my investments, but it is cleaner just to not write about them so there is no question. If I get too involved in investing in energy companies, it won’t be long before everything I write can be cast in terms of “Yeah, but is that an objective analysis, or because he has a vested interest?” If I short KiOR, then criticisms of any of Vinod Khosla’s other investments will be suspect in some people’s eyes.
Why Not Name Them?
There are two reasons that I didn’t name them. The first is that I don’t want there to be a perception that my prediction was a self-fulling prophecy. If I wrote a negative article and then the stock price fell, some may blame me, rightfully or not. I know because some angry investors blamed me for Xethanol’s plunge (note that I am not insinuating that I can influence a stock price – I am just addressing perceptions here). So I want to avoid the perception that I influenced a company’s prospects. That’s the same reason I didn’t name Range Fuels in my predictions for 2011. I wrote:
I also expect that the bills are going to start coming due for some of the high profile ‘next generation’ biofuel producers, and that we will see bankruptcies from some of the companies I have discussed in this column. Some of them – probably most of them – do not have a sustainable business model, and the length of time they will be able to avoid bankruptcy is going to be solely dependent on how much cash they can manage to get infused into their operations.
I was thinking specifically of two companies when I wrote that: Range Fuels and one other that has gotten a government loan guarantee (which I think will ultimately go the way of Solyndra) and will probably eek out another year or so before going belly-up.
The second reason is that I am not being paid to provide investment advice. I can be right nine times out of ten, and that one time I will have to deal with people who are angry over my free advice. And of course even if I am completely right about a short, the longs will be angry with me. So I just don’t see any benefit, but lots of downside, to offering free investment advice on publicly traded companies.
I adopted this position after a couple of incidents with companies I have discussed in this column. Pacific Ethanol and Xethanol were two examples. I was right, but I dealt with criticism from investors of both companies. But what if I had been wrong? I took a risk for no reward. I could have invited lawsuits from some random investor who lost money on the basis of my comments. So I try to play it safe.
Then why name KiOR now? Because they have already been downgraded and the stock has already started to fall. In fact, another blogger recently weighed in with the same sort of internal analysis that I had done:
The author, who did short KiOR, quotes me in the article and ultimately concludes that “KIOR’s present fair value is less than 10% of the current market valuation.” He also notes that it is “rumored” that the stock price is being propped up by one of the major investors buying up the float. That isn’t a rumor; you can see it in the SEC filings for KiOR.
So at this point, I am not saying anything that others have not now begun to say publicly. But I will continue to be very careful about publicly criticizing specific publicly traded companies because I do not want to influence anyone’s investment decisions on the basis of an article that may be lacking some specific caveats about the company.
I will continue to discuss big picture trends, but this blog will never provide specific investment advice. I will try to provide the tools and perspectives needed to do the technical evaluation for specific companies and sectors, but your ultimate investment decisions should be entirely your own.
As far as KiOR, I have been asked about the company’s prospects numerous times. I wrote an article about them previously – Crude Oil From Biomass: Evaluating KiOR in which I discussed their process. In a nutshell, I think they have a technology that does work and is scalable. However, I mention in that article that I think the nature of their product has been misrepresented – it is by no means a crude oil equivalent. Based on the nature of their product, it is hard to envision that the company will have high profit margins. Therefore, I will be stunned if they sport a multi-billion dollar market cap 2 or 3 years from now.
Further Reading: Due Diligence: How to Evaluate a Renewable Energy Technology