China Fishery – 1H 2009 Financial Review and Analysis

China Fishery reported a rather surprising set of 2Q 2009 results, with revenue falling 21.7% as the Company decided to shift their vessel allocation for the South Pacific ocean in anticipation of higher fishmeal and fish prices in 4Q 2009. However, for 1H 2009, revenue increased marginally by 6.8%. I will be reviewing China Fishery in the same fashion as per all my other companies; and this review and analysis will be the only one done as I only do two per financial year – one for half-year results and another for full-year results. There is only the requirement to re-look at the Company in the event of any significant corporate events taking place, of which I do not expect.

Profit and Loss Review and Analysis

It is interesting to note that the ITQ system kicked in during April 2009, and was in force throughout the entire 2Q 2009. The financial effects were pretty dramatic in that cost of sales for 2Q 20009 fell by 60.1% against a 21.7% drop in revenues. Charter hire expenses dropped as a result of lower utilization of vessels as some were deferred to 4Q 2009 where they will be deployed to the South Pacific to increase the quota there. However, for 1H 2009 cost of sales increased by 13.6% compared to a 6.8% rise in revenues; but overall cost of sales for FY 2009 is expected to drop further as the ITQ system continues to exert a positive effect on gross margins and to enhance cost effectiveness. Vessel operating costs fell by 29.1% for 2Q 2009 to US$44.6 million due to the drop in oil prices to around US$70 per barrel, compared to nearly US$147 per barrel during last June 2008. Unfortunately, for 1H 2009, there was still a slight increase in vessel operating costs of 7.6% (about US$8 million).

As a result of the reduction in costs, gross profit for 2Q 2009 only fell a marginal 0.6% and gross profit margin improved from 30.3% to 38.5%. For 1H 2009, gross profit also improved marginally from 36.9% to 37.3%. It is expected that with the ongoing ITQ system in place, this will allow for better control and rationalization of costs for CFG and gross margins should improve further moving forward.

Net margin for 2Q 2009 was 23.3% against 17.1% for 2Q 2008, with income tax expense increasing a significant 49.2%. Finance costs only dipped 3.3% and a still very significant worry of mine is the high interest expense they are paying both of their bank loans as well as their senior notes due 2013.

Balance Sheet Review

One immediately noticeable good sign in their Balance Sheet is the increase in cash and bank balances from US$7.6 million half a year ago, to the current US$20.4 million. This factor, coupled with an increase in trade and other receivables and a slight drop in current liabilities, helped to improve current ratio from 1.33 as at Dec 31, 2008 to 1.79 as at June 30, 2009. Inventories had also dropped from US$33.3 million to US$22.4 million, a sign that the large stockpile of fishmeal as at year-end was being cleared off.

Unfortunately, a glance at their debt shows that long-term liabilities increased from US$279 million to US$309.3 million, mainly due to an increase in long-term bank loans offset by a marginal drop in finance leases and deferred tax liabilities. Even though the press release maintains that net debt to equity fell from 92.2% to 81.7%, one should note in this case that the denominator had increased from US$335.8 million to US$403.8 million; but net debt in fact increased because long-term bank loans increased by US$33.7 million while cash only increased by about US$12.7 million. The press release conveniently glosses over this fact and a closer look at the numbers reveal that debt is not exactly being lowered in spite of the Group completing their upgrades for their supertrawlers. In fact, the Group may continue to maintain its high gearing to take advantage of the relatively untapped waters off the South Pacific to increase their catch of Chilean Jack Mackerel.

While it is noticeably certain that the Group is able to manage their gearing well as well as their high capex, it is obviously worrying to note that gearing is not being actively reduced, as the tenure of the senior notes has 4 more years to go, which means the clock is ticking for them to be able to generate enough sustainable operating cash flows to pay off this huge liability. The senior notes were issued in 2007 to be allow CFG to expand aggressively in Peru by purchasing supertrawlers, upgrading them, buying fishmeal plants and purse seine vessels. I would expect their expansion plans to at least taper off and die down by FY 2010 and that is when I would expect cash flow generation to improve greatly, thus reducing gearing drastically. I will have to observe their net gearing and cash generation capabilities in the next few quarters to reaffirm my understanding of their strategy; or else it would seem that this debt would not be paid off easily. The fact that they managed to secure an additional US$60 million 3-year term loan also attests to the fact that banks are very comfortable with CFG’s financial position and market power even in the midst of a severe downturn.

Cash Flow Statement Review

Net cash flow from operating activities was healthy at US$35.1 million (for 2Q 2009) compared to US$31.5 million a year ago (2Q 2008). At first glance, this looks roughly comparable with not much difference. However, looking at 1H 2009 there was a net operating cash inflow of US$53.3 million against a much lower net operating cash inflow of US$15.3 million for 1H 2008. The much improved numbers at least helps to instil confidence in me that CFG’s operations are generating very healthy cash inflows, and as soon as their capex plans (upgrading of supertrawlers, purchase of additional purse seine vessels) are done with, their cash balance would dramatically improve.

For investing activities, CFG spent US$73.1 million in 1H 2009, presumably on their capex plans for upgrading (elongation) of supertrawlers to increase fish hold capacity. The amount spent was much higher than 1H 2008’s amount of just US$5.3 million, as CFG had, in 2008, scaled down on their capex due to the (then) sharp economic downturn and drying up of financing. Only about US$8.6 million was spent last year acquiring a subsidiary (Peru fishmeal plant). It remains to be seen if the Group will spend even more on capex in 2H 2009, though I hope that most of the elongation and deployment will be done by 4Q 2009. For FY 2010, I would expect them to scale down capex unless absolutely necessary, in order to be able to slowly reap the cash flow benefits from their aggressive spending.

As mentioned in Balance Sheet review, the cash flow statement shows up that additional bank loans of about US$34 million were taken up in 1H 2009 (net off additions of bank loans against repayments), compared to an addition of just US$13 million for 1H 2008. I suspect these additional loans were taken up as short-term financing for their capex and for working capital requirements.

Prospects and Plans

The Group plans to shift more of their vessels to the South Pacific to be able to capture a higher quota there, and they are deploying their vessels there during 2Q 2009 to be positioned and ready. Since they are also considering leasing additional vessels, they must feel that there is vast potential in the South Pacific which has yet to be properly tapped and exploited.

With the Peruvian Government implementing the ITQ, this will result in more sustainable fish resources and a slower depletion of natural fish habitats, thus enabling CFG to continue to milk ocean catch and to make it more desirable than say, fish from aquaculture (which is also gaining in popularity). All fishing companies will enjoy better utilization of their vessels which in turn will reduce costs significantly (one example is Copeinca which reported a 20% rise in EBITDA as a result of ITQ); in time to come China Fishery should be able to reap the full benefits of the new system as compared to the “racing” Olympic system.

Management also hopes that with the gradual recovery in the economy, fish and fishmeal prices will slowly trend up and they can improve their selling prices. This may prove to be a further impetus for higher gross margins. However, with improved economic conditions also come higher oil prices, and this will offset the higher margins a little. I look forward to 2H 2009 when Management reports on their South Pacific strategy, and hopefully are able to provide clear direction and articulation of their strategic intentions for FY 2010 and beyond, with a focus on reduction of debt and paying off their senior notes by 2013.