Friday, July 27, 2007

Pacific Andes – Annual Report FY 2007 Review

As promised, this is my review and analysis of the Annual Report by PAH. Suffice to say that it has not been easy “reviewing” the Annual Report and I should be forgiven for missing out certain parts which may be of concern as there is really a truckload of information to go through. The problem is that most companies only give you something like 2 weeks plus to go through the Annual Report before holding their AGM. To me, this is just too little time !

This post will review the annual report and highlight areas which will cause concern for the shareholder. Suffice to say I took about 4-5 days to go through the entire report and I would like to point out the following items which may require further attention as we move into FY 2008. Note that I am commenting on some of these items in my capacity as an “finance guy”, and it may sound jargon-ish and technical to those who are not familiar with accounting concepts and principles (my apologies for that !):-

1) Debt-equity ratio has risen to an unhealthy 117% as of FY 2007, and this was caused by the issuance of the 5-year senior notes to raise money for CFG to acquire the purse seine vessels as well as to fund more acquisitions of companies operating in Peru. While the acquisitions are expected to be yield-accretive, we should note that PAH’s interest expenses will shoot up much higher in the coming years (it was HK$40 million for FY 2007 just for interest on senior notes as compared to zero for FY 2006, see Note 9 Finance Costs).

2) On Page 44 Note 2 regarding deferred charter hire, it is stated that this is capitalized as a prepayment and subsequently amortized off in the Income Statement over the period in which the benefits are expected to accrue. Since the charters are going to be for 5-10 years, the amortized cost will be over this period of time. The current portion in the balance sheet Page 33 is HK$173 million, while the non-current portion stands at nearly HK$1.8 billion. Shareholders should note that charter hire expenses form part of cost of goods sold and this could increase over time, thus having a dampening effect on gross margins even as the Group attempts to elongate its super-trawlers in order to maximize economies of scale.

3) Refer to Page 45 Note 2 on deferred expenditure, it is interesting to note that expenses on each voyage (to catch fish) are actually deferred until matching can be done between revenues and expenses (an accounting concept). This technically means that if the fish from the catch are never sold, then the expenses could be deferred indefinitely ! Also, there is a catch which says that if expenses actually exceeds the revenues from a particular voyage, it will be immediately recognized in the Income Statement due to the prudence principle. This rule means that expenses from many voyages could potentially be “deferred” by the Management if they wish to prevent recognition before a certain cut-off date, as all they need to do is to sell a different batch of fish. This is one possible avenue for manipulation.

4) Also on Page 45 Note 2 on deferred expenditure, charter hire fees are separated into fixed and variable. For the fixed charter rates, these are expensed off regardless of whether the vessels under the VOA are being deployed, which means that in theory, expenses could very well still be incurred during the vessels’ downtime ! This could potentially lead to higher expenses should any damage befall the vessels and it s significant risk factor in my opinion.

5) Under Page 49 Note 3 on critical accounting judgements, it is stated that the carrying amount of deferred charter hire is stated as such on the balance sheet (without provision for impairment losses) mainly because the charter hires are expected to be profitable in the foreseeable future. The risk here is a sudden decrease in the carrying amount of the charter hires (for whatever reasons relating to the fishing industry), thus causing the auditors to pass an entry to write-off a s significant amount of impairment losses over to the Income Statement.

6) On Page 55 Note 8, there is an exceptional gain on dilution of interest in CFG as a result of CFG doing a placement of shares. This exceptional gain must be deducted from the net profit after tax in order to arrive at the true EPS for the Group.

7) On Page 55 Note 9 on Finance Costs, pay particular attention to a more than 120% increase in finance costs from HK$103 million to HK$228 million in just one financial year. This is a cause for concern as the Group is gearing itself up more and more over the years (refer back to Point 1).

