Lamb Weston Holdings, Inc. (LW) Q1 2023 Earnings Call Transcript

Good morning and thank you for joining us for Lamb Weston's first quarter 2023 earnings call. This morning, we issued our earnings press release, which is available on our website lambweston.com. Please note that during our remarks, we'll make some forward-looking statements about the company's expected performance. These statements are based on how we see things today. Actual results may differ materially due to risks and uncertainties. Please refer to the cautionary statements and risk factors contained in our SEC filings for more details on our forward-looking statements. Some of today's remarks include non-GAAP financial measures. These non-GAAP financial measures should not be considered a replacement for and should be read together with our GAAP results. You can find the GAAP to non-GAAP reconciliations in our earnings release. With me today are Tom Werner, our President and Chief Executive Officer; and Bernadette Madarieta, our Chief Financial Officer. Tom will provide an overview of the current environment. Bernadette will then provide details on our first quarter results and our fiscal 2023 outlook. With that, let me now turn the call over to Tom.

Thank you, Dexter. Good morning, and thank you for joining our call today. We're pleased with our performance in the quarter. We drove strong sales growth, expanded our gross margin and nearly doubled adjusted EBITDA including unconsolidated joint ventures. Our results reflect our continued focus on implementing pricing actions to offset input and transportation cost inflation, driving productivity and cost-saving initiatives, increasing service levels for our customers in each of our sales channels, and supporting our people and talent. We’ve built good operating momentum over the past few quarters by focusing on these near-term objectives. And we're confident in our ability to deliver the upper end of our sales and earnings target ranges for the year. I'm especially proud that the Lamb Weston team has continued to generate solid results in a very difficult macroeconomic environment. We expect this environment to remain challenging at least through fiscal 2023, as inflation, a growing threat of recession, and industry-wide supply chain disruptions continue to pressure demand for fries as well as our cost structure. It's no surprise that inflationary trends for food, energy, and housing have affected restaurant traffic in the U.S. over the past six months. We saw similar restaurant traffic trends during The Great Recession as consumer discretionary income came under pressure. While traffic at quick-service restaurants has held up relatively well, it's come at the expense of casual dining and full-service restaurants as consumers increasingly choose less expensive options when dining away from home. In the past month or so, we've seen casual dining and full-service restaurant traffic tick up from summer lows, but traffic remains below levels achieved just prior to the war in Ukraine. Unlike traffic trends, fry demand continues to be solid when dining out. The fry attachment rate, which is the rate at which consumers order fries when visiting a restaurant or other foodservice outlets, remains above pre-pandemic levels. Fry demand in retail channels has also benefited as restaurant traffic slows. Overall, we expect volatility in restaurant traffic and demand trends will continue through fiscal 2023. But history has shown that this category is resilient during economic downturns. Although we may see some category weakness in the near term, we remain confident in the long-term growth prospects of the category in the U.S. and in our key international markets. In addition, as category growth returns to historical rates, we should be well positioned to capture at least our share of growth with our investments in new processing capacity in Idaho and China, as well as our newly announced expansion in Argentina. With respect to pricing, our overall price/mix growth accelerated for the fourth consecutive quarter. In our Foodservice and Retail segments, we continue to realize the carryover benefit of multiple product pricing actions that we have taken over the past 15 months and expect the benefit of these actions will continue to gradually build through the first half of fiscal 2023. In our Global segment, we made good progress in increasing price/mix through price escalators included in multiyear contracts, while also securing some price adjustments outside of these agreements. In addition, we nearly completed negotiating contract renewals that represent about one-third of our Global segment volume. Overall, we feel good about how the discussions played out and we'll generally begin to see the results of these new pricing structures during the second half of fiscal 2023. Finally, with respect to this year's potato crop, our preliminary view is the potato crop in our growing regions in the aggregate will be around the lower end of the historical average range. Specifically, the overall quality of the crop, including shape, color, level of defects and solid content, is good and consistent with historical averages. Yields, however, are below average. The unusually hot weather during August affected the growth of the potatoes and resulted in a greater than average proportion of potatoes failing to bulk up to the desired size. In response, we've already begun to secure the additional potatoes needed to meet our production forecast and expect to purchase most of this from growers in the Columbia Basin and Idaho. That's in contrast to last year when we purchased potatoes at significant premiums to contracted prices and transported them from as far away as the East Coast. As you may recall, our financial targets for the year were predicated in part on an average potato crop, and we believe this crop is broadly consistent with our expectations. While below-average yields will result in additional open market purchases at higher than contracted prices, we do not expect this to affect our ability to deliver our financial targets. To be clear, we view this crop as significantly better than last year's, which was poor both in terms of yield and quality due to the prolonged extreme summer heat in the Pacific Northwest. We'll provide our final assessment of the crop, including how it performs out of storage when we report our second quarter results in early January. So in summary, we generated strong sales and earnings growth in the first quarter by executing pricing actions in each of our business segments and driving productivity savings. We expect restaurant traffic and fry demand will be volatile in the near-term, as consumers continue to adjust to the inflationary environment. And on a preliminary basis, we believe that potato crops in our growing regions are at the lower end of the historical average range, and that any effect on our operations or financial performance will be manageable. Let me now turn the call over to Bernadette to review the details of our first quarter results and our progress towards our fiscal 2023 financial commitments.

