Darling International (DAR) is North America's oldest, largest, and probably the most innovative recycling and recovery solutions company serving the nation's food industry. The company is going through a transition within their business model and this evolution is presenting investors with an opportunity to purchase a company at value prices.
The company has undertaken several disparate acquisitions in the last several months presenting large potential synergy and cross-selling opportunities while offering investors the potential of a multi-bagger over time.
Recently, the Environmental Protection Agency surprised the biofuels industry by keeping the biomass-based diesel standard at 1.28 billion gallons next year, unchanged with 2013. The industry will far surpass that in production and is forecasted to hit 1.7 billion gallons by the end of December. This led to the share price falling 17% in a short time frame.
Business Overview
Darling International collects and recycles animal by-products and used cooking oil from food service restaurants and provides grease trap cleaning services to many of the same establishments. The company processes raw materials at 120 facilities located throughout the US, into finished products.
The business is operating out of two segments: Rendering (82.6% of total revenues) and Bakery (17.4%).
The rendering operations process animal by-products and used cooking oil into fats (primarily BFT, PG and YG), proteins (mostly feed grade and pet foods) and hides. They also provide the grease trap servicing to food service establishments in exchange for a collection fee. The company provides all these services under its Dar Pro Solutions brand.
The segment then produces finished products primarily through grinding, cooking, separating, drying, and blending of various raw materials. Using centrifugal technology, the company separates the oils and grease to create 'meals.' The meal is then sifted through screens and ground further to produce sized protein meal.
The bakery feed segment is a processor of bakery residual materials and processes the raw materials into bakery by-product (BBP), including Cookie Meal, an animal feed ingredient primarily used in poultry feed. The raw material is collected from large commercial bakeries that produce a variety of products including cookies, crackers, bread, dough, and potato chips.
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Drivers of the Business
Just by reading the above description, it is clear that the business is highly dependent on a number of factors:
- Finished product commodity prices
- Raw material volumes - the ability to procure these oils and fats
- Production volume and related yield of finished product
- Energy prices for natural gas that powers the facilities
- Collection fees and operation expenses
- Manufacturing process operating expenses
The finished products are a commoditized good in that Darling holds little pricing power over the end customers.
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Average prices for each of the underlying product lines can be volatile by type and by geography. Below are the average prices for 2012 and 2011 as reported to Jacobsen, an established trading exchange publisher used by the industry to monitor pricing and performance data on most biodiesel and by-product residuals.
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Approximately 75% of their raw material is procured under a processing agreement, whereby margins are established and the risk is shared. The balance is a "fee for service" business model which does contain more inherent risk. Raw material is well diversified:
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Industry
The US livestock sector processes more than 150 million head of cattle, calves, hogs, and sheep and more than 55 billion pounds of poultry annually. In addition to human consumption, the meat processing industry produces a significant amount of by-products that are transformed into approximately 20 billion pounds of feed and industrial products in the form of various types of fats and proteins.
Darling has just 13% of total raw material market share which means they have significant room to grow. The industry has evolved over the last decade into a shared-risk procurement model as pricing protocols have reduced exposure to commodity price fluctuation and also provide a floor in margins. US meat production (in lbs.) has been a steady but slow grower over the last decade at +1.13% per year according to the USDA. Darling has grown its share of the business both through acquisitions and organically.
The industry is setup with the large integrated renders, typically owned by the meat processing companies themselves, for example Tyson, Smithfield, and Cargill, and small independent processors who collect and process from many sources including small meat processors, meat processing facilities, grocery stores, restaurants, and other entities along the meat production chain.
Acquisition Spree
In 2010, Darling bought Griffin Industries Inc., a provider of value-added rendering, bakery feed, and cooking oil recycling services and is the precursor to the current form of the company. This acquisition for $840 million significantly increased the size (roughly doubled it) and scope of the company and made it the number one independent food by-products recycler. There was little overlap in collection point facilities and the purchase helped round out the geographic footprint of Darling. The combination also created a more diversified supply chain in the operations.
