Darling Ingredients Undervalued With Its Diamond Green Diesel JV Valued At Zero
Summary
- Darling came under our radar due to the out-performance of the Diamond Green Diesel J.V for Valero in the Covid-19 environment.
- It seems that the J.V is being given a zero value both for Valero and for Darling, while in Europe similar renewable diesel businesses are being given more reasonable multiples.
- Moreover, their base business is also undervalued and Covid-19 resistant.
- However, lacking a dividend means that price discovery could become the main mode of return, and given the somewhat speculative nature of their upside, Darling could become a portfolio clunker.
- Nonetheless, Darling's J.V interest puts it at the intersect of a Covid-19 resistant, ESG and sum-of-parts undervaluation thesis.
The reason we think that Darling (NYSE:DAR) could be an interesting pick is to do with the latest results coming out of Valero Energy Corporation (VLO). With that release it became clear that the Diamond Green Diesel (DGD) J.V with Darling was the source of an expectations beat due to superior feed-stock flexibility compared to biofuel benchmarks. Based on questions in the earnings call, it became clear that renewable diesel was a bit of a dark horse for the analysts. But before price discovery could proceed for Darling which reported later, Valero with the rest of the markets continued to broil with the general market turmoil.
Diamond Green Diesel, which is ahead of almost any other refiner in capacity for renewable diesel, produced renewable diesel at immense margins even in the Covid-19 environment. Based on our analysis, this joint venture is being given essentially a zero value by US market actors where similar companies like Neste (OTCPK:NTOIF) are valued at more sensible multiples abroad, where regulatory regimes and margins are even less favourable. Along with this severe sum-of-parts undervaluation, we see downside protection in Darling's Covid-resistant core business, upon which Darling is solely being valued. Moreover, in the most secular of time horizons, we think that Darling will benefit from robust demographic trends and multiple expansion deserving of a sustainable waste management ESG play. Below we explain how Darling manages to be an unprecedented triple whammy of coronavirus resistant, severely under-priced and exposed to secular and ESG trends.
Secular Trends and the Base Business
Before discussing the DGD J.V, and why it should be considered a valuable investment, we need to cover why the base business already justifies a higher valuation, especially in this environment. As the most straightforward point, we begin with the secular argument.
Secular Tailwinds for Base Business
Despite Meatless Mondays and plant-based protein alternatives, in 2018 Americans hit an all-time high in meat consumption of ~270.7 pounds/person/year. Though per capita consumption will likely rise slower (up 3% till 2030), the world’s total meat consumption will increase 15% driven by growing population.
(Source: BNP Paribas 2020 Annual Conference)
This increase in meat consumption will support all aspects of Darling's business. It creates a larger market for agriculture and animal husbandry, meaning more demand for feed coming from their base business, as well as driving growth in the feed-stock that Darling uses for its products. This growth in feed-stock will be helpful for Darling to increase the proposition of their renewable diesel production as a viable alternative to other renewable fuels and energy sources, as current soy-based and palm oil-based production is frowned upon due to environmental and biodiversity impacts.
Base Business Coronavirus Resistant
Besides the secular tailwinds, there is also the matter of coronavirus resilience which the base business provides to investors. Based on the recent WestRock (WRK) earnings release, their protein end-markets are still seeing quite a lot of corrugated packaging demand, which implies that protein products are still turning over. For Darling this means their feed-stock, which is derived from all sorts of animal by-products, is still coming through at decent rates to support production. Moreover, the decline in diesel prices also means that the fleet of trucks that Darling dispatches to collect their feed-stock will also be cheaper to operate as we've seen in the latest quarter's gross margin expansion.
In addition to throughput resilience in the Covid-19 environment, we think that Darling's pricing should be rather intact as well. Some of their large markets are animal feed for farming and products used in food and pet foods. Even these markets should see sustained demand during Covid. For example, Hill's Pet Food, a significant segment of Colgate-Palmolive (CL), performed remarkably well in Q1 2020 despite the ongoing epidemic. This was due to an e-commerce rollout, but it nonetheless indicates demand strength for this end-market. In the feed business, food activity has to continue as it is critical for all those staying at home. Even in the most premium protein sources like salmon, which is farmed primarily in the massive Norwegian aquaculture industry, supply is meeting demand with prices holding at average levels while production increases YoY. We can expect that the majority of meats which are cheaper than salmon should be seeing sustained demand too.
