Tuesday, February 24, 2009

China Fishery - FY 2008 Analysis and Comments

China Fishery (CFG) had released their FY 2008 financials some time back, and I had the chance to do a detailed review of the Company's financials. Suffice to say that I was not entirely happy with the numbers that I saw, and a few aspects of the financials caused me a considerable degree of worry and consternation. However, my fears were assuaged due to the fact that a lot of the debt in CFG's books had collateral tied to it (i.e. their fishmeal processing plants, fishing vessels and fishmeal inventories) and assured me that CFG could re-finance its short-term debt. I will be touching more on CFG's debt in the Balance Sheet review below. Perhaps astute readers out there can point out facts which I myself had over-looked when I decided to invest in this company. However, things change and the future is never certain; thus one must always question one's original premise for investing in a particular company.

Profit and Loss Analysis

In such uncertain times and in the midst of a severe recession, most investors would find it more prudent to scrutinize a Company's Cash Flow Statement and Balance Sheet rather than its Income Statement. This is because a strong Balance Sheet and regular and stable cash inflows can help a company tide through long downturns to emerge even stronger after that. CFG had managed to grow its top-line revenue by 13% from USD 406.4 million to USD 459.4 million. The rise in revenues was mainly due to higher catch volumes and higher selling prices for its fish with regards to its trawling division, which accounted for 74.7% of total revenue. The other 25.3% was made up of fishmeal operations and this created a minor drag on revenue as fishmeal prices softened during FY 2008 compared to FY 2007. A latest check on fishmeal prices from Copeinca's 3Q 2008 financial highlights shows that fishmeal prices averaged around USD 988 per metric tonne (MT), lower than the USD 1,100 to 1,200 per MT hit in FY 2007.

Gross margins dropped from 34.8% in FY 2007 to 32.3% in FY 2008. The main culprit was higher bunker fuel costs as the price of oil shot up to as high as USD 147 per barrel around July-August 2008. The ratio of fuel to total sales increased from 14% to 17.9% as a result of this. However, with oil prices slumping to below USD 40 due to the global recession, CFG should be able to regain their high margins again for FY 2009, barring unforseen circumstances.

Finance costs also rose slightly for the Company from USD 26.8 million to USD 31.2 million, a 16.4% increase. This was due to higher bank loans taken out during FY 2008 for the acquisition of fishing vessels and fishmeal plants. As the credit crisis dragged on and credit became tighter, the Company had also ceased their acquisition of assets until more clarity emerged. This will be discussed under future prospects and directions. As a result, net margins decreased from 21.8% to 20.5% (helped by a tax credit of USD 2.4 million from the recognition of tax losses carry forward by CFG Investment S.A.C.) and net profit rose just 6.5% from USD 88.5 million to USD 94.3 million. Using an exchange rate of 1 USD = 1.52 SGD, this translates to about SGD 143.3 million net profit. EPS is about SGD 18.3 cents and using the closing price of 60 Singapore cents as at February 24, 2009, this translates to a historical FY 2008 PER of 3.28 times.

Balance Sheet Review

Well, I have to admit CFG does not have one of the cleanest Balance Sheets around; after doing a quick comparison to companies such as Boustead and Tat Hong, I was forced to conclude that CFG's Balance Sheet represents a lot of risk and notwithstanding the fact that their trawling operations generate lots of operational cash inflows, the Management must make a sustained effort to reduce their gearing and improve their cash balance. A quick glance would show that the Company had debts amounting to USD 317.3 million for FY 2008 (bank loans + senior notes) of which about USD 60 million is up for re-financing within a year. Gearing is dangerously high at 43.6% debt to total assets and about 94.5% debt to equity ! The fact that the Company had a measly cash balance of just USD 7.7 million is of great cause for concern ! I will cover this aspect during the review of the Cash Flow Statement, and though this may be a timing difference, having so little cash in the face of so much debt is not something I like to see as an investor.

Current ratio actually improved from 1.05 in FY 2007 to 1.28 in FY 2008, mainly due to the increase in trade receivables and inventories, coupled with a large drop in trade payables. However, the worrying fact is that short-term debt increased in order for them to finance their acquisitions, and only the assurance of better cash inflows in future can make me feel more worry-free. Suffice to say this is a Balance Sheet which had me beleaguered for quite some time, but seeing that CFG and PAH have a good track record and are a major industry player, and that the CEO is prudent enough to manage inventories and debt; this has caused some of the worry to ease, though some doubts still linger which I will attempt to address at the upcoming Annual General Meeting.

