Description

Summary
Despite its strong brands, stable end markets and high returns on capital, Connors Brothers Income Fund yields 13% on depressed expected F2005 distributable cash flow and 16% on normalized distributable cash flow. Connors boasts dominant share in many of its canned protein categories (most notably in tuna with its widely-recognized Bumble Bee brand) and is #1 or #2 in all of its products. As a manufacturer of consumer staples, the business is relatively stable and generally well-managed. Through innovative new products, like tuna steak pouches, and strong promotion in its core albacore products, Connors is growing share in the higher margin value-added categories in which it participates. Shareholders benefit from the company’s tax-efficient income trust structure, which also provides an advantaged base from which to make strategic acquisitions.

Management’s guidance is for EBITDA of $80 million in F2005 and $86-$92 million in F2006; I believe earnings power on this basis is at least $95 million, or roughly what the company earned in F2004. There are three ways to make money on Connors: (1) through multiple expansion on depressed earnings to a more reasonable current yield, (2) through improvement in earnings from price increases, raw material cost reversion to the mean and resolution of factory inefficiencies, and (3) through a catalytic announcement regarding efforts to improve the distribution. The current price overly discounts the business issues and results in an attractive investment opportunity: EBITDA would have to drop by nearly 15% from these already depressed levels – and represent normalized earnings – in order to justify today’s price using conservative valuation multiples. In a year’s time I expect to have taken in a CAD 1.35 distribution and own a stock worth at least 10x CAD 1.35, for a very conservatively estimated base case upside of nearly 40% pretax. Assuming Connors can return to prior profitability and achieve a reasonable multiple, the investment could easily double.

As a brief history, the major Connors brands have been around for over 100 years. Private equity firm Centre Partners bought Bumble Bee from ConAgra for $185 million in a leveraged transaction in May 2003. Connors, which at the time it was converted into an income trust in 2001 was a small niche sardine manufacturer, purchased Bumble Bee in April 2004 from Centre Partners for $385 million, or 7x trailing EBITDA.

Note that the company reports results in US dollars; my references to dollars are US unless otherwise noted. As with most income trusts, distributions are paid monthly.

Products and Position
Connors is in the business of manufacturing, marketing and distributing canned protein products in the US and Canada, with nearly half of sales coming from tuna. Connors generates the bulk of remaining sales from canned seafood (sardines/herring, salmon) and various canned poultry and meat products. Broadly recognized brands such as Bumble Bee and Clover Leaf in tuna and salmon and Brunswick in sardines, coupled with the consumer staple categories in which Connors participates, have led to stable market shares and predictable revenues over many years. The company’s strategy is to increase its position as a canned protein manufacturer (as opposed to just a canned seafood manufacturer). By providing a full line of canned protein to its retail customers Connors becomes a more attractive supplier and can gain greater control over shelf design and product placement within stores. In January 2005, Connors purchased Castleberry (canned meat/clams) from private owners for $93 million, or less than 8x trailing EBITDA, and Sweet Sue/Bryan (canned and pouched meat) from Sara Lee for $45 million, or 5x trailing EBITDA. At the time these acquisitions were announced Connors was trading in the market at 11-12x trailing EBITDA. I expect the company will continue to make value-enhancing strategic acquisitions to further its strategy once its stock price recovers. Management usually looks to acquire targets at 5-7x trailing EBITDA and immediately garner the arbitrage inherent in the more tax-efficient trust structure, as well as any available cost or other synergies.

