Description

SUMMARY THESIS

Calavo Growers (Nasdaq: CVGW or “the Company”) is a straightforward and timely short opportunity with an estimated +40% return over the next two quarters. The rise in commodity avocado prices that benefited CVGW over the last several years on the way up is now going against it as prices have recently reverted much lower. The result: 1) structurally lower and declining revenue and profitability going forward; 2) a likely re-rating as the market realizes the degree of commodity exposure in the business; and 3) challenges within its Prepared Foods segment intensify. This unfavorable shift in the landscape is a result of a large expansion in plant production concurrent with intensifying competition.

The recently returned, former long-time CEO, Lee Cole, has set expectations for a recovery in performance and somewhat of a reversion to the glory days for the business. The reality is the Company is now operating in a much more competitive environment than when he was previously at the helm with headwinds beyond his control. Financial expectations have yet to reflect this reality. At the end of the day, Calavo is a commodity agricultural distributor with a very elevated valuation (50x ambitious consensus forward EPS). CVGW is currently GC (4% SI % of float).

GROWN SEGMENT

The unit is a packager and importer of avocados (90% of segment revenue) with tomatoes and papayas comprising the balance. The segment accounts for 55% of total LTM sales and 62% of LTM gross profit. Calavo sources 80-90% of its products from Mexico and 10-20% from California, Peru and Colombia with packaging and distribution centers in the US and Mexico. It sells its avocados to grocery and restaurant chains with Kroger, Trader Joe’s and Walmart representing 15%, 11% and 10% of total revenue, respectively.

Background & Current Environment

Calavo historically benefited from elevated avocado prices, lower competition from other distributors and outsized financial performance. Rising avocado prices drove a large increase in planted acreage that is now leading to a surge in production volume and resetting of prices. The volume of imported avocados increased 40% YTD resulting in a 25% price decline per avocado. The USDA projects import volumes to increase a further 35% during the harvesting season over the course of the next five months. This will almost certainly put further pressure on prices.

Concurrently, the elevated product price and distributor margins and returns attracted a massive increase in competition. As recently as 2019 there were only a handful of active importers of avocados in the US with Calavo, Mission Produce (AVO), Del Monte and Henry effectively dominating the US market. Now there are over 300 operators sourcing avocado and competing for the same wholesale channel (grocery stores and food service). Various larger Mexican growers’ have also become vertically integrated and started shipping directly into the US. These dynamics have resulted in structurally lower product prices and margins for this commodity product. What was once a low-teens gross margin business, peaking at 14% in 2019 for CVGW, has incrementally contracted each year to 7% in FY2022. Peer Mission Foods has reported similar results and trajectories.

PREPARED FOODS SEGMENT

This unit is a packager and distributor of fresh cut fruits and guacamole sold to grocery stores and foodservice. The segment accounts for 45% of LTM sales and 38% of LTM gross profit. The segment has been in a tailspin as competition and grocers themselves (produce internally) have pushed down prices. Gross margins in Prepared Foods have declined to 5% in the last fiscal year (ended October 31) from +10% in 2020 and prior. In the MRQ, its troubles increased with guacamole (which only accounts for 17% of segment sales) accounting for $3.7M of the total Prepared Foods $2.4M gross profit, implying the rest of the segment is losing money. Meanwhile, management has recently suggested it can get margins to the 20% level. Analysts seem to have conflated getting guacamole margins to that level with reaching those margins for the entire segment. It is worth noting that Cole’s prior focus was on the avocado side, not prepared foods.

If anything, performance in the segment is deteriorating further. Last week, the head of Prepared Foods abruptly announced her resignation with no successor yet to be named. In conversation with the CEO the week prior, he stated he believed he had the team in place to improve operations on that side of the business. This comes just as the segment is in need of the most help.

Customer Losses

Supply agreements are very short-term and relationships are transitory. Across both segments, increased competition has resulted in the Company conceding share with its largest customers with revenue associated with both Kroger and Walmart each declining over 6% since 2020. This has been a result of Walmart using other distributors and buying direct from producers (Walmart formed an internal buying team dedicated to avocado procurement). One grocery chain buyer noted, “we once had only two or three distributors calling us, now we have dozens.” These competitive pressures were magnified in 2022 when weak crop yields and a temporary import restriction from Mexico led to product shortages and a spike in prices. This compelled retailers to diversify suppliers and become more aggressive on price. This will likely not reverse anytime soon as guacamole and avocados are a critical menu item at certain food services companies and grocers want to always have the fruit on the produce aisle. 

Over the last two years, CVGW outright lost its contract with Taco Bell, Jimmy Johns and several other large QSRs. Mission Produce has also been taking business at Chipotle away from CVGW. Chipotle is the largest buyer of avocados in the restaurant channel and Mission is now its largest supplier.

FURTHER BACKGROUND

Avocado Industry Dynamics

Starting in 2010-2012 American consumers started developing an increased preference for avocados. Annual per capita consumption steadily rose from 4 lbs. in 2010 to over 9 lbs. in 2020. Growers responded to the demand by expanding production in Mexico (the largest grower) and a wave of new farms in South America, with planted acreage more than doubling from 2010 to 2021. Since it takes three to five years to grow an avocado tree, it took several years for production volumes to catch up with demand. This led to rising prices for the fruit and outsized returns for growers and distributors such as Calavo. However, this year there has been a surge in supply as these trees have reached production and as new growing regions have been granted access to the US market. Most notably, last year, the USDA approved the export of avocados from Jalisco, Mexico to the US. Previously only avocados from Michoacan, Mexico had permission to ship into the US. The addition of Jalisco is adding an incremental 5-10% of supply to the US market (there are 95 growers, 9,441 hectares and 11 packing houses in that state). An avocado tree in Mexico can yield fruit three times a year and is a year-round crop so this is not a temporary seasonal phenomenon. Prices at these levels are still quite profitable for growers as well and is leading to further acreage expansion.

