Salmon that Eat Bears
What the market misses about Mowi ASA (MHGVY)
We spend our days looking for problems hidden in the financial results of a large-cap and mid-cap companies. However, this also puts us in the position to come across instances where we believe the market is failing to appreciate a company’s value. This may be a result of Wall Street focusing on a false red flag, failing to recognize a hidden asset, unfairly extrapolating past problems into eternity, or incorrectly classifying a company as cyclical when a clear path to sustainable growth exists. We believe that Mowi ASA (MHGVY) is a good example of the last category and deserves consideration from investors looking for “real companies” in today’s market.
Mowi (MHGVY) is the largest salmon farmer in the world with a 20% share of the world salmon market. The company is based in Norway but it is available as an ADS. (US investors should evaluate some special conditions regarding the impact of currency translation on returns which we will discuss in a section below.)
The current trailing dividend yield is 3.1% and the company expects to pay out 50% of earnings as a dividend so we see strong potential for the yield to increase. Before Covid, Mowi’s dividend was often over 5% of the current stock price and the company has a history of paying special dividends as well.
Net debt is only 1.5x EBITDA. We believe the market is still missing the long-term potential here and only trades Mowi based on spot prices for commodity salmon with the memory of Covid lockdowns fresh on its mind. The lockdowns stopped many international flights, which made it cost-prohibitive to get fresh salmon to Asia which is a key market for the company. This in turn meant that supply headed to those areas was instead sold closer to where it was produced and glutted those markets driving down prices. Restaurant consumption was also decimated.
However, there are several factors that we believe make Mowi attractive to long-term investors that are currently under-appreciated by the market:
Free cash flow net of maintenance and growth-oriented capital spending plus working capital growth is more than twice the dividend offering a substantial cushion.
Mowi’s goal is to average an ROE of 12%. In 2020 during the pandemic it was 8.3% and 2021 started slowly at 13.4%. Before and after Covid, Mowi has been operating at more than twice its goal for years (currently 23.4%).
Salmon consumption remains very low – 1.7 kg per capita in the US, 0.6 kg in Japan, 0.1 kg in China/HK. Total protein consumption is rising worldwide and demand is growing faster than supply for salmon. Only 2 million tons of farmed salmon are eaten worldwide now.
Mowi’s growth investments will allow it to boost its own supply steadily for many years and it has brand names and consumer products that allow for premium pricing. It has already doubled German consumption per capita and has just started the same plan in the US. Every 20% increase in US per capita consumption requires 110,000 more tons of farmed salmon or 5.5% of the world supply. China/HK is about 80,000 tons of consumption now and tripling that would only move per capita consumption to 0.3 kg/per year.
Other investments will allow Mowi to reduce costs per kg of salmon produced. Mowi has seen success in this area already.
The industry has consolidated into more of an oligopoly and has several barriers to entry including few geographic locations to viably locate salmon pens, licenses are limited by governments, and it requires heavy upfront capital to open new facilities.
Strong Cash Flow Allows Ample Investments in Growth
The large holders of Mowi are more focused on dividends than share repurchases. The Norway Public Pension Fund owns just under 15% and billionaire investor John Fredriksen owns 27%. The company’s goal is to pay at least 50% of earnings out as dividends. It will also declare special dividends when it has excess capital. There is a history of that happening in 2017-2019.
During Covid, the dividend was suspended for the final three quarters of 2020. It has been reinstated as the salmon market recovered and the company’s increased focus on more growth investing in the business:
During 2017-19, Mowi boosted its debt from 0.9x to 1.5x as a way of paying out excess capital as dividends. Debt is 1.5x EBITDA now, but the free cash flow is also a much higher percentage of the current dividend. After 1Q22, Mowi announced a dividend hike that includes a special dividend that represents 68% of underlying earnings, so this trend may be returning. It is basing it on expectations for strong cash flow as industry supply growth is expected to be near zero for the rest of 2022 which should strengthen salmon pricing.
