Description

Lamb Weston (LW) is a high-quality business that operates in an oligopolistic industry structure that has exhibited rational behavior with consistent pricing power.  We believe that recent pricing initiatives combined with a more normal potato crop and easing supply chain pressures should allow LW to return to its pre COVID margin structure, creating substantial upside in the shares.  We estimate that LW should earn between $4.60 and $5.75 per share in FY2025 (5/31 year ending) compared to Consensus expectations of $4.11, and we value the stock between 20-22x EPS (lower than the historic average multiple of 24-25x for conservatism) and include $2.00 of dividends accumulated over the next 8 quarters.  This methodology results in a target price range of $94.00 to $128.50, or 32-80% upside in less than two years when valuing the stock on an NTM basis.

Attractive Industry Structure

LW is the leading global processor and supplier of value-added frozen potato products (i.e., french fries).  In North America, which makes up over 80% of LW’s consolidated revenue, the top three processors (LW, McCain, and Simplot) control nearly 90% of industry capacity, with LW having around ~40% market share.

LW management estimates that the french fry market globally grows 1.5-2.5% per year by volume.  Pre-COVID the market had been growing faster, as ~75% of the company’s revenues are derived from sales to food away from home outlets that were growing ~5% pre-pandemic.  In addition to annual volume gains, consistent increases in price along with positive mix effects lead to what we believe is a sustainable mid-to-high single digit organic sales growth algorithm.

LW operates across three core segments: 1) Global (~50% of sales) represents sales to large chain restaurants, mostly quick serve restaurants (QSRs), regardless of geography, 2) Foodservice (~33%) comprises sales to foodservice distributors as well as sales to independent and regional restaurant chains and convenience stores, and 3) Retail (~15%) reflects sales to the US retail channel (grocery, club, specialty stores). 

LW’s scaled processing plants are adjacent to the most productive potato growing regions in the world, predominantly in the Columbia Basin in the Pacific Northwest and Idaho.  In a normal year, the company sources the vast majority of its potatoes through locked-in contracts with farmers in these regions.  While these farmers could technically opt to sell their product elsewhere, desire for predictable product offtake coupled with high transportation costs makes this acreage effectively dedicated to LW’s operations on a long-term basis, creating a high barrier to entry. 

Rational Pricing through COVID

During the pandemic, the french fry industry’s market structure was put to the test by widespread lockdowns that hit the company’s Foodservice segment particularly hard.  From fiscal Q4 20 (ending May 2020), when COVID first hit, to Q3 21 (February 2021), Foodservice volumes fell an average of more than -27% year-over-year as consumers stayed home.  LW’s Global segment, which includes large domestic and international QSR customers, was more resilient but was still negatively impacted, with volumes down nearly -11% year-over-year.  Even though the value-added frozen potato industry processing assets were highly underutilized during this unprecedented period, Foodservice pricing increased 2.5% while Global pricing fell only 1%, as the big three processors held the line on price.

Transitory Factors Depressing Margins

Since the troughs of the pandemic, volumes have rebounded strongly and are approaching pre-pandemic levels.  However, earnings power has been depressed by four primary factors, all of which we believe are transitory.  These headwinds have had a significant impact and caused LW to guide its fiscal 2022 (ending May) gross margins to be 600-700bps lower than pre-pandemic levels. 

1. Logistical Bottlenecks: Around 20% of LW’s volume is exported, principally out of ports in the state of Washington, to key Asian markets as well as Latin America.  While bottlenecks in the Port of LA/Long Beach have been widely documented, ports in Washington have also suffered from throughput issues during the pandemic.  These bottlenecks caused LW to miss shipments, depressing the revenue and operating margin performance of LW’s Global segment, which represents a little more than half of consolidated revenue.  While shipping challenges continue to be a broader macro issue, our research suggests that Washington’s port operations are beginning to normalize.

2. Labor Shortages: LW has struggled to run plants effectively given labor shortages caused by the pandemic, including worker absenteeism due to the Omicron wave.  While labor concerns do continue, we believe the issue has peaked with more people returning to work.  The company has increased wages and stated that staffing levels are markedly improving, allowing it to run its processing plants at nameplate capacity.

3. Unusually Bad 2021 Potato Crop: Due to abnormally warm summer weather in 2021, LW experienced its worst crop in decades in the Columbia Basin, the company’s principal region for sourcing potatoes.  Growing yields fell 5% while quality was off ~5-7% in what has historically been the steadiest potato growing region in the world.  Due to this highly unusual shortfall in the company’s contracted supply, LW had to import potatoes on the spot market from Canada, the Midwest, and the East Coast at premium prices.  LW has agreed to a 20% price increase to improve its growing partner bottom lines and ensure quality supply in 2022.   While we cannot predict what the weather will be like in July and August in the Columbia Basin with pinpoint accuracy, the characteristics that have historically made this basin such a productive and reliable growing region persist. Weather so far season-to-date through the end of June, coupled with the long range weather forecast for July and August in the Colombia Basin, support the notion that this upcoming crop for LW should be average or better.

