High Liner Foods' recent Q1 earnings call (ref: Q1 2024 Earnings Call Transcript) was met with mixed reactions. While the company celebrated a 9.6% increase in adjusted EBITDA, the 15.9% decline in sales cast a shadow of doubt on the sustainability of this profitability boost. Most analysts focused on the obvious: a hyper-competitive retail environment, price-sensitive consumers, and a slowdown in the foodservice sector, especially in casual dining. However, a deeper dive into the transcript reveals a fascinating, almost counterintuitive dynamic that seems to have flown under the radar.

The hidden secret? High Liner Foods is actually *benefiting* from a decline in its lower-margin contract manufacturing business. At first glance, this seems nonsensical. Contract manufacturing, after all, contributes to plant efficiencies and helps offset fluctuations in branded business. Why would a decline be a positive factor?

Here's where it gets interesting. The transcript reveals that while High Liner has indeed experienced a decline in contract manufacturing, it has been actively replacing this lost business with *new* contract manufacturing contracts. The kicker? These new contracts are being secured in the second half of the year, and, crucially, will be coming online when raw material costs are expected to rise.

This subtle shift in timing has significant implications. By strategically securing contract manufacturing for a period of rising input costs, High Liner is essentially locking in a floor for its plant utilization and operational efficiency. This provides a safety net against potential margin compression that could arise from a combination of rising raw material costs and a still uncertain demand environment.

The numbers tell a compelling story. In Q1, sales volume declined by 13%, attributed in part to the drop in contract manufacturing. However, gross profit as a percentage of sales actually *increased* by a whopping 280 basis points to 23.6%. This suggests that the lost contract manufacturing volume was, in fact, of lower margin compared to High Liner's other business segments. The company, it seems, has expertly shed less profitable business while simultaneously bolstering its future operational base.

This strategy is a testament to High Liner's sophisticated understanding of the market dynamics. It also reflects the company's agile approach to navigating the current uncertain economic climate.

But is this strategy sustainable?

The answer hinges on two critical factors: the volume and profitability of the new contract manufacturing agreements, and High Liner's ability to successfully navigate the competitive pressures in retail and the potential slowdown in foodservice.

If High Liner can secure sufficient volume in these new contract manufacturing agreements at margins comparable to its other business segments, it will be well-positioned to maintain a healthy level of plant utilization and operational efficiency. This would mitigate the impact of rising input costs and further bolster profitability.

The success of this approach will also depend on the company's ability to balance promotional activity in retail with its commitment to brand preservation and long-term profitability. Deep discounting, as Paul Jewer, High Liner's CEO, rightly pointed out, is not a sustainable solution. However, the company's diversified portfolio and ongoing innovation initiatives provide it with tools to compete effectively without resorting to unsustainable discounting strategies.

Sales Volume and Gross Profit Margin

The chart below, derived from the Q1 2024 earnings call transcript, illustrates the dynamics between sales volume and gross profit margin in Q1 2024.

One intriguing anecdote not mentioned in the transcript is High Liner's long history of community involvement in its hometown of Lunenburg, Nova Scotia. The company is a major employer and actively supports local initiatives, further strengthening its brand image and consumer loyalty. This connection with its community could prove to be a valuable asset in navigating the choppy waters of the current market.

Overall, High Liner Foods' Q1 profitability surge, while encouraging, is underpinned by a strategy that is both bold and intricate. Its success will depend on a delicate balance of factors within and beyond the company's control. But if High Liner can execute on its plan, it may just have found the secret sauce to sustain profitability in a turbulent market.

"High Liner Foods is named after the high liner schooner, a type of sailing vessel used extensively in the North Atlantic fishing industry."