Thanks, Tom, and good morning, everyone. As Tom said, we're pleased with our performance in the quarter, and we are confident in our ability to deliver at the high end of our financial target ranges for the year. In the quarter, our sales grew 14% to more than $1.1 billion. Price/mix was up 19% as we continued to benefit from product and freight pricing actions that we announced last fiscal year and as we began to execute new pricing actions during the first quarter. Our sales volumes were down 5%, primarily reflecting the softer restaurant traffic trends in U.S. casual dining and full-service outlets that Tom described earlier, as well as the timing of shipments to large chain restaurant customers. In Retail, while branded product volumes were up, overall Retail segment volumes were down with the ongoing effect of losing certain low-margin private label business. Sales volumes in Foodservice and Retail also continued to be affected by our inability to fully serve customer demand as a result of constrained production at our facilities. Gross profit increased $122 million to $273 million in the quarter. Gross margin expanded nearly 900 basis points versus the prior year quarter, and 230 basis points sequentially to more than 24%. Pricing actions and productivity savings drove these improvements, more than offsetting the impact of higher costs on a per pound basis and lower sales volumes. Cost per pound increased high-single-digits with inflation, again, accounting for essentially all of the increase. Higher prices for inputs such as edible oils, ingredients for batter and other coatings, labor and transportation were the primary drivers. Potato costs were also up as a result of the poor crop that was harvested last fall. We'll continue to realize the financial impact of this crop through most of the second quarter of fiscal 2023 as we sell the final finished goods produced from the crop. And finally, we continue to incur higher costs and operational inefficiencies associated with labor, spare parts and ingredient shortages, and other industry-wide supply chain challenges. Benefits from our portfolio simplification, and other cost mitigation efforts, however, offset some of these higher costs. Moving on from cost of sales, our SG&A increased $25 million to $116 million, largely due to higher compensation and benefits expense and expenses related to improving our IT infrastructure, including designing a new ERP system. Equity method earnings from unconsolidated joint ventures in Europe and the U.S. increased nearly $170 million. More than $140 million of the increase was related to the change in unrealized gains for mark-to-market adjustments related to changes in natural gas and electricity derivatives, as commodity markets in Europe have experienced significant volatility. Another $15 million of the increase relates to a gain recognized in connection with us acquiring an additional 40% interest in our joint venture in Argentina. Excluding these comparability items, as well as other mark-to-market adjustments not associated with natural gas and electricity derivatives, equity earnings increased $13 million. This largely reflects improved results in our joint venture in Europe. In addition, in September, our European joint venture withdrew from its joint venture in Russia after receiving all regulatory approvals. In the prior year quarter, earnings from the Russia joint venture were not material. So putting it all together, adjusted EBITDA, including unconsolidated joint ventures nearly doubled to $228 million, while adjusted diluted earnings per share more than tripled to $0.75 per share. Strong sales growth and gross margin expansion primarily drove the increases. Moving on to our segments. Sales in our Global segment were up 12% in the quarter, price/mix was up 14% reflecting domestic and international pricing actions associated with customer contract renewals, inflation-driven price escalators, and higher prices charged for freight. Mix was also positive. Overall segment volumes declined 2% as North American volumes fell primarily due to the timing of shipments to large QSR chain customers, including the effect of lapping a notable limited-time product offering in the prior year quarter. Global's product contribution margin, which is gross profit less advertising and promotion expenses, nearly doubled to $84 million. Favorable price/mix more than offset the impact of higher manufacturing and distribution cost per pound. Sales in our Foodservice segment grew 14%, price/mix increased 26% as we continue to drive product and freight pricing actions that we announced throughout fiscal 2022 and earlier in the quarter to counter inflation. Sales volumes decreased 12% as casual dining and full-service restaurant traffic softened. While traffic trends progressively softened each month since the war in Ukraine began at the end of February, it began to tick upward in August. Sales volumes were also affected by the timing of incremental losses of certain low-margin non-commercial business, as well as our inability to fully serve demand as a result of constrained production. Foodservice's product contribution margin rose more than 40% to $138 million as favorable price more than offset higher manufacturing and distribution cost per pound and the impact of lower volumes. In our Retail segment, sales increased 28%, price/mix was up 32% reflecting pricing actions across our branded and