|Shares Out. (in M):||49||P/E||20||17|
|Market Cap (in $M):||2,557||P/FCF||25||16|
|Net Debt (in $M):||44||EBIT||0||0|
|TEV (in $M):||2,601||TEV/EBIT||0||0|
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Bakkafrost – new to VIC – is the state-of-the-art vertically integrated salmon farmer. With its whole operation based in the Faroe Islands the company benefits from a location advantage which translates into unparalleled economics despite being a relatively small industry player. The central points of the thesis are:
- Structural future mid-to-high single digit demand growth for salmon – historically at 7-8% CAGR since the beginning of the new century. Two main trends taking place.
(1) Demographic as a result of both population growth and rising income levels in emerging economies resulting in increasing penetration of protein per capita
(2) Healthier lifestyles translate into salmon taking share over other protein-rich options as pork, beef or chicken as salmon benefits from better nutritional value, more efficient production – feed to output – and less environmental impact.
- Long-lasting supply constraints that are unlikely to move away
(1) Wild salmon capture has stagnated amid fish pool depletion and regulation, with the supply growth essentially coming from aquaculture
(2) Only a few areas in the world meet the climate, biological and infrastructure conditions for salmon farming – Norway and Chile have historically comprised more than 70% of global supply.
(3) There is a biological limit in each of these areas beyond which the biomass faces disease and exponential mortality rates as a result
(4) Alternative farming methods as offshore and land farming have insofar proven to be respectively inconsistent and uneconomic at scale
- The Faroes are a remote archipelago that confers non-replicable advantages for farming
(1) Optimal water temperature, strong currents, market structure and regulatory environment minimize biological risk
(2) Comparatively low biological risk turns into reduced mortality rates and higher weight per fish, making the Faroese salmon farming economics the most attractive in the world in terms of predictability and unitary costs and revenues
(3) Autonomous out-of-the-radar region unlikely to confront trade restrictions
- As the largest player in the region by far in both volumes and number of licenses Bakkafrost benefits from additional advantages
(1) Full vertical integration in one of the few situations where it makes sense – increased quality, efficiency & raw material availability
(2) Regin Jacobsen is an honest, prudent and passionate owner-operator who inherited the business from his father – 1968 founder – and has been running it for three decades. Regin and his mother own almost one-fifth of the company together. Ah! And if you are worried about succession plans bear in mind that Regin is just 52! This is the magic of early promotion in a family business.
- I think the valuation is undemanding given the quality of the company and management and the current long-term investment program that will notably reduce bio risk and increase capacity by 2023 – up to ~76,000 tones from ~54,000 2017 tones. Potential reasons for cheapness are:
(1) Underfollowed Oslo-listed Faroese company that thus reports in DKK – the local currency as Faroes is an autonomous country within the Kingdom of Denmark jurisdiction – and trades in NOK. This set-up is unconventional.
(2) The market is extrapolating current weak volumes at Bakkafrost and projecting them into the future
The thesis is two-fold: (i) global supply volume will not outpace demand to a level that makes prices unsustainable and (ii) Bakkafrost will deliver on its 2023 76,000-ton plan.
For a quick understanding of the industry dynamics I avidly recommend reading Biffins write-ups on Marine Harvest or Austevoll. In the same fashion that Bakkafrost gets a great fish output for its feed input, you will get a good understanding on the industry dynamics in exchange for a little time reading. For those who want to get deeper I think Marine Harvest’s Annual Industry Handbook is fantastic.
On the demand side salmon is well positioned to capitalize on the increasing consumption of proteins. Some data.
- Salmon consumption worldwide has unevenly grown by ~6% CAGR for the last decade, with developed economies growing low to mid-single digit – 4%US, 4% EU, 1% Japan – and emerging economies high double-digit with Brazil and SE Asia in-China at ~20%.
- Emerging markets higher rates are simply the result of both their populations and per capita consumption growing faster. Who wants to cope with 7-day-a-week rice-only meals once the wallet allows for a healthier and tastier mix? As a premium product salmon is one of the last to get into the mix. As a data point each European or American consumes 2 and 1.35 salmon Kg per year respectively for only 70 grams of its Chinese peers – 28 and 19 times!. We are at a very early stage in Asia, Africa and South America.
- Compared to its land-based protein-rich rivals – chicken, beef and pork – salmon has the best feed-conversion-ratio (# kg of feed used to produce one kg of output) and edible yield (edible meat divided by body weight), a consequence of the cold-blooded nature of salmon that prevents it from using body-heating energy. The thing is that every year the humankind eats 118 million tons of pork, 118 of chicken and 70 of beef for only 1.4 of salmon. I think salmon might gain a bit of weight in the mix benefiting from the shift to healthier, more efficient and environmentally friendly foods. On top of it salmon has become relatively cheaper over the years vs. the other protein options.
