OME, which has previously been written up in the Value Investors Club in 2001 & 2002, is a commodity producer of fishmeal and fish oil from Menhaden fish, which it catches in the Atlantic and US Gulf coasts. Strong secular growth of global aquaculture and premium protein feed end-markets (like petfood and swine production in Asia) in recent years have led to a sharp tightening in the supply/demand balance of fishmeal and fish oil commodities leading to what I believe is a new paradigm in commodity fishmeal and fish oil pricing levels.  OME is a straightforward commodity story of price x volume, that based on this new paradigm of pricing is likely going to face higher average EBITDA levels going forward, which, due to temporary factors described in this write-up, has yet to fully show up in its results and has not been properly reflected in its share price.  Additionally, several recent near-term and longer term catalysts that should further amplify EBITDA and earnings, make this a lot more than a straight forward commodity story (albeit a very positive commodity story). These catalysts are also likely to result in higher valuation multiples beyond those that are normally afforded to typical commodity businesses. 

These catalysts are as follows:

·         Recent catalysts:

ð      Buyback of 36% of outstanding shares and removal of non-strategic majority owner.

ð      Recent publication of a National Research Council study calling for the inclusion of Omega-3 fatty acids in pet foods that if it happens will sharply increase domestic demand for OME’s fishmeal and fish oil products containing the Omega-3 fatty acids DHA and EPA.

ð      Shift in end-markets towards higher value less price sensitive end-markets (as described in the summary).

·         Near-term catalysts:

ð      High probability of El Nino effect in 2007.  A pronounced 1998 El Nino led to peak market conditions for OME.

ð      Possible litigation award. OME has filed suit against its insurance provider for non-payment of insurance recoveries from last year’s hurricanes and damages.

·         Free option and longer-term catalyst:

ð      Possibility of widespread adoption of Omega-3 as a beneficial food additive by food manufacturers through the use of refined fish oil owing to health benefits.  Refined fish oil sells at substantially higher pricing and profitability for OME.

 

At today’s price of $6.45 the stock is trading at an EV/EBITDA of just 5x the lone analyst’s ’07 EBITDA estimate of $33MM, essentially with a free option on possible wide-scale usage of Omega-3 containing refined fish oils as food additives.  OME trades at 8x '07 [EBITDA - maintenance capex] - Capex over the next 5 years is capped at $12MM annually over the next five years as per OME’s new credit agreement.

 

This idea has been previously written up in Value Investors Club by armand440 at 11/’01 with a follow up done 6/02.  The description of OME in those write-ups essentially remains the same.  OME fishes for Menhadden fish, a oily and boney fish, and processes that fish into commodity fishmeal and fish oil. 

 

The big difference between the business 5 years ago and today is that the end markets for fishmeal and fish oil have undergone a paradigm shift towards the higher value and secularly faster growing aquaculture, pet food and swine feed end-markets (driven in large part by Asia and Chinese demand).  This end-market shift has already resulted in fundamentally higher fishmeal and fish oil pricing levels (see pricing table below).  In short, higher priced demand has been growing in the face of constrained supply.  Global supply remains constrained by global fish resources stocks.  If anything, there is the possibility that the largest global fishmeal producers, Peru and Chile, may be depleting their resource stocks through over-fishing while OME’s Atlantic and Gulf Coast Menhaden resource stocks have been assessed as sustainable by the US government’s National Marine Fisheries Services (NMFS).  Further a look at fishmeal and fish oil prices over the past two years suggests that they may have already past an inflection point in mid-2005 and the pricing table below also suggests that fishmeal prices have also likely already decoupled from their traditional historic relationship with other commodity protein prices such as corn and soybean meals - though recent ethanol demand has driven these commodities markedly higher as of late.

 

Despite this fundamental macro improvement, the benefit of higher prices has not been materially realized by OME to date.  The primary reason for this is last year’s hurricanes which significantly impaired OME’s fish harvest and production capabilities. Hurricanes Katrina and Rita damaged 3 (out of a total of 4) of OME’s production plants located in LA and MS and also disrupted the 60+% of its fishing operations which take place in the Gulf Coast.  OME first only fully returned to complete production capabilities in this most recent Sep. quarter.  Also, due to lost inventories OME was put in the position of buying higher priced inventories to fulfill forward contracts and those lower margin inventories were only fully worked off in Sep.  With the lagging effects of the hurricanes now largely behind it, OME should now be in a stronger position to capture the upside of the higher priced commodity environment and in turn should generate higher average EBITDA levels and a higher share price. 

