SalMar (OTCPK:SALRF, OTCPK:SALRY) is a company that has acted as a gold standard in terms of aquaculture returns on assets. The problem is that the industry in Norway has been slammed, where taxes will be levied from aquaculture on Norwegian shores. SalMar has some non-Norwegian businesses in Iceland and Scotland, but the vast majority, more than 75% of volume, is in Norwegian markets and will be subject to those Norwegian taxes. Finally, the figure is settled in Parliament on how much tax will need to be paid, and while it is better than the initially proposed figure, it is still going to be high at 25% with the norm price system. Economics is bound to worsen.
Tax Effects
On top of the corporate tax, we are looking at another ground rights tax that is going to add another 25% to the marginal tax for corporations after an initial irrelevant tax free allowance, meant to help small producers. Together with the 22% corporate tax we have a tax rate that is almost 50%. There is also another wealth tax effect based on the value of the licenses that allow the companies to operate Norwegian pens, but this has been reduced meaningfully thankfully.
The tax will be applied retroactively on results from Jan 1st, so there will be a harsh cash tax impact on these businesses as they report in the coming quarters. There are other effects as well that are undesirable. The calculation of the tax will be based on the salmon index prices, and not actual realised prices by the company to prevent shenanigans. This means that there will be a problem with any longer-term contracts that may have sacrificed pricing for security. The effective tax will be higher on those contracts if the price is lower than what it turns out to be in the market index. As this dissuades the use of contracts, since it presents tax risks instead of a desirable reduction in market risks, SalMar is reducing contract rates which will come down from the current 25% to an end of year 12%. While there isn’t any particular reason to expect trouble in salmon pricing, it still affects the economics of these aquaculture businesses and does reduce the value of a means to smooth out earnings. This is not business friendly.
The run-rate impact looks to be basically a doubling of the current taxes paid. This could have around a 33% impact on net income figures which is severe. Prices, while up from where they collapsed to after the initial announcement, largely reflect the forecast changes in earnings.
Bottom Line
Otherwise performance has been good. Volumes are down slightly in a key Norwegian geography, and mix effects have shifted production to some of the less unit-profitable operations in Northern Norway which grew, but performance per kilo is still up meaningfully and overall operating profit growth is outstanding thanks to strong pricing in salmon markets. Overall volumes did grow, and SalMar is keeping guidance unchanged on the volume front. Salmon prices are reversing a bit, but at least the demand side is looking increasingly solid as Western geographies regain optimism and China moves towards a more real recovery at some point in the future.
Ultimately, the taxes are the main problem. If we assume the 33% net income hit, our coarse estimate is that run-rate PEs are around 20x. We are being conservative and undervaluing guidance that the company gave, although it indicates about a 40% increase or more in volumes. Taking that into account the run-rate PE is probably closer to around 14x.
Another caveat is that actual costs incurred by the company do reduce the tax basis. Investing into its own assets and generating related costs can bring immediate tax effects down but the impact is still felt and the business is going to become less cash generative.
It’s hard to argue that 14x is expensive for a company that has had such a good operational history and ROIC, especially if these companies are going to look to generate growth costs. But cash flows are going to be impacted by the new tax laws. SalMar prices don’t look unfair, and while this tax change likely marks the end for the time being of the government trying to carve value away from the salmon industry, it could signal the beginning of tax changes in other markets as well. Moreover, it highlights the fact that the government wants to tax and address social cost related to salmon farming as its dubious sustainability starts coming into focus, which was the reason why we avoided these investments altogether.
Besides the whole tax matter, at the valuation the business isn’t terribly interesting. There are other opportunities in the markets with similar RONAs at that valuation and lower.
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