DARLING INGREDIENTS INC DAR
October 15, 2014 - 3:30pm EST by
Enright
2014 2015
Price: 16.66 EPS $0.00 $0.00
Shares Out. (in M): 165 P/E 0.0x 0.0x
Market Cap (in $M): 2,751 P/FCF 0.0x 0.0x
Net Debt (in $M): 2,227 EBIT 0 0
TEV ($): 4,978 TEV/EBIT 0.0x 0.0x

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  • Agriculture
  • Biodiesel
  • Acquisition
  • Europe
  • Canada
  • Underfollowed
  • Transformation
  • Toll Booth Business
  • Meat By-Products
  • Meat
  • Renderer
  • Great management
  • Synergies

Description

 

 “I would characterize FY13 as one of the most pivotal years in the Company's 131-year history. It was a strong year, and one that focused on transformative global growth, diversification, and long-term opportunities, while navigating through a difficult and volatile price resetting environment.” – Randy Stuewe, CEO on 4Q13 EPS call 2/27/14

“And Colin reminded me as I was flying from London last night that it will be really hard to double this thing again in five years; and I said, no, no.  I already have the idea.  But I said, I have got to pay for this one first.” – Randy Stuewe, CEO at Lender’s Presentation 12/5/13

Thesis:

DAR has recently evolved from primarily a US based renderer of beef, poultry, pork, and grease by-products into a global provider of feed, food, and fuel solutions.  Over time it should be better understood as a high quality company with high returns, stable margins, a favorable growth outlook, and an impressive management team. 

We think the company is mis-valued for a number of reasons:

1)      Investors incorrectly believe DAR is susceptible to commodity price swings as their end products (used as animal feed) are substitutes with crops.  DAR has moved to minimize this exposure through formula contracts, a refining JV, and acquisitions.  This will result in more stable earnings versus history

2)      DAR closed 3 acquisitions between August 2013 – January 2014 which more than doubled the company’s enterprise value and turned DAR into a global player with more diverse earnings, more future sources of growth, and less commodity exposure

3)      Recent results have underwhelmed, but are not representative of DAR’s true earnings power.  Earnings are messy as a result of the recent acquisitions, falling crop prices (lagged contracts temporarily hurt DAR), and recent production issues at a JV.  The company also doesn’t provide earnings guidance or synergy targets   

4)      There is a lot of potential for management to grow the business through organic opportunities already in the pipeline (which have taken a backseat given the deal news) as well as more add-on acquisitions at high returns on capital.  By issuing some equity with the recent transactions, the company still has some debt capacity which should result in highly accretive growth going forward

5)      DAR is underfollowed as it is the only public rendering player and has historically had a <$2 bln EV

Background:

“Is it a process that's going to go away? The answer is no. There's too much of this stuff. It's the #1 killer of pathogens out there. As we've told people, we are the protector of the planet, to a degree, from disease. If you put all the meat scraps that are generated in this country into a landfill, you would fill up every landfill in the country in between 3 and 4 years. We're not going out of business and doing that.”   – Randy Stuewe, CEO at Investor Day 9/12/12

Legacy Darling:

DAR is the largest independent renderer in the US.  They collect beef, poultry, and pork by-products from slaughterhouses, restaurants, and grocery stores and process it mainly into animal fat and protein, as well as other value-add products.  These are then sold as animal feed, pet food, biodiesel, fertilizer, and various other products. 

DAR also collects used cooking oils and grease from restaurants (these are fats) which it processes into animal feed additives and feedstock for biodiesel.  In addition, DAR collects bakery residuals, which they also process into animal feed. 

DAR formed a JV with Valero in 2009, called Diamond Green Diesel (DGD), to produce renewable diesel from a variety of feedstock, including from fats that DAR produces.  DGD started up mid-2013, and has the capacity to consume 10% of the total US by-products supply of fat. 

Market Overview:

The US rendering industry processes ~60 billion pounds of animal by-products each year. The market is roughly equally divided between captive renderers (integrated meat processors like Tyson, Smithfield, etc.) and independent renderers like DAR.  DAR is by far the largest independent and all others are private.  We believe DAR has roughly a 30% share of the independent market (15% of total market).

