Description

Recent market concerns around the potential impact GLP-1s could have on consumer consumption and caloric in-take behavior have wreaked havoc across food-related stocks. Greasy fried foods are in the eye of the GLP-1 storm (patients rate this category as the highest for reduced consumption) and, as a result, Lamb Weston (“LW”), a producer of french fries and other potato products, has taken a beating.

Since July 2023, LW stock price has fallen ~30% and currently trades ~15x fwd PEx vs its historical average of ~22.6x (since the IPO at the end of 2016). We believe the baby is being thrown out with the bath water, and this is a very attractive entry point for a high-quality business with pricing power that can grow earnings HSD%-LDD% over the long term.

Why does this opportunity exist?

There are two main misunderstandings driving LW’s stock decline:

• LW reported volume declines of ~10% for 4Q23, which came as a surprise and the company commented that these volume headwinds could persist into FY24 (1Q24 volumes reported down ~8%).  The investment community viewed this volume drop as driven by demand, which led to more questions regarding pricing power and incremental capacity LW is bringing on-line over the coming quarters. In reality, this volume decline was due to (1) voluntary exits from low margin business (more than 50% of the volume decline) and (2) destocking within the international business and retail channel. Wal-Mart decided to blow out of a competitor’s private label product and make room for LW’s private label product. There is a lag between the time it takes Wal-Mart to clear their existing inventory and when they start to take on LW’s product, which led to this volume decline. Both of these issues are temporary and should benefit LW over the long term. The global demand vs supply growth picture remains healthy and generally tight from all of our industry calls.
• Investor concerns around GLP-1 reached peak fear around September 2023, which drove the stock down ~10% during that month. As more and more of the diabetic and obese population (~40% of the total US population) gain access and take these drugs, resulting in 25%-35% (50% in some cases) of declines in total calories consumed.  Based on patient surveys, the categories most impacted by these drugs are greasy/fried foods and sugary snacks. We believe the market is shooting first and asking questions later. We think (1) there are numerous reasons the total impact of these drugs is small and manageable, and (2) even in the worst case scenario, the headwinds are manageable.

Investment Thesis

LW is a leader within a consolidated industry with high barriers to entry

The industry has consolidated over time, from ~16 players two decades ago, to 4 real competitors today. The top 3 players (90%+ of market share) have added capacity rationally since. For much of the 2000’s, no capacity was added other than by Lamb Weston. This was due to (1) the hangover from capacity additions during the 1990s’ french fry craze when the industry was less consolidated, as well as (2) the diet fad of the 2000’s (Atkins), which was a headwind for french fry demand. Our calls with private competitors suggest that they are rational players. Today’s competitors lived through the tough times of the 2000’s and have learned to focus on ROIC and maintaining industry profitability.

Cost advantaged through high exposure to the Washington Basin

LW’s cost advantage results in margins that are ~500 to 700 bps higher than large US peers (McCain, Simplot). LW’s margins are ~1,000 bps higher than European peers (Aviko, Clarebout, Agristo). This cost advantage is driven by (1) its position within the Pacific Northwest ("PNW”) and (2) scale.  

LW’s manufacturing is skewed (relative to competitors) to the PNW. The company’s US potato supply is ~70% from the PNW vs peers at only ~40% on average or below. Location in the PNW is an advantage because (1) potato yields in the PNW are higher vs other regions (yields of ~600 cwt/acre in the PNW vs the US industry average of ~440 cwt/acre), (2) recovery rates in the PNW are higher (recoveries are 64% to 65% in the PNW vs other US areas ranging from 58% to 62%), and (3) potato quality, especially for use in french fries, is higher in the PNW (potatoes from the PNW are known for being extra-long, having better specific gravities and fewer defects). There is limited capacity to add manufacturing facilities within the PNW, creating another barrier for competitors that want to catch up to LW’s competitive position. The bottleneck is the amount of water needed to grow potatoes to supply new capacity in the area.

LW and its larger peers have scale advantages, including (1) incremental capacity costs are at least ~$300mm, creating a natural barrier to entry for any smaller players, (2) LW is big enough to justify investing in its own transportation, which lowers its costs, and (3) greater negotiating leverage over suppliers as farmers who walk away from LW or other big potato processors have a difficult time coming back into the fold (see next investment point).