private label portfolios, as well as favorable mix with the sale of more branded products. Volume was down 4% reflecting incremental losses of certain lower-margin private label products. We will be lapping the last of that lost private label business in the second quarter. Sales volumes were also tempered by our inability to fully serve customer demand due to the constrained production. Retail's product contribution margin more than tripled to $49 million behind pricing actions and favorable mix. This was partially offset by higher manufacturing and distribution cost per pound. Moving to our liquidity position and cash flow. We ended the quarter with $485 million in cash and a $1 billion undrawn revolver. While our net debt remained relatively flat at about $2.25 billion, our leverage ratio fell to 2.7x from 3.1x at the end of fiscal 2022 as earnings grew. We generated more than $190 million of cash from operations, which is up about $30 million versus the prior year quarter, largely due to higher earnings. Capital expenditures were about $120 million, that's up about $40 million as we continue to construct new French fry lines in Idaho and China. In addition, we paid about $42 million to acquire the additional 40% interest in our joint venture in Argentina. We now own 90% of that joint venture. We returned $64 million of cash to our shareholders in the form of dividends and share repurchases and have about $240 million of authorization remaining under our share repurchase program. Turning to our fiscal 2023 outlook, our financial targets for the year remain unchanged as we continue to build our operating momentum. While the macro environment remains volatile, we're on track to deliver at the high end of our sales target of $4.7 billion to $4.8 billion with price driving the growth. We'll continue to realize the carryover benefit of product pricing actions in our Foodservice and Retail segments. And in our Global segment, we expect to see the benefit of pricing actions, including pricing structures for contract renewals build as the year progresses. Forecasting volume continues to remain more difficult due to the near-term volatility in restaurant traffic and demand. As we saw in the first quarter, we believe that consumer behavior during inflationary or recessionary times will continue to affect overall demand, as well as our sales channel and product mix, with QSRs and retail outlets benefiting at the expense of casual dining and full-service restaurants. In addition, we expect our sales volumes will be affected by near-term production and throughput constraints as we continue to face disruptions in the availability of key product inputs and spare parts. Additionally, while labor and access to shipping containers have improved, we continue to see the impact of shortages. We're on track to deliver at the high end of the range of our earnings targets, including adjusted net income of $360 million to $410 million, adjusted diluted earnings per share of $2.45 to $2.85, and adjusted EBITDA including unconsolidated joint ventures of $840 million to $910 million. These targets exclude the items impacting comparability that I described earlier. We expect our earnings increase will be driven primarily by sales growth and gross margin expansion. We continue to expect gross margins during the second half of fiscal '23 to approach our normalized annual rate of 25% to 26%, and we feel good about the four key factors underlying this target. First, as Tom noted, we believe that potato crops in our primary growing regions will be at the lower end of the historical average range, and that any effect on our operations and financial performance will be manageable. Second, we're pleased with the continued progress in implementing pricing actions to counter cost inflation. Third, we're making steady progress in adding production workers to ease labor pressures in our factories. And finally, the availability of domestic rail and trucking assets, as well as access to shipping containers, continues to improve. While a broad rail strike has likely been averted, we continue to closely monitor the status of discussions with the West Coast dockworkers' union and the impact a potential work slowdown or stoppage may have on our exports. We continue to target SG&A expenses of $475 million to $500 million, which reflects higher compensation and benefits expenses to attract and retain talent, higher spending for our new ERP system and other IT infrastructure upgrades, higher advertising and promotion expenses as we look to return support back to historical levels, and overall inflation for third-party services. We continue to expect equity earnings of $25 million to $30 million, excluding items impacting comparability, but also expect increased volatility given the likelihood of a poor crop in Europe, as well as possible limitations on natural gas usage that may affect our production. In addition, we believe that the severe inflation outlook for Europe will likely translate into more pressure on restaurant traffic and demand. Our estimates for our other financial targets are unchanged, including capital expenditures of $475 million to $525 million, excluding acquisitions; interest expense of approximately $115 million; depreciation and amortization expense of about $210 million; and an effective tax rate, excluding items impacting comparability, of about 24%. Now, here's Tom for some closing comments.