The biggest raw material source is slaughterhouses, making up ~80% of industry raw material.  The other major raw material sources are from restaurant grease (think used cooking oil at McDonald’s) and grocery stores/butcher shops.

Products are sold mainly into animal feed.  There are numerous end products (depending on specific part of animal), and you produce roughly equal amounts of protein and fat from animal by-products (along with a lot of wastewater).  Proteins have more value-add applications than fats, which enables renderers to earn higher margins on them.  Fats are more of a commodity (DAR has cleverly diversified away from this, more on later).   

Demand: One interesting element of the industry is that it is supply driven.  The main end product is animal feed, which is substitutable with agriculture commodities.  As a result, end products are easily absorbed into the market and renderers can effectively sell as much animal byproduct as they can get their hands on without moving the market.

While US meat consumption is a mature market, the worldwide trend of increased protein consumption will benefit DAR.  Along with exporting more meats from the US (more by-product supply), DAR’s new global footprint will benefit in emerging regions.

Supply: A major barrier to entry is permitting restrictions as nobody wants a rendering plant in their backyard.  As a result, new plants are not an option and plant expansions are the most practical capacity additions.

Local monopolies: This is a high fixed cost business that requires high utilization rates to make money.  It makes sense to have one player supporting slaughterhouses in a certain radius.  Here is our understanding of the cost structure per ton of by-product:

Plant Operating Costs

 

Item

Cost/ton

% of Costs

Energy

 $          15

18.2%

Electricity

 $          10

12.1%

Labor

 $          15

18.2%

Deprec'n

 $          10

12.1%

Chemicals

 $             5

6.1%

Insurance/other

 $             8

9.1%

Transportation

 $          20

24.2%

Total

 $          83

100.0%

 

Note: assumes average transportation distance = 100 miles

The largest cost is transportation.  Transportation costs are $20 per ton for each 100 miles traveled, which is roughly ¼ of the total costs per ton.  As a result, it is a logistics game where the rendering plant closest to the slaughterhouse will win (if that plant is not winning, he is doing something wrong).  While renderers could keep each other honest by competing if margins get too high (by driving further distances), we believe the industry is pretty disciplined and is essentially made up of local monopolies / oligopolies.  Very simply, rendering services need to be performed and the local slaughterhouse is going to need to use the closest renderer – they don’t have a choice. 

Acquisitions:

“And really, as we leave you today and as we answer questions, we always like to tell you what we stand for in the sense of putting companies together.  Number one: Darling doesn't buy broken businesses. I'm not a restructuring artist. I don't know how to do that. I know how to take companies with great brands, great positions, and move them forward.  The second thing is we buy a great management team. We make sure they want to be part of our team going forward; they subscribe to our values, our cultures, our beliefs, our dreams, our visions.  The third thing we do is we pay a fair price. There is a price at which we'll walk away from some of this stuff, and we have…And the fourth part of that is still the piece that I want to talk to you -- and where you're very critical in this -- is for Darling. And my legacy, my management team's legacy, is putting in place what we call a no-fail capital structure. And that's one that's very important to us.” – Randy Stuewe at Lender’s Presentation, 12/5/13

In 2H13, DAR went into it’s “war chest” and made three acquisitions that transformed the company.  First, in early August 2013 they announced the acquisition of Terra Renewal Services for $120 mln.  Then in late August ‘13 they announced the acquisition of Rothsay in Canada for ~$600 mln.  And finally in October ‘13, they announced the acquisition of Vion Ingredients in Europe for $2.2 bln.

