Tasmanian salmon: A fishy business.

15 years ago, (pre-CSL), not a great deal was probably understood by local investors about the global blood plasma industry, whereas now any local healthcare analyst will have a complete understanding of plasma pricing and the broader immuno-oncology space. For the small cap investors, many would not have fashioned a complete understanding of the behavioural shopping habits of the Chinese consumer pre-2013, however after the success of Bellamy's (initially), A2 Milk and Blackmores the majority of the industry can now wax lyrical about the importance of the daigou and the brand preferences of Chinese mothers for the nutrition of their children.

Larger businesses as they grow typically take on more conglomerate-type structures, where different units of the business are exposed to various thematics through the economic cycle – this smooths out their returns but also dilutes the exposure to any one underlying theme. Small-cap managers would have undoubtedly licked their lips at the prospect of owning single exposure companies like Domain Real Estate (inside Fairfax), Bunnings (inside Wesfarmers) or Dan Murphys (inside Woolworths) as excellent leveraged plays on structurally growing industries. Unfortunately, while the growth of those businesses has been incredible in the past five years, the market caps of the conglomerates they sit inside haven't produced similar returns due to other underperforming business units.

While the ability to invest in emerging companies with singular exposures allows us the opportunity to generate great returns, the leverage of earnings to one sector, of course, works both ways - the recent trials of Bellamy's or the outdoor media names last year prove an obvious case in point. While we are constantly out looking for the next unique growth opportunity or sector, the team must also continually review the underlying business conditions of existing portfolio holdings by visiting sites, suppliers, competitors and customers to determine any noticeable changes.

These due diligence visits can lead us to some truly unique experiences and also right out of our comfort zones – the portfolio managers recalled recently with a smile (now!) of a trip to Karratha in 2010 where we were sharing a donga in 42-degree heat as we visited remote mine sites to understand the then-booming mining accommodation thematic.

We had a far more pleasurable experience recently seeking to understand the growth drivers of the emerging Australian salmon industry in the far more accommodating surrounds of the Tasmanian Huon Valley. The salmon market in Australia has seen continuing growth in per capita consumption, driven by the move toward healthier eating habits domestically. Meanwhile, global salmon prices have moved to a historical high, following an outbreak of sea lice in the key production regions of Norway and a deadly algae bloom impacting production in Chile.

A light has now shined upon the Australian salmon industry given the excellent biosecurity and ability for local players to ramp up production to meet growing demand.

The Australian salmon industry sits in a cosy oligopoly-type industry structure that we have learned to love in Australia, with the three key salmon producers all owning the key available strategic leases. Like other oligopoly industry structures including the Banks, Supermarkets and Insurers, the sector benefits from some degree of responsible pricing and the ability to sustain reasonable profit margins. The barriers to entry are high given the scale requirements and lack of availability of new leases, in addition to the financial strength required to trade through periods of lower prices - in 2014, global salmon prices plummeted following Russia’s decision to place a temporary ban on Norwegian imports, creating a global glut of frozen salmon across the wholesale markets.

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(As a side note, it truly is a great example of the interconnectedness of global markets when a northern European geopolitical dispute affects the salmon farmers of southern Tasmania!)

Given the industry dynamics and current favourable pricing matrix, we have initiated a position in Huon Aquaculture (HUO), one of the three key industry players in the space. The industry is recovering from an abnormally warm water season in 2016 that ultimately led to an elevated cost of production for Tasmanian salmon farmers as fish mortality rates weighed on their fixed costs of production. These elevated costs are now being cycled through, and after visiting a number of sites, we now expect to see a decline in production costs of ~$1/kg beginning in 2H17 into FY18.

On rough numbers, HUO made just over $1/kg of EBITDA in FY16, therein highlighting the material operating leverage a $1/kg reduction in cost can deliver over time. When we combine with materially higher wholesale prices that now sit over $2/kg higher than in FY16 (i.e., effectively doubling their total FY16 EBITDA margin), we feel this is a business that can meaningfully grow earnings from their current base. The pipeline for future growth looks sound with two sites at Norfolk Bay housing the ability to add 3,000t of production over time. We're very comfortable with management both at the executive and operational level and after visiting a number of HUO's and their competitors’ production facilities, we feel there is a good opportunity to grow our capital base invested.

This excerpt from the January 2017 Letter to Investors was contributed by Ophir Asset Management. Access the full note here: (VIEW LINK)