As these trends perpetuate – i.e. global population is estimated to grow up to 9.8B from the current 7.6B by 2050, unstoppable rising disposable incomes in China and emerging markets, and more awareness of the benefits of salmon– the most likely outcome is that long-term demand attains at least the 6% CAGR that it has achieved insofar for the last ten years or even the 7% since 2000 if one wants to be more optimistic. Some industry sources conservatively estimate LSD ~4% from 2018-23, yet I think long term growth will be a bit higher as soon as the wealth effects provokes salmon to consistently kick in consumer feeding habits. You get the point. This is a GDP+ CAGR in any case.
On the supply side the picture is the following.
- Salmon comes essentially from either the wild or aquaculture. Virtually all future supply growth will come from the latter as wild caught has stagnated for years as a result of regulation aimed to prevent fish depletion.
- Very few places in the world are well suited for salmon farming as the sites should meet some conditions in terms of water temperature – optimally between 8 and 14 Celsius, currents – so the flows of water allow for free movement of fish, infrastructure and an adequate regulatory environment driven by political willingness to farm salmon. In other words, salmon can only be farmed within certain latitude bands. These requirements pose a hurdle which leaves very few places to farm salmon, namely Norway, Chile, Faroes, Scotland, Ireland, Eastern and Western Canada, Eastern Russia and Tasmania. There are massive geographical differences in production with Norway and Chile producing roughly half and one-quarter of total volumes respectively. Faroes contributes ~3%.
- Alternatives like full land-based and offshore farming have not proven that successful to date. Land farming is particularly interesting as it largely reduces transportation costs by placing facilities close to the main markets and/or labor costs by placing facilities in low-cost countries. The few academic studies I have read suffer from small-sample bias and are somehow inconclusive concerning its economic unviability.
However as the absence of evidence is not the same as evidence of absence, I can give you some facts. The largest inland project is being developed by Atlantic Sapphire, a public company. Atlantic has been operating a near 3,000-ton “commercial pilot” facility in Denmark since 2011 and is about to open a 90,000-ton Miami-based facility to serve the large US market. The company claims to be able to reduce costs in the new plant to 36 NOK/kg vs. the 53 NOK/kg that a traditional Norwegian farmer spends in producing salmon and sending it to the US. The 17 NOK/kg savings distribute amongst 1 NOK/kg in feed, 15 in “no-air-freight” cost and 6 in other opex, while depreciation and interest together are 5 NOK/kg higher.
I am skeptical of these projections though. For one I think management should address why they think that depreciation costs for an inland operator are only
Second, when it comes to shipping costs management does not mention that the US is a big country and the facility is in Miami, not in Kansas. It would help if they gave some detail on how they think of logistics and distribution costs for a perishable product to distant places with high consumption levels as California. Sure! It might be that these costs are already included in the 15 NOK/Kg freight savings but let me doubt it.
On top of this, the company has distributed its 90,000-ton full-ramp up plan in 3 phases – 10,000 tons in one year, 20,000 in 2023 and the remaining 60,000 for 2026. 8 years. The only in-company precedent is the Denmark Facility which incidentally is still loss-making after 7 years of operation. The company claims this facility is just a “successful innovation” premise. It is telling that after 7-years of “successful” R&D spending the new US project also includes a material R&D budget and that the company has already raised its initial capex estimates by $15m before the facility has started production. I think Atlantic makes for a good entrepreneurial story but I am unsure it will be able to operate at scale ever.
Even assuming a scenario where Atlantic’s plan works out and the company adds that capacity, what I doubt even more is that land-based farming gets wide adoption. Like conventional farming, land-based farming also requires certain natural conditions to thrive, especially massive availability of water. As inland geology essentially does not offer unlimited/cheap water and does not allow for easy salt-water discharge, land farming gets confined to a few coastal areas with good enough logistics and infrastructure and low enough labor and electricity costs. That is the reason for the Miami-based factory.
Independently of the Atlantic project there is a dismal record of land-based farming ventures, Niri being the most prominent of them. You can read more about the story on the three links below, but long story short Niri had the largest land tank to farm salmon back in 2016. The technology was all about cleaning and recirculating water. In 2017 the water was contaminated with detergent, forcing the plant to discontinue production and losing all the water in the process. 2018... Founder and CEO is gone and the plant is for sale.
