Description

Summary

I’ve regretted not buying Lamb Weston (LW) immediately following its spin-off from Conagra in November 2016. It was valued at around $30 at the time of the spin and preceded to steadily climb to over $80 per share within two years. Although I liked the company, I didn’t pull the trigger as I watched the stock rise from undervalued to very expensive. However, I think the stock today represents a good value at a price near $69 per share, which is the same price the stock was trading at in the summer of 2018 despite EBITDA and free cash flow being significantly higher at present. The stock is down 24% from the pre-pandemic high in January of 2020 despite overall product volumes being very close to pre-pandemic levels. The stock price dropped 13.5% on July 27 when the company reported Q4 and FY 2021 results. The market didn’t seem to like the company’s commentary around inflation in edible oils (canola oil), packaging, and transportation which the CEO described as a “significant headwind for fiscal 2022.” While the company guided for sales growth above the long-term target of low-to-mid single digit, it noted that EBITDA “would be pressured during the first half by a step-up in input and transportation cost inflation as well as some residual effects of the pandemic’s disruptive impact on our manufacturing and distribution operations.” The CFO went on to say that they expect adjusted EBITDA to grow for the year (FY 2021 adjusted EBITDA was $748 million). Obviously, the market had been expecting more. Guidance for FY 2020 EBITDA (pre-pandemic) was $950 to $970 so there is still a ways to go for profitability to fully return despite sales very likely exceeding pre-pandemic levels in FY 2022. As the price today is where it was three years ago, I think the valuation has more than caught up, resulting in an inexpensive stock. Lamb Weston is a growing, high quality business which is likely to compound at a double-digit rate from the current price.

Overview

Lamb Weston was founded in 1950 in Oregon and in the ensuing 70 years, has grown into the second largest supplier of frozen potato products in the world. They have the largest market share in North America at 42% compared to McCain at 30% and Simplot at 20% with Cavendish and being the smallest large competitor competitor. LW is #2 globally with a market share of 23% and competes with the same large global companies in what is a highly concentrated industry. Including its three joint ventures, the company operates 27 manufacturing facilities around the world and sells frozen potatoes in over 100 countries with french fries being the primary product.

Given the large market shares held by a handful of global competitors, I think the industry can be characterized as an oligopoly. You’d think that vegetable processing would be a commodity-like industry characterized by low margins, low returns on capital, pricing pressure, and cyclicality. John Hempton provided some thoughts on this topic in an interesting blog post from early 2019: (http://brontecapital.blogspot.com/2019/01/the-myth-of-capitalism-monopolies-and.html). Yet in recent years, Lamb Weston has produced steady growth on rising margins and strong returns on capital which would indicate business quality. I think there are several reasons why Lamb Weston should be considered a good business.

·         While potatoes are grown all over the world, there are only a handful of regions which can grow a sufficient quantity and quality of potato to be utilized by the global processors. These areas have the proper environment, temperature, precipitation, soil quality, etc. for producing potatoes at high yields. The primary potato growing regions in the world are the Pacific Northwest and Northern Europe including Netherlands, Belgium, Germany, and France. The following chart shows the wide difference in average potato yield in various countries around the world. The best growing regions generate twice the global average yield as a result of not only natural advantages, but also decades of investment in research and infrastructure including transportation, storage and irrigation.

This is important because efficient manufacturing requires a year-round supply of high-quality potatoes. Given its origins in Oregon, LW secures a significant amount to its annual potato needs from the Pacific Northwest as well as Northern Europe for its joint venture with Meijer. In fact, the other large global players also secure significant raw materials from these growing regions and all have processing facilities in these regions. Combined, the US, Canada (McCain), Netherlands, and Belgium represent over 80% of global exports of frozen potato products.

·         Having been established for decades in the prime potato growing regions of the world, LW has deep relationships with its growers and can secure raw materials at a lower cost than smaller competitors. It is the largest buyer of raw potatoes in North American and buys at a scale greater than most of its competitors. The company maintains relationships with potato growers and enters into long-term supply agreements, and in certain instances, makes advanced payments to growers and/or provides financing guarantees. With much supply being procured by the four major producers prior to the growing season, volatility in potato prices has generally been more muted as compared to other agricultural commodities which has lowered business volatility for farmers. Plus, at least in the Pacific Northwest, there is little unused potato growing land which makes it difficult to meaningfully increase short-term supply.

