AJ Secrist from Firstlight Management on Lamb Weston $LW (podcast #141)
AJ Secrist from Firstlight Management discussed his thesis for Lamb Weston (LW). LW is a very strong business, and AJ thinks the market is missing just how much margin upside there is as COVID era deals with large customers reprice and the company laps 2021’s disastrous potato crop.
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Transcript begins below
Andrew Walker: Alright. Hello, and welcome to Yet Another Value Podcast. I'm your host, Andrew Walker. If you like this podcast, it would mean a lot if you could follow, rate, subscribe, and review it wherever you're watching or listening to it. With me today, I'm happy to have AJ Seacrest. AJ is the managing partner at First Light Management. AJ, how's it going?
AJ Seacrest: Good. Good, Andrew. Thanks for having me.
Andrew: Hey, thanks for coming on. Let me start this podcast the way I do every podcast. First, a disclaimer to remind everyone that nothing on this podcast is investing advice. Please consult a financial advisor. Do your own work. This isn't financial advice. The second is a pitch for you, my guest, we've been trading DMs with each other for probably almost two years at this point, and then a couple of months ago, we started hopping on the phone and stuff. You said, "Hey, I'm in the process of building my own thing," you know, the type of person I like to talk to, concentrated on fundamental deep work, and as soon as you know, it's like, "You've got to come on the podcast, this would make for a great pitch." So I think that's going to shine through today. I'll just turn it over. The company we're going to talk about is Lamb Weston. The ticker is LW, and I'll just toss it over to you. What is the company and why are they so interesting?
AJ: Yeah. Well, it's probably the best company in the best industry you never knew existed up until this point, operating in the very sexy industry of frozen french fry processing.
Andrew: I'm laughing because I think people knew this existed because this spun out in 2016 and it's been a fantastic stock since the spin-out. They either knew it existed and invested, or they knew it existed and didn't invest, and they're kicking themselves. But neither here, nor there, I guess.
AJ: Yeah. I mean, that's actually when I got to know the company. It was in Q4 of 2016 when it spun out of [inaudible]. As a guy who's basically lived on both coasts my whole life, I heard frozen and french fries and processing, and I just about threw up and thought, "Oh my gosh, this must have the worst demand trends on the planet." But I did some work anyway and quickly, I realized that this is actually a really good business and a really good industry. I owned a stock at 30-post spin-off, I ran up, I think to like 75 bucks within two years and I sold it, and I felt like a champ, and then it ran up to almost a hundred bucks at one point, and I felt like an idiot. But I continue to look for a chance to get back involved. What's really interesting about the company is despite all those descriptors I used earlier, frozen, french, fries, processing, and processed, despite what I thought, demand is actually really quite good. In the US and Europe, which are the most mature markets, demand grows by 100 to 300 PIPs per year. In Emerging Markets, it's more like mid-singles, high singles.
So globally, demand grows, 300 to 500 PIPs per year, quite consistently. It's recession-resistant, volumes actually grew in the financial crisis, which I think says, a lot. So demand is actually really quite good. But what's more interesting is really the supply side of the industry. So you've got three players in North America that control about 80 to 85 percent of capacity. So it's really kind of a three-player oligopoly in North America, and Lamb is the largest amongst those at about 40 to 45 percent capacity.
That's really interesting for a lot of reasons. First, amongst those players, Lamb is sort of uniquely competitively advantaged, and that is by virtue of their concentrated manufacturing footprint in the Columbia Basin, Eastern, Washington, and Oregon, which is the most prolific place to grow potatoes on Planet Earth in terms of crop consistency, in terms of yield, in terms of potato quality, in terms of water availability, and so on. So, by virtue of that fact... and they're also close to the ports in Seattle, so they have an advantage in the export markets. They have a margin advantage versus the two private competitors, [inaudible] and McCain[?], and I've heard it's as large as 400 to 500 basis points. So it's a pretty interesting industry structure, and these three players are pretty quite rational in terms of how they bring out capacity. The typical cadence is a manufacturer will put out a press release saying they're bringing on new capacity. They'll tell you where it's coming, how much capacity is coming on, what they're spending on it, and when they expect to have that plant up and going. They'll put out a press release, and it's about a year before they actually put shovels on the ground, then it takes about another year before the plant is actually built, and then it's about another 6 to 12 months before that plant is fully sold out.
So from where we're sitting today, we can have a very clear picture, three years into the future, of what Global Supply looks like. So you can have really high conviction in Global capacity utilization and what's going to happen, pricing going forward. So you put those two pieces together, where demand is pretty consistent, and supply is pretty benign in general with rational players. and Lamb is uniquely competitively advantaged against those competitors. That's a pretty good setup. Do you know why? That's all ultimately important. This business has a lot of pricing power. By virtue of a number of things, nobody's going to come in and undercut you on pricing because nobody has the capacity, and french fries are an extremely critical component of a restaurant's menu. It's typically the highest-margined food product on the menu, it's like 85 to 95 percent gross margins, so operators love selling french fries.