To sum up I believe it is unrealistic to assume that significant capacity will easily come from the land-based side of the market. Some links.
Regarding offshore farming as a viable option its main problem is inconsistency - changing currents, water temperature, waves and weather conditions - and maintenance costs. Salmar was the first company to set an offshore project in 2017. It is a 12-month pilot project and we are at a very early stage. Salmar put 1m smolts into the “Ocean Farm”, so best case scenario is 5,000-6,000 tons of additional capacity from the project. Salmar also got greenlight on new licenses to test a new concept to address the challenges high waves pose. While offshore farming might add capacity to move the needle at some point in the future as R&D seems to move in the right direction and higher salmon prices bode well for a higher cost base, it is difficult for me to think that it will happen anytime soon. Find some links on the project.
Salmon farming is exposed to biological risk - mainly diseases like ISA and algae - and Chile represents the “low-probability” high-impact event to restrain supply growth.
Although there is always a random non-controllable component biological risk is strongly linked to the regulatory environment, the number of players in each market, the technical development and the geographical nature of each farming site. The Faroes have arguably the lowest biological risk in the world. When biological risk materializes at scale it tends to do so by generating significant supply shortages as it happened in Chile after its waters were hit by the ISA virus. To give some context on the catastrophe, the first ISA case happened in 2007 and most industry actors dismissed it initially as unimportant. As the Chilean industry is very fragmented and lacked proper regulation the initial ISA outbreak soon combined with other diseases and production issues. The result was that compared to the peak production levels in 2008, supply contracted by 40 and 70% in 2009 and 2010 respectively and did not recover to previous levels till 2013.
While the regulatory environment has significantly improved– i.e. public-private cooperation, setting disease reporting standards, fish density per license requirements, specific rules for egg and smolt control, etc. – this is a necessary condition for risk reduction but not a sufficient one. The thing is that even after the crisis the market did not fully consolidate at all, with 30+ Chilean farmers in operation and the top10 just accounting for half of the production. Compare that with only 3 farming companies in Faroe and Bakkafrost comprising most of the volume.
Chile is simply the salmon version for the Tragedy of the commons, where the decisions of even the smaller players might have an enormous impact on the entire system. Incidentally, the Faroes were like Chile before 2003, with many actors and little regulation. After disease stroke in the islands, on top of stricter regulations the market eventually consolidated to 3 players, translating into closer cooperation between the companies and the government. Chile is certainly one out-of-the-money put option on global supply growth. Tail events are generally poorly priced.
- Supply from Atlantic salmon has grown by ~5% on the last decade, with significant variations per year. For example, global supply shrank 4% in 2010 following the misfortunes in Chile but expanded 22% in 2010. The main cause of these swings is that salmon has long production cycles, in the sense that it takes up to three years to grow salmon till it reaches an optimal size for harvesting, thus making it impossible to quickly bring new capacity online to meet demand. The table below shows supply growth estimates by Kontali, the leading research house on aquaculture in general and salmon in particular.
For the reasons I exposed above – few available places for conventional farming, unconventional methods still to prove at scale and Chilean risk –I think long-term supply will not outpace historical levels sitting at ~4-5% CAGR, a less conservative estimate for the thesis than Kontali’s 3%. ~4-5% is still well below what most industry sources heuristically consider the 7-8% long-term level where demand can safely absorb with no major impact on price. Prices have generally reacted more on the upside – especially when prices are particularly at low levels as in 2012 – under supply shocks than on the downside out of excess capacity. I think the numbers and graph below are a good indicator of that fact at a global level as there is strong correlation between salmon prices in Oslo and other markets.
As the best place in the world to farm salmon from any angle, the Faroes provide Bakkafrost with unique advantages on both cost and revenues. These advantages mostly derive from the fact that Faroese salmon average unit weight at harvest sits >5Kg, above the 4-5Kg industry average.
- Larger salmons have historically traded at a ~5-10% premium per kg as a sign of fish health and origin
- Costs per Kg decline with increasing harvest weight as economies of scale are present at all opex levels
Yes…. Sure… but why is the average weight higher in the Faroes?
(1) Location provides a biological advantage – Stable water temperatures, strong currents and separation between fiords translate into lower disease strikes and mortality levels, which in turn translate into higher average size as there are fewer cases of early removal to harvest. Steady water temperatures are particularly relevant – freezing kills the animal, too cold curbs growth and too warm accelerates growth but increases risk of epidemy. Faroese water temperature band is optimal and translates into lower feed conversion ratios.
