Description

Idea: Long Marine Harvest (Ticker: MHG NO)

Thesis:

Marine Harvest is an $8bn market cap company that is the world’s largest producer of farmed salmon and has never been written up on VIC before. Salmon continues to display long-term structural demand trends but faces continuing supply constraints leading to increased prices. In addition Marine Harvest is doing a great job of making high return upstream and downstream investments to increase vertical integration and margins. Marine Harvest is trading very cheaply at EV/EBITDA of 6.5x for 2019E and FCF Yield of 10%+ (and growing) for 2019E. I calculate base returns of greater than 50% over a 2 year period to my target share price inclusive of dividends.

Note: I have re-used some of my "sector description" from my write-up two years ago from Austevoll instead of just referencing/linking that write-up as I have expanded and edited portions of it and updated it and provided a lot more data and charts on the sector than previously so felt it was worth writing it again.

Sector:

Aquaculture is a very small part of the entire fish market globally. Most of the fish eaten globally is still caught at sea. And it is an even smaller part of the overall protein market globally. Needless to say there are some very large mega-trends at work which have been delivering very robust GDP+ demand growth for aquaculture and salmon in particular. There are

1. Demand for proteins has been steadily increasing at above global GDP levels as poorer countries in Asia and Africa are increasing their per capita protein consumption as they get richer.

2. Healthy living trends have been increasing the demand for fish at the expense of beef, pork and chicken, and demand for fish has been increasing faster than the demand for other proteins. 

3. Demand for Aquaculture is increasing faster than demand for fish as aquaculture is sustainable while a lot of fish stocks in the wild are getting depleted from overfishing and quotas and monitoring of fish caught in the wild are increasing to make wild fishing more sustainable. 

4. Demand for salmon within Aquaculture has been very healthy because of its very prominent use in sushi, and French and other cuisines, which are increasingly becoming more popular globally with a long runway still to go. 

All these factors have conspired to result in salmon demand growth of about 6% globally very consistently for decades now and likely to continue for the foreseeable future.

Infact as China and other Asian markets continue to become bigger consumers of salmon due to the increasing popularity of sushi, overall demand could even surprise to the upside, although that’s not required for this thesis.

In light of this reliable and steady demand growth, the commodity has consistently seen price cycles for decades now because of supply fluctuations. It takes 3 years to grow salmon to adult harvestable age. New capacity can be added fairly rapidly if space/location is available with logistical network in place and this supply will hit the market in 3 years as the fish gets older. This is the classic hog cycle from Economics 101 which is also prevalent in the salmon industry. The difference this time for salmon, after many decades of these cycles (the last downcycle was 2012), is that we are running out of places to farm salmon.

Salmon requires temperature in the water to be fairly cold all year round. This eliminates pretty much any place close-ish to the equator. It also requires water temperature to remain in a tight range all year. In the wild the fish just migrate to different areas of the oceans as temperatures vary. For farming you need the temperature to remain in a steady cold range. This eliminates any location that e.g. freezes over or gets too cold. The only locations left are Norway, Scotland, Chile, Kamchatka and eastern Russia, Eastern and Western Canada, Tasmania (a small island south of Australia). Of these Eastern Russia and Eastern Canada have no existing infrastructure or locations in play. Western Canada entered the market but has pretty much reached its limits due to First Nations issues in British Columbia. Scotland has been maxed out for a long time. Chile entered the market strongly and rapidly built up production capacity a decade ago and is now running into problems. And Norway is by far the world's biggest producer (Fish is norway's biggest export after oil and gas). And even Norway is now struggling to produce more. 

The reason for the problems is that there's a biological limit to how much fish you can farm in a given area before running into evolution fighting back. At some point some form of disease (lice or others) breaks out and spreads rapidly across the entire population and decimates the stocks. Hence smaller groups are strictly controlled and maintained with some distance from each other with no intermingling. Using medicines to fight back against these diseases still doesn’t allow much increased production as heavy use of antibiotics or other treatments leads to resistances developed that are passed down the generations and hence immunities developing.