Also, in an inflationary environment, pushing french fries is a way you can defend your margins too. So they're sort of becoming increasingly important to a menu. Also, think about how critical it is to a global QSR. Imagine McDonald's without french fries, it would be not McDonald's. This is a very, very small piece of the cost structure for an operator. For instance, in New York, if I go get a Big Mac at McDonald's, it's probably going run me 10 bucks, 11 bucks, something like that. The wholesale cost of those french fries is probably 13 cents, so it's 1%, 2%. We can get into the math, but suffice it to say, there's a load of latent pricing power here. So I've said it a lot, ultimately, it's a good business, good industry, shockingly good industry, and loads of pricing power. That's the general idea.
Andrew: No, that's fantastic. Look, I think, why don't we just dive right into valuation? Because the two critical questions that I think stem from everything you just said, are going to be the pricing power discussion, and especially the pricing power with their Global customers. We'll get into that, and then just how good of a business it is because that will play into the valuational discussion. So why don't we just go right into talking about valuation, then we can dive into those other... So valuation, as you and I are talking to each other, LW stock is trading for about $86 per share. That's about, I've got a 12 and a half billion market cap after you adjust for a couple of shares they issue, and then the most recent deal they did, which we'll probably talk about. Why don't we just talk about the twelve-and-a-half billion market cap, what's the valuation look like there?
AJ: Yeah. I mean, this year's a little bit wonky. Part of the thesis is, this was a 27% of gross margin business, Pre-Covid. Margins got wrecked through Covid, and not only Covid but more importantly, sort of the inflationary aftermath of Covid, and that was all compounded by what was the worst crop year in the Columbia Basin history this past year. So what was a 27 percent gross margin business? This past year, at one point, they were guiding as low as 17% gross margins. So margins are still depressed because they're still working through that crop year and because they basically fell behind on pushing price and pushing through freak surcharges and so on. I don't really look at valuation this year because margins are still depressed. How I think about it is, how long's it going to take us to get back to normalize margins or at least the prior all-time high, and then I put a Pre-Covid multiple on it. So this was, Pre-Covid, post-spin-off, very consistently 20 to 25 times PE. That's sort of in the ballpark of staples, and this is a staple of growth. So basically, I think they're going to get back to Pre-Covid margins this year and continue marching higher from there, and then I apply 22 and a half times PE because that's where I traded, basically, forever, prior to Covid.
Andrew: When you do that math, kind of what target share prices come out for you?
AJ: Yeah. So to give you context, as I said, this was 27% gross margins in 2019. I think they can get to low-30s gross margins by fiscal 25. This is a May fiscal year and so we're talking May 25. That would get me to almost $7 UPS, adjusted for some share-based [inaudible] stuff that will roll off. So, $7 on 22 times gets you into the 150-dollar ballpark.
Andrew: Exactly, for maybe six, you're talking about almost a double. You're talking really good business, quite economically resilient. I mean, even during Covid, these guys are... while margins are getting hit because of poor crops because a lot of their sit-down customers were there doing french fries, and aren't having traffic and everything, they're still positive, they're the leader in their industry. So you're talking about all that. I guess I wanted to dive into more pieces of that, but let's just take a step back. You've just painted business. You just painted a picture, good business, margins are going to expand, and these things normalize. But I could also paint the picture of, "Hey, this is trading at $86 per share." The guidance for 2023, the midpoint is $2.65 in EPS. That's about 32 times this year's PE. Yes, there's going to be margin expansion, but if I went back to fiscal 2019, which ends May 2019, they've got an office clear, they did $3.20 in EPS, right? So even on that, you're still talking about a pretty juicy multiple, and I guess my first pushback would be, "Hey, I don't disagree. This is good business, but it seems like the market's got this priced as a pretty good business. It does feel like you're getting a pretty full multiple. What's the real edge here that's going to give you... I don't disagree, this is a nice opportunity, but where's the real juice that gives you the Alpha here?"
AJ: Yeah. Well, I think if you look at the Sell-Side numbers, they never have margins getting above the prior high [inaudible], right? So they did 27% gross margins in 2019. The Sell-Side never has them breaking 27%, even in the out years. That doesn't make sense, right? They did $3.22 in fiscal 19. But between fiscal 19 and 24, your talk line has exploded because they brought on a bunch of new capacity and pricing is going bananas. So you're going to get higher margins on a much larger base. There are all kinds of data points to suggest margins are going to break the prior all-time high park of 27%. I can go through a laundry list of them, for instance, we haven't really talked about the segmentation of the business, but half the business is QSR, Global QSR that operates on multi-year contracts, those are slowly repriced. But about 35% of this business is Food Service which is selling it to the Foodservice Distributors and smaller restaurant operators and that's more of a spot business. So and in Q1 of this past year, the Food Service gross margins were higher than they were in 2019. So that's indicative of where the rest of this business goes as things reprice. So, that's number one.
