Top Five Ethanol Picks

This is not the best sector to play, but if you must, here are your safest bets.
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With corn prices up and ethanol prices down, profit margins for ethanol producers are brutally slim.

Shares of many ethanol companies have been in a freefall for months, a number plunging 50% or more, even as interest in alternative energy continues to gather momentum.

What's the problem? The market has a glut of ethanol, and there are still more than 80 new refineries slated for construction in the next year. And this comes at a time when corn-based ethanol is facing mounting criticism for its role in driving up food prices and questions about whether other feedstocks are less reliant on fossil fuels in the first place.

Though it's difficult to look past the growing hurdles, a few ethanol companies should ultimately prove hardened enough to survive, especially if the politicians in Washington provide an assist.

Ronald Miller, CEO of

Aventine Renewable Energy


, said in a speech last fall that many of the proposed ethanol plants ultimately won't receive financing if the broader problems persist.

That's great news for the best-of-breed ethanol companies. A thorough cleansing of the space is exactly what they need to eliminate the oversupply and fatten their margins.

Most analysts agree that stocks in the ethanol space will likely remain flat through 2008. However, investors with a slightly longer time horizon could reap rewards. Of course, not all names are created equal, so your best chance to find a winner lies in five stocks. Don't confuse this with a ringing endorsement. Instead, think of these as the best houses in a struggling neighborhood.

Top Players



is the popular favorite in the pure-play ethanol space, boasting the strongest analyst ratings of any name in the sector. The fact that its average rating is neutral reflects the problematic economics of the ethanol space itself, rather than the way that VeraSun is being managed.

The company harbors the most ambitious expansion program of any of its peers. After it announced last month that it will acquire

US BioEnergy


, its production outlook surpassed agriculture giant

Archer Daniels Midland

(ADM) - Get Report

, with an expected capacity of 1.75 billion gallons of ethanol by the end of 2008.

Like many producers, VeraSun is planning to extract and sell distillers grain as a byproduct of the ethanol-production process. The distillers grain can be sold as cattle feed. But VeraSun wants to go a step further and extract refined corn oil from the distillers grain, which the company says will increase its profit margins and make it more competitive than its peers.

VeraSun's growing operations are clearly visible in its financials. It generated $221.9 million in revenue in the third quarter, a 49.7% increase from the prior year. However, tighter profit margins hammered its bottom line, and earnings for the quarter fell to $7.8 million from $32 million.

Still, all things considered in an industry with substantial uncertainty, VeraSun is the best of the lot.

Next up is Archer Daniels Midland, which produced 1.07 billion gallons of ethanol last year and is planning on output of 1.62 billion gallons by 2010. As a broad agriculture company with various other businesses, ADM can adjust its capital spending when the ethanol environment starts to hurt, and its diversity is its advantage.

ADM did just that last year when corn prices rose above $4 a bushel and ethanol prices bottomed out near $2 a gallon. It moved more corn toward its sweeteners and starches business and less toward ethanol.

SMH Capital analyst Robert Lane thinks that agriculture names like ADM could be the best bet for investors who want exposure to ethanol. "Ag companies have the strongest position because they can run an arbitration model and decide whether it makes more sense to grind and sell their corn as food or to distill it into ethanol," he says.

Additionally, companies with ethanol refineries can operate similarly to natural gas companies, running the refineries at peak when the price of ethanol is highest. In contrast, most pure-play ethanol companies have to run their refineries full-bore all the time.

Buying Inputs

Green Plains Renewable Energy

(GPRE) - Get Report

is a smaller player ($92 million market cap) with a strategy that could pay off. It has one plant that produces 50 million gallons a year and another under construction, but it isn't counting on volume to increase its profitability.

Instead, the company plans to expand vertically to better control its profit margins, according to Scott Poor, director of investor relations. Green Plains is awaiting the approval of a merger with the Great Lakes corn cooperative, which will give it access to corn at wholesale prices. As high corn prices are largely responsible for the sector's bout of underperformance, this tactic could prove lethal to other companies of Green Plains' size.

Green Plains is a new company, and it first reported revenue in August. Its stock hasn't been kind to believers thus far, dropping by nearly half in the past 12 months to $12.75. However, if its merger with Great Lakes goes through, Green Plains could be well positioned to post margins that could handily beat out its peers.

Among the pure-play ethanol producers, Aventine Renewable Energy boasts the second-largest production train below VeraSun. Its $490 million market cap also puts it No. 2 to VeraSun ($1.2 billion) in terms of valuation.

Like VeraSun, Aventine can use economies of scale to squeeze out competitors, and its relatively strong balance sheet could allow it to go shopping for existing refineries.

Aventine has also done something unusual by creating a distribution network that transports its competitors' ethanol. This network of railcars and ethanol terminals provides Aventine with a relatively reliable cash-flow stream separate from its own ethanol sales.

Regardless of this effort, Morningstar analyst Michael Tian recently wrote in a report that he doesn't think Aventine "has sufficiently differentiated itself from other ethanol producers."

In short, if you have to pick one name, VeraSun might be the better option.

Geographic Distinction

Finally, there's

Pacific Ethanol

(PEIX) - Get Report


Most ethanol producers are located in the Midwest. Transporting that ethanol to blending stations that are typically along the coasts can be expensive. Pacific Ethanol is taking an alternate route, building small plants on the West Coast with better access to its customers.

The company will sell its distillers grain byproduct like most ethanol producers. Distillers grain usually must be dried to extend its shelf life, and drying the grain requires natural gas. Pacific Ethanol can bypass this process by building plants near cattle yards. This allows it to deliver its distillers grain wet, saving the company money on its energy bill.

Pacific Ethanol also has a very ambitious construction plan which would boost its production capacity from 60 million gallons in 2008 to about 400 million gallons at the end of 2010. But the cost of building plants has risen dramatically in the past year, and Tian thinks that this schedule could be too ambitious.

As infrastructure for the distribution of ethanol spreads across the country, Pacific Ethanol's protected market in the Northwest will be opened up to competition, and it will ultimately have to produce ethanol as cost-efficiently as its peers. For now, though, it has geography working in its favor.

I've set up a portfolio to track these five stocks. Check out the Ethanol Portfolio at