When you think of Australia’s agricultural boom, you probably imagine fields of cattle or wheat. But there’s another ag boom happening underwater.
The story follows a familiar line: As the world population grows – and grows richer – demand for high-protein diets has been rising. Demand for meat and seafood, especially in China, has been increasing at rates well above population growth.
In 2012, China became the world's largest seafood market, having overtaken the US and Europe. Seafood demand in the region has grown substantially over the past few decades, with per capita fish consumption increasing at 6% a year since 1990, according to a 2013 World Bank study. China now accounts for around 35% of global fish consumption.
Supply increase offsets demand
De Costi acquisition makes sense
Net profit overstates reality; Sell
And so, the theory goes, all this demand in China must be good news for Tassal, Australia’s largest aquaculture company. Right?
Analysts and the media love to project demand. It’s unknowable so you can fantasise about it as optimistically as you want. Demand forecasts make good stories.
But ballooning demand is only one side of the equation – there has also been a ballooning supply of fish farmers.
In 1960, global aquaculture produced around 1.6 million tonnes of seafood. Today, the industry produces around 90 million tonnes, roughly matching the wild catch. In China, aquaculture has been growing so fast that it now represents more than 70% of local fish production. Despite consuming a third of the global catch, China is actually a net exporter of fish.
The massive growth of the world's salmon aquaculture industry – which the UN Food and Agriculture Organization predicts will double again over the next decade – has almost perfectly offset the growth in demand.
As a result, the farmed salmon export price (in Aussie dollars), is no higher today than it was in 2000 – which means, in real terms, it has actually been falling. And despite producing a good 40,000 tonnes of salmon a year, Australia is still a net importer.
This is why it’s dangerous to throw Tassal in with beef and grain producers when talking of any global agriculture boom. Revenue has grown at an annual clip of 7% or so over the past five years, but that's due to increasing domestic fish consumption far more than it is the hungry mouths in China.
Tassal has actually been steadily withdrawing from the international market and its strategy is increasingly focused on higher margin domestic retail sales, which account for around three-quarters of total sales.
You’d think it would be fairly difficult to make one fish on the shelf stand out over another, but Tassal has done a commendable job of building brand loyalty. You can see that loyalty in its most recent sales figures.
Retail revenue grew 7.7% compared to volume growth of 6.5%, implying the company was able to push through price increases. That isn’t remarkable until it hits you that the company’s main customers are Woolworths and Coles, which buy in bulk and exert tremendous power at the negotiating table. Tassal’s brand recognition and distribution network gives it the muscle to push back.
De Costi acquisition
The company’s retail capability is stronger now than ever. In mid 2015 Tassal purchased De Costi Seafoods, which ‘has access to the best seafood range, a strong capability to process a wide variety of seafood, market leading seafood expertise, and a central location that enables it to service retailers down the east coast of Australia and south Australia’, said chairman Allan McCallum.
There’s plenty to like about the deal. For one thing, it expands Tassal’s addressable market to the $4.3bn Australians spend on seafood annually, rather than the $700m salmon market.
The price also seemed pretty reasonable. The company made a $50m upfront payment with the potential for growth-based earn-outs, or about five times De Costi's earnings before interest, tax, depreciation and amortisation (EBITDA) of $10m. Tassal itself trades on an enterprise value to EBITDA ratio of around eight.
But the real value in the De Costi acquisition is that it strengthens Tassal’s position as the lead distributor on the east coast and with that comes immediate access to customers in a highly competitive market and added bargaining power.
It’s no surprise then that Tassal recently extended its supply agreement with Woolworths for a further three years via the De Costi network and formed a new alliance with Aldi, which will replace De Costi’s use of imported salmon with locally grown fish.
In a traditional supply chain, every step involves a mark-up so the reseller can earn a profit. By progressively expanding up and down the aquaculture value chain, Tassal has eliminated the ‘middle man,’ allowing it to keep a larger slice of the pie – which is why the company's operating margin has increased from 7% in 2005 to 24% today.
Raising price guide
We’re increasing our recommended Buy price from $1.50 to $2.50 to reflect the growing business and a better outlook due to the increasing shift towards high-margin retail sales. We’re also raising the Sell price from $2.30 to $3.50, which would put the stock on a price-earnings ratio of around ten.
That may seem like an unusually low threshold, but we’re mindful that Tassal's accounting isn't conventional.
Tassal has reported $256m in pre-tax profits over the past 5 years, with an associated tax bill of $73m. However, the company has only handed $7.5m in actual cash taxes to the ATO. The rest of the taxes have been accumulating as a ‘deferred tax liability’.
This is because much of Tassal’s profit growth has come from an increase in the value of its ‘biological assets’ (ie fish in the pond), which are recorded at fair value on the balance sheet. Taxes accrue along with the revaluations, but are only paid once the fish is sold.
This accounting makes sense – there's a big difference between the value of an egg and a mature fish. However, there's also a big difference between the value of a fish on the balance sheet and cash in the hands of shareholders – especially given the threat that sea temperature spikes or disease can lead to widespread fish deaths and asset write-downs.
Revaluing its fish before they're sold makes for a more accurate balance sheet but also means that statutory profit consistently overstates economic reality while the business is growing. So if we can’t rely on statutory net profit, what's Tassal actually earning?
After adjusting for the $21m change in value of biological assets and the $6.4m of associated taxes, we reach an underlying profit of $35m in 2015 – well below the statutory profit of $50m. This alone ups the stock's underlying PER to 20 and reduces return on equity to around 10%.
On a free cash flow basis the picture looks even bleaker, with the business only producing around $6m in free cash flow available to shareholders. One year doesn't mean much, but over 10 years free cash flow still only came to $14m cumulatively. Tassal has paid $70m in dividends over that time, but also had a $67m capital raising. So where have all the profits gone? They're swimming off the coast of Tasmania.
We'd much rather own businesses that throw off lots of cash, such as GBST or Carsales.com (both on our Buy list). However, while Tassal is a cash hog, it is reinvesting profits at decent rates of return and has compounded tangible book value at 10% a year over the past five years. Given the risks associated with weather and disease, combined with Tassal's modest free cash flow and returns on capital, we’d only consider buying the stock if it were trading below book value per share of $2.54.
With Tassal’s share price nearly double that, and up 28% since Don’t get hooked on Tassal from 30 Sep 14 (Sell – $3.54), we’re sticking with SELL.