Description

The Brief Story
• Leroy Seafood Group is a lightly followed, small capitalization, small market company that is the premier player in a hated sector.
o Listed on Oslo Stock Exchange
o Involved in salmon farming, distribution and marketing
o $250 mil USD market cap
o 3 analysts cover the stock
o Leroy is low cost producer with great management team

• Earnings will nearly double in 2005 as salmon prices return to normalized levels after four years of trough prices
• At 40 nok/share Leroy is trading at 9-10x estimated 2005 earnings and 7-8x normalized EBIT. Leroy has peak earnings power of 9-10 nok/share.
• In addition, by virtue of its strong balance sheet, Leroy is uniquely positioned to capitalize on substantial value enhancing acquisition opportunities in this consolidating industry
• We think Leroy is worth 60 nok/share. We see potential upside beyond 60 nok if Leroy can use its advantaged competitive position to acquire additional salmon farming assets in 2005.

Background

Leroy Seafood Group is a Norwegian seafood company founded in 1939, with roots tracing back to the late 19th century. Its core business is the distribution and marketing of seafood produced in Norway and Scotland for export around the world. Leroy exports seafood to more than 40 markets, with France, Japan and Sweden being the largest markets. European end markets represent approximately 65% of Leroy’s sales. In 2004, Leroy exported 14.6% of the salmon produced in Norway and 10.6% of total Norwegian seafood production. The distribution business is the engine of the company; it is stable, has high-returns and is cash generative. Managing the details is critical in this business, with the most important success factors being risk control, working capital management, and marketing.

In the last five years, Leroy has expanded outside of distribution to become the 6th largest salmon farmer in Europe. It has done so via the acquisition of low cost assets at the trough of the salmon cycle. Today, Leroy produces approximately 35,000 net tonnes of farmed salmon per year. Its operating costs are approximately 10% (or 1.5-2.0 norwegian kroner/kilogram (“nok/kilo”) of fish produced) below the industry average. The earnings power of Leroy’s farming assets is, in our opinion, largely unrecognized by the market.

Leroy Seafood Group is family owned and operated. The Leroy family controls 15% of the outstanding shares. CEO Ole-Eirik Leroy is the grandson of the founder and his father, Hallvard Leroy Jr., is the former Chairman of the Board and a current Board member. Leroy went public in 2002 at 32 nok/share in the middle of the 2000-2003 trough in salmon prices. Shortly after going public, Leroy’s stock collapsed during an industry financial crisis, bottoming at 18 nok/share in March 2003. It has since slowly appreciated to close to 40 nok/share. Neither the CEO nor the Chairman has sold stock since the IPO.

As described below, we believe that consolidation of the salmon farming industry, combined with greater capital discipline emanating from the industry’s recent financial crisis, will be the catalysts to drive salmon prices and salmon company stock market valuations higher. Moreover, in Leroy Seafood Group, we believe we have found the class of the industry. The company has the best assets, the best balance sheet and the best management team in the sector.

Background on salmon farming

Traditionally, salmon, like all fish, has been caught in the wild. Over the past 30 years, however, the “aquaculture” industry (i.e., farm-raised seafood) has grown rapidly due to the depletion of wild fish supplies and to efficiencies associated with farming. The total world salmon market is roughly 2.2 million tonnes per year. Approximately 59% of salmon production is now farmed, up from 33% in 1994.

As the industry has matured, it has enjoyed massive reductions in production costs, from an estimated 38 nok/kilo in 1991 to approximately 20 nok/kilo in 2004. The primary driver of these declines has been a reduction in the feed conversion ratio, which represents the amount of feed that a farmed fish must eat to add one kilo of weight. This ratio has declined from roughly 3.5 in 1975 to 1.1-1.2 today - fortunately, human beings are not such “productive eaters”!!!! Lower production costs have translated into lower wholesale and retail prices, stimulating demand and migrating salmon from a luxury item to an everyday food.

While the industry’s growth has been positive for consumers, it has not always been so positive for salmon farmers. In the late 1990s, production growth far outstripped demand growth, leading to a collapse in prices. Salmon prices fell from a peak of 40 nok/kilo in May 2000 to 15 nok/kilo in June 2003. At the peak, many salmon producers were over-leveraged and had to “hand the keys” over to their lenders. Large banks currently control two of the top five Norwegian salmon producers, as well as numerous smaller players.

The Investment Thesis

The investment thesis for Leroy Seafood centers on our expectation of a positive turn in the cycle for farmed salmon. There are four principal factors underlying our bullish view on the salmon cycle: (i) biologic limits to further productivity growth; (ii) forced financial discipline; (iii) consolidation; and (iv) visibility on future supply.

Biological limits on productivity growth. Historically, improvements in feed conversion ratios have facilitated biomass growth above and beyond growth in the number of fish put in the water. That is, not only did farmers increase the number of fish in the water, but productivity improvements allowed each fish to grow bigger and faster than previous generations. However, industry-wide feed conversion ratios are now approximately 1.1 to 1.2, meaning that the average fish must consume 1.1 to 1.2 kilos of feed to add 1 kilo of biomass. Biologically, it is extremely difficult for a fish to add more weight than it consumes, and at the 1.0 barrier, there is a physical threshold. This means that productivity-driven supply growth should be much lower going forward.

