Description

Description:

Cermaq ASA – (CEQ NO)

The global salmon farming industry is just emerging from one of the worst cyclical downturns in history and all signs point to higher sustained pricing for the next couple of years. Cermaq is the best vehicle in which to play the current cyclical upswing in the salmon farming industry due to its relatively low valuation, low cost position, geographic diversity, and the fact that analysts are not properly forecasting the cost structure at Cermaq’s Canadian operations. Even though Cermaq has appreciated since its IPO in October, we believe that there is upside of at least 50% if you assume flat salmon pricing next year and over 80% upside if you assume significantly higher salmon prices in 2006. Our analysis points to a much higher salmon market price in 2006 and 2007. In a bull scenario, where 2006 salmon prices average in the mid - NOK 30’s (current pricing is at NOK 27), we think that the shares of Cermaq have upside of over 80% if a cyclical peak multiple of 5x is placed on 2006 peak EBITDA.

Background:
Currently, about 60% of the world’s consumed salmon originates from fish farms. This percentage has increased over the years due to the favorable economics of farming versus those of catching in the wild. Due to a combination of salmon biology and geographic factors, almost all salmon farming occurs in Norway, Chile, Scotland and Canada. Chile, in particular, holds a significant cost advantage arising from lower feed costs and higher yields due to stable water temperatures and lower pollution.

Driven by perceived health benefits and increased global wealth, salmon demand has grown at an average annual rate of around 10% for the last 10 years and is expected to grow at around 5-7% per annum during the next decade (from the Food and Agriculture Organization of the UN). During the last peak in 2000, when prices topped out at around NOK 40 per kilogram, farmers invested heavily in increased capacity. As it takes about two to three years to fully “grow” a salmon, the capacity additions during the peak years will usually lead to overcapacity a few years out. Like clockwork, in 2003 salmon prices hit a trough of about NOK 16 per kilogram which resulted in numerous farmers being taken over by creditors. This set the stage for the current cyclical upswing as rational operators brought capacity additions in the industry to a standstill, ensuring stable supply growth through 2007. The current supply/demand environment for salmon is a recipe for sustained higher prices for the next couple of years. Kontali, an aquaculture analysis group, estimates that salmon supply should be up around 1% in 2006 and 4% in 2007. While we have not assumed that pricing will revisit the extreme highs of 2000 in our valuation, the opportunity clearly exists.

Cermaq (CEQ NO) is the second largest salmon company in the world and currently derives about 75% of its operating profit from salmon farming with the balance coming from fish feed sales. Cermaq is a low cost salmon farmer, compared to its Norwegian listed competitors, due to the fact that about 55% of its production comes from Chile. Cermaq’s management intends to use their balance sheet to further expand in Chile through organic growth and potential acquisitions aimed at consolidating the industry.


In October, the Norwegian government publicly floated half of their 79% ownership stake at a price of NOK 44 per share. Just a few days before the offering, Fjord seafood, a Norwegian salmon farming company, offered NOK 47 for the government’s stake, but the offer was rejected. Fjord is 25% owned by a company controlled by John Fredriksen (the Norwegian shipping mogul). Fredriksen also has a 40% effective ownership in Pan Fish, another Norwegian competitor, and is seeking further consolidation of the industry.

Sentiment towards the salmon farming industry in Norway has been negative as the memory of the last cyclical downturn in 2003 is fresh in the public’s psyche. Sell-side analysts have been slow to turn positive on the industry but this is about to change. We still think sell side analysts are completely incorrect about their pricing for assumptions for 2006 and 2007. Most sell-side analysts have pricing flat or slightly down next year. Although they have started to increase their assumptions, we believe they are way behind the curve.

Salmon farmers are price takers so one of the most important ways to look at the farming companies is by operating cost per kilogram of salmon produced. We think that one of the biggest misunderstandings in the market is the operating cost of Cermaq’s farm in Canada. Cermaq made a very attractive acquisition this year in Canada (Heritage). Prior to this acquisition, operating cost per kg. in Canada was usually in the mid - NOK 20‘s range (including freight). Most industry participants and sell-side analysts we have spoken to have simply projected the existing Canadian cost structure into the future. Management has told us that the cost structure in Canada has completely changed due to this new acquisition and from the fact that increased volumes will bring down the average cost per kg. Management indicated to us that NOK 18-19 range for operating cost per kg. is a more realistic assumption going forward and that this should show up in their next quarterly report. The difference between this range and the street expectations of low to mid 20’s is massive. For example, if you model out 2006 (holding salmon pricing flat with this year) with a Canadian operating cost per kg. of NOK 19 vs. NOK 23, EPS increases by more than 20%.

