Introduction
It’s time to discuss a company I have never covered before, a company we are about to make a holding in various family accounts. That company is Lamb Weston Holdings (NYSE:LW), one of the world’s largest producers of frozen potato products (like fries).
In 2016, Lamb Weston became an independent company after food giant Conagra Brands spun off this business to become more streamlined.
Since then, it has outperformed its former parent by a huge margin, returning 164% since the end of 2016.
The company would also have outperformed the S&P 500 if it weren’t for its recent >20% post-earnings stock price decline, the biggest single-day decline in its history.
This decline triggered my interest in the company, which means I’m using this article to explain why I like the company at current prices.
So, let’s get to it!
A Fantastic Business I Would Like To Own
Lamb Weston sells fries, and it does this on a huge scale in a very efficient manner.
Looking at the map below, we see the company sells products in more than 100 nations, using 27 factories and more than 10,000 employees.
In its most recent quarter (fiscal 3Q24), the company sold roughly $950 million worth of products in North America. International sales were $511 million.
The company’s biggest customer is the McDonald’s Corporation (MCD), which accounted for 13% of its FY2023 sales.
Not only does the company benefit from McDonald’s being popular, but also from the fact that “everyone” loves fries.
According to the company, the favorite food of every generation is french fries, followed by burgers.
One of the reasons why I do not invest in restaurants is competition risks. The restaurant business is challenging. Lamb Weston solves that problem, as it sells to “everyone.” This allows me to invest in the restaurant business without the severe competition risks.
Not only does Lamb Weston benefit from a wider business moat but also from the fact that french fries offer high margins to restaurants, which is just another reason for restaurants to offer fries.
Among major side dishes, french fries tend to have the highest margins.
In fact, even including the pandemic, global frozen potato demand has grown by 3% per year in the 2017-2022 period.
In 2017-2019, demand has grown by 5% per year, which is great news, as global population growth is consistently below 1%.
The difference compared to population growth makes sense. After all, the global middle class is growing, which tends to benefit restaurants and higher-priced food.
As we can see below, global QSR (quick service restaurant) demand growth is elevated, with an elevated fry order frequency in all regions.
Even the U.S., one of the most saturated markets in this segment, is expected to see 3% annual unit growth in the 2022-2027 period.
Moreover, because LW produces its products so efficiently, it is able to keep prices very competitive.
Since 2018, its net price growth has been significantly lower than average menu prices. This allows LW to capture market share without sacrificing growth.
On top of that, the company is consistently creating new fries and potato products to offer differentiated products. This allows for better pricing and allows the company to stay ahead of the competition.
As weird as it may sound, figuring out new ways to cut and season potatoes is a form of “innovation” that has contributed significantly to LW’s success.
Personally, I have always been amazed by the variety of new frozen potato products in Western Europe (where I do most of my grocery shopping). As it turns out, many of these brands are owned by Lamb Weston.
Based on this alone, I was interested in digging deeper, as it allows me to own a major part of the food supply chain.
Shareholder Returns & Recent Sell-Off
Shortly after becoming independent in 2017, the company spent $27 million on dividends. Since then, and as of 1Q24, that number has grown to a cumulative $833 million. On top of that, the company has spent close to $380 million on buybacks.
After hiking its dividend by 28.6% on December 14, 2023, LW pays $0.36 per share per quarter in dividends. This translates to a yield of 1.8%.
This year, the company expects to generate $5.58 in adjusted diluted EPS. This would imply a dividend payout ratio of 26%, which is close to the lower bound of the company’s 25% to 35% payout ratio and a sign of potentially elevated future dividend growth.
In the valuation part of this article, I’ll discuss EPS growth expectations. If these turn out to be correct, LW has a lot of room to hike its dividend.
The dividend is also protected by a healthy balance sheet.
Although the company’s BB+ credit rating is below investment-grade, the company is expected to end this year with $3.5 billion in net debt. This implies a 2.2x net leverage ratio. That’s healthy. Through 2026, that number is expected to fall to 1.6x ($3.0 billion in net debt).
So, why did the company sell-off?
The problem is unexpected weakness in its just-released quarter (3Q24).
In this quarter, the company reported a 16% increase in sales, primarily driven by the acquisition of a business segment in the EMEA market.
However, excluding this acquisition, net sales declined by 12%. This was mainly due to unfilled orders resulting from the company’s ERP transition.
