Omega Protein: Why The Short Case Is Flawed

| About: Omega Protein (OME)
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Introduction

Omega Protein (NYSE:OME) stock took quite a dive on Thursday, plunging over 12% at the close. The company issued news release a day before about settling a long-running legal case with the EPA for $5.5 million, to which market reaction was generally positive. The apparent catalyst was a short case presented by an unnamed analyst succinctly identified as "LongShort 101", whose profile says that he works for a hedge fund. The only clues left are a picture of a young man in front what appears to be a Mao mausoleum and a prior similar article trashing USANA, whose price more than doubled since its publication. Not only do I disagree with the analyst, but I take offense to the analysts' anonymity as the article bore hallmark of a "hit-and-run" attack. There is a good possibility that the author has already covered his short position as his "facts" do not hold up to scrutiny. I have great respect for short sellers such as Jim Chanos, David Einhorn, or Bill Akcman regardless of my agreement with their conclusions because they are always transparent and never anonymous.

I know the company well, having been on and off investor for a couple of years, and recently had a chance to discuss the company prospects with its management. Omega is indeed a very volatile business with many moving parts, which present a big upside, but also carry a significant downside due to many factors outside of its control.

My article will not go over Omega Protein business in detail but instead will evaluate every explosive claim made in the "short" case article one-by-one.

Claim 1: Fish meal and fish oil price increase is temporary: it's bound to collapse.

Truth: The price has been steadily rising for many years.

The article correctly identifies animal feed fish meal as the main driver of Omega's revenue (72%) and profit (probably about 63%) in 2012. The other byproduct of fish catch, fish oil, which represents 19% of its revenue, is used in aquiculture. Omega is trying to grow its higher margin human nutrition business, which should reach double percentage digits this year.

If you read the article, you would think that the fish meal price spike occurred after October last year Peruvian government imposed a 68% quote cut. In reality, the fish meal production has been declining for seven years with Peru share staying steady at about 30% of overall production. This steady decline in supply is solely responsible for prices trending up as the demand has increased. Only soy meal being a partial substitute for fish meal prevented prices from going through the roof.

Chart 1: Soy oil and fish oil prices (Source: FAO Global Food Outlook)

Chart 2: Fish meal production (Source: The International Fishmeal and Fish Oil Organization)

Chart 3: Fish Meal Price (Source: ISTA Mielke GmbH, Oil World)

The price appreciation is clearly secular and is likely to continue in excess of the inflation for years unless a new fish meal substitute is found.

Claim 2: Peru fishing industry fell victim to "bad science". There is no overfishing of anchovies and Peru fishing restrictions will be lifted this year and the catch will fully recover in 2014.

Truth: While there is no consensus why the fish stock collapsed in 2012, the fish population may not fully recover for many years just like it happened in 1972.

There is a heated debate in Peru academic and business circles of whether Peru anchovy's population collapse is result of overfishing, change in the currents which drove the fish schools to different waters, or some other factors. I suggest a simple Google search on "Peru anchovies collapse" to find links to various opinions.

However, I am a big believer that the past is a good indicator of the future. I found this interesting quote (http://www.cotf.edu/ete/modules/elnino/crbiosphere.html):

The failure of the anchovy harvest in 1972 was blamed on El Niño, but overfishing had also played a part. Harvests prior to 1972 had been over the 9.5 million tons that fishery experts had estimated as the sustainable limit for the fishery (NOAA, 1997).

Chart 4: Anchovies collapse in the 70s (Source: FAO 2001)

Regardless of the actual cause, it took many years before the anchovy's population fully recovered which may or may not be the case this time.

Claim 3: Omega's labor price are about to skyrocket because of a lack of H2B visas.

Truth: Availability of H2B visas is only a minor factor in labor costs.

The author referred to these paragraphs from 2013 Q1 10Q filing when he calculated that additional costs will eat up 22% of EBITDA. However, he conveniently ignored the paragraph in bold regarding recent years and referred to old data from 2005 and 2006 instead:

Omega Protein's business is dependent on its ability to recruit, train and retain qualified marine personnel in sufficient numbers such as vessel captains, vessel engineers and other crewmembers. Omega Protein has experienced difficulty in recent years in recruiting its optimal number of employees

Omega Protein had historically utilized workers in the United States H2B Visa Program whereby foreign nationals are permitted to enter the United States temporarily and engage in seasonal, non-agricultural employment. The Company did not utilize that program from 2008 through 2010 due to the small number of employees available under the program. Omega Protein was able to utilize the program again for the 2011 and 2012 fishing seasons. Omega Protein made application relating to the H2B Visa Program for 2013 but its application was denied by the U.S. Department of Labor. Omega Protein has re-applied for the 2013 fishing season but cannot predict the outcome of the application process.

The true impact of the price differential of H2B workers and domestic workers is hard to isolate from other factors on the financial statements as their costs are included in "cost of revenue" along with other factors. The casual observation does not show any correlation between gross margins and guest workers availability:

Gross margin without H2B workers: 2008 - 31%, 2009 - 13%, 2010 - 38%

Gross margin with H2B workers: 2011 - 30%, 2012 - 25%

Finally, the author made an outright wild claim that an American worker on a ship would costs $35,000 a year when a fishing season is only 6 months (mid-April to mid-October). My estimate that an average hourly rate is only $13 an hour. Even if we assume that an American worker will ask for a 50% premium, it would only work out to about $20,000 a year. The difference to EBITDA would be only $2.2 million (348 workers * $6.5 * 1000 hours). I am still at a loss how he arrived at $8 million in extra costs.

Claim 4: Virginia has severally restricted the fishing quota which will hit hard Omega's fish catch.

Truth: The restriction was minor and the business impact is barely material

Virginia is responsible for about 33% of the overall catch. The new quota system allows Omega to catch only 80% of the average catch of the prior two years. This works out to about 6% reduction in revenue. In response to this new quota, Omega idled one of its Virginia eight ships thus saving on fixed costs. Realistically speaking, the catches in 2011 (602 thousand tons) and 2012 (578) were exceptional, well above 458 to 473 thousand tons prior four year range so the quota may have no impact at all.

Claim 5: All stars aligned for Omega in Q1 to produce a great quarter which will never be repeated.

Truth: Omega faced significant headwinds in Q1 resulting in unusually low gross margins

The fish yield, which is the amount of oil and fish meal produced from gross weight of the caught fish (the rest is water), was unusually low in 2012 (33.6%). The normal range in prior four years was 34.5% to 39%. The science explaining the amount of water in fish is imprecise. The scientists speculate that it depends on random factors such as average water temperature, fish nutrition, and current patterns. Should the fish yield return back to the average 37%, it would immediately add 3.4% to gross margins increasing EBITDA by 10-20%!

Conclusion:

The short case of Omega is resting on grossly exaggerated and inaccurate claims. I realize that Omega is a high risk/high reward investment requiring patience to tolerate quarter over quarter volatility. However, the long term fundamentals of this business are very attractive as the supply is constricted and the demand is growing and the prices for fish meal and fish oil have nowhere to go but up long-term.

Disclosure: I am long OME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.