Description

Bearings. Darling was written up last year on the VIC by doctorK. It’s worth reading that post to understand some of the background. This write-up will be an update to that posting with some discussion of the effects of the US/China trade war, current state of global low-carbon fuel markets, and some additional perspective on the value getting created by this under-the-radar, smelly-but-resilient, circular-economy business.

Consensus View. Darling is a cyclical protein-ag business that made some poorly timed acquisitions by an empire-building CEO right before the commodity markets turned in 2015. The rendering business generates poor returns on capital and the renewable diesel business, while a bright spot now, depends too much on the California low-carbon fuel standard subsidies.

Variant Perception:

(1)    Darling’s rendering business is much closer to a waste management business than a protein-ag business.

(2)    Darling’s protein business is experiencing both cyclically low pricing and disruption via US/China trade war; timing is uncertain but it’s the right time in the cycle to own this option.

(3)    With the expansion of Diamond Green Diesel, Darling is now the Exxon of renewable diesel in the US, and will make margin in both low- and high-price feedstock environments, increasing earnings stability. Deep and easily accessed overseas markets in Europe and an increasing focus on low-carbon fuel worldwide reduce the CA-centric low-carbon subsidy risk.

Company Description: Darling collects 10% of all the animal by-products from the slaughterhouses globally (primarily in US and EU) and renders those products into ingredients that supply the feed, food, and fuel industries. By weight, for every ton of by-products that come in, ~50% is rendered off as water. The remaining ~50% is split roughly equally into fats and proteins. The lowest quality fats and proteins are used for fuel and fertilizer. The higher quality fats and proteins are divided into species specific feed (e.g. poultry meal for fish farming) and food (gelatin for candy).

In October 2013, Darling acquired Rothsay, the largest rendering operation in Canada, and in January 2014, Vion Ingredients, the largest rendering operation in Europe. Together, these acquisitions would have nearly tripled revenues if not for corn and soybean prices each falling ~50% shortly thereafter.

VP 1 – Gross margin stability

Perhaps the most misunderstood aspect of Darling is the business does not take commodity risk the way that protein-ag businesses take commodity risk, and only benefits from additional throughput. Darling’s revenue model is tolling-based. They pay for feedstock based on where the end protein and fat markets are currently trading. They take 2-4 weeks of commodity risk while they are processing the throughput. This has enabled Darling to earn between 21-30% gross margins since 2000. This is much different than a Sanderson (SAFM), Cal-Main (CALM), or even a large-cap, diversified protein business like Tyson (TSN), which get bloodied with low-single digit or negative gross-margins every few years. Sanderson and its peers are spread commodity business that seek to maximize the spread between feed prices and finished protein prices. On the other hand, Waste Management (WM), Waste Connections (WCN), and Casella Waste (CWST) have exhibited similar tolling-based gross margin stability and benefit when throughput increases.

VP 2 – Protein cycle optionality

Roughly half of Darling’s feed business (67% of EBITDA) makes products (meat bone meal – MBM, poultry meal – PM) that compete with soybean meal (SBM) as a feed calorie. After peaking in 2012, soybean prices and SBM/MBM/PM had fallen to price levels in early 2018 last seen in 2006, unadjusted for inflation. This is in large part due to the decline in oil and gas prices (major inputs into industrial agriculture) as well as several years of stable weather. Then came the US/China trade war in mid-2018. Together the US, Brazil, and Argentina grow 80% of the world’s soybeans and China buys 50% of all soybean imports to feed its number one source or protein, the noble pig. With China redirecting its soybean purchases to South America (and concurrently killing millions of pigs due to African swine fever), a glut of soybeans in the US has pushed soybean meal and its competitor meals down to historic lows (adjusted for inflation). I would not invest in Darling’s stock on a pure soybean reversion to mean thesis, but stating the obvious…when it comes to commodity exposed stocks, it’s certainly better to own them at cyclical lows. I also would not base the entire thesis on a US/China trade war reconciliation, which would open up a flood of soybean exports to China, but for those following the dispute, news coverage does seem to point to a near-term reconciliation.

VP 3 – Fats business vertical integration

Similar to Darling’s protein business, Darling’s fat business competes with corn as a feed calorie. Waste fat – yellow grease (YG), and used cooking oil (UCO) – prices have been bouncing along near historic lows (adjusted for inflation). That is about to change as the waste fats can now, in a material amount, be upgraded to drop-in renewable diesel (distinct from biodiesel) and sold into attractive low-carbon-fuel subsidy markets in California, Oregon, Washington State, California, Sweden, Norway, Finland, the UK and Italy. Additionally many other countries around the world are considering similar programs.

Brought online at 160mm gallons in 2013, Darling recently expanded its own renewable diesel plant (50/50 JV with Valero) Diamond Green Diesel to 275mm gallons, completed in late 2018, and plans to expand DGD again to 675mm gallons, to be completed in 2H 2021. At 675mm gallons, DGD will convert around 1/3rd of all waste fats available in the US into renewable diesel, roughly half of which they can source from their own collection chain.

Though it’s uncomfortable to depend on low-carbon fuels subsidies to achieve attractive margins, Darling benefits uniquely in that there will be greater demand for the waste fats it produces on the rendering side of their business in any renewable diesel pricing environment; a fact that should generate higher and more stable margins for many years to come.

Valuation:

2022 Base Case

Rendering business normalizes at $570mm of EBITDA; DGD contributes $300mm of EBITDA. At 9x EV/EBITDA (historical average), Darling stock is worth $45/share, or 100% upside from here (assuming free cash flow is used to buy back shares). Using the same numbers, at 6x EV/EBITDA, (33% discount to historical average), Darling stock is worth $26.50/share.

Key Risks:

CA renewable diesel subsidies end – somewhat offset by deep renewable diesel market in Europe, currently served by Neste. DGD has easy deep channel access from its plant and can ship to Europe for 15-20 cpg.

Soybean glut gets worse – this is the dead money risk. Soybeans spoil and farmers will shift their crops, but it could take a few years which could lead to an extended period of lackluster earnings results.

Near-term catalysts:

US/China trade war reconciliation

Another good quarter at DGD

Medium-term catalysts:

Successful expansion of DGD to 675mm gallons

Continuous expansion of low-carbon fuel markets

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author and/or his employer has a position in this stock and may trade this stock. This analysis is intended only for VIC members and must not be distributed further.

Catalyst

Near-term:

US/China trade war reconciliation

Another good quarter at DGD

Medium-term:

Successful expansion of DGD to 675mm gallons

Continuous expansion of low-carbon fuel markets