The case for frozen potato manufacturer Lamb Weston (LW) is reasonably simple. Both the company and the stock have performed impressively well since Lamb Weston's late 2016 spinoff from Conagra Brands (CAG). Since the spin, LW has doubled; CAG shares have fallen 42%.) (Incredibly, LW's market capitalization now is almost equal to that of CAG.)
The company has dominant market share in the U.S. (40%+, per past filings) and is second globally to privately held McCain. U.S. markets are strong. International markets are a potential source of growth. Management has seemed impressive.
Indeed, I was bullish on LW soon after the spin - and I've seen little reason since to change my opinion on the company and its prospects. But owing to valuation concerns, I pulled back on my optimism toward the stock in May, with LW at $66. Nine months later, with LW at $70, I still see some reasons for caution. LW remains rather expensive, at 14x+ the high end of EBITDA guidance and ~38x guided free cash flow. And the stellar performance Lamb Weston since the spin is going to moderate in the second half - per LW management itself - and could face challenges in fiscal 2020 and beyond.
There's surely an argument that Lamb Weston is worth its premium to the CPG space, and this is a not a company I would short under any circumstances. But it does seem like the performance since the spin has benefited at least in part from a nearly perfect confluence of tailwinds. When those tailwinds fade, I'm not sure LW will look as attractive as it has - or quite attractive enough to keep existing multiples in place.
The Case for LW
The case for Lamb Weston is reasonably simple: its performance has been outstanding. Between 2015 and 2018, per figures from the 10-K, Adjusted EBITDA rose 55% - a ~16% CAGR. Performance in the first half of FY19 (ending May) looks just as strong, with revenue rising 12% in Q1 and 11% in Q2, and YTD Adjusted EBITDA growth of 14.6% suggesting both margin expansion and only a modest deceleration from recent results.
Adjusted EBITDA guidance has been hiked already, by $10 million ($860-$870M to $870-$880M) but that understates the strength of the performance. A weak potato crop in Europe hit the company's joint venture with Meijer, leading to a projected reduction in equity method earnings this year against initial guidance for ~flat performance. Despite that hit, however, full-year guidance was maintained after Q1. Guidance came up $10 million after Q2 despite the fact, per the Q2 call, that the benefit from the consolidation of another joint venture would be $10 million lower than originally thought due to the timing of the close.
In other words, the outlook for the base, wholly-owned, business has improved after each of Q1 and Q2. That continues LW's trend of underpromising and overdelivering. Meanwhile, Q2 added news of a 5% dividend hike, a $250 million share repurchase program, and a tuck-in acquisition of a potato processor in Australia. That's exactly the kind of combination that a compounder like LW can provide.
The Global segment (the top 100 chains in North America plus large international accounts) is performing well, thanks to strength in QSR (McDonald's (MCD) accounts for 11% of overall sales). Foodservice volume has been weak this year (flat in Q1, -2% in Q2), but Lamb Weston walked away from some lower-margin business in that segment. And Retail, while small, has been growing at a torrid pace, thanks to last year's launch of the Grown in Idaho brand and, to a lesser extent, supply disruptions at rival Ore-Ida. Overall margins continue to expand thanks in part due to steady pricing strength.
This simply looks like a company firing on all cylinders - and that's been the case since the company was spun 27 months ago. The worry at the moment, however, is that starting in fiscal Q3 LW might not look nearly as impressive.
The Perfect Environment
The primary concern here is simple. Lamb Weston has looked like an absolutely phenomenal business in its time as a public company. But over that time, it's benefited from an extremely beneficial external environment. Indeed, almost everything has gone right.
End customers are doing well - thanks at least in part to broad economic strength. In the Global segment, fast food operators have recovered over the past few years (including a traffic and sales turnaround at key customer McDonald's). LTOs (limited-time offerings) have provided another tailwind; for instance, the Nacho Fries at Yum! Brands (YUM) concept Taco Bell were the biggest launch in that chain's history. Foodservice operators are getting macro help. The Grown in Idaho launch was a roaring success, but Ore-Ida's slip certainly opened the door a bit wider for market share gains.
But the biggest boost here of late has been the industry environment. Per Lamb Weston commentary, industry utilization has been pretty much maxed out for most of the past few years. Potato crops in North America have been favorable. And so Lamb Weston has been able to take significant pricing. In each of FY15 and FY16, per the pre-spinoff information statement, price/mix had a negative 1% impact on revenue. In FY17, according to the 10-K, price/mix added 4%; in FY18, the benefit was a whopping 6%.