Indeed, this resilience is evident in the recently released quarterly results, where feed ingredients operating income grew 10%, and food declined slightly in revenues and margins due to the redirection of feed-stock to China due to the African Swine Flu shortfall, reducing volumes and worsening scale economics. This situation might improve since biodiesel (not renewable diesel) economics are very bad right now, so there will be less hands to grab at some of Darling's feed-stock options in this volatile commodity environment.
All This Yet Undervalued
Despite all this resilience it seems that even the base business, before considering a non-zero value for the DGD J.V, is already undervalued. There are many comps that could be applied to Darling's ingredients business, but let us illustrate the discount Darling trades at by comparing it to another company that supplies feed and food. If we consider the multiple analysis we did for Austevoll Seafood's (OTCPK:ASTVF) pelagic fishing business, which has arguably worse economics than Darling on the supply side due to higher input prices and volatility, we could value Darling at a 14x EV/EBITDA multiple where traditionally fishing and aquaculture businesses lie.
Comparing this as a fair multiple for a feed and food business to Darling, which has an EV currently of $5.15 billion, we see discrepancy on Darling's $437 million 2019 EBITDA. We'd see the exact same discrepancies applying identical waste management multiples, which could also be argued as appropriate given that Darling disposes of industry's used cooking oil and meat products in a manner similar to a waste management company.
Sum of Parts Valuation
Our thinking on renewable diesel derives from the research we've done on Valero and we are confident in the value of the DGD joint venture. Not only has it outperformed soy-based benchmarks in the coronavirus environment due to superior procurement and feed-stock from Darling, it is at baseline a very high ROIC business. In fact, the proposition is so good that virtually every refiner is rushing or trying to roll-out their own renewable diesel production, prioritising this CAPEX above all else even in this cash-strapped environment.
Alt-Fuels
Alternative fuel may be a viable solution to climate change concerns and is seeing institutional recognition by US and European authorities. In California, the programmes have been piloted through the California Air Resources Board since the late 00s when they started their initial research and studies. These biofuel programmes are being supported by federal legislation like the Renewable Fuel Standard and other blending requirements and incentives. The only state that has been setting blending requirements since before California was Minnesota, which has required high blending requirements in summer months since the turn of the millennium.
There are several reasons why renewable diesel could be here to stay. The first is that it favors oil companies as opposed to electrification, critical to assuage oil lobbies. Indeed in Canada, where Trudeau has been re-elected, accommodations are being made to oil producing provinces by focusing on green options related to renewable fuels. The second reason is also political, which is that American farmers are a very influential lobby, and cutting back on renewable diesel would not be looked kindly upon since their products are supported by renewable diesel feed-stock demand.
The third reason is that 70% of diesel consumed is by heavy duty trucks, which are unlikely to be electrified anytime soon. This makes the overall biodiesel market particularly robust, with renewable diesel likely to take all that market share soon.
(Source: BNP Paribas 2020 Annual Conference)
Renewable diesel is not as fringe as people might think. It's being used globally, and ends up removing hundreds of thousands of cars worth of emissions from US roads alone. The blending programmes have proven to be relatively robust in the markets where they've been piloted and the efficiency of sustainable feed-stock has been shown by DGD's operating margins improving to ~60% from superior feed-stock in Q1 2020. This was all obtained at more than 100% capacity due to the buffer from the fact that the US is a net importer of renewable diesel and this is a regulatory, mandated and somewhat volume decoupled market. Cash generation was substantially up in Q1 2020 to $600 million, allowing for fully self-funding capacity expansion and even paying out a dividend to each partner of $75 million. Moreover, with the potential recovery in diesel and heating oil prices, margins could end up improving towards the end of the year even more.
Valuation
In our Valero research, we valued Valero's stake (and consequently Darling's stake) in the renewable diesel JV at around $7 billion using a cash flow model. However, we will make a more compelling and conservative case by drawing from a public comp that would be obscure to the US investor base.
The most recognised comp, Neste (OTCPK:NTOIF), is Finnish and is the largest producer of renewable diesel in the world, outputting twice the amount that the DGD J.V does. Between 2007 and 2011 Neste had put in place a profound transformation process under which they have substantially divested from the oil sector and reinvested in renewable diesel. In five years, the company sold and divested most of its oil assets (for instance the self-service station chain in Poland) and reinvested in renewable diesel assets which produce the vast majority of their income.