We think it is important to see three other items within cash flow: growth capital spending, working capital growth, and ancillary cash flow streams. The company expects capital spending to be €300 million in total for 2022.
Working Captial Growth
Working capital consumes cash at Mowi as the company grows inventories with more fish plus inflation. They expect €90 million in total working capital build in 2022. The working capital drag is already reflected in the reported Cash from Operations in the prior table.
Growth Capital Spending
The growth capital spending is going into several areas and is part of the total capital spending in the free cash flow table. Of the €300 million of expected capital spending in 2022, €130 million is going to growth projects and €170 million is maintenance. Mowi is focusing its growth investments in several areas:
Building feed operations.
Mowi has mostly completed the expansion of its feeding operations which makes it more vertically integrated and gives it lower feed costs overall. It also enables Mowi to command higher prices for its salmon as it can show what the fish ate over its entire lifespan.
Expanding in consumer products takes Mowi further away from the commodity nature of salmon. Commodity salmon is called HOG (Head-On Gutted) fresh salmon. It’s the whole fish. Consumer products involve more processing for smoked salmon, smaller pieces cut as individual servings, sushi, and other customer convenience sizes and products. This enables Mowi to charge more for salmon, gives them more vertical integration, and provides a brand name to pitch. Mowi rolled this out in Germany in 2007 when Germany was eating 1.1kg of salmon per capita and about 500 tons was going into value-added consumer products. By 2015, Germany was eating 2.1kg per capital with 7000 tons going into value-added consumer products. Germany is now at 2.7kg per person.
Mowi is focusing its consumer products push in the United States. It has multiple processing plants in the US and is pursuing the same type of market growth it saw in Germany. The US currently consumes 1.7kg of salmon per capita now but is already the largest market in the world consuming 550,000 tons of salmon annually. Growing the US market per capita rate by 0.5-1.0kg means an enormous amount of additional salmon sales. Mowi has good shipping capacity into the US. The company produces 20% of the world’s salmon at just under 500,000 tons. If the US market grows from 1.7 kg to 2.0 kg per capita, that’s 110,000 more tons of salmon needed, and the goal is to double the US market over 10 years. China is 0.1 kg and Japan is 0.6 kg and both offer a big potential for growth.
Expanding freshwater capacity
This is the key to boosting volumes and this will be a continuing area of focus for capital spending for several more years. The problem with salmon farming is it requires colder ocean water that is also sheltered such as fjords in Norway or the long coast along Chile. There are not many other places to do this in a sizeable manner. Plus, the governments regulate the number of licenses given for seawater pens. While salmon are growing in the sea, they are also more subject to parasites like sea lice and gill diseases. In nature and in farming, salmon start their lives in fresh water and move to the ocean. So, when it’s tougher to boost fish raised in sea pens, the answer is to let them live longer in fresh water. Mowi has started this already and is forecasting that it will spend €400 million on this project from 2021-26.
Most smolts put into sea pens are < 100 grams in size. The goal of keeping smolts in freshwater longer is to let them grow to > 500 grams in size before putting them into sea pens. That means the fish spend less time in sea pens and the current sea pens can produce much more salmon as they turnover faster. Being in freshwater also reduces the exposure to parasites and other health issues. And larger fish should be stronger and healthier and more developed when they do reach seawater. Fewer health issues and stronger fish should also boost quality and result in premium pricing for Mowi salmon. With initial freshwater facilities in operation, Mowi saw 17% of its smolts put into seawater > 250 grams in 2020. By 2026, Mowi’s goal is to have 70% of its smolts > 500 grams going into sea pens.
Capital Spending on Improvements
This line item is a catchall of growth initiatives that include expanding sea pen capacity and reducing farming costs through more automation to minimize wasted feed and total labor needed. It can also mean more efficient harvesting with larger equipment and faster processing. Mowi has reduced fixed costs by €182 million since 2018 and pulled another €45 million out in 2021. It sees much more potential here in cutting overtime, FTEs in the process, and medical treatment costs.
