Omega Protein: Why EBITDA Is Set To Be Cut In Half

Jun. 6.13 | About: Omega Protein (OME)

The near doubling of the stock of Omega Protein (NYSE:OME), one of the last large-scale menhaden processors and fish meal producers remaining in the U.S., has come entirely as a result of fish meal supply reductions in Peru that we believe are entirely temporary and are abating as you read this. Versus the current share price of $10.70, we see potential downside to $6.35 on the basis of returning Peruvian supply and higher labor costs, with a potent additional catalyst available to drive the share price even lower.

The menhaden, a small, oily fish, is extracted in bulk by purse seine boats from the Atlantic and the Gulf Coast, and the entirety of the catch is then cooked, pressed to remove the oil, and subsequently dried and ground into fish meal. The meal, which comprises around 70% of the company's revenue, is used as a source of protein in feed for livestock, fish, and pets, while the oil is also sold as a feed ingredient but primarily for the aquaculture industry. Ignore the pictures of fish oil pills on the company's website and investor presentation: in 2012 the company's "human nutrition" segment made up less than 10% of Omega's total revenues. Rather, the company's oil and meal products are for the most part unrefined and fully commoditized products that are relatively fungible with other global sources of fish oil and meal, whether Scandinavian, Japanese, or, importantly, Peruvian - it is only the pure protein that matters to China, which thanks to its aquaculture industry is the largest consumer of fish meal globally (almost 40% of the Omega's revenue was generated by Chinese buyers in 2012).

Omega's stock is up more than 75% year-to-date. While the company has acquired an additional human nutrition business - oddly, a whey protein manufacturer in Wisconsin - the reality is that the gains to date have come entirely from one very simple thing: massively higher fish meal prices brought on by extreme government restrictions to the Peruvian anchovy catch, announced in October 2012. Peru's Ocean Institute (IMARPE) found last year that the anchovy biomass in Peru had fallen dramatically, resulting in widespread international press coverage and prompting President Ollanta Humala to announce to reporters last year that "the Peruvian anchovy is in danger of extinction." Production was subsequently cut 68% year-over-year. As Peru has recently accounted for roughly 30% of global fish meal supply, the cut was a huge boon to Omega Protein, which saw revenue rise 19% and gross profit 36% in Q1 2013 on the back of a 30% increase in global fish meal prices in the months following the implementation of the lower quota.

What investors are missing here is that the cuts were based on incorrect science and will likely prove only temporary: essentially, the government overreacted to bad data. The reality was that unusual climactic conditions caused by warm Kelvin waves drove anchovies to cold, deeper waters, which the government, according to Peruvian industry body the National Fisheries Society, misinterpreted as a severe reduction in the biomass due to overfishing, likely in part for political reasons. But the anchovies are now back in force, a fact which the government has evidently recognized. In April 2013 a second IMARPE study estimated anchovy biomass at 10.8 to 12.1 million tons, more than double the prior estimate of 5.3 million tons (versus a "sustainable" level of 6.0 million tons and an average level of around 7.4 million tons over the last 12 years). The new quota for the 1H'13 season is down only 24% year over year, and the director of Peru's top fish meal producer TASA stated in May that he expects the company's output to double and overall Peruvian production to return to normalized 2011 levels by 2014 (an increase of over 40% from anticipated 2013 production). Anticipating this higher output, prices have already begun to fall (despite the Peruvian fishing season having only just begun) - according to industry data, prices for standard Peruvian fish meal in Chinese ports are now down almost 10% from April, and with minimal buyer demand even at these lowered prices stocks are now accumulating in Peru.

On the basis of normalizing fish meal prices alone, then, the stock's recent rise should at least reverse itself over the next six months, but the company also faces two material additional risks that hold the potential for further downside. On the back of environmental concerns (given the importance of menhaden as prey for larger fish and birds), commercial menhaden fishing has been gradually banned in all Atlantic states but Virginia, which recently implemented a 20% reduction in the maximum legal allowable catch. Virginia has represented an average of 34% of the company's catch over the past five years. This reduction will harm not only the company's revenue but also its margins, as Omega experiences significant operating deleverage given its fixed fleet and plant costs. And the potential for further reductions looms large, especially given that neighboring North Carolina just completely banned commercial menhaden fishing in 2012.

Second, the company has historically been able to utilize foreign (largely Mexican) H2B Visa workers for temporary employment during the fishing season, but according to its 10-K the company's initial application for 2013 was denied by the U.S. Department of Labor. As of the filing of Omega's 10-Q on May 7 Omega's re-application had not yet been approved, and the company has already "embarked on a program to complement its workforce with non H2B Visa domestic workers." While Omega has not disclosed the dollar amount of its utilization of the program in 2012, according to a Freedom of Information Act request Omega Protein received 695 H2B visas for foreign workers in 2006 and 2007 at $12,000 per worker for the season. Given Omega spokesman Ben Landry's statement in reference to the program that "the average laborer, a young man, blue collar worker, can make an extraordinary rate in the oil and gas industry [in the Gulf] and it was something we weren't able to keep up with," if we assume a rate of $35,000 for 348 workers in 2012 (consistent with what the company pays in Virginia) that would represent an incremental $8 million in labor costs, which on its own would imply a 22% reduction to the $35.6M of adjusted EBITDA Omega reported in 2012.

With estimated 8% lower overall sales volume thanks to the Virginia restrictions, the noted $8M incremental labor costs, and a further drop in fish meal prices, we believe Omega's true normalized EBITDA to be approximately $23M (down 36% from 2012 levels), implying a fair value of $6.35 per share even at a healthy 5.5x EV/EBITDA multiple for what is in truth a no-to-low growth commodity business.

The bottom line is that at the current share price, the market is incorrectly extrapolating into the future the company's earnings power from an operating environment that was a pure and simple anomaly.

Disclosure: I am short OME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The firm I work for has a material short position in OME. We may change our views about, or investment positions in, OME at any time for any reason, including within the next 72 hours. This is not investment advice or a recommendation to buy or sell any securities, nor is it purporting to provide investment advice to anyone. The article is based only on publicly available information about OME and therefore could be incomplete. I make no representation or warranty, express or implied, as to the accuracy or completeness of the article. Readers should review the cited sources and other related materials and reach their own conclusions.