Description

At current levels, HQS trades for less than ~2.0x LTM EBITDA / less than 1.5x normalized EBITDA, has >$4.35 / share of PF cash of the balance sheet (which already factors in >$10MM of capex spend for capacity expansion that is now up / running) and has multiple mis-perceptions around end-market pricing (extrapolating the past 9 mths of -25% pricing deflation into the future which is very different than reality), working capital (embedded >$12.5MM of working capital release in the next couple qtrs) and underlying earnings power (>$1.50 of EPS potential in 10E given pricing, incremental volume on core biz and incremental volume on new capacity), that I think makes this an attractive risk / reward proposition with >80% return potential.  While HQS has been written up in the past (reference jon64's write-up from December 2007 and my earlier posting from November 2008), I think the equity is well worth revisiting (currently trading in the $6.80 / share range or ~81% of cash + AR + Inventory + PP&E). 

Despite operating in a very volatile environment this past year, HQS management has done an impressive job and has seen 15 - 25% volume growth in its core tilapia business, 5 - 15% volume growth from its marine bio-products division (on the most recent Q3 call, mgmt hinted at further growth driven by additional market penetration in China) as well as future growth from the recently completed capacity expansion (capex spend has been abnormally high at ~$10MM over the past 12 mths) which has resulted in >30% increase in HQS' total capacity and should be fully utilized in the next 12 mths which could have $0.25 - $0.50 of embedded EPS value once fully operational.  More notably, since the last posting in November 2008, the (i) balance sheet is cleaner (convertible note overhang has been removed as management issued 950k shares in October), (ii) the balance sheet has been further enhanced (to fund further capital expansion, management opportunistically raised an additional $10.5MM at ~$8.50 / share or 25% above current levels), (iii) core operating performance has shown incremental improvements (gross margins were up +151 bps YoY in Q1 09, +842 bps in Q2 09 and +274 bps in Q3 09 - showing greater stability in the 43 - 45% gross margin range) and yet the (iv) equity currently trades at ~2x LTM EBITDA and less than 1.5x my "normalized" EBITDA figure of $30MM). 

I believe the biggest mis-perception around the company / industry is that this is a broken growth story.  This belief is being based off of the simplistic view that top-line #'s that have been trending down (+17.7% YoY growth in Q1 09, +10.2% in Q2 09 and -1.4% in Q3 09).  The nuance that I think people are missing is the vicious deflationary pricing pressure in the tilapia market (pricing has dropped >25% in the past year).  So while volumes were up >15 - 20% YoY in Q3 09, the pricing degradation of -25% clouded the reality that tilapia continues to gain further market acceptance.  More pragmatically, the question is how long this pricing pressure can / will remain.  Based on comments from management, they are seeing and expect to see price recovery by the end of the Q4 ending December period.  Mgmt comments were the following: "Well, I think the -- we're in the tail end of the last part, the last chapter, if you like, of this story of the winter freeze in Mainland China killing off the Tilapia. A large significant amount of market share was lost by the Mainland producers and they're trying to earn it back by artificially keeping prices low and the farmers are resisting so at some point something has to give. Prices have to come back up, which is what we expect will happen in the coming weeks."     

While I think the investment merits are more-than-adequate given the absolute valuation levels (less than ~1.5x normalized EBITDA and less than ~4.5x normalized EPS) and the balance sheet (no debt and >$55.5MM of cash), I think there are multiple embedded levers of hidden value that the market is not factoring in.  Three levers include: (i) working capital should release over $12.5MM of capital over the next couple quarters (AR was abnormally built up as the company has grown out its bio-marine division + working capital has been built up in advance of its recently implemented plant expansion w/ NO real offsetting earnings power to date - more notably, over the past 19 quarters, working capital has averaged ~25% - 30% as a % of sales as compared to the September 2009 period of ~48.7% based on LTM sales ... assuming this normalizes, this should release over $12.5MM which implies PF cash balance is >$67.5MM), (ii) Q3 earnings were stronger than the initial headline #'s (EBITDA and EPS) - as management took a ~$1.3MM provision for extending longer payable terms to their bio-marine customer base (management noted on the call that they will receive these and that the provision was driven by an accounting requirement driven by aging of AR).

