Saturday, July 05, 2008

Pacific Andes - Rationale and Reasons for Increase in Stake

On July 3, 2008, I increased my stake in Pacific Andes at an attractive price of 44 cents per share, thereby taking advantage of Mr. Market's manic and depressive mood swings. Below are a list of reasons (including some risk factors outlined) which underlie my decision to purchase more of this company. This move was a calculated and well-thought out decision and was not made on the spur of the moment as I had been studying and reading up on the company and industry since my first purchase, and have been waiting for Mr. Market to sell to me at an attractive valuation. Please feel free to criticize or discuss the reasons below:-

1) Pacific Andes is in an industry which has high barriers to entry. Only a few large players have access to fishery resources and many players are limited by the high capex which is required to operate a fishing SCM system and fishmeal plants. Smaller players only own a few vessles and cannot achieve the economies of scale which will make their operations more efficient; thus they risk being bought out in an industry consolidation (which has been occurring during the last few years). PAH also owns 64.1% of CFG which is growing its business with respect to its trawling operations and has expanded its activities and fleet through their 3rd and 4th VOA. CFG has plans to grow its revenues and bottom line which will enhance the earnings flowing to PAH.

2) Dividend yield is attractive at my purchase price of 44 cents per share as the final dividend declared is 2.07 cents per share. This translates into a yield of 4.7% which is 5.3 times better than the prevailing interest rate offered by Maybank’s iSavvy account (0.88%) where I am stashing my opportunity fund.

3) Peru had recently, on June 28, 2008, introduced the ITQ (Individual Transferable Quota) system, and this will be applicable for the next 2 fishing seasons once all the applicable regulations and legislation are passed through. The benefits of this system are as such:

a] Ensuring the long-term sustainability of fish sources and preservation of the environment – this move will prevent over-fishing and is good for the long-term future of the industry and for all players within the industry;

b] Austevoll Seafood ASA and Copeinca have both commented on the ITQ as opposed to the old method using the “Olympic” system. Austevoll says that this will ensure a move away from an “expensive” way of harvesting to one which is more focused and will reap economies of scale and improvements in the quality of raw materials and finished products. This would translate into higher prices for the industry overall as higher prices accompany higher quality. Copeinca has also commented that it envisions a 30-40% increase in EBITDA as a result of greater efficiencies in fishing processes and deployment of vessels (in a separate press release). However, one small downside is the imposition of a new fee of USD 1.95 per ton of fish unloaded which is to be set aside for the fisherman’s retirement fund (this also helps to build loyalty among the fishermen and minimizes strikes and riots which could disrupt operations);

c] The new ITQ system makes it easier to schedule and plan for vessels to be allocated to various fishing grounds as it is no longer a “mad rush” to fish as much as you can before the season ends and the quota is reached. Thus, this benefits all players within the industry as they can now selectively deploy their vessels and schedule them for maximum efficiency; further enhancing economies of scale.

4) In the last 2 quarters (3Q 2008 and 4Q 2008), there has already been evidence of PAH achieving better efficiencies in terms of lowering their COGS with respect to their revenues. The growth of revenue is greater than the increase in COGS, which implies economies of scale from the Peruvian acquisition of fishmeal plants and vessels should be kicking in and showing its effects. For China Fishery’s 1Q 2008 financials, the results are very dramatic in that revenues dropped 2% while COGS dropped 42.3%, thus it shows the dramatic efficiencies being achieved for CFG with respect to its new fishmeal business as well as trawling operations. The ITQ system should help to enhance this efficiency and make it even more pronounced, but this will take time (probably in 2-3 years).

5) Valuations are attractive as PAH is only trading at a historical PER of 6.2 times (using net profit attributable to shareholders of HK$481 million @ 1:5 divided by share capital of 1.35 billion shares to get EPS of S$0.0713). Compared to global peers such Copeinca which are trading at 10-12x, this makes Pacific Andes under-valued (perhaps due to the China inflation factor depressing the valuations of many S-shares listed on SGX, regardless of the nature of the business or inherent characteristics of the company).

6) Management has a good track record and understanding of the business and they have built up many years of growth for the company by using strategies to grow their fleet organically (through fleet enhancements) and through acquisitions. It is because of this track record that I have confidence that Management can steer through any rough patches (which any normal business will encounter). Many Chinese companies have just come into the market (in 2 to 3 short years of operation) and hence lack a good track record to justify purchase.

7) Management is planning to add a new revenue stream from July 2008 by deploying 3 upgraded super-trawlers to South Pacific to fish in Chile. They will target a new species (Mackerel) and a new market (South Africa). This will add to the company’s top line and hopefully, bottom line as well.

