2023-08-18 14:38:18 ET
Summary
- Improved restaurant traffic, growing steady fry attachment rates, and continued popularity in retail channels shows consistently strong demand for Lamb Weston’s products.
- Although net debt for Q4 amounted to $3.3 billion, most of this can be attributed to investments in production capacity, which will benefit Lamb Weston's long-term earnings growth.
- In just 2 years, Lamb Weston’s revenue jumped 68%, while net income has shot up a whopping 661%.
- Although Lamb Weston is overvalued from an absolute standpoint, we believe that the company is fairly valued due to its key advantages over other food processing companies.
Editor's note: Seeking Alpha is proud to welcome Touchstone Research as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »
Overview
Lamb Weston (LW) is an Idaho-based company that sells frozen potato-based goods, such as French fries, sweet potato fries, and other potato-based products. Despite an earnings beat and guidance that met analyst expectations , Lamb Weston’s stock price fell 7% following their Q4 earnings report. We believe that this was driven by the company’s previously high valuation that led to unrealistic earnings growth expectations. However, with sales growth of 31% for 2023, the company is poised to benefit from continuously strong demand paired with skyrocketing potato prices. As their stock price approaches 6-month lows, we believe that this poses a great buying opportunity for Lamb Weston.
Rising Production Costs Will Boost Margins
The Frozen Potato Product PPI has a 2-year CAGR of nearly 20%, showing that inflation for Lamb Weston’s products is sticky, despite inflation decreasing in the broader macro environment.
As we can see from the graph below, frozen potato PPI is generally correlated with Lamb Weston’s operating margins.
Author
2023 was Lamb Weston’s strongest year following 2020, with gross margins increasing a whopping 32%. This was driven by a 29% rise in frozen potato PPI, resulting in greater pricing power that allowed Lamb Weston to further its pricing actions and outpace inflation, resulting in record operating margins.
We can see that as frozen potato PPI rose, Lamb Weston’s operating margins followed as the company successfully implemented pricing actions that more than compensated for increased input costs. Although frozen potato PPI growth has been slowing alongside broader PPI, we believe that Lamb Weston will continue to capitalize on high potato prices, allowing the company to maintain steady top and bottom-line growth throughout 2024.
Strong Control Over Supply Chain
Although demand for potato-based goods is rising, potato yields have been declining for 5 years due to factors like erratic weather patterns and logistical hurdles, leading to disruptions and shortages in the market. However Lamb Weston has shown resilience and efficiency in managing these obstacles, putting themselves ahead of many other companies that are still struggling with supply-chain issues.
Author (data from Statista)
Lamb Weston has made strategic decisions that promise to ensure a steady and reliable supply of potatoes while maximizing profitability. As the company approaches the early potato harvest in July, it has proactively secured enough open market potatoes from multiple sources , including the Columbia Basin, Idaho, and the East Coast. We believe that this sourcing strategy mitigates potential supply chain disruptions and optimizes cost efficiencies, providing the company with a strong foundation to meet production forecasts in the first half of fiscal 2024. Furthermore, Lamb Weston's agreement to a nearly 20% increase in contract prices for potatoes grown in the Columbia Basin and the successful securing of targeted contracted acres in the region demonstrate their confidence in market demand. By aligning contract prices with input cost inflation in other growing regions across North America and Europe, we believe the company is poised to capitalize on market dynamics and maintain its market competitiveness. These actions demonstrate Lamb Weston’s capability to handle supply chain problems, which improves product volume, revenue, and operating margins.
Although Debts Are High, They Will Bring Long-Term Benefits
Following the Lamb Weston/Meijer merger , Lamb Weston’s net debt amounted to $3.3 billion, resulting in a relatively high 2.7 D/E ratio. The vast majority of this can be attributed to the company’s capital investments in Idaho, Argentina, and EMEA. We can see that in FY2023 $1.34B cash was used in investing activities, an eye-watering 332% more than the year before the previous year.
Lamb Weston 10-K
We believe that these skyrocketing costs were mostly driven by new processing facilities and employees to increase production capacity, most notably in Lamb Weston’s acquisition of Meijer ($610 million). The joint company will add 6 new European factories that hold 2 billion pounds of processing capacity.
Lamb Weston 8-K
Although this consolidation and production expansion is very expensive, with the company taking on an estimated $800 million in debt, we believe that this will boost long-term revenue growth and volume, allowing Lamb Weston to better capitalize on rising potato prices and strong demand for its products. Furthermore, we believe that Lamb Weston should be able to manage any potential liquidity issues, with the company stating that they still have an unused $1B revolver
Strong Product Demand
In Lamb Weston’s Q4 report, the company highlights several factors that demonstrate strong demand for its products. Although overall volume declined 10%, total restaurant traffic has improved, as sales for Foodservice has increased to $404.9 million, a 26% jump from last year. Additionally, the steady fry attachment rate (the rate at which consumers order fries at Foodservice stores) has jumped to 24% of orders from last year's 22%, we believe that this indicates a solid frequency of consumers ordering fries when visiting restaurants. Moreover, the demand for fries in food-at-home channels remains steady, with consistent growth in shipments by the retail segment. Retail sales increased to $220.6 million, which is a 64% increase from last year's $143 million in retail sales, reinforcing the preference for fries among consumers at home.
Author
With multiple positive indicators such as improved restaurant traffic, growing steady fry attachment rates, and continued popularity in retail channels, we can see that Lamb Weston’s has consistently strong demand for its products.
