From a ‘story’ standpoint, there is an attractive short case for Omega Protein (NYSE:OME). Management decided to buttress the legacy – and volatile – menhaden fishing and processing business by using M&A to build out a more stable Human Nutrition segment. That process has failed, and that business looks worse by the quarter.
Meanwhile, fishmeal pricing has been favorable, and 2016 results benefited from yield above recent averages. But pricing may be heading back down, and yield fluctuates from year to year, usually from factors beyond management’s control.
So there’s a good, quick bear case here. Potential pricing pressure seems likely to lower margins in 2017 and beyond. Margins have been well above average for several years now, and the nature of the business implies a reversal to the mean at some point. Management questions, regulatory pressure, and a traditionally low valuation – the business generally has traded around ~5x EBITDA – could lead to an exit out of the stock if that pressure holds.
There are a couple of problems with that bear case, however. The first is that Omega Protein has used recent cash flow to deleverage completely, closing 2016 with $36 million in net cash (and just $1.1 million in debt). The second is that multiples already are compressed and were so even before a 24% post-earnings plunge earlier this month. OME now trades at barely 4x EBITDA, and on an enterprise basis ~9x and under 8x EPS and free cash flow, respectively. With a strategic review of the human nutrition business underway, OME’s story could get cleaned up, and a resolution there could provide a potential upside catalyst. That leaves the OME short case dependent basically on fishmeal pricing declines and/or regulatory risk. Both are possible, but I’m skeptical either is quite enough to support a short at current prices.
Cyclical Peak Or Secular Shift?
Source: OME January presentation
Omega Protein isn’t a new company, its operations date back to 1913. The core business in the Animal Nutrition segment is catching menhaden, an oily forage fish used primarily for fishmeal, fish oils, and to a lesser extent, bait. The fish are then processed (by Omega) into fishmeal and fish oil, which are used almost solely as feed for other fish, livestock, and companion animals. OME’s flagship plant is in Virginia, with operations in the Gulf (Louisiana and Mississippi) as well.
Historically, it has been a rather volatile business, one dominated by external factors. OME has little control over pricing since most worldwide production comes from overseas (Chile and Peru are two key markets). There’s the actual yearly catch, which can be impacted by everything from weather to stock levels to luck. From there, “yield” – how much meal and oil can be derived from each pound of fish caught – can fluctuate year to year for reasons the company itself writes in its 10-K “are not generally well understood.” Add to that some volatility in terms of input costs (labor and fuel, though OME does hedge) along with forex impacts (direct and indirect), and earnings move around quite a bit:
Source: Author from OME press releases; 2010 Adjusted EPS calculated by author
Note that (as we shall see) the Human Nutrition businesses have contributed to some of the recent growth, but not much.
Taking a longer-term look at GAAP gross profit margins gives a better view of just how lumpy the business can be:
Source: Author from OME SEC filings
So one of the key questions for OME is whether the pricing per ton, which was essentially flat in 2016, and gross margins really are at a “new normal”, so to speak. And there, I’m a bit skeptical. Figures from the International Fishmeal and Fish Oil Organization provided in OME’s 10-K show a reasonably sharp decline in production. 2016 estimated production levels of 4,400 metric tons show a 22% decline from 2010. That year admittedly was an outlier; but the trend still has headed downward.
Most of that production pressure appears to have come from Chile and Peru. But at least one industry analyst expects production in Peru to normalize starting this year, leading to potential pricing pressure in 2016. Omega itself said on the Q4 conference call that pricing was weakening modestly. The company has sold forward a large amount of product, locking in previous prices – though it’s contracted less than it did a year ago – which limits the near-term impact to earnings. But come the Q1 call in May, the supply/demand/pricing environment should be a little better understood. At the moment, it appears that investors should expect modestly lower prices in 2017.
