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Date : 09/08/2021

Costa Group Holdings

ASX :

CGC

Market Cap : $1.52 Billion

Dividend Per Share : $0.05

Dividend Yield : 2.74 %

Buy

52 Week Range : $2.78 - $4.81

Share Price : $3.28

Good operating performance, strong balance sheet, and cheap valuations. A "Buy" from us.

Company Analysis

Costa Group is Australia’s leading fruit and vegetable producer. The company grows and packs berries, citrus, tomatoes, avocados, and other high-quality produce sold to a range of domestic supermarket chains and independent grocers. Costa is also exporting to Asia, Europe, and North America. Most of the produce is grown on traditional farmland, but Costa is also known for its glasshouse grown tomatoes and mushroom growing facilities.

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Source: Tradingview.com

Since the last decade, Costa has been continuously undertaking strategic transformations focused on expanding its scale and vertical integration within its portfolio and reinvesting in the business to refresh its core assets and fund growth. This strategy has paid off as this led Costa’s share price to appreciate almost threefold from its debut at $2.25 per share to its all-time high at $8.55 per share in June 2018. However, the rally ended abruptly and last peaked in mid-2018 due to deteriorating growing conditions and supply issues at that time. We believe it is a lesson learned for the company and we have seen that Costa has addressed the issue since then.

Hence, the firm started to accelerate its expansion initiatives which comprised the development of the berry and sweet snacking tomato categories organically, leverage its long-term acquisition of Adelaide Mushrooms and the additions to its citrus footprint through the long-term leases of ex-Timbercorp orchards. Furthermore, Costa continued to expand its international presence in Morocco with its African Blue Joint Venture and progress its Chinese farming joint venture development. The recent operating improvements and an accommodative weather condition from early 2020 brought Costa’s shares back on track after the negative 73% multi-year correction.

From January last year to May, CGC went on a pretty nice run up by 100%. Unfortunately, the rally came to a brutal end on the 27th of May after the group’s Annual General Meeting (AGM). Following the AGM, Costa’s share price massively plunged by 24% which we assume was an excessive reaction from the market. Since then, CGC has been trading sideways, trapped in the $3.15 and $3.40 range. With the agricultural sector expected to rebound with material improvements ahead in crop production, we are quite optimistic that Costa’s share price will not take long to get back to its 2021 high above $4.80 given its solid fundamentals. Overall, we see Costa’s growth drivers being:

  1. the favourable weather conditions, and
  2. a solid balance sheet to support the group’s expansion and diversification.

Moreover, Costa is the leading fruit and vegetable producer in Australia which certainly gives an edge to the company. Costa grows and packs berries, citrus fruits, tomatoes, avocados amongst other high-quality products sold to a portfolio of clients that comprises local supermarket chains and independent grocers. We have also seen the group stepping up its capabilities for the export markets to Asia, Europe, and North America.

The majority of Costa’s produce is cultivated on traditional farmland, but we have seen substantial development of new techniques such as glasshouse grown products for tomatoes and mushroom growing facilities. This provides more stability and, in some way, removes a certain degree of risk vis-à-vis the weather factor. In parallel, with farming activities, Costa is also providing chilled logistics warehousing and related services within Australia. The logistics business segment represents about 12.5% of Costa’s revenue. On top of the group’s core Australian farms, Costa also has berry farming operations in China and Morocco and collects revenue from royalty coming from its blueberry varieties.

The Agricultural sector has not been fortunate over the last few years. We have seen extreme drought and poor weather conditions which originated in 2017. Encouragingly, since last year we started to see better-growing conditions with furthermore, July’s rainfall which has eased the severity of the long-term deficiency. We can expect the situation to improve progressively, hence, this has already been reflected in Costa’s better financial results. Revenues rose by 5.8% in 2019 along with crop pricing which increased significantly by the first quarter of 2020, mostly for berries and mushrooms. Not only did unfavourable agricultural conditions hit the firm, but COVID-19 was also particularly hard on the horticultural company. Thus, Costa is an essential part of the food supply chain and had to plough ahead whilst implementing strict hygiene and social distancing measures. Obviously, this brought a certain degree of difficulties to the farming process and created additional costs and operational inefficiencies. Despite facing such bottlenecks, we actually think that Costa did quite well to maintain crop yields and manage tough labour supply conditions during that period. Overall, we consider Costa’s CY20 results relatively good given the harsh situation faced by the company. Costa reported an 11.2% year-on-year increase in revenue to $1.16 billion and a net profit after tax which doubled up to $59.4 million. We like to see these figures growing as this attest to the resilient performance which reflects a strong recovery from drought and a solid contribution from an emerging international aspect of the business.

De-risking through diversification

Costa’s business model is built on the optimisation of its portfolio of integrated farming, packing, and marketing activities. After what the company has experienced, with multi-year harsh agricultural conditions, Costa is now striving to broaden its assets further to mitigate agricultural and market risks. We have seen many approaches by the firm to de-risk its business through diversification of categories and geographies. The company is also innovating for instance with growing in protected cropping environments using market-leading technology. Currently, Costa’s income is mainly coming from its products for the domestic market which represents 77% of the group’s total revenue. The international business segment is only 11%. However, this might change rather rapidly as Costa is embarking on a quest for diversification which involves acquisitions to extend its footprint and develop further its export market.

Timeline

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CY21 onward outlook: Costa back on the pathway to growth

Costa is undertaking a major growth initiative across its domestic and international segments. We have seen the company focusing on capital projects and acquisitions to increase its production footprint and drive increased earnings. Hence, not so long ago, Costa has entered into a binding conditional agreement to acquire 2PH Farms, a central Queensland based citrus grower for an upfront consideration of circa $200 million in cash. This in our opinion is a terrific play as it will enable Costa to ramp up its export supply to key Asian markets.

Currently, the citrus category’s income contributes to 30% of the group’s total revenue. With this acquisition, Costa expects to increase its citrus’ income to 35% of the total revenue. This new acquisition is expected to yield 24% of the total citrus production and contribute to a substantial increase in the group’s overall revenue. 2PH is a leading grower and breeder of seedless and seeded mandarins which could top up about $29 million to Costa’s EBITDA by the end of CY21. What is good about this acquisition is that the purchase is totally funded from the proceeds of a fully underwritten entitlement offer of $190 million, and from the company’s existing debt facilities. This capital raised has been announced on the 23rd of June 2021 with a new share issued at a price of $3.00.

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Source: Costa

Increasing insider activities

As you might already know, when insiders are buying shares, it is for sure a good sign. Hence, what is more, bullish than the Directors’ confidence in their company. In other words, the insiders think their stock price is likely to go up, and that is the case for Costa as we have seen quite some activities in the shareholdings department with major shareholders increasing their interests by about 16% on July 30, 2021.

Directors Interest Date Shares held prior to change Shares held Change (%)
Harry Debney Debney Super Fund 30-Jul-21 294,560 341,142 16%
Sean Hallahan Halaclan Super Pty Ltd. 30-Jul-21 10,990 12,727 16%
Janette Kendall Superannuation Fund 30-Jul-21 36,798 42,612 16%
Dr. Jane Wilson 30-Jul-21 37,500 43,425 16%
Neil Chatfield 30-Jul-21 375,000 434,242 16%
Peter Margin Margin Holdings 30-Jul-21 75,118 86,986 16%
Tim Goldsmith 30-Jul-21 37,500 43,425 16%

International footprint expansion

Costa is continuing its effort to diversify geographically by expanding its footprint. In Morocco, the group has recently conducted a variety analysis to support a five-year redevelopment programme that could potentially underpin future improvement in varieties and yields over the next 10-year. Costa is also progressively planting new genetics as part of the redevelopment of its blueberry farms in Northern Morocco. In the South, the group is working on the expansion of its farms to increase its production area to 102 hectares. One of the interesting ideas we really like is Costa’s development of a 52-week supply through its genetics which is now licensed to growers in South Africa and Zimbabwe. This will allow the group to furthermore supply products from June through December into its key UK and European markets, hence translating this to earnings growth.

The other key growth market is China. Costa is actually progressing rapidly in its expansion plan in the country. In CY20, the group completed on time its new 69 hectares farm at Guangmen with planting to support its goal of achieving maximum first-year yield realisation in 2021. Furthermore, Costa is also developing a 50 hectares farm in Baoshan intending to harvest early next year. All things considered; we think that Costa is on the right track to reap the fruits of its labour. Through its Chinese joint venture Driscoll’s Inc, Costa has plans to expand and improve fruit handling capacity as the total farm production increases. Costa is also starting to service Southwest China, which comprises the large population centres of Chongqing, Chengdu, Kunming, and Guiyang. This is a massive opportunity given the region has a total population of about 220 million people. Furthermore, the substantial price premium being received for Costa’s Arana blueberry variety reflects the growing market share of premium fruit due to increasing income levels and the burgeoning Chinese middle class.

Investment Thesis

Costa exhibits solid foundations to support its international expansion

Costa went through many years of challenges. First with unfavourable conditions due to extreme weather and then with the global pandemic which causes considerable operating headwinds. Nonetheless, Costa’s 2020 financial year was relatively good despite the circumstances. Costa delivered a $59.4 million underlying Net Profit After Tax. We can without hesitation say that these were solid numbers, where the company overcame the challenges of drought in the first half and successfully responded to the impacts of COVID-19. Over the years, the company more than capably met the challenges of the pandemic, delivering a strong result in the process. Despite contributing to only 11% of the total revenue, the international segment played an important role to keep the company’s earnings growth.

