Description

Austevoll is a Norwegian aquaculture and fisheries business. It's main asset is a 63% stake in Leroy Seafood which is the world's second largest salmon farmer after the Fredriksen owned Marine Harvest. Leroy Seafood is also publicy listed. 75% of the SOTP valuation for Austevoll comprises of the stake in Leroy and basically Austevoll is a cheaper way to buy Leroy than to buy Leroy shares directly as its other businesses are undervalued. There is no near-term catalyst to resolve the valuation discrepancy.

LEROY SEAFOODS

Leroy is the world's 2nd biggest Salmon farmer. Salmon is a commodity and there's effectively no difference between salmon farmed by any of the salmon farmers or salmon caught in the wild. Hence to understand why Leroy is attractive, you have to understand the salmon market. 

Aquaculture is a very small part of the entire fish market globally. Most of the fish eaten globally is still caught at sea. And it is an even smaller part of the overall protein market globally. Needless to say there are some very large mega-trends at work which have been delivering very robust GDP+ demand growth for aquaculture and salmon in particular. There are

1. Demand for proteins has been steadily increasing at above global GDP levels as poorer countries in Asia and Africa are increasing their per capita protein consumption as they get richer.

2. Healthy living trends have been increasing the demand for fish at the expense of beef, pork and chicken, and demand for fish has been increasing faster then the demand for other proteins. 

3. Demand for Aquaculture is increasing faster than demand for fish as aquaculture is sustainable while a lot of fish stocks in the wild are getting depleted from overfishing and quotas and monitoring of fish caught in the wild are increasing to make wild fishing more sustainable. 

4. Demand for salmon within Aquaculture has been very healthy because of its very prominent use in sushi, and french and other cuisines, which are increasingly becoming more popular globally with a long runway still to go. 

All these factors have conspired to result in salmon demand growth of about 7% globally very consistently for decades now and likely to continue for the foreseeable future.

In light of this reliable and steady demand growth, the commodity has consistently seen price cycles for decades now because of supply fluctuations. It takes 3 years to grow salmon to adult harvestable age. New capacity can be added fairly rapidly if space/location is available with logistical network in place and this supply will hit the market in 3 years as the fish gets older. This is the classic hog cycle from Economics 101 which is also prevalent in the salmon industry (you can refer to the discussion for Pilgrim's Pride idea). The difference this time for salmon, after many decades of these cycles (the last downcycle was 2012), is that we are running out of places to farm salmon.

Salmon requires temperature in the water to be fairly cold all year round. This eliminates pretty much any place close-ish to the equator. It also requires water temperature to remain in a tight range all year. In the wild the fish just migrate to different areas of the oceans as temperatures vary. For farming you need the temperature to remain in a steady cold range. This eliminates any location that e.g. freezes over or gets too cold. In the the only locations left are Norway, Scotland, Chile, Kamchatka and eastern Russia, Eastern and Western Canada, Tasmania (a small island south of Australia). Of these Eastern Russia and Eastern Canada have no existing infrastructure or locations in play. Western Canada entered the market but has pretty much reached its limits due to First Nations issues. Scotland has been maxed out for a long time. Chile entered the market strongly but is now running into problems. And Norway is by far the world's biggest producer (Fish is norway's biggest export after oil and gas). And even Norway is now struggling to produce more. 

The reason for the problems is that there's a biological limit to how much fish you can farm in a given area before running into evolution fighting back. At some point some form of disease (lice or others) breaks out and spreads rapidly across the entire population and decimates the stocks. Hence smaller groups are strictly controlled and maintained with some distance from each other with no intermingling. Heavy use of antibiotics or other treatments leads to resistances developed that are passed down the generations etc. The Norwegian govt hands out licenses and quotas and very zealously monitors these for fear of future outbreaks. The solution for a long time was to open more areas for salmon farming and slowly increase the quotes. But it's been known for a long-time that we're approaching the limit for what Norway can produce and the recent white paper (a govt study) on this matter effectively shut the door on any major quota increases. Chile, which was the last major location that was viable, entered the market and rapidly increasd share about a 5-10 years ago and has since run into consistent problems with lice and disease and even logistics and has failed to increase production last few years despite best efforts. 

Meanwhile due to the collapse of Oil and Copper respectively, Norwegian Krona and Chilean Peso have collapsed leading to a lowering of the cost curve globally and also of salmon price in USD. Salmon is quoted in Norway and prices appear very robust but in USD they are closer to the lows of 2012. Hence demand remains very robust for salmon. 

The biggest component for cost (half of total cost) is feed. Feed is constructed from a combination of fish oil and other ingredients. Fish oil is processed from fish caught in the wild. Most of the fish oil is produced from Pelagic fish caught in Peru (mostly) and some other places. Fish oil has recently seen an alternative demand from Omega-3 pills which are increasing in popularity and hence fish oil prices have been trending up over last decade. There is also concern that the recent oncoming El-Nino will depress pelagic catch in Peru and cause a spike in fish oil prices. 

Despite the good run over last few years, there are a number of reasons the salmon stocks remain cheap. One is the perpetual fear that the one way or another the hog cycle will hold and somehow, from somewhere, more salmon will come to the market and that this time is not different either. I respect that argument but the data increasingly supports that we've hit the biological limit in existing locations. For more salmon to be farmed, the options are basically onshore salmon (in massive drums), offshore salmon (way off from the shore), or new locations like Eastern Canada or Eastern Russia. All of these options are uncompetitive currently, although I expect a combination of all of these to happen eventually as salmon price keeps going higher. As we exhaust current sources of supply, and demand remains resilient, then prices will trend up to the point that more expensive and alternative sources are put in play.