The longer-term question is whether $1,300+ per ton pricing really will hold. Soymeal can be substituted for fishmeal, though a rather large pricing gap between the two products apparently has done little to impact fishmeal demand. U.S. East Coast quotas are rising, though (for now) Omega will be the prime beneficiary. There isn’t anything on the immediate horizon to imply a return of pricing back to the ~$1,000 levels seen at the beginning of the decade. But if South American production levels increase, there’s likely no support for more pricing gains.
Near-term pricing pressure, meanwhile, could lead 2017 margins and earnings down, particularly given projections of higher per-ton and corporate-level costs this year. That undercuts the bull case a bit, even at a single-digit earnings multiple. Mid-term, as difficult as prices are to forecast, it’s hard not to suspect that prices aren’t closer to a cyclical peak than a cyclical bottom, and it wouldn’t be shocking to see reasonable compression going forward. It has happened before, and it usually happens both quickly and violently.
There’s another factor to consider: whether Omega will be able to reach the same catch levels it has over the past few years. Catch, per figures from the 10-K, has been reasonably stable over the past decade or so, with spikes in 2011-2012 and 2015. Some of those gains have been offset by lower yield, which trended from the high-30s to 34-35% in 2014-2015 before rebounding last year.
But overall production has been pretty solid. The mid-term question is whether that might change. There have been on-again, off-again concerns about the health of the menhaden stock. For now, the species seems rather healthy: the Atlantic States Marine Fisheries Commission (AFSMC) has raised the quota 6% for 2017 across its 15 member states.
That’s undoubtedly good news for Omega Protein. The concern, at the moment, is that Omega Protein is susceptible to changes in how that quota is distributed. At the moment, Omega alone receives over 75% of the quota for the entire East Coast. This unsurprisingly has led to complaints from other states about the per-state allocation of the quota, Virginia gets a full 85%.
Added to that are concerns about Omega’s operations in the Chesapeake Bay (capped a bit over half of the company’s annual allocation, per the 10-K). Omega so far has fought off efforts to move its oversight to the Virginia Marine Resources Commission from the state’s presumably more amenable General Assembly. But the move could force Omega’s operations to what presumably would be more expensive offshore areas. (Virginia now is the only state that allows so-called “purse seine” fishing in state waters.)
Again, trying to forecast exactly how these issues will play out is difficult, to say the least. There’s disagreement as to the actual health of the menhaden stock. There are multiple interests and organizations with a stake in the regulatory outcomes, but Omega remains the largest and loudest voice. There’s little reason to see the status quo changing immediately, or even soon. But there are regulatory risks hanging over Omega Protein’s head.
To be fair, the concerns about revenue impacts from regulatory action or margin effects of pricing and/or yield changes aren’t new. And neither really rises to the level of a short catalyst at the moment, at least not a certain one. Rather, these questions always are part of the investment case for OME and a reason why there’s generally been a tight lid on the stock’s valuation multiples.
The lumpiness in the Animal Nutrition business is a reason why Omega decided to build out its Human Nutrition segment. In 2010, OME acquired nutritional supplement maker Cyvex Nutrition. The 2011 acquisition of InCon added omega-3 concentration capabilities. In 2013, the company purchased whey protein manufacturer Wisconsin Specialty Protein; its largest acquisition came the following year, with the $70 million addition of Bioriginal.
Simply put, it’s been a failure. Activist Wynnefield Capital criticized the strategy harshly in its campaign last year, which led to the addition of two firm-backed directors (one in a contested election). As Wynnefield has pointed out, CEO Bret Scholtes essentially admitted on the Q1 conference call that Omega Protein badly overpaid. Scholtes told analyst Tim Ramey in the Q&A of that call that “I agree with you” when Ramey posited that the business, which cost over $160 million, was worth in the range of $100 million.
Even that figure looks optimistic. Omega now has taken goodwill impairments on all four businesses, including InCon, which was divested last year. Note 10 of the 10-K cites disappointing performance and lower-than-expected sales of higher-margin WSP products, and lower sales and lower margins for Bioriginal. Segment revenue declined nearly 8% in 2016; Adjusted EBITDA (my calculation using segment-level figures in the Q4 release) did increase 10%, albeit to just $4.4 million. In other words, OME has paid about 37x EBITDA for the business, while its legacy Animal Nutrition segment trades at a bit over 4x.