Regarding valuation, total shares outstanding (PF for the recently issued shares from the convertible note) is ~15.6MM which equates to a PF market capitalization of ~$106MM.  Based on the September 2009 cash balance of ~$55.5MM + $12.5MM from working capital release = $67.5MM of net cash which results in a PF TEV of ~$38.1MM, which implies a ~2.0x TEV / EBITDA multiple (based on LTM EBITDA of $19MM) and ~2.2x TEV / EBIT (D&A is minimal).  Given the large cash balance, HQS currently trades at ~1.6x PF cash (which includes the working capital release); and approximately ~81% of cash + AR + Inventory + PP&E.  Given HQS' strong balance sheet, I think earnings power is effectively being given away for close to "free".  On that note (as it relates to earnings power), HQS has generated >$12MM of EBITDA and >53 cents of EPS in the YTD period ending September 2009 (I would anticipate an additional $6MM of EBITDA and 30 - 35 cents of EPS in Q4 09E which gets to around $18MM of EBITDA and ~85 cents of EPS for 09E).  Even if we IGNORE the (i) $67.5MM of PF cash on the balance sheet, (ii) future growth given the completion of an additional >30% increase in capacity and (iii) potential for pricing power inflection, HQS equity trades for ~8x 09E EPS of 85 cents (6.80 / 0.85) - which seems like a decent margin of safety with multiple ways to win: (i) global economic improvement and pick-up in tilapia expenditures, (ii) volume pick-up on 30% additional capacity, (iii) tilapia pricing starts to inflect up (mgmt noted on the call that pricing is starting to move up given inputs are also creeping up and competitors are acting less irrational - which could be a significant boon to their business)

Overall, HQ Sustainable Maritime presents a compelling risk / reward proposition, with total return potential of >80%.  Given the cash balance (still over $55MM and additional $12.5MM of working capital to be released), I believe you're effectively creating the business for less than 2.0x LTM EBITDA and getting the earnings power of what I believe is >$1.50 / share in 10E (based on incremental volume growth in 10E, new volumes from the >30% capacity expansion that was recently completed and currently up / running and stabilization / incremental improvements in tilapia pricing) as very cheap call option.    

UPSIDE / DOWNSIDE:

UPSIDE (25% probability): assuming 10x multiple to 10E EPS of $1.50 / share + $4.35 of PF cash = ~$19 / share (vs current of $6.80 / share or approx 280%+ upside)

BASE (55% probability): assuming 5x multiple to 10E standalone EPS of $1.25 / share + $4.35 of PF cash = $10.60 / share (vs current of $6.80 / share or approx 55% upside)

DOWNSIDE (20% probability): assuming 5x multiple to current 09E EPS of approx $0.85 / share + $4.35 of PF cash on balance sheet = $8.60 / share (vs current $6.80 / share or approx 25% upside)

CATALYSTS:

NEAR-TERM: Street recognizes that tilapia pricing is starting to inflect up and that top-line growth should continue to be in the 10 - 20% range (and perhaps much more than that in 10E - 11E given >30% increase in capacity)

NEAR-TERM: Street recognizes that equity trades (i) at less than 2x PF TEV / EBITDA and (ii) at approximately 90% of cash + AR + Inventory + PP&E (arguably fire-sale price for a growth biz with attractive l-term dynamics)

LONG-TERM: Street recognizes the underlying earnings power of the biz model and applies a "market" multiple to earnings power (upside case assumes ~10x earnings on $1.50 of 10E earnings power + $4.35 / share of cash = approx ~$19 / share vs current $6.80 / share)

Catalyst

NEAR-TERM: Street recognizes that tilapia pricing is starting to inflect up and that top-line growth should continue to be in the 10 - 20% range (and perhaps much more than that in 10E - 11E given >30% increase in capacity)

NEAR-TERM: Street recognizes that equity trades (i) at less than 2x PF TEV / EBITDA and (ii) at approximately 90% of cash + AR + Inventory + PP&E (arguably fire-sale price for a growth biz with attractive l-term dynamics)

LONG-TERM: Street recognizes the underlying earnings power of the biz model and applies a "market" multiple to earnings power (upside case assumes ~10x earnings on $1.50 of 10E earnings power + $4.35 / share of cash = approx ~$19 / share vs current $6.80 / share)