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GEVO > SEC Filings for GEVO > Form 10-Q on 2-Nov-2012All Recent SEC Filings

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Form 10-Q for GEVO, INC.


2-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statements

This report contains forward-looking statements. When used anywhere in this Quarterly Report on Form 10-Q (this "Report"), the words "expect," "believe," "anticipate," "estimate," "intend," "plan" and similar expressions are intended to identify forward-looking statements. These statements relate to future events or our future financial or operational performance and involve known and unknown risks, uncertainties and other factors that could cause our actual results, levels of activity, performance or achievement to differ materially from those expressed or implied by these forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Such statements are subject to certain risks and uncertainties including those related to the achievement of advances in our technology platform, the success of our retrofit production model, our ability to gain market acceptance for our products, additional competition, changes in economic conditions and those described in documents we have filed with the Securities and Exchange Commission (the "SEC"), including this Report in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors" and in subsequent reports on Form 10-Q. All forward-looking statements in this document are qualified entirely by the cautionary statements included in this document and such other filings. These risks and uncertainties could cause actual results to differ materially from results expressed or implied by forward-looking statements contained in this document. These forward-looking statements speak only as of the date of this document. We disclaim any undertaking to publicly update or revise any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. Unless the context requires otherwise, in this Report the terms "we," "us," "our" and the "Company" refer to Gevo, Inc. and its wholly owned or indirect subsidiaries, and their predecessors.

The following discussion should be read in conjunction with our unaudited consolidated financial statements and the related notes and other financial information appearing elsewhere in this Report. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation our Annual Report on Form 10-K for the year ended December 31, 2011, as amended (our "Annual Report"), including the disclosures made in Part I, Item 1A "Risk Factors" and the audited consolidated financial statements and related notes included in Part II, Item 8 "Financial Statements and Supplementary Data", and the disclosures made in Part II, Item 1A "Risk Factors" of this Report.

Overview

We are a renewable chemicals and next generation biofuels company. Our overall strategy is to commercialize bio-based alternatives to petroleum-based products using a combination of synthetic biology and chemical technology. In order to implement this strategy, we are taking a building block approach. Initially, we intend to produce and sell isobutanol from renewable feedstocks. Isobutanol is a four carbon alcohol that can be sold directly for use as a specialty chemical in the production of solvents, paints, and coatings or as a value-added fuel blendstock. Isobutanol can also be converted into butenes using straightforward dehydration chemistry deployed in the refining and petrochemicals industries today. The convertibility of isobutanol into butenes is important because butenes are primary hydrocarbon building blocks used in the production of lubricants, rubber, plastics, fibers, other polymers and hydrocarbon fuels.

We believe that products derived from our isobutanol will be drop-in products, which means that our customers will be able to replace petroleum-based intermediate products with isobutanol-based intermediate products without modification to their equipment or production processes. The final products produced from our isobutanol-based intermediate products will be chemically and visually identical to those produced from petroleum-based intermediate products, except that they will contain carbon from renewable sources. Customer interest in our isobutanol is primarily driven by our production route, which we believe will be cost-efficient, and our isobutanol's potential to serve as a cost-effective, environmentally sensitive alternative to the petroleum-based intermediate products that they currently use. We believe that at every step of the value chain, renewable products that are chemically identical to the incumbent petrochemical products will have lower market adoption hurdles because the infrastructure and applications for such products already exist. In addition, we believe that products made from bio-based isobutanol will be subject to less cost volatility than the petroleum-based products in use today.

