Description

SHORT: CALAVO GROWERS INC (CVGW)

We believe avocado middleman Calavo Growers (CVGW) represents a near-term, highly asymmetric short, with significant equity impairment or even bankruptcy plausible outcomes. Core to the current asymmetry, which will be the focus of this admittedly brief write-up, is a risk added to the company’s 10Q risk-section disclosure, that was clandestinely slipped into the 10Q filed post-close just this last Wednesday, and which we do not believe is broadly recognized or priced in. The risk that was introduced unveiled important new information, including that there is a lien on CVGW’s Mexican assets (where the vast majority of its avocados are sourced) and that an event of default and acceleration of indebtedness could result. Notably, we believe the recent stock decline is due to business issues facing the company (guidance recently reduced and then next quarter guidance not provided on Wednesday’s earnings call), not this new risk disclosure, which hasn’t been otherwise discussed by the company as far as we are aware. The lack of scrutiny is likely related to the modest short interest (<4%) and light sellside coverage (no bulge bracket, 6 total).

The new risk disclosure (included below) coincided with the resignation of the company’s CEO, who had himself only been in that seat for ~19 months, and which capped off an exodus of executive departures the likes of which we have seldom, if ever, seen. The company reported earnings post-close on Wednesday (the same time as the CEO’s resignation), and the outgoing CEO did not even join for the call. The call was led by the new “Interim CEO,” a board member who is now ALSO the Interim CFO (replacing the resigning Interim CFO, who only began that interim role in the last few months following the resignation of the company’s most recent CFO, who himself was only at the company for roughly a year).

We have and continue to believe that CVGW is a short for reasons unrelated to the above, but will keep this brief and focus on highlights given the nature of the situation and potential timeliness.

Some key points:

• Several characteristics, including low short interest, lead to high likelihood that this new risk has been missed by most investors.

• <4% current short interest.

• $700mm market cap and <$10mm ADV.

• Limited sell-side coverage.

• Intensity of C-Suite exodus appears to be more than a yellow flag. We have seen high turnover before, and specific situations always have nuances, but this seems above and beyond, culminating with the departure of the CEO and CFO in the last few months, each after less than two years in their seat. A few specific comments:

• In many cases, the individuals are leaving with short notice and without the company having a replacement lined up.

• Turnover has been in key leadership roles and/or high-level accounting/finance roles. In the last 3 years, this turnover has included the departure of:

• The well-regarded leader of Fresh (the most important segment)

• 2 CEOs

• 2 CFOs (3 including an interim CFO)

• Chief Accounting Officer and Corporate Controller (announced at the same time as the resignation of the first CFO in Feb-2020)

• In many cases, the departures are after only a limited period of time in the role. This has been the case for both the CEO and CFO roles.

• Kevin Manion announced his resignation as CFO in June 2021, only a little over a year after joining the company.  Interim CFO Farha Alsma then only remained in that interim role for a few months.

• James Gibson announced his resignation as CEO last Wednesday, after only a little over 1.5 years in that role. No new CEO was identified, leaving board member Steven Hollister to take over as BOTH interim CEO and interim CFO.

• We have included the exact language from the risk section from Wednesday’s 10Q below. However, a few takeaways, and qualitative background, worth noting.

• Takeaways:

• At issue is ~$150mm of taxes and $5.8mm of profit-sharing that Mexican authorities allege that CVGW owes from 2013. CVGW had filed an Administrative Appeal on this 2013 Assessment.

• On 3/12/2021, the Administrative Appeal “had been resolved against” Calavo. Somehow Calavo only became aware of this on 6/25/2021, so they did not appropriately respond.

• Calavo “failed to timely respond”, “rendering the 2013 Assessment as definitive.”

• As a result, there are now liens on the fixed assets and bank accounts of Calavo’s Mexican subsidiary. Calavo notes the potential that if they can’t somehow get the 2013 Assessment settled on acceptable terms, it could result in a default and acceleration of their debt.

• Other relevant qualitative color:

• CVGW became aware of this occurring on 6/25/2021 and does not appear to have found this to warrant an 8-K. Calavo sources 80%+ of its avocados from Mexico. This seems fairly material to us.

• The company also did not find this warranted discussion on Wednesday’s earnings call.

• All of this was occurring contemporaneously with the CEO and CFO departures above who, as noted, had each been in their roles for less than two years. The departing CEO also did not join for the call.

• While a different 2011 tax assessment was recently resolved by CVGW with a minimal payment, there are critical factual differences here:

• For the 2011 Assessment, CVGW’s administrative appeal was not resolved against the company, as it has been with the 2013 Tax Assessment.

• The 2011 case was not rendered “definitive.” In other words, in the 2013 case, two incremental steps were taken that were not taken in the 2011 case: (1) the administrative appeal was “resolved against Calavo de Mexico (CDM)” and (2) because CDM “had allegedly failed to timely respond”, the result was “rendering the 2013 assessment as definitive.”

• As a result of the foregoing, there were not liens nor the looming risk of default and acceleration related to the 2011 assessment. 

• While we are not experts on Mexican tax or legal issues. The fact pattern here – management turnover, the lack of discussion about this issue, and a layman’s reading of the disclosure language – seem highly disconcerting. We believe this presents an overlooked, highly asymmetric risk.