Management

In March, Lee Cole returned as CEO. He built Calavo into a public company and then departed in 2019. Since then, he had, by his own admission been “totally disengaged from the business and industry.” After his departure the Company had three CEOs in three years with nearly all Cole’s original team departing. As a consequence, Calavo lost a significant amount of operational know-how along with supply and channel relationships. Over the last couple of months, Cole has made ambitious promises regarding his plans to get the business back to where it was before he left. CVGW’s stock price ran-up on this news and his subsequent messaging despite limited details of what this turnaround will entail. The reality is the competitive environment evolved while he was away and his original team, which maintained critical industry relationships, have since retired. While we do not doubt his competence, he is simply fighting a battle he cannot control.      

FINANCIAL IMPLICATION & VALUATION

Avocado prices in Mexico (where CVGW sources nearly all of its fruit) and effectively set by the APEAM growers’ cartel on a weekly basis with all distributors paying the same prevailing price. Wholesale prices to US end-markets are determined by usual competitive forces. There is negligible value-add to this commodity product making distributors a pure price-taker on both ends. As previously noted, avocado distribution is an increasingly competitive and fragmented market. Industry gross margins are now at the 7-8% level so even if margins stabilize at this level, dollar profitability will be much lower given the reset in avocado prices/ revenue and fixed costs associated with this business.

The challenges facing the Company are intensifying while the market is expecting a recovery in performance with management guiding to EBITDA $40-45M in FY2023, requiring 2H’23 EBITDA to increase 94% Y/Y. Meanwhile, in the most recent earnings report, management indicated that avocado sales volumes are expected “to exceed prior year levels” with no commentary on pricing for 2H’23. Based on guidance from Mission Foods and Hass Avocado Board and USDA data through May, pricing is tracking to be down 50% Y/Y in FQ3/ CQ2 and likely heading lower as further supply comes to market. This implies a 45% revenue decline for the Grown Segment (assuming MSD volume growth). Note, CVGW does not own any farms so is competing for supply with the +300 other distributors and growers that ship direct such as Mission.

The Prepared Foods side is in shambles with revenue declining 15% in Q2 and 14% YTD due to customer losses. Even in a recovery scenario where revenue grows MSD and margins somehow stabilize, it will still only contribute approximately $20M in gross profit.

On the Grown side, approximately 25% of segment COGS are fixed (primarily packing and shipping). That amount for Prepared is likely significantly higher given the labor-intensive nature of cutting, etc. The majority of SG&A is also fixed. On a consolidated basis this equates to EBITDA of $5M for FQ3 and $9M for FQ4 or $21M for CY2023 versus consensus oat $35M and management’s guidance of $40-45M. For CY2023, CVGW is tracking to $8M in D&A ($14M of capex), $5M of SBC and $1M of interest expense results in pre-tax cash earnings of $6M and likely negative adjusted GAAP earnings versus consensus at $0.60 per share which is predicated on a major recovery in 2H. 

CVGW’s current market cap is $540M (17.8M fd s/o) and EV is $565M. On an LTM basis, CVGW is currently trading at 20x EV/ EBITDA with negligible adjusted earnings. Based on FY2023 consensus numbers, the stock currently trades at 16x EV/ EBITDA and 50x P/E.

Larger commodity agricultural producers and distributors such as Fresh Del Monte Produce (FDP) and Dole (DOLE) currently trade at 6-8x EBITDA and 13-16x EPS. At those multiples of consensus forward numbers, CVGW would trade at $9-13 per share, over 60-70% below current.

CATALYSTS

The stock will likely contract/ stock will re-rate lower in the near-term due to: 1) financial underperformance driven by lower avocado prices and realization that this has become an intensely competitive commodity business; 2) further deterioration in the Prepared segment; and 3) earnings and guidance revisions.

Risks & Bull Thesis  

• A recovery in avocado prices and return in margins to the 2019 period. This appears highly unlikely given the structural changes in the industry.
• A turnaround in its Prepared Food segment and return to profitability. This segment is rudderless and so far there has not been any plan set forth to recover this business.
• CEO was buying stock in the $24-$28 range in March. Presumably he could buy again if/when the stock gets back down to those levels.
• During his prior tenure as CEO, the Company was alleged to have systematically underpaid California farmers. This led to a significant loss of supply in that market. California once accounted for 35-40% of CVGW’s avocado supply base. Now it only accounts for 10%. The Company also underpaid local Mexican taxes under his watch. This has been a subject of ongoing litigation with Mexican tax authorities. Calavo has recorded an $11M provision in anticipation of an eventual settlement. It is unclear if Cole had a direct role in these unscrupulous practices but if the Company were to pursue similar tactics in the future, it would serve to temporarily boost profitability as it did when Calavo utilized them before. 

Catalyst

1) Financial underperformance driven by lower avocado prices and realization that this has become an intensely competitive commodity business

2) Further deterioration in the Prepared segment

3) Earnings and guidance revisions