We believe Lancaster Colony (Ticker: LANC) is a very timely short in the current market environment.  The downside to a short seems low: LANC, as many consumer staples names today, is priced for ‘safety’ at ~25x eps and 19x EBIT, consistent with where it has traded over the past five years.  The company has a clean balance sheet with net cash. Covered by three analysts, LANC consensus estimates call for modest 2-3% sales growth and 5-8% eps growth. Organic sales growth is overstated due to small tuck-in acquisitions over time.

What is Lancaster?

Lancaster Colony is $3.7 billion market cap. manufacturer of specialty food products, including refrigerated dressings, dips, frozen breads, shelf-stable dressings, and croutons.  Brand names include Marzetti, New York Bakery, Sister Schubert’s, Flatout, Bantam Bagels and Angelic. The company is run by an honest, straight-forward management team that has done a fine job over time creating leading market positions in these niche categories and driving shareholder value.  

Why is this a timely Short?

We believe LANC is a timely short because the market perceives the stock as ‘safe’ but misses the fact LANC is actually VERY exposed to COVID-19 pandemic as HALF its sales are to the foodservice channel, per Lancaster’s most recent 10K:

Relative to its Foodservice exposure, we believe the following to be important considerations:

·        Foodservice customers in distress.  The foodservice customer base includes large national chain restaurants, college & universities, healthcare facilities, and independent restaurants. While most of these customers are closed temporarily or partially operating, some of its customers, particularly independent restaurants, may not survive.  The company doesn’t disclose customer names, although it does disclose it serves 16 of the top 25 chains. We pulled an old company presentation (See Table A) where the company did disclose foodservice customers by name – we have no reason to believe the mix has changed materially. Many of the chains are suffering severe declines in sales and their stock price declines embed expectations on the earnings impact. 

o   MillerPulse SSS for week 12 shows Casual Dining SSS -65.5% and QSR SSS -26.7% (as off-premise is helping).  Performance is expected to range widely depending on relative off-premise/delivery mix and urban/suburban/geographical exposure.

·        Foodservice had been the growth engine.  The foodservice channel has been the company’s growth engine, with 2019 foodservice sales increasing 14% (9% pre-acquisitions).  With that said, the company guided down foodservice growth last quarter as one of their sole-source customers added a second supplier.  By contrast, the retail segment grew sales 1% in 2019 (.5% pre-acquisitions). In 1H20 (FYE June), Foodservice has continued to drive growth, with sales +7% total (+4% organic) versus +1% for retail organic.  

·        Destocking among concentrated distributor customer base will impact demand.  The 49% of sales in Foodservice is comprised of national accounts (37%) and branded & other (12%).  The top five direct customers accounted for 59% of 2019 sales with McLane, which distributes to several foodservice national chain accounts, as a 15% customer.  We believe it is likely McLane is working down current inventory in the current environment, impacting re-orders.

·        Darden potentially a big, negative exposure.  The company also discloses that “our net sales to a single national chain restaurant account, which are made indirectly through several foodservice distributors, represented 14% of consolidated net sales for the year ended June 30, 2019.”  Bloomberg data suggests this customer may be Darden. Darden reported on 3/19 and noted that in that week, same restaurant sales were down ~60% and it was suspending guidance. They are trying to ramp up curbside pickup and delivery but it will be very difficult to make up the lost business from sit-down diners.

·        Shared manufacturing will lead to operating deleverage.  In its 10K, the company discloses that 16 of its 17 food plants produce products for both the retail and foodservice segments. The products LANC sells in Foodservice (dressings & sauces, rolls, pasta and bread) are not the same as it sells in its Retail channel.  It seems likely the significant volume declines in foodservice will lead to fixed-cost operating de-leverage. 

In terms of foodservice datapoints from other companies, we would note the following:

·        Publicly-traded foodservice distributors have been hit hard as the market struggles to estimate the magnitude and duration of the decline in sales to its key customers, many of whom are closed. Sysco Corporation has declined ~45% from February 20th while Performance Food Group has declined ~48% over the same period.