In order to produce and sell isobutanol made from renewable sources, we have developed the Gevo Integrated Fermentation Technology® ("GIFT®"), an integrated technology platform for the efficient production and separation of isobutanol. GIFT® consists of two components, proprietary biocatalysts, which convert sugars derived from multiple renewable feedstocks into isobutanol through fermentation, and a proprietary separation unit, which is designed to continuously separate isobutanol from water during the fermentation process. We developed our technology platform to be compatible with the existing approximately 23 billion gallons per year of global operating ethanol production capacity, as estimated by the Renewable Fuels Association. GIFT ® is designed to allow


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relatively low capital expenditure retrofits of existing ethanol facilities, enabling a rapid route to isobutanol production from the fermentation of renewable feedstocks. We believe that our production route will be cost-efficient and will enable rapid deployment of our technology platform and allow our isobutanol and the products produced from it to be economically competitive with many of the petroleum-based products used in the chemicals and fuels markets today.

We expect that the combination of our efficient proprietary technology, our marketing focus on providing drop-in substitutes for incumbent petrochemical products and our relatively low capital investment retrofit approach will mitigate many of the historical issues associated with the commercialization of renewable chemicals and fuels.

In September 2009, Gevo, Inc. formed Gevo Development, LLC ("Gevo Development") to develop isobutanol production assets using GIFT®. Gevo Development has a flexible business model and aims to secure access to existing ethanol capacity either through joint venture, tolling arrangements or direct acquisition.

For financial reporting purposes, we have determined that we have two operating segments. Our Gevo, Inc. segment is responsible for all research and development activities related to the future production of isobutanol, maintaining and protecting our intellectual property portfolio, developing future markets for our isobutanol and providing corporate oversight services. Our second segment is comprised of Gevo Development and Agri-Energy, LLC ("Agri-Energy") which is currently responsible for the production of isobutanol, ethanol and related products.

At September 30, 2012, we are considered to be in the development stage as our primary activities, since incorporation, have been conducting research and development, business development, business and financial planning, establishing our facilities including retrofitting the Agri-Energy Facility (as defined below), initial start-up operations for isobutanol production at the Agri-Energy Facility, recruiting personnel and raising capital. Ultimately, the attainment of profitable operations are dependent upon future events, including completion of our development activities resulting in sales of isobutanol or isobutanol-derived products and/or technology, obtaining adequate financing to complete our development activities, obtaining adequate financing to acquire access to and complete the retrofit of ethanol plants to isobutanol production, gaining market acceptance and demand for our products and services, and attracting and retaining qualified personnel.

Agri-Energy

In September 2010, we acquired a 22 million gallon per year ("MGPY") ethanol production facility in Luverne, Minnesota (the "Agri-Energy Facility"). In partnership with ICM, Inc. ("ICM"), we commenced the retrofit of the Agri-Energy Facility in 2011, and commenced initial start-up operations for the production of isobutanol at this facility in May 2012. From commencement of initial start-up operations through October 31, 2012 we have produced approximately 100,000 gallons of bio-based isobutanol for future sale and customer testing. We expect to conclude initial start-up operations in the second half of 2012. These initial start-up operations included production of initial quantities of isobutanol produced at commercial scale, completion of initial commissioning of new equipment and development of operating discipline at commercial scale. During the 2012 third quarter, and as a result of a lower than planned production rate of isobutanol, we made the strategic decision to pause isobutanol production at the Agri-Energy Facility for a period of time during which we plan to produce ethanol at the Agri-Energy Facility, based on our assessment of then current economic conditions for ethanol production while we focus on optimizing specific parts of our technology to further enhance isobutanol production rates. Factors which contributed to this strategic decision included, among others: (i) producing isobutanol at the current rates while working to improve production rates would result in operating the Agri-Energy Facility at significantly below break-even level; (ii) we believe we had the necessary information required from the isobutanol production to enhance production rates at our testing laboratory in Colorado; (iii) we believe we can produce positive cash flows at the Agri-Energy Facility through the production and sale of ethanol versus maintaining the facility at idle until we resume the production of isobutanol; and (iv) we believe that it is important to demonstrate to future potential production partners our ability to switch between the production of isobutanol and ethanol. We believe that the ability to switch between isobutanol and ethanol production mitigates, depending on market conditions, certain significant risks associated with start-up operations for isobutanol production. While we believe we will have the ability to switch between isobutanol and ethanol production at the Agri-Energy Facility, there is no guarantee that this will be the case. We intend to resume isobutanol production at the Agri-Energy Facility in support of future commercial operations once this work has been completed. Based on our progress to date we anticipate resuming isobutanol production at the Agri-Energy Facility in 2013.

