Value Play: Stepan Company (NYSE: SCL)

Legendary Fidelity fund manager Peter Lynch, in his classic investment book One up on Wall Street, espouses investment criteria that are the antithesis of exciting. He has written that his perfect stock would have the following characteristics:

(1)   A name that is dull or, even better, ridiculous (e.g., Masco Screw Products or Pep Boys — Manny, Moe & Jack).

(2)   Does something that makes people shrug, retch, or turn away in disgust (e.g., it’s rumored to be involved with toxic waste and/or the Mafia).

To sum up, the objective of a value investor is to buy $1 worth of value for a price of 75 cents or even less and then wait for price and value to inevitably converge. What type of business that value can be extracted from is irrelevant, but it’s more likely to be found in boring and/or unpleasant businesses that most investors avoid (which causes the undervaluation). It’s really a very simple concept, but extremely difficult for most people to put into practice.

Part of my mission at Roadrunner Stocks is to help you embrace the value-investing philosophy and the profit-making potential of a “boring is beautiful” mindset. Stepan Company is the perfect example. The corporate name is simply the boring surname of the founder and its chemicals business is incredibly boring. But the most important thing to remember about Stepan is that it has historically been an incredibly profitable investment. The stock’s total return has outperformed the S&P 500 over the past decade by almost five-fold:

Source: Bloomberg

Illinois-based Stepan is a leading producer of specialty and intermediate chemicals. It is a family-run business founded more than 80 years ago by Alfred Stepan and the current CEO is Alfred’s grandson, F. Quinn Stepan. As I wrote in Founder CEOs are the Best Leaders of Small-Cap Companies, founders and their descendants take pride in the business and want it to succeed long term – which is the mindset that makes long-term investors rich. CEO Stepan owns 8.0% of the company and insiders in total possess a healthy 16.1% ownership stake (page 7).  

The Stepan family has been very shareholder-friendly and is committed to returning cash to shareholders. In fact, the company has increased its annual dividend for 45 consecutive years! According to dripinvesting.org, there are 104 U.S. companies that qualify as “Dividend Champions” with 25 or more years of consecutive dividend increases. Stepan is tied for 25^th place with five other companies at 45 years. Furthermore, whereas some of these “champions” maintain their dividend streak by raising the dividend by a minuscule amount, Stepan’s last dividend increase in October 2012 was a robust 14.3 percent.

Stepan’s chemicals business is divided into three parts:

1.      Surfactants (74.5% of sales) — additives for laundry detergent and other cleaning solutions

2.      Polymers (21% of sales) – coatings, adhesives, and foam insulation for commercial construction and aerospace

3.      Specialty products (4.5% of sales) — nutritional oils used in the food, nutrition and pharmaceutical industries.

Growth Has Slowed Temporarily

Unfortunately for Stepan, its largest business segment (surfactants) is not growing. In fact, the stock sold off substantially on April 30^th after first-quarter financials reported a sales decline in all three of its business segments. Earnings per share missed analyst estimates by a substantial amount ($0.94 vs. $1.18 expected). In the May 1^st conference call, CEO Stepan exhibited the Midwestern candor I have grown to love:

We had a rough first quarter. There is no doubt about it. The margins contracted. We think a significant portion of that contraction will go away as we move out in to next quarter or two.

Because the first quarter was lower for surfactants, it will make it more difficult to exceed last year’s surfactant performance. There is no question that the demand for commodity surfactants versus three or four years ago is down globally.

Doesn’t anyone wash anymore? All is not lost with cleaning solutions, however. Effective July 15^th, the company will raise prices for several of its surfactant products. In addition, Stepan said that non-commodity agricultural surfactants “continue to deliver strong volume growth.” Perhaps even more exciting is the prospect of utilizing surfactants in the energy drilling industry for “enhanced oil recovery.” According to Stepan, the company has more than 30 projects studying the use of surfactants in oil recovery and: “We remain enthusiastic about the opportunities for 2014 and 2015.”

Future Growth Drivers: Polymers, Oil Recovery, and Brazil

Stepan’s primary strategy for boosting growth is to diversify away from surfactants and expand its industrial polymer business, which arguably has a stronger growth profile in the future. To this end, in early June the company acquired the North American Polyester Resins business from Bayer MaterialScience, which consists of a 21,000 ton capacity manufacturing plant in Georgia. The deal is slightly accretive to 2013 earnings and provides the company with the manufacturing base needed to develop new polymer technologies.

Lastly, the company sees strong growth potential for its polymer business in Brazil, which “continues to deliver earnings growth,” and it plans on making additional investments to support Brazilian growth. Other global initiatives are taking place in Singapore and Poland. Stepan ended the conference call with an optimistic view of the future:

Today, we remain confident that our strategy will deliver long-term earnings growth. As we move forward, we will continue to evaluate additional investments that will accelerate growth and deliver value to our shareholders.