Thanks, Bernadette. Let me quickly sum up by saying we are managing well through this challenging environment and continue to build good operating momentum. We're well positioned to deliver at the upper end of our financial target ranges for the year, and we're making the necessary investments in our production capacity and operating infrastructure to support long-term growth and create value for our shareholders. Thank you for joining us today and now we're ready to take your questions.

I have a quick question for you. Congratulations on a very strong first quarter performance. It seems you are now aiming for the higher end of your guidance for the year. With this strong first quarter and the recovery in gross margin, it appears that stronger EBITDA performance is possible. I understand it's still early in the year, but I'd like to know if there are any items in SG&A where you can make investments or if there are considerations as you start to rebuild your production capabilities with better labor and availability. Are there factors we should keep in mind throughout the year that could constrain EBITDA performance?

Yes, Chris. It’s Tom. I'll just reiterate that we're off to a great start this fiscal year. Our focus has been on rebuilding our margin structure back to pre-pandemic levels, and the team has done an excellent job. Regarding SG&A, there has been some elevated spending due to the ERP, along with wage increases driven by market conditions. However, our main focus has been on mix margin management, which we’ve worked on over the past year. The team has executed that well. Currently, the volumes are somewhat unpredictable, and I expect that to continue for the rest of this fiscal year due to the economic environment and ongoing supply chain issues, like those related to freight and containers. It’s still early, and we need to see how the crop processes through the factories over the next 60 days. In Q2, we will reassess how we feel about the year.

And just a follow-up question on your gross margin. Obviously, it's a much stronger gross margin here in the first quarter than we expected and really more like your historical first quarter gross margin performance. I realize there's a lot going in the gross margin today from pricing and cost inflation and the old crop and all that. I just want to get a sense of the factors that are aiding the gross margin performance this quarter. And maybe along with that, just to get a sense of how much the supply chain challenges are still weighing on the gross margin?

Yes, Chris, last year we had a 15% margin. Our primary focus has been on adjusting pricing to deal with inflation. Like everyone else in the industry, we have taken on significant cost inflation. Therefore, we are increasing our prices to counterbalance this inflation and we are seeing considerable progress in that area. However, there's still much work to do, as we anticipate more input cost inflation in the future. We are modifying our pricing structure to mitigate these effects as much as possible, and we are confident that we will succeed. That essentially is the main factor, Chris.

Yes. And we are making steady progress as we add production workers, based on some of the actions that we've taken to attract and retain employees while there are still those labor shortages. We are seeing the impact of that, and some of the changes we've made to shift schedules and other things. Just getting back to your run rates and throughput question.

Yes, one of the significant challenges we are still facing is container issues for our international business, Chris. While the situation is improving, it continues to hinder our ability to ship to some of our international markets in a considerable way, which is affecting the overall volume in our Global business unit. The team is doing their best to work through it, but container challenges remain on the West Coast.

Tom, I just wanted to ask actually, like a more of a technical question, I guess, around the 2022 potato crop. Realizing that the yields are down and maybe the sizing is down a bit but with the quality being good, can you just, I guess, educate us a little bit more on why the quality being above average or very good kind of helps pull up maybe a down yield year, and what that does for you from a manufacturing standpoint?