The Agri-Energy Facility is a traditional dry-mill facility, which means that it uses corn as a feedstock. The retrofit of the Agri-Energy Facility includes a number of additional capital costs that are unique to the design of the facility, including additional equipment necessary to switch between ethanol and isobutanol production, modifications to increase the potential production capacity of GIFT® at the Agri-Energy Facility and the establishment of an enhanced yeast seed train to accelerate the adoption of improved


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yeast at the Agri-Energy Facility and at future plants. Further, total capital expenditures at the Agri-Energy Facility include upfront design and engineering expenses, plant modifications identified as necessary during initial start-up operations for the production of isobutanol as well as sales tax on equipment and capitalized interest. The enhanced yeast seed train will allow us to maintain direct oversight over our yeast material and provide on-site yeast production in the future.

We incurred approximately $21.2 million associated with design features for expanded capacity and the enhanced yeast seed train plus approximately $3.8 million for sales tax and capitalized interest. We do not anticipate installing an advanced yeast seed train at each future retrofit site. As of September 30, 2012, we have incurred total capital costs of approximately $55.6 million on the retrofit of the Agri-Energy Facility.

Until May 24, 2012, when we commenced initial start-up operations for the production of isobutanol at the Agri-Energy Facility, we derived revenue from the sale of ethanol, distiller's grains and other related products produced as part of the ethanol production process at this facility. Similarly, we expect to derive revenue from the sale of ethanol and distiller's grains during any period in which the Agri-Energy Facility is temporarily reverted to ethanol production, including the current reversion during which we will focus on optimizing specific parts of our technology to further enhance isobutanol production rates. However, the production of ethanol is not our intended business and our future profitability depends on our ability to produce and market isobutanol, not on continued production and sales of ethanol. Accordingly, the historical operating results of Agri-Energy and the operating results reported during the retrofit to isobutanol production will not be indicative of future operating results for Agri-Energy or Gevo once full-scale commercial isobutanol production commences at this facility.

Revenues, Cost of Goods Sold and Operating Expenses

Revenues

During the nine months ended September 30, 2012 and 2011, we derived revenue primarily from the sale of ethanol. Substantially all ethanol sold through Agri-Energy from the date of acquisition through September 30, 2012 was sold to C&N, a subsidiary of Mansfield Oil Company, pursuant to an ethanol purchase and marketing agreement. Our revenue also includes the sale of distiller's grains and other products produced as part of the ethanol production process to other third parties.

We also derived revenue from our grant and research and development programs. Our grant and research and development program revenue consists of the following: (i) revenues relating to government research grants and cooperative agreements; (ii) research services; and (iii) the procurement of our products for purposes of certification and testing.

Cost of Goods Sold and Gross Margin

Our cost of goods sold includes costs incurred in conjunction with the initial start-up operations for the production of isobutanol at the Agri-Energy Facility and costs directly associated with our ethanol production process such as costs for direct materials, direct labor and certain plant overhead costs. Direct materials consist of corn feedstock, denaturant and process chemicals. Direct labor includes compensation of personnel directly involved in the operation of the Agri-Energy Facility. Plant overhead costs primarily consist of plant utilities and plant depreciation. Cost of goods sold is mainly affected by the cost of corn and natural gas. Corn is the most significant raw material cost. We purchase natural gas to power steam generation in the ethanol production process and to dry the distiller's grains. We enter into forward purchase contracts and exchange-traded futures contracts associated with corn. Accordingly, our cost of goods sold also includes gains or losses and/or changes in fair value from our forward purchase contracts and exchange-traded futures contracts. See the discussion of accounting for derivatives below under the heading "Critical Accounting Policies and Estimates."

