We may be wired differently to the rest, but when we see companies fall by 20% or more in a day out interest is automatically piqued. Whether it is the need to search for a discount, or something contrarian in our blood, we tend to see value in these ‘fallen angels’. And with interest rates at an all-time low, markets and most importantly individual companies trading at stretched valuations, there seem to be more and more of these every month.
This week a client reached out and put some very simple words forward, being that the basis of education relating to economics and financial markets is still reliant on the ‘rational man’ concept. That being markets will react rationally and price in all relevant information at all times. Yet anyone who has been involved in investing at any time over the last 100 years knows this is simply not the case, investing is an inherently emotional pursuit and these emotions regularly result in mis-pricings.
This month we were surprised at the reaction to Costa Group’s earnings downgrade and weaker outlook for its many markets, with the share price falling 25% and reaching multi year lows.
Who is Costa Group?
Costa is Australia’s leader grower, packer and marketer of fresh fruit and vegetables with five core business lines: berries, mushrooms, tomatoes, avocados and citrus fruit. In fact, it is the number one producer of blueberries, raspberries, mushrooms, glass house tomatoes and citrus in Australia. That is some sort of monopoly.
Costa was traditionally reliant on the production of berries and citrus but post it’s listing in 2015 the company has invested substantially to diversify its earnings base, as has been seen in the revenue chart below:
The Costa business model is based around having a 52 week production cycle and diversifying its earnings base sufficiently to ensure a poor season for one type of fruit does not impact the business as a whole. This has been extended to overseas investments including Morocco and China, the produce from which is delivered directly into Europe and China respectively. This is going someway to remove the reliance on the major supermarkets who purchase 75% of Costa’s production.
So, what happened?
Anyone who shops at Woolworths or enjoys some blueberries on their morning muesli would have seen it coming. The price of both blueberries and avocados in 2018 dropped substantially selling for as little as a few dollars a punnet, and that was only the start of the problems for Costa.
The company was hit by a quadruple shock, with poor weather in Morocco resulting in its production being sold into Europe at the peak of supply, meaning lower prices were received. Next, the Australian mushrooms experienced an unseasonably warm growing season and the expanded growing centre was still waiting for commissioning which impacted production. Then raspberries were impacted by poor quality and fruit flies were detected in their citrus plantations. It couldn’t get much worse.
Yet it was still a shock when the company reiterated its previous guidance at the end of May and investors capitulated. The company confirmed that revenue was down 2.4% and EBITDA would fall 42% to $35.3m for the financial year. They indicated that the results for the full calendar year of 2019 would be in line with the previous year but below previous expectations due to the combination of events listed above. However, they clearly indicated that avocados, tomatoes and blueberries had not been impacted, which represent a majority of their revenue base.
We think Costa is a case in point as to why agricultural and food production companies have had such a difficult time on the ASX and in other listed markets. Costa is an example of a high-quality company, with great long-term assets and production schedule, but which became overvalued due to the exuberance of short-term investors. The company operates in a weather dependent industry, therefore, poor seasons will occur regularly and the companies annual profits will be volatile. This appears to have been misunderstood by the market.
As a smaller company, valued at $1.3bn we think Costa has some merit. The company is nearing the end of a significant capital expenditure cycle, having upgraded and planted out more of its core blueberry, mushroom and tomato plantations, costing some $200m. It continues to derive strong margins of around 14% from these business lines and delivers leverage thanks to its fixed lease agreements for the underlying properties.
We believe the various issues are cyclical and simply part of owning an agricultural company. Management have done a lot of work to diversify the business which will hold them in good stead moving forward. The company currently trades on a forward price earnings ratio of just 16x, which is a discount to most Australian food companies and most importantly much lower than global beers like Calavo Growers (25x) and Scales (18x).