Description

Here is an investment idea in a company with a long history of successful operation, has a dominant position in its niche, and has only recently been publicly traded. This company is Calavo Growers, Inc.

Since 1924 a California Cooperative has existed to provide growers a means of effectively penetrating the marketplace with their products. So successful was this concept that the coop grew to dominate their niche as the supplier to wholesale and retail outlets of “haas” variety avocados. In October of 2001 the company went public and distributed shares of the new company to Coop members. The new business entity was called Calavo Growers, Inc. and is traded under the symbol CVGW.

Being public has given this once small entity the ability to expand the reach of its expertise into new markets, while removing the restrictive shackles of being forced to serve only the needs of California growers. Instead of simply bagging avocados for resale, Calavo is now able to branch out into 3 primary divisions: 1) California avocados; 2) International Avocados and Perishable Food Products; 3) Processed Products. The ability to procure fruit from overseas ensures a more stable supply of products, which often times are cheaper and of equal quality to that procured from California.

In addition to the freedom to expand their expertise within the California marketplace, being public allowed the company to acquire another small fresh food producer, Maui Fresh International, Inc. which is a grower and distributor of chilies, papayas, and other exotic produce items which are closely allied to avocados in their consumption patterns and within the demographic of the typical consumer who would purchase avocados such as specialty shoppers or the Hispanic community. Together these facets make Calavo a tour-de-force in the fresh produce business.

As an idea of just how broad the reach of this company is consider the following bullet points:

- In 2003 34% of the California Haas avocado crop was handled
by Calavo.
- In 2003 31% of all Mexican imported avocados into the US was
by Calavo
- In 2004 it is projected that 100% of all Dominican
Republic avocados will be handled by Calavo
- In 2003 43% of all New Zealand avocados brought into
the US was by Calavo
- Calavo is the only company to provide the complete range
of processed avocado products including frozen pulp
and guacamoles, and frozen avocado halves.

Despite the Company’s dominance, no customer dominates Calavo. During 2003 the 5 largest customers accounted for 54% of all processed product sales, and only 23% of California Haas “raw” sales.

A number of initiatives are helping to propel this formerly quiet little Cooperative into a fresh food powerhouse. These include marketing initiatives aimed at both retail and wholesale customers. The other is a new processing facility built recently in Mexico which will leverage trends in the avocado business.

Retail customer loyalty is not high in the avocado business as the Company readily admits. Calavo has pioneered several techniques of procuring higher sales from retail customers. These include bagging of avocados which has been shown to snag impulse buys and to increase the unit sales volume from retail customers. Additionally the introduction of frozen avocado halves has led to increased retail sales as customers look to buy fresh and healthy foods with the luxury of prepared foods.

More important are the steps being taken to secure wholesale loyalty. Calavo has an extensive marketing database that facilitates sales reviews and helps customers plan and display. A proprietary program called ProRipe allows delivery of avocados of varying degrees of ripeness to the customer’s specifications. Certain customers are being paid in the form of rebates and exclusivity fees to secure brand loyalty where all else fails. The Company is serious about building and maintaining new outlets for its products.

Maintaining customer loyalty means nothing without a steady supply of fruit. The traditional source of supply for the Company has been California; however, a number of factors have conspired to make this source less reliable than in the past. As with the orange groves of Florida much of orchard land in California is under stress. The demand for new homes has led to many groves being permanently destroyed, and recently fires have damaged a number of groves. Calavo has a tremendous edge in the sourcing of fruit due to its strong overseas presence. The availability and price of California sourced Haas avocados is under pressure. In 2003 the amount of California avocados delivered to the Company decreased by 34 million pounds, a decrease of 23% over the prior year. Since Calavo maintained a market share of 34% in 2003 it can be assumed competitors are suffering as well. Without the constraints of being a cooperative Calavo is sourcing a tremendous amount of its needs offshore, and in 2003 16% more Chilean and 30% more Mexican avocados were handled. The Company is not just passively finding supplies overseas, but is rather leveraging a growing trend with significant infrastructure as well.

Clearly the trend in acquiring low-cost, reliable sources of fruit point to offshore suppliers. Most significant of these is Mexico, and in February of 2003 Calavo decided to invest substantially in this trend. It was decided to close 2 plants, one in Mexicali, Mexico and the other in Santa Paula, California and move their capacity to a new 90,000 sq. foot plant in Uruapan, Mexico. By consolidating a US based processing plant and a smaller Mexico based plant into a larger Mexico based plant the Company will reap many benefits and build substantial synergy for the future. Savings will then be realized in transportation costs, duplicative overhead structures, and in overall labor and service costs. This is in addition to the benefits of a steady supply of competitively priced fruit sourced from Mexico at competitive prices.

Major dietary trends in the United States include a penchant for low carbohydrate eating, and the avocado fulfills that role well. Additionally the fruit is high in potassium and “good” fats which makes them popular with the fish-oil and Omega fatty acids crowd. People under the sway of the Atkins diet could find themselves quite happy including avocados as a significant part of that diet.