Acqns:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Vion  Ingredients (in USD)

 

 

Rothsay (in USD)

 

 

Terra Renewal

 

Announced 10/7/13, closed 1/7/14

 

Announced: 8/23/13, closed: 10/28/13

 

 

 

 

 

 

 

 

 

 

Purchase Price

    2,221.0

 

Purchase Price

  615.0

 

Purchase Price

  120.0

Revs TTM 9/30

    2,185.0

 

Revs TTM 9/30

  236.0

 

EBITDA TTM 9/30

    22.0

Revs 2012

    2,088.0

 

Revs 2012

  227.0

 

 

 

EBITDA TTM 9/30

       265.0

 

EBITDA TTM 9/30

    85.0

 

 

 

EBITDA 2012

       251.0

 

EBITDA 2012

    87.0

 

 

 

EBITDA Margin TTM

12.1%

 

EBITDA Margin TTM

36.0%

 

 

 

EBITDA Margin 2012

12.0%

 

EBITDA Margin 2012

38.3%

 

 

 

 

 

 

 

 

 

 

 

EV/ TTM EBITDA

8.4x

 

EV/ TTM EBITDA

7.2x

 

EV/ TTM EBITDA

5.5x

EV/ TTM Revenue

1.0x

 

EV/ TTM Revenue

2.6x

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Vion Ingredients: This is a game-changer for DAR.  Vion Ingredients is the largest rendered in Europe.  This acquisition makes DAR a global player and also gives them a footprint in Asia and South America, markets which will benefit from increased protein consumption.   DAR bought Vion Ingredients from its parent company, Vion Holdings, which is primarily a food producer.  The main division of Vion had struggled and Vion Ingredients was used to funnel money up to the parent. 

In 2012 Vion Ingredients was responsible for EBITDA of 210 mln euros out of EBITDA of 212 mln euros for the whole company.  The “core” Vion Holdings did ~$8 bln euros in sales and was EBITDA neutral.  At the end of 2012, Vion had 1.036 bln euros of debt.  The company said they divested the Ingredients business (among other business lines) in order to lower their debt burden. 

While the Vion Ingredients assets are in good shape, the management team was limited in growth initiatives as a result of the parent.  A strong management team was a key focus of DAR CEO Randy Stuewe’s diligence of Vion Ingredients, as management will stay on to run the business.   Randy has referred to the ex-head of Vion Ingredients, Dirk Kloosterboer, as a counterpart with very strong operational skills (Dirk is now the co-COO of DAR and runs the International business).

In addition to the traditional rendering business which is similar to legacy DAR’s, Vion Ingredients also makes some value-add products that are new to DAR.  40% of Vion’s revenue and ~50% of profits come from its gelatin business.  Gelatin comes from animal byproducts and is used as a gelling agent in food and pharmaceuticals.  This product has steady margins in growing industries and is seen as the “jewel” of the Vion portfolio. 

Vion Ingredients as a whole has lower margins than legacy DAR.  This is somewhat attributed to tighter restrictions in Europe that result in less by-products being reusable as animal feed.  Vion disposes of the unusable material under government contracts at lower returns (steady/consistent business, though).  While this makes the overall market less lucrative, Vion has worked to develop new products to maximize returns on the byproducts that are reusable as animal feed. 

Rothsay: This is one of three major rendering players in Canada.  This market has high barriers to entry due to government controls and as a result, no new plants have been built in Canada in recent years.  Fewer players in the Canada market leads to less competition and structurally higher margins.  Rothsay was previously owned by Maple Leaf Foods, a meat producer, who was looking to reduce debt and exit a non-core business.  Maple Leaf was forced to sell Rothsay despite it being a cash cow, as they were running close to debt covenants due to poor performance in the core business (similar set-up as Vion). 

Terra Renewal: Pick up used cooking oil and process it, similar to DAR’s legacy operation.  There is overlap in territories which will lead to cost reductions (optimize routes and close processing facilities).  This business also picks up wastewater from slaughterhouses (fee for service business), which is what attracted DAR to the business.  Terra was bought at 5.5x EBITDA and there should be meaningful synergies. 