Valuation:

Stock price – NOK 54.75
Shares outstanding – 92.5m
Market Cap – NOK 5,064 ($750m USD)
Debt – NOK 2,081
Cash – NOK 168

EV – NOK 6,977

Assuming flat Norwegian salmon pricing next year (NOK 25) and slightly lower salmon pricing in 2007 (both assumptions are very conservative), we come up with the following numbers:



2004 2005 2006 2007
Revenue 5,582 5,817 5,907 6,154
EBITDA 650 933 1,107 1,004
EPS 2.94 7.23 7.80 7.00

EV/EBITDA 10.7x 7.5x 6.3x 7.0x
FCF Yield 5.4% -1.6% 14.6% 11.2%


If one were to assume an average Norwegian salmon price of NOK 35 (all regional salmon prices are a different due to transportation costs but they tend to move together) in 2006, the figures change dramatically:

2006
Revenue 7,029
EBITDA 2,229
EPS 19.51

EV/EBITDA 3.1x
FCF Yield 33.2%


Comps:

EV/EBITDA on consensus 2006 estimates:
Fjord – 8.2x
Pan Fish – 8.5x
Leroy Seafood – 8.5x
Nutreco – 9.5x

Nutreco trades at a higher multiple as it is a feed company with more stable margins. Given that Cermaq has both salmon farming and fish feed operations, we think it is appropriate to look at all of these companies together.

As the market starts to re-rate Cermaq to give credit to their new low cost structure in Canada, Cermaq should at least trade near the group average of 8.7x, which would value the stock at NOK 85 or up over 50% from the current market price.

We are not recommending Cermaq as a relative value trade but thought it was important to show that it is valued at the bottom of the group on consensus numbers. This valuation discount does not seem deserved due to Cermaq’s scale and low cost position. While we think there could easily be 50% upsides with flat pricing, we think that it is more likely that salmon prices will continue to increase and could possibly reach the mid – NOK 30’s. At this level of salmon pricing, we think the shares of Cermaq could reach NOK 100 (80% upside from the current stock price) if the market assigns a cyclical peak EBITDA multiple of 5x. While this is our bull case scenario, we are very confident that salmon prices will increase from current levels and will far exceed current assumptions in the market.

Margin of Safety:

We consider the NOK 47 bid by Fjord Seafood as our net asset value floor (14% downside). We use this since the replacement cost of assets is difficult to compute due to the fact that there is no market for salmon farming licenses.

Risks:

One of the biggest short term risks is a breakout of disease at one of Cermaq’s farms. Isolated breakouts of disease come to the industry every few years or so. Innovations in feed and the application of new antibiotics could make this less of a threat going forward. Obviously a breakout of disease at a competitor’s farm would be an unexpected windfall for Cermaq.

Just last week, Russia announced a ban on fresh salmon from Norway. From what we have heard this is politically motivated (probably due to drilling rights in the Barents Sea). The ban could temporarily depress salmon pricing but could actually end up being in Cermaq’s favor since the majority of their salmon is produced outside of Norway and is not subject to this ban.

Salmon farming is a cyclical industry and there is a probability that as higher salmon prices are realized, farmers will start increasing capacity that may enter the market in 2008 and beyond. Given that “biomass”, or industry fish supply, can be constantly monitored, we take comfort in the fact that there is minimal risk of any unexpected supply shocks. Prior to any meaningful increases in industry capacity, Cermaq should produce significant cash flow and has stated that they plan to pay out at least 30% of earnings to shareholders, which would equate to about a 4% dividend yield based on our earnings assumptions. Also, the feed business is somewhat counter-cyclical with volumes increasing with industry supply.

Although not part of our thesis, upside to our assumptions could be provided by the ongoing threat of Avian Influenza. From our channel checks, we have learned that recent demand for poultry in Europe has decreased by about 30% and that, as a substitute protein, salmon should benefit.

Catalyst

- Next quarterly report showing a drastic improvement in Canadian profitability
- Increased salmon pricing