Lamb Weston: Growth Prospects Remain Encouraging (NYSE:LW)

Investment Thesis

Lamb Weston’s (NASDAQ: NYSE:LW) revenue growth should benefit from moderating volume decline in the coming quarters as the company laps the divestiture of lower-performing product lines and businesses which began in Q2FY23. Moreover, channel destocking in international markets is also near completion, which should also give a boost to volumes. In addition, the carryover impact of prior price increases, good demand in the end markets, capacity expansion, and M&A should also support revenue growth.

On the margin front, the company should continue to offset inflationary raw material costs with price increases. In addition, improving product and business portfolio with high-margin product lines and business mix, and productivity gains should also help the margin growth. Furthermore, the valuation also looks attractive as the stock is trading at a discount to its historical averages. This combined with good near-term, as well as long-term, growth prospects makes the company a buy.

Revenue Analysis and Outlook

In my previous article, I discussed the company’s good growth prospects benefiting from price increases, good demand at QSR and retail channels, increasing capacity, and M&A. The company has reported a couple of quarters since then and has seen good growth.

In the first quarter of fiscal year 2024, the company continued its revenue growth momentum. The company saw benefits from favorable product mix, and carryover pricing as well as incremental pricing increases. Moreover, the Lamb-Weston/Meijer (LWM) acquisition also provided a good boost to sales growth. This helped offset the volume headwinds from the exit of lower-performing businesses, and channel destocking in international and some of the U.S. markets. As a result, net revenue increased by 48% YoY to $1.66 billion. Excluding a 33 percentage point benefit from the LWM acquisition, organic sales increased by 15% reflecting a 23 percentage point benefit from price/mix and an 8 percentage point volume decline.

Looking forward, I believe the company should be able to continue delivering sales growth as the volume declines moderate with the company lapping the exit of lower-performing businesses, channel destocking ends, and the company expands its capacity. In addition, carryover pricing, and inorganic growth from acquisitions should also continue supporting revenue growth.

Over the last year, the company exited its lower-performing and lower-margin businesses. This was a strategic decision by management to improve its product and customer mix. This led to negative pressure on volumes starting Q2 FY23. Now as we move forward in fiscal 2024, the company should start lapping these divestitures of lower-performing businesses. This should lead to a moderation in volume decline in the second half of fiscal 2024, benefiting sales growth.

Moreover, the volumes should also benefit from destocking nearing its end. Post pandemic, the channel partners in international markets started carrying high levels of inventory in response to supply chain disruptions. However, in the last few quarters, in anticipation of lower consumer traffic, they began to rightsize their inventory levels to align with the demand. Moreover, certain large retailers also started destocking to rightsize inventories of their private label products, delaying shipments of products that LW produced on their behalf. According to management, this destocking is nearing completion. So, the negative impact from destocking in the channel should abate in the next couple of quarters and be less of a volume headwind.

I also expect healthy demand moving forward. Over the last few quarters, the restaurant industry saw lower guest traffic count due to persistently high inflation which tightened consumer pockets. This also had an impact on the company’s sales as these restaurants are its customers. However, I expect trends of lower guest traffic to recover in the coming quarters thanks to moderating inflation. As guest traffic improves, demand for frozen potato products should also increase, helping volumes.

In October, the company had an investor day where management shared upbeat commentary on the medium term demand trend. Below is the relevant excerpt from the commentary of Mike Smith, LW’s COO,

…we expect the global frozen potato category to grow by 2% to 4% or 3.5 billion to 7 billion pounds over the next 3 years. And while developed markets are projected to grow at a slower rate in the low single digits over the next 3 years, keep in mind, they’re also off of a much larger base. Whereas emerging fry markets are expected to grow in the mid-single digits over the next 3 years, consistent with the more than 5% growth that they’ve experienced over the last 5 years.”

So, I expect healthy demand levels over the medium to long term. Moreover, I cover the restaurant industry closely and most of the QSR companies have shared their plans about strong unit growth in the coming years. This should lead to increased consumption of fries, helping the demand for the company’s products.

Also, the company is well on track to increase its production capacity. Over the last few quarters, the company’s biggest pain point has been its inability to meet the demand due to lower volume production as a result of labor and supply constraints. So to meet the favorable demand outlook over the coming years, the company planned to open additional production facilities across the globe. Last month, the company opened its new production facility in China which is expected to produce more than 250 million pounds of frozen french fries and other potato products per year. Moreover, in February ’23, the company acquired the remaining interest in its European joint venture, Lamb-Weston/Meijer, and gained full control over six factories with nearly two billion pounds of annual frozen food production capacity.