The Norwegian govt hands out licenses and quotas and very zealously monitors these for fear of future outbreaks. The solution for a long time was to open more areas for salmon farming and slowly increase the quotes. But it's been known for a long-time that we're approaching the limit for what Norway can produce and the last white paper (a govt study) on this matter done in summer 2015 effectively shut the door on any major quota increases from Norway in the foreseeable future to prevent disease outbreaks. Chile, which was the last major location that was viable, entered the market and rapidly increased share about a 5-10 years ago and has since run into consistent problems with lice and disease and even logistics and has failed to increase production last few years despite best efforts. 

The chart below indicates Norwegian standing biomass and theoretical capacity (the capacity is not going to be increased in the coming years). Also note the Norwegian export volumes in 2017 start of below 2016 levels.

In addition to this Chile, which was already suffering from increase disease outbreaks and lice issues and has hence seen its supply starting to decrease, got affected significantly by the volcanic eruptions in May 2015. It is unclear right now how much of the smolt (baby salmon) got damaged from the ash falling on the farms but it is expected to be significant, and supply won’t recover for a few years (since it takes 3 years to grow a salmon to harvestable age).

Putting these facts together paints a picture of negative supply growth in 2016 for the industry and muted growth even after that.

Salmon is quoted in Norway in Norwegian Krone and also in Miami in USD (for imports from Chile) and Seattle in USD (for imports from Canada) and prices appear very robust but in USD they are much more reasonable due to the strong USD, especially versus Norwegian Krone and Chilean Peso. Hence demand remains very robust for salmon. 

Due to the overall robust demand, the weakening Norwegian Krone, and the global supply constraints, prices in Norway have been very robust and are starting 2017 at the highest level ever. Marine Harvest’s share price has been strong but only in reflection to stronger earnings and the security has not re-rated as there is a lot of scepticism in the market around the sustainability of these prices, and the forward curve remains in backwardation. Note the Oslo salmon spot price below as well as the forward curve.

On the cost side the biggest component for cost (half of total cost) is feed. Feed is constructed from a combination of fish oil and other ingredients. Fish oil is processed from fish caught in the wild. Most of the fish oil is produced from Pelagic fish caught in Peru (mostly) and some other places. Fish oil has recently seen an alternative demand from Omega-3 pills which are increasing in popularity and hence fish oil prices have been trending up over last decade. There is also concern that the recent El-Nino will depress pelagic catch in Peru and cause a spike in fish oil prices. These have led to concerns of margin compression increased costs may not be passed through in increased prices.

A lot of these concerns about a spike in fish oil prices are overdone. Overfishing in Peru lead to a fall in fishing stocks which caused the Peruvian govt to reduce quotas dramatically to allow the stocks to re-build. The quotas were curtailed in 2010 and over the last 5 years the stocks have now replenished. And while fish oil prices dramatically increased during this stock rebuild, they are now stabilizing as the Peruvian govt moves to gradually increase Pelagic fishing quotas in the coming years. The other concern about a spike in fish oil prices are around the current El-Nino affecting catch sizes and causing supply issues, but recent incoming data indicates the concerns are unfounded and fish oil prices have come off from the 2014 highs and fell during 2015 and 2016.

Also fish oil and hence feed, is priced in USD, and it has gone up in NOK for farmers accordingly. But also fish oil has gone up due to alternative uses. Since part of the thesis is that supply is limited, I don't expect there to be a pressure on fish oil demand. Any spike from El-Nino has historically been short lived and so far has yet to materialize. And we still face the prospect of a potential "veggie fish" although the ultimate effect of that is unpredictable. Fish don't naturally have much Omega-3. They must eat other fish to produce it. Hence the need for fish oil in their feed. But the fish can also be given feed from veggie oils and they taste perfectly fine, they just don't have as much Omega-3. I can attest first-hand the two types of salmon are indistinguishable. Since Omega-3 has been such a marketing tool for creating demand, salmon farmers have been so far reluctant to switch to the far cheaper veggie oil based feed. If fish oil prices go beserk, they are likely to switch. 

We can see this substitution of fish-oil with veggie-oil as overall feed consumption has remained very manageable due to productivity gains, substitution and thrifting even as production has improved.

