This is a refresh of our analysis on High Liner Foods (OTC:HLNFF), which was originally published in August 2017 (link). Our original thesis stated that the then-current stock price represented a buying opportunity for an undervalued dividend stock. With the release of the firm’s fiscal 2017 results, we maintain our buy rating on the stock, with some minor concerns related to plant efficiencies and US tax reform.
Note: All figures in US dollars unless indicated.
We will not reiterate the original company overview from August 2017; for a detailed description of the business, please refer to our previous article. However, to summarize the firm’s business:
High Liner is the leading North American processor and marketer of value-added (i.e. processed) frozen seafood, producing a wide range of products from breaded and battered items to seafood entr茅es, that are sold to North American food retailers and foodservice distributors. The retail channel includes grocery and club stores and their products are sold throughout the U.S., Canada and Mexico under the High Liner, Fisher Boy, Mirabel, Sea Cuisine and C. Wirthy & Co. labels. The foodservice channel includes sales of seafood that are usually eaten outside the home and our branded products are sold through distributors to restaurants and institutions under the High Liner, Icelandic Seafood and FPI labels. The Company is also a major supplier of private-label value-added frozen premium seafood products to North American food retailers and foodservice distributors.
Source: 2017 Management Discussion & Analysis (“MD&A”)
There were three key themes prevalent which had a material impact on the company’s profitability in 2017:
Product Recall. In April 2017, High Liner executed a voluntary recall of a small set of its products – specifically certain brands of breaded fish and seafood products – which may have contained a milk allergen which was not disclosed on the ingredient label. The net impact of the product recall was a net loss of $13.5 million. Rubicon Resources, LLC (“Rubicon”) Acquisition. In 2017, the firm completed its acquisition of Rubicon. This acquisition added $76 million and $70 million in short-term and long-term liabilities respectively. Moreover, as the acquisition was completed mid-year, the effective net income which may have been realized by the acquisition (i.e. revenue and cost of goods sold pertaining directly to the Rubicon business) were only effective as of June 1, 2017. In short: High Liner is demonstrating the “full-year impact” related to the costs of the acquisition, but only seven (7) months worth of net income from the acquisition. Manufacturing and Product Mix Inefficiencies. 2017 was the first year that the firm was not able to leverage its New Bedford scallop business, which was sold in 2016. The firm has indicated that the challenges associated with this loss of production manifested itself as “residual manufacturing challenges”, which resulted in the firm being unable to keep up with product demand. This was especially prevalent in the 2017 Lenten season and was further amplified by an inadequate product mix offered by the firm. Specifically, the demand for traditional breaded and battered frozen seafood products was not as high as expected; this was a risk called out in our previous analysis. Viewed from another perspective, the product mix that the firm was targeting did not meet actual consumer demand, and this had a negative impact on overall product availability: the firm was not manufacturing what the customers wanted. Fundamentals Review
Summary financial data for the past 11 years, F2007-F2017, is shown below. For the first five years of that period, all figures were reported in Canadian dollars. Starting in 2012; however, the company started reporting in US dollars. For the purposes of our analysis, we use the Bank of Canada end of year USD/CAD exchange rate when converting to comparable Canadian dollars; this is especially important when calculating payout ratios since the dividend is reported and paid in Canadian dollars, but the comparable earnings per share are reported in US dollars.
Source: Company financial statements. Calculations by Author.
From a balance sheet perspective, year over year there has been a drop in the current ratio and a rise in the net debt to equity ratio. Generally speaking, we like to see an increasing current ratio (implying more short-term assets than liabilities) and a decreasing debt to equity ratio (implying increasing equity relative to net debt). For 2017, High Liner took on an additional $70 million in debt through a senior secured loan to finance the Rubicon acquisition. In addition to this, accounts payable increased by $76 million, which was the fair value of the outstanding accounts payable from Rubicon’s balance sheet at the time of acquisition. However, even with this additional debt load, with a net debt to equity ratio of less than 1.50, we see no need for concern at this time.
When inspecting the financials for overall profitability, High Liner was able to break its three-year streak of decreasing revenues in 2017 – High Liner actually set a new 10-year record for itself, exceeding $1,053 million during the period. That said, even with increased revenues, margins have dropped year over year, as has total return on equity attributable to net income; total net income dropped from $33.0 million to $31.7 million from F2016 to F2017. The primary driver for the drop-in profitability has been “raw material cost increases that have not been passed on to customers” as well as the plant production inefficiencies and product mix challenges highlighted earlier. (Source: 2017 MD&A). These plant inefficiencies dovetail with decreased total asset turnover. This metric – which measures the ability of the firm to utilize assets to support sales – has been slowly declining year over year from its most recent peak in 2014 of 1.49x to the most recent figure of 1.16x. All things being equal, this metric tells us that the firm is not adequately using its resources to produce products for its customers.
