Hawk Ridge Capital on the long thesis for Calavo Growers

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2016 Hedge Fund Letters

Calavo Growers is a cyclical, commodity processor of avocados trading at over 30x peak earnings and over 17x peak ebitda. As the business normalizes and overshoots to the downside – which we believe is in the process of happening right now – we think the stock is likely to decline substantially. We believe earnings will be $1.69 next year vs consensus of $2.30, driven by shortfalls relative to expectations in 2 of 3 segments. On this basis, at current prices, the stock is trading at nearly 40x our estimate of next years’ earnings vs the best peer (Fresh Del Monte) trading at 17x arguably peak earnings. We see 50 percent downside in the next 6 months if results normalize and investors better appreciate the headwinds facing the business.

Kjokkenutstyr / Pixabay

The stock is owned by GARP type investors who are attracted to the secular tailwinds behind avocado consumption in the US, predicting double digit growth for the foreseeable future. The company is covered (in our opinion poorly) by 5 small sell-side firms. The company holds no conference calls, and has a history of being promotional and overly optimistic in its press release and directional guidance. Unless you do substantial independent research, talking to growers, private competitors, and customers, there is little to counter management and analyst’s positive narratives. We think this simple to grasp story and strong recent results have lulled investors and analysts into a sense of complacency about an inherently volatile, cyclical, commodity business.

Basic thesis:

1) 50 percent of Calavo’s earnings come from packing and marketing fresh avocados to retailers and food service. A confluence of one-time events — namely rapidly rising avocado prices and a bumper avocado crop in California — has led to recent levels of profitability that we believe to be unsustainable. We believe current market conditions are in the process of turning this headwind into a tailwind and will contribute to lower earnings next year.

2) Calavo is losing market share in fresh avocados as competition intensifies and supply sources diversify away from California and Michoacán, offsetting much of the secular volume benefit longs are buying into. We think this is a low to mid-single digit growth area over time vs. consensus expectation of mid-teens.

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. We believe Calavo is benefiting from low cost avocado inventory it purchased and froze early in 2016. 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.

4). Although management has an attractive secularly growing business in RFG, where they prep ready-made food, pre-cut fruit and precut vegetable for grocery, there is not enough here (at 25 percent of gross profit and mid-teens growth) to offset challenges in Calavo’s core avocado businesses.

5). This is a low barrier to entry, commodity business in a growing market. We believe the commodity nature of the business will drive long term profits and multiple more than the secular avocado story, especially as the issues we cite in this write-up come to pass. As such, we expect this to over time be valued more like its peers Fresh Del Monte or JBSS, both of which have similar business models with similar levels of cyclicality.

6) There exists a variety of tail risks that are not properly handicapped by investors, including substantial risks related to the Trump presidency, the influence of Mexican drug cartels on the avocado trade, “trading risk” in the fresh segment, and demand destruction at retail driven by supply issues and subsequent dramatic price increases on avocados coming out of Mexico.

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.

1) 50 percent of Calavo’s earnings come from packing and marketing fresh avocados to retailers and food service. A confluence of one-time events — namely rapidly rising avocado prices and a bumper avocado crop in California — has led to recent levels of profitability that we believe to be unsustainable. We believe current market conditions are in the process of turning this headwind into a tailwind and will contribute to lower earnings next year.

Calavo owns pack houses in California, Michoacan (Mexico), and a new but unopened packhouse in Jalisco, Mexico. The company gives regular disclosures in their quarterly reports, which allows us to back into detailed volume and profitability levels for both their Mexico and California pack houses. This process is tedious but very helpful for analyzing the business, but something we believe most investors have not done. Avocados are typically sold on a box basis, which contains 25lbs. Calavo also sells some fruit on consignment (where they don’t own the pack house and just market the fruit), but this business is less than 10% of segment gross profit and is thus ignored for our purposes here.

In conversations with management, Calavo repeatedly states that they target to make somewhere between $2.25 and $2.40 of gross profit per box. History suggests this is in the ballpark

Calavo

On a quarterly basis, numbers can be substantially more volatile:

Calavo

Analysts and investors have made what we believe to be the mistake of assuming this continued level of performance going forward in their models, both because their volume & margin assumptions are too high. This gets to the heart of our thesis, short-term, which is that investors are extrapolating forward a unique combination of events that resulted in the best margin performance in Calavo’s history in any quarter. Unfortunately this is, in our view, likely to be followed by one of the worst quarters Calavo may ever see in this segment.

What drives gross profit per box profitability?

To the degree you are a consumer of avocados, you probably noticed or heard about an avocado shortage, which resulted in many restaurants taking avocados off their menus and grocers having no fresh avocados to sell. Do a simple google search and you’ll see plenty of articles explaining why this happened and its effect in the market. In short, there was a shortage of avocados in Mexico, first driven by a weak “floro loca” growing season, followed by grower protests that blocked shipments of avocados to packers for 2 weeks in early October. This led to shipments of avocados slowing to a trickle in the early weeks of October, and a subsequent tremendous spike in avocado prices, unlike the industry has ever seen:

Calavo

Pricing skyrocketed largely due to a shortage of fruit coming out of Mexico. According to the Hass avocado board, Mexican volumes were down 18% in CVGW’s Q3 2016 (Oct 31 year end) and down 20.4% for

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