2023-10-18 11:00:12 ET
Summary
- Recent financial results show a sequential increase in volume, alleviating concerns about a decline in volume.
- Pricing measures and contributions from acquired businesses have boosted top-line performance and improved EBITDA margins.
- LW is well-positioned to achieve its long-term growth guidance and could see a potential revision in multiples.
Summary
Readers may find my previous coverage via this link . My previous rating was a buy for Lamb Weston (LW), as I believed expectations were reset lower, and the bearish argument that volume was going to stay weak does not hold up in my opinion. I am reiterating my buy rating for LW as I believe the business can easily achieve its long-term growth guidance, and valuation should converge to peers' levels.
Financials/Valuation
LW reported on October 5th 1Q24 EPS of $1.63 with sales coming in at $1.67 billion better than consensus expectation of $1.61 billion and a strong gross margin performance of 29.4%. Consequently, EBIT margin came in at 19.8%, much higher than consensus expectations, which lead to a strong EPS performance.
The recent quarterly results of LW demonstrated a sequential increase in volume, which is a significant positive as it alleviated concerns regarding a potential further decline in volume. The organic volume for the first quarter of 2024 exhibited a year-on-year decline of 8%, surpassing the previously reported decline of 10% in the fourth quarter of 2023. While volume decline is still negative y/y, the magnitude of decline has improved and drastically after adjusting for the self-inflicted contract churns. Specifically, some investors may overlook the fact that the organic volume decline is potentially lower than the reported -8%. This is because management has explicitly stated that the decline is influenced by the decision to terminate four customer contracts, particularly in the International sector, which significantly contributed to the decrease in volumes during the quarter. In my perspective, this decision is appropriate as it allows LW to reallocate resources towards channels that generate greater value. Investors' fears of a drop in demand and increased pressure on capacity utilization should be allayed by this update.
Furthermore, pricing measures have continued to mitigate the effects of low volume. The primary factor contributing to the strong performance of the top-line was the combination of improved price/mix and increased contribution from acquired businesses in the EMEA region. This positive impact extended to the bottom-line, resulting in a notable improvement in EBITDA margin performance. Specifically, the EBITDA margin for the current period stood at 23.58%, surpassing the figures of 18.3% in the first quarter of 2023 and -5% in the fourth quarter of 2023. Also notably, the management's guidance for EBITDA margins in the International sector, despite experiencing a 27% decline in organic volume, indicates that the acquired EMEA business is performing considerably better than the initial projection of 10% outlined during the acquisition phase. This suggests that there has been an enhancement in the profitability of the business.
Based on author's own math Based on author's own math
Based on my view of the business, LW should be able to grow at the high end of its long-term guided range. Margin should improve alongside revenue growth as updated contracts should improve pricing, and volume growth should drive high incremental margins due to the fixed cost base. A big part of the upside is a revision in multiples from the current 14x to near peers' average of 16.8x, which I believe should crystalize as LW growth is in line with the expected consensus revenue growth of these peers (median of ~3.5% using Bloomberg estimates). The reason for the modest discount of 0.8x is because of the capex trajectory of LW, which will pressure FCF in the near term. Using these assumptions, I have a price target of $117.
Previously, I modelled LW to trade back to its historical average of 23x. While I believe LW can still trade back to that level, I have adjusted my expectations in the near-term to a much lower reversion magnitude given the near-term CAPEX concern. Note that LW has never traded at this level over the past 7 years, except during COVID.
Comments
I maintain a positive outlook on the LW business, particularly following LW's analyst day presentation. I hold a strong conviction regarding the newly established long-term objectives for revenue and earnings growth. I am of the opinion that these targets are readily attainable for LW. The overarching objectives encompass achieving a modest increase in revenue, ranging from low to mid-single digits, through a balanced combination of volume expansion and improvements in price and mix. I believe this is an easily achievable target, as this is in line with industry growth expectations.
LW
As LW revises its contracts with the aim of enhancing its value capture rate, I expect to see an increase in both the volume of its business and the prices it can command (which means top line growth should be faster than industry growth). During the analyst day, management elaborated on the measures it has undertaken in North America over the past year to effectively manage revenue growth and enhance profitability. A significant move has been transitioning more customers from multi-year fixed price contracts to annual agreements, and aligning LW's prices with the prevailing menu French fry prices at customers that have experienced faster price increases. This strategy has effectively expanded the overall profit pool within the category. I also anticipate that management will apply these initiatives to LW's recently acquired EMEA operations. With improvements in supply chain productivity and SG&A leverage, achieving mid- to high-single-digit EBITDA growth should be readily attainable, given that top-line growth is expected to surpass the guidance.
LW
Nevertheless, the aspect that caught the market off guard (and presumably led to the decline in stock price) was the management's projection for capital expenditures in FY25 to remain at a comparable level to that of FY24, despite the commencement of operations for newly established facilities. The projected medium-term capex is anticipated to be approximately 9% of sales, a figure that surpasses the previous levels observed before the fiscal year 2023, which ranged from 4% to 7%. It is anticipated that capex will remain at a heightened level of $800 to $900 million annually in the upcoming two fiscal years. While it remains elevated, I would caution investors not to take this as face value and sell off the stock as the near-term FCF becomes pressured. I support the perspective of management that these capital expenditures are crucial as they contribute to the modernization of the plant and enhance production capabilities. This, in turn, is expected to strengthen LW's long-term competitive position and improve its earnings.
Risk & Conclusion
There are several significant risks that should be taken into consideration. Firstly, there is the potential for a decline in consumer demand and a decrease in restaurant traffic (which happens during high inflation period). Secondly, there may be an increase in competitive intensity following a successful new potato crop.
I reiterate my buy rating for LW, as the business seems well-positioned to easily achieve its long-term growth guidance. Recent financial results have demonstrated a sequential increase in volume, mitigating concerns about a volume decline. LW's decision to terminate certain customer contracts to reallocate resources appropriately has been seen as positive. Pricing measures and contributions from acquired businesses have further boosted top-line performance and resulted in significant improvements in EBITDA margins. Looking forward, LW should be able to achieve the high end of its long-term growth guidance, with margin improvements expected alongside revenue growth due to updated contracts. A potential revision in multiples could further enhance valuation, leading to a price target of $117.
For further details see:
Lamb Weston: Long-Term Guidance Easily Achievable