When I look at the financial statements of industrial stocks, volatile profit margins tend to be the norm, with commodity and raw materials being the bogeyman. Darling International (DAR +2.39%), the largest U.S. recycling solutions company serving the food industry, seemed to be a notable exception.
Darling derives more than 75% of revenue from the rendering segment, where it processes animal by-products and used cooking oil into fats and protein. Other businesses include the bakery segment, which processes waste collected from bakeries into bakery by-products.
Stable gross margin growth
Darling improved its gross margin from 21% in 2006 to 27.6% in 2012, which represents a margin expansion of more than 600 basis points. There are three key reasons for Darling's pricing power, notwithstanding volatile commodity prices.
First, Darling has limited supplier concentration risk, with only 25% of its raw materials sourced from its ten largest suppliers. This suggests that Darling has stronger bargaining power over its suppliers, since it is not dependent on any single supplier.
Second, approximately 75% of Darling's raw materials are priced under formula arrangements, where the prices that Darling pays to its suppliers are linked to the commodity prices for the finished products. As a result, Darling's margins are protected to a large extent, with formula-based pricing lowering its exposure to commodity price fluctuations.
Last but not least, Darling has significant cost advantages vis-à-vis its competitors, given its status as the country's largest rendering company with a 13% market share. Owning one of the largest private trucking fleets in the country, it derives significant economies of scale in costs relating to the collection of raw materials.
Upside from biofuels venture
Darling started Diamond Green Diesel, or DGD,, the largest animal fat to hydrocarbon recycling facility in the U.S. This was a joint venture with Valero Energy, with expected production of approximately 9,300 barrels of renewable diesel per day.
Unlike other companies that engage in upstream vertical integration to streamline costs, DGD has a natural advantage over other competitors in terms of both supply availability and costs. DGD is privileged to be assured of a stable supply source of feedstock such as animal fats and used cooking oils from Darling. Also, DGD's processing costs, on a per-gallon basis, were estimated to be about 25% cheaper than that for biodiesel processing.
It is noteworthy that this was not an impulse decision by management to join the bandwagon of the latest hot trends. While Darling started studying the possibility of biodiesel from its feedstock in 2004, it was almost a decade before the facility was eventually up and running. Darling did not rush into it and was patient in waiting for the right partner (Valero) and the most efficient process (renewable diesel).
Future outlook
Darling's financial performance for the second quarter of 2013 was not impressive. Revenue and EPS decreased by 3% and 29% respectively. Lower finished product selling prices, general and administrative expenses related to medical costs, and start-up expenses associated with DGD contributed to the decline in profitability. Still, I am optimistic of Darling's future prospects.
Apart from the biofuels venture, future growth will likely be driven by consolidation activities. Darling announced the acquisition of Rothsay, a leading Canadian recycler of animal by-products. Investors concerned over integration risks and shareholder value destruction associated with M&A will be reassured by Darling's track record. It has acquired and integrated 10 companies for more than $1 billion in the past decade. During the same period, Darling increased its market capitalization 10-fold.
Peer comparison
Waste Management (WM 1.59%) and Stericycle (SRCL +0.00%) are similar to Darling in two key aspects. First, they are all perceived as boring, low-growth stories because they make money from waste. Second, they all operate in capital intensive businesses where leading market share is critical to achieving economies of scale, particularly in the area of logistics.
Waste Management is the largest provider of waste management services in the U.S. It benefits from strong barriers to entry. New landfill approvals are rare because of the 'not-in-my-backyard' mentality. Plus, the low value-to-weight ratio of waste makes transportation over long distances uneconomical, nullifying any threats from foreign imports.
Waste Management grew income from operations and earnings per share by 9.4% and 15.6% respectively for the second quarter of 2013. This good set of results was achieved despite lower commodity prices affecting its recycling operations. Going forward, the non-discretionary nature of its services should help Waste Management maintain its profitability in an uncertain macro environment.
Stericycle, the largest U.S. medical waste disposal company, boasts of strong earnings growth and margin stability. It grew its earnings by a 10-year CAGR of 19% and has consistently delivered stable gross margins of 43% to 47%. Given that the improper disposal of medical waste can potentially lead to lawsuits and penalties for Stericycle's clients, they are cautious in selecting vendors and would prefer to stay with trusted partners like Stericycle.
Stericycle impressed with its recent second-quarter results: Revenue and diluted EPS were up 12.3% and 14.4% respectively. Stericycle's gross margin also increased to 45.2% in the most recent quarter, with its growing small account customer share being a key contributor. Looking ahead, Stericycle is looking to grow its share of small account customers, who are more profitable in terms of gross margin.
Bottom line
Compared with its peers, Darling combines the best of stability and growth. Its core rendering business is largely shielded from the volatility in commodity prices because of the unique formula-based pricing protocol for the industry. On the other hand, its biofuels venture, DGD, is a growth story in the making. However, Darling is expensive at 20 times trailing and 15 times forward earnings. So you may want to wait for a more attractive entry price.
