Description

Description:  Lamb Weston is a leading producer of value-added frozen potato products (French fries, hash browns, potato skins) with #1 share in North America and #2 globally behind McCain.  LW generates 52% of sales from  its Global segment which represents large US-based chain restaurants (McDonalds, Burger King) and all international business. 31% of sales are to the Foodservice segment which represents smaller regional chain restaurants, independents and domestic foodservice distributors. 17% of sales are to Retail,& Other which includes both private label and Alexa branded retail products. LW experienced a 6.3% CAGR in organic sales growth since 2003, one of the better results in the packaged food industry. LW was spun-off from ConAgra Foods (CAG) on November 10th, 2016.

Thesis: As a recent spin-off, LW is not well followed as a stand-alone company. The frozen potato industry is capacity constrained which should lead to very favorable pricing in fiscal 2017 - up double digits potentially for a third of the business. Concurrently, potato crop pricing has fallen double digits yr/yr. Likewise, consensus estimates for 2017 are way too low as is management guidance which calls for low single digit revenue growth and high single digit EPS growth.

The frozen potato industry is capacity constrained - Pricing Up Double Digits: Industry checks suggest the industry is capacity constrained. I believe McCain is turning away business because it can't meet demand in the United States. The industry is highly concentrated amongst a few large players with LW, McCain and Simplot collectively garnering almost 70% of the global market. The industry is very disciplined with respect to pricing and supply growth. Although there is some modest supply coming online from LW and Simplot (Notably, not McCain), this will not happen until late 2017. In the interim, my checks suggest pricing will go up double digits for many foodservice customers except for the largest global players like McDonalds, Burger King and Wendy's. The smaller regional QSRs and casual dining customers will experience DD growth. Anecdotally, I learned a mid sized regional restaurant chain is experiencing 20% price increases or roughly $.04-$.06 per pound. Although this is large in percentage terms, the industry should be able to absorb such price increases. French fries are the highest margin food in a restaurant with gross margins of about 85%.  Restaurants sell French fries for $5/lb yet purchase them for around $.75/lb. Additionally, the fastest growing QSRs like Shake Shack, Chik fil A, Five Guys, Smashburger, etc. have French fries as part of their brand identity and consider it a core menu item. I believe pricing can increase 15% for about 30% of the customer base which equates to nearly 5% revenue growth just from price vs. management guidance (and consensus) of "low single digit" revenue growth.

Potato Costs are Coming Down Double Digits: Strong crop yields during late summer/early fall has led to a steep decline in potato pricing. Potatoes represent about 50% of COGS. Assuming a 10% drop in potato prices, I believe gross margins can expand 400 bps when combined with the aforementioned price increases. This would lead to EBITDA growth significantly greater than the "high single digits" guidance from management. The price declines should start to show in the financials this quarter as pricing was set around Sept/Oct time frame.

Strong Secular Story within Staples: LW's 6% long term sales CAGR is one of the highest in the industry. This growth has been driven by 1) the growth in burgeoning QSR chains and 2) greater mix and variety of French fry menu items such as sweet potato fries, waffle fries, seasoned fries, etc. Additionally, per capita consumption of French fries is considerably lower in Asia and emerging markets, providing a source of growth particularly with the rise of QSRs overseas. Longer term opportunities may arise from the proliferation of food delivery services that make the experience of take-out even easier (Uber Eats, Grubhub).

Consensus Too Low: Only a handful of sell-side analysts cover LW and the projected FY'17 estimates range from $1.86 to $2.07. Most sell-side analysts simply take management's guidance for LSD sales growth and HSD EPS growth and plug that into their models without a thoughtful analysis on underlying supply/demand dynamics. Consensus revenue growth is just 3%. Of note, LW revenue growth in Q1 under CAG was +4%, higher than full year consensus view of +3%. I estimate 2017 EPS of $2.29 (consensus $1.99) and 2018 EPS of $2.49 (consensus $2.13).

Attractive Valuation: LW trades for just 13x my fiscal 2017 earnings estimate vs. peer average of 20x and trades two turns cheaper on an EV/EBITDA basis despite superior growth prospects. Given the enterprise value and niche portfolio of LW, I believe it is a likely take-out candidate in a couple of years and an acquisition would be highly accretive to an acquirer at this valuation.

Valuation: Using a market multiple of 18x (vs peers at 20x) equates to $41 price target or 25% upside.

Risks: Loss of key customer accounts (MCD is an 11% customer), stronger dollar impacting the export business (20% of volume is exported), health perception of French fries, commodity costs.

Catalyst

No specific catalyst other than better than expected earnings. Logner term LW will likely get acquired as many consumer staple spin-offs have (see Hillshire Farms, Mondelez, WhiteWave, etc.).