Grease Costs More at Bio-Diesel Pioneer Gushan Energy

• The Company: Gushan Environmental Energy, China’s largest producer of biodiesel as measured by annual production capacity.
• The Filing: Form 6-K filed with the SEC on August 15, 2008.
• The Finding: Jianqiu Yu, Chairman and Principal Executive Officer, said Gushan Environmental plans to raise its annual biodiesel production capacity from 290,000 tons to 400,000 tons by the end of 2008 and 600,000 tons by the end of 2009. Despite a continuing shortage of diesel supply in China, however, operating profitability at the company could come under pressure in coming quarters.

The Upshot: Gross profit margin for the second-quarter of 2008 ended June 30 fell 250 basis points year-over-year to 41.3 percent. Respective increases in sales volume of biodiesel of 21.8% (to 59,921 tons) and average selling price per ton of 33.5% (to $865.00) were more than offset by a decline in sales of higher margin, chemical by-products, such as erucic acid and erucic amide (sold directly to foundry, pharmaceutical, and food customers).

In addition, the overall average unit costs for the primary feedstocks, vegetable oil offal and used cooking oil, escalated 31.2% year-on-year to $348.40 per ton in the second-quarter of 2008, a result of Gushan’s suppliers passing on their own running cost increases.

As Gushan expands operations to new locations in China, management expects the usage ratio of used cooking oil to increase because used cooking oil is more readily available in these expansion areas, according to the company’s 2007 annual report filed on June 30 with the SEC.

Unlike vegetable oil offal, used cooking oil produces comparatively lower quantities of by-products. By utilizing a greater percentage of used cooking oil as a portion of raw materials, management expects the percentage of revenues contributed by by-products to decrease, which could adversely impact profitability.

Direct users (including marine vessel operators and factories), petroleum wholesalers, and individual retail gas stations represented 47.6 percent, 34.2 percent, and 18.2 percent, respectively of 2007 biodiesel revenue.

The government of the People’s Republic of China controls the retail price of biodiesel through ‘guidance pricing.’ As such, Gushan is looking to expand sales to chemical customers (at higher average selling prices than it receives from other direct users). These customers use biodiesel to produce a variety of products, including elasticizers, surfactants, leather greasing agents, and anticoagulants

The Question: Can Gushan shift more production to higher-margin chemical markets to offset potential volume losses of profitable by-products?