Forced financial discipline. Beyond the impact of biological constraints, the salmon farmers themselves are contributing to more controlled supply growth. The 50% peak-to-trough decline in European salmon prices from 2000 to 2003 precipitated a financial crisis that has forced salmon producers to focus on fixing their balance sheets rather than growing production. This rationalization has been aided by the transfer of control of many over-leveraged salmon farmers to their lenders. We estimate that 28% of current European farmed salmon production and 17% of current world production is grown by companies controlled by banks or the Norwegian government. This is significant because the major lending institutions have publicly stated that they want to take capital out of the salmon farming industry, not put it back in. Salmon farming is a very working capital intensive business as it takes nearly two years to grow a fish. Thus, access to capital is a precondition to growth. Bank control over salmon farming assets is a critical component of our confidence that production will be more rational in the coming years.

Consolidation Should Make Industry More Rational. While still a fragmented industry, consolidation in recent years has placed control of the industry into fewer hands. The most significant of these combinations is the recent decision by Nutreco and Stolt Nielson (Oslo: SNI NO) to form a joint venture with their respective salmon assets (Marine Harvest and Stolt Sea Farm, respectively), with the ultimate goal of taking the combined “new” Marine Harvest public when synergies are achieved and salmon prices improve. By combining the industry’s largest producer (Nutreco) with the fifth largest (Stolt Nielsen), the joint venture creates a dominant, number one player in the sector with 25% market share. The next largest player has just a 9% share. Moreover, under the terms of the joint venture agreement, Nutreco has incentive to clean-up and spin-out Marine Harvest, as Stolt Nielsen has an option to sell its stake to Nutreco if there is no IPO prior to January 1, 2007. Given these terms and each company’s stated interest in exiting the salmon farming business, the Marine Harvest joint venture has a significant incentive to behave more rationally in the hope of influencing salmon prices. Between the new Marine Harvest and the large Norwegian banks, we estimate that 36% of world farmed salmon supply is in the hands of parties with significant incentive to help move prices higher.

Visibility on future supply. Lastly, salmon are animals, and, thus, their production cannot be turned “on” and “off” at will. The typical growing cycle from egg to smolt to salmon is 18-24 months. Because there are two to three generations of fish in “production” at any given time, future supply can be predicted reasonably well by measuring the industry’s “biomass” levels, which is the total live tonnage of fish growing in the water at a spot point in time. Statistics provided by Kontali, a Norwegian-based aquaculture market research firm, show that December harvestable biomass levels in Norway increased year-over-year by 4% in 2002, were flat in 2003 and declined slightly in 2004. Furthermore, industry experts estimate that the salmon biomass in Norway at the end of March 2005 was 1.3% less than it was at the same point the previous year. While there is some variability in production due to the impact of weather conditions on feed conversion rates, directionally, one can say with reasonable certainty that the recent deceleration in biomass growth will translate into lower production growth rates in 2005 and 2006. Stated differently, salmon supply (and thus salmon prices) in 2005 and 2006 will primarily be a function of decisions made in 2003 and 2004, when industry participants were focused on paying down debt, rather than on growing biomass.

Summing up our view on the salmon cycle, we believe that forced capital discipline, coupled with the benefits of consolidation and the biological limitations described above, will lead to a sharp deceleration in production growth in 2005-07. Specifically, we expect salmon prices to return to more normalized levels in upcoming years (24-25 nok/kilo).

The Valuation Case for Leroy Seafood Group

Based on a forecasted improvement in salmon prices from 20-21 nok/kilo to 24 nok/kilo, we estimate that Leroy’s earnings will increase from the 2.36 nok/share that it earned in 2004 to greater than 4.00 nok/share in 2005. Leroy trades at approximately 40 nok/kilo and thus at approximately 9-10x our view of normalized earnings. It has a reasonably strong balance sheet, with net debt to capital of 30% and ebita/interest coverage of 8.3x at 2004 prices. Fully consolidating all of the debt in its joint ventures, Leroy trades at 7.2x our 2005 forecasted ebita. Importantly, we believe that Leroy has peak earnings power of 9-10 nok/share.

In our opinion, Leroy’s leverage to salmon prices is underappreciated, for the following reasons: (i) it built this earnings power via acquisition at the trough of the cycle over the past five years, and these assets have yet to contribute materially to earnings; (ii) half of Leroy’s farming assets are owned in the form of joint ventures, which are not consolidated; (iii) Leroy’s roots are as a fish distributor rather than as a farmer; and (iv) investors, having been burned by Leroy’s larger peers (Pan Fish; Fjord Seafood; Nutreco; and Stolt Nielsen) during the last down cycle, are not closely monitoring salmon farming stocks.

Beyond the earnings story, we believe that, by virtue of its strong balance sheet, Leroy is uniquely positioned to capitalize on substantial value enhancing acquisition opportunities over the next few years. Leroy conducted a secondary offering in January 2005 to allow it to move quickly to capitalize on any acquisition opportunities that arise. In an industry where very few strategic buyers have the balance sheets to make acquisitions, and there is little appetite on the part of the lending community to increase their exposure to the sector, Leroy’s strong balance sheet is a material competitive advantage.

Catalyst

Salmon price recovery in 2005 driving substantial earnings beat
Acquisitions solidifying and extending Leroy’s competitive advantages