Those pricing gains obviously help revenue - but have a magnified impact on margins, particularly COGS. And so this business looks in the past two years like it's capable of consistently driving mid- to high-single-digit revenue growth and double-digit annual increases in Adjusted EBITDA - but over the long haul, that's likely not the case. Even considering some near-term effects from inflation (in labor, input costs, and freight), Lamb Weston's pricing has provided an abnormal, unsustainable boost to margins and profits.
And that boost is coming to an end, as even CFO Rob McNutt admitted on the Q2 call:
We've got our competitors, it's well known in Europe and North America that capacities coming online, we've got capacity coming on in our business and we're going to maintain discipline in our business and maintain our pricing, maintain our discipline, but the overall margin expansion is not going to be as pronounced as it has been in the last 3 or 4 years to your point. So – but I feel really confident about – when you step back and look at the big picture, the category continues to grow, our projections are 1.5% to 2.5%, that's a big – that's a critical element of driving our overall profitability, but the margin expansion is not going to be as pronounced as it has been in the last 3 or 4 years. There's no doubt about it.
In fact, the boost is ending pretty much right now. The price increases that hit in Q3 this year, according to commentary on the call, are smaller than those from the year before - which are now being lapped. With inflation still an issue, Lamb Weston itself is guiding for a significant deceleration in growth. Lower LTO revenue and tough compares are pushing revenue expectations down as well.
Implied guidance for the second half of the year in fact suggests that Adjusted EBITDA will be flat year-over-year ($435-$445 million implied against $440 million in 2H FY18). And that's with the twin benefits of $8 million in one-time spend in Q4 2018 (due to the establishment of a charitable foundation and a conversion to a direct sales model, according to commentary on that quarter's call) and the ~$10 million from the JV consolidation. Combined that's four points of help to 2H FY19 performance - yet guidance still implies just 1%+ growth at the high end.
The impressive headline numbers that Lamb Weston has posted over the past nine quarters are going to fade starting in Q3 - and the benefit of tax reform will be lapped in that quarter as well. And it's worth noting that the slowdown is coming only in a more normalized environment - not a negative one. Capacity will still take some time to come online (LW's expansion in Oregon will start up in May). Macro trends continue to benefit customers in foodservice and QSR. This isn't a bad environment for Lamb Weston by any means - it just may not be quite as good as it's been the last several quarters, in particular. And that, combined with four straight tough comparisons, suggests that growth is going to decelerate markedly in the near term.
Certainly, to some extent the market has priced in a deceleration. The EV/EBITDA multiple actually is modestly lower than it was nine months ago. 38x FCF guidance sounds aggressive, but that multiple is inflated by high capex this year (for the aforementioned expansion). P/E relative to FY19 consensus is a more reasonable ~23x, and that consensus actually looks low based on the particulars of updated post-Q2 guidance.
The valuation certainly isn't high enough to consider a short - and, again, this is not the kind of company or management team I'd be thrilled about betting against. Still, it's high enough to see some potential risk in the near- and mid-term. It's worth noting that LW sold off rather sharply (-6.7% the first day, followed by more weakness) despite the strong Q2 along with raised guidance. Clearly, investors were looking for more, given that it seems like Lamb Weston has guided conservatively in its time as an independent company.
Those expectations could be problematic in Q3 and Q4. Based on guidance, Lamb Weston is going to shift from posting double-digit revenue growth in the first half to low- to maybe mid-single-digit growth in Q3 and Q4. Adjusted EBITDA growth is expected to be up flat to up slightly, and margins are likely to compress. Without tax reform help, EPS growth may well be limited.
Simply put, LW is going to look like a very different company in the next four quarters than it has in the last nine. And there's still the mid- to long-term risk of the environment moving from 'close to perfect' to 'still good' to 'problematic'. We haven't seen, for instance, what impact a below-average potato crop in the U.S. And we certainly haven't seen the effects of a recession on away-from-home demand and thus French fry sales.
Again, this is not to say that LW's current earnings are unsustainable, or that the stock is headed for collapse. The company still has room for growth, and is in the market for M&A in Europe, with hopes that the weak crop will lead to a better deal. (My personal sense from post-Q2 commentary was that something is in the works over there, but that's purely speculation.) The concern isn't that this is a bad company propped up by industry conditions; rather, that the outlook and growth potential isn't nearly as good as the last few years have led investors to believe.
To some extent, that concern is priced in. But LW still trades at a significant premium to other suppliers (3+ turns on the EBITDA front, though peer comparisons to lower-growth and more grocery-exposed plays obviously are imperfect) and at earnings and cash flow multiples that suggest consistent multi-year growth. That's what Lamb Weston has provided so far. But it may not stay that way forever.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.