Time to Invest in Omega-3s

2007 is shaping up to be a significant year for omega-3 food product launches. Omega-3 ingredients have long been a research focus at Canaccord Adams, given our belief that the ingredient class would become a major category. Likewise, this topic is of significant interest to our institutional investors. The ingredients, including fish and algal oils, remain one of, if not the, fastest growing nutritional ingredient categories. The omega-3 opportunity is now being realized and is approaching an inflection point where broad consumer demand for omega-3 fortified foods will materialize and the companies producing these products will become very attractive investments. This belief is founded on food companies’ gravitating toward healthier options and on a dietary supplement market opportunity that is well developed yet still growing. According to surveys conducted by Nutrition Business Journal, an estimated 60 percent of the U.S. population is aware of omega-3s.

Given the health benefits and rising consumer recognition, the supermarket aisles are growing with omega-3 products. Omega-3 fortified food launches more than doubled in 2006 to 250 launches, from 120 in 2005, according to Mintel. Additionally, given that the development cycle of a new food product often takes at least 18 months, and there has been broad interest and discussions between food companies and omega-3 suppliers over the last couple of years, we are on the verge of seeing a rapid escalation of the pace of new food launches. Currently, most of the product introductions have been in beverages, spreads, dairy products (i.e. yogurt), eggs, nutrition bars and baked goods.

This year could be an even more significant year for omega-3 growth. During the first quarter, Tropicana launched an omega-3 fortified orange juice utilizing MEG-3 from Ocean Nutrition Canada (ONC), while Silk soymilk launched a product enhanced with Martek’s Life’s DHA. Recently, Horizon Organic launched a couple of SKUs of organic milk with Martek’s DHA (docosahexaenoic acid). According to Packaged Facts, the retail sales of foods and beverages fortified with omega-3s could surpass $7 billion by 2011, compared to $2 billion in 2006.

The most publicized challenge fish oil companies must surmount—which at this point is more a marketing problem than a development problem for quality manufacturers—is reports that fatty saltwater fish often contain various toxins due to pollution and mercury contamination. While research has broadly indicated the majority of fish oils are free of pollutants, the issue has given Martek (NASDAQ:MATK), which derives its DHA from algae, a marketing advantage that the company hopes can help justify its premium prices. Martek has exclusive DHA supply agreements with Breyers, Dean Foods, General Mills, Kellogg, Odwalla and several smaller food manufacturers. Principal food launches to date include Yoplait Kids yogurt, Silk Plus soymilk, Horizon organic milk, Fujisan Sushi and Odwalla Soy Smart drink.

The other leading player is ONC, a privately-held company based in Nova Scotia. ONC utilizes a patented microencapsulation technology for its MEG-3 brand of fish oil, which appears to have given the company a significant advantage in the food ingredient market, given the higher stability and shelf-life of its products. To name just a few of the numerous launches to date, its ingredients can be found in Danone yogurt (Cardivia and Danino in Canada), Tropicana orange juice, A.C. Larocco pizzas, and Wegmans brand bread. We also believe ONC provides the DHA source for Gerber’s recent launch of fortified baby foods, including a few dry cereals and several purees. ONC dominates the fish oil ingredient market in North America and recently partnered with Alicorp S.A.A. of Peru to expand its manufacturing capacity by 200 percent.

There are numerous other suppliers of omega-3 ingredients for food. This includes the publicly traded Omega Protein (AMEX:OME) in the United States, which markets what we would consider a commodity form of omega-3s from fish oil; and Neptune Technologies & Bioresources Inc. (NTB-V on the Toronto Venture Exchange) in Canada, which has a patented method of extracting its oils from krill. Neptune has a very promising product that appears to have meaningful advantages to traditional fish oils given the presence of a phospholipid attached to its omega-3s; however, it is relatively early in its development of a food ingredient and has several hurdles yet to overcome. There are several privately held players in the market as well and the growth and opportunity in the market has attracted intense competition over the last couple of years, including entry into the market by large players such as Procter & Gamble’s ingredient division. While the ingredient market is highly competitive, ONC and Martek are in the best positions given ONC’s microencapsulation technology and Martek’s position as the vegetarian source with controlled production methods.

Beyond the ingredient supply market, there is an additional publicly traded company with significant exposure to the omega-3 market. Nutrition 21 (NASDAQ:NXXI) purchased Iceland Health Inc. in August 2006. Iceland Health has the exclusive U.S. rights to market and sell fish oil manufactured by an Icelandic company to pharmaceutical standards utilizing a patented distillation process to remove toxins and dioxins. Iceland Health manufactures omega-3 supplements and traditionally marketed its products through the direct response channels, but is in the process of expanding into traditional retail distribution. Nutrition 21 has seen significant growth of its omega-3 direct response revenue primarily through utilization of television infomercials in the United States.

A significant market opportunity for omega-3 fortified foods is expected to emerge and omega-3s could become one of the most broadly used functional food ingredients. The omega-3 dietary supplement market is among the largest categories in the United States and continues to grow at a rapid pace. Education and awareness programs on functional foods are broadly increasing, aiding the growth opportunity for omega-3s in functional food products. The clinical support for omega-3s remains significant and is now expanding beyond cardiovascular health into neurological benefits for adults. While omega-3s are not a wonder-drug, the ingredients create a quality product with strong nutritional support. Investors can look for strong returns by investing in the omega-3 category, using a basket approach, as the market remains relatively young and the ultimate winners have yet to be decided.

David Thibodeau is the managing director in Canaccord Adams Investment Banking Group, and head of the firm’s Consumer Health, Wellness & Lifestyle business, which specifically focuses on mergers and acquisitions as well as public and private financings in North America and Europe. Thibodeau’s operating experience and finance background offers clients a unique combination of industry and corporate finance skills. He has more than 20 years of corporate development, finance and operating experience with particular expertise in the food and beverage industry.

Health Claims Drive Consumer Interest

The National Institutes of Health (NIH) compiled a list of potential uses of omega-3s based on scientific evidence and graded them from A (high) to D (low) based on strength of evidence. Various benefits to the heart were discussed: Hypertriglyceridemia and secondary cardiovascular disease (CVD) prevention were rated “A”; primary CVD prevention was rated B; angina pectoris, atherosclerosis and cardiac arrhythmias received a C. Primary and secondary CVD prevention by alpha-linolenic acid (ALA) also received a C. The following were also reviewed and graded: