Pricing Sours For Costa, Yet Sell Off Looks Overdone

This story features COSTA GROUP HOLDINGS LIMITED. For more info SHARE ANALYSIS: CGC

A sharp drop off in demand for some of its produce over December and into January caused Costa Group to flag a flat net profit outcome for 2018. Brokers believe the market reaction was overdone.

-Weak demand for tomatoes, berries and avocados key to downgrade
-Good volume growth opportunities seen in the medium term
-Although some recovery in pricing will be required to meet guidance
-Scale and diversity likely to support a smoothing of pricing/volatility over the year
 

By Eva Brocklehurst

The outlook for Costa Group ((CGC)) has been soured by the company anticipating flat net profit in 2018.This substantial downgrade to previous forecasts has driven brokers to review their assumptions. Underpinning the downgrade were softer Australian demand and produce pricing in December and January.

Citrus was weaker because of an early end to the season as well as the lower quality, given it is a biennial crop, and there was a delay in the expansion of the mushroom business (Monarto) in South Australia. The company has reiterated 2019 guidance, which implies net profit of over $78m.

Yet the update has highlighted the risk of oversupply, in Ord Minnett's view. The broker believes the company has good volume growth opportunities for the medium term, but some recovery in pricing will be required, as well as a strong profit gain in the six months to June 2019, in order to meet full year guidance.

The former lofty share price, Credit Suisse acknowledges, did imply hope for long-term high-output pricing, as well as significant margins. Still, tough domestic conditions have provided a reason to reconsider assumptions. Credit Suisse believes 2019 net profit growth should remain strong and above guidance of 30% growth versus 2018.

The key news in the announcement was the fact domestic berry pricing was soft in late December and early January. However, Credit Suisse notes the big swing in 2019 profit versus 2018 is likely to be driven by citrus and the international business, not the domestic berry market. Domestic berry operations are a fairly mature business, the broker points out.

Macquarie agrees the company remains well placed, with a solid market position, but its high PE (price/earnings) status meant a severe negative reaction in the share price, and multiples de-rating by over -20%.

Management signalled that 80% of the downgrade to profit estimates was based on subdued demand for tomatoes, berries and avocados in December. Ord Minnett suspects a re-rating is unlikely until the market is convinced the issues are temporary.

Demand Clarity

UBS suspects questions will be asked about the cause of the declines in price and, although the company has stated the issues are not structural, an oversupply in a number of core categories has always been a risk.

The main concern for UBS is the subsequent impact on prices for avocados, tomatoes and berries. The broker is concerned about whether consumers may be trading down, or whether the company's categories are becoming mature.

Also, is Costa Group losing market share? The company believes market share has been maintained. Even so, while retaining a Buy rating, UBS has become less convinced about the outlook. The broker acknowledges a good job in mitigating supply side risks but the risk on the demand side was previously underestimated. The broker suspects the issues regarding declines in prices will persist beyond 2019.

International

In its defence, the company has a leading market position and strong intellectual property, while the international business underpins a double-digit growth outlook. UBS expects international business will comprise around 41% of group earnings (EBITDA) by 2025 and, if the expansion in China proves successful and further plantings are announced, this could move to over 45%.

Management has emphasised second half 2018 losses in Africa, as it consolidates operations, and Credit Suisse suspects the 12-month margins may not be fully understood as yet.

Meanwhile, China is a start-up operation and 2019 revenue is expected to double off a low base. Hectares bearing fruit are expected to double in 2019. Credit Suisse significantly lowers medium-term margin assumptions, acknowledging its estimates were too high for the international business.

Goldman Sachs believes drivers of earnings growth are unchanged and 2019 is likely to be a strong year as capacity in Morocco and in China is ramped up. The broker, not one of the eight monitored daily on the FNArena database, envisages 31% upside potential to its new target of $5.90 and upgrades to Buy from Neutral.

Credit Suisse agrees investors have become overly nervous, as the announcement does not have material consequences for 2019, and the net profit impact for 2018 is immaterial to valuation. The broker upgrades to Outperform from Neutral as a result.

Macquarie points out that the company's scale and diversity tends to smooth out pricing/volatility over the course of the year. The broker notes the earnings profile has become skewed to the January-June half year, which is more pronounced in 2018 because of the additional farming cost investment that was required over July-December, and thereafter as a result of expansions in both Morocco and the avocado business.

This has been further complicated by the decision last August to change the company's financial year end to the calendar year. Macquarie points out, in practice, this means Costa Group on a calendar basis will bank a large percentage of its profits in its new first half to June, and, thus, there will be more visibility on the outcomes for the full year at the mid year. This compares with the former position where a large second half skew meant profits swung late in the year, which reduced visibility.

Costa Group has a $5.67 consensus target on the database, signalling 13.2% upside to the last share price. This compares with $7.47 ahead of the downgrade. There are three Buy ratings and one Hold (Ord Minnett).

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