Should you take a bite of the Costa Group Holdings Limited IPO?

Costa Group Holdings Limited (ASX:CGC) is a market-leading supplier of fresh fruit and vegetables, but is it a market-leading investment?

a woman

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It is rapidly becoming part of the investment consensus that Australia's next boom will not come from what can be mined from below the ground, but what can be harvested above it.

But although the opportunity to supply high quality food and drink to Asia's rapidly growing middle class is easily understood, there are very few ASX-listed companies that give investors the chance to invest in this thematic.

But that will change shortly when Costa Group Holdings Limited (ASX: CGC) hits the ASX boards on July 24. So should you be queuing up to buy stock in the IPO or afterwards?

Reasons to buy

Costa Group has some of the hallmark attributes of being a strong business, including a dominant market position. In fact, they are Australia's largest horticultural company.

This number one position has been earned by being the largest supplier of fresh fruit and vegetable to Australia's major retailers. That means that the customer list of Costa Group includes Woolworths Limited (ASX: WOW), Coles and Aldi. With the supermarket giants looking to out-compete each other on their fresh food credentials, that places Costa Group in a strong position.

Costa Group is also the most dominant supplier of raspberries, blueberries and tomatoes and citrus in the country, commanding over 70% market share in berries. Again, this feeds into a hard to replicate competitive advantage for the business, as major customers do not have viable alternative options to source these products at volumes that will adequately supply their national store networks.

A further advantage of Costa Group is the steps that management has taken to insulate the company from the typical pitfalls of agriculture: the weather and resource availability. For example, Costa's tomatoes are grown in purpose built, large scale greenhouses, where everything from the light levels to the air humidity is measured and optimised.

Costa also invests heavily in the distribution chain to ensure the freshness and quality of its products, with a fleet of refrigerated trucks delivering produce directly from temperature controlled growing environments to customer distribution centres.

This investment also means that the proven processes and value adding activities of Costa Group can be replicated and exported to other regions. That is precisely what the company is doing in Morocco and China to lower costs and gain access to markets that are too far away to be supplied by the Australian growing regions.

The reasons to avoid

One of the biggest issues I have with the float is the way the business assets has been divided. New shareholders will own shares in the business including the growing operations, logistics and manufacturing systems. However, the majority of the land on which all of this happens will remain in the hands of the Costa family.

And of course, the Costa family will be paid commercial rent on their landholdings, which amounts to a sort of quasi-dividend from the new publicly traded business to the tune of around $20 million per year.

Another potential pitfall is the fact that the "new" Costa Group will start life with debt of around $142 million. That is a fairly substantial debt burden for a company that is not throwing off huge amounts of free cash flow, with a forecast net profit of $47 million and ongoing capital expenditure requirements to keep the substantial infrastructure of the business in good working order.

Should you buy?

If Costa Group was being offered as a whole business without the overhang of millions of dollars annual rent paid to the former owners, it would be an almost irresistible investment proposition. Even with that factor in the negative column, the powerful investment theme of feeding Australia and Asia with fresh Australian produce will likely see strong demand for the shares on their debut.

If you are also a believer in this theme, then buying the shares could be a shrewd long-term investment, but as Costa Group is still an agricultural stock, be prepared for some short-term volatility along the way.

Motley Fool contributor Ry Padarath has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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