Monday, March 14, 2016

Omega Protein: Low Expectations and Activist Presence

Omega Protein ("OME") catches fish then processes them into fish meal and fish oils. It has two segments, Animal Nutrition and Human Nutrition, corresponding to the use of its products. Profit mostly came from the former while the latter is currently losing money.

In the Animal Nutrition segment, fish meal and fish oils are used as feed in aquaculture, swine, and pet food industries. Aquaculture customers have become more important in recent years. I expect this tailwind to remain the next few years as the Atlantic salmon producers increase capital expenditure and production.


Earning expectations through 2017E are now reasonable and beatable. Valuation is undemanding at 11x forward PE.

Wynnefield Capital is trying to get OME to dump the money losing Human Nutrition segment. The company has been conducting a strategic review and is scheduled to announce a decision in a couple quarters. The activist wants to nominate their own directors, further putting pressure on the company.

For now I see the activist stuff as bonus. Given the valuation, the key is to make sure earnings are not going to fall off a cliff.

The Core Animal Nutrition Segment

After the latest earnings OME stock took a hit and earnings estimates have been cut, so there’s already some de-risking here.

Currently sell-side expects 10% and ~6.7% EPS gains for 2016 and 2017, respectively. Much of the growth can be fulfilled by just 2015 revenue getting pulled into 2016. 4Q15 was weak on revenue but productions sold forward were up some 20% yoy. Given the big jump in inventory, Omega should be able to fill these orders. Here are details on the forward contract from the 10K.
“As of December 31, 2015, Omega Protein has sold forward on a contract basis approximately 72,000 short tons (1 short ton = 2,000 pounds) of fish meal and 10,000 metric tons (1 metric ton = 2,204.6 pounds) of fish oil for 2016, contingent on 2016 production and product availability… As a basis of comparison, as of December 31, 2014, Omega Protein had sold forward on a contract basis approximately 54,000 short tons of fish meal and 14,000 metric tons of fish oil for 2015.”
Pricing has marched steadily upward the past few years. Management says the 1H2016 forward sales are generally at or slightly below 2015 levels. Global productions of fish meal and fish oil have been depressed the past few years, providing some support for pricing.

Cost per unit is driven by production volume (93% R-squared the past 5 years), which itself is catch volume multiplied by yield percentage. As the company explains it, yield is basically luck.
o The “total yield,” or the percentage of fish meal, fish oil and fish solubles products derived from the menhaden fish has fluctuated over the years and from month to month due to natural conditions relating to fish biology over which Omega Protein has no control “
o The Company believes that fish oil yields are influenced by multiple factors, including but not limited to, fish diet, weather, water temperature and nutrient content, fish population and age of fish, but such possible relationships and inter-relationships are not generally well understood.”
It sounds awful that a key driver should be left to chance, but that’s actually positive in this case because yield has been well below average (see chart below), so mean reversion would lead to higher yields.

Fish catch volumes are in line with historical norm. Combining a stable fish catch volume with better yield percentage should mean improved production, so cost per unit could improve over the next few years. The company is also investing $18mm on equipment to increase productivity.

Margins should hold up given these unit price and cost outlooks. Add in 15-20% increase in volumes, I can certainly see big revenue and earnings bump from Animal Nutrition segment in 2016.

If they ditch or fix that money losing Human Nutrition segment then earnings have further upside.

Omega Protein production yield

Omega Protein fish catch, production, and sold volumes

Omega Protein Unit costs depend on production volume

Downside and Conclusion

This is simply a crappy business. There’s little competitive advantage or moat. The fish processing business is growth constrained – harvest volumes are capped by quotas and fish in the sea which is gradually deteriorating. The company can make it up with higher prices but price is constrained by substitutes (fish farms can use vegetable based protein instead of fish based, even though the latter is considered higher quality). The company has little control over key drivers of production, as yield is basically luck of the ocean.

Management has not done well. The company takes impairment and “non-recurring loss” almost every year. In recent years the company has ramped up capital expenditure. Acquisitions have been questionable.

The unattractiveness of the business are mitigated by the fact that stock trades at ~11x PE – hey you get what you pay for. Throw in low expectations through 2017E and some activist presence, I’m inclined to roll the dice on this one.

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