Synergies:

DAR plans to follow a similar roadmap to the one they followed after acquiring Griffin in 2010 for $840 mln (7.4x EBITDA).  Griffin was the second largest independent renderer in the US at the time.  DAR kept senior management from Griffin and successfully integrated the business into DAR.  They shared best practices from each organization, optimized raw material procurement, raw material mixes at different plants, customer logistics, etc.  They also entered new businesses, the most notable of which was the Bakery business, which DAR didn’t participate in before.  DAR recently said that they realized $30-40 mln of synergies from the Griffin acquisition (~7% of Griffin’s legacy sales).    

Revenue Synergies: The different companies create different value-add products.  Vion has over 100 R&D experts who focus on this.  As a result, there should be opportunities to cross-sell successful formulas to different markets.  DAR should also benefit from the unique products that Vion has created to deal with stricter legislation in Europe as the new DAR is able to sell these products more broadly (most notably gelatin and separating blood into red/white cells).  Management has said that Vion was able to get 30-40% higher yields on some by-products, and will try to duplicate that in legacy DAR plants with the help of Vion management (note: DAR was successful in taking best practices from Griffin to realize synergies as well). 

 “I'm about an hour and-a-half old into this. As always, as we were successful in National Byproducts, Griffin Industries, I think there's ample synergies here. I don't know what they are today. Clearly, we have some basic ideas that revolve around product marketing, product creation, value-added products. Like I said, the extension of the blood line into the US, extension of bone processing into the US. We both make different poultry grade products and so you get into lots of different marketing opportunities.

It was amazing as we looked through the customer base how similar the customers were, if not the same customers, globally. The suppliers underneath the business are very familiar to many of us, both in North America and Europe. So, lots of synergy opportunities. As we said, some may take a little capital going forward, but at the end of the day we're not ready to put a number on it, but we truly believe there's some great upside here as we learn each other's business.” - Randy Stuewe 10/7/13 on Vion deal call

At DAR’s 2014 Investor Day in early September, Stuewe discussed opportunities to increase returns at Vion.  The company was bought at 8x EBITDA, which does not meet the company’s target return profile of atleast 15% return on gross investment (a metric the company refers to as “ROGI,” which is calculated as EBITDA / Gross Investment).  Stuewe believes the deal will reach those returns in 2-3 years as a result of 60m euros of debottlenecking / operational improvements, however he has not given details on this and the Street is not giving credit. 

We also believe that DAR will act as a consolidator in the European market, and try to boost returns through more aggressive pricing initiatives, similar to the strategy taken in the US over the last decade.  Stuewe believes Europe is about 10 years behind the US in terms of consolidation. 

Cost synergies: The company is seeing cost synergies from the Rothsay acquisition. DAR has already started to takeout costs by getting rid of legacy management.  We believe there are more costs to be taken out as the operation remains fatter than legacy DAR, but this will take time due to labor contracts.  We also believe there will be operational improvements from moving to DAR’s best practices.  Stuewe has also alluded to “low hanging fruit” capital investment projects at both Rothsay and Vion as a result of under-investment by previous owners.   According to management, a number of these have 1-2 year paybacks.

Growth opportunities:

 “The beauty of putting all these companies together, aside from the great management teams, is that the great management teams have the same vision we do. They want to grow. And so, we've got to make sure that we've got availability as we can see around the world the opportunities. I use the line -- we can see what no one else can see today because we get to see it on all continents from rendering to blood to gelatin to the different businesses -- the opportunities that exist around the world. And we want to make sure we have capacity to participate in those opportunities.” - Randy Stuewe 3Q13 call 11/8/13

Aside from synergies and sharing of best practices, we think there are a lot of benefits of Vion and Rothsay being under DAR’s control.  These were tertiary arms of their previous owners and the parent companies were levered with struggling core businesses.  As a result, growth was not a focus for the rendering businesses, which we think creates a nice opportunity. 

While Vion management has been limited due to leverage at the parent and an auction process, they didn’t stop looking and have a big to do list according to IR.  It sounds like Vion will be a good growth platform and their knowledge of the global rendering markets should expedite DAR’s expansion into Latin America and China, two growth markets.  A similar sentiment has been described at Rothsay, where entrepreneurial stuff wasn’t on the table under Maple Leaf ownership according to IR.     