• Valuation and what’s priced in:

• Many might look at the stock price chart and conclude that CVGW is beaten down and cheap. We disagree and believe it was just inexplicably over-priced previously.

• Avocado packing/distributing is a competitive business without, in our view, any significant competitive advantage. As a result, we think the most relevant metrics are multiples of replacement cost, and the most relevant comps are Fresh Del Monte (FDP) and Mission Produce (AVO).

• FDP currently trades at ~1.1x TEV / Tangible Net Cap.

• AVO, a recent IPO, currently trades at 3.4x TEV / Tangible Net Cap.

• CVGW currently trades at 2.7x TEV / Tangible Net Cap.

• We think the FDP multiple, a long-time publicly traded company producing and selling produce, will ultimately prove closer to correct than AVO. However, the key takeaway in our view is that the skew is to the downside. And that is before incorporating: a) the current significant fundamental issues plaguing CVGW’s business, b) the inexplicable management turnover, and c) the knockout risk noted above that has not been addressed.

• Fundamental issues:

• The core issue with CVGW’s business, and the way it has been valued for the last several years, is that the street was extrapolating unsustainable earnings, themselves a function of temporary tailwinds. This led to the market putting a lofty multiple on inflated earnings (>20x EBIT, peaking at >6x P/B).

• Among the core benefits to CVGW’s core Fresh segment were:

• Heightened volatility in Mexico’s avocado industry, themselves due to drug wars in the avocado producing regions and other idiosyncratic factors, presented an opportunity for CVGW to temporarily benefit as a middleman.

• Gain on sale benefits when avocado prices were rapidly increasing.

• Less competition in Mexico for sourcing avocados. Since then, FDP has opened a large-scale state of the art packing facility in the core avocado producing region.

• A general overview of CVGW and some other relevant issues for its Fresh and Renaissance Food Group (RFG) business can be found in Sleuth Investor’s article on Seeking Alpha.

• https://seekingalpha.com/article/4290202-calavo-growers-structural-issues-70-percent-downside

New Risk from 10Q

(Note: There is further discussion of this on pages 15 – 17 of the 10Q. Highlighting below is ours.)

Our dispute with Mexican tax authorities related to the 2013 Tax Assessment may have a material adverse effect on our results of operations and financial position. This dispute has resulted in liens placed on the fixed assets and bank accounts of Calavo de Mexico.

In July 2018, a local office of the Servicio de Administracion Tributaria in Mexico (the “SAT”) issued a final tax assessment (the “2013 Assessment”) totaling approximately $2.6 billion Mexican pesos (which includes annual adjustments for inflation, and equals approx. $128.8 million USD at July 31, 2021) related to a fiscal 2013 tax audit. This amount has been adjusted for inflation as of July 31, 2021 to the amount of $3 billion Mexican pesos (approx. $150 million USD).

Additionally, the tax authorities have determined that we owe our employees profit-sharing liability, totaling approximately $118 million Mexican pesos (approx. $5.8 million USD at July 31, 2021). In August 2018, we filed an administrative appeal (the “Administrative Appeal”) on the 2013 Assessment, appealing our case to the SAT’s Legal Administration in Michoacan.

On June 25, 2021, we became aware that the Administrative Appeal had been resolved against Calavo de Mexico (“CDM”) on March 12, 2021, and that CDM had allegedly failed to timely respond to and challenge the SAT’s notification of such resolution, therefore rendering the 2013 Assessment as definitive. In addition, the SAT has placed liens on the fixed assets of CDM, with a net book value of approximately $26 million USD, and on bank accounts of CDM totaling approximately $1 million USD in order to guaranty the 2013 Assessment.

While we have taken measures to vigorously defend our position that the 2013 Assessment is without merit, including filing a writ with the SAT requesting a substitution of a financial bond for the above-mentioned liens, filing an Administrative Reconsideration (the “Reconsideration”) before the Central Legal Department of the SAT located in Mexico City, filing a formal complaint, or queja, (the “Complaint”) before the PRODECON (Mexican Tax Ombudsman) to request their assistance with having the SAT act upon the Reconsideration and filing an Annulment Suit (the “Suit”) with the Federal Tax Court, which among other things, contends that the notifications made by the SAT to CDM and its designated advisors of the resolution of the Administrative Appeal in March 2021 was not legally communicated and asserts same matters central to the Reconsideration as wrongly concluded in the resolution of the Administrative Appeal, we cannot assure you that any of these measures will be successful or that we will be able to settle the 2013 Assessment on terms acceptable to us or at all. Such outcomes could have a material adverse effect on our results of operations and financial condition and could result in an event of default under our credit facility and the acceleration of indebtedness under such facility. Further, we cannot assure you that the provision for this matter in our financial statements will be adequate to fund any settlement we may ultimately enter into or any amount of taxes that the SAT is ultimately able to recover.

Catalyst

• Ramifications of Mexican Tax Dispute, including potential debt acceleration, become more widely appreciated
• Broader recognition that current earnings expectations extrapolate unsustainable cyclical tailwinds, resulting in reduced expectations for normalized earnings power