Buy Value at a Discount

In summary, the stock has sold off on short-term weak sales and is trading at an attractive price. Valuation is reasonable, with a relatively-low PEG ratio and an enterprise value (i.e., market capitalization plus debt minus cash) equal to only 8 times EBITDA. Profitability is strong, with positive earnings in each of the past 10 years and a return on equity above 16.5% in each of the past five years. The balance sheet is strong (debt-to-equity ratio of only 39.2%, current ratio above 2.1) and the company’s growth should reaccelerate with a stronger global economy and new technological developments.

The best time to a value stock is after the underlying business has suffered a temporary setback and price has come down. For Stepan, now is that time. While you wait for the stock price to rebound, you can feel comfortable knowing that family-run management has a long-term focus and that a dividend increase is likely to occur year in and year out.

Stepan Company is a buy up to $60; I’m also adding the stock to my Value Portfolio.

Momentum Play: Darling International (NYSE: DAR)

Let the battle of the biofuel producers begin! In the March issue of Roadrunner Stocks, I recommended buying FutureFuel (FF) in the Value Portfolio because of President Obama’s strong support for renewable energy. The stock has done well — up 13 percent — since its recommendation.

Government support for biofuels is so strong that I don’t think it is too late to double-dip in the sector. The Momentum Portfolio deserves a chance to benefit from renewable energy also, and Darling International looks like the best bet right now.

Every few months, President Obama seems to give another speech on renewable energy. Back on March 15^th he gave a speech at the Argonne National Laboratory outside of Chicago pitching a $2 billion, 10-year plan to develop clean energy transportation fuels. Just this week, on June 25^th, Obama gave another clean-energy speech at Georgetown University, this time focusing on climate change and the need to reduce carbon emissions.

In this week’s Georgetown speech, Obama said the following:

Today, we use more clean energy –- more renewables and natural gas -– which is supporting hundreds of thousands of good jobs.  We waste less energy, which saves you money at the pump and in your pocketbooks.  A low-carbon, clean energy economy can be an engine of growth for decades to come.  And I want America to build that engine.

In the “Climate Action Plan” accompanying the speech, biofuels is mentioned in the section entitled “Building a 21^st Century Transportation Sector.” In addition to implementing tougher fuel economy standards, the transportation plan emphasizes the importance of renewable fuel standards (RFS):

The Administration will also support the Renewable Fuels Standard and invest in research and development to help bring next-generation biofuels on line.

The 2008 Farm Bill – which established several subsidies for renewable energy production (including biodiesel) — expired on September 30, 2012, but the American Taxpayer Relief Act of 2012 extended all 2008 farm bill provisions for one additional year until September 30, 2013. Among the extended provisions include the $1 per gallon biodiesel credit. With the defeat of a new 10-year farm bill in the House of Representatives, there is uncertainty about government subsidies for biodiesel after September 2013, but the most likely outcome is another stop-gap extension. Unlike the uncertainty surrounding biodiesel credits, the Renewable Fuel Standards (RFS) – which require the production of a minimum quantity of 1.0 billion gallons per year — don’t expire until 2022. In addition, the Defense Production Act authorizes the Department of Defense, the Department of Agriculture, and the Department of Energy to each spend $170 million over three years developing a domestic biofuels program.  

Lastly, federal regulations are not the whole story. California – the 9^th largest economy in the world — implemented low-carbon fuel standards (LCFS) in January 2010 and is continually amending the regulations to make them more comprehensive. According to a recent Seeking Alpha article, the LFCS “has the potential to provide significant earnings power to biomass-based diesel producers” because the standards get automatically stronger each year through 2020. California is the largest transportation fuel market in the United States, so these regulations can have a material impact. Of particular importance are still-developing regulatory requirements for blending biofuels into diesel:

Not well known to the investment community, the California Air Resources Board is working on state regulations that will help the adoption of blend rates of up to 20%. The increase in the blend rates is to accommodate future LCFS requirements. The finalized terms of the regulations are expected to be completed later in 2013 and could be a significant catalyst for the entire biodiesel sector. 

Why Darling International is Special

As I wrote in reference to FutureFuel, given the uncertainty of biofuel subsidies, I don’t want to invest in “pure-play” renewable energy companies, but instead want to focus on companies that have a solid core business outside of renewable energy, but which can benefit from a renewable-fuel kicker while Obama is in office. Darling International satisfies this criterion because it has been around for 131 years, ever since 1882 when the meat packers of Chicago needed someone to haul away the animal waste from its beef slaughtering operations. Darling recycles the animal waste into usable components of several consumer and industrial products, including soaps, chemicals, pet food and animal-feed proteins, organic fertilizer, fats and oils, plastics, cleaning solutions, printers ink, and leather hides. Biofuels is only the latest recycled use for these waste products. Meat recycling is 80% of the business, with the 20% remainder focused on recycling of bakery waste (e.g., bread, pasta, crackers) into animal feed called “Cookie Meal” and recycling restaurant cooking oil.