Our gross margin is defined as our total revenues less our cost of goods sold.

Research and Development

Our research and development costs consist of expenses incurred to identify, develop and test our technologies for the production of isobutanol and the development of downstream applications thereof. Research and development expense includes personnel costs (including stock-based compensation), consultants and related contract research, facility costs, supplies, depreciation and amortization expense on property, plant and equipment used in product development, license fees paid to third parties for use of their intellectual property and patent rights and other overhead expenses incurred to support our research and development programs. Research and development expenses also include upfront fees and milestone payments made under licensing agreements and payments for sponsored research and university research gifts to support research at academic institutions.


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Selling, General and Administrative

Selling, general and administrative expenses consist of personnel costs (including stock-based compensation), consulting and service provider expenses (including patent counsel-related costs), legal fees, marketing costs, corporate insurance costs, occupancy-related costs, depreciation and amortization expenses on property, plant and equipment not used in our product development programs or recorded in cost of goods sold, travel and relocation and hiring expenses.

We also record selling, general and administrative expenses for the operations of the Agri-Energy Facility that include administrative and oversight, labor, insurance and other operating expenses.

Critical Accounting Policies and Estimates

Our unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") and include our accounts and the accounts of our wholly owned subsidiaries, Gevo Development and Agri-Energy. The preparation of our unaudited consolidated financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the applicable periods. Management bases its estimates, assumptions and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Different assumptions and judgments would change the estimates used in the preparation of our unaudited consolidated financial statements, which, in turn, could change the results from those reported. Our management evaluates its estimates, assumptions and judgments on an ongoing basis.

The accounting policies and estimates, which we believe are critical and require the use of complex judgment in their application, are those related to:
(i) stock-based compensation; (ii) revenue recognition; (iii) cost of goods sold and derivatives; (iv) impairment of long-lived assets; and (v) accounting for convertible debt and embedded derivatives. Except as noted below, our critical accounting estimates and policies have not changed from those reported under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of our Annual Report.

Accounting for Convertible Debt and Embedded Derivatives

In July 2012, we sold $45.0 million in aggregate principal amount of 7.5% convertible senior notes due 2022 (the "Convertible Notes"). Terms of the Convertible Notes, include, among others: (i) rights to convert into shares of the Company's common stock, including upon a Fundamental Change (as defined in the indenture governing the Convertible Notes (the "Indenture")); and (ii) a Coupon Make-Whole Payment (as defined in the Indenture) in the event of a conversion by the holders of the Convertible Notes on or after January 1, 2013 but prior to July 1, 2017. We have determined that these specific terms are considered to be embedded derivatives in accordance with U.S. GAAP. U.S. GAAP requires embedded derivatives be separated from the host contract, the Convertible Notes, and carried at fair value when: (a) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract; and (b) a separate, stand-alone instrument with the same terms would qualify as a derivative instrument. We have concluded that the embedded derivatives within the Convertible Notes meet these criteria and, as such, must be valued separate and apart from the Convertible Notes and recorded at fair value each reporting period.

For purposes of accounting and financial reporting, we combine the two embedded derivatives and value them together as one unit of accounting. At each reporting period, we record this embedded derivative at fair value which is included as a component of convertible notes on the consolidated balance sheets.

We have used a binomial lattice model in order to estimate the fair value of the embedded derivative in the Convertible Notes. A binomial lattice model generates two probable outcomes - one up and another down - arising at each point in time, starting from the date of valuation until the maturity date. A lattice was initially used to determine if the Convertible Notes would be converted, called or held at each decision point. Within the lattice model, the following assumptions are made: (i) the Convertible Notes will be converted early if the conversion value is greater than the holding value; or (ii) the Convertible Notes will be called if the holding value is greater than both (a) the Redemption Price (as defined in the Indenture), and (b) the conversion value plus the Coupon Make-Whole Payment at the time. If the Convertible Notes are called, then the holder will maximize their value by finding the optimal decision between (1) redeeming at the Redemption Price or (2) converting the Convertible Notes.