Strong Earnings Growth
In Q4, Lamb Weston reported $1.7 billion in sales and $499 million in net income. In just 2 years, Lamb Weston’s revenue jumped 68%, while net income has shot up a whopping 661%.
Author
This stunning top and bottom-line growth was primarily attributed to Lamb Weston’s pricing actions in 2022 and 2023. Despite overall volumes decreasing 10%, retail segment sales increased 25%, driven by previously implemented price increases. Additionally, retail’s product contribution margin increased to $83 million (100% YoY), as cumulative benefits from pricing actions have more than offset higher manufacturing costs.
We believe that with the company’s excellent value capture, successful pricing actions, and increased production capacity, they will be able to continuously increase their earnings going into Q4.
Asset Growth Outpacing Liabilities
Over the past year, Lamb Weston’s assets jumped $2.38 billion, while liabilities only increased $1.33 billion. The Lamb Weston-Meijer merger was a primary driver behind these changes: although cash & equivalents decreased $220M, this was well offset by the infrastructure and manufacturing footprint gained in the acquisition. Property, plant and equipment shot up $1.23 billion, while goodwill increased $723 million.
Lamb Weston
Even with such a large bolstering of Lamb Weston’s balance sheet, the increase in debts has been rather limited, with long-term debts only increasing $553 million. We believe that with a fairly strong cash base of $305M paired with almost double inventory levels, short-term liquidity should not be an issue. In our view, we believe that the Lamb Weston-Meijer merger will bring great long-term benefits that will help solve the company’s volume issues. With such a great increase in manufacturing footprint especially in Europe, we believe that Lamb Weston’s growth can rely more on volume rather than elevated potato prices.
Valuation
Multiple SA authors have pointed out overvaluation as Lamb Weston's main flaw in prior articles. Although we agree with other authors that Lamb Weston is overvalued from an absolute standpoint, when comparing Lamb Weston to competitors, we believe that it's actually fairly valued due to its key advantages in earnings growth and investor return.
Author
For valuation, we used Graham’s Valuation Formula on Lamb Weston. We assume the Lamb Weston can maintain an EPS growth rate of 11.2% and generate $5.20 in EPS, which were the company's forecasted earnings for 2024. We believe that Lamb Weston will be able to achieve this relatively moderate earnings growth as potato prices continue to steadily rise, allowing the company to further its pricing actions used in 2022 and 2023. When we plug in these numbers into the valuation model, unsurprisingly, it implies a 15% downside from fair value. We believe that this overvaluation has been caused by Lamb Weston's tapering EPS growth and historically high corporate bond rates of 5.26%. As a result, we believe that Lamb Weston is overvalued from an absolute standpoint.
However, when comparing Lamb Weston to competitors, we believe that their valuation nowhere near as bad as Graham's Valuation points it out to be. Despite Lamb Weston's growth slowing down from 2022 highs, their forward CAGR metrics are still significantly better than competitors. Although their gross margins are about average, their 125.8% ROE shows that Lamb Weston has and will continue to focus on investor returns. As expected, debt/equity is very high, due to the expensive Lamb Weston-Meijer acquisition and other long-term investments. As stated before, we believe that this high D/E simply indicates valuable investments that will drive long-term earnings growth, rather than a potential liquidity issue. In terms of price, Lamb Weston also around average when compared to competitors, with a P/E of 20.24 and EV/EBITDA of 12.19. Since the company matches / outperforms competitors in both growth and investor return metrics, we believe that Lamb Weston is undervalued from a relative standpoint.
With this in mind, we believe that Lamb Weston is fairly valued despite the overvaluation pointed out by Graham's Formula. Although Graham's valuation method implies a 15% downside, Lamb Weston well outshines competitors in growth and investor return metrics in our comparative valuation. Our view is that while shares are still not cheap from an absolute standpoint, Lamb Weston holds multiple advantages over other food-processing competitors that justify its premium valuation. For these reasons, we believe that Lamb Weston is fairly valued.
Risks
We believe that Lamb Weston Holdings faces significant risk due to its substantial debt sitting at approximately $3.3 billion as of Q4, including short-term obligations. This high credit burden could impede timely debt payments and redirect a substantial portion of operational cash flow toward debt servicing, potentially limiting resources for vital purposes such as supply agreements and corporate initiatives. Moreover, the company’s vulnerability to economic downturns could escalate, given the strain of debt repayment. The restrictive settlement within the debt agreements may hinder a swift response to market changes, potentially placing the company at a competitive disadvantage. Breaching these settlements could also trigger defaults and credit rating downgrades, constraining access to capital markets and elevating borrowing costs. We believe Lamb Weston’s substantial debt exposure warrants careful consideration.
Another risk is the possible normalization of potato prices. For 2022 and 2023, sales growth was entirely driven by Lamb Weston’s pricing actions. While this was previously afforded due to skyrocketing potato prices, we believe that Lamb Weston may be unable to sustain sales and margins should prices fall back to normal levels. A drop in potato prices would be compounded by the fact that overall volumes have actually shrunk. With overall inflation slowing, we believe that Lamb Weston’s high earnings growth may be in danger.
Conclusion
We are bullish on Lamb and Weston due to its strong earnings growth and long-term investments in production infrastructure. Despite a lukewarm earnings guidance for 2024, we believe that the company will continue to perform well carrying over into next year.
For further details see:
Lamb Weston Holdings: A Buy Following Solid Q4 Results