Costa Group Holdings Ltd (ASX: CGC) is one of Australia’s largest horticulture and fresh produce suppliers; selling avocadoes, citrus, blueberries, mushrooms and tomatoes to the likes of Coles Group Ltd (ASX: COL), Woolworths Group Ltd (ASX: WOW) and Aldi.
In all, 80% of Costa’s profits are from the sales of fruit and vegetables, with the balance derived from logistics and international licensing agreements (blueberries).
Historically, agricultural companies listed on the ASX have struggled. Investors have not enjoyed the volatility of earnings and have continually been disappointed by poor seasons (Prime Ag, AACo) and poor capital allocation and management. For example, the likes of AACo, Murray River Organics Ltd (ASX: MRG) and Beston Global Food (ASX: BFC).
Costa, An Exception?
Defying this trend, the market has looked favourably on Costa Group since listing in 2015. Having initially hit the boards at $2.25, the market darling rallied to a high of $9.04 in 2018 on the back of what can only be described as avocado mania. Investors were willing to pay 43 times 2018 underlying earnings to own a piece of this business.
While this euphoria has subsided a little, Costa shares are still changing hands at 26 times underlying 2018 earnings. This valuation still appears rich when the following is considered:
Private Equity Sell-down
Paine & Partners used the IPO to sell down their majority stake in 2015. The group has now fully exited the business, with their board representative resigning in late February 2019. Interestingly, the Costa Family have also continued to sell down their remaining holding post listing. When the founding family and Private Equity backers exit, one needs to ask themselves whether the good times have already been had.
Significant Debt And Lease Obligations
At Dec 18, Costa Group’s interest coverage ratio (its ability to service debt) was 2.4x. On top of these debt payments, Costa Group does not own most of the land and water assets it utilises to grow its produce. Instead, it leases most of these assets through long term agreements with the likes of Macquarie Asset Management and Vitalharvest Trust (ASX: VTH). It is worth remembering that Costa Group must meet these obligations annually before it can attribute any return to its equity holders.
Selling Into An Oligopoly
Costa Group’s largest counterparties are Woolies, Coles and ALDI. They account for ~2/3rds of Costa’s total sales. There is a risk that Costa can get squeezed should the major supermarkets start a new price war.
General Agricultural Risk
Disease risk, water availability and general production risk are being taken on by equity holders of the business.
International Expansion
Costa Group has in recent years expanded its footprint into blueberry operations in Morocco and China. There is a long list of ASX listed management teams who have unsuccessfully attempted international expansions in the name of growth. Time will tell whether Costa Group’s management can successfully execute this expansion.
The Verdict
While the thesis for investing in Costa might seem enticing at face value (domestic population growth, healthy eating thematic, Australian as Asia’s food bowl), the risk/return being offered at current prices does not seem to add up to me.
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