 

In addition to this base improvement in the underlying fundamentals of its core business, there are several recent, near-term and longer term catalysts and free options that could drive the value of OME shares even higher, they are as follows:

 

·         Recent Catalysts:

ð      Buy back of 9MM (or 36% of outstanding) shares from majority owner Zapata (ZAP) at discounted price (timing - announced in Sep and completed 11/28):  Zapata’s 5MM remaining shares were subsequently sold to institutional investors.  Zapata is majority owned by the Glazer family and their business focus in recent years has been directed more towards professional sport franchises than towards the fishing business.  The removal of Zapata as an owner could result in greater strategic freedom for OME’s management going forward.  The buyback is also very EPS accretive.

 

ð      Pet food requirement - Recent studies and potential guidelines calling for inclusion of Omega-3 into pet food (timing – this past year):  Earlier in ’06 the National Research Council (NRC) published a study of Nutrient Requirements of Dogs & Cats recommending the inclusion of Omega-3 in petfood.  In August of ’06 the Association of American Feed Control Officials (AAFCO), which regulates petfood dietary guidelines, accepted the study and assembled a subcommittee to study its recommendations.  Past history has shown that guidelines typically get issued 2-5 years following recommendation.  The best source for Omega-3 is fish oil.  Some premium dog food providers have already started to include Omega-3 ahead of the guidelines (competitive positioning).

 

ð      Higher mid-cycle commodity pricing for fish meal and fish oil due to tighter supply and demand (timing – past year and half):  As described in the summary, improved pricing has already begun to happen.  The primary driver of higher prices has been sharp growth in aquaculture (fish farming) and swine production, which along with improving pet food formulations, has led to a widening of end-markets willing to pay a premium for the superior characteristics of fishmeal and fish oil relative to other protein and fat sources (soybean meal, corn etc.).  This in turn has diverted fish meal and fish oil away from its historical and lower priced end-markets of poultry, dairy and beef towards these premium end-market segments.  Historically, while fishmeal would trade at a modest premium to soymeal it would trade directionally in line with these competing protein prices. As a result of the aforementioned end-market shift and as can be seen in the pricing tables below this historic relationship appears to have permanently decoupled starting in 2005 (new paradigm).

 

        Fishmeal   Soymeal            Fishmeal

Year     $/ton      $/ton      Ratio   5-yr avg

1997     599        265(H)     2.3X

1998     700        160          4.4X  - El Nino Year

1999     491        140(L)     3.5X

2000     443        178         2.5X

2001     527        167         3.2X     552

2002     627        170         3.7X     557

2003     612        202         3.0X     540

2004     656        233         2.8X     573

2005     637        188         3.4X     612

‘06YTD 1011        174         5.8X     708

For reference the 5-yr historical average ratio between fishmeal and soymeal leading into 1997 was 2.4X with a max ratio of 2.9x and a minimum ration of 1.6X.

 

·         Near-Term Catalysts:

ð      Expected 2007 El Nino effect could result in peak pricing in 2007 (timing - 2007).  Globefish’s November 2006 Fishmeal Market Report writes “The El Nino is confirmed for late 2006, early 2007.  While some months ago, the phenomenon was assumed to be of a rather mild nature, now there are indications that it will be stronger than initially forecast.  As a result, catches of small pelagics [anchovies, sardines, mackerel, etc] and likewise fishmeal production will not be much better than during the last season (2006)”. 2006 production YTD is itself down from 2005 levels.  The El Nino weather effect causes water temperatures to rise off the coast of Peru and Chile (the 2 largest fish meal and fish oil countries accounting for over a 1/3rd of global supply).  Higher water temperatures send the fish deeper down into the ocean and away from fisherman resulting in lower catches.  While the El Nino effect results in lower supply from Peru and Chile it also generally improves the US menhaden catch as resulting higher rainfall in the US increases the nutrient flow to the Gulf thereby increasing the Gulf coast fish catch and fish oil yields.  To gain perspective for what the financial impact of El Nino could be to OME it is worth noting that the last El Nino resulted in OME recording $24MM in net income ($1.50 EPS using today’s share count) and $45MM in EBITDA.  It is also worth noting that pricing in the last El Nino then reached a peak of almost $800/ton.  Current Peruvian spot fishmeal pricing is already over $1,100/ton and this is even before the El Nino has begun, meaning that the pricing impact of this coming El Nino could likely be even more dramatic than last.  Somewhat offsetting the higher prices, though, is OME’s operational costs which are much higher than they were in 1998 (primarily higher fuel costs).