More substantial is the growing influence of Latino culture in the United States. By best estimates Latinos eat 10 times more avocados than the US per capita average (about 25/2.3). While the high-pressure guacamole product will increase Calavo’s market penetration in the “snack” category, a significant market to be sure at $50 million in 2002 and growing by 10% annualy, the use of the fruit in Latino diets crosses into the staple category. It isn’t then simply used occasionally but rather included as a central component of many dishes, and an omnipresent garnish for others. Additionally when considering the inclusion of other recently added Calavo products such as chiles, this trend’s impact on the bottom line could be huge. This is largely what the Company envisioned with its $4 million acquisition of Maui Fresh in 2002.

A steadier supply of fruit from so many foreign markets might have been difficult to deliver in a meaningful fashion in the past. Recently however Calavo has developed a system to control the fruit ripening process. This will enable the ripening process to be evenly controlled and smooth out periods of over or under-delivery. In addition this system will allow the Company to deliver fruit of a very specific ripeness to a customer. ProRipe is the name given to the process, and the company is promising that is will revolutionize aspects of the industry, although they decline to give many specifics. Clearly however when dealing with a relatively fragile product this type of process is substantial in its ability to reduce spoilage and ensure a steady supply of just-in-time and just right fruit.

Clearly the Company is positioning itself to benefit from industry trends, and is a leader with substantial expertise. Let’s look at some financials (millions except per share):


2001 2002 2003 2004(e) 2005 (e)
Total Revenue 218 243 247 292 338
Gross 19 26 26 34.3 43.0
Gross % 8.6% 10.6% 10.3% 11.7% 12.7%
SGA 12.6 13.9 14.8 13.5 13.0
SGA % 5.8% 5.7% 6.0% 4.6% 3.9%
Tax Rate 42% 45% 38% 40% 40%
Income 3.8 6.9 7.2 12.5 18.0
EPS 0.37 0.60 0.55 0.93 1.33


What is clear is that significant new trends as well as substantial cost-savings are being harnassed within the Company as it moves away from its roots as a coop. For 2003 flat revenues were largely a result of reduced volumes of fruit from California growers due to fires, windstorms, and a fruit fly quarantine. It is reasonable not to expect such a triple-witching to occur again in the California market, and volumes should rebound to more normal levels in ’04 and beyond. The 2003 drop in the California segment of 9.4% masks some exciting trends: an increase of 27.5% for International products and an increase of 8% for processed products. Since the California segment represented a large (60%) but rapidly diminishing portion of the business the relatively small drop in performance there was able to mask big gains elsewhere. In the past the constraints of having to source fruit solely from California growers would have hamstrung the company. The shackles are now removed, and with offshore sourcing and other initiatives growth is coming on rapidly as the following table helps illustrate:

2001 2002 2003 2004(e) 2005(e)
California Revenues 149 165 150 155 160
International Revenues 47 59 75 100 135
Processed Revenues 30 30 32 37 43
California % Revenue 68.1 68.0 60.6 53.1 47.3
International % Revenue 19.9 22.2 28.0 34.2 40.0
Processed % Revenue 12.0 9.8 11.4 12.7 12.7
California Gross 11.9 17.3 14.9 16.9 17.4
International Gross 0.7 3.7 5.6 10.0 16.6
Processed Gross 6.2 4.8 5.0 7.4 9.0
Total Gross 18.8 25.8 25.5 34.3 43.0
California Gross % 8.0 10.5 9.9 10.9 10.9
International Gross % 1.7 6.9 8.1 10.0 12.3
Processed Gross % 23.4 20.3 17.9 20.0 21.0
Total Gross % 8.6 10.6 10.3 11.7 12.7


Clearly domestic operations in 2003 helped hide growth elsewhere. Net 2003 sales within the California division contracted 9.4% for reasons stated above. The same period saw 27.5% sales growth in International avocados. Unfortunately California avocados still dominated the company in ’03, but moving forward this will not be the case.

For 2004 my breakdown of estimates for the 3 primary divisions includes a small recovery in California fruit sales to 155 million. This is still conservatively below the ’02 level of 165 m., and just 4% above ’03 levels, plus margins should improve slightly as 2 small outsourcing contracts utilized to temporarily bolster fruit supply will terminate as inventory levels stabilize. Real growth should be evidenced in international operations, with the Uruapan plant coming on line fully in ’04. Roughly doubling the growth of sales originating from international avocados puts a very reasonable expectation of 32% growth in sales from this division, or 100 m. The 3rd primary division, processed products, should also see growth in ’04 due to the introduction of a new line of guacamole. This product, more stable than competitors will be produced at the Uruapan plant. Estimates are for 3.5 million in sales from this new product in ’04. A second high-pressure production machine, larger than the first and sorely needed, will come on line in Q1 ’04. I added last years 32 million plus the additional guacamole revenue of 3.5 million plus small organic growth in other processed lines of 5% to put processed sales estimates at million for ’04. Additionally the guacamole production was previously handled in 2 stages, with the initial pulping performed in Mexico, and the finishing done in Santa Paula, California. Now all this will be performed in Uruapan, saving an estimated 2 million per year in shipping and handling costs alone. In addition to the added sales coming on line, margins should increase significantly.

