PotaeRin
Summary
Lamb Weston (NYSE:LW) manufactures and distributes a wide range of frozen potato products, including fries, oven-roasted potatoes, potato chips, and other frozen potato products. Readers may find my previous coverage via this link. My previous rating was a hold, as I believed the risk-reward ratio was a lot less attractive after the strong rally from the low $60s to the previous high of $110+. I am revising my rating from a hold to a buy as the valuation is now attractive after the stock price dip. I believe expectations have now reset lower, and the bearish argument that volume is going to stay weak does not hold up in my opinion. I think volume will recover eventually, as the factors that impact volume today are non-structural.
Financials / Valuation
LW reported a total revenue of $1.695 billion, with a decline in organic volume of 10% being more than offset by a rise in price and product mix of 23%. The unfavorable mark-to-market lead to a GM decline. Nonetheless, the interesting part was the EPS, which, at $1.22, was 17% higher than expected (but the stock still took a dive!).
Based on author’s own math
The situation has flipped again. With the price dip, I believe the valuation is attractive today. Valuation has now dipped below the stock’s historical trading range (19x to 26x forward PE), for reasons that I believe are non-structural. Using consensus figures and assuming multiples will revert back to 23x forward PE, there is a 35% one-year upside. Unlike the high expectations previously, I think expectations have reset with this price dip. The soft volume situation should recover as time passes, and margins should improve as management shaves off low-margin contracts.
Comments
I’d like to start by addressing the significant price drop, which I attribute to a number of factors, including high expectations prior to earnings and the weak underlying demand that management has highlighted. Despite softer volumes, quarterly results showed continued strength in pricing across channels. A combination of factors, including a dip in underlying demand, destocking by some international clients, a delay in retail orders, and a strategic realignment of the portfolio mix away from lower-margin businesses, have contributed to the soft volume. When considering all four components, I believe the first three are cyclical in nature and will ease over time. The slowdown in demand (including international customer destocking and the timing of retail orders) is probably due to the weak economy and low business confidence. The final point, moving away from lower-margin businesses, is one I think is worth highlighting because of the potential benefits it could bring. Management explained during the call why it decided to stop working with certain low-margin clients in favor of focusing on higher-margin ones. While this will have a short-term effect on volume, it will improve the company’s margin structure in the long run. Taken as a whole, I conclude that the low volume is just a matter of time and will rise again. However, I believe it is fair to argue that there may be some lingering volume headwinds into FY24 in the retail (products late to be shipped out) and global segments (delayed China reopening and capacity constraints).
“And fourth, certain large retail customers temporarily lowered prices to rightsize inventories of private label products, delaying shipments of products that we produced on their behalf.
“In addition, we expect our capacity to produce coated fries, specialty cuts and chopped and formed varieties, such as puffs and hash browns will remain constrained until our new production facilities in China and Idaho become available late in fiscal 2024.” Source: 4Q23 earnings
The remaining factor in LW’s growth equation involves pricing. Unlike my perspective on volume, I am optimistic about pricing due to LW’s strategic measures to counteract incremental inflation in the potato crop. Particularly in North America, this concern is mitigated as LW has already implemented price adjustments in Retail and Foodservice, addressing a portion of the 20% increase mentioned during the 4Q23 earnings call in its farmer contracts for this year. Moreover, this year’s Pacific Northwest potato crop appears to be performing better compared to previous years, which could substantially alleviate LW’s contracted potato inflation and subsequently reduce the necessity to acquire spot potatoes at inflated costs.
“Together, our sales and operating momentum drove sequential gross margin improvement in the quarter and have us well positioned to better manage the upcoming cost pressures from this year’s exceptionally poor potato crop in the Pacific Northwest.” Source: 4Q23 earnings
European pricing will go into effect very soon, and global pricing will pick up speed sometime in the new year. I would recommend looking at LW’s past performance if you are concerned about the company’s pricing power. For context, there have been only two years with a negative contribution from pricing and product mix since 2006.
Risk & conclusion
My rating for LW has been upgraded from hold to buy due to an attractive valuation following the recent price dip. While the dip was attributed to various factors including high expectations and weak underlying demand, the fundamental strengths remain intact. Despite a decline in organic volume, strong pricing across channels provides a positive outlook. Soft volume is likely to recover over time, with cyclical factors easing. Management’s strategic shift away from lower-margin businesses should enhance long-term margin structure. Notably, the price dip has reset expectations, and the stock’s valuation now sits below historical ranges.