Marine Harvest:

The sector commentary should have demonstrated the reasons farmed salmon is a good place to be as the sector demonstrates healthy demand trends and supply constraints leading to robust prices, while costs remain in control. Marine Harvest is one of the biggest beneficiaries. It benefits handsomely from the falling Norwegian Krone as well as increasing price as it benefits from both translation (it reports in NOK but has some operations outside Norway) and transaction (it exports most of the salmon produced in Norway) effects.

Marine Harvest is primarily owned by John Fredriksen who is a very well respected investor and has a history of prudent capital allocation decisions.

In addition, Marine Harvest has actively looked for ways to improve profitability via high return investments both upstream and downstream. Once Marine Harvest ran out of expansion opportunities due to hitting the biological limit, and refusing to do M&A to grow (not the Fredriksen way, and trading prices for licenses in Norway are nosebleed high as they should be), it decided to grow via investing in vertical integration. Marine Harvest invested heavily in a very large feed facility which is just now coming online and which has significantly added to global feed capacity and which will run at full capacity. The top 3 feed producers Skretting, Ewos and BioMar account for 88% of fish feed and have seen their large customer take significant demand internal. Overall capacity utilization at these facilities will likely fall and could pressure their margins and lower feed prices. Marine Harvest also invested in a 2nd facility in Scotland which has also been successful.

Marine Harvest has also invested in downstream with investments in processing and packaging as well as developing its own brands to market the salmon directly. All these investments have been low cost

Despite the good run over last few years, there are a number of reasons Marine Harvest remains cheap. One is the perpetual fear that the one way or another the hog cycle will hold and somehow, from somewhere, more salmon will come to the market and that this time is not different either. I respect that argument but the data increasingly supports that we've hit the biological limit in existing locations. For more salmon to be farmed, the options are basically onshore salmon (in massive drums), offshore salmon (way off from the shore), larger smolt (bigger onshore hatcheries) or new locations like Eastern Canada or Eastern Russia, and other more exotic ideas (like an egg shaped drum, to reduce the effect of lice etc). I am not going to get into a detailed debate on all these options but all of these options are uncompetitive currently, although I expect a combination of all of these to happen eventually as salmon price keeps going higher. As we exhaust current sources of supply, and demand remains resilient, then prices will trend up to the point that more expensive and alternative sources are put in play. This is how bull cycles work. More expensive production comes into play at higher commodity prices to meet demand that cannot be met by cheaper sources.

Valuation:

The Marine Harvest stock price is not even remotely reflecting the robust spot prices as the shares are trading on 7.7 P/E for 2017 at spot prices. The backward sloping forward curve (with minimal volumes) and general trepidation around the cycle coming to an end leads both buyside and sellside investors to use extremely conservative forecasts of salmon prices going forward. This is why despite the strong share price movement over last 2 years, the stock as actually de-rated to a lower multiple and is even cheaper due to the robust movement in earnings. I expect prices to remain stronger than expected from here for the various reasons outlined earlier. 

Marine Harvest has a small operation in Chile, which also was affected alongside other Chilean salmon farmers from both disease and the volcano. This operation is also in the middle of a recovery from these issues two years ago. As the recent major investments wind down over the coming years, Marine Harvest is moving to producing close to 12-13 NOK per share in FCFs in 2017 to 14-15 NOK per share in FCFs in 2018-2019. At a current share price of almost 147 NOK, that represents approx 8% FCFs next year and 10% FCFs and more in 2-3 years. And that’s not counting any additional accretive investments or how successful the downstream investments will be in developing its own brand.

In light of this robust financial health, Marine Harvest has been significantly ramping up dividend payments over the last year and it’s yield is likely to closely match the FCFs going forward. Marine currently trades at 6.5 EV/EBITDA for 2019 and using a target of 8.5x EV/EBITDA (based on current comps for other Norwegian farmers) for 2019E or 6.5% FCF Yield (what I deem appropriate although it could be lower still but this is conservative) for 2019, gives me an average 2-year target price of 190 NOK, up 42% from today’s price plus 2 year’s dividends of about 13% (6-7% each year) to give a total return of about 55% in 2 years.

And all this is without expecting any significant re-rating of the business. If the market becomes less sceptical and starts understanding the structural drivers behind the robust salmon prices, we could see a higher multiple and increased returns.

Catalyst

Salmon prices continue to surprise to the upside!