Note: Original article from June 28th, 2019 analyzing High Liner Foods can be found here. “Declining profitability and a deterioration of financial health have created many doubts surrounding High Liner Foods’ future prospects.”

Thesis

High Liner Foods (OTC:HLNFF) has shown positive signs for investors in the first half of 2019. Although sales volume continued to decline, the company has shown improvements in its operational efficiency and cost reduction. The end of various non-recurring expenses associated with management’s turnaround could see strong profit margins for the remainder of the year.

Introduction

High Liner Foods is a long standing frozen fish supplier, operating out of Nova Scotia and delivering its products throughout North America. The company has been operating, in one form or another, since the late 19th century. A span of 5 years or so may hardly seem significant in comparison to a history spanning over a century. For shareholders however the recent history has carried far more weight as the share price went through a steep decline starting in 2015/2016.

After bottoming out in late 2018, High Liner Foods’ stock had an impressive start to 2019, increasing over 40% from its lows. A drop following the release of its second quarter results quickly reversed and the company is trading within a range we previously indicated as its fair value. Relatively strong results when it comes to cost management are the main drivers of the stock’s strong performance to start the year. Although sales volume continued to decline, the firm showed greater operational efficiency, in line with its critical initiatives undertaken in 2018.

Narrowing margins due to poor cost management had hindered company performance in the past. The turnaround initiative undertaken by management was intended to exit low margin product sales, with the goal of creating greater costs savings, and returning to profitable growth by 2020. Management’s efforts have thus far appeared successful. Slight improvements to High Liners balance sheet, coming from strong cash flows, are also promising signs for investors. Headwinds are still present moving forward, but success to date has been relatively in line with previous guidance.

Reduced Debt Improves Financial Strength

High Liner Foods, as with many food suppliers, relies heavily upon its working capital accounts to effectively operate its business. The company’s balance sheet is made up in large part by it’s current accounts , as opposed to other businesses where non current accounts, such as PP&E, make up the majority of the asset base. For example High Liner’s inventory makes up 33% of its total assets. In the first half of 2019 High Liner saw a fairly significant improvement in its current account ratio, improving from 1.95 in 2018 to 2.59 in June. The improvement came on the back of strong cash flow that allowed the company to reduce just over $31MM in short term debt. The non cash working capital accounts fluctuated modestly but stayed in line with seasonal expectations.

For a business of such nature, a strong working capital position bodes well for the company. Even more so in High Liner’s case, given that the firm’s revolving credit facility is asset-based and collateralized by the firm’s working capital accounts (accounts receivable and inventory) as well as other personal assets. Deterioration in these accounts could pose a threat to the firm’s liquidity position. Investors would be wise to monitor the firm’s ability to maintain this position or improve it throughout the remained of the year.

From a liquidity stand point the company should have no issues meeting operational expenses as it currently has $146.7MM of available credit to draw from its $180MM revolving line, with a April 2021 maturity. Combined with its cash position of $13.3MM, this gives High Liner foods approximately $160MM in readily available funds. This amount provides a sufficient cushion to combat any possible downturns in operations. Reliance on debt has not been an issue to start the year as the company’s cash flows have proved sufficient to fund all operations.

Looking beyond 2019, one can see that High Liner does have a sizable obligation within the medium term, a $324MM of a term loan facility coming due in April of 2021. The ability to continue producing strong cash flows will likely see this amount reduced prior to the maturity, but it still poses a significant obligation. The likely scenario will see the firm refinance the outstanding portion upon maturity. This refinance will require the company to continue making improvements to its balance sheet in order to establish a stronger financial position, and ideally with it a lower cost of borrowing.

(Source: High Liner Foods Q2 MD&A)

In the first 26 weeks of 2019 financing costs have risen year over year (YoY) from $10.7MM to $11.4MM, or roughly 6.5%. The increase adds to a slight trend that has been emerging over preceding quarters as financing costs nominally, and as a percentage of sales, are rising. At current levels the costs are not a critical issue, representing approximately 2.3% of revenue, but given the trend of declining sales, investors would prefer to see improvements. Moving forward if the company is able to continue making improvements in its cost efficiency, management should have sufficient free cash flow to further pay down debt, and consequently see financing costs reduced.

Strong Cash Flows For 2019

High Liner’s ability to generate relatively strong cash flow came out as a bright spot in the first half of 2019. Adjusted EBITDA increased in the second quarter by 48% YoY to $17.88MM, and in the first half of 2019 by 38% YoY to $50.1MM. These increases were fairly strong and give credibility to management’s success in implementing their turnaround initiatives. The ability to increase EBITDA during a period of declining revenue, and thus increase EBITDA margins, can act as some relief for investors concerned with the declining sales volume.

(Source: High Liner Foods Q2 MD&A)

Alternatively looking at cash flow from operations reiterates the point; net cash flows provided by operating activities increased close to 50% year over year in the first half of 2019. This is likely an indication that management is focusing the company’s efforts on higher margin product lines.