Cash Flow Statement Analysis

A quick glance at their Cash Flow Statement shows that CFG generated healthy operational cash inflows of USD 65.4 million for FY 20008, down from USD 172.8 million for FY 2007. Knowing that their business is very cyclical and is based upon quota allocation and fishing seasons, one might attribute the changes in working capital to such seasonal fluctuations and the fact that the Company is gearing up for its first ITQ fishing season in 2009. The entire year's cash inflow is just about sufficient to cover the short-term debt which is due for re-financing (or repayment, assuming they have the cash to do so). I have no doubt that CFG can generate strong cash inflows from their trawling and fishmeal operations, but a major problem now is that they are paying out USD 28.4 million just in interest alone, so unless they reduce their debt quickly, a lot more of their cash flows will go into feeding the banks and bankers' salaries rather than being ploughed back into the business to generate higher ROE. This in itself is very worrisome.

For investing activities, CFG spent USD 57.5 million acquiring PPE which consists of fishmeal plants and fishing vessels. Note that part of this money may also be capitalized expenses resulting from the elongation of existing super-trawlers; thus CFG's growth is part organic and part acquisitive. Another USD 19.7 million was spent acquiring a subsidiary (which includes fishing permits as well). All in all, they spent significantly less in FY 2008 on investing activities as compared to FY 2007, when a massive USD 277.7 million was spent on acquiring PPE, subsidiaries, fishing permits and prepayment of charter hire.

For the financing side, more bank borrowings were raised to acquire assets, while the final dividend for FY 2007 paid came up to USD 12.6 milllion. The result was a net cash inflow of USD 8.8 million, and was lower than FY 2007's fund-raising efforts which saw issuance of new shares as well as bank borrowings totalling USD 96 million.

For FY 2009, my wish is to see CFG halt all acquisitions and focus their efforts on building up their operational cash inflows in order to pay down their bank loans (and possibly redeem some of their senior notes due 2013). During lean and tough times, organic growth may be preferred to acquisitive growth especially since the Company is already so highly leveraged. If CFG had a lot of cash on hand and no debt, I would encourage more asset acquisitions at fire-sale prices. Because of the fact that they have so little cash and such high borrowings, I would rather the Company focus on cash generation, in order to avoid the risk of ending up as another "Ferrochina".

By the way, another indication that the Company is cash-strapped is the declaration of a share dividend (scrip instead of cash) of 6.03 Singapore cents per share. I see this move being purely cosmetic as the Company can choose NOT to declare a dividend and cause dilution to EPS, so I will bring this issue up at the AGM too.

Disappointing though the above sounds, I do still have faith that the Management Team can steer the company to better times with their growth plan, assuming nothing drastic occurs in the meantime.

Prospects - ITQ Implementation

The long-awaited ITQ (Individual Transferable Quota) system will be in place in Peruvian waters in the first fishing season of 2009. This was issued by the Peruvian Government on June 28, 2008 and places individual limits of capture per vessel instead of having a quota for a specific specie of fish. A maximum limit of capture will be set and vessels will not need to "race" to catch as much as fish as they anymore. This was the case for the old system called the "Olympic" quota system, in which the Ministry of Production decides the total quota for the country and each vessel owner must then rush to maximiser share of the total quota. The fishing season then ends when the quota has been achieved.

For the ITQ system, each vessel can catch the allocated quota at heir own discretion. There are several advantages with regards to the ITQ as compared to Olympic system:-

1) There will be better rationalization of plants, fishing vessel fleet and personnel as scheduling becomes more efficient and effective. Previously, during the "race" to catch as much as possible, it would have been difficult to plan for and allocate vessels to maximise catch. However, under the ITQ, this would now be possible. The result is better economies of scale and hence lower cost of goods sold (translating into higher gross margins).

2) There will also be significantly improved utilization of assets as a result of the economies of scale. The projection by Copeinca (a major competitor of CFG) is that EBITDA will increase 30-40% as a result of this.