Finally, when you examine the numbers further, it is evident that the Rubicon acquisition is what helped High Liner break its three-year losing streak on a purely sales volume (measured in pounds) metric:
One key concern is the effect of the US Tax Reform on High Liner’s net income. The effective tax rate for 2017 was -80.5%. When one examines the profitability of the firm before and after taxes, it becomes clear that the lion’s share of profitability for this period is due to tax credits on its income statement:
Source: Financial Statements. Calculations by Author.
Reviewing the gross profit margins, the firm had 17.7% gross profit in F2017 vs. 21.2% gross profit in F2016, and the respective earnings before taxes were 4.3% and 1.7% in F2016 and F2017 respectively. It is not until the tax credits are factored in that the overall profit margins begin to converge, where the F2017 profit margins more closely align with historical norms. However, the company has already called out that the headwinds, and as such, we expect gross profit margins to align more closely with the historical norms for F2018. All things being equal, if the company is able to do this, then the net profit margin in F2018 should align with the running average of 3.1% since F2013, even when no longer having a tax credit at its disposal.
Dividend and Valuation
When reviewing companies such as High Liner for consideration in a dividend portfolio, the key metrics to observer are EPS and the dividend itself.
In our previous analysis, the firm had exhibited 17.9% compounded annual growth in its dividend and 16.4% compounded annual growth in its share price. The dividend has continued to grow, and the compounded growth now sits at 18.9% over the same duration. The share price, as illustrated, has started to falter and now only exhibits an 11.9% compounded rate of growth as of the F2017 fiscal year end, and at the current price (C$10.91 as of March 8, 2018), only an 8.5% compounded annual growth rate over the same period.
Since the EPS low of 2012, the dividend payout ratio has consistently been in the 30-40% range. High Liner’s unofficial dividend policy states that “[a] payout of between 30% and 35% of trailing adjusted earnings per share is generally targeted, but no set dividend policy exists” (Source: 2017 Annual Information Form). The most recent fiscal year has a payout ratio of 46.1%. This in and of itself may warrant concern, except for the fact that the firm still increased its dividend by 66% between 2012 and 2013, even when the 2012 payout ratio was in excess of 250% of earnings.
When comparing the stock price to the theoretical Graham price, as of the end of 2017, the stock is trading at a 0.89x multiple, meaning that is undervalued relative to the Graham Price, with 12.5% upside potential. As of March 8, 2018, closing price of C$10.91, there is 53.0% upside potential. If anything, the stock would have to break the C$16.50 price before it could be considered even fair valued.
Whilst reviewing the Price-to-Equity and Price-to-Book metrics, we normally look for a P/E less than 15, a P/BV less than 1.5, or a combined ratio of less than 25.0. For the year ending F2017, the combined ratio came in at 17.8 which is close to historical lows. This reinforces the Graham Multiple of 0.89x in our previous graphs, which further demonstrates the undervalued aspect of this stock.
In summary, while dividend and share price growth have been impressive over the past 11 years, they pale when compared to last year. As of this writing, the stock yields 5.32%.
We still consider High Liner Foods a buy given its current market price; if anything, it would have to exceed C$16.50 before even being fairly valued using conventional metrics for valuing value stocks. Given that the company has been very forthright in identifying known headwinds and the company’s history of strong results after weak periods, we feel that High Liner will continue to perform in F2018. Moreover, with the re-appointment of Henry Demone as CEO – discussed in our 2017 analysis – we see little need for concern. The firm recently announced its Canadian COO was leaving the organization and there were no plans to replace that position. This in and of itself indicates that the company already has a strategy in mind for the rest of the year to improve its overall operations. Increased productivity, product mix realignment, and improved supply chain management should help to increase the asset turnover ratio, increase gross profit margin, and overall, increase EPS.
Appendix NOPAT: Net Operating Profit After-Tax, is defined as Net Income plus After-Tax Interest Expense less After Tax Interest Income Free Cash Flow: Cash Flow from Operations less Capital Expenditures Profit Margin: Net Income divided by Revenue Operating Profit Margin: Operating Income divided by Revenue
Disclosure: I am/we are long HLNFF.
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.
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