Financial Characteristics
Although most of its products are fairly commoditized, Connors enjoys a low cost position driven by economies of scale within its product lines. The P&L is characterized by very low fixed costs (perhaps 5%-10% of sales, mostly consisting of factory overhead and HQ) and, by corollary, high variable costs (of which the vast majority is fish/protein; transportation, cans and third party sales force make up the rest). Operating margins are around 10%. Although revenue growth in core markets likely will be unexciting, pacing around 0-2% per year over time, there is an opportunity to drive growth by expanding tuna use beyond the traditional lunchtime sandwich and salad and into higher margin dinner products like flavored tuna steaks. Capex tends to be fairly low due to the relatively unsophisticated nature of the equipment and management’s intention to hold back investment in tuna processing on the assumption that tariffs will ultimately be removed and the company will shift to third party processing. Economies of scale coupled with relatively low capital requirements have resulted in a return on capital north of 25%, despite uninspiring margins. The operating company maintains some leverage, with net debt of around $175 million.

Tuna
Canned tuna is considered a consumer staple, with 95% of all households purchasing the product each year and two thirds purchasing at least once a month. Canned tuna is the third fastest moving item on supermarket shelves after sugar and coffee. As such, grocery stores frequently use canned tuna as a loss leader, promoting special deals to drive traffic into the store (60% of lightmeat tuna made on promotion with an average discount of 30%). Bad press related to mercury in fish has had a marginally depressing impact on sales across the industry.

The canned tuna market in the US is a largely rational oligopoly, with Del Monte/StarKist, Connors/Bumble Bee and Thai Union/Chicken of the Sea representing close to 90% of the market. Canned tuna is sold in two basic categories: lightmeat (mostly skipjack) and white meat (albacore). Consumers pay up for albacore – in 2004 albacore was 33% of case volume but 48% of dollar volume. Connors focuses on albacore, where it has dominant share and benefits from its ability to flexibly source tuna from oceans across the globe. Branded tuna manufacturers possess pricing power and typically raise prices to the trade whenever tuna costs are high. Consumer demand is very price sensitive, however, so when tuna prices increase volume tends to drop. This is truer of lightmeat tuna than albacore: one study claims that for every 1% increase in price, lightmeat tuna volumes decline by 1.6%, versus only 1.2% for albacore (a major advantage for Connors).

Tuna is generally fished from the ocean (not farm raised) and brought to loining facilities near where the fish is caught to be cleaned, gutted and chopped into loins. Connors then ships the loins to canning facilities in the US where the final product is produced and shipped to retailers. The two-stage setup is meant to avoid the need to pay tariffs on imported canned tuna, which can run as much as 35%.

Struggles in F2005 and Distribution Cut
In F2005 the company suffered a decline in profitability, with EBITDA falling from approximately $94 million in F2004 (pro forma) to an expected $80 million in F2005. As a result of the falloff, management announced it would cut the distribution by 10% to bring the payout ratio down from ~100% to a more comfortable 85%-90%. Management had considered other alternatives (likely including accretive acquisitions, asset sales or leveraged share repurchases) and I would not be surprised to see these eventualities ultimately play out as potential catalysts.

The decline in profitability is all in the gross profit line, half of which stems from high fuel, freight and warehousing expenses, with the remaining half from a mixture of high fish and can costs, production inefficiencies resulting from a botched plant consolidation and poor overhead absorption in its sardine facilities. Each of these is addressable and likely to resolve through management attention (tuna pricing, plant consolidation) or basic reversion to the mean (fuel/freight, can costs, sardine cost absorption).

Albacore and lightmeat tuna costs together are the largest single component of cost for Connors. Tuna prices tend to reflect fishing conditions (mostly driven by weather) and are somewhat unpredictable in that sense. However, in general tuna costs tend to fall within a predictable range. In F2005, management did not react to higher albacore costs because they anticipated a return to normal pricing in the back half of the year. When that did not occur, management realized its error and began to raise prices, though these price increases will not impact the P&L until FQ106. I would expect the tuna cost/price spread to return to normal once those price increases run through.

The botched plant consolidation occurred on the back of Katrina, as the company was amidst combining its meat canning facilities from Athens, AL into Augusta, GA. The acquired plants, which were not particularly well-run, have proven harder to integrate and improve than management originally anticipated. What’s more, the hurricane hit just as the consolidation was going through and sent the factory into a frenzy as demand for canned goods went through the roof. Conversations with the team lead me to believe that operations are improving already and should be back on track by the middle of F2006. The company has been otherwise successful in its cost reduction efforts, including elimination of two sales forces and consolidation of two herring facilities.

