Valuation On Calavo Too Optimistic

Sep.12.13 | About: Calavo Growers, (CVGW)

"They call it green gold," wrote a New York Times reporter in 2004. Avocados are big business. The dual force of the health-conscious consumer and the growing Mexican-American presence are wetting appetites for the avocado. Calavo Growers (NASDAQ:CVGW), a global marketer and distributor of avocados, has benefited from the boom in avocados, but the stock is ripe for a correction. The company suffers from long-term competitive pressures and an overly optimistic shareholder base.

Avocado consumption has risen dramatically over time. Domestic per capita consumption grew from 1.1 pounds in 1989 to 4.5 pounds per capita in 2011. That trend has only sped up of late. In 2012, avocado consumption increased 34% from the year before. One contributing factor to this trend is an increasing Mexican-American population. Consumption of avocados in Mexico is about 20 pounds per capita.

On the surface, the picture appears bright for Calavo. The company makes money by marketing and distributing avocados. It also offers value-added services such as ripening and bagging, and it produces, packages, and distributes guacamole, fruit salad, and salsa chips. In addition to marketing and distributing, the company also owns interests in avocado growers. As avocado consumption grows, the company has more additional units to sell and more value-added services for which to charge.

The underlying picture is more bleak. Calavo's value chain is easily and often duplicated in an industry which competes on little else but scale where the value of that scale is highly uncertain. There are 9 major avocado handlers in California including its largest competitor, Mission, a private company. Like Calavo, Mission offers value added services such as ripening, grading, sizing, labeling, and packing. Calavo has 3 packing houses, 3 value-added depots, 1 distribution center, and a processing plant. As far as the outsider eye can see, the technological barriers to entry are not high for the likes of Dole Food Company (NYSE:DOLE), Fresh Del Monte Produce Inc. (NYSE:FDP), or Chiquita Brands International Inc (NYSE:CQB) which all enjoy superior financial strength and logistical expertise. Add to the mix competition from Mexico, the largest grower of avocados, legally permitted to import into the U.S. beginning in 2002, and Calavo's prospects begin to deteriorate.

Return-on-invested-capital ("ROIC") is 24.84%. This number is subject to decline as margins come under pressure. Results released September 9, 2013 show gross margin dropping from 10.5% in the third quarter 2012 to 9.3% in the third quarter 2013.

Calavo is valued at an expected FY 2013 EBIT/EV ("earnings yield") of 5.19% after removing a $38 million equity investment in Limoneira Company (NASDAQ:LMNR) from its market value. With a pre-growth free cash flow ("FCF") yield of 3.5%, Calavo offers a margin-of-safety of just 0.7% above the risk-free-rate, and a negative margin of safety with a more conservative risk-free-rate assumption of 4%.

Any justification for buying at current levels requires confidence about adequate future growth. An excellent scenario would be that the US population increases personal consumption to 15 pounds per year; not quite Mexico, but still more than three times current consumption. If that growth comes to fruition over the next 15 years, 10% growth for the first 5 years, 8% from 5-10 years, 5% from 10-15 years, and a steady 2% after that, then you get a discounted cash flow ("DCF") value of $357 million market capitalization, or $24.33 per share. That assumes steady FCF margins throughout, and a discount rate of 8% which provides for a 4% margin-of-safety above a 4% risk-free-rate.

$24.33 per share amounts to a 22.84 Price/Free Cash Flow ratio, and the business is well capitalized with a 33% debt-to-equity ratio, so there are no pressing downward adjustments for credit risk. Adding Limoneira back in boosts per share value to $26.97, but that still equals an 8% discount to the market price today. Carrying out this valuation exercise shows how strenuous the Calavo valuation has been.

The scenario I have used is optimistic, and I see Calavo outperforming that outlook in a limited number of ways above and beyond my assumptions: 1) higher FCF margins, 2) higher market share, and 3) faster near-term growth. While 1 and 2 are quite possible, I believe the company will face increasing competition and margin pressure over the long-term as explained above. Faster near-term growth is possible, but leaning towards conservatism in valuations demands that the relied upon growth assumption not be absolute best case scenario.

Calavo is selling a commodity product after all. Unlike oil, where profits have been made since Drake at Titusville, cultivating the avocado requires no great amount of risk, expertise, or capital. The long-term competitive advantages are minimal and profits are subject to erosion. When you buy Calavo, you rely on the strength of future performance over the long-term. Although the future of the avocado business in the U.S. has an obvious trajectory, choosing to participate in that growth through an easily replicable vehicle promises rotten results, especially when the price you pay requires stellar performance for decent or less than decent returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.