The quality of the potatoes we are processing is good, with solid texture and color, and the length is acceptable. Last year, we faced numerous issues with the crop, but this year the quality is solid, which means the finished product will be more consistent. The yield is lower because there are fewer potatoes per plant compared to historical averages. However, I am confident in our ability to source the necessary potatoes, as we do every year. Although the yield is not at historical levels, we have a strong agricultural team that will help us navigate this situation and ensure we provide our customers with the products they need.

Yes, and Tom, if I add on to that. In terms of the quality component being better this year where it was worse last year, last year that lower quality really resulted in lower potato utilization. So it required more potatoes to produce the same amount of finished goods. And we're not going to have that issue this year with a better crop in terms of quality. And then potato quality also affects line speed times in our plants. Again, we won't have that issue this year with a better quality crop.

Got it. That was going to be my follow-up, so thanks for that, Bernadette. And then maybe just as a second question, more of a technical question for modeling purposes. Just can you quantify at all that the shipment timing impact on QSRs in the first quarter? Does that shift to the second quarter at all? And then just again, seasonally, I think historically gross margins tick up from 1Q to 2Q in a normal year. Should we expect some of that normal sequential acceleration into the second quarter?

Yes. As it relates to our gross margin, we'll continue to see the normal seasonality. And then as it relates to the first question and the impact to the QSR, we don't give specific guidance pertaining to specifics, but essentially, that will flow through in the second quarter in terms of timing just given the delay in shipments.

I wanted to ask on COGS inflation expectations. Sounds like based on Bernadette's prepared remarks that maybe it decelerated just a little bit in the first quarter. Is the assumption that as the year progresses, you see the rate of inflation ease a little bit? Just wondering what's kind of embedded in that?

Yes. So we did end the quarter with high-single-digit cost inflation, including transportation. But then we also had some of the increased costs related to inefficiencies for run rates. So those were the two pieces. As it relates to inflation though going forward, although they've come off their recent highs, they still do remain well elevated compared with pre-pandemic levels. And then it also will be impacted going forward by the timing of when some of our hedges drop off for some of our natural gas.

And then just maybe get a quick recap of pricing actions at this point. You cited list price increases that flowed through during the first quarter. So I guess presumably, though, there'll be carryover in the second quarter. From a list price standpoint, is there anything beyond that at this point, or is kind of a next step up as we move into the New Year and Global contracts are adjusted?

So the big thing, Tom is our Global contract negotiations are kind of wrapping up for this next fiscal year. Most of those will start falling through in the back half. And as I said in the remarks, we feel good about where all those ended up. So we'll start seeing realizing those in the back half. In terms of the other segments, we've been ahead of the curve in terms of the pricing to offset inflation. And we, as we always do, will continue to evaluate based on what we're seeing on our cost structure, evaluating when we go to market and change prices going forward in the Retail and Foodservice segments.

That's right. And then the last pricing increase that we announced in Foodservice and Retail in July, you'll begin to see more benefit of that in Q2 and Q3.

You might start to see a little bit of slowdown in transport, though, to say. You have that. So remember, you've been talking about product pricing here. But transport will start to come off a little bit, just as the cost of transport goes down as most people on the call know that we try to make that as a pass-through as possible. It’s over time, it tends to be gross profit neutral, but it will be a little bit more volatility on the top-line because of that.

Maybe just got a follow-up on the gross margin in the back half. Q1 gross margin was obviously pretty impressive…

Hey, Rob, you're breaking up a little bit.

Yes. I'm sorry. Yes, sorry. I was just saying, gross margin in the first quarter was obviously impressive, not that far from expectations in the back half. And it sounds like contract negotiations this summer in Global going well. So I guess, as we think kind of just to that Q3 time period, with some of the incremental pricing coming through, Tom, what would you consider some of the drivers that might get you at the high-end of that gross margin guide in the back half, maybe some of the drivers to get you to the lower half or to the lower end? It sounds like it’s kind of more of the demand side relative to maybe volatility on cost or pricing or anything around the crop. Thanks.

Yes, Rob, I feel positive about the direction of our gross margins as we move toward our historical averages in the latter half of the year, pre-pandemic. This is our primary focus, and we're making good progress in that area. I'm confident that we'll return to normalized levels. Rather than discussing the specifics of high-end or low-end projections, it's about the overall progress we are making, and I believe our team is executing well on this.