Over the past 10 years, Darling has been a true momentum growth stock, growing both revenues and earnings per share by 20% annually. Its stock price has destroyed the S&P 500, rising almost seven times as much (717% vs. 103%):

Source: Bloomberg

Part of Darling’s investment allure is its consistency – earnings per share have been positive every year since (and including 2003). The quality of those earnings has been very high – in eight out of the past ten years (including each of the past seven), free cash flow has been higher than net income. A large reason for Darling’s consistent success is its risk-sharing business model — 100% of bakery waste, 70% of meat waste, and 45% of cooking oil waste are covered by formula-based contracts that guarantee Darling a fixed profit margin. When finished product prices more than cover Darling’s processing cost and fixed profit margin, Darling rebates the difference to its suppliers. In contrast, if finished product prices are less than Darling’s processing cost and fixed profit margin, Darling charges the suppliers extra to make up the deficit.    

Darling’s strong historical growth has recently accelerated further, thanks to the acquisition of Griffin Industries in December 2010, which doubled the company’s revenues and expanded its footprint beyond its Midwestern roots as a beef renderer into bakery and chicken recycling in the Southeast – as well expanding its biodiesel capabilities. Just look at the difference between fiscal 2010 and fiscal 2011:

Darling’s Growth Spurt

Green Diesel is a Future Growth Driver

A second transformational deal involves Darling’s 50-50 joint venture with refiner Valero Energy (VLO) – called Diamond Green Diesel (DGD) — to construct and operate a bio-diesel refinery in Louisiana. The refinery is:

capable of annually converting 1.1 billion pounds of fat into 136.7 million gallons of renewable green diesel, or an estimated 9,300 barrels/day.

Diamond Green Diesel will consume approximately 11% of our nation’s waste animal fats and greases. The combination of Darling’s ability to provide low-cost carbon-friendly feedstocks, and Valero’s experience as North America’s largest independent petroleum refiner and marketer, has the potential to create a sustainable biofuel facility that can meet America’s growing renewable energy demands. 

Apparently green diesel is not your run-of-the-mill biodiesel. Darling claims green diesel is better than biodiesel because it can be transported like oil:

Renewable (or green) diesel is a true hydrocarbon just like diesel fuel, which has a different molecular structure from the biodiesel predominately produced today. Because of this structural difference, green diesel can be distributed using the current petroleum distribution system (pipeline), while biodiesel requires truck or rail transport. Additionally, green diesel has no cold flow issues and won’t thicken and clog engines in cold weather as may happen with biodiesel.

According to a June 2013 presentation (slide nos. 38-40), green diesel is seven times more profitable because (1) it uses cheaper feedstocks (corn oil, yellow grease, poultry fat) than biodiesel’s soybean oil; and (2) its processing uses hydrogen instead of methanol, which is 25% less costly. The end result is that a gallon of green diesel generates EBITDA per gallon of $1.39, whereas regular biodiesel generates EBITDA per gallon of only $0.19. Darling plans to source 60% of the feedstocks for DGD from its own waste recycling inventory – this vertical integration of feedstock sourcing with end-product processing provides significant cost savings and gives Darling a competitive advantage compared to other biodiesel manufacturers.    

Bottom line: the DGD project will increase Darling’s EBITDA by $98 million (30.2%) in 2013. That’s huge. Given the company’s 118.2 million shares outstanding, the per-share increase in EBITDA will be about $0.83. Multiply this figure by the Darling’s current EV-to-EBITDA ratio of 7.22, and the end result is an increase in price per share of $6.00.  Has some of this incremental value already been anticipated by investors and factored into Darling’s current share price of $18.50. Of course, but even if half has already been factored in, that leaves $3 of appreciation still to occur – a 16.2 percent increase from the current stock price.

Big Upside for Darling’s Stock Price

On June 21^st, Wedbush initiated Darling at “outperform” with a $23 price target. On June 26^th, Darling announced that DGD had achieved mechanical completion and the start-up process would soon lead to full-scale production of green diesel. had commenced operations. Given Darling’s low EV-to-EBITDA valuation and solid growth prospects, the stock could reach $30 (62% upside) within a couple of years if green diesel takes off as expected.

The company’s balance sheet is strong with a debt-to-equity ratio of only 23% and a current ratio of assets to liabilities of 2.56. With $122 million in cash on the balance sheet and substantial additional cash flow coming on line from DGD, Darling has indicated a desire to make another earnings-accretive acquisition or return cash to shareholders. In the May 10^th first-quarter conference call, CFO Colin Stevenson said the following:

To openly talk about M&A is very difficult. So I try not to. There are opportunities out there. It’s the start of a new year. There’s always opportunities, whether or not they’ll be priced at a level that is reasonable and something we think that is sustainable and accretive to our shareholders.

We’ve got a pretty large war chest. If we’re unsuccessful in M&A, then the board has a decision to deploy the capital back to the shareholders, either in the form of a buyback or some type of ongoing meaningful dividend. Both are under discussion. 

In summary, Darling International is a market leader in meat and bakery recycling with a low-risk, vertically-integrated business model that generates remarkably consistent profits. In addition, it has a near-term catalyst of substantially-increased cash flow coming from a new and exciting green diesel manufacturing plant that is in the sweet spot of President Obama’s clean-fuels initiative. All this stability and growth potential combined with a reasonable EV-to-EBITDA valuation near 7 makes Darling a compelling investment idea.

Darling International is a buy up to $20.50; I’m also adding the stock to my Momentum Portfolio.