David Brown’s Hawk Ridge Partners L.P. is betting against the shares of Calavo Growers Inc as the fund believes the stock’s valuation has got ahead of the fundamentals and industry trends are moving against the business.
Hawk Ridge has reported a steady stream of successful longs and shorts since its inception in October 2005. Founded by David Brown at the age of 27, to the beginning of this year Hawk Ridge has returned 12.4% net per annum for investors, outperforming its benchmark, the Russell 2000 by 5.7% per annum over the same period.
- Hawk Ridge Management: Up 7.7% In 2015 Likes MLPs
- Hawk Ridge Partners’ Unique Valuation Approach
Calavo Growers has now become a key short position for the fund. David and team believe that the packer has benefited from one-off factors over the past few months, which have helped to inflate the group’s valuation but these factors won’t last for long, and over the next twelve months, Hawk sees “earnings reverting to a more normalized level.”
Hawk Ridge Partners: Sell Calavo Growers Inc
The key one-time events that have lead to Calavo’s earnings spiking in recent months are rapidly rising avocado prices and a bumper avocado crop in California. Calavo has benefitted from this trend due to management’s foresight. The group purchased and froze a large portion of its avocado inventory in early 2016 at lower prices. Thanks to this foresight, Calavo’s business of selling frozen and UHP guacamole to food service and retail has benefitted from widening margins. As this inventory is used up and replaced by much higher cost fruit being bought today, margins in this segment should fall more in line with historical levels. This compares to consensus, which continues to extrapolate record margins into the future. Sales of frozen avocados account for 25% of Calavo’s gross profit. Also, the company has benefited from rapidly rising avocado prices and a bumper avocado crop in California. This has led to levels of levels of profitability that Hawk Ridge believes “are unsustainable.” 50% of Calavo’s earnings come from packing and marketing fresh avocados to retailers and food service.
Hawk Ridge might not have to wait long for its short thesis to play out. According to various news outlets, avocado prices are already dropping from their all-time highs printed last month. After hitting a high of $1.23 per unit at the beginning of October, up from $0.86 per unit at the beginning of the year, the price for a case of avocados has come down to $56 to $59 from $80 in October and up from $30 at the beginning of the year.
Based on these trends, it seems outrageous that shares in Calavo are trading at over 30x peak earnings and over 17x peak EBITDA. Hawk Ridge calculates that as avocado prices continue to slide and frozen inventory runs out, earnings will be $1.69 next year vs. consensus of $2.30. y. We believe earnings will be $1.69 next year vs. consensus of $2.30. On this basis, at current prices, the stock is trading at nearly 40x next year’s earnings vs. the best peer (Fresh Del Monte) trading at 17x arguably peak earnings. Overall, Hawk Ridge sees a 50% downside in the next six months if results normalize and investors better appreciate the headwinds facing the business.
In their own words:
1) 50 percent of Calavo’s earnings come from packing and marketing fresh avocados to retailers and food service.
2) Calavo Growers is losing market share in fresh avocados as competition intensifies and supply sources diversify away from California and Michoacán
3) 25 percent of Calavo’s gross profit comes from selling frozen and UHP guacamole to food service and retail. This business is also achieving profits that we believe to be unsustainable.
4). Although management has an attractive secularly growing business in RFG…… not enough ….. to offset challenges in Calavo’s core avocado businesses.
5). This is a low barrier to entry, commodity business in a growing market.
6) There exists a variety of tail risks that are not properly handicapped by investors, including substantial risks related to the Trump presidency
7) Although a short here is not without risk, we believe there is enough going wrong in the business that positive surprises that could appear elsewhere are unlikely to make up for shortfalls we foresee.
Regarding Trump the hedge fund specifically states:
The immediate short-term impact of the Mexican peso devaluing is modest positive, but to the degree you think there is a meaningful risk of trade relations with Mexico you will be hard pressed to find a stock with more risk. There is a fascinating history here that there is a book on which you can find on google, but bottom line is before NAFTA we didn’t get avocados from Mexico, now we do, and it remains to be seen what will happen if our relationships with Mexico devolves under the new administration. One concern being floated around industry is that a Trump administration will levy hefty tariffs on Mexican agriculture to help pay for the wall. It’s also worth noting that despite becoming a more mainstream fruit, avocado consumption among Hispanics are about 4x per capita more than for other demographics. To the degree you see pressure on that demographic, it should not bode well for overall avocado consumption.
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