Description

Darthtrader’s recent write-up on Salmar is a good call given the COVID-driven weakness in salmon prices in the short-term. While I lack any sort of forecasting abilities on specific price levels longer-term, I think there is a sensible case for higher prices as a result of the rising demand and supply constraints which darthrader pinpoints as I also did  on Bakkafrost’s 2018 write-up.

I am typically not a fan of posting old ideas again, but I think Bakkafrost deserves revisiting as it is fundamentally a different business now from what it was in 2018. In September 2019 Bakkafrost acquired The Scottish Salmon Company (SSC), the #2 farming operator in the area after Mowi by harvesting volumes, putting an end to a five-decade status as a Faroese-only company. This transformational acquisition alongside the opportunity that still remains in the Faroes, in synchrony with the recent share price decline bode well again for an attractive entry point to own the shares for the long run.

Some updates

(1) The playbook to reach 76,000 tonnes in the Faroes by 2023 from the current 57,000 remains intact – if anything prospects are better as the investments in the larger-smolt strategy and the biogas plant translate into progressively reduced biological risk.

(2) SSC will likely add an additional ~43,000 tonnes of Scottish Salmon by 2024. 

(3) SSC was mismanaged and there is a large room for improvement by leveraging Bakka’s feed and procurement capabilities and extracting revenues and cost synergies.

(4) As COVID-crisis has knocked down salmon prices by 1/3rd and Bakka’s share price has responded accordingly, sliding from above 700 NOK in late February to the current 505, valuation has become attractive. To put things in context, Bakka’s share is selling below pre-SSC transaction announcement levels.

Investment Plan

Bakka sticks to the 5-year DKK 3B that announced in mid-2018, with still 1.2B to be invested. The long production and investment cycles make it difficult for these investments to be quickly accretive to the bottom line. We will see most of their impact from next year as some hatcheries have been recently expanded and indeed the new hatchery – Strond – ramps up to full utilization this year. To the Faroese investment program, the company now adds DKK 350m annual investment to improve the new Scottish operation till 2024, or DKK 1.75B total.

Committing almost DKK 3B is not small deal for Bakkafrost. Contextually, the outflow is almost 4x its 2019 net income. How do I know these significant investments will truly pay-off? This is the small leap of faith – in combination with rising or at least stable long-term salmon prices – that you need to adhere to the thesis. I can tell you there are two facts, not beliefs, that make me confident and comfortable.

First, there is an absurd amount of scientific data and on-site evidence which proves the fact that operating with larger smolts, by reducing the time fish remain at the sea, translates into significantly lower mortality rates and larger and healthier fish without a proportional increase in costs, thus resulting in much better economics per kg. You can check the cost table in my previous write-up or google for information yourself. There is lots of data.

Second, and maybe more relevant for the specific case, the company has invested nearly DKK 3 billion since 2013 in all parts of its value chain. In 2013 Bakka sold 41K tonnes and did DKK 2.5B sales and 586m EBIT. In 2019 it sold 57K tonnes for DKK 4.5B sales and 1.3B EBIT. Volumes, sales and EBIT have respectively grown at 6%, 9% and 15% CAGR respectively. Bear also in mind that there is significant untapped operating leverage associated with larger volumes, so these compounded growth rates are understated. All in all, I think it is very difficult, to say the least, to connect these numbers to poor capital allocation.

The acquisition

Bakka paid DKK 4.35B EV for SSC on 25th September – technically it acquired a 68.6% stake triggering a subsequent mandatory offer for the rest. To give some colour on the acquisition size, 4.35B represented 20%+ Bakka’s market cap at the time and all of its accumulated net income since 2015.

Is it that Bakka overpaid? I do not think so. In fact, I think paying 7.2x EBITDA for a farmer that sells premium salmon like Bakka considering that Bakka was selling for more than 16x can only be explained under the prism of SCC’s mismanagement. SCC BoD and management were not “salmon people”, but a combination of investment bankers and VC-type entrepreneurs with strong links to Russia. Leaving aside their incompetence to run the operation, with everlasting unsolved problems with sea lice and other biological hazards, the anecdotal evidence they acquired a restaurant operation tells you a lot in terms of their capital allocation mentality.  

Now Bakka’s management can transfer its best practices to the SCC operation. As Bakka supplies its own fish and feed with a higher marine component, it can leverage the procurement to serve the Scottish operation. Management estimates this will lead to DKK 70m annual synergies from 2022 onwards, equivalent to ~1.7 DKK per kg. This is included in the model below. Not included but also real are the synergies derived from the sales channel utilization and SG&A reduction – i.e. leaner head office structure in Scotland mostly by discontinuing SCC’s listed functions and eliminating management and Board duplicities.

Bakka will also transfer the large-smolt practice (Scottish smolts are currently 90g vs. ~200g for Bakka in the Faroes and trending to 500g by 2022) to reduce bio risk and improve the unit economics. I do not claim that EBIT/Kg in Scotland will even converge to the Faroese ~20 DKK/kg level. The Faroese provenance is certainly unique in terms of market perception and water conditions. Scotland however is also a great place to farm larger premium salmon and SCC brands are also well regarded. Hebridean, Tartar or Lochlander salmon anyone? It is sensible to assume Bakka’s management can conservatively sustain at least 13-14 DKK/kg EBIT for Scotland under a base case pricing scenario.

Finally, there is also a geographical diversification benefit as more than half of SCC’s sales are directed to the UK market and less than 5% to Asia. Having an Scottish firm in operation splits also a bit the risk of geopolitical unfavourable events like the Russian embargo. https://www.fishfarmermagazine.com/news/russian-ban-on-bakkafrost-salmon-could-cost-30m/

How did Bakka fund the acquisition? It was a combination of debt and share issuance, the later ~20% Bakka’s share capital – 15% via accelerated offering plus 5% directed to Northernlink, the former owner. The CEO Regin Jacobsen was allocated 120,000 shares at 500 NOK, which was the share issuance price to the public. I know that 120,000 shares is not a lot when he already owned 9m of them, but it shows commitment considering that most of his net worth is already invested in the company.

Transitory facts explaining the current share price level 

• Recent salmon price weakness amid COVID .

• Some disruption in the supply chain when re-deploying units in the sales channel from restaurants to retail. 

• Challenges to export to China during the initial phase of COVID with the market now virtually reopen. 

• Severe storm in the Faroes on late february provoked around 6,000 tonnes of lost fish

Catalyst

- Large-smolt strategy

- SCC's accretion and operational improvements