The company plans to spend ~$75 mln/yr on growth cap ex and continue to look for bolt-on acquisitions.  They target atleast a 15% ROGI over the life of an investment (which is the metric managers are compensated on).  Stuewe said at the 2014 Investor Day that the company has more actionable projects than they have money to spend.

Management has come out with a 800m EBITDA target for 2017 (vs current runrate at 600m in 2014).  They have numerous projects already in the queue, as well as others on the backburner.  We think this EBITDA target is conservative and believe management’s true target is significantly higher.

As a result of issuing some equity with the recent acquisitions, future growth should come from cash flow generated and additional debt, which will be highly accretive.  

Management:

We believe Stuewe is a very strong CEO.  He came in in 2003 with the company on the verge of bankruptcy and has revitalized the company.  The share price has risen from $2.90 to $19 and the enterprise value has gone from $300 mln to $5.4 bln. 

Stuewe has taken numerous initiatives to grow the business, make it more stable, and create shareholder value. 

Move From a Commodity Exposed Business to Largely a Fixed Fee Business:

 “So when you combine the new business structure, we look at it, from a management team, that we had already de-risked the Darling model with the Diamond Green Diesel investment.  By layering on Darling Canada, Rothsay, and Vion, we’ve now even further reduced the commodity exposure.  Thus we talk about now – instead of a rendering or a commodity feed ingredient company, we’re now a global ingredients company.” - Randy Stuewe 12/5/13 at Lender’s Presentation

The biggest issue with the business historically was the exposure to crop prices.  Many of DAR’s products are competing with corn and soybeans as feed for livestock.   As a result, historically prices moved with crop prices, creating a lot of volatility in earnings. 

To get rid of the volatility, DAR moved to fixed margin contracts.  DAR charges slaughterhouses a fixed fee for their services, and gives the slaughterhouse a rebate depending on the price of the end product DAR sells.  They are essentially transferring the commodity risk to the raw material supplier and taking away their own earnings volatility. This is a key point to the business.

“I always try to discourage people from talking about revenue, because we are a spread business.  We are a business that manages a margin.  I don’t really care whether I sell it for $2 or $3.  Very different than a retailer.”  - Randy Stuewe 12/5/13 at Lender’s Presentation

“Because what we’re trying to do is lock in a margin or a spread at the front end, and control what we can control, not what the markets for the finished products control out there” - Randy Stuewe 12/5/13 at Lender’s Presentation

Step 1 to removing commodity risk: Diamond Green Diesel (DGD)

 

While Stuewe gradually removed commodity risk where possible by moving customers to fixed margin contracts, he was unable  to do so in the used cooking oil business (55% of this business is not on formula) and the Bakery segment (100% profit sharing with bakery).  Cooking oil (which is a commodity fat) and bakery residuals compete with corn as a calorie substitute for livestock, and as a result, their prices are highly correlated to corn prices.  Combined, these two businesses represented 30% of legacy DAR’s raw materials. 

In order to limit commodity exposure, Stuewe devised a plan to build a renewable biodiesel plant that would take in commodity fats (used cooking oil and others) as a raw material and turn them into biodiesel.  As a result, the same commodity exposure that legacy DAR has to fats would be offset by the refinery using fats as raw material.  For example, if corn prices went down, causing cooking oil prices to go down (thus the Rendering profits that have commodity exposure), then this earnings decrease would be offset by DGD which would benefit from lower raw material prices.  This works because biodiesel prices off of diesel, which won’t be driven by crop prices.

Stuewe had been looking into this idea since 2005, and in 2009 formed a JV with Valero to make it happen.  Each party put in roughly $115 mln of equity, and they raised $221 mln in debt.  The plant successfully started up in mid-2013.  At the Investor Day in 2012, Stuewe called the plant a “pretty big career bet.”

The plant is the first of its kind in the US and has a significant cost advantage over other renewable biodiesel plants, as the raw materials it is taking in are cheaper and they create more co-products. 

