2023-09-08 01:58:15 ET
Summary
- Darling Ingredients released a strong 2Q23 financial report, but the share price since has been weak.
- Diamond Green Diesel had a record quarter and is on track to achieve the guided 1,200 million gallons of RD.
- DAR management reiterated guidance of $1.85 billion EBITDA. If achieved, DAR appears undervalued.
Investment Thesis
Darling Ingredients released a strong 2Q23 financial report and reiterated 2023 EBITDA guidance. And yet the market has sold the share price down by 15%. The share price move has been solely driven by P/E multiple movement, not analyst consensus forecast downgrades.
This is presenting investors an opportunity to buy Darling at a cheaper valuation than previous without seeing a degradation in fundamentals. In this article I'll analyse the 2Q23 report, what I believe the market is expecting from the company, and present an updated valuation that suggests DAR is a buy.
2Q23 Result Details
In the second quarter, sales increased by 25% to $252.4 million, EPS grew 26% to $1.55 - higher than the sales growth rate, implying higher margins, which is a great result because the increase in revenue resulted in a more than proportionate increase in earnings per share.
Combined Adjusted EBITDA (which includes the contribution from Diamond Green Diesel) for the quarter increased 26.3% to $508.3m, however, there was $18.5m impact from the inventory acquired from Gelnex. Otherwise, the Combined Adjusted EBITDA would have grown 31%.
This growth seems excellent on the surface, but we know the company has been quite acquisitive recently and has used debt to fund it, so has the company just gone and bought revenue without contributing to shareholder value? Analysing EPS can help, but if the acquisitions were funded by debt, this will boost EPS (and ROE for that matter) without actually enhancing returns for shareholders.
Annualised return on equity ((ROE)) was 22.7%, a very good result, and is an improvement in the 2Q22's ROE of 20.7%. Return on invested capital for 2Q23 (which includes debt in the calculation for capital) was 15.9%, an increase from 15.3%. This is also a good result because it is higher than DAR's cost of capital. This is my first hurdle in checking whether or not this was a quality result.
The company repurchased about $9m in stock, which was not a huge contribution, and suggests to me other capital allocation priorities such as investing in DGD and repaying debt, which is currently elevated post the acquisition of Gelnex this year.
Darling also received a maiden dividend from DGD of $101.4m in the quarter with a further $62.2m received in 3Q. DGD also repaid $25m in debt to DAR. These cash flows will help to deleverage DAR, as will 2 full quarters of Gelnex contribution, but it should also be noted that DAR had invested $75 million in equity into DGD in the 1Q, which in my mind dampens the success of the dividend payout so soon after. Nonetheless this is a very positive step for both the DGD joint venture and Darling Ingredients.
Diamond Green Diesel
I, and others on Seeking Alpha, have noted previously how critical DGD is to the success of DAR. The core rendering business is a very stable cash cow, while DGD is the growth engine that is riding tailwinds towards a greener energy economy.
This was a record quarter for DGD, selling 388 million gallons of renewable diesel at an average EBITDA per gallon of $1.28. The 388 million gallons is well ahead of the run rate required to achieve the 1,200 million gallons of annual production guided to during the previous quarter. However, it appears this includes some catch up from the first quarter, which only sold 255 gallons. This was foreshadowed in the 1Q23 conference call with some March shipments being pushed out into 2Q. The capacity was clarified in the 2Q23 Q&A , with management noting that DGD produced (not sold) 340 million gallons, which, annualized, is 1,340 million gallons. CEO Randall Stuewe noted that the official nameplate capacity is 1.2 billion gallons, which accounts for scheduled downtime for maintenance and other "hiccups", but in good years 1.25 billion or even, 1.3 billion is well within the realms of possibility.
The EBITDA margin of $1.28 is in broadly line with the $1.25/gallon guidance for 2023, however, based on a comment in the 1Q23 Q&A that I quoted in full in my last article , Stuewe hinted that the margin for the quarter could be north of $1.50/gallon. If this was an expectation set by the market, this could be a key reason the market has been selling DAR.
The improved margin was helped by lower fat prices, which is a dynamic that showcases the diverse nature of the business that has a built in hedge. Lower fat prices hurt margins in the Feed segment, as they sell the fats for use in other products, however, fats are also a key ingredient in producing renewable diesel at DGD, so the loss in margin in Feed is more than made up for in the Fuel segment.