Number two, just mathematically, if you just run through the pricing that they've taken and the most recent quarter in Food Service, say, they've without 26%, I think in the last quarter, that's going to run out 12 months, they're going to lock that. That doesn't go from 26 to 3 next quarter. So that's going to stick in there for another 12 months unless you think COGS per pound are going to go up another 20%, 25%. Mathematically, you're going to get margin expansion in Food Service. Then on the global side, they don't give you these numbers. This is what you've got to find by doing checks but pricing is up something like 25 to 30$, from what I understand on contract renewals. Those are typically three-year contracts. So 1.30, where business is repricing higher at somewhere around 30%. So you're going to get low double-digit pricing in half of your business. Again, unless you think COGS per pound, which was already up a ton last year, is up another ton this year, mathematically, you're going to get a ton of expansion over the next 12 months in that business as well. So that's number two.
Number three, unsurprisingly, I've talked to loads of folks in the industry, both the big private competitors are pretty optimistic about their margin outlook, and this year is their best year ever. So there's this big discrepancy between what the private guys are saying and what the street expects for Lamb. I could go on and on and on. Another good data point is, management is guiding to the second and a half of this year looking like 2019. If you go historically and say, what does the second half of one fiscal year suggest for the next 12 months mark, the subsequent fiscal year gross margins? And in every case, in the subsequent fiscal year, gross margins are higher than the second half that they printed previously. So, if this year, in the second half they're back at normalized margins, and the following year, fiscal 24, if it falls, the historical pattern should be higher. There are lots of reasons to think that the pattern should be even stronger this year. Because again, they're finally getting pricing on global and on the global segment and we're lapping the worst crop year in the Columbia Basin history. It's also really impressive that this year in Q1, the gross margin is only off about 100 PIPs from Q1 of 2019. Again, this is with the worst crop year in the Columbia Basin which annihilated margins. Still, I could go on.
Andrew: No. Good.
AJ: So I mean, just an enormous amount of evidence to suggest margins will be at an all-time high this year, I think, and they're going to continue marching higher from there. The Sell-Side thinks all-time high, and we're going to flatline from there, which doesn't make much sense to me.
Andrew: So let me just dive into a couple of different things. You mentioned a few times, COGs were up about 20% last year. You mentioned how bad the crop was for last year. So I want to ask two kinds of basic questions, but I think they're important both for the listeners and for [inaudible] thesis.
Number one, why was COGs up 20% last year? Then somewhat related, why was the crop so bad last year? For those of you who don't know, the potato crop, if I remember correctly, runs July through October, so their last earnings call was kind of mid-October. I know you've done tons of checks so you've obviously got more data than their last earnings call. But we obviously have some data on how the most recent potato crop is. So we can say, "Hey is this an awful crop? What's this year's crop?" And all that sort of stuff. So I think I threw three questions over at you. I'll just turn it over to you.
AJ: Yeah. Okay. If I lose track, just get me back on track. So why were COGs so bad last year? So on my numbers, COGs per pound of capacity was up about 14 and a half percent last year, and it's a little bit funny because the company is a little bit black boxy. I'm sure as you went through and did your work, you're probably surprised by how little they get away with this close, right?
Andrew: Yep.
AJ: They don't give you ASPs. They don't give you [inaudible]. They don't break out COGS for you. The stuff's kind of hard to really figure out, they don't just hand it to you. So, why was COGs up so much? Well, it's hard to tease out because they don't break down straight. But let's just talk qualitatively about what went wrong Pre-Covid, and the aftermath. Basically, every item in your cost structure went the wrong way, in a big way. So let's talk about manufacturing. The typical channel mix is 50% Global QSRs, 35% Foodservice, and about 15% retail. Through Covid, obviously, your tail mix went poorly wonky. Because your channel mix was totally wonky, you're running different product lines at plants that were not set up to run those product lines, and as a result, your logistics mix was totally messed up as well. What was typically a contracted rail business, they were doing tons on spot try, which is just much more expensive. On top of that, you had absenteeism, and your labor costs blew out as well. So COGs were a disaster from those, and then you get into just the like-for-like increases from canola oils, edible oils, batters, and greens. Spot trucking was up a ton, as we all know. Wages were up a ton, as we all know. So you had all these like-the-like product cost increases as well.
Then the cherry on top was just this Columbia Basin crop disaster this past year, and as I understand it, that was a function of all the heat in the summer of 2021, I guess it was now, compounded by all the smokes. We had all these huge wildfires in Washington that year. So what you need for potatoes to reach maturity are cool evenings. I've learned a lot about potatoes. You need evenings around 60 degrees Fahrenheit. I have a quick link on my browser to see the weather in Richland, Washington. You need evenings to be around 60 degrees and they weren't getting there because the smoke was trapping all the heat. So there was this, what is a historically uniquely competitive advantage for Lamb turned into a unique competitive disadvantage as the Columbia Basin was just socked in with heat and smoke in the summer of 2021. So, what happened is, typically, they contract 98% of expected potato needs, and their potato volumes and yields were down, I think double digits, right? So historically, you need to go out and buy 2% of your potatoes in the spot market. They had to buy something like 12% of what they needed. The Spot Market is also about 20 to 40 percent more expensive than the pricing they contract at. Then on top of that, the quality of the potatoes was just garbage as well, and so quality means, you need more potatoes to create one pound of french fries, to process one pound of french fries. So the potatoes themselves were smaller. There are more defects. So they ended up having to buy, something like probably 15-ish percent of their potato volumes in the spot market. What really hurts is, the only place that had potatoes was Canada and the midwest, and the Northeast. So you're buying these potatoes which are more expensive than the spot market and you're paying to have them shipped across the country.