While this project makes a ton of sense (on a standalone basis let alone as a hedge), there are very few people that can do it.  For one, you need access to an enormous quantity of fat.  This plant will consume over 10% of the by-product fat supply in the entire US.  As a result, DAR is the only company that can provide that type of backstop to a plant that requires full utilization.

At the same time, the facility will run like a refinery, which requires complex operational know-how and is why DAR needed Valero.  Because the plant is built on an existing Valero site (as opposed to a greenfield), it has great inbound (rail) and outbound (pipeline) access that leads to further cost savings. 

We believe there is ~$1.00/gal EBITDA differential between DGD and the marginal cost producer (who uses soybean oil as a raw material).

Note: RIN values have fallen off recently due to uncertainty surrounding the Renewable Fuel Standards and the Renewable Volume Obligation that will be mandated (the RVO is the minimum amount of biofuel that will need to be consumed by refiners). The marginal producers, soybean based biodiesel producers, are losing money and it is widely believed that the current operating environment is not sustainable.  Even so, these producers are continuing to run at a cash loss as they are hopeful the RVO will increase (therefore increasing biodiesel demand), and lead to higher RIN prices.  We are expecting legislation later this year to provide more clarity so that the economics for less profitable players becomes clearer.  Even in the poor operating environment, at current economics, DGD would generate over $50 mln in pre-tax income for DAR (on a $115 mln equity investment).    

In total, we believe DAR’s EBITDA will move ~$10-15 mln for every $1/bu move in corn prices going forward.  That is less than a 3% change in EBITDA per a $1/bu move.  We believe this is transformational in terms of its risk profile. 

  • For every $1 move in corn, the Bakery segment EBITDA moves ~$20 mln.  This is based on the linear relationship between EBITDA and corn prices that Stuewe has described
  • For every $1 move in corn, the used cooking oil business EBITDA moves ~$20 mln.  This is based on the price relationship between used cooking oil and corn, where a $1/bu move in corn equates to a 6c/lb move in used cooking oil (over time the relationship is very good as this represents an equivalent amount of calories when used as animal feed).  We have an estimate of the # of cooking oil lbs DAR collects that are not under a formula based on DAR market share ests and data from the National Rendering Association. 
  • For every $1 move in corn, DAR’s share of EBITDA from DGD moves ~$30 mln in the inverse direction from the used cooking oil and bakery businesses exposure to corn (i.e. natural hedge).  The plant uses ~1.25 bln lbs of fat (DAR’s share is half this), and it uses mainly used cooking oil and inedible corn as raw materials, both of which are correlated to corn.   

Unfortunately, the market is yet to see this reduction in corn exposure for an extended period for two reasons.

  1. DGD was barely functioning in 2013, and then in 3Q14 as corn prices plummeted, DGD had a fire.  The plant is currently offline and the company expects it to be back online in late September.  We will see the natural hedge DGD provides in 4Q14 and the full effects in 2015
  2. Corn prices have plummeted.  Corn prices have fallen from around $5/bu in 1H14 to below $3.50/bu currently (from over $6/bu in ’13).  This impacted DAR in two ways:
    1. Ex DGD (which is offline), the impact of falling corn is magnified (~$40 mln in EBITDA per $1/bu move)
    2. Contracts in core rendering business are lagged.  DAR prices based on what they expect the corn price to be when they sell the product.  When prices are falling, they are playing catch up as they price the contract today and sell into the spot market with a delay.  This temporarily hurts margins when prices come down

We expect 4Q14 to be a much cleaner quarter with DGD back online, and the true earnings power of the business to show in 2015.

Step 2 to removing commodity risk: acquisitions

 

Vion and Rothsay also work to reduce the entire portfolio’s commodity exposure.  Neither have a Bakery business, and used cooking oil is a very small piece of sales.  These are the two businesses legacy DAR had trouble earning a fixed margin on.

 

By doubling the company with businesses that have minimal commodity exposure, the percentage of the total business that is exposed goes way down.  This is similar to DAR’s acquisition of Griffin in late 2010, as almost all of Griffin’s business was under fixed fee formulas, and therefore lowered the combined DAR’s commodity exposure meaningfully.