Got it, fair enough. And then just quickly, Tom, I know you said early on in the call, it sounds like you've been able to secure incremental supply, just given a little, the lower yield on the crop. At this point kind of given where you stand, is it fair to say that you have plenty of supply, right, you have plenty of potatoes? As you kind of get through the fiscal year, this shouldn't be like an issue, or sitting here in March or April such that the markets are all out trying to fight for potatoes in the open market? And that's it. Thanks.

Yes. Rob, I feel great. We have great partner growers. We work in tandem with them on our needs and we got a great ag team that has tremendous relationships with our growers. So I feel confident that we'll be able to execute against our production plan and sales plan for the year and we have some things we can do to adjust new crop, old crop. So I feel good about where we're positioned going forward.

It’s actually Gary Moore stepping in for Adam. I was wondering if you could help us understand a little bit better your underlying assumptions as it relates to your guidance. You reaffirmed it. Now that we have three more months, has anything changed in terms of your underlying price/mix assumptions or volumes?

Yes, I think that, no. There are four key factors that we've alluded to in our prepared remarks as it relates to our guidance that we've been watching, and that's crop, pricing, our run rates, and then logistics. And we feel good about where we're at on all of those. And therefore, we will be at the higher end of the range of our earnings targets that we have outlined. So feel good about all four of those factors.

That's helpful. Thank you. And as a follow-up, as it relates to your investment in Argentina, how does it benchmark in terms of profitability versus the rest of the portfolio?

Well, this is Tom. It's consistent with our long-term strategic growth plans. It provides us with in-country production capabilities, in addition to our joint venture there. It establishes our presence in the South American market, which is significant, and we currently have a smaller market share, making it highly cost-competitive. I am confident in our investment as it aligns with our strategic long-term plan that we have been implementing for the past six years. I am excited about it, and it will offer us a substantial competitive advantage in that market moving forward.

Yes. And we expect that the return on that expansion to be attractive and in line with our other expansions.

I just have two. The first is, with the second year of below-average crop yields, has there been any change in the amount of area or land that is being dedicated to the production of potatoes? I'm wondering whether there could be long-term implications if some of the growers aren't making as much money as they historically did?

No, this is Tom. The acres fluctuate a bit, but nothing major. The acres around our growing areas have remained pretty consistent over time. There is some change, but it hasn't been material as long as I've been in this business.

Great to hear. And then kind of on a related topic, there is some trade press that suggests that some of your contract negotiations in the Columbia Basin are already complete for calendar year '23. Is there anything you can provide there in terms of color?

Yes, no. We won't provide any color on that the next couple of calls as some of those things finalize. As we always do, we'll communicate that on one of these calls in the near future once everything is done.

I'm wondering, you've been spending a lot of your investing on additional capacity. Can you talk about whether your view towards M&A or further JV investments may change as those facilities are done? Or is that not inhibiting any of your M&A or JV investment opportunities?

It’s Tom. Strategically, our investment in expanding capacity has been very consistent. As we see the category growth and we think about the next really two, three, four, five, seven years, as the category continues to grow even at low single-digits, it's a big growth number in terms of overall volume. So over time, we're going to continue to invest in the business and invest in the growth of the category. In terms of M&A, I've been very consistent since I've been sitting in this chair that we are as active as we can be in pursuing M&A actions. But the timing of those is always hard to predict. But it is absolutely going forward part of our growth strategic plan, organic capacity investment and potential M&A as those opportunities present themselves.

Okay, great. Did you mention a leverage target?

Yes, so our leverage target remains the same at 3.5x to 4x. Certainly, we're considerably below that right now. But we maintain that strong balance sheet during these periods of economic volatility, and it preserves optionality for M&A.

That's great. And then just one last one on hedging. Can you just talk about what you can and are hedging and if your view or policies are changing there just in light of the current environment?

Yes, just high-level, we do hedge our natural gas and oil that's used in processing our potatoes. Our policies have not changed. We've always had a risk oversight committee that has monitored the markets and we've entered into those contracts as we've seen appropriate.

Have you said how much you’re hedged in for the year?

We haven't disclosed that.

Thanks for joining us today. If you want to set up a follow-up call, please email me and we can set up a time to either today or in the following days. Thanks again for joining and I'll talk to you later. Bye.

Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day.