Ancillary Cash Flow Streams
Cash from Affiliates includes dividends and proceeds from sales of those investments. There were three of these: Nova Sea 49%, FinnoyFisk 45%, and Dess Aquaculture 50%. In 2020, Dess was sold with the proceeds arriving in 2021. This cash is NOT in the free cash flow table above.
Mowi Is Not as Cyclical as Many Think
Salmon farming has been around for decades. In the early days, there were many small players that lacked the capital and knowledge to do it well. Production was characterized as trial and error and shoveling huge amounts of ground-up fish parts into pens to feed salmon. That feed attracted other fish and parasites. Parasites were treated by dumping chemicals into the pens. There would be population crashes in pens at times and two years' worth of salmon would all die while others would escape the pens. If the market prices were high, some producers would harvest early to capture that higher price even on lower volume and hurt the pricing. Much of that has changed for the better as we have already discussed above.
There can still be hiccups to this for a quarter or two if a particular region harvests more fish earlier than expected. This generally self-corrects quickly because now that company/region is low on fish to harvest going forward and supply drops. It takes time for the new fish to grow. We should also mention that there is seasonality to this market as wild salmon enter the market more heavily in late summer.
Other developments in the market:
The mom & pops are gone. This industry has consolidated significantly. Norway had about 70 competitors in 1997, it now has 23. Chile has dropped from 35 to 10. Scotland has 4, Australia has only 2. The ones that remain are better capitalized and have a commitment to building toward a growing market. The market requires players to produce enough salmon to deal with the high fixed costs of the business to remain competitive.
The governments have created huge barriers to entry. Not only do companies need to buy licenses for salmon pens, but regulations have also been established for farming methods, oversight on fish health put in place, regulations on the use of medicines, and limits on fish numbers in pens. All of that costs more money now than it did 25-30 years ago and our discussion in the prior section shows how much cash for working capital, maintenance, and growth projects consume.
Farm-raised salmon is still a niche market. The world is eating about 2 million tons of farmed salmon per year vs. 70 million tons of beef, 109 million tons of pork, and 129 million tons of poultry. Protein consumption from animal sources is rising. The wild salmon market is declining, and many other wild sources of fish are too. It is possible to grow the farmed salmon market and not even need people to switch from beef or chicken to salmon.
Demand is rising faster than supply and this has been the case for years. Covid was the exception when there were fewer flights from Chile to the US or from Norway to Shanghai. Supply growth has stalled industrywide from a normal 5%-6% CAGR before 2017 to the current 3%-4% which is expected through 2025 (with 0% to negative growth in 2022). That compares to demand growth that has been running at 8% except for a dip during Covid. Efforts to spur demand including more people opting for healthier protein sources should keep demand strong and help pricing remain firm.
In addition, Mowi has several reasons why its pricing can be higher than the industry overall.
As noted above, branding and consumer products give it more value-added product to sell which is higher than commodity salmon prices.
Mowi often sells much of its salmon (40%-60%) on contract to remove some of the short-term gyrations of pricing. When pricing is very high, it will put more contracts on or when lockdowns were ending, Mowi took many contracts off to gain spot market price exposure.
Vertical integration allows it to show full chain of custody of fish, what it ate, where it was raised, health inspections, when it was harvested, and when and where it was processed. All of this gives Mowi the ability to charge more as well as have a higher percentage of their harvest rated as superior in quality. That adds to pricing too.
Some fish get premiums based on size – a 6kg fish may sell for more per kg than a 4kg fish. With the investments to enlarge current sea pens, Mowi may be able to produce more fish that grow to 6kg. With the investments in freshwater helping fish grow stronger and healthier, they may grow more quickly in the sea pens as they will not have periods of slower eating. That too may produce more large salmon.
Two Accounting Issues to Watch
Mowi has a large asset on the balance sheet called “Biomass” which represents the estimated value of the salmon being raised. The company adds new smolts (young salmon) to its pens and then typically harvests them in three years at a weight of 4.8 kg. Biomass increases when new fish are added and decreases as fish are harvested. However, estimating the value of the biomass requires several assumptions that are all subject to change and error such as:
The company must estimate the survival rate of new smolts.