With the new plant infrastructure in place margins will float with the volume of fruit handled. As volumes increase margins will increase out of proportion. By segment for 2004 gross margins should increase across the board, with the smallest gains coming from California operations. These can be expected to be approximately 100 bp better than last years due to the cancellation of 2 small supply contracts and slightly higher fruit volumes, or about 11% and 17m. Real gains can be expected in the international division. With the new plant up and running in Uruapan and supplies of fruit assured margins of 10% and 10m should be easy to achieve. Finally the processed division should benefit from the new guacamole line and can easily be expected to attain a 200 bp increase over ’03 levels or 20% and 7.4 m. Again this is largely a result of leveraging now exising infrastructure with increased volumes, plus the new guacamole product line. SG&A savings in ’04 are largely a result of consolidation. New packing and warehousing colocated in Uruapan reduces freight and storage charges among formerly disjointed plants, and streamlined office and other operations will help as well.

For 2005 numbers take 2004 and for revenue add the ’03 – ’04 growth numbers plus 3% additional organic growth for market penetration and demographic trends. Margins in the international avocado segment should continue to improve as the Uruapan plant becomes fully utilized and volumes increase. This is a volume story and ’05 should allow the facility to realize its true potential, and I’ve added an estimated gross % increase of 50 bp to International for ’05 or 12.3%. The processed segments second and larger high-pressure machine should be fully utilized in ’05 and margins will thus improve for that segment as well, as will volumes as market penetration takes hold. Estimates for the guacamole line in ’05 are for an additional 5 m in revenue, putting ’05 processed revs at 43 m. Additionally I’ve added 100 bp to margins. SG&A for 2005 should be slightly reduced in absolute terms as well as the final consolidation is made from plant closures and operation synergies are realized. I made a smaller downward revision of just 500k for the year. For 2004 and 2005 numbers my average number of shares for EPS calculations was 13.5 million and a tax rate of 40%.

Not calculated into the above is an added sweetener – Maui Fresh. Not only will this recent acquisition be accretive to earnings, but it broadens the product offering of Calavo. Last year’s revenues for Maui Fresh as a stand alone entity were roughly 20 m, but I have left this out of calculations and mention it only as a beneficial aside to future growth.

This company has positioned itself for the future. With new infrastructure in place margins will benefit substantially with volume. The combination of increasing margins plus increasing volumes will provide an amazing boost in earnings which is on the cusp of being realized. A stellar combination of market positioning, regulatory benefits, and a newly leveraged infrastructure are coming together all at once. On top of that the company is basically debt free.

Lastly Calavo is compelling and unusual simply by virtue of its recent morphing from cooperative to publicly traded company. As a cooperative Calavo largely operated under a socialist type system of management and was beholden to the desires and motives of its grower members. The above arguments show just how little the company is focused purely on the California avocado market at this point. Recently the USDA has authorized a lifting of import restrictions on avocados from Mexico. Rather than resist this as it must have under its old structure, Calavo is now leading the charge for foreign fruit while still participating strongly in the domestic market. Other measures being aggressively pursued are infrastructure efficiency measures such as plant consolidation and warehouse co-location. Again this was much more difficult under the cooperative structure. This new focus on delivering value to shareholders while still producing a superior product will be a win-win for shareholders.

A component of demutualisation has also been the selling of shares in the open market by growers. Certainly a number of growers have taken the opportunity to raise cash by flipping their shares, and this has helped to suppress the share price. Agricultural incomes are notoriously unsteady, and farmers live in a perpetual boom-and-bust cycle with regard to their income. During periods of depressed income the temptation to sell shares is simply too great, and some indiscrimnant selling has no doubt occurred. This should slow with time as stock is dumped into stronger hands who recognize the long-term value of holding stock for the growth it represents.

Risks are relatively few but significant. Primary among these would be a clamping down of import restrictions on avocados by the USDA. Calavo has invested heavily on being able to source and process avocados from other markets, but Mexican avocados represent their biggest infrastructure outlay. Fortunately the trend here seems to favor the Company, and I think it is recognized that foreign fruit is needed to meet demand. It hardly needs to be said that farm oriented risks are always present in a company such as this. I think I’ve shown however that by outsourcing fruit from many markets this risk is mitigated significantly, as evidenced by the Company emerging relatively unscathed from last year’s California fires which damaged some groves. Competitive risks exist, although the Company has a fairly firm hold on the marketplace. Fresh Del Monte is a player, especially in the hothouse items such as chiles, and could represent competitive pressure from a worthy contender.

Overall I view Calavo Growers as a company worthy of your further analysis. Substantial ongoing direct buying by the Chairman, Mr. Cole is encouraging, and he holds over 1.5 million shares of the company and can be expected to add additional shares in the future. A sweetener is possible interest by a suitor with bids most likely coming from Fresh Del Monte, possibly at a substantial premium to current valuations. Calavo represents a good value now, and a potentially blowout value in the not too distant future.


Disclosure: Long

Catalyst

Movement away from Cooperative business structure. Increased access to foreign market supplies, leading to beneficial smoothing of agricultural cyclical limitations. New overseas infrastructure completed leading to decreased unit costs, and increased production capacity. Consumer demographics improving.