·        J&J Snack Foods, which has 64% of revenue tied to foodservice, has declined 36% since February 20th.  The company has significant exposure to venues and locations that have shut down or curtailed food service.

·        McCormick & Co, which has 20% of sales to foodservice stated in their 4/1 Q1 earnings call: “I will say that – I would expect that the restaurant industry impact will be pretty heavy in the second quarter. Again, the complete closure of restaurants in some areas, even though it's the minority of our business is going to be a drag that I think it's hard to see the consumer side overcoming in this particular quarter.”

·        Conagra, said in their 3/31 Q1 earnings call: “Just as the retail businesses are seeing a surge in demand, our Foodservice business, which is about 10% of total company sales, is beginning to experience the negative impact of the COVID-19 situation. So far in Q4, Foodservice shipment declines have accelerated and trends imply a Q4 organic net sales decline that could be in the range of down to 50% to 60% versus last year.”

·        Lamb Weston said the following on its 4/1 call: Prior to the adoption of more severe social and movement restrictions, we saw little change in orders and shipments to QSR as increases in drive-thru traffic as well as higher delivery orders cushion much of the decline in on-premise dining. However with the adoption of more severe restrictions across more states, we're seeing orders beginning to slow…. Traffic at full service restaurants and operations in the US is expected to be down much more sharply than the QSRs. While many of these operators are taking steps to boost takeout and delivery sales, we expect this will make up only a fraction of lost business. So our sales to these types of customers are more at risk.

·        CSFB, utilizing Euromonitor data, estimates a peak sales decline across the U.S. foodservice landscape of 30-40% with an impact lasting one calendar quarter, followed by a multi-quarter recovery as stay-at-home and social distancing is relaxed and the economic slowdown plays out.

We would note the shareholder base of LANC is heavily weighted to ‘passive’ and quant funds that are unlikely to be paying attention to the fundamentals. 

What are the key near-term risks to the Short?

We see the following as the key near-term risks: 

·        Sales acceleration in the Retail segment more than offsets weakness in the lower margin foodservice segment (in H1-YTD, foodservice operating margins are ~14% vs. retail at ~21%).  This is possible although we imagine it will be difficult to efficiently manage any demand surge within the retail supply chain while also mitigating the large operating deleverage impact from foodservice, given shared manufacturing facilities. 

o   We believe retail has accelerated due to pantry stocking although would note the categories in which LANC participates will likely have seen less of an acceleration.  We do not believe the market will capitalize the incremental acceleration as, when the virus ultimately abates, the company will face the headwind of pantry destocking.

·        M&A risk.  We believe it is highly unlikely the company could go private given the high valuation and financing environment.  We also believe it is unlikely to pursue a game-changing acquisition. LANC historically has made small (~$25 million) deals in niche categories.  The company made two deals in 2018 (one was a troubled supplier) and is busy integrating them. In addition, the company is 1/3 thru an SAP ERP implementation.  Given this project in addition to navigating through the current business environment, we doubt M&A is high on management’s agenda.

LANC has ~9% short interest and trades ~$20 million per day.  The borrow is GC. Free float is ~65%; the founder and related trusts own just under 30%.  The company beat earnings by $.10 last quarter but missed revenue consensus by $10 million, with the shortfall split between retail and foodservice.  LANC next reports on 4/24.

Many of the ‘safety’ trades in the market (e.g. COST, CLX, GIS, CPB) have traded down from recent highs.   Given LANC’S foodservice exposure, positioning in low-growth retail categories and high absolute valuation (25x eps, 19x EBIT), we believe the prospect of a significant de-rating on missed earnings is high while the risk of getting ‘blown up’ in the short is quite low. 

Disclaimer:

This report is for information purpose only and does not serve as investment advice. I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise currently hold a short investment in the issuer's securities.  This position is subject to change at any time.