Another reason stocks have been somewhat depressed is that we just had 2 relatively warm winters in Norway and even though quotas are monitored, there's some natural variation on how much the fish grow and they grow a bit bigger over 3 years if the winters (when they grow the slowest) are warmer than usual. This led to a robust harvest of salmon in May and hence prices were a bit weak as they fell from 42-43 NOK to 35 NOK but they have since recovered. I expect prices to further strengthen from here as prices are already fairly depressed in international currencies and demand should be robust. 

And a final reason is the expectation that costs will continue to trend up. Fish oil and hence feed, is priced in USD, and it has gone up in NOK for farmers accordingly. But also fish oil has gone up due to alternative uses. The coming El-Nino has also raised concerns about causing disruption in fish oil feedstock and hence cause a spike in fish oil prices or shortage of fish oil. Since part of the thesis is that supply is limited, I don't expect there to be a pressure on fish oil demand. Any spike from El-Nino has historically been short lived. And we still face the prospect of a potential "veggie fish" although the ultimate effect of that is unpredictable. Fish don't naturally have much Omega-3. They must eat other fish to produce it. Hence the need for fish oil in their feed. But the fish can also be given feed from veggie oils and they taste perfectly fine, they just don't have as much Omega-3. I can attest first hand the two types of salmon are indistinguishable. Since Omega-3 has been such a marketing tool for creating demand, salmon farmers have been so far reluctant to switch to the far cheaper veggie oil based feed. If fish oil prices go beserk, they are likely to switch. 

There's another recent that feed costs might actually fall. Marine Harvest is the world's largest salmon farmer. Once it ran out of expansion opportunities due to hitting the biological limit, and refusing to do M&A to grow (not the Fredriksen way, and trading prices for licenses in Norway are nosebleed high as they should be), it decided to grow via investing in vertical integration. Marine Harvest invested heavily in a very large feed facility which is just now coming online and which has significantly added to global feed capacity and which will run at full capacity. The top 3 feed producers Skretting, Ewos and BioMar account for 88% of fish feed and have seen their large customer take significant demand internal. Overall capacity utilization at these facilities will likely fall and could pressure their margins and lower feed prices. Marine Harvest can do a 2nd facility as well in a JV with another Norwegian player (it can't consume all the volume of another facility internally). 

Leroy has recently completed some substantial investments over the last bit of increased quotas allowed. It also has improved operations with greater use of cleaner fish so it doesn't have to halt operations as often for medical treatments. This will lead to improved costs over next few years. Keep in mind, these effects aren't major relative to items like feed costs or costs of medicine. Leroy also steadily improved the revenues generated from Value added Processing to almost 11 NOK per kg and it's still slightly trending up. Leroy will likely maintain the 30 NOK per kg in added revenue generated (on top of raw fish prices) for Sales and Processing. The operating costs have jumped up recently as fish oil prices in NOK have gone up and also as medicines costs went up slightly. Both of these will likely flatten or decline slightly going forward.

I use a range of 40, 45, 50 for salmon price sensitivity for Bear, Base, Bull scenarios and a range of FCF yield valuations 2 years out as well as EV/EBITDA multiples and averaged them. The bear scenario is close to current trading price so effectively market is pricing in my bear scenarios of 40 NOK and low end of FCF Yield or EV/EBITDA. I think salmon prices are likely to be mid 40s if not higher in 2 years and as the thesis firms up, the valuations will strengthen. 

OTHER ASSETS

Excluding Leroy, Austevoll's main assets including fishing assets in Peru. It controls 7% of the anchovies quota in Peru. The company also has onshore fishmeal and fish oil production facilities. Austevoll also has 9% of the jack mackerel market in Chile and canning and frozen fish processing facilities. It also owns 49.9% of Birkeland which is accounted as associated income, which is another salmon farmer in Norway. It also the largest processor of Pelagic fish in North Atlantic via a 50% stakje in Pelagia. All these assets are currently being valued at an implicit value of 1.3b NOK at current trading value of Leroy and for negative value in my base target price for Leroy in 2 years.

The El Nino event in 2H 15 could affect volumes in Peru, which is likely the reason Austevoll has underperformed Leroy recently. These assets are priced even cheaper today. Once quotas normalize, and forecasting a normalized earnings / EBITDA going forward. Most of the inflection in EBITDA of consolidated assets is the increased in EBITDA from Austral in Peru as volumes from quotas normalize. At the moment this business has fallen to almost breakeven levels due to under-utilization and significant fixed costs, while it generated closer to 300m NOK EBITDA couple of years ago. 

SOTP VALUATION

Austevoll is cheap. So is Leroy. I suppose buying just Leroy is the cleaner thesis to the trade and provides significant upside and will obviously have no "holding company discount". I am recommending Austevoll since the non-Leroy assets are currently being valued implicitly at 1.3b NOK and I believe they are worth significantly more than that and the earnings power of those assets will become clearer. Also Leroy will likely keep increasing dividends closer to earniings/FCF levels so any holding company discount will further shrink/disappear. Plus Austevoll has added catalyst of being able to divest some/any assets to realize some of the discount gap. Plus Austevoll is naturally hedged against some of the bear thesis around fish oil prices spiking as it has significant upstream operations.

I believe both Leroy and Austevoll are excellent investments on my base case I see about 100% upside in Leroy in 2 years and 150% upside in Austevoll in 2 years. 

Catalyst