Andrew: Exactly. Yep.
AJ: Your plants in the Columbia Basin. What I've really learned here is, what really kills you is logistics costs in this business. When logistics get messed up, that's where [inaudible] really get hit in this business. Because not only is that really expensive, but that's something that's really hard to pass through immediately to your customers. I think that was the biggest driver of the margin decline from 27 to 20. They actually printed 20 last year, but they were guiding as little as 17%. That was the story with COGs and what happened last year. Now, they're going back on offense. They're pushing the price. They've implemented a bunch of freak surcharges. They've also got off-cycle price increases as I understand it from folks, from the customer base the customers, frankly, due to the fact that nobody has capacity. So if people aren't willing to take price increases this year, there's a chance that they don't get supply when their contracts come up for renewal. That's the story with COGs.
Andrew: That's great. So I think if we're just summing that up, what it is is, "Hey, they've got all the issues with trucker shortages, increased supply costs, and all that. But they almost have it on steroids because of all of their contractor's supplies in their Basin. They have an awful crop year. They have to import everything. So you get hit on the spot market, and you get hit with extra import costs. Your whole thing just isn't set up for this.
AJ: Yeah. Literally, every item in the cost structure went the wrong way.
Andrew: Then I guess we could simply say for 2023, and obviously, they've got to distance up like... We've got early results. It seems like the crop, as I understand, is slightly below average, but it's close enough to average where, you know, last year was historically bad, and this is like a C-. So they really start normalizing. Tell me if I'm wrong on any of that though.
AJ: Yeah. No, this year's crop is not average, it's below average. Yields are down, probably low single digits versus average, which is unfortunate. But quality is actually quite good, so that offsets a little bit of that. But still, it's still not an average crop this year.
Andrew: Maybe on a normalized basis, margins would be a little below average this year. But when you compare it to the hellscape that was last year, with way below-average margins, you're paying all this for supply. So you've got that marginalization. I guess, the best way to show this and kind of roll this in is, I think, when people look, and people can de-loop as a sponsor. I'll include a link to the de-looper model, or you can just go look at two of the last [inaudible] case. I think the best way to show this is you go and look particularly at the global segment margin. As you said, Global is where they sell to the top 100 QSRs. McDonald's is their major customer, 10% of overall sales which would mean they're about 20-25% of global sales if I'm doing that math in my head right. In fiscal 2019, Global margins are 23%, and by fiscal 2022, Global Margins are 12% versus food, which is everyone who's outside of the top 100. 35% margins, basically, in fiscal 2019 versus 34% margins in 2022. So I want to say, you can confirm or deny those numbers, but let's talk about it. Why is global the one that's getting this huge margin squeeze, when they're managing to pass, basically, off this through on food service? I think you've alluded to it earlier, but I think that's really one of the key points to the thesis of this margin reversion going forward.
AJ: Yeah. It's just a function of timing, really. I mean the global customers are on three-year contracts, so you can only reprice a third of those per year approximately, right? That's part of the thesis, right? Margins cracked, and my view is, that's temporary because they can finally start going on offense and pushing prices on those big customers.
Andrew: Yep, and as you said, contract renegotiations were underway. On the most recent earnings call, they said, they feel good about it. Obviously, you've done channel checks, and you think that these renegotiations are going to go really well, they're the largest buyer here, and all that sort of stuff. Let me mention a couple of different things. You mentioned the supply, and one of the things is, you are ultimately supplying a commodity, right? You're supplying frozen french fries, and you're supplying it to McDonald's, it's 10% of your sales. They can go to someone else. I want to talk about, these guys have big shares, why is scale such an advantage here? And then I want to dive a little bit more into the rational supply, come online, that you talked about earlier. Why is scale such a big advantage here?
AJ: Well, I mean the way you fill a plant is you typically want some really high-volume SKUs to take a big chunk of your capacity, right? That's going to be your anchor volume. So McDonald's fries aren't the highest margin fries for you?
Andrew: Yep.
AJ: They might even be the lowest margin, but they're important for your throughput and you're processing efficiency. McDonald's triple sources their fries, right? So they get fries from everybody because they need to, they need to secure their supply and all the big guys do that as well. So if you are a player in this industry, you sort of have to have several billions of pounds of capacity to even register at McDonald's or Burger King, or Chick-fil-A. If you don't have those billions of pounds of foundational capacity, it's gonna be really hard to compete for those lower volume SKUs with higher margins because you won't have the same efficiency.
Andrew: It's the way to think about it, almost in a way, I mean, Global, obviously, you're thinking they can get their margins up from these 12% level. But Global, it's almost the cost of playing, right? You're not going to all in, you're not really going to make an economic profit on your Global, on your sells to McDonald's, you're selling to Chick-fil-A, that's just kind of covering the baseline fixed cost. Then where you really make your profit is on the food server side, everything outside the top 100, where you're selling to small customers. Is that kind of the way to think about it?
