High Liner Foods (HLF-TO)

November 25, 2020

BACKGROUND

Originally founded in 1899 in Nova Scotia, High Liner Foods has grown into the North American leader in value-added frozen seafood products. The Company operates in both the retail, and foodservice space. In Canada, HLF holds a leading market share position in both retail and foodservice, while in the US the Company holds the number 2 position in retail-value added and is also the leading supplier of value-added products in foodservice.

In foodservice, HLF sells products to commercial end markets including restaurants, hotels, and institutions. In the retail segment the Company sells its products to grocers and club stores.

High Liner Foods has a long history of acquisitions and, through several transactions, the Company more than tripled in size, by revenue, from 2007 to 2014. HLF then made a series of smaller acquisitions between 2013 and 2015. Unfortunately, this period was also defined by steady organic revenue and EBITDA declines, largely due to industry dynamics. At the time, the Canadian Food Retail industry was dominated by “the Big Three” grocers, namely Loblaws, Metro, and Sobeys. With nearly 85% market share, these firms were able to significantly squeeze suppliers thereby impacting margins. Unfortunately, the US side of the business also suffered as the breaded and battered product category, which accounts for much of the value-added product sales, experienced a multi-year decline in demand, most acutely felt in food service. The result was HLF falling short of previously stated EBTIDA and margin targets, and significant share price weakness.

In 2015, through supply chain optimization, the Company’s results began to reflect a lower cost structure and quarterly cost savings reached over $4 million. These efficiency gains, combined with significantly lower acquisition costs, resulted in double digit EBITDA margins, cash from operations of $80 million and a stock price of $26 in 2016. However, significant debt increases combined with a sizeable acquisition (Rubicon) and declining organic revenue saw the stock price decline to a low of just over $7 in 2018. These missteps prompted a significant management re-shuffle and restructuring program focusing on 5 key initiatives: (1) Organizational realignment, (2) Business simplification, (3) Supply chain excellence, (4) Rubicon alignment, and (5) [achieving] Profitable organic growth by 2020.

High Liner Foods has made significant progress towards these goals by combining business lines, exiting low margin products, increasing cash flow, and reducing leverage. As expected, COVID-19 has had a dramatic impact on the business, however we have been impressed with management’s ability to navigate these complex times through operational improvements.

VARIANT PERCEPTION

The market seems to be punishing HLF for previous missteps and attributing little value to recent performance and potential. High Liner’s previous growth through acquisition strategy resulted in a complex business, however through product eliminations, management is reducing complexity from procurement, to manufacturing, to marketing, to sales. Furthermore, the Company has a new, integrated end-to-end supply chain, that operates cross-border, led by a single “Supply Chain Officer”. Finally, management is focused on organic growth and deleveraging which reduces the likelihood of sizeable acquisitions in the medium term.

Throughout 2020, sales volumes have declined, but much less than expected implying significant organic volume improvement year on year, especially considering the aforementioned product discontinuations. In retail, sales have increased double digits due to a surge in COVID-19 demand, however at 35% of 2019 revenues, the segment performance is insufficient to fully compensate for weakness across food service. As government mandated restrictions are lifted, we would expect a significant rebound in this segment, something that the market seems unwilling to even partially price in at this time. Gross margins have also increased in 2020 due to market share gains in non-restaurant categories, improvement in product mix, and government wage subsidies. These positive operating details, combined with operating expense savings tracking well ahead of expectations, have led to a recent 40% dividend increase, a share price rebound of 100% from the March lows, and the expectation of a year-on-year EBITDA increase in 2020. As the trend in top line sales stabilizes in 2021, we expect profits to increase materially due to the new gross and EBITDA margin profile. It is our assumption that much of the additional margin expansion will come from new product offerings and mix, rather than from internally generated efficiency gains. Finally, we expect a drastic reduction in leverage over the medium term and model a 2021 Net/Debt to EBITDA exit multiple of 2.5x

VALUATION

High Liner Foods is undeniably a deep-value opportunity with a recovering balance sheet, and promising mid-term top and bottom-line prospects. In fact, under very conservative assumptions and across a wide range of valuation techniques, our analysis struggles to find a scenario where the long-term share price has meaningful downside relative to its upside potential.

Our valuation analysis began with a comprehensive discounted cash flow model. In this we took a conservative approach at modelling both top line and EBIT assumptions, consciously tapering off margins before our perpetuity assumptions. In fact, with average revenue growth of 2% and only a slight uptick in EBIT margin, we achieve a target valuation range of $10 to $20.

The working capital changes assume strong inventory build in 2021 followed by a slight reversal in 2022 due to the anticipation of a full year of restaurant openings in the food service sector.

The situation is similar when looking at peer multiples. HLF has consistently higher operating metrics than its peers yet trades at significant valuation multiple discounts.

Using reasonable high and low peer multiples, we achieve a target share price range between $11 and $21 for EV/EBITDA, $9 and $20 for P/B, and $11 and $17 for P/E.

Finally, in order to complete our valuation framework, we looked at precedent transactions; most notably the recent purchase of Clearwater Seafoods Inc. by Premium Brands Holding Corp. and Mi’kmaq First Nations. The deal was valued at approximately $1 billion, including debt, representing an EV/EBITDA multiple of 9x. Applying this to HLF, we derive an offer price of $15.30. We view HLF as a prime candidate for a takeover, especially as leverage is reduced. In conversations with management, we believe that a reasonable offer would be considered by the board and not automatically rejected by the large shareholders with a blocking stake.

TARGET PRICE

Our internally generated blended target price for High Liner Foods is $15.58.

RISKS

In our view the biggest risk to High Liner Foods relates to market forces. While we have evidence of traction in terms of operational performance, the oligopolistic nature of the Canadian grocery market, combined with the unpredictability of the restaurant industry presents cause for concern. Should the grocery chains engage in a price war, High Liner’s margins will undoubtedly come under pressure. Additionally, should the COVID-19 related shutdowns continue longer than we anticipate, our target price may change materially. Additionally, HLF has a long history of growing through acquisitions and we cannot rule out the possibility that the Company may engage in M&A, especially considering the depressed prices in the industry. Finally, the Company has a global supply chain, so any deterioration in trade relationships combined with COVID-19 related supply chain disruptions could have an impact on results.

RISK PRICE

Our risk price for High Liner Foods is $8.

INSIDER BUYS / MANAGEMENT OWNERSHIP %

While current management owns approximately 4% of the outstanding shares, 37.5% of the shares are owned by Thornridge Holdings Ltd., an entity owned by David Hennigar (and the Hennigar Family), a member of the High Liner Board since 1984. This provides strong alignment between shareholders and the Board of Directors. In all, insiders own over 40% of the outstanding shares.

ANALYST COVERAGE

High Liner Foods is covered by 4 analysts with a consensus rating of HOLD and a blended price target of $14.

CONCLUSION

High Liner Foods represents a significant value play. Recently, the Company has demonstrated its ability to manage operations in the current complex environment, proven by margin enhancement and free cash flow growth. As the industry conditions begin to normalize, we expect HLF’s shares to increase materially. We would look to re-evaluate our position over $15.00 per share.

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This communication is intended to provide you with information about the current thinking, views, and outlooks of Aventine Investment Counsel. Aventine Investment Counsel is a registered trade name of Aventine Management Group Inc. a securities registrant in multiple jurisdictions across Canada.  This letter does not constitute an offer or solicitation to anyone in any jurisdiction in which such an offer or solicitation is not authorized, or to any person to whom it is unlawful to make such an offer or solicitation. All investors should fully understand their risk tolerances and the suitability of any proposed investments prior to making any commitments to invest their capital.

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