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Brussel Sprout anyone? CGC

Costa Group shareholders (CGC) could be forgiven for thinking they had joined the eponymous Mushroom Club.

It is Australia’s leading horticulture and global produce supplier, a company with annual sales of $1 billion. But mushroom consumption was the biggest drag on earnings in the recent first half results, down 8%. Problems with mushy raspberries also didn’t help.

Costa has a broad production base – it’s a grower, packer and marketer of fresh fruit and vegetables in Australia, China and Morocco. Fresh produce accounts for 83% of sales and 78% of EBITDA.  

Domestically Costa grows berries, tomato, avocado, mushroom, citrus and grapes. International focus is on berries – China is a big market for blueberries and raspberries. And the company grows blueberries in Morocco to supply the European market.

Mushroom price rises domestically have outstripped food inflation affecting its affordability relative to other vegetables. And consumption has fallen sharply. Costa is hoping this will be reversed in the current half. Australians consume about 2.6 – 2.8 kilograms of mushrooms per year according to Horticulture Australia data. But the trend for a structural uptick in mushroom consumption is not convincing. Although veganism and healthier eating may help, at the margin.

So what has created the perfect storm in the mushroom market? Mushrooms are one of the most expensive vegetable products on a per kg basis and consumers will contemplate other vegetables when times are tough. Prices for mushrooms have increased over 20% in three years according to Horticulture Australia data, most other vegetables are up 1%-9% over the same time.

Costa is the 800 pound gorilla in the mushroom market with close to 40% production. Retailers have pushed for alternative sources of supply. And it demonstrates that delicate balance between supermarkets using contract growers and accessing wholesale markets as vegetable prices oscillate. As mushroom prices stabilise it is possible in the coming 6-12 months margins will be restored. But it will be a slow process. Costa expects mushroom sales for FY20 to be in the vicinity of $211 million at an average price of $7.20 a kg.

The Australian vegetable industry had a gross value of production of around $3.45 billion in 2016-17, roughly in line with its average value over the past 20 years. It represents a little over six per cent of the total value of Australian agricultural production.

Over 90 per cent of all fresh vegetables sold in Australian supermarkets are grown in Australia, with the few imports covering vegetables with production windows that are restricted to small growing seasons, like asparagus and garlic.

Potatoes are by far the biggest vegetable commodity grown in Australia by volume, with over 1.3 million tonnes of potatoes grown followed by tomatoes, carrots, onions and head lettuce. Many of the other most valuable vegetable crops in Australia also reflect an overall higher price per tonne, rather than a value supported by weight of production, such as mushrooms ($396 million), leafy salad vegetables ($304 million) and broccoli/baby broccoli ($229 million).

Costa’s forecast EBIT is around $102 million for FY20. Which suggests Net Profit after Tax of $65 million and Earnings per Share (EPS) of 20 cents. Dividend payout is estimated around 50-60 %, – at the low end of the scale because of the capex debt load the company is carrying. 

The upside Costa’s product base is berries. And the company is an agricultural stock subjected to market pricing vagaries. But as Costa builds a presence in larger overseas market some of the geographical earnings risk is diminished.

Berry revenue rose 12% with blackberries contributing more than half the growth. North Queensland blueberries and the larger Arana premium berry (20-25% of blueberry hectares) also made a greater contribution. This reduces exposure to the commoditized blueberry harvest in northern NSW where pricing is more competitive. Given blackberries are only 5% of the company’s hectares, they have made a larger contribution given the time of the year they are harvested. Costa has said that blackberries will reach 52-week supply in FY20e.

Costa’s maintainable earnings are in the immediate vicinity of around 22 cents rising to around 27 cents in FY21. On that basis with earnings growth of about 10% pa the stock is trading on a forecast P/E of around 12 times. Which is a little low.  A P/E of around 15 looks more appropriate with a price target of around $4.20.

The size and scale of the Australian vegetable market, plus its use of technology best practices to increase yield and production potentially makes it subject to scrutiny from overseas buyers. Witness the furore and somewhat ridiculous prices Chinese companies are paying for organic Australian baby milk producers like Bellamy’s. 

The overseas production arm of Costa I think adds to its attraction to an Asian buyer. And I suspect there might be one or two corporate opportunities emerge in the not-too-distant future for Costa. One of these may be to substantially reduce debt by a strategic placement to an Asia buyer. And in one of these situations the stock could head back to its previous highs of $6.00. But wait for the earnings momentum to build. Indeed, it seems all the bad news is in the Costa share price

Now who is for another spoonful of brussel sprouts with dinner tonight!

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