Strong competitive position with leverage over both supplier and customers

Suppliers – Raw potatoes have a limited transport radius, essentially marrying potato farmers with whomever happens to be the local potato processor. LW’s facilities are typically located only ~150 miles from the potato farmers’ fields given potatoes damage easily in transport and can’t travel too far. Between the inability to transport their products to processors that may offer better deals in other markets, and the need to lock in a buyer prior to planting, farmers are captive suppliers to local processors in their market. Potato production is highly sought after by farmers, given it (1) produces a higher contribution profit per acre vs other crops, (2) is less risky than other crops (e.g., demand is stable, so profitability tends to be stable outside of vagaries caused by mother nature) and (3) has generally grown over time. This gives potato processors like LW greater power because they know farmers are loathe to switch to another crop. Additionally, for farmers, growing potatoes is associated with a certain cache/point of pride, given it tends to carry greater and more consistent profitability. Potato farming’s profit per acre is ~$750+, which is difficult to achieve consistently with other crops. Potato farming requires a $5,000 per acre investment, on which the farmer seeks a ~15% return. Potato demand is relatively consistent and growing, driven by french fry demand. Potato farming requires a sizeable upfront investment, also increasing switching costs for farmers that would consider moving to another crop. Large potato farmers have invested tens of millions of dollars into equipment and other infrastructure to farm potatoes.  We are told that ~80% of potato supply is from large farmers with sizable investments who have a very low likelihood of switching. Farmer relationships with LW and other producers go back for 2 to 3 generations.

Customers -- French fries are a “must-have” item for restaurants, given they are one of the highest profitability items for which there are no substitutes. French fry contribution margins are considered to be the highest amongst food categories for restaurants (~81%). In some ways, you “must” have french fries on your menu, b/c nothing else works as a combination with other menu items (e.g., Burgers with mashed potatoes or broccoli just isn’t the same as french fries). In fact, 8x more servings of french fries are sold then the next most popular appetizer or side.   French fries are not a commodity from the customer’s perspective, given they must meet stringent specifications. French fries are spec’d into large customer’s menus through an RFP process and multi-year contracts, and restaurant customers are accustomed to french fries having a certain taste at that particular restaurant.  Consequently the quality and consistency of the frozen french fries provided is important.  Technology and innovation are even more important now as delivery and takeout penetration from restaurants has increased post-pandemic. French fries need to travel well and not arrive soggy and Lamb Weston’s battered and coated fries that maintain crispiness for longer, is higher margin and value-added to customers.

Margin opportunity through Europe consolidation and mix shift towards higher valued-added battered and coated fries

In February 2023, LW acquired Lamb Weston Meijer (“LWM”), which was previously operated as a 50/50 JV between LW and Meijer Frozen Foods.  LWM operated in the European marketplace.  With 100% control of this entity, LW will be able to apply best practices and potentially consolidate the frozen potato industry in Europe. LWM has gross margins that are almost half of what LW generates in its North American business . Post the acquisition, LW will be able to improve margins through improved potato sourcing, less spot market purchases and using Europe as a source to export to the US East Coast which could be more efficient than servicing from the PWN. Additionally, there are a handful of privately owned European competitors that LW could potentially acquire. Rolling up the industry in Europe would lead to better scale, margins and rational competitive landscape.

The increase in take-out orders during Covid-19 started a trend towards specialty fries. Restaurants needed a product that didn’t arrive soggy and the solution was crispy battered and coated fries (including waffle fries, tater tots and other specialty cuts). These products have grown 2x faster than the overall US french fry market and are more profitable vs uncoated products. LW’s market share of coated fries has increased 14 percentage points since 2019. There are currently a number of customers testing coated products and some who would like to shift to coated fries sooner rather than later. LW is looking to supply this demand with the new 350 million lbs. state of the art facility in American Falls, Idaho (coming online Spring 2024). The company also plans to modernize older plants by investing in the ability to flex between coated and uncoated products. The mix shift towards LW’s more premium/value-added products should result in margin expansion.

GLP-1 concerns are overblown for multiple reasons

While the headlines make GLP-1s sound like a significant headwind for the food industry, we believe there are multiple reasons these fears are overblown.