The result was pleasing for a couple of reasons, not least of which it demonstrated the strength and resilience of Costa’s business model and the company’s ability to bounce back after such a challenging CY19, which was dominated by drought. All things considered; we believe Costa is now a stronger business coming out of COVID-19 than it was entering it. For CY20, Costa saw its revenue up by 11.2% year-on-year primarily supported by increased trading volume combined with improved pricing for Avocado and Citrus categories. The group also displayed an impressive, improved EBITDA-SL of 47.3% year-on-year led by an earnings growth from the international segment as well as solid sales from its berry and avocado categories in Australia.

Source: Costa

Revenue forecast and valuation

What we really like about Costa is that they never failed to maintain a solid balance sheet even when facing a global pandemic. Furthermore, we have seen the company’s fundamentals going stronger in 2020, hence, leverage is low at 0.99x and ahead of the management plan. Costa’s debt remains perfectly reasonable as attested by a manageable 27.4% of the capital structure with $143.9 million. This should continue to support them to pursue growth opportunities and new funding. The group exhibits a robust cash position as well which we expect to remain well above $30 million for the next three years. A decent amount of cash is by the way good for the dividend’s payout, and according to our analysis, we expect Costa to maintain a stable fully franked dividend distribution of 10 cents per share over the next 3-year period which is an annual yield of about 2.74%.

In terms of valuation, the latest consensus estimates point to an EV/EBITDA multiple of 8.9 times for FY21 and 7.3 times for FY22. Given Costa’s earnings per share growth rate of 33% and 9.9% for these years, we are quite convinced Costa to be much at a discount. Furthermore, we also like the fact that Costa’s business is supported by an underlying demand with healthy pricing. For the last three years, the group embarked on an ambitious strategic plan to grow through aggressive acquisitions. We like the idea as we are convinced it is the way to mitigate the risk of the agricultural core business which is through diversification of product categories and geographies. So far, we have seen the strategy starting to bear fruit through improved yields, optimised costs, and less exposure to climate risks. Overall, we forecast Costa’s revenue growth to be on a constant upside at a CAGR of 11.19% for the next three years. Accordingly, we assume a stable EBITDA margin above 12% from the current financial year to FY23.

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Technical Analysis

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Trend

We can surely say that Costa’s share price has been on a roller-coaster since its debut on the ASX. CGC started on the stock market at $2.25 per share and climbed rapidly to its all-time high at $8.55 before encountering a massive one-and-a-half-year correction all the way back to its IPO price level. The massive sell-off started around mid-June 2018 and lasted until January 2020. This was due to investors loss of confidence in CGC due to unfavourable weather and growing conditions. Since early 2020, the situation improved which brought CGC price action back to its bullish momentum sending the shares up by more than 100% to near the psychological level of $5. Unfortunately, the last AGM triggered what we believe to be an overreaction from the community of investors which brought the share price down by more than 24% in just a day. Since May, Costa’s share price is consolidating in a tight range between $3 and $3.5. Given the first bull-run of 2015 to 2018 which propelled CGC share price by threefold coupled with the current price at just 42% above its IPO price, we assume Costa’s valuation to be technically cheap. Furthermore, since May’s correction, CGC’s price action on the weekly chart is also in divergence with the RSI indicator which indicates a potential trend reversal.

Key price levels

The first level to watch is the $2.92 – $3 area which represents the 78.6% Fibonacci retracement level from the January rebound. We think that this level might attract market participants given a relatively fair price. On the upside, the $3.5 – $3.64 range is the nearest resistance level which is also the 50% retracement level from the previous swing high. Once a clear breakout of this price range occurs, CGC may have the potential to rally back to its recent high above our first target at $4.5 per share.

Volume and momentum

Volume decreases since the last 200-day with the 20-day volume average down by -13%. The price action remains neutral in the near term, evolving in a range between $3 and $3.5 per share.

Trade consideration

  • Market participants might be interested to enter at key support levels: $3.20 and $3 per share
  • Primary target price above $4.50 per share
  • Secondary target price at $5 per share

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Recommendation

Costa went through many years of challenges. First with unfavourable conditions due to extreme weather and then with the global pandemic which causes considerable operating headwinds. Nonetheless, Costa’s 2020 financial year was relatively good despite the circumstances. What we like about CGC is its ability to maintain good operating performance and a solid balance sheet. This should continue to support Costa in its quest for future acquisitions and new funding. Also, the group exhibits a robust cash position, which translates into stable dividends and fuel for growth. All in all, we believe Costa has a solid foundation to support earnings growth and given an EV/EBITDA estimated at 8.9 times, CGC appears to be fairly cheap, and we recommend long-term investors to “Buy”.

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