Description

• Declining production
• Rapidly rising costs
• Ever-present regulatory risk

 Although Omega dominates the U.S. fish meal and fish oil industry, it is not without competition.  The U.S. accounts for less than 15% of global fish meal and fish oil production; the biggest producing countries are Peru and Chile, which together account for more than 65% of the global industry (other notable producing countries include Japan, Thailand, and Denmark).  In addition, several substitute products for fish meal and fish oil exist, most notably soybean meal and soybean oil.  Soybean oil and fish oil are especially substitutable, so prices for those commodities tend to move in tandem.  Soybean meal is less of a direct substitute for fish meal (fish meal has higher nutrient content), so fish meal has historically commanded a premium, and the prices for these commodities can diverge on occasion.

Omega's earnings have been inflated by non-recurring compensation payments from BP:
Because of the BP oil spill in 2010, Omega had to temporarily relocate 9 out of its 49 vessels during much of the 2010 fishing season, although the effected fishing grounds all reopened by September of 2010.  It's debatable how much of an impact the spill really caused, as Omega actually caught more fish in 2010 than it did in either of the two previous years.  Nevertheless, Omega claims that the spill caused them to miss their Gulf of Mexico catch plan by 22%.  As a result, Omega has been able to get a total of $44.9 million in compensation payments from BP.

The first $18.7 million of these payments were made in September and October of last year, and Omega accounted for them by using the payments to reduce the cost basis of its inventory.  Thus, this $18.7 million has flowed through the income statement in the form of reduced cost of goods sold.  $10.5 million of this payment flowed through the income statement in the second half of 2010, and the remaining $8.2 million flowed through the income statement in the first half of 2011.

In addition, in April of 2011, Omega received another $26.2 million from BP as a final settlement (Omega has waived all future claims against BP).  Omega accounted for this $26.2 million as its own line item, and the entire amount flowed through the income statement in 2Q11.

All told, over the past twelve months, Omega has received $44.9 million in payments from BP, all of which have now flowed through the income statement.  I estimate that the after-tax impact of these payments has been an increase to EPS of $1.49.  As of 6/30/11, Omega's reported LTM diluted EPS was $2.26; without the BP payments, EPS would have been $0.77.

Omega's earnings have been inflated by a spike in commodity prices that may or may not be sustainable:
As mentioned above, soybean oil and meal are substitute products for fish oil and meal, so soybean pricing heavily influences fish meal/oil pricing.  The table below depicts annual average per-ton pricing for Omega's fish oil and fish meal as compared to soybean oil and soybean meal pricing:

Year                       Soybean Oil        OME Fish Oil       Soybean Meal         OME Fish Meal               OME Adj. EPS*
2006                       $551                       $665                       $194                       $660                           $0.22
2007                       $800                       $788                       $264                       $799                           $0.42
2008                     $1134                     $1367                       $368                       $815                           $0.73
2009                       $787                       $888                       $359                       $805                          ($0.37)
2010                       $925                       $943                       $331                     $1132                           $0.63
6mos2011            $1257                                                      $397                                                           $0.32

*EPS in this table is adjusted to exclude the after-tax impact of gains/losses on asset sales, debt refinancings, etc.  The 2010 and 1H2011 EPS figures also exclude the after-tax impact of BP compensation payments.

A few notes/observations about the table above: Omega often locks in pricing on some of its production as much as a year ahead of time, which explains some of the year-to-year variation between fish oil/meal prices and soybean oil/meal prices in the table above.  Also, you can see that 2008 and 2010 were both excellent years for Omega pricing-wise, as fish oil prices spiked in 2008 and fish meal prices spiked in 2010.  The 2008 spike in fish oil prices can be explained in large part by the spike in soybean oil prices that year (as well as many other commodities).  The 2010 spike in fish meal prices cannot be explained by a rise in soybean meal prices.  Rather, one of the main culprits for the 2010 fish meal price spike was the February 2010 earthquake in Chile, which reportedly destroyed between 20 and 30 percent of Chile's fish oil/meal processing capacity.

Regardless, in looking at the table above, it becomes apparent that OME only generates EPS commensurate with a double-digit stock price in years when fish oil/meal prices are dramatically rising; note that in 2009, Omega actually lost money even though pricing was still higher that year than it was in 2006 and 2007.  To be sure, commodity prices could continue to rise from here, and Omega could be bailed out by continued higher prices for its fish meal and fish oil.  That said, I think there is more downside risk than upside to Omega at current commodity price levels.  Recent prices for fish meal have been inflated at least in part by a natural disaster (the Chile earthquake).  And whereas soybean prices are high right now, farmers can always plant more soybeans next year to either stabilize or bring the price down.