(Source: High Liner Foods Q2 MD&A)

Aside from exiting lower margin product sales, management made greater supply chain efficiency a central initiative in the firms turnaround, as they described it creating “One High Liner Foods”. Some indication of success could be found in cost of sales which saw a reduction in the first half of 2019 YoY by 13% in $ terms. This improvement helped slow the decline in gross profit at -4.8%, which is a positive when compared to the drop in revenue of -11.3%, all of this likely a positive impact to CFO. Greater operational efficiency is a good sign as the company had been criticized in the past for failing to fully integrate some of its acquisitions such as Rubicon. Poor supply chain management had driven up cost of sales, and thus began eating away at profit margins. A reversal of this trend, even in a falling sales environment is a positive, as it indicates a more effect utilization of revenue generated.

Additionally, cash flows from non-cash working capital saw a substantial increase, particularly in the second quarter. This increase was largely a result of favorable changes in the account receivable which saw a 11.2% reduction from YE 2018. The company’s ability to effectively generate cash flows from its non-cash working capital accounts had not been a major cause for concern in the past, but always comes as a positive sign.

The dividend cut from USD $0.435 to $0.15 (assumes a 1 USD to 1.33 CAD Exchange) per share annually that came in May removed a substantial cash outflow for High Liner Foods. Although not affecting EBITDA or CFO, the dividend cuts will free up capital for other possible uses . Management has indicated in the second quarter report that this cut is expected to save approximately $10MM annually, going towards further debt reduction.

All of these changes in cash flow are positive signs for investors in the short term. Long term success for the company however is not realistic if the downward trend in sales persist too long into the future. Management has indicated that cost reductions should more than offset dropping revenues before the company returns to organic growth in 2020. Investors will likely have to be patient to identify if the company can succeed on this guidance and begin showing stronger profitability. The remainder of 2019 will serve as a good indication of how close management is to achieving this target.

Prospects of Strong Profitability

As revenue declined with the lower sales volume, High Liner’s profitability has been steadily deteriorating. As can be seen the EPS generated through the first half of the year was moderate, with the majority coming in Q1 and falling off substantially into Q2. This drop is in line with the seasonal nature of High Liner’s sales, but on a year over year basis the drop is obviously more pronounced. A major contributing factor to the drop off in Q2 came from termination benefits paid out to employees previously laid off, as the firm saw a 14% reduction in its salaried work force announced at the end of 2018.

(Source: High Liner Foods Q2 MD&A)

Management has indicated no further termination benefits are expected in relation to this workforce reduction. This should allow High Liner to exhibit strong profit margins in the remainder of 2019. Adjusted net income removes these non recurring expenses, as well as other expenses related to the turnaround initiatives, and could be used by investors as a more likely indication of what future margins may look like. If the company can keep its costs down heading into the remained of 2019, stronger EPS may materialize.

Additionally the reduction in Selling, General, and Administrative (SG&A) expenses comes as a good sign as the firm finds further costs savings. Although not very significant compared to revenue, in times of falling sales anything helps.

(Source: High Liner Foods Q2 MD&A)

Originally management had indicated that the cost savings from the critical initiatives would be a minimum of $10MM per year, not including the more recent $10MM in savings generated from the dividend cut. In the MD&A of the second quarter report it was highlighted that High Liner had brought in AlixPartners, a consulting firm, to “help further analyze and identify improvements associated with our supply chain and other cost savings opportunities”. This, in conjunction with an expansion of the critical initiatives is expected to have a “significant increase in the total net annualized runrate cost savings […] as compared to the $10.0 million cost savings target previously disclosed”.

The savings produced are expected to more than offset the drop in sales volume moving forward. Although the ability to reduce costs is a positive sign for the firm, ultimately investors would like to see a return to profitable growth. As management has indicated it expects this to materialize in 2020, the remained of the year will be an important indication of the likelihood of this scenario.

Conclusion & Valuation

The first half of 2019 saw High Liner produce relatively positive results, although sales volume continued to decline, this was largely expected. The positive impact of the critical initiatives undertaken has begun to show signs of reducing costs and potentially generating stronger profit margins going forward. With much of its non recurring expenses related to the turnaround completed, the firm should be able to produce stronger profits through the remained of the year.

While these improvements to operational efficiency come as a positive sign, ultimately the dropping sales cannot continue indefinitely. Management has indicated a return to profitable growth by 2020; the second half of 2019 will serve as a measuring stick to identify the probability of this outcome. Further strong cash flow leading to a reduction in the company’s debt position should be expected, and any misses on this front would come as a concern.

We will reaffirm our fair price target of $8.25 to $9 USD based on an Enterprise Value to EBITDA ratio of approximately 10x (currently in USD, EV= $573.91MM, EBITDA= $63.4MM, EV/EBITDA= 9x). While the signs YTD are promising, the dropping sales still poses as a concern, even if it is forewarned. Early signs of a return to profitable growth could see this revised upwards, as management thus far has had a strong showing for its critical initiatives. Although the stock has been relatively steady over the previous months, any increased volatility could create a buying opportunity. We would again suggest taking a conservative approach, and waiting for an entry point below $6.75 USD per share. If further success is achieved and the fair value moves upwards, this could change as well. Although the overall picture is turning around for High Liner Foods, there is still room for improvement.

Author’s Note: If you found this article intriguing and/ or useful, please like and leave a comment below. For more articles, be sure to follow my page by clicking the orange button at the top of this page.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HLNFF over 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.

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2019-08-22