AJ: I mean, it's certainly a lower margin. I mean, I'm sure it's economic, you make money on your fries, you're selling to McDonald's for sure. Actually, roughly, I think for Food Service, the price point is probably 2 to two and a half x to what McDonald's pays. I sort of have a view that the big guys can actually pay a lot more or should pay a lot more because french fries are so much more important than the value prop at a McDonald's or a Burger King than it is at Big Bear Diner or something like that. I think going forward, there's a lot more pricing power that could be flexed at the global customers.
Andrew: I do hear you. McDonald's is making... everybody remembers when they were taking business 101, and somebody would say, "Hey, McDonald's. The burger is not where they make their money. They're making their money on the fry sales and the coke sales and all those extras." So I do hear you on that, but at the same time, McDonald's has been doing that for 50 years. What's changed versus five years ago or something, where McDonald's is going to kind of not give, but LW is going to be able to demand a little bit more margin from McDonald's than they did five or seven years ago or something?
AJ: Yeah. I mean I think it's just capacity realization. Literally, no one has the capacity and because we can map out Global Supply looking out for years, we have a very good view that there's not going to be excess capacity going forward. So the industry has consolidated, that helps. But also, capacity is just really really tight and it's going to get even tighter as Global Demand grows by 3 to 5 percent. I've got Global Supply growing out. Past this year, there is some supply coming this year, but after this year, it's more like 2%. So the industry is going to continue to get tighter and McDonald's and the big guys, dual and triple source their fries. So for instance, let's say one of the processors says, "Hey, Global QSR. We're going to raise our prices on you by 5%. The QSR could say, "I'm not okay with that. I'm pulling my volume from you." Well, good luck finding capacity elsewhere, and if you do, you're just going to displace higher-margin food service. So that processor would lose the global business, but they will be able to pick and choose whatever higher-margin Foodservice stuff they want to take.
To give you just one anecdote about how tight the industry is. One of the private guys, private processors made quite a splash recently when they unilaterally avoided all their short-term food service contracts. Everybody that is on a one-year or two-year contract, it's null and void, we're moving everyone to the spot. Good luck finding capacity elsewhere if you don't like it. So the processors have all of the leverage right now and barring some incredible disaster and on-demand on the man side, they're going to continue to have all power for at least the next three or four years.
Andrew: So, in many ways, like a lot of things we've seen coming out of Covid, this is a supply constraint story, right? Where for one reason or another, supply didn't get invested in and, demand went down, which is probably one of the reasons supply wasn't getting invested in. And now that demand is starting to fully return, I don't believe demand has fully returned for these guys. But now that it's starting to fully return you run and you say, "Oh, our supply is still at 2019 levels and demand is now at 2019 times 1.025 to the fifth [inaudible] get to 2024 levels." And it takes two years, or three years for supply to come online so you're facing supply shortages. And that's why a lot of the demand, especially in the near to medium term, shifts over here and why you can see expanding margins.
AJ: Yeah. I don't think it's a function of under-investing in supply, though. I don't think it was, Covid hit and the industry just slammed on the brakes on capacity additions. I think it was, they continue to bring on capacity. Lamb has continued bringing on the capacity. It's just the industry is pretty rational and pretty patient in how they bring on capacity. They consistently add a little bit less than the demand growth.
Andrew: What if, if I took the other side, right? So we've already got this year's potato crop. If we had an unbelievable potato crop next year, just potatoes out of the wazoo, would you run into an issue, where, "Hey, you're oversupplied," right? Or is the limit really at the kind of frozen french fries processing and manufacturing plants? So that would actually be great where your input costs, your supply is just getting crushed because there are so many potatoes, but you're still capacity constrained on the actual making of the french fry.
AJ: Yeah. I know, I think the plant is the bottleneck. I mean these guys, at least Lamb is contracted, as I said earlier, like 98% of their volumes, what they are going to need and they contract the price. So they've already contracted for 98% of the volumes and price, and so if you have a bumper crop, that doesn't change, right? Your volume and your price are what they are. That 2% that you need to find a spot market would be down, which is nice, but who really cares? There's also some nuance as to regions where the potato crop is. You've got a bumper potato crop in terms of how margins and how pricing is affected vis-à-vis the competition. But bumper crops, you don't really get the benefit of those, at least in North America, but you would in their European business. But in North America, it's not really windfall.
Andrew: Perfect. Let's talk about Capital allocation here, right? So obviously, you think the stock is so cheap. You think it's about kind of almost half of where it can trade in a year or two on the normalized numbers. You talk about the multiple. We've talked about all that type of stuff. I want to talk about Capital allocation. I mean the two places where they are putting their money are, they do have a small dividend, but it's share repurchases and MNA. I think they're definitely leaning on the MNA. We saw that recently with the... they bought out the European JV, but they're under-leveraged. I think there are a lot of options going forward. Let's just talk about Capital allocation. What makes sense to you going forward?