Omega's production is steadily declining (-3% CAGR over last 10 years):
The year-to-year figures bounce around, but on average, Omega is catching fewer tons of menhaden each year over time, and the yield (measured as the amount of fish oil and fish meal that can be extracted from a ton of raw fish) of the fish it catches may be declining slightly as well.  Over the decade ending in 2010, Omega's production volume declined at 3% CAGR:

Year       Thousands of Tons Caught           Thousands of Tons of Product Produced                     Yield
2000                       621                                                              237                                                38%
2001                       628                                                              264                                                42%
2002                       607                                                              242                                                40%
2003                       543                                                              208                                                38%
2004                       535                                                              202                                                38%
2005                       522                                                              202                                                39%
2006                       541                                                              203                                                37%
2007                       542                                                              206                                                38%
2008                       458                                                              179                                                39%
2009                       469                                                              180                                                38%
2010                       474                                                              175                                                37%

Omega's production has been declining in large part because it appears that overall menhaden stocks in the Chesapeake Bay and the Gulf of Mexico are declining.  Environmentalists argue that the culprit is overfishing on Omega's part, whereas Omega argues that other factors are at work.  If you want to read more, this article in the Richmond Times-Dispatch provides some color on this issue:  http://www2.timesdispatch.com/news/2010/mar/02/fish02_20100301-221805-ar-4418/

Year                       COGS per Ton
2000                       $324
2001                       $321
2002                       $355
2003                       $411
2004                       $470
2005                       $471
2006                       $546
2007                       $611
2008                       $717
2009                       $766
2010                       $797*

*In 2010, Omega's cost of goods sold was reduced by $10.5 million due to BP compensation payments (Omega accounted for a portion of BP compensation payments by lowering the cost basis of its inventory); for the purposes of this table, I've excluded the impact of these BP payments (if you include the BP payments, COGS per ton in 2010 was $732).

Omega Protein always faces the threat of increased regulation of menhaden fishing:
While this is not key to my investment thesis, it is a downside risk that Omega faces.  Because of the increasing recognition of the environmental importance of the menhaden as a key part of the marine food chain, regulation has already impacted Omega's business, and the potential for increased regulation remains.

On the Atlantic Coast, Virginia is now the only state that still allows commercial menhaden fishing.  In February of 2007, Virginia did impose an annual cap on Omega's catch in the Chesapeake Bay equal to the average catch of the past 5 years, although environmental groups think this isn't restrictive enough.  In January of 2011, legislators in Virginia proposed bills that would lower the cap and/or transition management of Virginia's menhaden fishery from the General Assembly (which tends to be business friendly on fisheries issues) to the Virginia Marine Resources Commission (which manages all other state fisheries and would likely be more strict in its regulation of the menhaden fishery).  These bills failed to pass, but if they ever regain traction, Omega's production volumes in the Atlantic will likely decline even faster.

Restrictions on menhaden fishing are less severe in the Gulf of Mexico.  The state of Texas did impose an annual cap on Omega's catch in Texas waters beginning in 2008, but thusfar this restriction has not had a material impact on Omega's volumes, since Omega only catches about 2% of its annual volume in Texas waters.

After selling no shares in 2009 and 2010, Omega insiders began selling shares again earlier this year:
If you look at a chart of Omega's stock price, you'll see that the last time Omega's stock price got to double-digit levels was in the spring and summer of 2008 when fish meal/oil prices were spiking.  Between February and August of 2008, Omega officers and directors sold more than 1.1 million shares of stock at prices ranging from $12.00 to $17.35; these sales represented nearly the entire saleable stakes of Omega's officers and directors at the time. 

With few saleable shares left, Omega insiders did not sell any shares in 2009, and sales were minimal in 2010 as well.  Vesting of old options as well as the granting of new stock options in the past two years have begun to replenish the stock holdings of Omega's insiders.  With the stock price rising above $10 as of mid-February this year, insiders have begun selling again.  In March, Omega officers and directors sold 331 thousand shares at prices ranging from $12.30 to $14.58.  These sales represented approximately 29% of the saleable shares held at the time by Omega's officers and directors.  To be fair, Omega's insiders haven't sold any shares since March, so they are not sending as clear of a signal as they sent in the summer of 2008.  Nevertheless, when measured as a percentage of what was available to sell, the March 2011 sales were significant.

Risks:
The primary risk of shorting Omega Protein is a continued rise in commodity prices.  I take some comfort in the fact that Omega's increasing costs mean that commodity prices have to rise just for margins to stay where they are, but regardless, it's the most significant risk in the trade. 

Another risk is that Omega may have a very good year production-wise (catch volumes do bounce around from year to year) this year.   Indeed, in their most recent 10-Q, Omega noted that for the first third of their 2011 fishing season (the season runs from April through October in the Gulf of Mexico and from May to December in the Atlantic), catch volumes have been very good.  That said, volumes in the first part of the fishing season aren't always a great predictor of overall volumes for the season.  The table below shows catch levels through June 30^th of each year as well as total catch levels for the year:

Year       Thousands of Tons Caught as of 6/30      Thousands of Tons Caught Entire Year
2007                       155                                                                    542
2008                       149                                                                    458
2009                       139                                                                    469
2010                       167                                                                    474
2011                       188                                                                      ? 

One nice thing about shorting Omega is that is not yet a crowded trade.  As of July 29^th, less than 6% of the float was short (and that's not due to a lack of availability, as I've been able to find shares to borrow at reasonable rates).

Catalyst

• Reporting of quarterly results that don't benefit from BP compensation payments, which will cause Omega's reported EPS to decline
• Stabilization or decline in agricultural commodity prices
• Hurricanes (which can disrupt Omega's fishing activities)