Description

Company Overview

Founded in 1882 by the Swift meat packing company and the Darling family, Darling Ingredients is a global renderer of animal by-products.  The company performs a much-needed service by collecting the unused animal parts from slaughterhouses, grocery stores, butcher shops, along with used cooking oil and trap grease from restaurants, and repurposing them into value-added fats and proteins.  Those fats and proteins become the raw materials used by the pharmaceutical, pet, animal feed, industrial, biofuel, and fertilizer industries.  Over the past 140 years, Darling, through acquisition and organic growth, has grown to represent 15% of the global animal rendering industry.

In 2011, Darling Ingredients entered into a 50/50 joint venture with Valero Energy Corporation to form Diamond Green Diesel (DGD), a multi-feed refiner that converts fats, greases, used cooking oil, and other agriculture oils into renewable diesel.  The original 160mmgy (million gallons per year) facility was built next to Valero’s St. Charles oil refinery in Norco, Louisiana and has since been expanded to refine 675mmgy.  DGD is in the process of expanding its operations into Port Arthur, TX (adjacent to another Valero refinery).  Once completed, DGD will have a nameplate refining capacity of just under 1.20bngy.  Besides being a multi-feedstock refiner, both DGD facilities have the added advantage of an established infrastructure to receive raw material and deliver renewable diesel via rail, truck, ship, and pipeline (just east coast deliveries of renewable diesel).  These refining and logistics advantages reduce DGD’s operation costs creating a significant competitive advantage.

Industry

In North America, about 56 billion pounds of animal by-products are collected and rendered into approximately 22 billion pounds of fats and proteins each year.  The proteins are used in pet food, livestock feed, and agriculture fertilizer, while the fats are converted into oleic acid, glycerin, and stearic acid and are used in lubricants, textiles, solvents, inks, consumer products, and refined into biofuel.  Rendering is a key component to the global food industry by repurposing billions of pounds of waste that, if thrown away, would add to the already growing greenhouse gas (methane & CO2) problem.  The roughly 60% of animal by-product (by weight) that is not rendered is mostly water.  Rendering facilities are required to treat and clean the water so that it can be safely used in the plant, discharged into municipal sewer systems, or returned to rivers and streams within the community.

Meat rendering has been around for centuries but over the past 90+ years it has scaled into a global industry.  The industry can be very cyclical as animal feed prices, energy prices, consumer demand, and dietary trends for meat can frequently fluctuate, influencing both feedstock prices and end-market sales.  Navigating the industry cycles and sustaining long-term profits can be very difficult and a major reason why the once fragmented North American market has consolidated to just three major players:  Darling Ingredients, Tyson Foods, and Baker Commodities Inc.  The key to profitability in meat rendering comes down to scale and logistics.  A renderer needs to have a steady flow of feedstock (animal by-products) to keep its plants running at a high utilization.  Since most feedstock has to be processed within 24 hours of collection, or risk spoilage, a renderer also needs to be able to optimize the timing of feedstock collection while also focusing on keeping collection costs low, especially when fuel prices are quickly rising.  The location of the rendering facility also plays a significant role in profitability.  The plant needs to be located within 200-250 miles of the slaughterhouses, groceries, and butchers it services, while meeting special zoning requirements that have strict restrictions on air emissions and odors, water and waste treatment, and ambient noise.  Finding locations that meet these two criteria is what restricts new greenfield rendering plants from being constructed.  Assuming a company was able to find an optimal location that met zoning requirements, it still would need to convince feedstock providers and end market customers to use its services.

Even with the recent decline in North American meat consumption over the past decade, North American production continues to grow as global demand, especially in emerging markets where higher income and wealth are leading to more protein choices, has offset the North American decline.  In total, global meat production is growing around ~3% per year. 

Investment Thesis

Darling Ingredients through its scale, logistics, and long-term relationships with both feedstock providers and end customers will continue to expand its business and improve its margins in all three segments of its operations.  Its Diamond Green Diesel joint venture with VLO is expected to complete its 470mmgy expansion in Port Arthur, TX by Q4 of 2022, expanding its nameplate capacity to just under 1.2bngy.  By 2023, DGD cash flows will once again be dividend out to Darling and Valero instead of being used to fund the roughly 870mmgy expansion that took place over the past 3 years.  That money will give Darling the flexibility to pay down its debt, continue to expand its global footprint, repurchase shares, or issue a dividend.