·         In addition to growers, LW has long-term relationships with its customers including the largest quick service restaurants (QSR) in the world as well as the major North American food distributors. In FY 2021, McDonalds represented 11% of total revenue, or $404 million worth of fries. LW also has long-term relationships with Burger King and Wendy’s. These relationships are governed by one-to-three-year contracts and typically include annual price escalators. LW has worked with the largest QSRs in the US for many years and these supply arrangements are generally renewed without issue. The bargaining power of the large QSRs is considerable, however given the oligopolistic structure of the industry and LW’s pricing discipline, the company has been able to maintain and grow margins in recent years. The large QSRs typically procure fries from two or three of the major global processors. Given the low number of suppliers with the capacity to produce fries at scale, there simply aren’t a lot of alternatives for QSR and distributor fry procurement. Plus, fries are not only one of the most popular menu items for restaurants, but also one of the most profitable. And with limited freezer space and high inventory turnover, QSRs depend on reliable frequent delivery of consistent product. Again, only scaled suppliers can provide this level of service and quantity.

·         As previously mentioned, scale is crucially important for fry processors in terms of procuring supply as well as ability to serve customers. It is also very important when it comes to manufacturing efficiency. Potato processing is capital intensive with processing plants costing hundreds of millions of dollars to construct. With fixed costs relatively high, an efficient production network results in lower costs per pound compared to smaller, less efficient producers. Processors that can secure the highest quality (size, density, blemishes, etc.) potatoes of the right variety, cost-effectively transport the raw materials to the right plant, and have efficient production runs can leverage their fixed costs and produce at significantly lower cost per pound than competitors lacking scale. 

The opposite of efficient manufacturing was on display during the initial weeks of the pandemic as volume to large chain restaurants fell 50% and foodservice (i.e. full service restaurants not in the top 100, hotels, schools, sporting venues, workplace cafeterias, etc.) volumes fell 80% while retail spiked 50% year-over-year. This increased costs as certain foodservice-oriented production lines were redirected to produce retail products and production schedules and run times were adjusted to spread out production across the factory network to keep workers employed. In addition, costs were incurred and production further disrupted as workers contracted the virus and factories had to be shut down, cleaned, and restarted while production had to be shifted to other facilities in the meantime. Moving around production also led to higher freight costs as LW relied more heavily on spot-trucking rather than rail. In Q4 FY 2020, LW’s revenue declined 16% yet EBITDA declined 64%.

While that past sixteen months has been difficult, I think manufacturing problems encountered during the pandemic have provided the company valuable insights into ways to improve manufacturing efficiency moving forward. On the Q1 FY 21 call, the CEO noted that “our supply chain team has been able to significantly reduce our incremental production costs and inefficiency as compared to what we incurred in the fourth quarter of fiscal 2020. We’ve also taken a range of steps to aggressively manage our SG&A and administrative expenses….” The pandemic forced the company to experiment in ways that would have been impossible otherwise which will likely be beneficial over the long-term as the company takes these learnings and uses them to operate more efficiently and optimize its production and distribution network. It is also noteworthy that given the dramatic decline in demand and resulting available capacity in the industry, pricing remained rational in FY 2021. Price in the Global segment was flat, however pricing in Foodservice and Retail gained 7% and 5% respectively. And LW plans to take price further in FY 2022 to counteract input cost inflation.

Financials

LW’s fiscal year ends May 31, so it just completed FY 2021. For the year, revenue totaled $3.67 billion compared to $3.79 and $3.76 billion in FY 2020 and FY 2019, respectively. In the five years prior to the pandemic, net sales grew by 5.9% annually, split between volume and price/mix. Margins declined during the past two fiscal years as Q4 of FY 2020 included the first three months of the pandemic. Prior to FY 2020, gross margins and EBITDA margins had increased year-over-year for several years in a row, averaging 24% in FY 18 and 19; however, the EBITDA margin declined to 20.4% in FY 2021 which impressively still exceeded the FY 2016 EBITDA margin. During the five years prior to the pandemic, EBITDA had increased at a compound annual rate of 12.5% as the company took price due to tight industry-wide capacity and recognized leverage on growing volumes.