Neste's EV is substantial at 23.94 billion EUR, which is equivalent to $25.96 billion. Although most of its income comes from renewable diesel, for precision we will imply the multiple on the renewable diesel business using its 2019 financial statistics and a refinery multiple from HollyFrontier (HFC), basically a refinery pure-play.
(Source: Mare Research Database)
From this process we arrive at a 10.21x multiple for a recognised renewable diesel business. This multiple is definitely too low due to the excellent business economics, but we use it anyway to be as conservative as possible. Applying this multiple to the DGD J.V's 2019 figures from Valero's FY 2019 press release:
(Source: Mare Research Database)
Above is the value of the whole DGD joint venture. Consider that the J.V is a debt-free entity. 50% of its value can be attributed to Darling. Given that Darling's multiple seems only sensible when ignoring the value of the DGD J.V, because the J.V is greater than Darling's current market cap, we have to assume that US markets are giving it a zero value.
ESG Play
The final prong to the Darling investment proposition is that it's an ESG play. Consider some of the following:
- Because of their critical involvement in procurement for DGD, they contribute to eliminating the equivalent of 450k cars worth of emission from roads every year.
- Because of state mandates to use alternative fuels for public electricity production like in the Netherlands, Canada, Belgium and states in the US, Darling provides ~12,000 homes with green electricity.
- Avoids 5.4m metric tons of CO2 emissions in the US alone.
- Produces 3.3bn pounds of low carbon intensity feed-stock for biofuel, against horrible alternatives like palm and soy-bean oil fuel which supports destructive industries and practices.
- By using waste products as inputs, they return 10 billion gallons of water to the environment with their production.
Risks and Concluding Remarks
There are certainly risks to the thesis. A slowdown in real GDP growth could exacerbate the headwinds caused by the current global over-supply of proteins. Most critically, the upside in our thesis relies heavily on renewable diesel which is still somewhat marginal from a regulatory point of view, although its longevity lends it some kind of legitimacy. Without a dividend, for this stock to not become a clunker, one might have to wait for it to enter the US overton window, which may not happen even though it has in Finnish markets. There are also risks in the base ingredients business, as meat industry consolidation results in the employment of captive rendering companies, which would mean less business for Darling.
However, renewable diesel continues to perform extremely well managing to self-finance and pay out excesses to the partners. Additionally, the piloted programmes have seen success in achieving state emission objectives. Moreover, Valero-Darling will have 10x the renewable diesel capacity in 2025 than its closest US renewable diesel competitor HollyFrontier (HFC), meaning that it'll have the assets to generate obscene amounts of cash at highly value-accretive rates for quite a while. Even if renewable diesel does not become well recognised by markets, there's still a hope that the business is intact years down the line, avoiding clunker status with an eventual dividend from what would end up being a massive and profitable asset base. On the other hand if renewable diesel out-performance, emphasized in this period of low refiner revenue, becomes recognised in refiner results during this crisis, we wouldn't have to wait as returns would come front-loaded.
To add to the evident margin of safety, consider that we are using a multiple from an already undervalued European business, which is subject to a more unfavourable regulatory environment as seen in the EU Taxonomy final report, so Darling should have a much higher multiple. But even with these conservative assumptions baked into the valuation, we can substantiate a massive discount using 2019 figures and balance sheet data from the most recent quarter:
(Source: Mare Research Database)
Though the renewable diesel business might not be receiving recognition from markets, refiners are desperately expanding their capacity because the ROIC of these investments are extremely high. Indeed, Neste revamped its entire business to become almost entirely about renewable diesel. To give credit to the market, we think this pessimistic view can make sense if analysts are assuming renewable diesel will collapse within the decade, since under those assumptions the short-payback periods would mean no value destruction, but the terminal business would also result in little value creation.
However, in the not-so-speculative instance that renewable diesel becomes entrenched, thus justifying our valuation rather than the zero the market is giving it, Darling goes from being a bit undervalued to being at more than a 50% discount. You may not be paid to wait, but if renewable diesel becomes recognised for the out-performer that it is, returns might be front-loaded. If not, years down the line a dividend will likely be paid if the business is intact despite staying obscure. If we're right about Darling that dividend will be massive on your initial investment, funded by the expansive asset base that DGD's head-start in renewable diesel would afford. In either case, Darling is a clear buy.
This article was written by
Analyst’s Disclosure: I am/we are long DAR. 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.
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