Pacific Andes – 1H FY 2008 Results Review and Analysis (Part 1)

On November 14, 2007, Pacific Andes released their 2Q and 1H FY 2008 results (the company has a March 31 year-end). Suffice to say that growth was not as impressive as I had expected, and my fears about the high interest expenses on the covertible bonds and senior notes came true as finance costs had soared as compared to the same period last year. This could possibly be a major source of headache for the company moving forward as it drains a lot of cashflow. On the positive side though, the recent acquisitions and move into the fishmeal industry has helped to smooth revenues somewhat, as can be seen that 2Q, which is traditioally a weak fishing season, showed better revenues as compared to a year ago. What Pacific Andes (PAH) needs to do is to better control costs and improve efficiency of operations, otherwise the company will not be able to add value to shareholders in the long-run.

My review will be in the usual two parts, the first concentrating mainly on the Income Statement and Balance Sheet, while the latter part will be on the Cash Flow Statement and future prospects:-

Income Statement Review (note: all figures quoted within are for 2Q 2008, not 1H 2008)

Revenues increased 111.1% from HKD 751.9 million to HKD 1.59 billion, which was mainly due to their increase in fishmeal and fishing activities through CFG (China Fishery Group) as well as their recent stake increase from 28.8% to 63.9%. However, cost of goods sold remained high, rising 116.1% to HKD 1.25 billion, thus leaving a gross profit of HKD 337 million (margin about 21.2%). Comparatively, for 2Q FY 2007, gross margins were slightly higher at 23.0%. Sadly, the momentum generated in the revenue increases could not be brought to bear on the net profits, as most of the increase was absorbed by higher selling and distribution expenses and finance costs. Selling and distribution expenses increased 4-fold (up 427%) to HKD 32.5 million, while finance costs ballooned 218% to HKD 101.5 million. These two expenses make up 8.44% of revenues already and play a big part in “shrinking” net margins for 2Q 2008, as compared to 2Q 2007. Net margin for 2Q 2008 was low at 10% compared to 15.9% a year back, largely due to these two costs. Selling and distribution costs have increased in line with the increase in operations for the Group, which I can understand, but 400+% seems a little surprising nonetheless. Finance costs are a major drain on cash and though the debt is used to fund expansion, it has not really translated into much earnings accretion (yet !). Fortunately, PAH has mitigated the risk of interest rate increases by “locking in” the interest rate on the senior notes and convertible bonds. Hopefully, in the next few quarters, there will be more margin improvement as a result of better streamlining of operations and better efficiencies resulting from economies of scale.

Profit attributable to shareholders increased 46.2% for 2Q 2008 and for 1H 2008, the increase was 41.5% to HKD 182 million. According to Note 6, EPS is now HKD 18.83 cents based on a weighted average share capital of 966 million shares; but the fully diluted EPS (taking into account full conversion of all convertible bonds) drops to HKD 17.63 cents. This is not even counting in the full effects of the 1:1 rights issue which has doubled the share capital base, thus I forsee more earnings dilution as a result of this. I will give an estimate of about 80% of fully-diluted EPS to be conservative, which is about HKD 14.1 cents. This translates to about 2.82 Singapore cents per share, or 5.64 cents per share annualized. At Friday’s closing market price of 71 cents, this values the company at about 12.6 times PER. At my current buy price of 65.5 cents, the PER I purchased at is about 11.6 times. If profit worsens or drops unexpectedly and causes my margin of safety to narrow, I will not hesitate to dispose of this investment. My concerns relate to the high gearing for PAH and I need to see Management do more to improve margins and lower costs in future periods. That said, 2Q did see a major cash outflow due to the acquisition of the additional stake in CFG, which may have distorted the results a little (the acquisition was only completed on July 23, 2007). I shall wait for the 3Q 2008 report to see if things have improved.

Balance Sheet Review

PAH’s balance sheet has traditionally held a lot of debt, which I am not particularly comfortable with. I acknowledge that it might be a necessary evil if the company has to resort to debt to expand its operations quickly and gain a stronger foothold in the fishmeal industry in Peru. Compare PAH’s method with Ezra and Swiber, where both companies also rely heavily on debt financing to boost their fleet of vessels. In PAH’s case, they need to increase their reefer vessels to cope with better SCM, purse seine vessels to catch more fish and put their super-trawlers for elongation and enhancement in order to fish in new waters. All this costs money and the non-current liabilities has seen an increase of about HKD 548 million for convertible bonds. Current ratio is 1.58 for Sep 30 compared to 1.91 for March 31. Quick ratio is 1.32 against March 31’s 1.51, as a result of an increase in current liabilities and a drop in current assets (lower inventories). Their interest-bearing bank borrowings together with senior notes forms HKD 3.1 billion, which is almost equivalent to their total current assets. I see this as a potential risk area for the Group moving forward, and hope that Management can find ways to bring down this high debt. Otherwise, PAH as an investment would not seem very attractive in the long-run.

Part 2 will be continued on a later date, do stay tuned and feel free to comment and give your opinions on the Company and Group.