• High cost of drugs – These drugs are not cheap and can cost up to $1,300 per month if you don’t have insurance coverage. Our industry calls suggest that only 20%-30% of self-insured large employers cover these drugs for weight loss purposes while the large fully insured managed care companies do not offer coverage (~65% of commercial lives are self-insured). Furthermore, commercial insurers are increasingly adding coverage restrictions as more patients sign up for these drugs and drive up costs for insurers. Some insurance companies will mandate members get on diet programs and show progress before approving GLP-1 coverage; some require members to pay out of pocket for a certain period of time before they start covering the drugs. In some cases, once the patient achieves a targeted BMI or weight level, the insurer will stop coverage.  Other employers are dropping weight-loss coverage of the drugs.
• Low persistency rates – Real world studies and scripts data show low persistency (% of patients who stay on GLP-1 drugs after 1 year). Prime Therapeutics, apharmacy benefit manager that has ~35 million covered lives, conducted a study of ~4,000 insured GLP-1 patients and found that only ~1/3 of patients remained on the drugs after 1 year. IQVIA scripts data (study across 60 million people in the US) shows persistency falls to ~30% over 3 years.
• Side effects – While long term side effects are still unknown, the major immediate complaint from GLP-1 patients is the nausea and vomiting experienced as dosage increases. In some cases, patients need to purchase other medicine to counter the extreme nausea from taking GLP-1s. In addition, likely due to reducing the dose to manage the nausea, another real world study (not clinical study) showed that actual weight loss on GLP-1 drugs was <5% after 1- year.  Some studies also show that 50% of the weight loss achieved through GLP-1s comes from the loss of muscle mass, which can ultimately lead to lower bone density and accelerated aging. This is particularly dangerous for the older population, because it is increasingly harder to gain muscle mass after the age of 60.
• Low usage among males – Sellside caloric intake models assume a 50/50 mix of males and females taking GLP-1 drugs over the long run, however we believe males are much less likely to take these drugs.  In addition, given male caloric intake is greater, they make up a greater share of the overall calories consumed.  The lower propensity for men to take these drugs, and the lower caloric reduction even when on GLP-1s, means that the effective reduction in caloric intake from this pool, and thus, from the population overall will be much lower than predicted by the sell-side.  The clinical trials that were conducted only had approximately 20-25% of the population representing males, likely due to the much lower number of men on these drugs. The lower propensity to use the drug may result from a few factors.  Studies have shown that males tend to lose less weight than females when taking GLP-1 drugs (one study found women to lose 16% of their weight while men only lost 9%). Surveys show that very few males are unhappy with their existing dieting routines versus a large majority of women are unsatisfied.  This may explain why most commercial dieting companies target female customers today.  Finally, the definition that is utilized to determine whether someone is obese is based on a body-mass index (BMI) score of >30 regardless of gender, build and athleticism.  This score is literally derived from weight and height which can erroneously classify many more men as obese due to higher lean muscle mass.  By this standard, Michael Jordan at his prime would have had a BMI of 28-29, nearly obese, with a waist size of 30! On a side note, one of the many side effects of GLP-1 for men, that could dissuade their use, include the loss of libido and the disruption of testosterone levels which can lead to erectile dysfunction.

Even in a downside scenario, the total cumulative impact to calories consumed is ~7% (less than 1% annually assuming uptake of 7-years). LW should be able to fully offset this headwind with an incremental 30bps of pricing annually given their competitive position and pricing power. For this downside scenario we assume 100% of the diabetic population and 100%/60% of obese women/men take GLP-1s which result in a 37%/22% decrease in caloric in-take for women/men, on average. For those on the drugs, we assume a 50% - 55% persistency rate.

If GLP-1’s impact is more significant, LW and peers are rational players and will act accordingly. There are a handful of production lines across the globe that are getting near the end of their useful life and can/will get taken down if the demand is not there. This rational behavior will support industry utilization rates and pricing as a result.

2025 / Long-term targets are conservative and LW’s management’s incentives are aligned with shareholders

We believe the LT growth targets for 2025 and beyond are prudent and easily achievable.

• LW’s LT volume growth CAGR is 2% - 4%. The new capacity additions that are coming online over the next 3 years mathematically suggest LW’s volumes should grow at 5% CAGR. The company has announced 1.25 billion lbs. of new capacity globally. 600m lbs. of this new capacity is expected to come online over the next 12 months (350m lbs. in Idaho ramping spring 2024 and 250m lbs. in China currently ramping).
• LW’s LT sales growth CAGR is LSD% - MSD%. If volumes are 5% (from new capacity) and LW can achieve 2% - 3% pricing along with some incremental mix benefit due to a shift towards higher value battered/coated product, sales should grow at least MSD% – HSD% over the long term.
• LW’s LT Adj EBITDA growth CAGR of MSD%-HSD% seems conservative and isn’t baking in an appropriate return on the expected capex spend of 9% of sales to drive capacity modernization to add flexibility to make more battered/coated product. Historically, when LW spent this level of capex, they were able to grow Adj EBITDA in the mid-teens%.  In addition, given the likely sales growth over the long-term, this assumes no margin improvement despite the mix shift to value-added fries and the opportunity to integrate and improve European margins.

