Have you ever stopped to think about what happens to all the parts of a cow or a chicken that don't get sent upriver for human consumption? You know, the stuff known as "animal byproduct"? What about all the grease a restaurant throws out after it's done cooking your filet mignon or leg o' lamb or chicken tenders?
Personally, I never gave any thought to such things until I realized I could profit off of them. How? Through Darling International (NYSE:DAR), a company in the business of recycling animal byproducts. Moreover, let's just say that I'm glad someone exists to clean up the mess caused by humans being at the top of the food chain, and I don't just mean environmentally.
Darling provides recycling and rendering services through which animal and food waste products are turned into useful commercial goods, including tallow, protein meals (meat and bone meal), and yellow grease. Darling also serves the restaurant industry by removing used cooking oil and pumping grease traps.
The grease collection part is easy to understand. The rendering aspect requires some explanation. Darling collects byproducts from meat packing plants, butcher shops, grocery stores, and independent meat and poultry processors, such as former Motley Fool Stock Advisor pick Sanderson Farms (NASDAQ:SAFM), Tyson (NYSE:TSN), and Pilgrim's Pride (NYSE:PPC). Yes, that means they scoop up blood, guts, bones, and anything else humans can't (or won't) eat. From these yucky raw materials, Darling is able to create two major finished products: Meat and Bone Meal (MBM) and Tallow. These things are subsequently converted into a lot of useful everyday products. Have a look at their product flowchart. After the waste is prettified into feed or soap or candles or explosives (really!), they sell and export them around the country and the globe.
Grease is king
You don't need to understand how this is done, just that Darling is the best at doing it. So, just how good a business is this? Let's start by reading about the company's most recent earnings report. Of some concern is that sales decreased 1%. I'm picky, so normally I might close the books right there and move on. But Darling is a commodity business, so we must ask why sales were off.
Darling's 10-Q gives us these reasons for the sales problem:
Reduced availability of raw material supplies. Fewer cattle were available for slaughter because of something the commodity business calls "negative margins." This essentially means that the cattle cycle is at a point where there are fewer cattle of slaughtering age than there are younger cows (who still need to be fed and aged properly).
Higher energy prices. Darling uses a lot of natural gas to heat the BMB and Tallow in order to make products from them. Natural gas prices are very high, as is the price of diesel fuel, which the company's trucks use to haul renderings and finished product.
Inability to export finished product. Many countries refused to import any kind of meat-based product after one case of mad cow disease was reported in the U.S. in December of 2003.
At this point, some of you might be thinking, "Cut this one loose, already!" But when you look at these three sales suppressors, notice one thing they all have in common: they're temporary. The raw material supply problem is a cyclical issue, as is the pricing of natural gas and diesel fuel. The ban on importing U.S. meat will come to an end, most likely in early 2005. The government has addressed global concern by creating strict regulations regarding beef processing that makes it nearly impossible for mad cow disease to enter the food supply, with other regulations pending that Darling may even be able to exploit as a new revenue stream.
Grinding up the digits
So, despite all these challenges hitting Darling at the same time (one might even say a "perfect storm"), sales only decreased 1%? And they still managed to be cash flow positive, to pay down $1.25 million in debt, and make money? Can you imagine how profitable this business will be when these issues clear up? If you still aren't convinced, look at the company's financials:
| Measure | Amount |
|---|---|
| Stock Price | $3.79 |
| Enterprise Value ($ Millions) | $266.41 |
| Total Cash (mrq, $ Million) | $36.51 |
| Total Debt (mrq, $ Million) | $58.83 |
| Free Cash Flow (ttm, $ Million) | $35.60 |
| P/E (ttm) | 10.86 |
| Forward P/E | 10.83 |
| PEG Ratio | 0.23 |
| Price/Sales (ttm) | 0.71 |
| Enterprise Value/EBITDA | 5.41 |
| EV/FCF | 7.61 |
| EV/FCF/G | 0.23 |
| Net Margin (ttm) |
6.32% |
| Return on Equity (ttm) |
39.85% |
| Revenue Growth (ttm) | 18.00% |
| Earnings Growth (ttm) | 33.00% |
Darling comes awfully close to satisfying Rich Smith's method for finding Hidden Gems.
- Market Cap of $100 million to $2 billion? Yes.
- EV/FCF ratio under 10? Big Yes.
- Historical and Projected Earnings Growth? Strong.
- EV/FCF/G Ratio of under 1? YES!
- EV/FCF/ROE ratio of under 1? How does 0.19 sound?
- Insider Ownership of 10% to 50%? Nope. Only 1% here.
- Share Dilution under 3%? Only 1.2% this past year.
- Net margins of 7% or more? Close. They're at 6.32.
Does Darling have a sustainable competitive advantage? The business is too disgusting for the weak of stomach to enter, that's for sure. It also requires expertise in some very complicated areas (chemistry, agriculture, skill in meeting complex government regulation). So I say "yes".
What about management? They are on top of their game. Even though they currently have less cash than debt, the cash flow they generate will make that issue vanish sooner rather than later. They are also building their cash war chest to address government regulations and to pay down debt. They recognize that new regulations may create an opportunity for them to offer services nobody else has. They also have an outstanding return on equity and have hedged themselves well against both rising fuel costs and decreasing commodity prices.
Finally, the very low EV/EBITDA hints they may be ripe for a takeover. Wouldn't Pilgrim's Pride or Sanderson Farms just love to have their own rendering business?
Yes, Darling is a sub-$5 stock and, while we always must be cautious about such things, let's remember that Darling is a real business with real earnings. It's also a boring company that's under analyst radar (only one guy tracks it), deals in a disgusting business, and doesn't get any press. That's all great news if you're uncovering value investments. As far as I'm concerned, this company qualifies as a hidden gem, or at least what I'd call a "gem-in-the-making." I opened up a small position, and will keep watching to see if things improve. If they do, I'll be the first to dive into their grease traps to buy more of the gross stuff they're selling.
Like the idea of finding a diamond in the rough -- er, a gem in the grease? We have an entire newsletter devoted to such beauties. And you can take a free trial of Hidden Gems today.
Fool Contributor Lawrence Meyers owns shares in Darling International and Sanderson Farms. He also likes a good rib-eye steak, medium-rare.