There are assumptions for what the pricing will be for harvested fish and the amount of feed that the fish will eat. Both are heavily influenced by fluctuations in the price for salmon and current costs of feed.
Labor, overtime, fuel, and treatments for fish all have assumptions too in the computing biomass.
Over the three years, assumptions can change for the positive or negative leading Mowi to change the estimated value of biomass. Changes in the estimated value of biomass are reflected in reported earnings and the equity balance. It bounces up and down.
The easy inputs to understand are salmon prices and feed costs. Both of these can change with basic supply and demand factors. Other less obvious factors include:
Fish health can be impacted by parasites and diseases which do multiple things to biomass.
Sick fish don’t eat as much and therefore don’t grow as quickly. At harvest time, the whole pen is emptied at the same time and fish that are below the 4.8kg forecast are worth less.
At times, the whole pen may be harvested early as a preventative method. That saves on feed and treatments, but the lower total weight impacts the revenues.
There are also additional costs of treating fish. Mass drug treatments are down considerably over the years. However, manually picking up fish and removing lice is required at times which involves more labor cost. These fish may also eat less and their growth may slow being handled out of the water.
Fish that have treatments are not as large, and often sell for less per kg than fish that have not – which hurts biomass because it lowers pricing too
Size of the Smolt
The larger smolt are when they go into the sea pen, the higher the starting biomass will be. We expect this to increase going forward and will explain below in freshwater expansion.
Mowi reports results with and without this biomass adjustment (Operational Biomass). The total amount of biomass is now €1.66 billion. In the last five years, this non-cash adjustment has been positive and negative:
2021 saw higher forward prices boosted biomass, but a lower amount of fish partially offset the pricing
2020’s Covid made it difficult to get salmon into all markets with grounded international travel, which glutted local markets and reduced forward pricing
2019 saw some lower pricing and a reduced fish count
2018 had higher pricing and fish counts improved
2017 had adjustments to the biomass change process and fewer fish after a big 2016
We expect biomass figures to generally increase going forward driven by several factors:
Demand is exceeding supply, which is expected to continue and is helping pricing
Inflation is boosting feed costs and that also adds to biomass
MOWI expects to grow smolt size, which means more investment in new fish as they go into pens
Currency Impact on Cost and Pricing
Another factor to watch is foreign exchange relationship: the NOK (Norwegian Krone) to the Euro and NOK to the US Dollar. The company reports its costs and revenue in Euros. Its larger competitors in Norway report revenues and costs in NOK. So, when the NOK depreciates against the Euro as happened during Covid several things occur:
Norwegian competitors can sell at lower prices in Euros initially and report higher margins because fish grow for three years and much of the feed that already went into fish was cheaper.
However, the cheaper NOK causes competitors’ feed costs to increase faster than Mowi’s going forward.
This is a wash over the life of the fish, but there are quarters where Mowi’s profit looks lower due to the FX change and competitors show higher margins. This reverses quickly as the competitors see costs increase faster in the future. It’s a timing issue.
Since 2015 the NOK/Euro exchange rate has been about 9.5 with spikes to 11.5-12.5 during Covid. It is currently at 10.1, so this may be more likely to decline a little and help MOWI more than its local competitors.
Special Currency Considerations for the ADS
Mowi trades in NOK in Norway and its ADS in the US trades in dollars. Norway produces lots of oil and the last time oil prices were well above $100, the NOK was about 5 to the dollar. Since oil fell from $100+ in 2014, the NOK has traded about 8.5-9.0 to the dollar, other than spiking to nearly 12 early during Covid. At the current exchange rate of 9.5x and oil at $122, we think the NOK has more reason to strengthen than depreciate. Appreciation of the NOK moves the ADS’s price up in dollar terms and vice versa. The NOK rising to 8.5x, is about a 12% positive move in the ADS price. The reverse is also true. The NOK falling to 10.5x, should cut the ADS price in dollars by 10%.
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