Darling Ingredients: Acquisitions Cannot Sustain Growth Forever (NYSE:DAR)

Darling Ingredients Inc. (NYSE:DAR) has grown fast over the past decade via acquisitions. But, acquisitions may prove expensive in the future due to high interest rates. The company does not offer a dividend and may be fully valued at current prices.

In Q3 2022, Darling Ingredients reported net sales of $1.7 billion compared to $1.2 billion in the previous year. The company’s Feed segment is the most significant, with $1.27 billion in sales in Q3 2022. The company’s Fuel segment is the smallest, with $126.5 million in sales in Q3 2022. The company’s gross margins came under pressure due to high input and inventory costs (Exhibit 1).

Exhibit 1:

The company has seen increasing inventory, but since sales have increased almost proportionately, the days’ sales in inventory have seen a slight increase compared to the previous years (Exhibit 2). High inventory may not pose a challenge for the company.

Exhibit 2:

Darling Ingredients has grown by using acquisitions across its business segments. For example, in May 2022, the company acquired the Brazilian rendering company FASA Group for $542 million. The FASA Group acquisition will help grow and diversify its supply chain for waste products for producing renewable diesel and sustainable aviation fuels. In December 2021, the company acquired Valley Proteins for $1.1 billion. This purchase allowed the company to gain 18 rendering plants and used cooking oil facilities throughout the southern, southeast, and mid-Atlantic regions of the U.S. The company sees an opportunity to expand its Fuel segment in the wake of a speedier transition to renewable and cleaner burning fuels and the massive subsidies offered globally. But, the company’s acquisitions have added to the goodwill carried on its balance sheet (Exhibit 3). This goodwill has reduced its capital turnover and after-tax return on invested capital (Exhibit 4).

Exhibit 3:

Exhibit 4:

The premium paid for acquisitions above the fair market value is goodwill. Goodwill is an intangible asset that needs to be accounted for while calculating the return on invested capital. The company’s capital turnover drops to 1x, and its after-tax ROIC drops to 5% when goodwill is accounted for in the invested capital.

Expensive business of collecting raw materials for green diesel

The process of collecting raw materials can take time and effort. Collecting and processing rendering is a localized business; thus, Darling Ingredients needs rendering plants across a country or a region. The company has been successful in acquiring companies thus far. But, it may be challenging to fund and pay a premium for acquisitions in this high-interest-rate environment. Given the distributed nature of procuring the raw material for green diesel, green diesel may be costly compared to diesel produced from fossil fuels for a long time. I posed this hypothesis: Diamond green diesel, a product of the joint venture between Darling Ingredients and Valero, is more expensive than regular diesel from fossil fuels to ChatGPT.

Hedge funds, large banks, private equity firms, and high-net-worth individuals have used AI tools in their investment decisions. ChatGPT is the breakout AI tool causing a global stir and may challenge Alphabet’s search business. This tool may have opened the floodgates for regular investors to use AI tools in their research investment decisions. Microsoft (MSFT) might acquire the parent of ChatGPT since Microsoft is an investor. Here’s my prompt to ChatGPT:

Production cost of Diamond Green Diesel compared to diesel

Here’s part of the response from ChatGPT:

However, in general, the production costs of renewable diesel fuels like Diamond Green Diesel may be higher than those of fossil-based diesel fuel due to the added costs of sourcing and processing the feedstocks. On the other hand, renewable diesel fuels can offer a number of benefits, such as reduced greenhouse gas emissions and improved air quality, which can justify their higher production costs.

It is worth noting that the costs of renewable energy technologies, including renewable diesel fuel, have been declining in recent years due to advances in technology and increased production scales. As a result, the gap between the production costs of renewable and fossil-based fuels may continue to narrow over time.

Based on the answer, renewable fuels need to see more cost efficiencies to compete better against diesel from fossil fuels. The response by ChatGPT turned out to be ambiguous, yet offered some insights confirming my hypothesis. AI is getting better at answering complex questions, and investors should learn to use these tools to their advantage. ChatGPT has been trained on data until 2021 and lacks knowledge of financial data. But these limitations may get resolved in the future.

The inconvenient truth is that subsidies have propped up most green energy sources, from electric vehicles to renewable fuels. Governments across the globe have spent billions of dollars supporting these industries. There are signs that governments are getting tired of these subsidies and are looking to pull back these incentives. Darling Ingredients should use this largesse from governments to their advantage and invest in R&D and technology to reduce production costs.

CapEx spending reduces free cash flow

One would assume that given the company’s acquisitions, it would have acquired good-quality plants and hence would have to spend less on CapEx. That may not be the case, given the company’s continuing expenditures on CapEx. The company has consistently spent more on CapEx than it registers in depreciation (Exhibit 5).

Exhibit 5:

This CapEx lowers free cash flow, which, in this case, is calculated as the difference between operating cash flow and CapEx. The company’s free cash flow margin over the past decade averaged 5%. Assuming the company can grow its revenue at 6% annually (Exhibit 6) for the foreseeable future, equity value per share works out to $29.61 at a 10% discount rate (Exhibit 7). The shares are trading at $62.27.

Exhibit 6:

Exhibit 7:

If the company spends less on CapEx in the future, that may help increase its free cash flow, or the company has to continue its acquisition-driven growth strategy, which is not sustainable in the long term. If the company can improve its free cash flow margin to 9%, its shares would be worth about $68, much closer to the current share price. The company trades at a trailing GAAP P/E of 13x and a forward P/E of 12x. The company may be fully valued at these levels, given its poor free cash flows.

The company carries $3.2 billion in total debt with a debt-to-EBITDA ratio of 1.23 and a current ratio of 1.4. Its debt is within manageable levels. The company does not offer a dividend. The U.S. and most of the developed world may be entering a period of low growth. It may be important for investors to accumulate dividend paying stocks to generate a good income and return. The lack of dividend payout is a negative for the company.

Darling Ingredients’ Incredible Past Performance

The company has performed exceedingly well over the past ten years returning 300% compared to 232% in total return for the S&P 500 Index (SP500). The company has dropped 8.4% in the past year, while the S&P 500 Index has dropped 20%. The stock has much higher volatility in its average monthly returns compared to the market, as measured by its beta of 1.22. The RSI and MFI technical indicators are below 50, another sign of weakness in the stock (Exhibit 8).

Exhibit 8:

Darling Ingredients Inc. plays in attractive end-markets. Its Fuel segment is benefitting from government subsidies, but investors need to pay attention to cost efficiencies that could drive down the price differential between green diesel and diesel from fossil fuels. Many green technologies and fuels have yet to prove that they can be profitable businesses without government subsidies.

Darling Ingredients Inc. may find it difficult to drive growth via acquisitions given the rapid rise in interest rates in the past year. The company has to grow exceptionally fast for the foreseeable future to justify its valuation. Investors may be better off waiting to buy Darling Ingredients.