2023-05-02 09:37:10 ET
Summary
- The recent performance of LW in 3Q23 was exceptional, with strong pricing growth and product mix leading to higher margins and better-than-expected results.
- Margins are already at all-time highs, making further margin improvement difficult to underwrite, and potential price competition in a commoditized market must be taken into account.
- The stock valuation at 23 forward PE does not provide enough margin of safety to protect against a miss in gross margin expectations.
Summary
Lamb Weston ( LW ) manufactures and distributes a wide range of frozen potato products, including fries, oven-roasted potatoes, potato chips, and other frozen potato products. Over the past 12 months, the stock price has risen dramatically, from the low $60s to the present $110+. Since the beginning of the year, earnings per share estimates have increased from $3 to $4.50 for FY23 and from $3.90 to $5 for FY24, as such, I believe the risk reward is a lot less attractive at these levels. As such I recommend a hold rating to it. Nonetheless, based on the company's solid performance in 3Q23, I remain optimistic about the company as a whole. The bullish thesis holds that margins are increasing as a result of price increases and reduced stress on the supply chain, and that additional earnings growth is possible as a result of increases in both volume and the consolidation of the Europe JV. LW can likely use its pricing power to take advantage of the French Fry market's long-term growth potential. However, the lack of safety in the stock valuation cannot be made up for by all these optionality, especially when inflation will soon die down, removing a good "excuse" for LW to raise prices.
Recent quarter (3Q23) performance
Strong growth from pricing and product mix ultimately led to stronger margins, helping LW achieve exceptional performance in 3Q23 that surpassed the streets estimate. Gross margin rose by 860 basis points to 31.7%, which is nearly 200 basis points higher than what the market had expected. The flat sales and enormous cost growth have been more than compensated for by this huge beat. All market segments performed above average, but the food service and retail markets stood out due to the durability of price increases that resulted in record-breaking profit margins. Global quick-service restaurants and strong retail performance drove demand growth, which was partially offset by softness in traffic at casual and full-service establishments. I think it's crucial to note that, despite the drastic price changes, the average number of French fries ordered by diners remains at healthy levels. This tells me that the French fry market is underpriced relative to its potential revenue. I would not be surprised to see further margin expansion as a result of the price increase's pass-through of nearly 100% incremental margin.
Margin concerns
Overall, I'm impressed by management's ability to maintain strong execution in the face of the current weak macro and inflationary environment, all the while improving operational efficiencies and driving significant pricing growth. I would point out, however, that LW margins are already extremely high, with gross margin at 32% and EBIT at 21.2% in 3Q23-the all-time highs-making the expectation for further margin improvement difficult to underwrite. It will be more difficult for management to increase prices, in particular, if cost inflation is decreasing. It's also possible that LW's margin will contract if it finds it necessary to lower prices in order to compete (while there is no indication of this happening today, it is a concern to take note).
Guidance
Another indication of the company's health is management's revenue guidance for 4Q23, which, when extrapolated to an annualized rate, would amount to about $1.2 to $1.3 billion, or 20-30% higher than its initial $1 billion guidance. In addition, management discussed LWM's $100 million normalized run rate EBITDA, stressing the presence of clear opportunities for development. I take this comment positively with the understanding that there are further synergies to be made.
Valuation
As I previously stated, valuation could be an issue. The stock is not where it was last year, when expectations were extremely low. While the valuation has remained relatively stable (23x forward PE), earnings expectations have risen significantly, which I believe has pushed the stock price into less appealing territory. Using consensus figures and the current multiple, there is a 13% one-year upside. However, as previously stated, my concern is the underlying assumptions that must be underwritten today. Gross margins must remain at all-time highs, while net margins return to pre-covid levels (implying a higher new cost base). Consensus appears to have emerged in LW's ability to continue raising prices, which I believe should not be taken for granted because inflation will eventually fall and competition will drive prices down in a commoditised market. Given the higher cost base, if gross margins fall to the mid-20% range, net margins will suffer significantly.
Conclusion
While LW has had a price run over the past year, with a significant increase in its stock price and EPS estimates, I believe that the risk-reward ratio is less attractive at these levels. Therefore, I recommend a hold rating for the stock. However, LW's strong performance in 3Q23 and the potential for further earnings growth through margin expansion and market consolidation make me optimistic about the company's prospects in the long term. Nevertheless, margin concerns and potential price competition in a commoditized market must be taken into account. Therefore, investors should exercise caution and carefully consider the underlying assumptions (at the current valuation and street estimates). Overall, I believe that LW is a solid company with growth potential, but its current valuation and potential risks warrant a cautious approach.
For further details see:
Lamb Weston: Valuation And Consensus Estimates Pricing In High Margins