THE HEDGEYE EDGE
Everything has been going perfect for Lamb Weston (LW) since its IPO; solid crops, good demand and high capacity utilization highlight their strengths to date. The company produces, distributes, and markets frozen potato products worldwide. LW utilizes a three-tier pricing approach in this segment: premium–branded (Alexia), mainstream-branded (Grown in Idaho) and private label.
We don’t believe the overly bullish sell-side is taking the warnings signs seriously and we believe the conditions in the marketplace will be worse than what management has anticipated. We think the end is near for the pretty much perfect run for this company since the IPO.
Recapping the Quarter
LW put up a strong quarter, but all the drivers of growth will continue to slow and the issues that are impacting its European JV’s are only just beginning:
- Adjusted diluted EPS was $0.73, up $0.16 YoY (and beat consensus by $0.05). Importantly, $0.10 or 62% of the increase benefited from applying a lower tax rate YoY.
- Despite the strong quarter, adjusted EBITDA (including unconsolidated joint ventures) to be in the range of $860 million to $870 million. Despite beating consensus estimates across the board for revenues and EBITDA in 1Q there is no upside to estimates.
- European joint venture earnings being pressured, and the news flow will continue to be disappointing.
- The imposition of new tariffs remains a risk.
- Sales growth will slow significantly in the back half of FY19 as they lap significant FY18 tailwinds.
- Yes, the restaurant industry had a great summer, but sales trends will slow over the next 6-months.
- Still some potential issues around the potato crop as they hit the storage facilities.
- Operating environment in Europe is going to volatile.
As a commodity CPG company, LW is priced for perfection and the pressures on revenue continue to grow. Please see our deck for the details around our short thesis.
Key Thesis Points
1. Margin Profile Under Threat: Limited sell-side coverage (7 analysts) with 57% buy ratings and 29% hold ratings has a lot of optimism projected in their models. When compared to other branded CPG manufacturers, LW trends towards the lower end of the gross margin range, but to the higher end of the operating margin range.
This is a commodity business at the end of the day and as they continue to face costs across their business due to rising manufacturing/transportation costs, droughts in Europe/UK, capacity investment and increased SG&A expenses, we think the model will come under threat.
2. QSR Slowdown: Volume has drifted lower as the majority of top-line growth is now price. What happens when pricing isn’t available and volume stays the same while you are getting pressured on the cost side of the equation? We believe that the potential for a slowdown in the QSR category is not priced in.
The restaurant industry is lapping meaningful YoY comparisons in the back half of 2018 and 2019, while key customers such as McDonald’s (MCD) (which makes up 11% of Lamb Weston sales) is mismanaging their business – a thought that is certainly not consensus (MCD has 61% buy ratings)! MCD U.S. SSS and System-wide SSS have a correlation of 0.77 and 0.53, respectively to LW’s Global Segment sales. Global sales are slowing for MCD, and we believe they have more trouble ahead driven by both internal and overarching macro issues.
3. Underappreciated Drought: Since our first note on the worsening drought conditions in Europe, it has become a more widely appreciated topic in regards to LW.
The Potato Processors Association recent commented on the potentially negative impact of the weather on this years crop: “It is extremely likely that there will be serious issues in terms of availability of potatoes that are suitable for processing... It is also likely that there will be less crop going into storage, and not all stored crops will be of optimum quality. This will mean that impacts for UK potato processors will last well into the first half of 2019…. The lack of a definitive position on potato and potato seed importation, post-EU exit on 29 March 2019 only adds to the challenges that we face.”
Bottom Line
We don’t see upside to the multiple, and given the cost and fundamental headwinds that are popping up we believe there is downside risk to EBITDA estimates. Last provided guidance by management for adj. EBITDA was $860M to $870M, we don’t believe that fully takes into account the deteriorating trends in Europe as well as accelerating costs in the U.S.
ONE-YEAR TRAILING CHART
