Monday, February 18, 2008

China Fishery - FY 2007 Analysis and Review (Part 1)

China Fishery (CFG) released its FY 2007 results on February 14, 2008 and they were largely in line with expectations, except that at a glance, it can be seen that costs have increased significantly as compared to revenues. This resulted in an 84.5% increase in net profit on the back of a 160% increases in revenues. I will be analyzing the financials using my usual method of moving through the Income Statement, Balance Sheet and Cash Flow Statement in order to gain a holistic overview of how the company has fared in terms of capital allocation and profit generation. Finally, I shall touch on strategies which the company may be employing to grow their business further in FY 2008 and also CFG's long-term prospects.

Income Statement Analysis

As a result of the increase in the scope of their activities, CFG's revenues have increased by 160% from US$156 million in FY 2006 to US$406.4 million in FY 2007. Recall that the company had secured their 3rd and 4th VOA (Vessel Operating Agreement) in early 2007, which helped to increase their fishing catch volume by increasing their trawling fleet size from 14 to 23. Their expansion in Peru and penetration into Peruvian fishing grounds through the acquisition of 16 purse seine fishing vessels and 3 fishmeal plants also helped them to build their numbers strongly. Throughout FY 2007, they concentrated on building their fishmeal processing capability by acquiring (among other assets) a canning plant, fishing vessels and a dock; and their most recent acquisition was on October 10, 2007 when they purchased their 7th fishmeal processing plant. Readers can look into more detail by reading through their press releases on SGXNet, but the crux of what I am trying to say is that CFG has expanded very aggressively in FY 2007 which justifies such numbers. One testament to their rapid expansion is also the massive increase in costs, especially for cost of sales and vessel operating costs which increased 732.8% and 152.4% respectively.

The establishment of the Peruvian fishmeal operations in its first year obviously took its toll on CFG's margins, as the incremental costs needed to set up new operations would be high when compared to a lower base. I anticipate that when economies of scale kick in, CFG can then better streamline its costs and enable synergies to be achieved among its operations. Gross profit margin fell from 38.2% in FY 2006 to 34.8% in FY 2007 as a result of the aforementioned reasons. It will be important to watch out for CFG's results in 1Q FY 2008 and 2Q FY 2008 to see if they have managed to keep costs under control and restore margins; otherwise it could be the case where higher revenues do not justify the higher costs.

Selling expenses also increased by 738.6%, again due to the low base used for FY 2006. Now that CFG has taken on a new business unit (i.e. fishmeal operations) as compared to just trawling in FY 2006, selling expenses have understandably increased as well. Finance costs are a worrying aspect of the business as these are likely to persist as a result of the issue of their 9.25% Senior Notes due 2013; but this can be argued to be a necessary evil in order for them to expand their operations and acquire assets to build their vessel fleet. If one takes a glance toward their Cash Flow Statement (CFS), it can be seen that they are generating very healthy cash flows of US$173.9 million from operating activities. Thus, I do not forsee any immediate problems in servicing this long-term debt, and CFG has indeed shown that they can deploy capital efficiently in order to grow their operations. What may not be immediately apparent are the economies of scale which are necessary to restore margins to respectable levels, and I shall be watching out for how Management controls costs, as well as to engage Management in conversation during the AGM on plans to grow the business. For information, net margins fell from 30.7% in FY 2006 to 21.8% in FY 2007.

Balance Sheet Analysis

As CFG has a rather complex and detailed Balance Sheet, I shall attempt to run through various sections of it one by one to enable easy understanding; and to avoid using overly technical accounting explanations as, after all, I am analyzing CFG from the perspective of an accounting analyst.

Current Assets for CFG have decreased from US$167.8 million as at Dec 31, 2006 to US$120.7 million as at Dec 31, 2007. As explained in Note 1, this was mainly due to the decrease in the balance owing from the arrangers of the first three VOA. Cash and bank balances also fell from US$57.7 million to US$20.6 million due mainly to the cash outflows from investing activities (I will elaborate more when analyzing the CFS in Part 2). The current portion of deferred charter hire increased as a larger portion of it became "current" from "non-current", thus providing a small boost to current assets. Current Ratio for FY 2007 was only 1.01 compared to 3.46 for FY 2006, due to lower current assets and significantly higher current liabilities.

Current Liabilities increased nearly 300% from US$48.4 million to US$118.9 million mainly because of the increase in bank overdrafts and current portion of bank loans. The CFS states that about US$23.32 million was borrowed from the bank during FY 2007 to finance the acquisitions which were made during the financial year, and thus total bank loans (adding current and non-current) came up to US$67.32 million for FY 2007 compared to US$42.3 million for FY 2006. Total debt to equity ratio stood at 112.7% for FY 2007 compared to 228.8% for FY 2006; but CFG reported debt to total assets ratio which they stated at 44.9% as at December 31, 2007. In terms of liabilities, CFG has its senior notes which significantly bumps up its total liabilities. One must remember that the purpose of these notes is to enable them to acquire assets to boost their fleet and capture a slice of the Peruvian Anchovy catch, as well as increase their fleet of supertrawlers and purse seine vessels. Even though value investing principles would eschew avoiding companies with high debt, my personal view is that I have faith in Management being able to grow the business for so many years, and that they will eventually be able to reduce their liabilities. One indication of this is in the CFS which I will touch on in Part 2.

One would realize by now that total long-term liabilities did not increase much year-on-year. In fact, it was more a case of an increase in current liabilities as a result of bank borrowings which worsened the current ratio and caused the higher debt-to-equity ratio. With strong operating cash flows, CFG should be able to gradually reduce their reliance on loans and generate more FCF to fund their operations. Of course, it would have been nice if CFG had a "war chest" of cash such as Boustead has, but the nature of their capital intensive operations in terms of expansion into Peru and South America necessitates the use of debt, and I will not argue against this as it is an alternative way of financing growth rather than relying on equity which will dilute shareholders.

In Part 2 of my review, I will touch on the CFS and also CFG's plans and strategies for growing revenues, margins and profits for FY 2008.

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