Maksim Labkouski
Shares of Darling Ingredients Inc. (NYSE:DAR) fell 4% in generally upbeat markets in response to a >$1 billion deal in Brazil. The move is substantial in relation to the valuation of this deal, as investors apparently have some doubts on the transaction.
My last take on the company dates back to May of this year, when I concluded that Darling Ingredients was providing a perfect mix. The company has seen excellent momentum coming out of the crisis and issued a strong guidance for 2022. This provided confidence which triggered management into pursuing a billion-dollar deal in 2021 and a substantial deal in May of this year as well, with the next deal already reported now.
Transformation
For years, Darling has been a somewhat boring and challenging processor of animal by-products. Following a transition, it has become more focused on food recycling, transforming into a value-added ingredient and solution provider for food and to feed the world.
The company uses by-products from livestock suppliers, meat processors, and food production companies to create products and ingredients used by pharma, health, biofuels and green energy producers.
Ahead of the pandemic, Darling posted $3.3 billion in sales for the year 2019 across various divisions, including a substantial equity stake in Diamond Green Diesel, a very successful joint venture which the company has with Valero Energy (VLO). Including earnings from this JV, the company reported operating earnings of $486 million and net earnings of $313 million, for earnings of $1.86 per share. A $28 stock ahead of the pandemic resulted in a 15 times earnings multiple as the company had some debt, as well as non-profitable segments, creating the potential to create value here.
The pandemic provided a mixed bag, with 2020 sales up 6% to $3.6 billion, yet adjusted earnings fell eight cents to $1.78 per share, as shares rallied to the $60 mark in anticipation of improved results. Shares rallied a bit further to the $80 mark early in 2022 as the company enjoyed a strong 2021 with sales increasing to $4.7 billion on which the company posted EBITDA of $1.23 billion. This worked down to reported earnings of $3.90 per share on a GAAP basis.
With the company trading at a 20 times trailing multiple, I was performing a balancing act. The company is well positioned, benefiting from ESG and green trends, as the business has seen very strong margin momentum already, creating risks to the thesis in case of a margin pullback. Operating momentum triggered the company into pursuing a $1.1 billion deal to acquire Valley Proteins late in 2021, adding multiple rendering and cooking oil facilities to produce renewable diesel and aviation fuel.
The company furthermore acquired Brazilian rendering company FASA Group in a $560 million deal in May of this year, adding more rendering facilities. These deals resulted in a pro forma net debt load of $3.3 billion, and given that increased debt load, it was good to see increased momentum. First quarter sales rose 30% to $1.36 billion, as operating earnings rose just 16% to $233 million amidst a lower equity contribution from the Diamond Green Diesel JV, with earnings reported at $1.14 per share.
With full year EBITDA seen around $1.55-$1.60 billion, pro forma leverage comes in around 2 times, as I saw no reason why earnings could not rise to $5 per share, implying that multiples contract to 15-16 times, amidst a strong positioning. With shares trading in the mid-seventies in May, I was willing to buy on dips, given the solid long-term positioning as I have initiated a small position in the low-sixties during the pullback seen this summer.
An Update
Amidst skyrocketing energy prices, Darling reported very strong second quarter results. Revenues rose 38% to $1.46 billion as operating earnings improved in a very modest fashion to $278 million as growth in the core business was offset by a lower earnings contribution from the Diamond Green Diesel JV. Net earnings came in at $202 million, with earnings inching up six cents to $1.23 per share, for a $2.37 per share earnings number in the first half of the year. Net debt of $2.75 billion was reported ahead of the FASA acquisition (which closed on the first of August) for a $3.3 billion pro forma net debt load, as the company maintained the full year guidance.
To finance the deal, Darling issued a $250 million unsecured senior note offering in mid-August at a yield around 6%, with financing arriving at a steep price.
With the investment thesis still fully on track, earnings were seen around $5 per share, for a 15 times earnings multiple. Leverage remains in check, around 2 times, as the company announced its next deal by mid-October. At the time, Darling has reached a deal to acquire Gelnex, a producer of gelatin and collagen products, in a $1.2 billion deal. This is the second Brazilian deal in a row, albeit the acquired company has a facility in the U.S. as well.
While no financial details have been announced, pro forma net debt would increase to $4.5 billion. With EBITDA seen around $1.6 billion this year and the deal likely adding more than a hundred million dollars in EBITDA, leverage ratios will increase to 2.6 times, assuming the hundred million dollar EBITDA contribution. This feels a bit high, given these times of uncertainty and higher interest costs.
The market seems cautious as well, with shares down 4% on the back of the deal announcement. This is a big move, as the $1.2 billion deal tag is equal to about 8% of the $15 billion enterprise valuation at the time, being a clear vote by the investor base if you ask me.
Concluding Remark
I would like to urge for a bit of caution here amidst valuation multiple contraction following rising interest rates and greater uncertainty, as a bit more conservatism with capital allocation would be welcomed.
Nonetheless, solid growth for Darling Ingredients is still seen, and the leverage situation is manageable (at least for now). Hence, I am sticking to a modest long position in Darling Ingredients, seeing no reasons to alter this right now, yet a bit more conservative practices would be welcome.
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