Company Outlook
Management reiterated their EBITDA guidance of $1.85 billion, which, as discussed in my article last quarter, could look conservative. In fact, given that the company came in at the top end of 2Q guidance given last quarter and favourable commodity pricing, the question of guidance conservativism was the first one asked. In response, management focused on fat pricing, which I discussed above, and noted that the double-edged nature of fat pricing now allows them to have confidence in the guidance regardless of where fat prices move.
This was further clarified by another questioner, who noted that without a one-off inventory charge from the acquisition of Gelnex the current EBITDA run rate exceeds the guidance. And that is before such benefits, some of which I pointed out in my last article, as improved fat prices, a full half contribution from Gelnex, and improved DGD margin. Stuewe was quite candid in saying he expected 3Q23 to weaker than the second quarter due to rising fat prices and also the fact that summer tends to impact rendering margins, both of which will impact the second half EBITDA. DGD also had about 3-4 weeks of downtime in July, which will mean lower RD volumes produced.
Clearly there are a lot of moving parts and management seem comfortable that the current guidance is achievable based on the positive and negative contributions that they can calculate.
Market Expectations
While the sales result missed market expectations by about 4%, the EBITDA result was a modest beat if you exclude the one-off Gelnex inventory expense of $18m, mentioned above, and the EPS result was a mere 1.8% miss.
However, it is fair to say the commentary given by management on the conference call, as I believe I have outlined above regarding the third quarter, may have spooked the market. There were some small consensus downgrades of 2.5%-3.0% to sales and EPS, but EBITDA forecasts were largely unchanged for both next quarter and the fiscal year. The fall was a result of P/E multiple compression from 12.4x to 10.5x, shown on the chart below. The correlation between price and P/E is as tight as you'll see.
There were no rating downgrades by Wall Street post result, with 13 out of 15 analysts surveyed by FactSet continuing to rate the company a buy and the remaining 2 continuing with their hold rating. I must admit, I always take sell-side reports with a grain of salt but to not see even one analyst defect on their rating is telling only because it is unusual.
There is also no obvious correlation between Darling's recent trading and that of its commodities prices. Indeed, most have been strong through the quarter and since the result including diesel, Brent crude, and soy meal.
DAR share price index to relevant commodities (FactSet)
Thesis Remains On Track
My thesis for Darling Ingredients rested on a belief that Darling Ingredients was trading around my estimate of fair value or the low end of a valuation range based on varying outlook assumptions. These assumptions were based on the belief that management provided guidance for 2023 that seemed conservative and could realistically be upgraded throughout the year. While there was no upgrade in 2Q23, the weakening share price -- without any discernible deterioration in the business fundamentals -- has introduced a margin of safety to my base case valuation that is predicated on the company simply achieving guidance -- anything else will be considered a bonus.
I have used a 4-year DCF to value the business and have used the same inputs as my last valuation, including an 8.8% WACC. Assuming DAR achieves guidance of $1.85 billion EBITDA in 2023 then proceeds to grow at a modest 7% in 2024, 2.5% in 2025, and 1% in 2026, this produces a valuation of $67.16, implying a discount of 16%.
Author's analysis based on FactSet data
Where We Could Be Wrong
In the short term, the risks to the thesis were all mentioned on the call. Fat prices have been rising in recent months, and while this is now both a benefit and a negative for the Feed and Fuel segments respectively, the impact skews to DGD in the Fuel segment.
We could also see further short term share price weakness if the 3Q is weaker than expected. Consensus is already (and was prior to the 2Q result) forecasting a lower result than the 2Q, but if the downtime in July had a larger impact than expected or if DGD margins revert lower, we could see further share price weakness.
Conclusion
Darling is a business that operates at the mercy of commodities prices. Predicting these movements in the short term can be difficult, but the company has shown astute management to become an integrated global business riding a tailwind of heightened demand for renewable fuels. In the medium to long term margins should even out and capacity will be added, starting with sustainable aviation fuel, planned for completion in 2024.
Recent share price weakness provides an opportunity for long term investors with a willingness to look through short term volatility to buy a growing company with quality management at an attractive valuation.
For further details see:
Darling Ingredients: Share Price Weakness Widens Margin Of Safety