HQ Sustainable Maritime HQS W
November 10, 2008 - 10:25pm EST by
todd1123
2008 2009
Price: 3.80 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 46 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

As a follow-up to jon64’s write-up from December 2007 (price at the time of the long equity recommendation was ~$7.50 / share and peaked at $16 / share in July 2008), I am recommending a long equity position in HQ Sustainable Maritime (HQS) which presents a compelling near-term risk / reward proposition, with total return potential of >100% over the next 3 – 6 months (based on probability tree matrix further below). As you recall, HQS is a vertically integrated processor of tilapia and shrimp in China as well as production of marine bio-products and healthcare products (please refer to jon64’s posting to get a fuller description of the business). HQS is a high-quality company positioned in an attractive / high-growth industry with dominant positioning that trades for less than cash on its balance sheet (~$4.20 / share in net cash vs current share price of $3.80 / share) and approximately 50% of book value / share. Ultimately, given the cash balance (which the management team has recognized they will likely deploy some for the expansion of their production facilities / acquisitions), I believe you’re effectively creating the business for free (cash on balance sheet) and getting the earnings power of what I believe is >$1.00 / share in 09E (on current / standalone biz – w/ no growth spending) as a free call option.

Earlier this evening, HQS reported Q3 results that came in significantly ahead of my expectations. Revenue was up ~42% YoY and gross profit was up ~23% YoY. Not that we hang our hat on this figure, but EPS came in at 43 cents / share (vs Street expectations of 23 – 26 cents) and the relative quality of earnings (10-Q posted earlier this evening) was very good. Moreover, on the conference call, management provided clarity around new customer wins / longer-term growth plans that were encouraging.

While I don’t profess to be an expert re: the tilapia industry, I’m encouraged to see greater industry acceptance of / appetite for tilapia in the US (as witnessed via HQS new customer wins w/ large North American food chains) and think the margin of safety to the trade opportunity provides a compelling risk / reward (w/ minimal impairment risk and significant upside optionality). Moreover, given clarity around Q3 results (which were posted earlier this evening / followed by a mgmt call) which came in significantly above my expectations (43 cents of EPS for Q3 period), I feel more comfortable around the call option portion of the trade (earnings power on standalone biz / ramping of production should yield >$1.00 of earnings power).

VALUATION:

HQS currently trades for (i) a discount to cash on the balance sheet ($50MM of cash per Sep 08 10-Q posted earlier this evening / approx 12MM shares outstanding = approx $$4.20 / share) and (ii) trades for approximately 56% of book value ($81.2MM of book equity / 12MM shares = approx $6.75 / share of book value / share). Given the cash balance, the underlying earnings power of the business (approximately $0.50 - $1.00 under current standalone biz w/out acquisitions) is an embedded call option. Assuming a reasonable 5x earnings multiple on $0.50 / share of earnings (low-end of earnings power), gets to an all-in valuation of $4.20 in cash + $2.50 in earnings power = $6.70 / share (vs current $3.80 / share or approximately 75%+ upside).

UPSIDE / DOWNSIDE:

  • UPSIDE: assuming 10x multiple to 09E standalone EPS of $1.00 / share + $4.20 of cash on balance sheet = $14 / share (vs current of $3.80 / share or approx 250%+ upside)

  • BASE: assuming 5x multiple to 08E standalone EPS of $0.60 / share + $4.20 of cash on balance sheet = $7.20 / share (vs current of $3.80 / share or approx 90% upside)

  • DOWNSIDE: assuming 5x multiple to current YTD EPS of approx $0.30 / share + $4.20 of cash on balance sheet = $4.80 / share (vs current $3.80 / share or approx 25% upside)

WHY THE DISCOUNT:

Three primary reasons: (i) technicals (sell-off of anything to do w/ China as well as likely "forced" selling from selected shareholders given redemptions, etc) (ii) Q2 results reported in July came in softer-than-expected (largely driven by margin dynamic w/ input / output pricing – mgmt noted on the call that this was a temporary issue) and (iii) mgmt un-deservedly lost credibility driven by #2 above (while I think they’re good operators, they’re less-than-crisp with regards to answering questions on public calls). While frustrating on all three fronts (and may deserve a slight discount), these "slip-ups" have ultimately created the opportunity to buy a "growth" biz for free as the cash balance provides a downside cushion.

RISKS:

  • mgmt team burns through a portion of the cash balance on dilutive production plans

  • core earnings power (on current standalone biz) erodes and is less than my view of $0.50 - $1.00 longer-term (margin of safety to the trade is anything above $0.00 of earnings power and >0x multiple should result in upside)

  • tilapia industry is an unattractive industry vertical and my channel checks / anecdotal evidence prove to be mis-informed

CATALYSTS:

  • NEAR-TERM: Street recognizes that equity trades (i) below cash value on balance sheet and (ii) at approximately 50% of book value / share (arguably fire-sale price for a growth biz with attractive l-term dynamics)

  • LONGER-TERM (3 – 6 months): Mgmt regains credibility (q3 results were an early / encouraging indicator of moving the right direction in re-gaining trust

  • LONG-TERM: Street recognizes the underlying earnings power of the biz model and applies a "market" multiple to earnings power (upside case assumes ~10x earnings on $1.00 of 09E standalone earnings power + $4.20 / share of cash = approx $14 / share vs current $3.80 / share)

 

Catalyst

NEAR-TERM: Street recognizes that equity trades (i) below cash value on balance sheet and (ii) at approximately 50% of book value / share (arguably fire-sale price for a growth biz with attractive l-term dynamics)


LONGER-TERM (3 – 6 months): Mgmt regains credibility (q3 results were an early / encouraging indicator of moving the right direction in re-gaining trust


LONG-TERM: Street recognizes the underlying earnings power of the biz model and applies a "market" multiple to earnings power (upside case assumes ~10x earnings on $1.00 of 09E standalone earnings power + $4.20 / share of cash = approx $14 / share vs current $3.80 / share)
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