“The three business models combine more towards an annuity model than anything we’ve ever had in the past, thereby supporting a different leverage ratio than we’ve had in the past.” - Randy Stuewe 12/5/13 at Lender’s Presentation

 

“The supply chain: it's hard to duplicate. It's got the built-in margin management. I just want to reinforce that. The margin management of this business is far different than it's ever been in the past for the old Darling. To me, that's what's even more transformational, with 10,000 people and a lot of emerging market” - Randy Stuewe 12/5/13 at Lender’s Presentation

 

We think DAR today is a very good business.

We believe that this is a business with stable earnings and high sustainable returns on capital (both on existing capital and incremental capital going forward). 

We think the bumps along the way in historical performance have reasonable explanations, and overall the business has been transformed with the recent startup of DGD and recent acquisitions.

Legacy DAR EBITDA margins and after-tax return on capital employed  vs corn prices 1996-2013 – this is a much improved business vs history:

 

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corn Price

 $  3.55

 $  2.60

 $  2.20

 $  1.89

 $  1.86

 $  1.89

 $  2.13

 $  2.27

 $  2.47

 $  1.96

 $  2.28

 $  3.39

 $  4.78

 $  3.75

 $  3.83

 $  6.02

 $  6.67

 $  6.15

EBITDA Margin

12.9%

10.8%

6.0%

8.1%

10.6%

12.6%

14.3%

13.1%

14.3%

10.3%

9.8%

16.1%

16.5%

16.2%

17.3%

21.9%

18.6%

16.9%

Post- tax Return on Capital Employed

13.1%

6.9%

-5.1%

-6.2%

-3.5%

3.2%

17.7%

21.3%

23.5%

11.8%

10.2%

34.6%

44.4%

28.2%

21.2%

47.5%

31.3%

21.1%

The margins have been pretty consistent since 2007.  We believe this had to do with improved management, more value-added products (if products have more energy, they are worth more as animal feed), and increased formula based business (corn prices were still in the $3s/bushel in ‘07, ‘09, and ‘10).  Excluding 2011 which was a record year for the industry (due to peak used cooking oil prices from renewable biodiesel demand in Europe), margins have been fairly consistent.  Going forward, with the more diversified portfolio and the benefits from DGD, we expect DAR to have stable margins even after corn prices have recently reset ~50% lower than 2011-13 levels. 

DAR has also had very strong returns on capital even as the company has grown significantly (note: all growth is coming recently, so this capital should be properly stated on the BS).

Also worth noting, the weak performance in 2005-06 was largely caused by a spike in natural gas prices.  This is 15-20% of costs, and many formulas at the time did not have an energy adjustor when nat gas prices doubled (the contracts are now more robust and include an adjustor). 

We think this is a high quality business and the returns speak to this being a business made up of local monopolies. 

Why We Think It Can Be Seriously Mispriced

  1. Undercovered by sell-side / unknown to most investors

GS is the only bulge bracket bank that covers DAR. 

Why we think its undercovered: This is not a massive market – 50% of the rendering market is controlled by captive renderers (where rendering is a tertiary business) and DAR controls ~30% of the independent market. 

In August ‘13, DAR’s market cap was only $2 bln.  After issuing stock to fund the acqns, the company now has a $3 bln market cap and trades ~$20 mln/day.  We think this remains a sleepy company that has a much better business than is being realized.