 

ð      Potential insurance litigation proceeds with a possible award of almost $90MM (timing – 2H’07):  OME has filed a lawsuit in the federal court of Western LA against its insurance providers for breach of contract by its insurance provider for not honoring insurance recovery assessments of damages OME suffered as a result of hurricanes Katrina and Rita.  By OME’s own estimation it suffered $29MM in damages as a result of the hurricanes, which resulted in damage, temporary closure and impaired production at 3 out of its 4 production plants in LA and MS.  The insurance company assessed only $12MM in damages and subsequently paid only $4MM of that amount.  With recoveries, damages and penalties OME could potentially be looking at around $90MM in awards.  I would not normally be inclined to attribute much value to potential litigation awards but the egregiousness of the non-payment of the insurance company’s own estimate along with the venue of the case suggest otherwise.  The lawsuit is going to be tried in LA with a LA judge and jury (the same populace that has itself been burned by non-paying insurance companies).  Timing of a trial is expected in 2H’07 and OME’s plaintiff’s attorney has agreed to take the case without receiving any remuneration until the first $12MM is recovered.  My own sense is that the insurance company is likely to settle for some fraction of the potential amount before the case goes to trial.  If OME were able to get half the potential $90MM, those proceeds could be sufficient to pay down all the debt used to fund the recent shares bought back from Zapata.

 

ð      Increased pet food demand (timing – now thru 2010).  There is the possibility that for competitive reasons some pet food providers start to adopt Omega-3 formulations ahead of the previously mentioned potential pet food recommendations (a small number of premium pet food formulations already include it today).  The global pet food market is a $53BN industry expected to grow 14% by 2010 (over 2005 levels), with the fastest growing segment being premium dog food, which is expected to grow by almost 22% over that same period.  There is also the possibility that AAFCO decides to deliver a recommendation sooner rather than later.

 

 

·         Long-term catalyst and free option with significant upside potential:

ð      Widespread usage of Omega-3 refined fish oil as a food additive (timing – uncertain): Refined fish oil is one of the best natural sources of Omega-3, containing high concentrations of DHA (think Martek) and EPA.  OME’s menhaden derived fish oil is the only fish oil source of Omega-3 that has been recognized by the FDA as Generally Recognized As Safe (GRAS) and approved for use as a food additive for 29 different food categories. There have been numerous scientific articles and studies showing that DHA and EPA have health benefits for the treatment and prevention of cardiovascular and inflammatory disease and also for brain and eye health and development. Recent articles even suggest positive implications for the treatment and prevention of Alzheimer’s (see the following links to recent NYTimes articles).
NYTimes article on cardiovascular benefits:
http://www.nytimes.com/2006/10/03/health/03fish.html?ex=1317528000&en=1e953e11bac34784&ei=5088&partner=rssnyt&emc=rss
NYTimes article on link between Omega-3 and reduces incidence of Alzheimers:
http://query.nytimes.com/gst/fullpage.html?Sec=health&res=9A04E5D7163EF937A25752C1A9609C8B63
The economic significance of widespread use of refined fish oil for its Omega-3 content is substantial as the price OME sells its refined fish oil, OmegaPure, ranges from $5-$8/lb ($11,000-$18,000/ton) as compared to plain crude fish oil prices which have ranged from $400-$750/ton range.  If a large sized food manufacturer were to start adding Omega-3 to product offerings (think along the lines of Calcium in OJ) the revenue and profit opportunity for OME would be tremendous.  While there already are some isolated and small scale instances of Omega-3 fortified products like SmartBeat margarine, there has yet to be any wide-scale adoption of its usage within the manufactured food industry.  This food additive story has long been the unfulfilled upside promise of the stock since OME shares went public in 1998 at $16/share and subsequently traded as high as $18.67 not long thereafter.  While this part of OME’s business continues to be a disappointment, there is little if any value is attributed to the shares today for it.  At the same time, I would argue that, with the mounting scientific evidence and increasing public awareness about Omega-3’s benefits, we are likely closer to a possible inflection point towards wide scale usage as a food additive than at any other point in time since OME went public eight years ago.  The value of this option as I will show in the following valuation paragraph could be substantial.

 

Valuation:

Pre-Zapata deal:

shares 25.3MM, net debt $14.7MM = EV $176.6MM

Post-Zapata share buy back:

            shares 16.0MM, net debt $62.2MM = EV $164.6MM

 

EBITDA past 10 years and 10-year average:

            1997 - $23MM

            1998 - $45MM (El Nino)

            1999 - $6MM (Low soymeal prices)

            2000 - $2MM

            2001 - $15MM

            2002 - $30MM

            2003 - $23MM

            2004 - $17MM

            2005 - $18MM (excludes loss from unrecovered hurricane damages)

            2006E- $25MM (impaired production resulting from '05 hurricanes)

In both 2005 and 2006 OME's production was impaired preventing it from capturing benefit of higher fishmeal and fish oil prices.

