Description

Lancaster Colony (LANC) is a short because:

·       New product introductions and pricing catch-up have masked underlying volume declines. These benefits should abate in the coming quarters which will highlight the secular challenges facing LANC’s core business.

·      F2024 estimates are too high.

 ·    LANC trades at >20x this year’s EBTIDA or about 50x FCF. Fair value is roughly 40% below the current price.

Business Overview

Lancaster has two business segments:

Retail (64% of estimated run rate EBIT pre-overhead) – Sells packaged food to grocery stores. Shelf-Stable Dressings, Sauces & Croutons is the largest segment category at 41% of sales. Most of these sales are from the company’s branded partnerships with Chick-fil-a, Olive Garden and Buffalo Wild Wings. Frozen breads is the next largest category with 36% of segment sales. Primary frozen bread brands are New York Bakery and Sister Schubert. The remaining 23% of sales is refrigerated dips and dressings which is mostly from the category leading Marzetti brand. Walmart is the largest customer accounting for 32% of segment sales.

Foodservice (36% of estimated run rate EBIT pre-overhead)  – This segment sells into restaurants and foodservice providers including 17 of the top 30 largest US chain restaurants. 75% of sales are from dressings and sauces while frozen breads are the remaining 25%. National accounts represent about 77% of total foodservice sales, of which about 80% is QSR and 20% is casual dining. The remaining 23% of sales that are not national accounts is a collection of regional chain restaurants and institutional foodservice providers. Delivery is handled by a distributor of the customer’s choice such as Sysco or McLane.

Retail has Benefited from New Products and Higher Pricing

From CY 2019 to CY 2022 retail segment sales grew 41%. 75% of this growth is from Shelf-Stable Dressings and Sauces (which more than doubled over this period) as the result of the introduction of Chick-fil-a and to a lesser degree Buffalo Wild Wings. These products now account for over 20% of segment sales with margins that are slightly better than segment average. National rollout of these products began in spring of 2020 and took approximately 5 quarters to fully ramp which explains why year-over-year segment volume began to fall when the completion of this roll out was lapped in the June 2022 quarter.

In the last several quarters retail volume declines have been offset with higher prices. While the Foodservice segment contracts have automatic pricing adjustments based on a basket of commodities, Retail segment pricing must be individually negotiated with each account. As such, pricing in the retail segment tends to lag input cost change which explains why LANC’s retail pricing growth was only realized in the last several quarters.

Figure 1: LANC Retail Segment Trends

The Core Retail Business Faces Secular Challenges

Under the surface, the retail segment faces long-term secular challenges as evidenced by the last 3 quarters of falling volume. Retail volume is falling despite benefiting from the national roll out of Arby’s sauces starting in September 2022.

LANC’s volume declines are the result if long-term secular trends. For years consumers have been shifting their food purchases away from branded processed packed and frozen foods sold at traditional grocery stores. Higher end consumers increasingly buy more fresh, healthy and organic foods while less affluent customers choose private label products and shop at discount chains such as Trader Joe’s, Aldi and Lidl where LANC does little business. These trends will be a headwind for LANC for the long-term.

Foodservice should be a flat to LSD volume grower over-time with dollar margins growing in-line with volume. Over the last couple of quarters, LANC’s foodservice volumes have outperformed the industry due to limited time promotions featuring a new sauce. However, it doesn’t seem like this promotional driven volume growth is sustainable to a significant degree.

The national retail roll out of Arby’s sauce began in September 2022 and should be largely completed by the end of March. We expect this to help volumes for the next few quarters (although the impact will be much smaller than Chick-fil-a / Buffalo Wild Wings). Similarly, retail pricing will be fully caught up by the end of the March 2023 quarter. Once the benefits of price increases and the Arby’s roll out fade, LANC will show very low to negative top line growth. When this occurs it’s hard to see the stock maintaining its current lofty multiple.

F2024 Estimates Are Too High

F2024 estimates assume retail segment margins return to about the 22% level where margins were prior to the food price spike which began in 2021. However, Lancaster’s retail business sells into a concentrated and sophisticated customer base. While these customers understand that costs are rising and will allow for price increases when this occurs, these price increases are meant to maintain dollar margins, not percentage margins. CEO David Ciesinski explained this on the FQ4 22 earnings call:

“if you look at between fiscal year '22 and '23 and the magnitude of pricing that we're taking, you are going to see some diminution on margin just because of that spread, right? We pass on price for the cost not the margin percentages. So you're going to see some weight against overall margin recovery”

As such, percentage margins should be lower than historical levels in this cost environment meaning F2024 estimates are too high.

Shares trade at 50x Cash Flow with EBITDA Multiples Similar to the Highest Quality Staples

On CY2023 numbers LANC trades at about 21x EBITDA or 50x FCF. Using our estimates of run rate EBITDA and normalized capex, shares still trade at 20x EBITDA or 37x cash flow. Only the highest quality staples peers such as KO, MKC, HSY and CLX trade for 20x EBITDA today – all of which are much better businesses than LANC.

Figure 2: LANC Run Rate Earnings

Fair Value is Roughly 40% Below the Current Price

Using a 9.5% discount rate and 5% long-term growth rate yields a justified multiple of 22.2x. Applying this multiple to LANC’s run rate cash flows post Arby’s ramp and adding the excess cash on the BS yields a fair value of $124/share or about 40% below the current price. $124/share would imply 12x EBITDA or in line with more appropriate comps like CAG, KHC, SJM and SYY.

If LANC is viewed as a truly secularly challenged business its not hard to see shares trading lower than this.

Figure 3: LANC Fair Value

Key Risks

Falling food prices – Just as rising food costs will temporarily depress margins as pricing lags the rise in input costs, falling food costs will temporarily increase margins as prices tend to be sticky. Even if declining input costs cause a short-term margin boost, falling food prices should also decrease sales helping to spur the stock re-rating by showing declining revenue.

Successful new product introductions – It is possible LANC creates a new product as successful as Chick-fil-a sources. Given the unique strength of the Chick-fli-a brand and no pending new brand launches we don’t see this as likely. While there are planned extensions to different product lines including Chick-fil-a, product launches and curtailments within existing product lines are always occurring and should be thought of a part of normal business activities. 

Catalyst

Low to negative resported revenue. Esimtate decreases.