AJ: Yeah, well, let's level set. The capital allocation vault policy is 30% of earnings, it's a 30% payout ratio, right? So 30% of your earnings are going to dividends. Then after that, I think they have a strong preference for capacity ads. So I think, three or four months ago, they announced a new plant in Argentina. These are big expensive plants. They're typically 300 to 500 million pounds of capacity and about $1.20 per pound, in terms of CapEx. So you're looking at like 300 to 400 million dollars per plant, and they've spent a lot of money on building out capacity, historically. So they're still doing that. I think the order of preference for the company is number one, maintain the dividend. Number two, build capacity. Number three, look for, I think, three, buybacks, and MNA are probably three and four. They just bought out the European JV for 700 million euros. I think that was a special case. I think they sure love to buy more players in Europe, but that's historically proven to be pretty, pretty slow going. I don't think they're going to go out of their lane and do something crazy, anything outside of potato processing. I certainly hope not. But that's sort of the order of preference of the company.
Andrew: Perfect. I guess, they've said their leverage target is three and a half to four x. I think, after buying the European JV, they'll be around 3x, probably by the time it closes, just given the cash flow dynamics here, they'll be a decent little bit below 3x. It does sound like they want to do more MNA. It does sound like Europe would be a nice area of focus for them. But given the stability, they're at three times [inaudible], and that's without any of the margin benefits that you and I have talked about. Why not get more aggressive on Capital returns in some form here?
AJ: Yeah. I mean I agree. Like any good hedge fund bro, I want them to lever up and buy back stock, right? If your view is that the stock is going to be 2X and 2 years, then you should be buying back as much as you possibly can. I've expressed that to them and they do what they do with my opinions, which is probably throwing them in the trash. I mean, I would be fully on board with them levering up, and buying back more stock. I think that's a phenomenal use of capital. If you think the stocks going to do X. Small aside, they granted a new management equity plan back in July, and this was largely leverage performance units with stock price vesting thresholds. The top two thresholds to keep in mind on the stock price are 140 bucks and 212 bucks. I mean, that's where it caps out. That would be wild. But say, 140 bucks, which is where the CEO gets 300% of the target LPOs. So it maxes out at 300% of the target LPOs, and that's at 140 bucks. That's by May of 2025, right? So, two and a half years, 140 bucks, basically overlap with where I think the stock is going to be. That 140-dollar target is not pulled out of thin air, that's a function of the comp committee pulling, presumably a budget and looking at historical multiples and saying, "Okay, 140 is a reasonable target for everybody involved."
Andrew: If I could just add something, I'm looking at that 8K, as you say it. And that 8K was filed on July 26th. The awards were granted on July 20th. I could be slightly one or two days off on the timing here. But my overall conjecture is they awarded that and then they announced really nice earnings, and the stock went from 76 to 80. Obviously, 76 to 80 is not 120 to 140. But that's the type of dark arts games that companies play and when you see that, and you see they're setting targets for, "Hey, you get a full payout at 140. You get paid out at 200." They're probably doing that with, "Yeah, we're not guaranteed to be 200 plus in two and a half years," but they probably do have a thought process for, "Here's our internal plan, here's the margin expansion. Here's how we get to... 210 would probably take $10 per share in earnings in two and a half years." They've probably got a line of sight to a plan, especially when you see someone doing that right before the [inaudible] There's some gamesmanship playing and they've got an idea of how they're going to realize that.
AJ: Yeah, yes. Yeah. I mean they're not just pulling numbers out of a job. That's for sure, right? There's some plausible path to get to those numbers. It was nice to see that that overlaps with my view on valuation more or less. Just on the point of the grant timing, it was kind of funny because the 8K came out, I think on July 25th. We had earnings on July 27th, and then the grant price on July 29th. So they actually had an incentive on earnings to be considerate, right? To not talk up the company to not take up guidance. This is a company that I think was conservative Pre-Covid. Post-spin-off, Pre-Covid, this was just a routine beat and raiser, it was awesome. And through covid, I think they've gotten quite shell-shocked. I think they become even more conservative after the debacle that they've had. So I think they certainly want to get back on the beat and raise trajectory.
Andrew: What do you think and games for them? Because look, as we talked about, it's a twelve and a half billion company, but they're just in frozen french fries. Is this long-term? They're just, "Hey, we're a public company. Right now, we probably have a line of sight low to mid-single-digit growth plus margin expansion, plus some pricing power." But if you and I are sitting here doing this podcast in five years, are we talking about them? And it's like, "Hey, they're just a french fry company growing at some kind of rate." Would anyone strategically want them? It does kind of seem like a private equity play in some shape or form. But it's tough because there's Mom and Pops to roll up, I guess, but there's no real angle of other things you're going to get with this, you know?