 

  1. 2015 estimates can prove conservative
    1. There were several moving pieces in 2014:

                                                               i.      Corn prices move from $6/bu in ’13 to $4.75/bu in 1H14 and $3.50/bu in 2H14

                                                             ii.      DGD has a poor operating environment in 1H14 (due to RFS uncertainty) and has an unexpected outage in 3Q14

                                                            iii.      Company is in the process of integrating three major acquisitions that more than doubled the company’s size

  1. We expect the true earnings power to be better understood in 2015 as the company begins reporting clean numbers including DGD

                                                               i.      Commodity exposure will be clearer with DGD running

  1. We think the company has attractive growth opportunities at high incremental returns
    1. Acquisition synergies – these haven’t been quantified and are therefore not in consensus numbers
    2. Growth opportunities from newly acquired businesses should be plentiful - Vion and Rothsay were limited as a result of prior ownership
    3. DGD plant - once this is running effectively, they will likely expand it.  We think DAR will likely double capacity (est. $60 mln EBT contribution)
    4. Hampton extraction plant – potentially high return capital project that is ramping up.  Have opportunities to build similar plants if successful ($25-40 mln per plant, looking for less than 4 year payback)
    5. ERP system – have been moving all of the legacy systems onto a SAP platform.  This is a long-term project that is coming through the P&L at $2-$2.5 mln/qtr.  When its complete in 2015, these costs will go away and there should be operating benefits
    6. South America and Asia provide longer-term growth: with increasing incomes will come more protein in diets.  This is another avenue of growth which is helped by Vion’s pipeline of acquisition targets in these regions

 

  1. Management team seems like the real deal and is highly motivated to create shareholder value

CEO Randy Stuewe built this business into a US rendering powerhouse with the Griffin acquisition, and is now looking to create a global presence.  He shows a deep level of knowledge in all aspects of the business and has a vision for the company. 

Randy owns 938k shares.  He also has 411k options (312k exercisable) at an average exercise price around $10/sh and $5 mil in unvested stock awards.  All in this is about $30 mil in equity at the current stock price.  He is also is getting paid $4-5 million in options/restricted stock per year. 

Valuation:

With conservative synergy assumptions, we are at $650 mln in 2015 EBITDA (consensus at $640).  Adding in pre-tax income from DGD using a $1/gal EBITDA assumption (where the marginal cost producer is roughly breakeven), adds $60 mln in pre-tax income.  The company will generate $1.53/sh in cash eps in ’15 (12.3x) and $1.99/sh on a maintenance FCF basis (9.5x).  At a 15x 2015 maintenance FCF multiple, we get to a $30/sh, or 50% upside.   We prefer to look at cash eps due to the amortization from the recent acquisitions.  We think that’s a fair multiple for a company with double digit EBITDA and eps growth runway for the foreseeable future. 

While we prefer to use a FCF multiple, we can look at it on an EBITDA basis as this is how the company talks (and how the Street values the company).  We are at $799m in EBITDA in 2017 (which we deem as “normal” for a $3.50 corn environment).  Conservatively assuming the company uses all excess cash to pay down debt, and continues to invest in growth capital at the current rate, on an 8.5x forward multiple, the stock will be worth $33 at the end of 2016.  Discounted back to end of ’15, we get a 2015 PT of $30/sh.

We think the valuation is too cheap for a quality business with sustainable high returns, let alone one that has plenty of room for continued growth.

Risks:

-          Integration risk from acquisitions: they have transformed the company in a short amount of time so there could be some friction costs

  • This risk is partially mitigated as management teams will remain onboard and we haven’t seen any issues to date

-          DGD plant has trouble running or remains offline for an extended period

-          Decreased slaughter rates hurt volumes more than expected

  • Hog are hit by disease this year, but DAR has limited exposure here.  Beef production is down in ’14, but poultry is up
  • We don’t expect this situation to get worse from the current operating environment and volumes should improve in 2015

-          Stricter legislation relating to animal by-products

-          Consolidation of meat producers who have integrated rendering operations

  • This has been a long-term trend, which has not had an impact on DAR

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 

Potential Catalysts:

-          2015 results

  • People get to see the earnings power of the new DAR for the first time
  • #s better than feared with lower corn prices

-          Renewable Fuel Standards increase RIN prices in Fall 2014

  • Potential retroactive tax credit would give extra upside (at a $1/gal credit, DAR would receive ~$50m.  We put the odds of this at 50-50)

-          DGD runs full, shows earnings power, and proves to be a successful hedge

-          Story becomes better understood

  • Increased sell-side coverage
  • More interest in the stock
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