Using this lattice, we valued the embedded derivative using "with-and-without method," where the value of the Convertible Notes including the embedded derivative is defined as the "with", and the value of the Convertible Notes excluding the embedded derivative is defined as the "without". This method estimates the value of the embedded derivative by looking at the difference in the values between the Convertible Notes with the embedded derivative and the value of the Convertible Notes without the embedded derivative.


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The lattice model requires the following inputs: (i) price of Gevo common stock;
(ii) Conversion Rate (as defined in the Indenture); (iii) Conversion Price (as defined in the Indenture); (iv) maturity date; (v) risk-free interest rate;
(vi) stock volatility; and (vii) estimated credit spread for the Company.

The following table sets for the inputs to the lattice model used to value the embedded derivative.

                                     Issuance Date        September 30, 2012
        Stock price                  $         4.95      $               2.14
        Conversion Rate                    175.6697                  175.6697
        Conversion Price             $         5.69      $               5.69
        Maturity date                  July 1, 2022              July 1, 2022
        Risk-free interest rate                1.62 %                    1.65 %
        Estimated stock volatility               72 %                      80 %
        Estimated credit spread                  30 %                      33 %

The following table sets forth the value of the Convertible Notes with and without the embedded derivative, and the fair value of the embedded derivative as of the issuance date and September 30, 2012 (in thousands).

                                                  Issuance Date            September 30, 2012
Fair value of Convertible Notes:
With the embedded derivative                     $        45,000          $             30,000
Without the embedded derivative                           17,000                        17,000

Estimated fair value of the embedded
derivative                                       $        28,000          $             13,000

Changes in certain inputs into the lattice model can have a significant impact on changes in the estimated fair value of the embedded derivative. For example, a decrease in the estimated credit spread for Gevo results in an increase in the estimated value of the embedded derivative. Conversely, a decrease in the price of Gevo common stock results in a decrease in the estimated fair value of the embedded derivative. From the date the Convertible Notes were issued through September 30, 2012, we observed a significant decline in the market price of our common stock which resulted in the $15.0 million decline in the estimated fair value of our embedded derivative from issuance through September 30, 2012.

Cost of Goods Sold and Derivatives (forward purchase contract and exchange-traded contract derivatives)

Our activities expose us to a variety of market risks, including the effects of changes in commodity prices. These financial exposures are monitored and managed by our management as an integral part of our overall risk-management program. Our risk management program focuses on the unpredictability of financial and commodities markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on our cost of goods sold and operating results.

We enter into forward purchase contracts for corn to be used in the production of ethanol. During 2011 we used the "normal purchases and normal sales scope exception" guidance of US GAAP for our forward purchase contracts and, as a result, they were not marked to market during 2011. To qualify for the normal purchases and normal sales scope exception, a contract must provide for the purchase or sale of commodities in quantities that are expected to be used or sold over a reasonable period of time in the normal course of operations. For new contracts entered into beginning January 1, 2012, we did not apply the "normal purchases and normal sale scope exception" to our forward purchase contracts and, as a result, we began to record forward purchase contracts at fair value. The changes in fair value associated with our forward purchase contracts which have been included as a component of cost of goods sold in our consolidated statements of operations, were not material during the three and nine months ended September 30, 2012.

We also enter into exchange-traded futures contracts for corn as a means of managing exposure to changes in corn prices. These contracts are recorded as a derivative asset or liability on our consolidated balance sheets at fair value. Changes in the fair value during a reporting period are recognized as cost of goods sold in our consolidated statements of operations.


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Both our forward purchase and exchange-traded futures contracts are considered to be derivatives and they do not include any credit risk related contingent features. We have not entered into these derivative financial instruments for trading or speculative purposes, and we have not designated any of our derivatives as hedges for financial accounting purposes. . . .

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