Under the Radar: Peak fish

PORTFOLIO POINT: Our small-cap column returns with an aquatic tiddler that’s got big things ahead of it – including potentially a private equity bid.

In June last year, we relaunched our occasional small-cap column, Under the Radar, with a fisheries company, Clean Seas Tuna Limited (CSS). This year, I want to go one better: Tassal Group Limited (TGR), which produces Tasmanian salmon, a fish variety that many readers would probably prefer.

If you think there’s something fishy about this, then you're right. The global fishing industry is one of the most unsustainable anywhere and if you're worried about issues like peak oil, you should really be worried about peak fish. Since the late 1990s, world volumes of fish captured have been steadily declining against a backdrop of increased animal protein demand globally.

Source: FAO Fisheries Global Information System

And in terms of deep value Australian stocks, there are also few places richer than the deep blue sea. The global fisheries story, which should be bullish for Australian producers that invest in sustainable methods, has been almost completely undone by the strong Australian dollar and competition from cheaper exports out of Southeast Asia and South America, where standards are very different. While the macro picture thus looks very prospective, by looking at the share prices you wouldn’t know it.

As for Tassal, since the company's December 2009 interim report, both half-year and annual underlying post-tax earnings figures have been in steady decline. The Aussie dollar, in the meantime, has gone from strength to strength.

But now, with signs of an AUD/USD reversal continuing on an anticipated terms-of-trade shift (Moody’s estimates that iron ore prices will likely drop), in addition to the possibility of a rate decrease next week (see The RBA’s double act), Australian exporters – Tassal included – could enjoy a drop of relief. The Aussie has already fallen this week on indications from the US Federal Reserve's Beige Book that Treasury yields could remain low, but QE3 is unlikely (for more discussion, see Ten-gallon stock tips).

Back home, adding to this relief is the announcement from Coles last month that unsustainable fish varieties – many of which are exported, hurting the competitiveness of local catches – will be phased out. The sustainability study, conducted by the World Wildlife Fund, meanwhile gave Tassal a tick of approval.

It is partly for these reasons that Tassal interests me at current levels, which are only just off post-crisis lows. The other reasons include the company's low forward PE – 8.09 times June 2012 estimated earnings, based on the consensus of seven brokerages that cover the stock – and its robust return on equity (ROE) levels: 12.59% on an annualised basis for the December 2011 period, just reported. And while ROE figures, in tandem with earnings per share growth, have been in decline, they still indicate a strong profit buffer.

Contributing to the attractions of this buffer is the fact that as at December 31, Tassal had very little debt (net debt to equity is at 30.65%, down from 35.96%) and net tangible assets per share stood at $1.68. Effectively, the company's break-up value is worth more than its market value. Company cash flows are robust, despite lower earnings and higher feed prices, and there was a $4.39 million net cash increase for the most recent half, building on a $3.71 million net cash increase in the year to June 2011. Operating cash flow in the December half was in fact a record at $19.10 million.

If I were a private equity investor, I would be fishing around businesses such as this and indeed this is what I suspect might be happening.

Early last year, Tassal shares climbed to a high of $1.81 on rumours of a controlling interest bid between $2 and $2.25 from Paine & Partners, a Chicago leveraged buyout firm that already owns Icicle Seafoods, a Seattle fish processor, and Scanbio Marine Group, a fish oil maker from Norway (for its Australian equivalent, see my Under the Radar profile on Clover Corporation). Most interestingly, Kevin Schwartz, a partner at Paine & Partners, spoke on a panel several weeks ago at a New York investment forum, indicating continued interest in the sector.

Holding up a full takeover, however, is 19.8% shareholder Pacific Andes, a Hong Kong-based seafood wholesaler, which bought its stake from Tasmanian agricultural group Webster in late 2010 at $1.79 per share. Pacific Andes, which also owns most of Singapore-listed China Fishery Group, plus plant and vessels in Peru, could use controversial 3% creep provisions within the Corporations Act to buy more of Tassal at current levels.

More importantly, strong salmon supply figures out of Norway and Chile are hurting takeover chances, as additional production could eat into margins. Until this supply glut eases, value-conscious private equity owners may just wait in the wings. Personal investors wanting to take advantage of Tassal's already cheap value may therefore be in for a wait as well.

Nonetheless, with currencies in a volatile flux (and not just the AUD/USD, but also the NOK/USD), plus much higher fish prices being the clear long-term trend, both on reduced global supply and growing Asian demand, the long-term picture is bright in my estimation. Tassal, which is regarded as a leader in sustainable practices, has furthermore given additional incentive to invest in the form of a 4 cent (unfranked) interim dividend. Broker consensus is that another 4 cent unfranked dividend will be declared for the June period this year, which implies a 6.18% yield based on current prices.

On the topic of broker consensus, I believe that the company's target price at $1.39 is too low, however, considering the macroeconomic picture for fisheries and the Australian dollar as I see it. Using a simple Graham-Dodd PE valuation, if Tassal's earnings were to be valued at industry averages, the company's stock would be worth at least $1.93 based on 2012 forecasts.

Ultimately, whether it earns capital growth in a period of weeks, months, or years, investors would be wise to be exposed to agriculture as a thematic. As I wrote on February 20 (see An Emerging Opportunity), rising oil prices and consumer price inflation in China bode for another bout of 'agflation', as they did when we last witnessed a food price spike in 2008 and 2010 – the latter spike contributing directly to the events of the so-called Arab Spring.

Aquaculture is only one small part of that dynamic, but with the world potentially "fishing down the food chain" – the theory that large predators are first overfished, followed by forage fish, followed by, eventually, things like shrimp and plankton – farmed and sustainably caught fish like those produced by Tassal and Clean Seas will not only outperform, but provide a much-needed solution to an ecological catastrophe.

An investment in Tassal may take at least six months to be rewarded in terms of price appreciation, but at current levels I see downside minimised and further see a 12-month price target of $1.80 as being well within the realms of reason. Even adjusting for the glacial speed at which private equity firms operate, I would not be surprised to see a bid launched before that time as well.