Is Costa Group’s share price decline cyclical or structural?

One of the more significant de-rating stories over the past 12 months has been that of fruit and vegetable grower Costa Group (ASX:CGC), which has had to issue two earnings downgrades over this period due to a variety of weaker pricing and agricultural-related issues.

After touching a high of around $9.04 in June 2018, the share price has fallen approximately 58 per cent to near $3.80, erasing most of the strong gains it recorded over the past 18 months (but still trading above the IPO price of around $2.25 from July 2015).

Costa share price since Jan-2017

Source: Bloomberg

The share price decline sees it back at levels last reached in February 2017. The price fall is more interesting in the context of the company’s earnings per share expectations (EPS), which despite being reduced by approximately 13 per cent to 20.5 cents per share (cps) for 2019, remain comfortably above earnings per share of around 19.0cps in 2017.

Costa share price and Costa 2017 (red) & 2019 (green) EPS expectations

Source: Bloomberg

There are a couple of reasons for this:

• The company has a higher debt profile of around $200 million – a function of major expansions in mushrooms and berries, as well as a growth push internationally (including an increased holding in its Morocco berries venture).

Costa share price and debt profile

Source: Bloomberg

• The multiple of earnings the market is willing to pay for the company’s future earnings has “de-rated”.

Share price declines – fall in short-term earnings expectations vs market de-rating

To understand how a company may have de-rated as part of a significant share price fall, the downgraded earnings expectations need to be separated from the fall in the earnings multiple.

For example, in the case of Costa Group, the analyst expectations of EPS in 2019 has declined by approximately 13 per cent as previously shown. Short-term earnings expectations are usually more heavily influenced by temporary, cyclical factors. In the case of Costa, there have been a myriad of factors that have negatively impacted its near-term outlook vs prior expectations including price (mushrooms, tomatoes, and blueberries both domestically and internationally), a shorter citrus season than expected, and pest and disease impacts (i.e. “agricultural” issues).

These factors should generally be temporary in nature, although price impacts are arguably more structural if they are associated with significant increases in supply (potentially the case with blueberries), or changes in consumer preferences.

Without any de-rating, the fall in the share price would reflect the fall in earnings per share expectations – in this example 13 per cent.

Impact of market de-rating exacerbates downgraded earnings outlook

This is reflected in the decline in earnings multiple investors are willing to pay as reflected in a share’s price-earnings multiple. The approximate 60 per cent fall in Costa’s share price was partly driven by the 13 per cent fall in EPS, with the remaining 45 per cent driven by a fall in the PE multiple.

As shown in the chart below, the Costa PE ratio has fallen from a peak of 35x in mid Jun 2018, to 18x in May 2019.

Costa share price and PE multiple (red)

Source: Bloomberg

Costa presents itself as a structural growth story, with investments made in its various fruit and vegetable categories to increase production, as well as potential offshore (Morocco, China) and export opportunities cited as factors to justify its premium rating. This was supported by Costa’s EPS growth over the past 3 years of more than 30 per cent, which helped drive much of the share price performance prior to its fall. Given this EPS growth profile, it is easier to justify a higher PE ratio.

While Costa’s growth story is unchanged, it is clear from recent developments that the company is not immune to risks that are common to almost all agriculturally related businesses – namely price and volumes – which are largely outside of their control (volumes being a function of all things “ag” related, including weather, pest / disease, water, crop quality etc). The market’s assessment of the earnings growth may remain intact, but the market’s risk assessment of the earnings has predictably declined with a greater level of awareness of the potential volatility of earnings in any given year.