Description

Summary

We believe this is a simple investment thesis: “information arbitrage” on a company that is one quarter into a minor turnaround - we think this story will play out over the next few quarters and once priced in, there is substantial upside to Calavo’s earnings and share price. 

VIC is familiar with Calavo - It was written up as a short twice in 2021 and June 2023. We encourage everyone to read those write-ups and comment sections for background and good discussions. Deerwood makes a strong case for a structural change in the avocado industry, however it is our belief that there is upside first based on a near-term turnaround at Calavo, before any potential downside as any structural/industry issues play out (if at all). 

Background

Calavo is the middleman between avocado growers and avocado buyers (Kroger, Trader Joe’s, Chipotle, etc). The company takes in raw avocados and pays growers, then sorts, packs, ripens and delivers avocados to customers. 80% of profitability comes from avocados, while the remaining is from a prepared foods business. 

Lee Cole, the company’s long-time CEO (1999 to 2019) took the company public in 2002. From there to 2019, the stock went from single digits, to over $100 per share - driven by a steady increase in earnings, FCF and dividend, as well as an ever-growing consumer love for avocados and guacamole. The company also bought its prepared food business (Renaissance Food Group) in 2011 with ~$150mm of revenue and grew it to nearly $500mm in 2019. 

However, that growth (and related multiple expansion) collapsed the past few years - the company lost share in its avocado business (due to underpaying growers) and had numerous challenges in its prepared foods business (due to customer losses and execution challenges) which caused margins to suffer. Lee Cole retired as Calavo’s CEO in January 2020, after having been in the seat since 1999. Since then, the company had two CEO’s, one interim CEO, and two CFOs - and now since the end of March, Lee Cole has been back in the seat. 

The share price has been volatile since the Cole re-took the helm. The stock price has gone up to $36, down to $22, and is now at $30. We believe this is market and sentiment-related. Putting aside the market for small caps being volatile the past 6 months, the company reported one quarter under the new CEO and is now about to report its fiscal year end on January 16th. In that one reported quarter, EBITDA beat expectations, however, FCF was weak (and heavily negative) leading to mixed sentiment on the stock. A recent Jefferies note asks the question “are the business improvements sustainable” - we believe they are, at least in the near term.

We think the crux of the thesis here is that prior management teams didn’t have any idea how to run an avocado business. They came from the general fruit and prepared food industry, and made their cases to us during diligence calls about how they can turn around the prepared side of the business. That never happened, and meanwhile the core avocado side of the business was clearly neglected. With Cole back in the seat, we think the company is returning to its roots and there’s going to be an upcoming period of earnings growth/normalization, FCF upside, and sentiment improvement that will drive the share price higher. 

New (Old) CEO

Our confidence here is built around multiple conversations with Cole. We think there’s a number of reasons to believe the CEO, and why the market may be mispricing this story:

1. Information vacuum - Mr. Cole never did conference calls, unlike the previous management teams (2020-2023).  And now that he is back, the company is back to not holding conference calls. So this is a small-cap, underfollowed stock and the best information comes from calls with the CEO directly. He is open to talk and we have found no reason not to believe him as his track record has been good. 

   1. More recently, the company reported its Fiscal Q3 in early September, and is now reporting full fiscal year results in mid-January. There are no press releases, meaningful 8Ks or road shows, creating a four-month information gap on shares (where shares swung wildly down and then up with other small cap names). On top of that, people were expecting a report in Mid-December, but the company pushed it to mid-January because they fell below the market cap size on SEC reporting rules and can now take more time to report/file their 10K. 

   2. We think this also provides a potential upside should Cole decide to do conference calls (something we have pushed him to do on multiple occasions)
      
      

2. Calavo has reported one full quarter under Cole’s helm - and results have improved from the previous management team. Most importantly, gross profit in the core avocado segment has improved in just one quarter. The lines below delineate Cole’s prior tenure (ending just before Q1-20), the new management teams (Q2-20 to Q2-23), and then the one clean quarter that’s been reported since Cole’s return (Q3-23). 
   
