We are ceasing coverage of Costa Group Ltd (CGC.AX) due to a private equity takeover by Paine Schwarz Consortium. The shares will be suspended from trading at the close of market on Thursday 8 of February 2024. The Scheme of Arrangement will be implemented on 26 February 2024.

Costa Group reported overall EBITDA up 7% in 1H23, with International EBITDA up 43% and Produce EBITDA down 53%. The weakness in Produce earnings reflects poor price realisation and rising costs. While conditions may improve slightly in 2H23e, it is more a FY24e and FY25e debate about the normalisation of citrus quality and pricing.  The earnings drop impacts the bargaining power of Costa with Paine Schwartz (potential suitor).

Costa Group has received an indicative acquisition proposal at $3.54 per share including potential dividends. Due diligence by Paine Schwartz, the potential acquirer, will conclude on 1 August. We see a 90% probability of a takeover proceeding. The indicative offer is 35% higher than where the shares were trading just prior to a news article speculating on a potential takeover and the multiple is well ahead of its average over the past three years. There is an argument that the margins are depressed, and past capital investment and acquisitions are yet to bear fruit (pun intended), but the company has inherent earnings volatility and there is an oversupply in blueberries and avocados keeping a lid on margins.

While retailers and manufacturers have grappled with a range of cost pressures already, wage cost pressures are only starting to build now. In Issue 3 of Price Watch, we analyse the size and scope of likely wage pressure facing companies. As most retailers are inextricably linked to broader wage-setting mechanisms, we may see an additional 2%-3% higher annual wage inflation over the next two years. The companies with the highest sensitivity to wage inflation are Inghams, Costa Group, Coles and Woolworths.

Costa held a site tour of its expanded Guyra, NSW tomato growing facility. The company has added technology in propagating, growing and packing that will improve yields and lower costs per kg. The medium-term opportunity is growth in snacking tomato sales which generate a much high price per kg and could add up to $40-60 million to revenue on our estimates. See the report for more insights about its expanded facilities.

Costa reported FY21 EBITDA growth of 11%, or 4% excluding acquisitions. The company had lower prices in avocados in 2H21, but berries and mushrooms had a good second-half. There should be strong EBITDA growth in FY22e given acquisitions, tomato production expansion and a recovery for grapes. We forecast FY22e EBITDA of $265 million, up 21%. However, with changes to its lease structure, we only forecast 6% NPAT growth.

We initiate coverage on Costa Group, the largest fruit & vegetable grower in Australia. The company produces mushrooms, citrus, berries, avocados and tomatoes. The key determinant of earnings over the next three years will be price realisation across its domestic and international markets. We expect pricing has stabilised in Australia, but we are cautious about blueberry pricing in China and Morocco in the next 12 months. The company has a promising path for earnings growth over the next three years given increased citrus exports, its tomato glasshouse expansion and hectare growth in China.