(2) Regulation and market structure additionally reduce biological risk – The 3 industry players in the region (Bakkafrost, Marine Harvest and Luna) are in close contact amongst themselves and with the government. From 2001 to 2004 Faroes were badly struck by ISA and the government reacted by passing the “New Veterinary Model” in 2003 which has resulted in one of the most predictable production environments in the world with reduced mortality and feed-conversion ratios and higher growth rates. Look at the structural shift since 2003.
In addition to the apparent advantages that location, regulation and cooperation provide, as an out-of-international-politics nation the Faroes are less likely to confront trade issues as embargoes, quotas or sanctions from other countries. Norway is at the other side of the spectrum as its relations with China have always been sort of tense. Licenses in the Feroes are automatically renewed every 12 years so in fact are permanent in practice and there is no limit on MBA – maximum allowed biomass per farming site. It is not surprising that the 3 Faroese farmers benefit from an operating margin advantage vs. its peers in other areas.
Given the remarkable advantage that operating in the Feroes provides it seems obvious that Bakkafrost should have superior margins, which seems validated by the following table (I exclude the weaker and mostly unprofitable Chilean operators).
The fact that Marine Harvest has a small operation in the Faroes is irrelevant for the case - it represents less than 3% of its sales - as it is the fact that Marine, Leroy and Salmar’s annual volumes are 8, 3, 3x respectively those of Bakkafrost. Size is not a big factor on margins. Location is. It certainly feels like Bakkafrost is the best, most profitable company. Alternative sensible explanations to higher profitability though are (1) vertical integration inflates margins and (2) Bakkafrost is underinvesting in things like people.
(1) Like Bakkafrost, Marine-Leroy-Salmar-Grieg are vertically integrated in the sense that they all grow the smolts in their own hatcheries, farm the fish in their own nets, harvest and process the salmon in their own factories and reach the end customer through their own sales and distribution networks. Unlike Bakkafrost, Leroy-Salmar-Grieg source all their fish feed externally. Marine has a feed plant and is in the process of building a new one, yet with these two plants it will be able only to source its European operations leaving its Canadian and Chilean segments to external feed suppliers. Bakkafrost is in fact the only company that sources all its feed from its own integrated plant.
Why? One, the proximity of marine raw materials in the region makes it possible. Two, feed is critical to its model. While comp’s typical feed recipe only contains ~20% of marine raw materials (fishmeal and fish oil) with the rest consisting of non-marine ingredients (wheat, soy, etc.), marine comprises almost half of Bakkafrost recipe. While a higher marine index means higher raw material costs, the company benefits from healthier and thus larger fish with the impact in profitability I described. A higher Omega-3 component also makes for a better selling proposition.
As vertically integrated companies transform in profit centers what to non-integrated ones are input costs by eliminating the intermediary, vertical integration confers an inherent margin advantage. This is a fallacy though. As integration essentially means entering a new business and the need to deploy capital for it, it might be the case that while margins improve returns on capital for the new division and by extension for the whole company diminish. In assessing company profitability vs. peers it is easier to “fool” margins than ROCEs. The thing is that Bakkafrost also has superior returns on its capital, which seems validated by the fact that despite being more capital intensive as it brings a feed plant on its PP&E and larger fish on its biomass inventory, its asset and capital efficiency are not particularly lower than comps.
(2) Bakkafrost had ~960 full time equivalent employees (FTE) in 2017 YE with ~220 of them in the farming segment (hatcheries, farms and vessels) achieving 55K tones ready to harvest. 250 ton-per-farmer. Marine Harvest had 39 FTE in Faroes with 13K tone capacity for 333-ton-per-farmer. On top of it Bakkafrost employs 90 people on its feed plant and Marine 67 for a plant with notably more capacity… So it does not seem that Bakkafrost is underspending. In fact, quite the opposite.
The remarkable thing is that despite investing more in its payroll and in higher-marine content feed Bakkafrost’s margins and returns on capital have no rival. Its location and culture generate a virtuous circle: higher investment – larger and healthier fish – lower costs per kg – larger fish higher price per kg – brand loyalty – higher profitability – higher reinvestment capacity.
Path for growth
Since its 2010 IPO till 2017 Bakkafrost has grown sales, EBIT and CFO by 24, 28 and 33% respectively with no equity dilution and a low levered balance sheet – now (and historically) equity ratio stands ~70% and net debt-EBITDA Bakka will be a Faroe-only company for years to come.
Now that most vertical and horizontal inorganic growth has exhausted – i.e. Bakkafrost already sources its feed internally and regulation prevents Bakkafrost from acquiring licenses from the other two players – and the company has no plans to expand abroad a sensible question is what the growth story stands for now.