AJ: Yeah. I mean, it would be challenging for private equity to do this because it's a giant company. I mean it's a twelve, thirteen billion dollar cap plus some debts like a 14 to 15 billion dollar enterprise value if the stock performs right, I certainly hope it does. We're talking about 25 to 30 billion dollar Enterprise Value, and then add a control premium on top of that. We're talking like enormous, enormous equity check in a couple of years. I think the end game is, I'd be quite happy if they just continue to grind out mid-teens, EPS growth forever and consumer staple, I'd be okay with that. I think there are a couple of huge levers that they have yet to pull, one is really pricing power. On my numbers, 1% to price all sequels about 6% EPS. So why couldn't you pull an extra 3% price per year and send your EPS growth into the stratosphere? What's a 20% EPS grower and consumer staple [inaudible] worth, it's a lot. So they could potentially pull that lever lightly, but consistently. If they can't do that, for whatever reason, this is the only public company in the space. So competitors and suppliers and customers, i.e. McDonald's can see exactly what they're saying and how they're performing, and so on. If they can't do that in public markets, maybe this business is worth more in private hands and should be sold. Now, that's a challenge for private equity guys to do that because it would be a huge check. There are a variety of strategies that might make sense. Like I don't know, Cargill or... POST actually bid for them pre-spin-off...
Andrew: Now that you said that, I think that's sitting in the back of my mind. This does kind of seem like a Warren Buffett business in some ways, right? Consistent...
AJ: That was my punchline.
Andrew: We know the man loves potatoes...
AJ: Yeah. I mean it's a giant check, so he likes that. It's an awesome business, he likes that. It's folksy, right? I mean, can you imagine him getting up on stage at his AGM because like, [inaudible] french fries? It's like perfect.
Andrew: He can fund it with that insurance money. So, he's funding it with a negative cause float. It sucks up, what, a month's worth of profits for him at this point. But yeah, it really does fit. Let me just go and do two more pushbacks. A lot of the stuff we've said, we said, "Hey, a hundred forty dollar, a hundred fifty dollar price target is kind of 7x a year or two out EPS. Once they get the margin expansion, times, 20, to 25 times PE, which is their kind of historical margins." I know the company certainly thinks about those historical margins. If you read through both their margins and circle multiple if you read through the recent JBD, they talked about that a lot. But one pushback would be, "Hey, you guys are throwing out a 23 times historical multiple. That was the multiple in 2018, and 2019. Interest rates were lower then. Inflation was lower then. The stock market had a better multiple then. So are you properly adjusting here?" Because if I came out and said, "Hey guys, I think the right multiple is 17 times." I mean, they're still there, so pretty good upside there but, you know, it starts really cutting into that margin of safety, and then you say, "Oh, if DPS is going to be 6 instead of 7 and you're talking, let's say, 16 times instead of 22 times, all of the sudden, all the upside has been captured there." So I just want to throw that back. It does come back to a valuation point, but I think that's the fairest pushback. And I think a lot of viewers or listeners will have that in their mind when they're hearing this.
AJ: Yeah. I mean, Look, I wish I have a much better read on earnings than I do multiples. Right? Multiples will go or multiples will go and my hope is that I'm sufficiently right on my earnings expectations and that I don't get blown up by multiples going in reverse. But that said, you can look at the universe of branded CPGIs that grow at fractions of the growth rate through trade, 20 to 30 times PE.
Andrew: I just pulled up Coke because we were talking about that. I just pulled up Coke and you look at them, you say, "Oh they're treating, I don't know, probably approaching 25 times EPS, and they're not really growing EPS," and I know there's a little bit of noise in there. But they're not really going people are just willing to pay that for the brand and eventual pricing power and everything.
AJ: Yeah. I mean, there is no brand at Lamb, right? But it's a consumer staple that grows. People like that stuff. So you can look at the universe of branded CPG food or just branded CPG and, you know, pretty consistently 20 to 25 30 times range. That gives me some comfort.
Andrew: Let me...
AJ: And actually, another good comp is probably just the Foodservice Distributors. Lamb is, I think, unequivocally, a better business then, and those guys are mid-high teens to 20s. Cisco today is trading at 20 times.
Andrew: Yeah, no, no disagreement there. Just the last one, this is always tough because one of Finchwood's[?] favorite things is never bad against the American eater, right? So it's always hard to say this. But I do look at this and I certainly... I always had a burger and fries for lunch today in preparation for this. But you know, it does strike me like, for years, everyone said, at some point, the American diet has to change. There are trends against sugar, trends against potatoes, and trends against carbs. Honestly, those trends, I do think they're a little more, I want to use the right... I do think they're a little more kind of on the coast versus the Mom and Pops, everybody always wants to be healthier, but I don't think there's any way... I do remember back in like the late 90s or early 2000s, I remember my dad was doing the sugar buster's diet. I think I remember a lot of companies coming on and being like, "Oh, we sell sugar and we're having issues," like the sales are down because there's this low-carb trend. Could there be some low-carb trend and you just see... You know, everything's at the margins, right? They're selling a commodity. A big part of this is, the supplies are a little bit constrained, and demands go under and through it. If demand comes back a little down, you've got excess supply. That's a disaster for everything, but especially in things like commodities. What happens if you get into a low carb... I don't even know what I'm saying. But there's like a tickle of risk in the back of my mind there.
AJ: I mean, yeah. I mean, consumer preferences matter, right? It's a risk. I mean the industry has lived through Atkins, it's lived through South Beach. It's lived through all these other stuff and it's been pretty resilient.