According to SAP:
ERP stands for enterprise resource planning, but what does ERP mean? The simplest way to define ERP is to think about all the core business processes needed to run a company: finance, HR, manufacturing, supply chain, services, procurement, and others.
Total sales volumes declined by 16%, driven by unfilled orders from the ERP transition, soft restaurant traffic trends, and the impact of exiting lower-margin business.
According to the company, despite extensive planning and preparation, the transition to SAP’s ERP system turned out to be more difficult than expected.
This difficult migration had an impact on multiple areas, including receiving and processing customer orders, trade pricing, inventory management, scheduling, transportation, invoicing, and cash management.
The transition to a new enterprise resource planning (“ERP”) system in North America negatively impacted our financial results in the quarter by more than we expected,” said Tom Werner, President and CEO. “The ERP transition temporarily reduced the visibility of finished goods inventories located at distribution centers, which affected our ability to fill customer orders. – Lamb Weston
This caused shipping delays, canceled orders, and overall lower volumes.
As a result, the company worked closely with customers to minimize the impact on their operations. It also resulted in a temporary loss of sales to competitors. After all, customers need their fries.
The good news is that these issues are temporary and that overall demand remains healthy.
While inflation continues to be an issue, pressuring traffic in major markets like the U.S., the company noted that overall demand for French fries remains resilient.
[…] overall, global French fry demand remains resilient, but we believe it’s currently at or below the historical annual growth rate of about 2% to 4%. According to restaurant industry data providers, restaurant traffic trends in the U.S. have been generally flat to slightly down during the past 6 to 9 months as consumers continue to adjust to the cumulative effect of inflation on menus. – LW 3Q24 Earnings Call
Outlook & Valuation
In light of these challenges, the company revised its full-year sales and earnings targets.
Specifically, we reduced our annual net sales target to $6.54 billion to $6.6 billion from our previous target range of $6.8 billion to $7 billion. The updated range includes $1.1 billion of incremental sales attributable to the EMEA acquisition during the first 3 quarters of the year. – LW 3Q24 Earnings Call
The good news is that the company expects a recovery sales growth in the fourth quarter, driven by improvements in price/mix, albeit partially offset by lower volumes.
Valuation-wise, LW trades at a blended P/E ratio of 14.0x. This is way below its long-term normalized P/E multiple of 24.6x.
Next year, EPS growth is expected to be 11%, potentially followed by 9% growth in the year after that.
Although I wouldn’t apply a 24.6x multiple here, I believe a lower 18x multiple is appropriate for these growth rates. This would imply a fair price target of roughly $131. That’s 60% above the current price.
I expect this target to be hit over the next 3-4 years.
If I weren’t in the “higher for longer” (inflation) camp, I would be even more bullish.
The current consensus price target is $117.
That said, “we” currently own a starters’ position in a family account. However, I will not officially disclose that “I’m long,” as I advise these accounts for fun. I do not benefit from potential gains in any way.
Depending on my own financial situation (I have a big watchlist, tax obligations, and other investments), I may buy LW soon as well.
Takeaway
Lamb Weston Holdings presents a compelling investment opportunity despite recent challenges.
The company, which is a leader in the frozen potato products market, has a major global presence, efficient operations, and a diverse product portfolio.
While facing temporary setbacks due to ERP transition issues and softening restaurant traffic trends, LW remains resilient with healthy long-term demand prospects.
With an attractive valuation and solid dividend growth potential, LW offers significant upside potential for patient investors.
Pros & Cons
Pros:
- Strong Market Position: LW is a dominant player in the global frozen potato products market, with a wide-reaching distribution network and a diverse product portfolio.
- Resilient Demand: Despite recent challenges, LW benefits from consistent demand for french fries and other potato products.
- Efficient Operations: The company’s efficient production processes and innovative product offerings contribute to its competitive advantage.
- Dividend Growth Potential: With a healthy balance sheet and a track record of consistent dividend increases, LW presents an attractive opportunity for dividend growth investors.
Cons:
- Short-Term Headwinds: Recent issues related to ERP transition and softening restaurant traffic have impacted sales and could continue to pose challenges in the near term.
- Dependency on the Restaurant Industry: LW’s business is closely tied to the performance of the restaurant industry, exposing it to fluctuations in consumer spending and dining trends.
- Potential for Supply Chain Disruptions: The company’s operations may be vulnerable to other supply chain disruptions in the future.