The investment plan
One of the main challenges in the farming industry is the bottleneck that biological risk means to the supply chain as there is a strong direct causality between such risk and the amount of time the fish spend on seawater. The more time the smolt spends in the hatcheries before being released into the ocean the lower the risk. The typical production cycle spans 30 months. The first 12 related to the freshwater stage with the smolt confined in the hatcheries till they each reach 100g or so, then released into seawater for additional 18 months until they are ready to harvest.
Interestingly Bakkafrost plan is all about debottlenecking the supply chain by reducing the time the fish spend on seawater and lengthening the freshwater stage till the smolt grow to 500 rather than 100g. This shift indeed reduces the overall production cycle as “exponential growth” math shortens more the seawater period than lengths the freshwater one. As the Faroese regulator does not impose a MAB – Maximum Allowed Biomass limit per license – by investing in capacity expansion at the hatchery and farming site levels Bakkafrost can increase seawater fish turnover and then expand its harvesting capacity without taking into higher biological risk. Central points for the 2018 updated plan.
- 3B DKK investment with 3/4th of that investment related to increase capacity and efficiency at the farming and smolt operations
- Harvesting levels of 76,000 tons in 2023 of vs. the current ~46,000 tons in 2018, so 10-11% volume CAGR
- Included in the 3B plan there are a biogas plant, an investment in an in-house broodstock operation and a new harvesting facility that will support brand by differentiation and will further diminish bio risk by reducing the dependency from external egg suppliers and increasing the waste and veterinary controls
Since the 2013 original plan till 2022 Bakkafrost will have invested ~5.3B with still ~3B to be invested. I guess you might be thinking that the 900 million for the original plan is an absurd underestimation of the final 5.3B total investment, but the thing is that the original plan contemplated a 65,000 ton capacity rather than the current 100,000 in the last update (despite harvesting might sit at 76,000 there will be still further 24,000 to be used if things develop smoothly to that point in terms of execution and biological control) and did not included things like the biogas plant, the centralization of several sites into one or the incremental expansion needs of the hatcheries to support at least 50% of additional harvesting capacity.
Bakkafrost released very weak Q3 volumes, down 38% YoY and 44% QoQ. In fact volumes are at the lowest level since 2011Q1 when it had not still acquired Havsbrun, which came with additional 5 farming licenses on top of the feed production facility. Furthermore current like-for-like volumes, as Bakkafrost operated just 16 licenses back then vs. the current 21 might be the lowest as a public company. The company has lowered the initial 51,000-ton volume guidance it had for 2018FY to 49,000 in Q2 and further to 46,000 in Q3 amid delays in opening the new harvesting factory till early 2019. On top of this 2017 and 2018 have been unusually bad years in terms of biology. In 2017 there was an ISA virus that made for accelerated harvesting. There were also abnormal levels of sea lice. And now in 2018 Q3 an algae problem has shown up resulting in the loss of half of the fish (still at smolt size) on a site. So in Q3 the lower volumes and the increased costs amid those volumes and the algae issue = Q3 Sales and operational EBIT down 23 and 33% YoY respectively.
I think however that these headwinds are temporary. On the algae problem, there are three conditions that need to be present so that the algae grow to a size that is a hazard for the fish. One, algae should be present in the fiord as it is in many Farose fiords. Two, prolonged good climate conditions generate lower currents. Three, algae must get food to grow. Condition one cannot be changed. It is nature and it is mostly permanent. Condition two is also nature but is unlikely to be as bad as it has been. But the most important one, condition three, is highly solvable. The thing is that some reckless cattle farmers have lately dropped fertilizers and other wastage into the water which has nourished the algae. Bakkafrost is currently addressing this issue in close cooperation with the authorities and the farmers. I guess that in a 50,000 people place – and that is for the entire 18-islands archipelago, not for each island! – it is not difficult to know who works on what and who did this or who did that… More importantly the incident did not expand – no issues detected at neighboring sites – and the remaining half of the fish in the fiord remained in good shape. The other 2017 main issue – the ISA case – seems to be just that, an isolated case that was quickly treated. All factors considered the company has guided for 53,000 tons in 2019 and keeps its compromise of 76,000 tones for 2023.
Reducing the case to a simple format we need three things to project into the future (1) revenues, (2) margins and (3) capital intensity.
- Volumes – 11% CAGR to deliver on the investment plan is realistic, given the abysmal 2017 levels and the debottlenecking of the supply chain.
- Price – The historical NOK/Kg graph below is just the reflection of sustained demand and structural supply constraints that have simply resulted in long-term upward trending prices. Short term fluctuations are very high as you might appreciate.