Effective August 26, 2013, Darling acquired all of the shares of Terra Holdings Company, for $121.4 million in cash. Terra will increase the company's rendering portfolio by adding to the existing rendering businesses that collect grease while adding an industrial residuals business as a new line of service for the company's rendering raw material suppliers within the rendering segment.
Darling purchased Rothsay, a division of Maple Leaf Foods, on October 28th, 2013 for CAD$645 million and significantly expanding the company's reach in Canada while creating North America's largest provider of independent rendering and recycling services. Rothsay had six rendering plants in Manitoba, Ontario, Quebec and Nova Scotia and also a biodiesel operation in Quebec. Rothsay had EBITDA of CAD$85 million in each of the prior two years.
In early October 2013, Darling purchased Vion Ingredients, a division of Vion Holding for the sizeable price of $2.2 billion. Vion Ingredients is a renderer of animal by-products into a variety of end products serving the pharmaceuticals, food, feed, pet food, fertilizer, and bio-energy markets. In fiscal 2012, revenues were $1.6 billion while EBITDA was approximately $200 million. The company is financing the purchase with a combination of bank debt, public debt, and equity. They expect the transaction to be immediately accretive to earnings per share before synergies and one-time charges- always a key statement to look for in acquisition announcements by management.
Joint Venture with Valero
Diamond Green Diesel is a joint venture between Darling and Valero Energy Corp. (VLO) to produce bio-diesel using recycled food by-products. The refinery will be located in Norco, Louisiana and began production earlier this year with a capacity of 9,300 gallons per day or 137 million gallons a year.
The company reported an investment of $116.3 million at the end of the third quarter, as compared to $62.5 million at the start of the year. Net income from the venture was $12 million for the quarter compared to a net loss of $0.8 million a year ago. The increase is a direct result of the commencement of the venture's operations and sale of renewable diesel fuel in late June as compared to noncapitalized expenses during the construction phase in the prior year.
The total projected cost is $427.5 million including working capital expenses funded with $206.5 million in partners capital along with joint venture debt of $221 million.
The process by which Green Diesel differs from traditional biodiesel is in the molecular structure:
Renewable diesel is a true hydrocarbon just like diesel and meets ASTM International's standard for Diesel Fuel Oils (D-975). It has a different molecular structure from biodiesel, which is a methyl-ester. Because of this structural difference, renewable diesel is a superior product with a higher cetane index than typical ultra-low sulfur diesel (ULSD), and unlike biodiesel, an energy density value equivalent to ULSD.
Renewable diesel can be distributed using the established petroleum pipeline system, while biodiesel requires truck or rail transport. Additionally, renewable diesel has no cold-flow issues and won't thicken and clog engines in cold weather as may happen with biodiesel.
Environmentally Friendly Process
The process by which Darling converts these by-products into its end-state products are much more modern and environmentally friendly compared to the most common form of food recycling, composting. The slide below shows a nice illustration of the process and compares it to the typical composting operation. It is possible that new rules and regulations passed down from the Environmental Protection Agency could make the old process obsolete, greatly increasing Darling's value.
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EPA RVO Numbers for RFS
On November 15th, 2013, the Environmental Protection Agency announced its proposed biofuel volumes for 2014 for the Renewable Fuel Standard. For the first time since the US passed the Energy Independence and Security Act in 2007, which contained the first biomass-based diesel requirement, the amount of biofuels for all categories was reduced.
The EPA's release of the 2014 renewable fuel standard (RFS2) renewable volume obligations (RVO) proposed biomass-based diesel at 1.28 billion gallons. The details also make it probable that producers will carry-forward compliance credits, driving the production volumes even lower, closer to 1 billion gallons. This would likely reduce raw material demand by 2.5-3 million tonnes.
