Quick Pitch: Costa Group Holdings (CGC:AX)

Merger Arbitrage – 20% Upside

The idea was shared by Povilas. Costa Group, an Australian producer of fresh fruits and vegetables with a market cap of A$1.4bn, received a non-binding acquisition proposal at A$3.50/share from its largest shareholder Paine Schwartz Partners (PSP), which owns a 15% stake. Due diligence began in June and is expected to be completed soon. PSP reconfirmed its indicative proposal in July, and Costa Group said last week that talks are ongoing and it would provide an update on the transaction in September. The market had been viewing this as a nearly done deal given that CGC used to trade with a low 3%-6% spread to a non-binding offer, until recently. This is not surprising, given that PSP is a very credible buyer and a former parent of Costa Group. PSP first invested in Costa Group in 2011 and led its IPO in 2015. The privatization setup here is rather curious, as it is rare to see a former parent trying to take a company it took public many years ago back to private markets. However, the spread suddenly widened to over 20% last week after Costa Group reported a deteriorating outlook for its citrus category (c. 15% of total revenue) for the second half of 2023 due to adverse weather conditions. Separate category earnings are not provided, however, Costa Group estimates that the hit to its total 2023 EBITDA will be A$30m, compared to the A$215m EBITDA it reported in 2022 and the A$150m EBITDA it reported in the first half of 2023. 2023 EBITDA is now guided “in excess” of last year’s earnings. The market is concerned that this news could derail the deal or lead to a significant offer price cut. However, there are several reasons to believe that investors have overreacted:

• Together with last week’s H1’23 results, CGC has decided to defer the dividend until the sale process conclusion is reached, saying “there is a potential transaction coming up for a change of control”. This seems to be a signal that negotiations are already at a very advanced stage and management sees a high chance that the deal will happen.
• The hit to citrus segment revenues/outlook was likely old news for the buyer. There were two main factors behind the slowdown: adverse weather conditions in 2022 and a climate phenomenon called La Niña (which causes sea surface temperatures to cool down, leading to excessive rainfall and lower fruit size/quality and volumes). The impact of last year’s conditions has been known for a long time already. Meanwhile, the impact of La Niña was indeed more significant than management initially expected in February 2023 (during the annual report), as the climate phenomenon ended one month later than anticipated (March 2023 vs. February 2023). Given that CGC has made no detailed updates on this since then, the market’s recent reaction to the suddenly soured guidance is somewhat understandable. However, I believe that it is highly unlikely that PSP, a highly sophisticated agribusiness industry player and a long-time shareholder of CGC, was not aware of these climate impact dynamics until last week. Especially considering that buyout negotiations began in April and PSP reconfirmed its proposal in July, after already having conducted due diligence for 4 weeks. Therefore, I believe that the market’s recent reaction to the guidance update does not reflect the buyer’s intentions for the buyout.
• Furthermore, PSP is a buyer with a very long-term horizon and has already been invested in CGC for many years. Such temporary climate impact definitely shouldn’t have swayed its intentions here. The overall risk of PSP walking away seems low.
• Peer comparison suggests that PSP is not overpaying with the A$3.50/share proposal. The bid values CGC at 10x TTM EBITDA and 9.2x normalized EBITDA (excluding the recent one-off climate impacts). The closest competitor T&G Global, a New Zealand-based producer and distributor of fruits and vegetables, is currently trading at an 11.3x multiple. The peer is significantly smaller with a market cap of AS$219m vs A$1.4bn for CGC. TGG has also displayed lower operating margins in recent years (1-3% during FY16-22 vs 1-9% for CGC) while growing at a comparable pace (7% CAGR in FY16-22 vs 9% for CGC).

There is a good chance that both parties will enter into a binding agreement in September. I expect the spread to narrow to a minimal 1-3% level after that. The main risk is that the buyer may use the recent market reaction as an opportunity to push for a price cut. However, even if that happens, I do not expect the final price to fall below the A$3.20-A$3.30/share price range within which both parties engaged in verbal discussions back in April.

The downside is a bit tricky to estimate, but I expect it to be fairly limited in a no-deal scenario. CGC currently trades around pre-announcement levels, however, if the deal doesn’t materialize, the stock would likely fall to reflect the recently announced weaker outlook for H2’23. Peer’s TGG share price has remained flat since August 24 (the date of CGC outlook announcement) and have declined by 5% since July 4 (the date when PSP reconfirmed its buyout intentions and the non-binding offer was announced publicly for the first time). It’s a guessing game at this point, but adjusting the pre-announcement price with the share price reaction after the recent earnings update would imply the deal-break price somewhere around A$2.50/share (10%-15% potential downside).

PSP is a private equity firm with $5.5 billion in assets under management (AUM). It specializes in the food and agribusiness sectors, and has made a number of investments in these areas, including the recent privatization of AgroFresh (April 2023). PSP reduced its ownership stake in PSP from 54% to 12% during its initial public offering (IPO) at A$2.25 per share. It then sold the rest of its shares in CGC in the range of A$2.76-A$5.42 per share in 2016 and 2017 (see here, here and here). Paine Schwartz opportunistically returned to CGC’s shareholder register in October 2022, acquiring a 14% stake at around A$2.60 per share. The move came shortly after CGC cut its guidance for the citrus segment’s EBITDA in 2022 due to challenging weather conditions, which led to a 13% drop in the share price.

Since the IPO, Costa Group has gradually compounded its topline (A$1.4bn in 2022 vs. A$0.9bn in 2015) while displaying consistent profitability on operating income level and gradually increasing gross margins.