8) Mr. Dennis Chan has mentioned in an earlier interview that PAH intends to increase its investment in Peru, though he did not give details due to disclosure confidentiality requirements. The fishing industry there is still very fragmented (according to a discussion with him during CFG’s AGM) and there are many opportunities for PAH to acquire smaller players in order to boost their fleet.

Risks involved in this investment decision

9) Even though a key risk is bunker costs rising as a result of record high fuel prices, this is an industry which can raise prices without affecting demand too much as it is controlled by a few large players, and fish are part of the staple diet of much of the world’s population and also a good source of protein. Hence, I see short-term price pressures which may push down net margins due to high fuel costs; but the trend for fish and fishmeal/fishoil prices is upwards over time, due partly to food inflation and rising consumption of fish by the world. In the long-term, I believe this risk will be mitigated.

10) PAH has always had high gearing and finance costs are a major source of expense which will eat into their net margins. However, CFG and PAH are in a business with high operational cash inflows, as observed by their financials over several quarters (adjusted for some timing difference in recognition of receivables and inventories). Thus, I see this gearing as merely assisting them in aggressively expanding their fleet, which they can then use to generate FCF to pay off their loans, bonds and notes gradually. As mentioned in a previous posting on leverage, it is difficult to determine the optimal amount of leverage required for a company operating in a certain industry, unless we are keenly aware of how that industry works. For example, Olam is also aggressively taking on debt in order to finance acquisitions which are earnings accretive to its business, and which help it to vertically integrate. Thus, it can be argued that high gearing is not necessarily bad as long as the company knows how to properly manage it and not to let it get out of hand.

11) As a result of high finance costs and record-high oil prices (US$146 as at time of writing July 3, 2008), PAH and CFG could see short-term margin squeeze which would affect profits in the next few quarters. However, taking a long-term perspective, there is much to look forward to with regards to their business model and expansion plans as Management have a clear vision of what they wish to achieve and are NOT in a hurry to execute. Instead, they are adopting a more cautious stance amidst the current economic slowdown and choosing to conserve cash; while trawling out (mind the pun !) for quality opportunities to increase their asset base through acquisitions of vessels or plants.

My average cost has been reduced from 65.5 cents per share to 54.75 cents per share as a result of the purchase. This will be reflected in my next portfolio review due on July 15, 2008.

23 comments:

Anonymous said...

hi musicwhiz, read yr article on Pacific Andes. Great one, especially coming from someone who has been tracking the business for a long time. Can u email me at ct.leong@nextinsight.com.sg? Just want to ask u something. Thanks.

Simon said...

do u know what is the current average cost of debt for pacific andes, i.e. average interest charged for their debt? And also the debt retirement profile, i.e. when do they have to refinance their debt in the future? And should they refinance their debt now, what is the increase in the cost of debt? Cos im concerned that cost of debt has gone up a lot.
actually, r they even confident of refinancing their debt? cos if not, they have to sell some of their assets to repay some of their debts, and that is disastrous for the share price. I think u should pose these questions to management. Who is their bank btw?

Anonymous said...

one big concern for me is that PAH effectively depends on its fishing operations for the majority of growth - and from the recent years the growth seems to have come primarily from them getting more vessels. not sure that this is sustainable?

musicwhiz said...

Hi anonymous,

Thanks for reading my article.

Regards,
Musicwhiz

musicwhiz said...

Hi Simon,

I am waiting for PAH's latest Annual Report which should be in some time next week, then I will answer your questions. The financial statements released on SGXNet will not have that kind of detailed information you request. However, during discussions with Mr. Dennis Chan during CFG's AGM, he did mention that for the 9.25% senior notes, the effective interest rate was only about 6%+. I would assume bank loans grant rates which are averaging that or are even lower. Taking FY 2007 AR, the interest rate for unsecured borrowings was pretty high at 6-14% per annum and are repriced quarterly. I believe this should be reduced for FY 2008 as interest rates have been falling (include LIBOR rates which some of their secured loans are pegged to).

Actually, in the current low interest rate environment, I think it would do PAH and CFG good to re-finance some of their loans. Swiber recently issued bonds at about 4% per annum so I think we can use that as a benchmark; I think it should be favourable compared with the older debt which they took on.

I don't see why they should not be able to re-finance. Some of the debt will be pledged to assets and the asset backing acts as the collateral for the loan facility given by banks. Hence, I don't see a problem in terms of re-financing as PAH have the asset backing to put down as collateral. Also, banks have no reason to immediately recall the loans unless the suspect something amiss. Similarly, convertible bond holders should also not demand redemption of their bonds unless there was a crisis of confidence in the Management or business, which I do not forsee.