Andrew: Do you know what demand looked like at the height of Atkins or was that just too long ago?
AJ: It's just too long ago. We only have Standalone financials for Lamb, going back to like 2014.
Andrew: [inaudible] obviously do a lot of international. I think international demand is better for a lot of reasons.
AJ: Yeah. I mean that's what I was going to say. I mean globally, french fry consumption is approximately 50% US and Europe, and 50%, in the rest of the world. And the rest of the world business is growing a lot faster than in the US and Europe. In the US and Europe, it's like 100-300 PIPs per year. So if that were to go negative 5 or something, that would be a big problem. But I guess it's a question of how severe consumer preferences change and how quickly.
Andrew: What is emerging market growing? You said that the US and Europe are kind of growing at the rate of GDP. What's emerging and growing?
AJ: I mean, it's like mid-singles to high-singles, depending on which market.
Andrew: How much of their sales are coming from... I did most of my work on Us and Europe, which is where basically all their earnings are confirmed. But how do they have kind of similar good share in emerging markets?
AJ: Well, depends on the market. You know, the plant that they're building in Argentina, they have very little presence in South America. McCain is number one in South America. McCain is number one in Europe, and Lamb is, I think, a 19% share in Europe. Europe serves a lot of Africa, a lot of the Middle East, and so on. I mean, basically, all the processors are based in North America and Europe, and they largely just export to emerging markets.
Andrew: And that is why they were talking about the... Again, they just recently bought out their big European JB. And that's why they're saying, "Hey, we want to do this. We'd love to continue buying Europe because when we buy Europe, we're also buying Africa. Africa, in particular, is just way under-penetrated for french fry trends. So you're kind of getting that built-in growth. All right, I think we've covered everything I had in my prep notes. Anything we didn't hit that you think we should have been talking about or anything we kind of glanced over that you think we should have talked about harder?
AJ: Well, one more point on consumer preferences. One thing we didn't talk about that's very important is Nacho Fries.
Andrew: From Taco Bell?
AJ: Yeah. So in fact, consumers' preferences are going the other direction.
Andrew: Yep.
AJ: Because Taco Bell has this really successful LTO that they offer periodically, nacho fries. So people love fries, man.
Andrew: I love french fries. Everybody loves french fries.
AJ: I mean operators also have a big incentive to push fries too, right? I mean, through the years, we've seen the introduction of like sweet potato fries, which is...
Andrew: I was actually about to ask, do they do sweet potato fries as well? Is that a whole different thing? I don't even know. Okay.
AJ: Yeah, yeah. So I mean there are different variations on the theme that are either actually healthier or perceived to be healthier, but they sort of manage through it, and everybody in the supply chain, including the ultimate, you know, customer, which is the restaurant, have big incentives to continue making fries. They have these side dishes of choice.
Andrew: Here's a question I didn't even think about, I just thought these guys, they do french fries, they do frozen french fries as part of their QSR. You and I, LW hits 170 next year, we're celebrating by going to a steakhouse, right? We order the steak fries... I guess if you go to high-end places that are making their fries, that's not getting sourced by LW in any way, shape, or form, right? They're just ordering potatoes. So this is more QSR, so we're doing Frozen french fries, dumping them in the fryer, and popping them out.
AJ: Yes. Correct. I mean In-N-Out isn't a customer, right? In-N-Out buys their potatoes, chops them, and they fry them in their units.
Andrew: But Chick-fil-A is, right? Because I think Chick-fil-A...
AJ: Yeah. They do the Waffle fries. That's a good product from them.
Andrew: So I guess the other risk, which we didn't talk about, but I'm thinking through is, I think Five Guys freezes their fries, I'm not sure, But I guess the other risk would be, "Hey, you get more of the higher-end, fast-casual type thing... Chipotle and stuff obviously, Chipotle doesn't have a potato product but you get the moe, "Hey, we're going to make all our fries fresh in store." I do think most places realize, "Hey, frozen fries taste about as good as freshly made fries and it's a lot, less logistically complicated. So you might as well freeze." But I guess your other risk is the Shake Shack, the In-N-Out sort of just giving fresh fries, you have that and that takes a lot of shares. But you know what, at this point, it goes back to what you said, these guys have survived Atkins. They survived and I think we've got 70 years of consumer preference of, "Give me the french fries. Give me as many of them as cheaply as possible. And let me cover them in sauce and stuff them in my mouth."
AJ: That sounds delicious to me.
Andrew: It does to me too, to be honest. Anything else we should be covering?
AJ: I think we got it. This is great.
Andrew: Cool. Hey, AJ. This was great. I really appreciate you coming on. I'm going to tag AJ's Twitter here. So anybody who wants to reach out to AJ can go do it. I know there's another idea that we've been talking about a lot. I'm hoping to have you on for a second one, for a pretty, pretty sexy one, that has some interesting similarities to this one, but we'll probably have to wait till the new year for that one. AJ, thanks for coming on and we'll chat soon, man.
AJ: Well, thanks, Andrew.
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