Trailing 10-yr average EBITDA $20.4MM; Trailing 5-year average EBITDA $23MM.

 

My sense is that due to higher average fishmeal and fish oil pricing going forward, and some of the catalysts mentioned in this write-up, average EBITDA over the next several years is likely to be upwards of $30MM.  Again, Capex over the next 5-years has been capped at $12MM annually by the company’s new credit agreement suggesting that [EBITDA-Maintenance capex] should average over $18MM.  At $30MM EBITDA and 8x EV/EBITDA multiple the shares would be worth over $11.  If sometime over the next year the company were to receive half of the $90MM in damages sought in conjunction with the insurance litigation it would boost the share value to $14 w/o any change to EBITDA or multiples and still with a free option on widespread use of Omega-3 as a food additive for human consumption.  When looking at the potential value of that option, it is worth noting that Martek (MATK), a DHA supplement provider to the baby formula industry, trades at 2.8x EV/T12 Sales.  If OME was able to sell just 10% of its 45-65K of annual fish oil production as refined fish oil for the food additives market it could generate anywhere from $50-$115MM in incremental and highly profitable revenue, which at half of MATK’s valuation would suggest an additional $4-$10 of value per share (possible putting the shares in the $20-$25 range).

 

1.)     Fishing is an inherently uncertain business:  As has been amply demonstrated by the past several years of results the fishing and harvesting of Menhaden is subject to the inherent uncertainties and vagaries of marine fishing including weather conditions (though I would argue that last year’s hurricanes were a rare extreme).  A derivative risk, as has unfortunately been the case in the 2006 Menahden harvest, is yields of fish oil from the Menhaden catch.  The lower oil yields of this fishing season will again inhibit OME’s ability to fully capture improved commodity pricing due to lower volumes of fish oil produced and available for sale – this will remain the case in the next two quarters until OME begins next year’s fishing harvest. While Menhaden is one of the oiliest fishes in the ocean, the actual oil content in any given year is variable and is in part also dependent on weather variables.  For example it is believed that this year’s historically low fish oil yields are somewhat attributable to drought in parts of the Mississippi valley which resulted in less nutrient run-off into the coastal areas of the Gulf and as a result thinner and less oily fish.

2.)     Politics: Over the past number of years there has been a steady outcry against Menhaden harvesting in the Chesapeake Bay by sports fishermen who contend that over-fishing has caused depletion of the Menhaden stock in the Chesapeake causing a decline in the stock of prized Striped Bass who feed on Menhaden.  While the political uproar has been substantial, recent studies by the National Marine Fisheries Service, a division of the US Department of Commerce, has concluded that both the Atlantic and Gulf Menhaden stocks are not over-fished and are sustainable at current levels.  However, in response to the uproar in the Chesapeake, OME recently endorsed a VA-state proposal that would cap OME’s annual Chesapeake Menhaden catch based on 5-yr average levels and with the ability to bring forward and make-up any shortfalls from previous years catches – OME does not see this cap as an impairment to its ongoing operations (less than 40% of its catch comes from the Atlantic and a smaller portion of that from the Chesapeake and the limit allows OME to bring forward any shortfall in one year to the next meaning that its actual catch going forward should not differ materially from its average catch over the past 5 years).

 

Omega Protein (OME) is the largest N. American industrial fisher and processor of Menhaden fish (a Herring-like bunker fish with high oil content). OME has a near-monopoly over the US fishmeal and fishoil business, accounting for over 70% of Menhaden fish landings in the US. It has a fleet of 40 ships and 36 spotter planes with 4 fish reduction processing facilities – 2 in LA, 1 in MS (used for the Gulf catch) and I in VA (used for the Atlantic catch).  In addition to its reduction facilities the company opened an advanced health and science center for state of the art fish oil refining in October 2004 adjacent to its VA plant.  OME’s fishing season lasts from May until December in the Atlantic and from April until October in the Gulf.  Fishing operations are conducted using purse seine fishing nets, harvesting large schools of Menhaden spotted by the spotter aircraft.  On average the company harvests anywhere from 500-600K metric tons of Menhaden annually which is reduced into about ~150K tons of fishmeal and ~60K tons of fish oil.  The company competes globally with all fishmeal and fish oil suppliers, the largest of which are Peru and Chile.