FDP - Fresh Del Monte: Strong Margin Expansion May Not Be Sustainable

2023-08-24 11:08:58 ET

Summary

• FDP has had mixed track record and volatile earnings over the past decade despite being a leading player in the food industry.
• While the company has had strong earnings, there are concerns that gross margins may have peaked and downside risks to gross margins may arise.
• We believe there is limited margin of safety at 11x Forward P/E. Initiate at Neutral.

Investment Thesis

Fresh Del Monte Produce (FDP) has had a volatile track record over the years despite being a leading player in its industry. After touching the highs of over 60s in 2016, the stock languished back to sub-30 levels and has significantly underperformed its peers.

It has reported strong quarters of growth for the year with record banana prices and has also been deleveraging rapidly amidst high interest rate scenario. It has also partnered with Kraft Heinz to provide fresh fruit under its 'Lunchables' to consumers taking further steps in branding. However, we believe given its operations primarily as a commodity business and margins topping, there might be limited margin expansion and would have to rely on volume growth which could be further tricky. We initiate at Neutral given limited margin of safety as the stock trades at 11x Forward P/E and more significant downside risks.

Company Overview

FDP is a leading producer and marketer of fresh fruits and vegetables as well as canned fruits, beverages and snacks providing all products under its Del Monte brand. It has operations in over 80 countries, however predominant in North America that contributes over 60% of total sales. Key products include bananas (37% of total sales), fresh-cut fruits and vegetables (20% of total sales), pineapples (13% of total sales), avocados (7% of total sales). It is also engaged in manufacturing and distribution of prepared food products through licensing partnerships across 100+ countries in EMEA and few Asian countries.

Strong Earnings But May be Topping

FDP reported strong earnings for Q2 2023 with revenues declining 2.5% YoY, slightly missing estimates, driven by an increase in both volumes and unit pricing for bananas offset by decline in unit pricing for avocados which declined over 50% YoY and fall in volumes within tropical fruits. Fresh cut fruit and vegetable segment remained flat due to lower volumes for the vegetables across channels while fruit volumes increased but the growth was stalled due to capacity constraints. Gross margins continued its uptrend expanding by 320 bps YoY driven by pricing actions in Bananas (GM in bananas expanded by 600 bps) and lower distribution costs in fresh and produce segment. This also comes as a result of relatively favorable tailwinds from base effect where Q2 2022 was negatively impacted by FX effects in Costa Rica which has relatively eased by ~100 bps.

However, given its exposure to significant pricing variations, weather and market conditions for its commodity products, the company has significant variations in gross margins. We believe the current gross margins may well be peaking as historically over the past decade, gross margins went above 10% only in 2016 for a brief period.

In addition, Banana prices are trading at all-time highs historically and there might be potential downside risks to the gross margins to sustain heading into 2024 as food inflation cools off which in turn would compel the producers to slash prices.

The record gross margins in Bananas dates back to 2016-17 areas where FDP was able to achieve 10%+ margins during the period due to lower unit costs and favorable pricing. However, the management maintained that the H2 2023 is likely to be softer which can put downward pressure on the gross margins.

Third quarter and fourth quarter and the second half of the year is usually much softer on the bananas than the first half because of the summer fruits and competing other items and the heat and occasions...We see a pattern like the historical patterns that the market – and the banana market and the consumption has gone down quite..I believe that it’s not a total collapse, but it’s definitely softer, much softer than the second quarter and the first quarter.

- Mohammad Abu-Ghazaleh, Chairman and CEO, Fresh Del Monte Produce

Adj. EBITDA margin expanded 260 bps YoY driven by strong gross margin expansion while sticky SG&A expenses and fixed costs remained relatively flat. It reported Adj. EPS of $0.96 for the quarter more than double the previous quarter and topping analyst consensus pegged at $0.61.

Balance sheet position continues to be strong as the company continue to repay their debt obligations proactively amidst higher interest rates. Total debt outstanding decreased to $400 mn from $472 mn in the previous quarter and $542 mn at the end of last year with Debt / EBITDA of 1.6x.

Valuation

FDP primarily operates as a commodity business with its long term median gross profit margin is around 8% compared to Darling Ingredients ( DAR ) and Ingredion ( INGR ) commanding 20%+ gross margins while Bunge ( BG ) and Archer-Daniels-Midland ( ADM ) also having mid single digit gross margins. As a result, its EBITDA margins are also volatile and has its margins in mid-single digits significantly below DAR and INGR.

FDP trades at 11x Forward P/E in line with its peers including DAR and INGR which still has better growth and profitability metrics. We believe with the gross margins crossing 5 year high, this may well have peaked and it could not be sustainable going forward. We believe there is limited upside and any major catalyst at 11x Forward P/E with potential downside risks. Initiate at Neutral.

Risks to Rating

Risks to rating include

1) FDP operates in a commodity business and is subject to significant changes in the price of the end product due to weather, political or other disruption as observed historically and any price increases may not be able to absorb the increase in costs. Even in the current quarter, while prices of bananas inched up to all-time highs, prices of avocados halved.

2) It focuses on a lot of perishable products within its fruits and vegetable segments and needs to distribute and market in a timely manner. Any supply chain disruption or failure to timely source and distribute can significantly impact its end product

3) Big retailers like Walmart forms a sizeable chunk of FDP's revenue and has better pricing power to push FDP to lower prices

4) It operates in a significant competitive environment including a range of large multinational companies as well as small producers across each category and any impact as a result of quality, pricing or promotional activity can impact the sales

5) FDP has strong procurement and sourcing abilities with a vast network across the globe and its continuing ability to procure products at relatively lower unit costs may enable them to maintain or improve its margin profile

6) FDP has consistently increased its dividends over the past years after halting it during COVID-19 with the forward dividend yield of ~3%. Given the payout ratio is just ~25%, management has ample room to increase its dividend payouts which can support the stock.

Conclusion

FDP has witnessed significant disruptions in the past 3 years as a result of COVID-19 as well as in the past. We believe the company has taken positive strides in the right direction and reported solid results so far this year, however, the margins may well have topped and does not look sustainable in the wake of sticky wage costs and fixed costs along with moderating food inflation. We believe there is limited upside at 11x forward P/E and there are more downside pressures going forward. Initiate at Neutral.

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