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Company Description:

Darling (NYSE:DAR) engages in rendering, cooking oil, and bakery byproduct recycling by collecting and recycling animal by-products, bakery waste and used cooking oil from poultry and meat processors, commercial bakeries, grocery stores, butcher shops, and food service establishments. The Company also provides grease trap cleaning services to many of the same establishments. Darling's end products include protein, animal feed, and pet food.

As an investment Darling is an agriculture play. The pricing of its end products are correlated to the price of corn, soybeans, and soybean oil. However, the majority of their gross margin (~70%) is protected because their raw material cost is based on a formula that is related to the commodity price. It is also a play on greater protein consumption around the world as growing middle classes in developing countries increase their protein consumption which requires feed to sustain the animals before they are slaughtered. Darling's feed can be thought of as a cheaper substitute for corn and soybeans in the animal diet.

In December 2011 Darling acquired the private family-owned company Griffin Industries for $840mm in cash and stock, effectively doubling the size of the company and diversifying into poultry rendering and bakery by-product recycling.

For more detail on the company I would recommend reviewing Darling's latest investor presentation from early June along with the 2011 10-K filing.

Investment Thesis

Darling's current valuation alone (5.7x LTM EBITDA) supports the long investment thesis given the growing protein consumption amongst the rising middle class in developing countries. However, a significant catalyst exists in their JV with Valero (NYSE:VLO) (discussed below) that could significantly increase Darling's EBITDA. Together, this creates a material margin of safety for a long investment in Darling.

Current Valuation ($millions, except per share values):

Darling's valuation can be broken down into two components. The first is the core business that generated $393.5mm of EBITDA and $180.7mm of free cash flow in 2011. The second component is a 50/50 joint venture with Valero (ticker VLO) that will use Darling fat as an input to produce biodiesel.

To level set some current relevant trading metrics are as follows:

Stock Price

$15.39

Market Capitalization

$1,834

Cash

$28

Debt

$250

Enterprise Value

$2,057

LTM EBITDA

$359

EV to LTM EBITDA

5.7x

LTM FCF

$142

FCF yield

7.7%

Wall Street research's consensus estimates for earnings per share and EBITDA for 2012 and 2013 are as follows and do not appear to reflect the impact of the JV:

2012E EPS

1.293

2013E EPS

1.544

2012E P/E

11.0x

2013E P/E

9.2x

2012E EBITDA

353

2013E EBITDA

371

2012E EV / EBITDA

5.4x

2013E EV / EBITDA

5.1x

The 50/50 JV with Valero

The renewable biodiesel facility, co-located with an existing Valero refinery in Norco, Louisiana will be completed in late 2012 or early 2013. It will produce 137mm gallons of renewable diesel annually using DAR-rendered fat as feedstock. Valero is the off-taker with the 137mm gallons of renewable diesel meeting Valero's requirement under the Renewable Fuel Standard (RFS2). The facility will cost $400mm, with $93mm in equity coming from each of DAR and $221mm of financing, which is already in place. The renewable diesel is chemically identical to road diesel and can be used in existing infrastructure without alteration.

The value of the JV to Darling is driven by the spread between the cost of alternative renewable feedstock (i.e. soybeans) and Darling's feedstock. Using the current yellow grease fat price per gallon of 0.395/lb, the JV would generate EBITDA of approximately $86mm. Darling's 50% interest or $43mm would increase 2011 EBITDA by 11%.

Back testing to 2004, using historical fat and renewable diesel prices suggests that the average annual EBITDA the JV would have generated is over $150mm per year, representing almost 21% of Darlings current LTM EBITDA. Further, to produce 137mm gallons of renewable fuel requires 1.1 billion lbs of Darling's fat. This represents 10% of the total U.S. fat industry. With 10% of the market diverted, the JV supports pricing of the overall fat market helping Darling's base business maintain pricing levels. And should fat prices increase making the JV less profitable, Darling's fat business would benefit.

Summary Investment Thesis:

Darling is trading at a historically low multiple and has a significant catalyst coming at the end of 2012.

Catalyst

The most important catalyst will be when the JV comes online and Darling can begin to report of the profitability of the JV, which will likely be in their Q1 2013 earnings.

Valuation

Risks

Fat and soybean fuel prices are volatile impacting the profitability of the JV. Further, in Darling's core business rendering and bakery byproduct volumes can be influenced by weather and general economic conditions.

While the majority of the gross margin is protected, significant swings in corn or soybeans can impact earnings.

Conclusion

Darling is trading at a historically low multiple and has a significant catalyst coming at the end of 2012. As the only public rendering company there is no clear comparable to point to, but prior to its purchase of family-owned Griffon Industries Darling tended to trade at 8-10x EBITDA. Pro forma for the JV assuming current fat and soybean pricing, Darling is trading at only 5.1x. At this valuation Darling has a material margin of safety. Given ~$200mm of annual free cash flow generation and current leverage of less than 1x, Darling is also a take private candidate at a significant premium to its current valuation.

Source: Darling International's Joint Venture With Valero Makes This Value Stock More Valuable