Australia | Aug 26 2019
This story features COSTA GROUP HOLDINGS LIMITED. For more info SHARE ANALYSIS: CGC
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Can Costa Group prevail against the seasonal vagaries that affect agricultural stocks? Several brokers consider the business has strong potential in this regard.
-Significant period of expansion underway in China and Morocco
-Mushroom affordability an issue relative to other vegetables
-Domestic berry category expected to benefit from varietal improvements
By Eva Brocklehurst
Fruit and berry producer Costa Group ((CGC)) continues to be hampered by a swathe of negative factors, some of which are one-off but also reflect the nature of agricultural production. Demand/supply conditions were volatile over the first half and 2019 guidance has been downgraded, with the company signalling further potential for downside. Prior guidance for net profit of $57-66m was not restated.
Macquarie suggests a very strong December half year in produce is now required to achieve guidance and citrus is the main driver. The harvest of the citrus crop is slightly delayed. Mushroom pricing, down -20% over the year to date, is reflecting weak demand. The company considers pricing to be unsustainably low but remains unsure as to when this will change.
The company is in the midst of a significant period of expansion as it completes major growth projects in tomatoes, mushrooms and invests in China and Morocco. While a weak result was expected after the January and May trading updates, China, Morocco, mushrooms and raspberries were all weaker than Morgans expected.
The broker downgrades to Hold from Add, believing the poor visibility over the near-term is weighing on the stock. Morgans emphasises a conservative approach, attempting to capture the negative impact of the potential downside. In doing so net profit forecasts fall -9.8% for 2019. More material downgrades are made for 2020/21.
The broker recognises there are a range of growth projects that should support a recovery over 2020-21, particularly when combined with a seasonal and cyclical return to more normal conditions and will be looking for signs of an improvement in mushroom prices to alleviate short-term concerns.
2019 is shaping up as a tough year but not one to capitalise, Citi asserts, given the expenditure programs that will deliver growth in 2020 and 2021. The broker notes mushrooms were the largest drag on the first half earnings.
Credit Suisse suggests there is a dilemma in whether the company is an agricultural stock or a growth business with protected markets and technological advantages. Taking a view that this is an agricultural stock, and there are challenges such as weak output prices, low yields and rising costs, then the valuation is lower than if assumptions are made that margins can be grown through the maintenance of prices and economies of scale.
The company should achieve the latter through genetics and technical knowledge and by exploiting shoulder timing of crops while investing in acreage. Credit Suisse projects Costa Group's operating earnings margin over many years will rise to 14% and probably be leading the industry.
Issues
Mushroom affordability is an issue relative to other vegetables and recent price rises have outstripped food inflation. Still, Credit Suisse expects the Monarto expansion will consolidate the company's position as the number one player.
Blackberries contributed more than half of the revenue growth in berries, and initiatives in Queensland blueberries over the next two years are designed to reduce the exposure to the more commoditised harvest in northern NSW.
Macquarie points out this is now the fourth disappointment versus expectations in 12 months. The broker assesses the problems with raspberries have continued and, while the brunt of the impact is being experienced in 2019, there is likely to be a negative impact again in 2020.
Earnings benefits from the ramp-up of the tomato expansion are also likely to be pushed further out, Macquarie suggests, and there is additional blueberry supply in the second half looming. The broker observes increasing agricultural and seasonal risk is leading to greater earnings volatility. On the positive side the company has refinanced senior debt and growth projects are on track.
UBS believes six out of the nine main divisions have had issues that are out of the company's control in 2019 but this should normalise to an extent in 2020. The broker remains comfortable with the balance sheet, assessing a further -28% decline in operating earnings is needed to breach covenants.
Another challenging year in 2020 could put pressure on the balance sheet, although Morgans expects the net debt to earnings ratio should fall in 2020. The broker expects top-line growth over 2020-21 will be supported by additional mushroom and tomato volumes, ongoing maturity of the avocado footprint and increased berry production area in China.
The domestic berry category is also expected to grow from the benefits of the varietal improvement program. Cash conversion at 48% was similar to the first half of 2017, which included a comparable biennial citrus crop.
Morocco
The company is taking steps to improve its Moroccan blueberry business. Morgans notes structural pressures in the northern farms and strong price competition with competing Spanish supply. In a normal season, around 30-40% of the northern farm production should occur outside of the Spanish season.
The company is taking steps to reduce the reliance on seasonal conditions by expanding further south to capture early-season supply. Wilsons lowers margin forecasts for Morocco, assuming most of the pricing issues in the past two years are structurally derived.
However, it takes time to establish a footprint, Morgans counters. The company is also developing early-season tropical varieties of blueberry that are more suited to the climatic conditions of far North Queensland, China, Morocco and Mexico. While re-basing expectations for Morocco, relative to the record levels of profitability delivered in 2017, Morgans recognises this could prove premature if pricing outcomes do not improve.
Wilsons accepts value is emerging in the share price, although requires further improvements in earnings predictability. The broker, not one of the seven monitored daily on the FNArena database, has a Hold rating and $3.31 target. The database has three Buy ratings, two Hold and one Sell (Ord Minnett, yet to comment on the results). The consensus target is $4.23, signalling 40.9% upside to the last share price. Targets range from $3.40 (Macquarie) to $5.20 (UBS).
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