Additionally, LW issued a one-time special performance-based equity award for the 3-year period ending May 2025. The program is set up so that if the stock price goes up +25% from its initial price of $79.66, participants get paid out 75% of target, an increase of +50% in share price results in participants getting paid out 100% of targets, and an increase of +75% gets participants 300% of target. This provides management a large incentive to get the stock price over $140/share by the end of this program.

Company Overview

Lamb Weston (LW) is the leading North American producer of value-added frozen potato products, including french fries, hash browns, tater tots, etc. The company has 42% market share in North America (#1 position), and 23% market share globally (#2 behind McCain). Revenues are 80% in the United States and 20% outside the US. Recently, LW acquired the remaining stake in LWM, which gives LW control of their European business

The company previously reported 4 segments (below), however going forward they will shift to reporting by geography.

• Global (52% of Revs) – Sales to large (i.e., top 100) chain quick service restaurants (QSR) globally and large chain full-service restaurants domestically. Segment’s revs mix is 50% domestic QSR, 40% international QSR and 10% domestic full-service restaurants.
• Foodservice (31% of Revs) – Sales to commercial distributors, restaurant chains generally outside the top 100 North American-based restaurant chains, and noncommercial channels (e.g., hospitality, healthcare, schools, sports venues). Segment’s revenue mix is 75% small/regional restaurant chains and 25% noncommercial sales.
• Retail (13% of Revs) - Consumer facing frozen potato products sold primarily to grocery, mass merchants, club, and specialty retailers. Retail segment’s products are sold under owned brands, including Grown in Idaho and Alexia, licensed brands (Nathan’s, Arby’s, etc), and private label. Segment’s revenue mix is 60% private label and 40% branded product.
• Other (4% of Revs) – Vegetable and dairy business.

LW has multi-year contracts with both customers and suppliers. QSR contracts are typically 2 – 3 years and negotiated between May and October during a renewal year. These contracts usually have a price step up in year 1 and inflation escalators in years 2 and 3. Foodservice contracts are largely annual with evergreen provisions. The industry typically has one price hike each year, which takes ~6 months to flow through, depending on the timing of contract renewals. Supplier contracts can range 3-10 years, with prices set annually around January/February, before crop seeds are planted in March and harvested from May to October

Industry Overview

North America produces nearly 60 billion pounds of potatoes annually (the US accounts for 48 billion lbs. and Canada for 12 billion lbs.). The Pacific Northwest comprises over 50% of North American production, particularly Idaho (25%), Washington (18%), Oregon (4%), and Alberta (4%). Of the 48 billion pounds of potatoes produced in the US in 2019, 38% were used for french fries, followed by 33% for table potatoes (fresh potatoes used for cooking – not processed). According to the USDA, processed frozen french fry volumes have grown at a 2% CAGR from 2010 – 2019. Foodservice (i.e., away from home consumption) accounts for 80% of global sales -- french fries are among the top three most profitable items on a restaurant’s menu, along with soft drinks and ice cream.

The company’s main competitors in North America include McCain (30% share in North America), JR Simplot (20%) and Cavendish (8%) – all of which are private family-owned businesses. The industry has consolidated into these four main players from ~16 players over the past 2 decades. We believe this has resulted in a more favorable oligopoly dynamic and rational competitive behavior for the industry.

LW has multi-year contracts (3 – 10 years) with potato farmers near their production facilities, and oftentimes LW’s relationship with these farmers span multiple generations. The company contracts on acres, not volumes. Farmers allocate certain acreage to LW and whatever they grow on that land is sold to LW for an agreed upon price, as long as it meets certain quality specifications. Pricing is struck annually around January/February before crops are planted in March. The potato harvesting season is from May – October (higher quality Russet Burbank potatoes are harvested later). The harvested crop is used to supply demand for the following year, with much of the crop put into cold storage until needed. LW’s potatoes are ~70% sourced in the Columbia River Basin, which is the best region in the world for growing potatoes. The area’s volcanic sandy-loam soil, steady irrigation from the Columbia River, long sun-filled days and cool nights make this region ideal for growing high quality Russet Burbank potatoes, and it has higher yields than any other region in North America.

Catalyst

Earnings