“My theory is that, especially in Australia, economic growth is slowing and people are eating less smashed avocado at $25 a time,” he said, referring to the favourite cafe brunch order. “If this is true, then Costa is a stock that is far more cyclically-exposed than we thought.”
Mr Debney said it was a host of temporary demand issues coming to fruition at the same time that caused the downgrade, rather than a structural problem.
“The issues we’re dealing with at the moment are across a number of our categories but we don’t see them as being structural,” he said.
Costa was hit with lower-than-expected berry prices, particularly for raspberries, and overproduction in truss and snacking tomatoes, due to dry weather across Australia. At the same time consumers demanded fewer avocados than expected.
Overseas ventures to revive growth
Despite weak avocado sales hurting Costa’s bottom line, Avocados Australia CEO John Tyas said domestic demand for the fruit had increased 6.3 per cent per annum since 2005-06 to 2017-18.
Mr Tyas said a rapid increase in Australian avocado production meant the Australian market is approaching saturation. He said it is “imperative for the industry to access and develop new markets” as a result.
Mr Debney said the company’s overseas operations would help to revive growth. He said expanded Chinese production of blueberries, raspberries and blackberries, along with blueberries in Morocco, combined with South Australian mushroom production picking up, would drive future sales growth.
Over the 2019 calendar year growth would be in line with previous guidance, he said.
Investors who joined the company at the initial public offering in 2015 have experienced good growth in the stock until a more volatile period over the past 12 months. The share price when the company listed in July 2015 was $2.25 and the stock reached an all time high of $8.98 in June 2018.
A hedge fund manager who is short Costa and declined to be named said this downgrade was foreshadowed.
“The structure of Costa’s relationship with its major landlord VitalHarvest, who earns most of its income from a revenue-sharing agreement with its tenant, and the Costa family’s decision to sell out of their exposure to this entity via the VitalHarvest IPO last year, foreshadowed what insiders thought about the true prospects for the 2019 year,” the hedge fund manager said,
Costa’s poor sales performance was exacerbated by delays in a planned upgrade of its Monarto mushroom facility, the citrus off season finishing earlier than expected and ongoing costs from new investments, the company told shareholders.
Macquarie analysts said in a note the downgrade was a “fairly significant change” in a short period, given a statement from Costa at its annual general meeting in November 2018 that said it was “off to a solid start to year”.
The analysts, led by John Purtell, said the downgrade was especially surprising at this stage in the financial year because the typically bigger June half of the year was still to come.
Late on Thursday, JPMorgan cut their price target for Costa from $7 to $4.74 and downgraded the stock from overweight to neutral.
The analysts said “although the company believes these issues are not structural, oversupply in a number of Costa’s core categories has always been a risk, and is now firmly in focus”.
Costa has had an intense investment schedule over the last 19 months, said a note from Credit Suisse released in December 2018. The company acquired a large presence in avocado production, increased control of its Moroccan berry operation African Blue to 89 per cent, continued to expand its mushroom capacity, furthered berry expansion in China and increased its hectares of citrus production by 25 per cent.
Credit Suisse highlighted the main risk facing Costa was “output price and volume fluctuations due to short-term supply demand dynamics”.
According to Macquarie, Costa’s downgrade was the second miss to guidance in the last six months, after poor weather in Morocco impacted its blueberry production there in August 2018.
Costa will provide a guidance update at its results release in late February.
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