As to which bank they are financing with, according to the FY 2007 Annual Report (this might be outdated), the banks include:-

a) HSBC
b) Landsbanki Islands Hf
c) Rabobank International
d) Standard Chartered Bank (HK) Ltd

Regards,
Musicwhiz

musicwhiz said...

Hi Anonymous,

If you read my post, you will note that growth is not just acquisitive, but also organic. Some examples:-

a) PAH/CFG enhancing their supertrawlers to increase hold capacity so that each trawler can hold more fish (thus, less to and fro travel time to unload fish to the plants).

b) Economies of scale in integrating their Peruvian operations which is beginning to show in terms of lowered COGS compared to revenues (i.e. increased GP margin)

c) Sourcing of new species of fish (e.g. Mackerel) in new areas in South Pacific Ocean to sell to new markets (i.e. Africa). PAH are also conducting studies to see if other species can be caught to substitute some current ones so as to create new revenue sources.

d) Better scheduling and planning once ITQ system kicks in within next half-year; thus improving efficiencies even WITHOUT increasing fleet size.

Regards,
Musicwhiz

Anonymous said...

i was pretty impressed by mr ng when he commented his vision of owning the oceans of resources to take pad/cfg forward. i've good faith that pad is able to weather the current downturn as long as prc continue to eat fish, the core biz where pad take their earnings. doubts lingers on the impact on prc whether economy downturn in the globalise world would affect the people eating habits or if the damage to the world ego system cause living creatures in the sea to reduce extra-ordinarily. but markets risks or weather change are to remote for us to grasp and thinking long-term erase most of these doubts. thanks for the write-up.

Collin Yeo said...

Hi Musicwhiz

What are some of the major difference between Pacific Andes and China Fishery? I am looking to enter CFG but do you think we should focus on Pacific Andes instead since it owns a major stake in CFG?

Thanks.

Simon said...

yup, the cost of debt may be attractive now (even though i have to say more than 6% is quite high), but may not be when they have to refinance their loans in the future. libor is one thing, but we have to check with management as to the spread over libor. this could go up a lot when they need to refinance their loan as banks are increasingly reluctant to lend money. So it's quite important to get the debt expiry profile. If their debt expires after 2010, maybe things would get better and it wont be too bad after all. If it's 2009, things may get ugly b4 it gets better. One thing you can do is to ask management how confident are they of refinancing their loan at the current spread that they had the last time.

Anonymous said...

wow MW,

my remiser actually emailed this article written by you to his clients today(me included of course!!)

Congrats!

SJ Reader

musicwhiz said...

Hi Anonymous,

Thanks for your comments. I think Mr. Ng has a good vision and strategy for the company but execution is the main risk here. Also, the current storm in world markets, economies and the persistently high oil price all come together to negatively impact CFG and PAH. But over time, I think the company should be able to weather the rough seas and emerge stronger. This is the faith I have in Management, and I hope they do not disappoint. However, seeing their track record, I feel a lot less worried. :P

Regards,
Musicwhiz

musicwhiz said...

Hi Collin Yeo,

The difference is that CFG is doing the upstream part of the entire value chain (i.e. catching the fish), while PAH is doing the mid-stream portion of trading and SCM (including logistics). PAIH (the Hong Kong listed entity) is doing the downstream fish processing with the new Qingdao facility coming on-stream soon. Thus, this is how the whole Group covers the entire value chain for fish products and one can see that they are vertically integrated.

Well, the upstream business (CFG) commands strong net margins of up to 30% while the midstream (PAH) only 2%; but as more earnings will crystallize from CFG in time to come, I see the net margins for PAH rising in tandem. The economies of scale effect will also kick in eventually to lower costs for PAH and raise net margins.

The only good reason I can think of to own CFG instead of PAH would be that they pay dividends twice-yearly instead of PAH which has said they will pay just once per year. In terms of yield, both offer about the same yield at current prices.

Ultimately, the decision is yours to make after studying the two companies' pros and cons.

Regards,
Musicwhiz

musicwhiz said...

Hi Simon,

Thanks, those are good points you raised about cost of debt. I agree 6% isn't exactly low, but if they can achieve high ROE of >10% then it will justify taking up this loan, wouldn't it ? I shall remember to check with Management on their loan repayment and whether any of it needs to be refinance, assuming I can make it for the AGM.

As for their debt profile, I think more light will be shed once I receive the Annual Report, which should be latest by next Friday (18th July).

Regards,
Musicwhiz

musicwhiz said...

Hi SJ Reader,

Haha thanks yes NextInsight requested for permission to reproduce my article on their website and I agreed to it. I didn't know that remisiers are passing my write-up around ! Talk about copyright issues....LOL !