In one sense, that’s “spilled milk,” as Ramey put it on the Q1 call. The problem is how Omega has reacted. In response to Wynnefield’s initial stake, the company announced it was reviewing strategic alternatives. That process took eight months, much to the activist’s displeasure, and resulted in basically nothing but a $40 million share repurchase authorization.
Then, in February, the company announced that it was, again, reviewing strategic alternatives, this time for the human nutrition business alone. Scholtes said the difference in the second review was that it would focus on the Human Nutrition segment alone, which raises the question of what exactly was going on during the eight months it took the original review (which started 17 months before the second one). Meanwhile, of the $40 million in authorized share repurchases, Omega didn’t spend a dollar, and now has paused the program as it figures out what to do with Human Nutrition now.
That’s not the only issue. The 10-K disclosed a subpoena from the SEC “in connection with an investigation” regarding “compliance with probation terms” and its treatment of whistleblowers. That’s on top of a CID (civil investigative demand) from the DOJ in October related to a False Claims Act investigation (an act that allows for treble damages). And both appear related to two separate Clean Water Act violations, one in Louisiana and one in Virginia, that have the company on probation.
Management has pointed to the performance of its stock price and earnings growth in defense of its actions so far. But it’s not hard to argue that the company has destroyed $100 million in shareholder value in Human Nutrition (something close to $5 per share) alone, and the improvements in the Animal Nutrition business are coming in large part from external benefits (pricing, most notably). Omega has invested capex in its operations and appears to have improved efficiency, so capital allocation hasn’t been a total wipeout. A newly instituted dividend offers a ~1% yield as well and could be boosted. The balance sheet is clean as well.
But there has to be a concern as to what management actually plans to do with the cash being thrown off the business in 2017. The legal issues don’t seem likely to break the company, but Omega did pay out nearly $10 million in total fines and contributions in the two Clean Water Act violations. Further spend could be material, and the consistent legal problems don’t raise a ton of confidence.
To Short Or Not To Short?
The question is whether any of the concerns regarding OME rise to the level of a short catalyst. While valuation can change if pricing gives out, the single-digit P/E and P/FCF multiples still seem to provide some cushion against further downside.
There’s maybe a case that each concern can apply enough pressure to send the stock down in sum: EPS pressure in 2017 plus a material fine/regulatory impact, plus a disappointing outcome to the Human Nutrition strategic review could each have a reasonable impact, and in sum, push shares down. But multi-step short cases are fraught with risk. And in that scenario, OME still likely maintains single-digit multiples (on an enterprise basis) in what is at the moment a bull market with few similarly ‘cheap’ stocks that aren’t secularly challenged (like retailers, for instance).
Long story short (too late), there are a lot of reasons to see potential problems for OME, even at current multiples but in those reasons, not a concrete, material catalyst for a short. Pricing could be pressured, but that’s a result of a worldwide market heavily influenced by (literally) dozens of individual regulatory bodies. Quotas could be reduced, but not in 2017. The Human Nutrition strategy didn’t work, but that’s in the past. Legal problems could cost the company cash, but general counsel John Held said in the Q&A of the Q4 call that there was “some element of materiality” in the decision not to disclose the subpoena in December when it was received. That seems to imply that Omega Protein, anyway, doesn’t see the investigation as the type of action that can drive the share price down on its own.
The irony of OME at the moment is that the short case reflects in large part why the Animal Nutrition business doesn’t get a high multiple, and why Omega Protein wanted to build out the Human Nutrition business in the first place. It’s an extremely difficult stock to analyze because of the difficulty in accurately modeling future earnings. It’s the type of stock that can go into the so-called “too hard” pile from the long side. At the moment, it seems similarly positioned from the short side.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.