8) For Page 65 Note 21 on Other Intangible Assets, it is good to note that fishing permits are essentially perpetual in nature and do not have a finite useful term. Thus, there will be no amortization expenses associated with the acquisition of these fishing permits ! Unless there is a drop in the carrying amount of these permits, it is unlikely that there will be any impairment loss recognition in the books in the near future as permits are no longer issued by the Peruvian Government.

9) For Page 67 Note 25, note that prepayments for fish has increased substantially from HK$135 million in FY 2006 to HK$500 million in FY 2007, almost a 270% increase. It will be good if Management could explain what this prepayment was for and whether the amounts are collectible; including why there was such a substantial increase (could it be due to fishmeal ?).

CEO Statement Review

The chairman Mr. Ng Joo Siang gives an operations review, financial review and an outlook and forecast for the financial year ahead. This is pretty standard fare when it comes to giving statements, and encompasses most aspects of the financial year under review.

For operations, he mentions that China has grown and expanded as one of their key markets and they expect to maintain growth in the current financial year. He also touches on the three new VOA acquired under CFG, as well as the integration of their newly acquired Peruvian operations into PAH’s vertically integrated business model. All this is pretty standard fare for a shareholder who has been actively keeping up with the company’s announcements (including CFG’s), but will act as a useful summary for a new shareholder or a person seeking to invest in PAH.

In the financial review, he basically touches on increases in revenues, net profit for the year and net profit attributable to shareholders. He also gives a year-on-year comparison for performance of net profit after excluding exceptional items, which is the correct approach considering that PAH have an exceptional gain due to dilution of interest in CFG. The dividend is also stated (0.54 cents per share post-rights) and he goes on to elaborate on how PAH and CFG tapped on the capital markets to issue debt such as convertible bonds and senior notes to accelerate their expansion. For readers of the Annual Report, this should sound alarm bells for them to check on the Balance Sheet’s liabilities section and the section on loans and finance costs under Notes To The Accounts.

The outlook ahead section is perhaps the most important as it gives shareholders guidance on the future for PAH. I have summarized the section into several points which are noteworthy:-

1) PRC market volumes for fish has increased 14.1% from 2001 to 2006, thus more growth momentum is projected for fish demand in the PRC. The PRC government is active in promoting aquaculture, and want aquaculture production to hit 46 million tonnes by 2010, which is an annual growth rate of 6%. Analysis: If the above measures are true, then there is room for growth within PAH’s largest market which is China (it constituted 76.1% of their total revenues for FY 2007, according to Note 6 Page 54).

2) Strengthening the harvesting capacity and efficiency of existing vessels, and also building up the fishmeal division to ensure it contributes more strongly to revenues and bottom line. He expects the fishing division to contribute strongly to growth in FY 2008, as the harvest volume has not increased to 270,000 tons after acquiring more vessels. Analysis: PAH is focusing on organic as well as acquisitive growth as it seeks to increase the holding capacity of its vessels by acquiring more, as well as by elongating their supertrawlers. It remains to be seen if these will translate into better margins as a result of economies of scale, but at least shareholders are being informed of the said improvements which we can look forward to.

3) The fishing division is set to lookout for other attractive opportunities to acquire more Peruvian assets which will be earnings accretive to the Group. Analysis: Whatever acquisitions CFG makes has to be value-added, meaning there must be economies of scale and must substantially increase CFG and PAH’s operating capacity above current levels, as well as (possibly) reducing costs. The acquisition should be priced at a reasonable level to ensure that it is a good deal (the Group should avoid paying more than it should even though it may sound like a good deal).

Overall, the tone of the Annual Report is one of optimism. Apart from the following points mentioned above, the rest of the numbers look good and I look forward to engaging the Management in a frank discussion of the Group’s prospects and strategies for FY 2008.


Anonymous said...

I read with great interest and would like to comment on your point 3. There is a profit sharing (after expenses), some 20%, with the owners of the vessels. This is also expense to PAH shareholders and hence the reason of the clause. For any loss making biz, the owners of the vessels would also not receive any profit. From this point of view, wouldn't it be beneficial to PAH and the shareholders, not to payout the profit until to profit is recognised? Is interesting to find out whether they are able to sell all the fish they catch though!

musicwhiz said...

