HQ Sustainable Marime HQS
December 17, 2007 - 3:17pm EST by
2007 2008
Price: 7.68 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 96 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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  • vertically integrated
  • China
  • Food Manufacturer
  • Micro Cap


Business description:
HQ Sustainable Maritime is a vertically integrated processor of toxin-free tilapia and white legged shrimp in China (65% of revenue) and is one of the only companies to be certified by the HACCP, EU and ACC. It has cooperative arrangements with local farmers in China for the supply of tilapia and then processes the fish before exporting mainly to the U.S., Japan and Europe where the fish has historically been sold to wholesalers, but is now being branded and sold more to retailers. It also produces and sells marine bio and healthcare products like shark cartilage capsules and shark liver oil products exclusively in China (35% of revenue).
Investment Thesis:
Not only is HQS trading at 5.5x our ’08 EPS estimates, but they benefit from two powerful trends (acquaculture and chinese herbal medicine) that could triple EPS in a 3-4 years. With the emerging wealth in China, the Chinese medicine market is estimated to grow at a 40% CAGR over the next 3-5 years. HQS may be able to gain share due to a crackdown on lower quality suppliers. With increasing worldwide demand for protein and fish in particular, but a flat to decreasing supply from the oceans thanks to overfishing, aquaculture is the only solution. Tilapia imports to the US have grown at a 22% CAGR over the last 5 years. In addition, HQS should be able to have a significant increase in margins as they transition from selling commodity fish to both branded and eventually organic certified fish, which command up to 3-6x the dollar profit per lb of fish. There is a clearly lot to be shown here, but there’s plenty of margin for error. A minor addition positive is that this could serve as a hedge against avain flu, once a major concern, as the protein demand would shift from poultry to fish causing a spike in fish prices.
Aquaculture contributed 59.4MM tons of fish in 2004 and according to the Food and Agriculture Organization (FAO) of the United Nations, it is estimated that in order to maintain the current level of per capita consumption, global aquaculture production will need to reach 80MM tons of fish by 2050. The FAO also reports that most of the new demand for fish will have to be met by aquaculture, which could account for approximately 39.0% of all fish production by 2015.
Citing this trend, Jacques Diouf, Director-General FAO, recently mentioned that the further development of aquaculture should be a priority for the international development agenda. 
The FAO estimates aquaculture to be a $60BN industry.
Capture Fishing              $80.0
Aquaculture                   60.0
Primary Processing           60.0
Secondary Processing     120.0
Distribution                     80.0
Total                             $400.0
Source: FAO.
Tilapia Industry:
According to the American Tilapia Association, tilapia will become the most important aquaculture crop in the century, potentially reaching $5.0 billion in global sales. Commercial production of tilapia has become popular in many countries around the world. Touted as the “new white fish” to replace the depleted ocean stocks of cod and hake, world tilapia production continues to rise and at least 100 countries currently raise tilapia, with China being the largest producer. Demand for the fish has also been steadily growing in the U.S. and is expected to be one of the top four seafood products by 2020 according to the USDA.
US Total Tilapia Import (In 000's tons)
1999                 37.6
2000                 40.5
2001                 56.3
2002                 67.2
2003                 90.2
2004                 112.9
2005                 134.9
2006                 155.3
Source: Company estimates.
Investment Merits:
  • New feed mill and processing plant: Follow-on proceeds are going to be used towards a new processing plant ($13MM) and a feed mill ($5MM) that should be ready by 2H08. The plant will allow the company to double its current capacity and the feed mill (which is EU certified) will allow them to cultivate 100% organic tilapia at a much lower cost than their competitors. In addition the supply of fish feed has not kept pace with the increase in aquaculture so this also gives HQS an opportunity to sell its excess feed to other farmers.
  • Shift to branded and organic products: Management is committed to increasing branded and organic sales and thinks that it can achieve a 50-50 mix by 2010.  Only around 15% of the company’s current sales are branded so there is a lot of potential for margin improvement as company executes on its plan.
    • Its branded product is called “TiLoveYa” and is currently sold to QFC, Sam’s Club and Grocery Outlet to name a few.
    • During Q108 they’re going to start selling block frozen products to McDonalds, which will lead to an additional 4,000 tons / year
    • The U.S. doesn’t currently allow the sale of “organic” tilapia as they’re trying to institute guidelines for what exactly it means to be an organic product but management thinks this will resolve itself by 2009. Currently selling organic skin on Tilapia to WMT Mexico. The following is a summary of margins and capacity:
Tilapia Economics         Generic    Branded   Organic
Revenue / lb                 $1.60            $2.30        $3.50
Costs / lb                     $1.35            $1.53        $1.93
Net / lb                        $0.25            $0.77        $1.57
   EBT margin%              16%            33%          45%
Capacity (tons '000s)       2008   2009    2010
   Live weight                40          60        60
   Fillet (1/3 of total)      13          20        20
   Whole Round               5           8         8
   Total                         19          28        28
Source: Company estimates.
  • Reduction in Competition for the Health and Bio Segment: According to management all plants in China need to be certified by the end of the year to remain in business – there are currently 6,000 plants in China and only 8-12% are certified so they expects demand for the products to go up on account of diminished supply.
  • Vertically integrated: The FAO studied the distribution of benefits from two developed countries fisheries and two developing country fisheries. As seen below, the FAO study indicates that the majority of benefits generated throughout the value chain are captured by the retail/wholesale/secondary processing sector of the industry. The same applies for products originating from developing countries and developed countries fisheries. Independently of the FAO, Glitnir Bank undertook a similar study and ended up with the same conclusion. This is good news for a vertically integrated company like HQS that stays away from the actual farming of fish and that’s increasing its presence at the end of the chain.
FAO Value Chain Revenue Distribution
                                                            FAO Study                  Glitnir
                                                IC        TN      DH      MA                 
/Secondary Processing                        54%     61%      75%     75%         50%
Processing                               27%     18%      17%      21%          15%
Capture                                    18%      16%      8%       4%           20%
Aquaculture                                                                                 15%
Source:  World Fish Congress.
Note: IC = Icelandic Cod; TN = Tanzania Nile Perch; DH = Danish Herring; MA = Moroccan Anchovy
Note: Unclear why TN doesn’t =100% in the study
Investment Risks:
·         Customer concentration - top 5 customers accounted for over 50% of sales in 2006
·         Organic ramp contingent on the U.S. allowing the sale of organic fish products - guidelines are currently under review and scheduled to be completed by 2009
·         Negative publicity for aquaculture in China (see the NYT article from this weekend - http://www.nytimes.com/2007/12/15/world/asia/15fish.html?ex=1355374800&en=45d0ec60b98921d1&ei=5088&partner=rssnyt&emc=rss)
o        We believe articles like this actually benefit HQS because it distinguishes them from some of the other farms in surrounding areas as their water is potable and they have a number of hard to get certifications
  • Our base case assumes that they are able to achieve a 50-50 branded and organic sales split by 2010. We get $4.28 of 2010 EPS leading to a high $40s stock price. This is a somewhat aggressive forecast, in our opinion, but possible.
·         Sale of organic products in the U.S. once guidelines are decided
·         Investors/sell-side discover the company
Disclosure: We and our affiliates are long HQS, and may buy additional  shares or sell some or all of our shares, at any time.  We have no obligation to inform anyone of any changes in our views of HQS. Do your own work, this isn’t a recommendation to buy or sell shares.


· Sale of organic products in the U.S. once guidelines are decided
· Investors/sell-side discover the company
. Trading at 5-6x next years EPS
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