4. Input Cost Inflation:  Even before the Ukraine crisis, LW was facing steep input cost inflation.  After potatoes, which make up approximately half of cost of goods sold, energy, corrugated containers, and vegetable oil are the Company’s largest cost items.  Costs for these items are each up double digits year-over-year.  In response to widespread cost inflation, LW has announced a series of price hikes that the other major potato processors have followed.  List pricing in the Foodservice segment is up in the high 30% range year-over-year.  This pricing will flow through over the next few quarters, and we believe is not properly captured by the Street.

Price/Mix Offsets in Strong Demand Environment with Tight Supply

Due to the impacts discussed above, fiscal 2022 EBITDA margins are expected to be ~15% vs. margins for the three years prior to COVID all being greater than 20%.

We believe that LW is in a very strong position to drive price increases that will enable margin recovery.  Both foodservice and QSR demand are extremely strong coming out of the pandemic and french fry supply is tight given the short 2021 crop and limited processor capacity growth.  French fries themselves are typically one of the cheapest food items on a restaurant’s menu yet have superior gross margins (~80%).  Despite the low-ticket price, french fries are incredibly important to the brand and identity of QSRs.  Most consumers attach french fries to their more expensive protein-based orders, and, for many consumers, the french fry itself is the reason that they will frequent a particular QSR.  As such, a QSR cannot afford to run out of french fry supply or compromise on quality.

In the last 12 months, LW and the other potato processors have implemented substantial price increases.  Based on our analysis, even if LW only realizes half of its announced list price increases, in-line with its historical average realization, the company will be able to offset inflationary its headwinds. However, price realization the last two quarters has been well above the historic average as LW and the other key processors are discounting less than normal in a tight demand environment. If this trend persist, then there will be upside to our EPS forecast, which is already well ahead of Consensus.

Unlike Foodservice contracts, which are typically based on spot pricing, QSR contracts in the Global segment average two to three years in duration.  The longer term of these contracts could be superficially interpreted as making it harder to implement timely price increases to offset inflation.  However, we do not believe the market appreciates that many QSR contracts have specific inflation escalators for potatoes, vegetable oil, and corrugated containers.  Potato price escalators typically occur in July, in line with the timing of the annual harvest, while vegetable oil and corrugated adjustments often occur on a more frequent basis.  Therefore, we see an opportunity for LW to take large realized price increases on QSR customers over the next 12 months as: 1) the strong demand environment should enable LW to increase price on the ~1/3 of QSR customers that come up for contract renewal each year and 2) for the other ~2/3 of QSRs not up for renewal, LW likely has inflation adjustment provisions for key inputs that should flow into LW’s pricing.  As such, we believe the market is under-estimating the amount of near-term price that LW will be able to take in the Global segment.

In addition to price, mix is an important earnings driver given the industry’s ongoing shift towards premium french fries.  Fries for delivery (e.g., DoorDash, UberEats) are often battered so that they stay fresh longer compared to conventional fries.  For instance, in September 2021, Wendy’s rolled out a totally revamped battered fry across the US and Canada, to take advantage of the growing opportunity in delivery.  We estimate that seasoned, battered, or coated fries make up ~40% of fries in North America, and that the mix improvement has been 700-800bps since the beginning of the pandemic.  We believe that processors like LW charge 20% or more for premium fries.  Compared to its competitors (i.e., McCain and Simplot), LW has a larger percentage of its french fry capacity dedicated to premium fries and, in our view, is the best positioned processor to take advantage of this growing trend.

Assuming a normal Columbia Basin crop in 2022 and a continued easing in logistical bottlenecks, we estimate LW should be able to achieve normalized margins as soon as two to three quarters from now with the price initiatives it currently has in place.  As the processed potato industry has recently shown during the freefall in demand during the depths of the pandemic, pricing is incredibly sticky.  Longer term, we believe the company’s margins may re-base at structurally higher levels than those achieved in fiscal 2018 and 2019. 

Significant Upside

Looking forward, on a conservative basis, if we assume that LW achieves EBITDA margins ~150bps below the company’s prior peak in 2018, we project the company can earn $4.60 of fiscal 2025 earnings.  Since spinning off as a public company in 2016, LW has averaged a P/E multiple of 24-25x.  Assuming a 20x P/E multiple implies a $94.00 stock including $2.00 per share of cumulative dividends, or 32% upside in slightly less than two years (recall LW has a May fiscal year end).  This scenario also assumes no earnings upside from the ~$1.4 billion of capex investments the company plans to deploy from 2022 to 2024, primarily for additional processing capacity.  Note that LW has historically exhibited a high-20s percent pre-tax return on invested capital.

In a more constructive case, we assume fiscal 2025 EBITDA margins are 90bps ahead of 2018 and that the new plants begin to contribute to volume growth in the back half of 2025.  This scenario results in fiscal 2025 earnings of $5.75.  At 22x earnings and including $2.00 per share of cumulative dividends, LW is worth $128.50 in less than two years for 80% upside.

Catalyst

Earnings beats.