|Shares Out. (in M):||165||P/E||15||0|
|Market Cap (in $M):||2,944||P/FCF||9.6||0|
|Net Debt (in $M):||1,614||EBIT||332||0|
Darling Ingredients is an ingredients and biofuels company that has enormous tailwinds from regulations around the globe. It is completely misunderstood by the sell-side who do not see the potential. This takes a bit of an introduction so bear with us.
We recently met with an energy specialist who had done quite a bit of work on California’s Low Carbon Fuel Standard (“LCFS”) program. This program was developed under Governor Arnold Schwarzenegger and was implemented in 2011. It encourages the use of biodiesel and other alternatives to fossil fuels. LCFS credits are generated when low carbon fuel is sold to customers. Sellers of fuel are fined if they do not meet the standards or buy an offsetting credit. Over the last few years, as the carbon reduction targets have increased, the price of the carbon credits has also started to increase. What is interesting about this market, and not widely appreciated, is that the credits will very likely continue to increase in value as the standards are ratcheted up annually.
As the markets began to catch wind of this impending deficit, credit prices appreciated from $100 per metric ton to as high as $155 per metric ton over the past two months. It should be noted that LCFS credits traded between $70 and $100 per metric ton for most of 2017. There is a soft cap for the credits at $200, however there is currently no mechanism in place that would actually cap the credits there. Our research indicates the California Air Resources Board (“CARB”) would not like to see the credits move meaningfully above $200 since that would move gasoline prices up too much and could cause political backlash.
On February 20th, CARB released a preliminary proposal to modify the program which will be voted on in April. This proposal contains two changes to the LCFS reduction schedule. First, instead of the initially mandated 10% carbon intensity (“CI”) reduction from the 2010 baseline in 2020, the 2020 reduction is proposed to be 7.5% with the 10% reduction delayed two years to 20202. Second, instead of the 18% CI reduction in 2030 from the 2010 baseline in prior CARB documents, the proposed reduction target is increased to 20% in 2030. We believe these amendments are being contemplated for two reasons:
1) 1) The California Air Resources Board (“CARB”) published an analysis showing that the current inventory of credits (which built up during the first years of the program) will be practically exhausted by 2020. In other words, the program was too stringent and prices were on a collision course with $200 per ton during the course of this year. We believe CARB wants to smooth out the program in order to ensure its long term effectiveness.
2) 2) Oregon, British Columbia and some Scandinavian countries all have similar programs. It is notable that the Canadian government plans to announce soon a national program that may be similar to the one in California. In addition, when CARB announced the modification, we learned that Brazil is contemplating a similar program. Given the impending surge in demand expected for biofuels, CARB took its foot off the gas in order to help make the inception of the new LCFS programs more smooth.
Following this modification, LCFS prices are at $125 per metric ton. One thing that is quite clear is that the LCFS programs across the globe may be a compelling investable theme. The prime and perhaps only true public beneficiary of this trend is Darling Ingredients.
Darling is the world’s largest renderer and owns a 50% interest in Diamond Green Diesel (“DGD”), a plant outside of New Orleans that turns animal fats and used cooking oil into biodiesel. What is noteworthy about DGD’s diesel is that it receives the best carbon intensity scores from the California LCFS program since the feedstock comes from waste products, instead of vegetables or crops. It is also worth mentioning that in January, the European Parliament decided to phase-out palm oil by 2020 and cap crop-based biofuels. In turn, biofuels derived from waste products will take the bulk of the share of the vacuum created by this policy change. This policy shift should result in an increase in demand for the renewable diesel produced by the DGD plant as well as an increase in demand for the animal waste and fats collected by Darling’s base business.
If you were a private equity investor thinking of a way to play the LCFS/biodiesel theme, you would try to re-create Darling. However, over the last six or seven years Darling has been anything but a Wall Street darling. The decline in corn prices hurt its animal feed business and a strong U.S. dollar hurt the translation of its European earnings. In addition, management’s capital allocation abilities look suspect as it made two large acquisitions right before industry fundamentals took a large turn for the worst. We believe this negative sentiment in combination with the complexity of the story result in the shares being meaningfully undervalued if the California and global LCFS market plays out as we expect.
Darling’s management has stated that they believe that their DGD facility should generate north of $1.25 of EBITDA per gallon once they start selling all of their biodiesel into California based on current market prices. When speaking with the company, we learned that they are already at a run rate well north of this. The sell-side is overly focused on near term issues such as the 45 day period that the company will be closing down the plant while it increases its capacity. In addition, analysts are very skeptical of the company’s ability to generate margins north of $1.00.
At current LCFS prices, we estimate that DGD is earning $1.65 per gallon of EBITDA. At these prices, DGD will generate $226mm of cash per year for Darling. In 2018, Darling and its joint venture partner Valero Energy Corp. are analyzing whether or not they should double it in 2021. We believe the California market alone justifies the 2021 expansion. The economics of the expansion are pretty compelling as capacity could be built at $2.00 per gallon. Starting in 2022, using the same assumptions, DGD would be generating $453mm of cash for Darling per year. This represents $2.20 in EPS for Darling just from DGD. Please note that for the purpose of this analysis we are assuming that the U.S. Congress does not renew the blenders tax credit, which gives blenders of biofuels $1 per gallon. However, we assumed DGD would get back half of the $1 per gallon via an increase in the market value of RINs (Renewable Identification Numbers) which are credits that measure compliance with the federal Renewable Fuel Standard.
As these expansions happen, DGD’s growing demand for animal fats and used cooking oil will be positive for Darling’s core business. DGD currently consumes 10% of all used cooking oil and animal fats produced in the United States (practically all of which are supplied by Darling). As DGD expands, this will tighten up the market for both products, and should help improve the earnings of the core business. If the 2021 expansion happens, DGD would be consuming one-third of all of the used cooking oil and animal fats produced in the United States.
Darling’s core business generated an average of $458mm of EBITDA between 2014 and 2017. We believe the pickup in animal fat prices and used cooking oil could add $40mm to $60mm over time. The recent appreciation of the Euro versus the U.S. dollar should add approximately $25mm to earnings. Growth from the deployment of capital into new plants and organic growth in the business should add at least $25mm.
We view the core operations as ultimately having the capability to generate approximately $550mm of EBITDA, which would translate into approximately $1.37 per share of free cash flow without any contribution from DGD. In 2022, we believe DGD will earn $3.70 per share if the LCFS value is $200. Combined, we believe Darling will earn $5.07 in 2022 and take the shares to $60 or $70 versus a current price of $17.
We believe that in 2018, the core business will generate approximately $460 million in EBITDA. After netting out $83 million in interest expense, $25m in taxes and $219m in maintenance capex, the core business will generate $133 million in free cash flow, or $0.80 per share. To be conservative and using the company’s (north of) $1.25 per gallon EBITDA guidance of DGD, the company will exit 2018 at a $1.04 run rate from DGD. Therefore, without even contemplating the improvements to the base business from the pull due to the LCFS programs, the company is trading at less than 10x current free cash flow.
Implemenation of Canadian, Brazil and European LCFS programs
Incresase in California LCFS credit prices
One or two quarters of results showing the earnings potential of DGD
Sell side waking up