Darling Ingredients is a good hedge against the recent spike in inflation as the price for its fats, used cooking oil, and proteins have moved higher in concert with other commodities such as oil and agriculture products.  Over time, as inflation abates and the prices of fats, UCO, and proteins trends lower, Darling Ingredients’ reduction in revenue and profits will be more than offset by the higher profits from DGD.

Operations

Darling Ingredient’s operations are divided into three reporting segments:  Feed Ingredients, Food Ingredients, and Fuel Ingredients.  Feed Ingredients represents 64% of the company’s revenue and 45% of the combined operating profits (includes DGD’s contribution).  This is Darling’s legacy rendering business that collects animal by-products from slaughterhouses, butchers, meat packing, and grocery stores as well as used cooking oil and trap grease and converts them into fats and proteins to be resold.  Over the years, Darling has been able to hedge price declines for its finished fats and proteins by establishing formula contracts with its feedstock suppliers.  These contracts are tied to finished product pricing and are adjusted weekly, monthly, or quarterly based on demand, volumes, transportation costs, yield, and the type of raw material received.  Darling has established these contracts with roughly 80% of its Feed Ingredient customers.  In essence, DAR’s feedstock providers share in the cyclicality of the fats and proteins prices.  The remaining 20% of customers operate under non-formula agreements where feedstock suppliers are paid a fixed price, are not paid for their feedstock, or are charged a collection fee.  By establishing formula contracts with the majority of its feedstock providers, DAR has converted a volatile and cyclical segment of its business model into a spread business, leading to more predictable outcomes.

The Food Ingredients segment represents 27% of the company’s revenue and 15% of its operating profits (includes DGD’s contribution).  Unlike the Feed segment which generates 85% of its revenue in North America, 52% of Food Ingredients revenue comes from Europe with North America and China representing 23% and 18% respectively.  The Food Ingredients segment was developed around the acquisition of Vion Ingredients which included Rousselot, the largest producer of gelatin in Europe.  Over time, Darling has been transitioning that business to focus on hydrolyzed collagen which is a higher-value product used by the pharmaceutical, nutraceutical, and biomedical industries requiring stringent safety and quality specifications.  These result in higher-margin sales.  Over time, Darling expects that its Food segment’s margins will surpass those of its feed segment.

Darling’s Fuel Ingredients operation represents 10% of the company’s revenue and 48% of its operating profits (includes DGD’s contribution).  This segment converts organic sludge and food waste into biogas and is where Darling Ingredients reports its DGD profits.  Roughly 100 percent of the revenue is generated in Europe.  Biogas is a relatively new energy supplement to the supply of natural gas and is widely supported in Europe.  Darling’s Ecoson is the largest industrial digestion operation in the Netherlands and in February of 2022, DAR purchased Group Op de Beeck the leading organic waste processing company in Belgium.  The company expects this segment to continue to grow steadily while continuing to maintain or improve margins over time.

Acquisition

A majority of Darling Ingredients’ growth over the past 12-plus years has come through key acquisitions as the company first focused on domestic expansion and then transitioned overseas.  In the past, management has been criticized for the timing of its purchases as a number were executed at the top of the feed and food cycles.  However, in all of the larger acquisitions (Griffin (2010) – $847mn, Rothsay (2013) - $614mn, and VION Ingredients (2014) - $2.2bn) Darling paid ~7.2x EBITDA once the initial integration took place.

In May of 2022, Darling Ingredients purchased privately owned Valley Proteins which processes 2.4mmt of animal by-products and used cooking oil and was the last renderer of size left in the North American market.  Valley Proteins S. Eastern and Mid-Atlantic US footprint, with a handful of operations located in or around the state of Texas, will help strengthen and optimize Darling’s domestic operations.  Since May, Darling has already adjusted its pickup and delivery schedules to optimize routes and lower expenses.  Over the next 18 months, the company expects to upgrade facilities and use best practices to improve utilization and operational throughput.  During the Covid pandemic, a toxic environment developed between Valley Proteins’ employees and the Smith family that owned and ran the company.  As a result, workers left the company and production declined.  Since the acquisition, Darling has already increased employees’ pay and improved safety regulations across all plants.  Customer contracts are the next area of review.  Over time, Darling Ingredients believe that ongoing synergies and integration will improve profitability as they are guiding 2023 EBITDA to be around $150mn up from an expected $105mn for 2021.