Katrina not only resulted in higher fuel costs but also caused massive transportation cost increases as trucks were in short supply just at the peak of seasonal truck demand. High fuel/transportation costs are impacting all consumer packaged goods company, so either these costs will revert to more normal historical levels, or the industry as a whole will adjust (likely through general inflation). I suspect the same will occur with can costs (aluminum and steel). Within the canned seafood industry, all of the participants are experiencing similar material price pressures, so Connors is not at a relative disadvantage regarding its cost issues.

The final issue affecting F2005 results relates to the herring segment. Most of the company’s herring supply comes from the Bay of Fundy, where the catch size is regulated by government. Total allowable catch (TAC) can fluctuate from year to year, though in general the supply of herring is not considered to be in any danger. In 2005 TAC was reduced from 83,000 Mt to 50,000 Mt, the lowest level ever. This reduction caused a fish supply shortage that in turn led to problems with overhead absorption at Connors’ two herring facilities. TAC is expected to be higher in 2006 and should return to normal levels of around 75,000 Mt in a year or two.

Management
Management owns over 5% of the company in stock (not options), most of which is held by the CEO (2.5%) and COO (1.2%). The CEO, Chris Lischewski, has been with Bumble Bee since 1999 and in the seafood business since 1991 (prior to Bumble Bee he ran Heinz’s European seafood division, and prior to that was a Group VP for StarKist). Although the investor community has soured on management as a result of several downward earnings guidance revisions in F2005, both the CEO and COO are held in very high regard in the industry. Management believes the stock is undervalued and following a recent blackout related to the decision to cut the distribution I would expect to see insider buying activity at these prices.

Valuation
In looking at valuation I felt it wise to separate the tax asset (you can think of it as a non-expiring non-depleting NOL) from the operating business. As the tax statuses of the trust and US subsidiaries are vulnerable to political whim, I view the earnings from tax savings as inherently less valuable. Given the stable, low-growth characteristics of Connors discussed above, I believe the operating business should be valued to yield 8-10% on fully-taxed distributable cash flow, and that the tax savings should be valued at 6-8x. For comparative purposes, other food-related income trusts trade at around a 10% distribution yield (note this is actual distributions, not distributable cash flow) while comparable non-trust companies trade at around 7-8x EBITDA (but of course none have the income trust tax shield).

If we look at three profit scenarios and use the ranges I describe above, we have the following (exchange rate of 1.15 CAD/USD):

- Assuming no improvement from F2005 (EBITDA of $80 million) results in a unit price of CAD 11-14, for upside of 5-35% (plus interim distributions)
- Assuming return to F2004 profitability (EBITDA of $94 million) results in a unit price of CAD 13-17, for upside of 25-60% (plus interim distributions)
- Assuming return to F2004 profitability and achievement of synergies (EBITDA of $100 million) results in a unit price of CAD 14-18, for upside of 35-70% (plus interim distributions)

Risks
- Elimination or reduction of the tariffs on canned tuna could undermine the cost competitiveness of Connors’ tuna processing facilities. Such a change might reduce profitability but would not be devastating and management is anticipating this eventuality
- Increase in private label market share, particularly to leverage distribution costs
- Impact of negative press related to mercury in tuna, including the lawsuit in California related to Prop 65
- The income trust structure could come under renewed attack as new governments replace old ones; US subsidiaries may be required to pay tax in the US
- Further increases in raw material and energy costs, issues with plant consolidation and/or low herring TAC
- FQ405 is expected to suffer from many of the same problems we’ve seen throughout the year; there is always the risk of another short-term miss
- Bird flu fears could impact chicken products

Catalyst

- Price increases; fix plant problems; raw material price normalization
- Insider buying