Despite the downturn last year, LW still generated over $400 million in free cash flow and leverage is manageable at 3x. The first significant debt maturity isn’t until calendar year 2025 and the company could repay this with internally generated cash flow between now and then. However, refinancing is more likely as LW is at the low end of its target leverage ratio. Capital expenditures will be elevated for the next two years as the company invests to increase production capacity in Idaho and is opening a new processing facility in China to meet growing fry demand in Asia.

Returns on investment in the past have been very strong. Looking at the five-year period of FY 2015 through 2020, LW invested a total of $1.45 billion primarily in capital expenditures and acquisitions to a lesser extent. Over that same time frame, EBITDA increased from $526 million to a pandemic-impacted $800 million in FY 2020 representing an incremental return on capital of nearly 19%. And this understates the return as the pre-pandemic guidance was for FY 2020 EBITDA of $960 million and the company made acquisitions totaling $117 million in FY 2020, the potential of which was obviously not fully realized during FY 2021.

Valuation

Based on the current price of $69, LW’s market capitalization is $10.1 billion and EV is $12.04 billion. The stock is valued at a levered free cash flow yield of 4% based on depressed FY 2021 free cash flow. On a normalized basis, the free cash flow yield is most likely greater than 5%. Using initial guidance of $960 for FY 2020, the company trades for 12.5x EBITDA. Obviously, there is still uncertainly surrounding the pandemic and the outlook for dining out, especially in foreign markets. However, at this point the greatest uncertainly surrounds cost inflation and the impact on margins. LW is projecting revenue growth above its long-term average of low-to-mid single digits, yet EBITDA is only projected to grow compared to FY 2021’s $748 million. The EBITDA margin in Q4 of FY 2021 was around 16% which reflected the price of canola oil doubling in the past year as well as elevated costs for packing, transportation, and ongoing costs related to the pandemic. However, the company expressed confidence that the EBITDA margin in the back half of the year would approach pre-pandemic margins as volumes continue to recover and pricing initiatives take effect.

Obviously cost inflation is a problem but it is something that everyone is dealing with and will most likely not be permanent. At some point the supply chain bottlenecks in the economy will work themselves out and costs will normalize, yet the pricing taken by LW and others in the potato processing oligopoly likely won’t revert back. Given price hikes, continued volume growth, and processing and logistics efficiencies gained during the pandemic, I think there is a high likelihood that margins are higher in a couple of years compared to prior to the pandemic. Assuming 7% revenue growth this year and 4% thereafter (2% price/2% volume) and margins that revert to historical levels by next year, I can model double digit compounding assuming leverage remains at 3x and excess cash is used to retire shares. However, I think future growth could surprise to the upside as evidenced by the company’s growth capital expenditures for expansion in both Asia and North America. LW recently acquired processing assets in Australia and is expanding in China to satisfying growing demand from emerging markets. With per-capita fry consumption significantly lower in many emerging markets as compared to North America, there is still room for significant volume growth going forward, a portion of which LW will capture.

Conclusion

LW’s stock price has gone nowhere for over three years and investors are losing patience as evidenced by the stock’s 13.5% decline due to a lackluster earnings report. While I’ve always admired the business, the stock was simply too expensive after rising three-fold in just over three years following the spin from ConAgra in November 2016. With the price having gone nowhere for three years and expectations lowered, I believe how is a good time to buy the stock. LW is a high-quality company operating in a disciplined oligopoly with longer-term growth tailwinds as global fry consumption increases. Currently trading at a mid-single digit normalized free cash flow yield with appropriate leverage and a high likelihood of 4 to 5% revenue growth going forward and margins reverting to and possibly surpassing pre-pandemic levels, I think the probability of double-digit compounding is high from a price of $69.

Catalyst

Margins reverting to historical levels

Revenue growth greater than anticipated

Low valuation