   
   

3. While there’s a lot said about avocado pricing, this is a spread business and the main metric is profit per case. Prior management teams completely lost focus on this key driver and were subsequently hurt when avocado prices fluctuated. We heard from Cole:

   1. Prior CEO lived in Arkansas/Kentucky, and flew out to California a few times a month. They let the Avocado division run itself without any attention, while focusing on turning around prepared foods. If at all they were focusing on the avocado business, it was in cost cutting - two examples we heard were laying off the most experienced (and therefore expensive) people, and trying to change to a cheaper box company but whose box couldn’t hold the weight of avocados leading to lost/crushed product and customer frustration/losses. Cole has since re-hired key people and fixed some of those mistakes.

   2. Avocado prices are published daily, and someone needs to focus on hand-to-hand combat. One penny per pound to the growers up or down can swing profit by $1mm for Calavo. So now the CEO is next door to the sales force, and setting/focusing on daily prices to growers and customers and capturing spreads is the first thing he focuses on every morning when he walks in the door.

   3. Avocado prices spiked in the summer, but have otherwise remained steady. This is a good environment for Calavo to get its steady spread. The CEO also described to us his proactive actions in the summer price spike, which allowed them to report good avocado gross margins despite commodity volatility - which allowed them to beat earnings estimates this past quarter.
      
      Source: Agronometrics
      
      

4. The CEO has purchased $5mm of stock since coming into the seat, increasing his stake by ~50%. We’d note: Mr. Cole is an excellent trader of Calavo stock. We plotted below his previous large buys and sells. An $8mm purchase and subsequent 70% run in the share price, a $10mm sale and subsequent 30% drop in the share price, and a $15mm sale and subsequent 50% drop in the share price (with that period ultimately coinciding with Cole’s retirement).
   
   And then most recently - two purchases of a total of $5mm of stock. In total, he has ~$15mm worth of stock. One of the things he told us was he came back because he was concerned about the slumping share price being such a large holder (3% of the company).
   
   

5. There are a number of issues mispriced or even unknown by the market:

   1. Last quarter, earnings beat expectations ($14mm EBITDA vs. $12mm estimate) - however Free Cash Flow was heavily negative ($-17mm). According to the CEO, this was a one-time issue with a new customer start up, along with working capital consumed due to reversing prior managements’ unsustainable strategy of stretching working capital.  Reversing this strategy hit free cash flow last quarter, but should now be normalizing.

   2. The Mexican tax matter from 2013 (see the 2021 VIC write up) has been resolved seemingly in Calavo’s favor. While the company has reserved $11mm due to the Mexican government to settle the underpayment of certain taxes, it also, however, has $54mm due from Mexico in IVA tax refunds that was stuck in courts and in a tit for tat holding pattern with the government. The Mexican government has seemingly been more open to paying the larger balance that Calavo is owed. In June 2023 Mexico started paying interest and penalties to Calavo in cash, indicating the matter is coming to a resolution. Given the company has $42mm of revolver debt, $54mm inflow vs. $11mm outflow in cash is very meaningful in whatever fashion this happens (likely in a drawn out fashion).

   3. We think Cole has a logical and steady capital allocation plan once FCF normalizes, which will help the stock price: paying off the revolver first, then increasing the dividend, and then buying back shares. Finally - we believe there’s also a potential for Cole to sell/spin off the prepared foods division which would all be immediately accretive to the share price. That non-core division and its underperformance has dragged the share price for years (including during Cole’s last tenure) - we don’t see why he needs it around.  Besides some purchasing synergies, there’s no reason the prepared foods business belongs with the core business.

   4. The company believes that due to weather patterns impacting the different geographic locations of growers, its product and therefore market share against Mission in California will improve meaningfully, which if true should support earnings in 1H 2024 

Catalyst

1. Lee Cole’s turnaround starts to gain traction - only one quarter has been reported, so another quarter or two of beats would substantially change sentiment on this stock

2. Potential for Cole to re-instate a conference call to better disseminate information

3. Steady core avocado earnings, combined with improved Free Cash Flow in FQ4 2023 - negating the bear thesis from last quarter

4. Pay down of debt as well as an increase to the dividend