2024-01-16 06:31:39 ET
Summary
- Lamb Weston's Q2 2024 revenue came in strong, with 35.7% YoY growth, driven by price/mix and international sales.
- Volume decline is gradually improving, and I expect volume growth to turn positive in CY2024.
- Margin performance is expected to improve as one-off cost items are eliminated and supply chain productivity improves.
Summary
Readers may find my previous coverage via this link . My previous rating was a buy, as I believed the expectation for Lamb Weston ( LW ) has been much lower and that volume growth is unlikely to stay weak. The LW share price has performed very well since my last update, and I believe there is still room for more upside. I am reiterating my buy rating for LW as I expect volume growth to start turning positive sometime in CY2024 and margins to improve from here due to improved supply chain productivity, the absence of one-off cost items, and top-line growth.
Financials/Comments
LW 2Q24 sales came in strong at $1.73 billion, representing 35.7% y/y growth and being 1.6% above consensus estimates of $1.705 billion. Breaking down the revenue line, North America reported $1.17 billion in revenue, with price/mix being the main driver (14 points contribution offset by 4% volume decline). International sales came in at $565 million, driven by a 22% decline in volume, a 10% increase in price/mix, and the remainder from acquired business. I believe LW's 2Q24 performance has shown that volume headwinds are gradually easing, and things should start to inflect positively in the coming year. For North America, volume decline has been improving on a sequential basis, from -9% in 2Q23 to -4% in 2Q24. In addition, if we stack up all the volume decline since 4Q22, the cumulative decline is slightly over 30%, which means volume levels are now back to FY21 (pre-covid) levels (1Q22 and 2Q22 grew volume by 24% collectively). As there is a base level of volume demand in the industry, volume cannot decline forever unless the number of restaurants is in a permanent decline as more Americans are eating out. My opinion is that volume growth will recover to positive sometime in CY2024 as the industry digests that pulled-forward demand post-Covid.
Based on author's own math
As for international volume growth, I believe the headline numbers do not reflect the actual underlying demand, as a large part of the decline is by choice. LW is deliberately exiting its lower-priced and margin businesses; hence, volume is declining. Based on management guidance, this deliberate exit should end soon, as they are guiding the y/y volume trend to improve sequentially. Similar to the North American consumer, I expect global consumers to dine out more often as the upcoming generation of the population is Gen Z and millennials, who value convenience and experience, which is a secular tailwind to volume growth. Also, LW's new greenfield processing facility is now operational in China, which should help ensure sufficient capacity to meet additional volume growth once the global macro economy turns better eventually.
Moving down the revenue line, LW reported adjusted gross margins of 27.6% and adjusted EBITDA of $376.9 million. In my opinion, LW's headline margin performance is not reflective of the actual business performance as it has been impacted by one-off line items. In 2Q24, margin was dragged down by inventory write-downs due to excess potatoes. If we were to exclude the one-time inventory write-down, LW's gross margin would've been around 31%, which is ~300 bps higher than LW's pre-covid result (2Q22). As gross margin gets adjusted upwards, EBITDA margin would be closer to 25.5%, similar to 2Q22 levels as well. As for 3Q24, LW would be, once again, impacted by a one-off line item-ERP integration-which will continue to depress headline gross margins. Management also highlighted that the 3Q24 gross margin would not follow the same seasonality trend. As such, if we exclude these two events that shouldn't recur next year, LW's gross margin should be in the >30% range, which is near the all-time high, if not possibly the highest for LW operating history. However, the consensus estimate is for FY25 gross margin to be 29.6%, which I think is too low given that 2Q24 normalized gross margin is already at 31%. Note that LW should also benefit from improved supply chain productivity and increased utilization of its China facility, both of which should have a positive impact on margins as well. All in all, as we move past the one-off items and LW reports stronger-than-expected margin performance, we should see upward revisions in consensus estimates, pushing the stock further upwards.
Valuation
Based on author's own math
Based on my view of the business, LW should start to see revenue growth accelerate as volume growth starts to turn from negative to positive in FY25 and FY26. Growth should also benefit from the fact that more consumers are dining out, which will drive more demand for raw materials at the restaurant level. Improving volume (operating leverage), productivity, and the absence of one-off cost items should drive improvements in margins. I believe as LW performs according to my expectations, the market will continue to re-rate LW valuation multiple times higher, especially as consensus appears to be underestimating LW gross margin performance (i.e., expectations are low). I assumed 19x forward PE; this is the low end of the LW historical trading range (which historically trades between 19x and 26x). LW could jolly well trade much higher, possibly back to its historical average of 22x, once the business shows that everything is back to a normalized level.
Risk & conclusion
Volume could continue to stay weak for longer than expected if the macro conditions deteriorate from here. This would cause more consumers to cut back on discretionary spending in the near term. The implication is that restaurants will downsize their required inventories due to the weak expected demand, thereby pushing the base volume requirement lower. This naturally impacts LW's performance.
All in all, I remain buy-rated for LW. Despite the stock's strong performance since my previous update, I believe there is room for more upside. LW should start to see positive volume growth in CY2024 as North American volumes are showing sequential improvement, and volume appears to be back to pre-Covid levels. International volume declines are strategic and expected to reverse as LW completes its exit of lower-margin businesses. Margin performance should improve from here as LW benefits from supply chain productivity improvements, ramp-up of utilization at the China facility, and one-off items do not reoccur.
For further details see:
Lamb Weston: More Upside From Here As Topline And Profitability Grow