Today, the majority of gasoline sold in the US is now "E10" which is fuel with up to 10% ethanol. Production of renewable fuels has been growing rapidly in recent years. Since production has increased so rapidly and significant supply has come online, the country has now reached what is dubbed the "E10 blend wall," the point at which the E10 fuel pool is saturated with ethanol. If gasoline demand continues to decline due to weak economic growth and better fuel (CAFE) standards, continuing the growth in ethanol would require greater use of higher ethanol blends such as E15 and E85, or its export.
Diamond uses the most economical feedstock available in an effort to be the low cost producer of the highest quality product capable of fulfilling the RFS2 biomass diesel mandate. To produce the 137 million gallons per year would require over 1.1 billion pounds of distillers corn oil, yellow grease, or poultry fat. This represents over 10% of the total raw material of those segments.
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The utilization of lower priced feedstock allows for some margin of safety for operating margins. Additionally, as noted in the caption from Darling above, the processing of the materials into the finished product is more energy efficient than the traditional biodiesel process. The first quarter 2013 cost per gallon for Diamond was $0.12 while the entire biodiesel industry average was $0.16. Lastly, since Diamond utilizes higher pressures and temperatures than for traditional biodiesel processing, the process is "exothermic" meaning the heat generated results in little actual energy usage during the entire process.
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If E85 (85% ethanol, 15% gasoline) comes online at a faster rate, the biofuel industry is likely to benefit greatly as it would eliminate the current blendwall. Until then, the biodiesel industry will rely on traditional operating leverage and lowest cost producer advantages.
In the third quarter, the JV had an issue with heat exchangers and procuring and shipping the "right" raw materials. They admitted to running low on inventory and impacted feedstock prices within the region. They ended up transporting some soybean oil which narrowed the margin spread considerably (see chart on cost per gallon: cost per gallon of soybean oil is one of the highest which reduces margins considerably). Management indicated that earnings would have been $0.03 higher had they been able to use the feedstock they wanted.
Rebound from 2012 Results and Future Growth
The principal factors that contributed to the $82.3 million decrease in operating income over 2011 were decreases in finished market product prices, net of reduced material costs, decreased raw material volumes, an increase in payroll and benefit costs and a prior year (2011) purchase contingency gain not recurring in 2012. All of these negatives were partially offset by a decrease in energy costs, primarily natural gas and diesel fuel along with an increase in yield.
On the call, management was sanguine about the prospect of higher prices going forward and the ability of the company to synergize the recent acquisitions. Additionally, they continue to manage their operating leverage and expense structure implementing a company-wide ERP-system that will help analyze efficiencies and improve the supply chain.
Valuation
Due to this cut by the EPA, the share price of Darling fell approximately $4 or 17% in less than a month. Wedbush Securities downgraded the stock based on the news of the EPA mandate for biodiesel. The thesis on the stock is currently relying on the fact that the entire biofuel industry will suffer because of these mandates without any discerning of which players will survive and which will cease operation. Given that Darling is one of the lowest cost producers out there and the ethanol producers are higher cost producers, currently, there appears to be an opportunity for the biodiesel players.
The newest biofuel (or next-generation biofuel) is cellulosic (non-food crop based) which is made from wood chips, switch grass, and other inedible plant-bases. The first commercial cellulosic plants are coming on-line and the advanced biofuel proposal of 2.2 billion gallons is 20% below 2013 levels, with a new cellulosic target of 17 million gallons. This is likely to chill any future investment with many plants that were slated to start production likely to be shelved or retooled for other uses. In other words, between high cost producers being forced out and new investment stifled, there is a decent chance Darling could actually benefit.
The new mandate will likely cause significant shake-out and consolidation in the industry with small-scale producers likely to be harmed the most. RIN values, used to track compliance of the renewable fuels standard, have been declining rapidly. Refiners have attributed this to excessive biofuel blending mandates. Valero, in its second quarter earnings release, anticipated the potential costs of complying with RIN credits of up to $800 million.
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Overall, too much focus is being placed on the biodiesel segment at the expense of the more diversified, stable, and growing rendering into feed business.