My write-up can be found here:-
http://www.nextinsight.com.sg/content/view/447/60/

Cheers,
Musicwhiz

Zr said...

hi mw,

was wondering how would you decide at what price would be a good discount to the stock value before buying it?

what are the methods do you go about valuating a stock?

regards,
Zr

musicwhiz said...

Hi Zr,

For myself, I use PER as a guide only after evaluating all aspects of the business and found them to be satisfactory. I will also compare PER to competitors in the same industry as well as use an average PER (e.g. 10x) for comparison. Single-digit PER is safer as it means you are paying more cheaply for a company, assuming consistent growth in EPS of 20-40% annually.

It's not an exact science, much of the analysis comes from qualitative factors, only some of it is quantitative in my case.

Regards,
Musicwhiz

john said...

Hi Musicwhiz,

I was attracted by your last posting in Wallstraits re PAH giving the option of receiving dividends in scrips. I then looked closer into its biz of fish trawling and processing which is rather quite unique for a S'pore coy and am prepared to buy at its current price. However, I am not quite confident about its fishing part of the biz. Fishing depends on having good and loyal master mariners (captains) to run their expensive trawlers. I have no direct experience with such people, but I tend to think such character are a rare breed and rather unpredictable or difficult to manage? Don't you think the coy is ever at the mercy of such people and thus makes owning it rather risky financially?

I am still interested in any company who is paying or intending to pay dividends in scrips. You know which companies in the STI doing it?

John

musicwhiz said...

Hi John,

Good point that you brought up ! Well running the business for PAH/CFG means managing staff which will include the fishermen that you mention. I assume that if PAIH/PAH and CFG have had no problems thus far with the fishermen on their vessels, this should simply continue. However, as you pointed out, there is a real risk of problems occurring due to high oil prices thus straining the livelihood of such fishermen. It is in the interest of PAH/CFG management to keep these fishermen happy so that the business will not be affected. I trust that Management will know how to manage their expectations. With the new ITQ system coming in, there will be an additional fund for these fishermen and acts as an added incentive.

Right now, I am unsure of any other companies doing scrip dividend, so I cannot tell you offhand.

Regards,
Musicwhiz

Anonymous said...

What are your thoughts of PAI?
It is at the top of the pyramid and the Ng family owns more than 50%. Wouldn't the incentives be there for the management to what is in the best interest for that company? You mentioned that PAH does midstream and CFG does upstream. Doesn't PAI own 64% of PAH and 40% of CFG making it exposed to all elements of the fish producing/catching/packaging cycle?

Anonymous said...

Musicwhiz,

Please could you tell us when is the last day for deciding whether to accept scrip dividend or cash dividend?

Also have you receive any forms to fill the option yet?

Thanking in advance, and

Best Wishes.

musicwhiz said...

Hi Anonymous,

Yes, PAIH is exposed to the entire value chain of the fishing industry. They do all the way from the top to the bottom (vertically integrated).

Not much thoughts on PAIH as I do not really keep track of the parent company, but I do know they have a Qingdao processing facility which is just about ready to commence operations.

Regards,
Musicwhiz

musicwhiz said...

Hello Anonymous,

PAH will send a form by August 20 to let you choose scrip. If you ignore the form, then you will receive the dividend in cash.

Regards,
Musicwhiz

Ogoo said...

I was impressed by your depth of knowledge of this industry.

Overpaying for CFG
-------------------
I feel that PAH itself has endup overpaying for CFG aquisition. This is against our philosofy of value investment.

If CFG business is so attractive why whould its founder would sell his stake to PAH? Do you about this?

CFG+PAH Aquisition
-------------------
What I understand from company's explanation is that the company's main reason for aquisition of CFG is to benefit from CFG growth rather then create synergies.

Knowing that CFG operates in upper part and PAH operates in middle and lower value chain how they will create operation synergies. For example PAH will buy fish from CFG at market price which doesn't give any synergy.

Mgmt Honesty
---------
I always look for honesty of the management first. They never report executives remuneration mix (fixed vs variable performance based bonus) consistently siting the reason of staff porching. I don't buy this justification. Off-course since mgmt has marjor stake holding in company they should be modivated to perform well. But I feel honesty issue here.

Threat of Aquaculture
-----------------------
There was independent reaserch done by a body ( I can send you separately) which shows that captured fish demand/production has been not growing as strong as Aquacultured fishes. Do you think Aquaculture will be threat to sea captured fish business?

Low Price vs High Price fish
------------------------

In 1H08 report CEO has mentioned that due to economical turnmoil people will move to low priced fish which I believe have margin pressure in short to mdeium term. What do you think?

Thank you.