3) The quality of fish and fishmeal will also improve as there is no rush to catch as much as one can, thus compromising on the quality of catch due to the race for quantity. This would translate into higher selling prices for the fish and fishmeal and again improves gross margin.

4) The ITQ system will also continue to ensure that fish populations are sustainable and do not deplete too quickly.

However, one thing to note is that the full effects of the ITQ system will probably not be felt until FY 2010.

Prospects - Fish Demand and Fish Prices

Worldwide fish demand is expected to remain consistent with moderate growth as the global recession kicks in. The move towards more healthy diets means that more will start consuming fish instead of red meat; however this effect is likely to be mitigated by the loss of wealth in affluent countries as a result of the economic crisis; therefore the income effect may cause people to temporarily downgrade to cheaper alternative sources of protein, thus neglecting fish. However, I do not see a major negative impact for this as fish consumption should remain relatively steady and demand should stay resilient despite the growing recession.

As for fish prices*, consumers will start to switch to alternative species in the more affordable range and this will boost sales volume, though margins are likely to stay constant. Expected worldwide deflation may also cause prices to drop, though a >10% drop is not likely and should not be prolonged. It is expected that fishmeal prices should stay steady at around USD 1,000 per MT in the near term, with the long-term trend showing a steady increase.

Prospects - Deployment to South Pacific

CFG had mentioned deploying super-trawlers to the South Pacific which is currently relatively unexplored and has untapped fish resources. CFG was in the midst of upgrading their super-trawlers in FY 2008 and perhaps this was one reason why they could not ahieve full potential during FY 2008. As of year-end 2008, two super-trawlers had been deployed to the South Pacific Ocean and more (exact number unknown) will be deployed there in FY 2009. This has to be confirmed with Management during the AGM.

Falling oil prices will also benefit these super-trawlers which are able to increase their hold capacity after elongation (I checked this during the last AGM). Naturally, being larger, they will consumer more fuel than non-upgraded super-trawlers so the fall in bunker prices will benefit CFG greatly, plus the increased hold capacity means more fish can be stored for transport to the nearest fishmeal processing facility.

The Future - Krill ?

Apparently, during an interview with The Edge Singapore (August 18, 2008 issue), Ng Joo Siang mentioned that he thinks there might be big demand for krill some day. This is a minute marine bio-organism which can be found in the Antarctic in large numbers. They are at the bottom of the food chain (whales eat them in abundance) and there have been warnings by conservationists that removing them from the food chain may severely impact other species and cause a catastrophe in terms of bio-diversity. Notwithstanding this, the potential for krill is good because it can be made into krill oil and krillmeal for animals and is also rich in Omega-3 fatty acid. In some news reports, krill is also being tested for use in skin care products !

Thus, I will be bringing up the subject of krill to the Management to see if there are any plans underway to harvest this new species, and the potential for growing this business.

*Note: Fish prices relate to prices of Peruvian anchovies as well as Chilean Jack Mackerel.

I will provide another update for the Company come AGM time. In the meantime, I expect to hear more news of the scrip dividend scheme and hopefully it will allow me to average down my cost without me having to cough up extra funds.


Akatsuki said...

Mz, i must say, your analysis on CFG made me review all the companies i bought so far, checking their balance sheet's health. Luckly, all of them are still healthy, as such i'll be looking at how you will handel this investment should CFG no longer meet your requirements as a value stock to hold for long, will you sell it at such a depressed price? Or continue to hold it, in hopes that the company can correct themsevles in time.

musicwhiz said...

Hi Akatsuki,

Well all I can say is that one should always review the Balance Sheet and Cash Flow Statement periodically for all the companies he owns. That is part of my requirement for investing.

So far things still look OK to me in the medium-term, so I don't see a problem with being a shareholder at least until end-FY 2010.

The Company borrowed heavily to fund its foray into Peru and South Pacific (fishmeal), and it's got good margins + generates healthy op cash flows. Thus, I don't think it's something they need to "correct", it's more of the strategy they use moving forward to reduce their heavy reliance on debt and to slowly reduce their gearing. I hope to see Management moving towards this direction. The senior notes are due 2013 so they technically still have about 4 years more to build up sufficient reserves to pay back the note-holders.