Hmm, well from that perspective I guess the owners of the vessels would ensure PAH does book some profits so that it flows back to them eventually. However, I think the risk is for them to understate or "delay" expenses due to incomplete voyages, which may then distort the books. It is subtle and probably not noticeable, but it still is a possibility.

As for whether they can sell all the fish, with rising demand from China and most of their markets; I think this should not be a problem in the near term.

Anonymous said...

point 4 - i guess there is no free lunch. maintenance costs for the vessels could have been taken as a total package of the voa. of note, the CFIL mgt (63.9% part of PAH on 23 jul 07) has exercised a prepayment of the fixed charter hire for voa1 for the initial 10 yrs instead of daily expenses per vessel, saving a great deal. Is this a sign of prudent?

Anonymous said...

on point 6 agreed with you totally. as such 38.1% growth should be used in all intrinsic value calculations for conservative investors, and not the 49.7%. could you then attempt to est this value?

Anonymous said...

on point 9 - this prepayment should be the us$82m paid to the vessels owners for the initial 10 yrs. value seems close anyway.

Anonymous said...

Hi, I have been following your blog and I personally find it insightful and learnt a great deal of stuff. So just wanna say thanks for sharing.

With respect to Pac Andes results, I share the same sentiments and find the high level gearing abit uncomfortable. The only comfort I get is that the operating cash flows still covers the interest expense at ~1.9x and EBITDA covers the finance cost ~4.28x (including removing the gains from dilution). So still pretty alright in my opinion.

I was equally puzzled on Note 25, where the prepayments for fish has increased substantially to HK$500 million.

Another concern I have is that the current portion of interest bearing bank borrowings stands HKD 1246.664 million. I am wondering what is the mode of repayment for this current bank loan.

I understand that I still do not have much experience but I hope that I can get some pointers and learn from the more experienced people around me. Thanks!

musicwhiz said...

Hi Anonymous,

For Point 4, yes there is no free lunch and I think Management is prudent to split the charter into fixed and variable, such that as you said, the expenses do not stack up daily.

Point 6 - A little hard to estimate this value as right now it is unclear how the earnings apportionment works for CFG and PAH. The fact that they have different financial year-ends doesn't help either. Wish PAH or CFG would align their financial year-end to ensure conformity in reporting.

Point 9 - Hey thanks ! It could indeed be possible, as you mentioned. If that's the case, then I think the increase is justifiable.

To: another Anonymous

Yes, the higher gearing as a result of this rights issue exercise and CB issue is of concern. But as you rightly pointed out, the operating cash flows from their fishing activities still manages to voer their interest and finance costs. Whether they can continue to do so is the question, but I remain fairly optimistic. Only when global fish supply decreases or global fish demand tapers off, then I will start getting worried.

For the Note 25, refer to Anonymous' previous point which indicates it may be due to the US$82 million paid to vessel owners for the use of their vessels.

Usually, for bank loans, the repayment is monthly with interest imputed, with a certain fixed repayment period. The company can choose to slow down or speed up payments in order to reduce the interest computed on principal.

I think your observations are pretty good ! Please continue to share, it's been a learning experience for me as well....:)

Anonymous said...

Investors must estimate the intrinsic value of the biz to be sure of the investment, esp. when the company is going thru major changes for further growth into the future. This is equivalent to investing into a new business (not withstanding the Rights excerise has been completed).

Let me harzard my calculation: based on last year CFIL earns US47M for PAH (discounted by 36.1%). This is conservative as not all VOA have not been fully running last year. Assuming PAH biz earns similar percentage of 39% next year. (Not excessive as for the past 7 years, PAH growth is 43%). With these one can expect PAH profit to be in the region of S$150M (or about 88%) next FY, hence EPS of $0.095. With a discounted rate of 4% (US treasury rate into the future for the next 10 years), one can expect PAH value to be in the region of S$1.60