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Published: September 7, 2010
Legendary fund manager Peter Lynch went out
of his way to find companies that did yucky things because they
were often great businesses. My approach takes that concept one
step further: I've found one stock that provides an underlying
service for a whole sector, a service the sector simply can not
do without, yet the business is so gross, so undesirable, that
it's shares are sharply undervalued by Wall Street.
Have you ever wondered what happens to the parts of a chicken
that don't get eaten? Or the grease a restaurant throws out
after it's used? After all, someone also has to remove used
cooking oil and pump grease traps. Turns out there are companies
that provide 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.
The largest company of this kind is Darling International (NYSE:
DAR). Darling collects the grease from restaurants and along
with the byproducts from meat packing plants, butcher shops,
grocery stores and independent meat and poultry processors. From
these raw materials, Darling creates two products: meat and bone
meal, and tallow. These items are converted into a lot of useful
everyday products, including feed, soap, candles and even
explosives. These products are then sold globally.
Who would've thought a company like this would even exist? Yet
it does, and has since the late 1880s.
I don't like to throw a lot of numbers around, but it's
important for investors to look at the table below because it
summarizes why I think Darling is a compelling value that is
being totally overlooked by the market.
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I happen to be very big on the PEG ratio as a guide. When I see
a PEG near 0.50, it suggests that the stock's fair value is
about +100% higher than where it currently trades. Another ratio
I look at as a guide is the EV/EBITDA ratio. (This assigns a
multiple to stocks and allows investors to gauge a company's
value as a takeover target.) Anything under 7.0 for a stock in
this sector has historically been undervalued, when one looks at
buyout offers made during the past 20 years.
Sure enough, the stock's all-time high was
$17.19, more than double its recent price.
This is where investors should ask about three other important
issues.
First, does Darling have a sustainable competitive advantage?
Yes. Anyone else looking to get into this business must have
expertise in chemistry, agriculture and in meeting complex
government regulations.
Second, what about management? It improved a negative
cash flow
situation during the mad cow scare of the early 2000s and is now
generating more than $50 million a year in cash. Its paid down a
lot of debt over the years and also recognizes that new
regulations may create an opportunity to offer services nobody
else has. Management has also posted an outstanding return on
equity and has hedged the company well against both rising fuel
costs and decreasing commodity prices.
Third, is the company so undervalued that a takeover could
happen? This isn't a requirement for me to buy the stock, but if
the answer is affirmative, it provides extra incentive.
The very low EV/EBITDA is the ratio to watch, and as I said, it
is under the target for a takeover. There are chicken companies
out there, such as Pilgrim's Pride (NYSE: PPC), that
would benefit from having its own rendering business. Pilgrim's
has $180 million of net cash on its books, which isn't nearly
enough to take out Darling, but a private-equity fund that wants
to play along would make that acquisition feasible.
Action to Take --> Buy
Darling. It's the largest company of its kind. Everyone eats
meat and chicken. The company is an experienced player in a
sector with high barriers to entry, on solid financial footing
and is extremely undervalued. I see an easy upside of +100% from
here and possibly a buyout within five years.
-- Melvin Halcomb
Contributor
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