Recall, the overall profitability of the company is driven by raw material volumes and related yield on the finished products. Finished product prices were down sharply yoy with especially weak prices within the bakery segment (CORN).
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On a qoq sequential basis, the prices showed stabilization for average commodity prices for proteins and fats. However, corn within the bakery segment still showed considerable weakness mostly due to a strong yield within the industry and weaker demand. But, the company does hedge out corn prices and as of September, they had a nice unrealized gain of nearly $3 million in those derivatives.
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Over longer periods, you can see there is really more stability within the prices than the quarterly numbers suggest. In fact, over the first nine months, MBM and PM prices are up mid-to-upper single digits with BFT, PG, and YG down roughly the same.
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Additionally, the majority of their gross margin is protected through clauses within their contracts whereby raw material costs is based on a formula that passes-through some but not all commodity prices. The chart below is a good illustration of this 'built-in margin,' something I do not think investors appreciate fully.
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I typically do not like investing in or recommending the investment in, commoditized businesses. In Darling's case, there is a decent short-term opportunity resting on the massively lowered sentiment and large synergies likely to materialize.
EBITDA within the individual organization pieces before the acquisitions were: Darling core $140 million, Rothsay $80 million, VION $270 million, and Terra at $22 million equates to a total business run rate of roughly $500 million at the end of the fourth quarter without any changes to the underlying businesses. Applying a 6x EV/EBITDA multiple to that figure results in a business valuation of $3,072. Again this is without factoring the underlying price declines in the end-markets, the biodiesel mandate decline and the resulting decline in revenues from the JV, nor what will materialize and actually accrete to Darling post-mergers. With a share count of 119 million, this equates to a valuation of nearly $26 per share.
When companies are in a transition phase, I like to model several possible scenarios based on a bear case, base case, and bull case. I then compare the outcomes and the risk/rewards of the possible scenarios. Below are three scenarios and the probabilities in their outcomes:
Scenario #1- base case (50%):
Scenario #2- Bull case (15%)
Scenario #3- Bear case (35%)
The probabilistic outcome of 2015 figures equates to a valuation of approximately $26 compared to the current trading price of $20.51.
Risks
The company's finished products are, with minor exceptions, commodities which the firm has little control over. The changes in the price of corn, soybean oil, and other feedstock fluctuate in response to a number of outside factors. In addition, the market prices of raw materials would require the company to seek increased selling prices for the company's premium, value-added and branded products to avoid margin deterioration.
The business is dependent on the procurement of raw materials, which is the most competitive aspect of the company business, rather than the sale of finished goods. Pronounced consolidation within the meat packing industry has resulted in mass factory slaughterhouses the majority of which use captive renderers. Simultaneously, the number of small meat processors, which have historically been a dependable source of supply for non-captive renderers like Darling, have decreased significantly.
The joint venture, to which the company has significant investment within, is dependent on governmental energy policies and programs, such as the National Renewable Fuel Standard Program (RFS2), of which I described above as a source of the recent weakness in the shares.
Catalysts
- Long-term natural gas boom lowering operating costs
- Under appreciated synergies from acquisitions
- Rebound in prices for finished products
- Lower cost producer into BioDiesel Process
- Decent chance of a change in the Biofuels mandate
- Lower retail (RBOB) gasoline prices likely to increase demand
Conclusion
The recent sell-off by investors focusing solely on the EPA's RFS2 mandate for 2014 presents a buying opportunity. There are several short and long-term catalysts that have the potential to significantly reward investors. In the short-term, I think there is at least a reasonable shot the EPA updates their 2014 RFS2 biomass-based diesel mandate. That would surely boost the share price. Also in the near-term are the potential synergies from their acquisition spree which more than doubled the size of the company. As the company consolidates its operations, I think EBITDA will jump and significantly increase the value of the firm. This company has the potential to reward its shareholders with a multi-bagger over the next several years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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