FASA Group in Brazil is a pending strategic acquisition that Darling announced in May of 2022.  The company processes more than 1.3mmt through its 14 rendering plants and has 2 plants currently under construction.  The deal is for roughly $560mn and is expected to close by the end of 2022.  Brazil is a growing market for animal agriculture and for 2023, DAR is guiding $100mn in EBITDA and expects those profits to increase as the two new plants become fully operational.  Darling’s existing Brazilian operation is already delivering fats to DGD.  After the proposed FASA acquisition, DAR will process more than 15mmt of animal by-products or approximately 15% of the global supply.

Both Valley Proteins and FASA Group acquisitions coincide with a 60% refining expansion (DGD 3) at Diamond Green Diesel.  Darling expects to supply around 60% of DGD feedstock needs going forward and the two acquisitions will help in expanding its delivery.

Diamond Green Diesel (DGD)

Renewable diesel (RD) is a transportation fuel that is refined from fats and oils and is chemically identical to petroleum diesel but with a much lower greenhouse gas footprint.  Demand for renewable diesel has been growing steadily over the past 5 years as the environmental benefits of using the cleaner-burning fuel is being recognized.  To reduce greenhouse gas emissions and encourage the production of biofuels domestically, the US government created benefits like the Renewable Fuel Standard (RFS) – minimum level of biofuel to be blended with petroleum fuel each year, the Blenders Tax Credit (BTC) - $1/gallon credit to blenders of renewable diesel with petroleum diesel, and Renewable Identification Numbers (RINS) – which tracks the production of each gallon of biofuel and the compliance by US oil refiners to blend those products.  In addition to Federal Government incentives, US states are also encouraging the use of biofuels by providing their own tax incentives (Illinois, Iowa, Minnesota, Texas, with California & Oregon – using Low Carbon Fuel Standards (LCFS) – which incentivizes the refining of fuel from low carbon-intensive feedstock).

Diamond Green Diesel is in the process of expanding its production by nearly 60% with the construction of DGD 3, a 470mmgy nameplate renewable diesel refinery in Port Arthur, Tx.  This is on the heels of the recently completed DGD 2 expansion (400mmgy) that became operational in Q4 of ’21and enlarging its Norco, LA refining capacity to 675mmgy.  When DGD 3 is completed (expected in Q4 of 2022), Diamond Green Diesel will have a nameplate capacity to refine 1.15bngy of renewable diesel.  Given that St. Charles is expected to produce 750mmgy with DGD 2 just months into service, an investor can reasonably expect that Diamond Green Diesel’s effective refining capacity will exceed 1.2bngy in the short run.  Over time, DGD 2 and DGD 3’s supply chains, logistics, and refinery turnarounds will be optimized leading to even higher production volumes and greater profitability.  

Since its refining operations commenced over eight years ago, Diamond Green Diesel has produced a median EBITDA of $1.81/gallon with the last four years producing a median of $2.27/gallon.  For 2022, the JV is guiding EBITDA to be $1.25/gallon as feedstock prices, like all commodity prices, have spiked and renewable diesel prices (mostly because of RIN & LCFS prices) have not kept pace.  With all the uncertainty and volatility surrounding the energy market and biofuel incentives, it is unlikely that DGD’s EBITDA/gallon will be over $2.00 in the near future.  Over time, feedstock prices and incentives should find a balance and Diamond Green Diesel’s refining margins and profitability will improve from their current levels.  It is important to remember that there is global demand for RD from countries in Europe, Asia, and Canada and the decision of where to ship is based on profit margins.

