High Liner Foods (HLF CN) as Long Potential?

Catching a falling knife, or not?

We are posting the following idea in search for some feedback.  After doing a review of the company, it appears to be an interesting situation with unique risk-reward.  It appears that the assets are not yet trading at distressed levels. It is an old roll up (naturally a negative connotation) that has stumbled and we’ve laid out the case long and short for the equity.

Opportunity

High Liner Foods (HLF CN) – Leading North American processor and marketer of value added frozen seafood including breaded and battered products

o    #1 in Canada with +50% market share

o    Estimated #2 in US in retail value added seafood products

-         The company has been punished in recent months (down 44% YoY and down 58% since November 2016) due to:

o    Declining demand in breaded and battered food products which has been an ongoing phenomenon in the past few years (shift to healthier foods)

o    A voluntary one-time product recall last year had severe impacts in 2017 due to a supplier fault (which resulted in $13.5M of loss in 2017) and resulted in operational inefficiencies

o    Residual negative impacts on supply chain management from closure of one of the company’s four facilities in 2016

-          The overall industry has been struggling over the last few years (despite the company outpacing the industry, it has been hurt by the negative trend in breaded and battered demand)

-         The decline, however, has abated (from (10%) decline last year going to (2%)- 0% decline this year for industry) and the company achieved organic growth of ~0.5% in Q1/18 after years of decline.

-          The company last year completed a $107M acquisition in Rubicon (frozen shrimp business) which diversifies its product portfolio away from breaded and battered products and can add over $235M of revenue and $16M in EBITDA

o    Rubicon had a slow Q1/18, recording revenues of $42M and $1.1M in EBITDA

-          Company recently hired a new CEO (Rod Hepponstall) on May 1, 2018, filling the vacancy created by the departure of the former CEO in who left in August 2017.

o    He has extensive packaged food industry experience including 25 years in the North American food industry, most recently at Lamb-Weston, a leading producer, distributor, and marketer of value-add frozen potato products.

-         As operations normalize following recall issues, plant consolidations and supply chain optimizations, stock has near-term potential to be re-rated to 11x 2018 EBITDA vs. current 9.1x, and potentially run up to share price of $16.50 or higher (historically traded in low-$20s for majority of 2013-late 2016)

o    Majority of efforts seem to be underway/recently achieved and will likely be reflected in the coming quarter

Long Thesis

-          Decline in breaded and battered industry is believed to be normalizing

o    Decline has abated from (10%) last year and going to (2%)-0% this year

-          Return to more normalized production levels expected following a few quarters of negative impacts from product recalls and transition from closure of under-performing New Bedford facility

o    Supply chain optimization initiatives include elimination of unprofitable SKUs, full transfer of New Bedford facility to the VA and NS facilities and other supply chain managements

o    Expected to increase margins from 3% in 2017 and 3.2% in Q1/18 to 8% (and 9% in bull case)

-          Market leader with brand name recognition in Canada and US

-          Highly aligned board members with ~35% ownership (have owned for years)

o    David Henningar (Vice Chairman; Director since 1984) is Executive Chairman of Thornridge which owns 34.5% of HLF.

-          Appointment of a new CEO with extensive packaged food industry experience after the departure of the former CEO almost a year ago. 

-          Product diversification resulting from the acquisition of Rubicon Resources and initiatives to introduce new products

o    Integration mostly completed and starting to have positive impacts in 2018

o    New product line introduced in May in Canada is receiving positive reviews and impacts became noticeable in Q1/2018 (lent period) and are expected to continue

-          Higher revenue/pound as HLF moves to higher quality products in recent quarters has helped improve margins – expected to continue

-          History of successful deleveraging following acquisitions

o    Completed 5 acquisitions in the last 10 years (excluding Rubicon), all followed by significant de-leveraging within 4 quarters

o    Current leverage ratio is 5.5x due to Rubicon acquisition

-          Company has returned to YoY organic growth by latter part of 2017 and Q1/18, driven by product diversification/new offerings, increasing manufacturing and supply chain efficiency, and easier YoY comps

-          Attractive dividend yield of 5.4% with a sustainable payout ratio (cash flow): <20% in 2016 & 2017

o    18% dividend CAGR in the last 11 years and mgmt considering a small increase for 2018

o    Mgmt expectation of potential dividend raise in 2018

-          Company announced in January 2018 that they will be repurchasing and cancelling common share (up to 0.78% of the float) throughout 2018

-          Trading near 12-month low and wide multiple gap vs. peers (HLF: 8.7x EV/’19 EBITDA vs. Peer Avg. of 11.9x)

o    Historical trading range of 7.5x-11.5x forward EBITDA for HLF

-          Strong cash flow profile – The company generates substantial free cash flow ($63M in 2016, $65M in 2015, and expected to rise significantly in 2018 and 2019 vs cash burn in 2017).

o    Generated $8.9M cash from operations and net $406k in Q1/18

-          Company uses cash flow to deleverage and pay dividends, as it has minimal capex (~$20M expected in 2018 and 2019)  

Key Risks to Long Thesis

-          Struggling restaurant environment in the US and uncertain retail environment induced by entry of AMZN (via Wholefood acquisitions) – Can reduce HLF negotiating leverage and be a headwind.

-          If declining demand for frozen foods, especially in breaded and battered products turns permanent

o    However, the drastic declines in the last few years have resulted in a much-reduced industry base where further significant decline is less likely

-          Residual impact from product recall – experienced losses throughout 2017 but reported none in Q1/2018

o    There is the possibility that current recalls may continue, or new ones might arise

-          Longer than expected timeline in achieving supply chain improvements and manufacturing optimizations or additional unexpected recalls

-          CEO turnover so quickly isn’t a good sign

o    This risk may be mitigated by Henry Demone being Chairman of the Board

-          Management generally has less experience with non-value-added products (where they are diversifying to)

o    Value added-products were 67% and are now 50% of total revenue post-acquisition

-          Slower than-expected integration of the Rubicon acquisition (which has limited cost synergies – a big part of prior acquisitions)

-          Slower than-expected deleveraging driven by rise in inventory levels following recent setbacks

-          FCF will be smaller in for 2018 than in 2015 and 2016, due to operational issues mentioned and due to inventory build-up post recalls

-          Weak recent track record of meeting street expectations – Missed 7 of last 10 revenue and 8 of the last 10 earnings expectations

o    Some of the recent misses have been close, and large ones were driven by unexpected events

-         Lost sales from large retailers moving non-value added products to private labels – Sam’s Club announced they were making that switch with shrimp and other retailers could follow