The company is also building additional production capacity in Argentina, Idaho, and the Netherlands, to support long-term sales growth. These facilities are expected to come online in the next 18 months. This should help in sales growth given the favorable demand outlook.

The company should also benefit from revenue synergies resulting from Lamb Weston’s acquisition of a full 100% share in the Lamb-Weston/Meijer (LWM) joint venture in Europe. Over the last two quarters, this acquisition has led to more than a twofold increase in the company’s revenue in international markets. This acquisition helped the company expand its presence in Europe, the Middle East, and Africa and I expect the company to continue seeing cross-selling benefits.

Looking ahead, management plans to actively engage in M&A. The balance sheet also looks healthy with a net debt-to-EBITDA ratio of 2.3x and management is comfortable with increasing the leverage to 3-4x in case an attractive M&A target comes along.

Hence, I believe the company’s revenue growth prospects are sound and management should be able to achieve its revenue growth targets of 27% to 31% in fiscal 2024 with organic growth of 6.5% to 8.5%. Over the medium to long term, the company should easily be able to deliver its long-term organic sales growth target of low to mid-single digits with additional upside from M&A.

Margin Analysis and Outlook

In the first quarter of fiscal 2024, the company’s margins continued benefiting from price increases. In addition, improved supply chain efficiencies, and lower trucking and freight costs also supported the margin growth. This helped offset inflationary raw material costs and volume deleverage and resulted in a 510 bps Y/Y increase in gross margin to 29.4% and a 400 bps Y/Y in adjusted EBITDA margin to 24.8%

Looking forward, I believe the company should be able to continue growing margins. The carryover impact of price increases and incremental price increases should continue to support margins and help offset higher prices of existing contracts (which were negotiated during the challenging potato harvest of 2022 and inflationary pressures in 2023). Further, according to management, the recent potato crop harvests in North America and Europe, are expected to align with historical averages. This suggests that the renegotiation of contracts for fiscal 2025 could be done on favorable terms to reflect lower potato prices, providing a favorable medium-term cost outlook.

Furthermore, as volume declines moderate moving forward, volume deleveraging should also reduce. Additionally, the company’s strategic move to divest lower-performing, low-margin businesses and product portfolio should improve the mix. The company has also increased the production of higher-demand and high-margin products like retail fries, premium fries, and batter-coated products with its increasing capacity. As the volume lost from divesting lower margin businesses gets backfilled from higher margin products and businesses, we should see good contributions from a favorable mix.

In addition, the company should also benefit from supply chain productivity gains. Since fiscal 2021, the company has realized approximately $185 million in supply chain productivity savings by cutting costs in procurement, transportation, warehousing, and manufacturing. Moreover, in the last two years, LW has trimmed its range of SKUs by around 30%, resulting in fewer changeovers in the factories, enhancing throughput, and improving planning and execution. I expect these savings to further increase and support margins due to the following reasons:

• These productivity savings over the last couple of years were somewhat constrained by inflationary challenges. So as inflation moderates, these savings should see an uptick in the future, contributing to improved margins.

• Moreover, LW’s existing lines require modernization to drive efficiency and flexibility within its footprint. So, management plans to keep investing in its manufacturing footprint to implement cost-effective measures. This should also increase productivity savings.

• Lastly, the company is also in the middle of implementing its new Enterprise Resource Planning (ERP) system. Once successfully implemented over the coming years, this should also unlock productivity savings and support margins.

Hence, I am optimistic about the company’s near-term as well as longer-term margin prospects.

Valuation and Conclusion

Lamb Weston is currently trading at a 17.74x FY24 (ending May) consensus EPS estimate of $5.90 and a 16.52x FY25 consensus EPS estimate of $6.34. This is a discount to its historical 5-year average forward P/E of 27.20x. The company should see healthy revenue growth benefiting from easing comparisons, completion of channel destocking, capacity expansion, and M&A. Margins should also see benefits from pricing, moderating inflation, and productivity gains. Hence, I continue to rate the company a Buy.

Risks

The company has a meaningful international presence. So, its results may be impacted by adverse FX movements.

If the company is not able to renegotiate contracts with potato farmers on favorable terms, its margins may be impacted.

The fries and other potato-based products are not generally regarded as a healthy food category and any shift towards healthy eating preferences may impact the company’s business in the long run.