The DGD 2 and DGD 3 projects are expected to cost a total of $1.1bn ($2.75/gallon) and $1.45bn ($3.09/gallon) respectively.  This attractive return on investment is encouraging a number of oil refiners to repurpose segments of their operation to refine renewable diesel.  By 2023, domestic renewable diesel production is expected to grow to over 3.5bngy from its current level of approximately 1.5bngy.  Just like with oil refining location, logistics, and scale impact operating profits but with refining renewable diesel, the type of feedstock used also has a significant impact on a refiner’s profitability.  California is the top domestic market for renewable diesel because of its established low carbon fuel standards (LCFS), a rating system that provides higher credits for fuel refined from low carbon-intensive feedstock (UCO and waste fats).  Currently, renewable diesel refined from UCO receives California incentives that are over 2x greater than ag products like soybean oil (SBO).  The main issue with all the domestic expansion of renewable diesel is that there is not enough low carbon feedstock (fats and UCO) available to satisfy the proposed refining capacity.  To meet the over 3.5bngy of RD capacity expected by the end of 2023 would require feedstock greater than all the fats rendered and UCO collected in North America.  Of course, biofuel is not the only destination for fats as it is a key ingredient for the production of lubricants, paints, textiles, and solvents.  A refiner could substitute ag oils like soybean, canola, or corn but would be cutting their LCFS incentives by at least half.  Currently, Darling Feed provides less than 50% of the feedstock for the DGD JV.  Darling has announced that once DGD 3 is up and running, Darling Feed will be providing 60% of their feedstock needed.

Valuation

In its most recent earnings call, Darling guided EBITDA to be around $1.5 billion for 2022 which includes a small contribution from the Valley Proteins acquisition and higher refining volumes from Diamond Green Diesel.  By 2023, EBITDA should be closer to $2.1 billion based on DGD’s higher refining capacity, full-year contributions from Valley Proteins, and FASA contribution (deal expected to close in 2022).  This assumes that DGD’s EBITDA/gallon remains flat over the next two years.  Using a conservative 8.5x EBITDA multiple and net debt of $1.6 billion values the company at $98/share.  Of course, if EBITDA per gallon were to increase either because of higher demand, improved RIN and LCFS pricing, lower feedstock prices, or a combination of the above, then a higher EBITDA multiple could be justified.  Diamond Green Diesel’s EBITDA margin is higher than Darling’s Feed Ingredient segment, so the negative impact from lower fat prices on Darling’s Feed EBITDA will be more than covered by DGD’s improved EBITDA/gallon.

It is important to remember that in 2023 DGD’s operating profits will be once again distributed to Darling Ingredients and Valero instead of being reinvested in the company’s ongoing expansion projects (DGD2 & DGD3).  Management has already indicated that they are reviewing their capital allocation strategies, including paying down debt, funding upgrade projects to improve both utilization and throughput, future acquisitions, share repurchases, and a possible dividend. In 2021, DAR repurchased $167 million of its shares at $67.62/share and $11.2 million at $60.87/share.

Risks

Besides the ongoing global uncertainty surrounding continued inflation and the strong possibility of a future economic recession, it’s the cascading impact those concerns are already having on food prices, fuel and energy costs, protein demand, and reduction of consumer purchases that has begun to and will continue to disrupt many if not all of the industries that Darling and Diamond Green Diesel sell into – not to mention disrupting Darling’s feedstock suppliers.  Often businesses can prosper during challenging economic environments by gaining loyalty, especially in the short run when they work closely and are helpful to their suppliers and end customers.

Summary

There is a high barrier to entering the meat rendering business.  Not only is Darling Ingredients’ global footprint nearly impossible to replicate but its 50% ownership of Diamond Green Diesel creates significant cash flows and provides a hedge against the cyclicality of fats and used cooking oil prices.  Given the expanded size of DGD’s refining capacity, lower fat and UCO prices will have a more meaningful impact on Darling’s portion of DGD’s profitability vs. the negative impact on profits from Darling’s Feed and Food segments.  A major reason is that Darling’s Feed Ingredient segment uses formula pricing contracts with its feedstock providers that are tied to finished product pricing which helps maintain margins in a declining pricing environment.   In addition, Darling’s Food Ingredient segment has been moving away from commoditized gelatin products and into higher-value collagen peptides used by the food, beverage, pharmaceutical, nutraceutical, and biomedical markets.  

Once DGD’s Port Arthur expansion is completed, the refiner will have a nameplate capacity that is just under 1.2bngy but given that St. Charles is expected to run above nameplate just months into service, an investor can reasonably assume that Diamond Green Diesel’s effective capacity will exceed its nameplate capacity.  In the long-run, DGD 2 and DGD 3’s supply chains, logistics, and refinery turnarounds will be optimized leading to even higher production volumes and greater profitability.  Over time, it is expected that the market will recognize and reward Darling Ingredient for its stable profit margins on its Feed and Food segments and increasing volume and EBITDA/gallon at its Diamond Green Diesel joint venture.

Catalyst

Continued support and expansion of renewable diesel both domestically and internationally