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Mathew Ingram

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Seafood king

Mathew Ingram

TORONTO (GlobeinvestorGOLD) — Clearwater Seafoods Income Fund, based in Nova Scotia, is a giant when it comes to the harvesting and processing of fresh fish, lobster, shrimp, scallops, crab and other creatures of the sea. It employs a fleet of 21 boats, runs several processing plants, has more than two thousand employees and sells 80 million pounds of seafood a year in North America, Asia and Europe. As far as business in Atlantic Canada is concerned, Clearwater is definitely a major player.

Such a commanding presence in a key segment of the food industry must make the company a pretty compelling investment, right? Not exactly. In fact, units of the seafood fund haven't been a great holding for the past year or so. The reason for that has relatively little to do with the health of the seafood industry or the business acumen of the company's founders, and everything to do with currency markets — specifically, the weakness of the U.S. dollar and the strength of the Canadian loonie, which have put the squeeze on the company's profit margins and payout ratios.

While the strong Canadian dollar has been a boon for companies that have to import raw materials or equipment into Canada, since it gives them greater purchasing power, it has done the exact opposite for companies such as Clearwater. Because the seafood processor gets all of its raw materials from the Atlantic Ocean and pays its employees in Canadian dollars, that means higher costs; and the weaker U.S. currency means that Clearwater's products effectively become more expensive to American buyers. The result is lower sales and thin profits.

The Clearwater fund owns 56 per cent of the outstanding units in Clearwater Seafoods Limited Partnership, which actually operates the business that John Risley started in the late 1970s — and Mr. Risley's private Clearwater Fine Foods Inc. owns the rest. In the first quarter of last year, Clearwater lost close to $3-million, due primarily to a $10-million foreign exchange loss, and sales fell to $72.7-million. In the second quarter, revenue actually rose to $85-million, but profit slid by almost 50 per cent to $8.7-million.

The units started sliding about that time too, falling from the $12 range. By the third quarter, when Clearwater reported that its revenue fell by 8 per cent and its distributable cash also dropped from the year-earlier quarter, most analysts and shareholders were unsurprised to hear that the income fund had deferred a decision on distributions for the subordinated unitholders. According to Clearwater, the payout ratio for the year up to that point — that is, the amount of free cash flow the company was distributing to investors — was 111 per cent, meaning it was paying out more than it was generating. In most cases, that means a cut in unitholder distributions is around the corner.

Sure enough, Clearwater said in January of this year that it was cutting its annual payout to 84 cents a unit from $1.15, due to the effect of the weaker U.S. dollar on its sales and margins. By the time the company made the announcement, the units had already dropped in price to about the $8.50 range, so they didn't react that strongly to the news — in fact, they moved up in the weeks following the cut. Then the unit price began to falter again, however, and over the past several months it has continued to fall, dropping to the $6.50 range, down by more than 45 per cent from a year ago.

The problem is a simple one: while Clearwater has improved its margins by cutting costs and boosting sales of more value-added products, it continues to be hammered by the foreign exchange imbalance. According to some analysts, that means the fund will likely have to cut distributions again, since it is still paying out more than it is generating in cash flow. Adding fuel to that theory is the fact that the yield on the units — that is, the payout divided by the price — is higher than most other income funds, at about 13 per cent. That would be great if Clearwater could keep it up, but when yields get to such levels it often means that a distribution cut is coming soon. Before the January cut, Clearwater was trading at a yield of 17 per cent.

According to Canaccord Capital, another reduction in payouts is a virtual certainty. The brokerage firm recently initiated coverage of Clearwater with a report entitled "Rough waters," and a "sell" recommendation. While the company is currently paying out 84 cents a unit, Canaccord said that its cash-flow model for 2006 (using an 80-cent Canadian dollar as a constant) showed free cash flow of just 51 cents a unit. The firm said that it expects the unit price to "trade down to $5.50" based on that assumption. While the company has been doing a good job of growing its business, Canaccord said, distributable cash is still likely to come in far below where the company's current payout sits.

Unfortunately for Clearwater, being the king of the seafood business just isn't as valuable as it was when the Canadian dollar was weak and the U.S. dollar was strong. Until that situation returns, the fact is that the fund's units aren't likely to look very attractive, even with a high yield.

Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.

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