Shares of Lamb Weston (NYSE:LW) garnered some interest over the past week as it acquired the remaining shares in its European joint venture. This is sufficient of a reason to update a long overdue investment thesis which goes back all the way to spring of 2017, when I wondered if the company was seeing peak potato margins.
To see where the business has been coming from and what its prospects are, I am going back to 2017, picking up the thesis here.
Lamb Weston has been spun off from Conagra Brands (CAG) in 2016, and it quickly delivered on handsome returns for investors. Investors appreciated the strong brands, market position and earnings power of the business.
The company focuses on the production of frozen potatoes which includes french fries, curlies, hash browns and sweet potatoes. The company held a 20% market share of the global frozen potato market at the time, generating $3 billion in sales in the process from its North American operations, European operations, as well as operations in the remainder of the world. A focus on innovation and automation has allowed for stronger than reasonably expected margins or what essentially is largely a commodity product.
The company has steadily grown sales by 6-7% per annum in the decade leading up to its spin-off. In the couple of years ahead of the spin-off, the company posted EBITDA margins equal to 16-18% of sales.
At the time of the spin-off the company was saddled with $2.5 billion in net debt and with EBITDA trending at $700 million a year, a leverage ratio of 3.5 times was high but manageable given the growth of the business. Earnings were up 17% to $1.80 per share in the first three quarters of the year, trending around $2.40 per share, resulting in a reasonable valuation multiple with shares trending around the $40 mark in spring of 2017.
EBITDA margins at the time came in around 22% as the question was if these were above-average margins, or not. I worried how far margins could normalize to the downside. If they reverted to 17%, I pegged earnings power around half a dollar lower, and leverage ratios a bit higher, which was a risk as well.
Furthermore, a lack of capacity being available meant that the company needed to invest quite a bit on capacity expansion with net capital spending pegged at $200 million at the time, equal to about 60% of the earnings numbers, creating a huge drain in free cash flow, as this made me quite cautious.
Shares kept on rising in a dramatic fashion as they rose to the $80 mark in 2018, to nearly hit a high of $100 in early 2020. Ever since shares have largely traded in a $50-$80 trading range, now trading at the higher end of the range again.
Compared to the 2016 results, I am moving to the summer of 2021 when the company posted its fiscal year results for the year 2021. Full year sales fell 3% to $3.67 billion, still up some 20% from five years before. Adjusted EBITDA fell 6% to $748 million, for 20% margins, as operating earnings fell 15% to $475 million amidst the impact from the pandemic. This especially hurt fries demand from restaurants which were closed during the pandemic.
Earnings power share fell 14% to $2.16 per share, marking modest progress compared to 2016 as well. Net debt has fallen to $1.95 billion, as leverage ratios fell to 2.8 times, yet expectations remained elevated. Net debt has been coming down as capital spending on new factories was equal to, or actually just below the annual depreciation charge.
Following the first quarter earnings release for 2022, the company warned of inflationary pressures related to transportation and labor, and their availability, weighing on the full year results, with first quarter earnings down two-thirds on the year before.
This summer, the company posted its full year results with sales up 12% to $4.10 billion on the back of inflationary and pricing trends, as well as a modest 3% increase in volumes. Margin pressure amidst these inflationary trends meant that EBITDA fell 3% to $726 million with adjusted earnings down 4% to $2.08 per share.
The outlook for 2023 was convincing however with sales seen between $4.7 billion and $4.8 billion, adjusted EBITDA seen between $840 million and $910 million, and earnings seen between $2.45 and $2.85 per share. This is a comforting guidance with net debt posted at $2.20 billion by the end of the year, as net debt inched up a bit amidst buybacks and higher capital spending.
Momentum Is There
In October, Lamb Weston posted solid first quarter results as it initiated cost-saving measures, while it benefits from pricing with some inflationary trends reversing. First quarter sales for 2023 were up 14% to $1.13 billion as earnings rose sharply, and the company reiterated the full year outlook. The growth even understates the dynamics as a 19% increase in prices was offset in part by a 5% decline in volumes.
With 145 million shares trading at $82, the $11.9 billion equity valuation comes down to a $14.1 billion enterprise valuation if we factor in net debt. That is equal to about 3 times sales seen this year, 16 times EBITDA and around 30 times earnings, a steep valuation multiple by all means.
Later in the month Lamb Weston announced a substantial deal. Taking advantage of the softer Euro, the company announced an EUR 700 million acquisition of the remaining equity stake in its European joint venture Meijer Frozen Foods B.V. Three quarters of the deal will be paid for in cash, resulting in a $2.9 billion net debt load, as the remainder EUR 175 million deal tag will be financed with the issuance of equity, with just over 2 million shares being issued here.
The EUR 700 million deal implies an EUR 1.4 billion valuation which looks very modest given the $955 million sales contribution for the business. The valuation comes in around 1.5 times sales which is half the sales multiple at which Lamb Weston itself is trading. That can easily be explained by the fact that adjusted EBITDA margins of the activities are very modest at just around 5%, comparing to numbers closer to 15% for its own activities.
The truth is that I remain puzzled with the high multiple which is applied to the business, despite a very strong market positioning and solid margins. The move to control is former JV in Europe looks like a decent move, yet the margins of the acquired activities are very low, as it remains to be seen how “normal” these margins are. The reality is that the transaction will not alter the earnings power, or investment case in a substantial way, as the deal tag is equal to about 6% of the pro forma valuation here.
Amidst all of this I remain fully appraised of Lamb Weston, yet I see no reason to pay such a big premium for the shares, certainly not in this interest rate environment.