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Lamb Weston Holdings Inc. (NYSE:LW) is an American food company that is one of the world’s largest producers and processors of branded and private-label frozen potato products. Founded in 1950, Lamb Weston is now a $9 billion (by market cap) food giant. Lamb Weston primarily produces and processes frozen French fries, but also provides related frozen potato products that include sweet potato fries, tater tots, mashed potatoes, and hash browns.
The company reports results across two business segments: North America, 67% of FY 2024 revenue, and International, 33%. The company’s largest single customer is McDonald’s Corp. (MCD), accounting for 14% of Lamb Weston’s total net sales.
When I first started investing back in 2010, I preferred to invest in very simple business models that I could easily understand. That led me to companies that produced products I used on a regular basis, which was a great starting point (from which I grew and evolved as an investor). Well, Lamb Weston fits the mold. We’re mainly talking about French fries here.
Not hard to understand at all, especially seeing as how almost all of us at least semi-regularly consume this type of food. In fact, the broad popularity of potato foods across North America – a popularity that has proven to be enduring – is one of the best things about this business, as it’s highly unlikely that demand for its products will suddenly fall off.
Moreover, Lamb Weston has proven itself able to provide consistent quality at scale, which is why McDonald’s leans so heavily on Lamb Weston. While a lot of people like to (needlessly) complicate investing, the truth is that some of the most basic business models can lead to great long-term investment results. Lamb Weston is a perfect example of this, as it’s built itself a bit of a frozen fries empire that continues to crank out more revenue, higher profit, and larger dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for eight consecutive years. While the track record might seem short, it’s only because Lamb Weston was spun off from former parent company Conagra Brands Inc. (CAG) in 2016. So this dividend growth track record is as long as it could be, as Lamb Weston declared its first dividend as an independent company in 2017 (as soon as it could).
By the way, what a start Lamb Weston has gotten off to. The five-year dividend growth rate is 7.9%. Not bad, right? Well, it’s even better than it looks. There’s been a major acceleration in dividend growth, with the most recent dividend increase coming in at 28.6%. And the dividend raise before that one came in at 14.3%. Big jumps.
Plus, the stock yields 2.3%. That’s a very solid yield when you’re seeing double-digit dividend growth come to fruition. This market-beating yield is also 110 basis points higher than its own five-year average. A noticeable spread.
And with a payout ratio of only 28.9%, this dividend has plenty of headroom to head higher over the coming years. This is an under-the-radar name, but the dividend numbers stack up really nicely.
Revenue and Earnings Growth
As nice as the metrics look, though, many of them are looking backward. However, investors must always be looking forward, as today’s capital is risked for tomorrow’s rewards. That’s why I’ll now build out a forward-looking growth trajectory for the business, which will be highly useful when the time comes to estimate fair value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth. And I’ll then reveal a professional prognostication for near-term profit growth. Lining up the proven past with a future forecast in this manner should give us enough information to make educated decisions on where the business may be going from here.
Now, because Lamb Weston went independent in 2017, I’ll only be looking at revenue and profit growth from FY 2017 onward. Lamb Weston moved its revenue from $3.2 billion in FY 2017 to $6.5 billion in FY 2024. That’s a compound annual growth rate of 10.7%. This is strong top-line growth. I usually like to see a mid-single-digit (or better) top-line growth rate from a fairly mature business such as this, but Lamb Weston easily exceeded that.
Meanwhile, earnings per share grew from $2.22 to $4.98 over this period, which is a CAGR of 12.2%. Well, that’s even better. Lamb Weston is putting up surprisingly impressive growth. I don’t know how many people would expect this from a frozen potato business. I’ll note that improving profitability helped to drive some of this excess bottom-line growth, although margins have been a bit lumpy. Looking forward, CFRA believes Lamb Weston will deliver a 3% CAGR in its EPS over the next three years.
So there is one big issue that relates to the somewhat dour leaning, as a 3% CAGR would be about 1/4 of Lamb Weston’s EPS CAGR since being spun out in 2017. The issue is this: The company is still reeling from the recent rollout of an ERP (enterprise resource planning) transition – a transition that caused chaos, impacted Lamb Weston’s ability to fulfill orders, reduced visibility into inventory, and harmed customer confidence. CFRA calls this a “botched” transition that ultimately led to a loss of customers. This shows up on the bottom line. Despite the 12%+ CAGR shown above, FY 2024 EPS came in markedly (~28%) lower than FY 2023.
In addition, there’s been excess supply in the market, which has caused double trouble for Lamb Weston. I’ll put it bluntly: Recent numbers out of this business have been disastrous. And the market has responded, sending the stock down nearly 50% from its recent all-time high. But that’s precisely why I’m covering Lamb Weston for the first time.
In an alternate universe where the ERP troubles had never occurred, and the stock were flying high, it’d be much more expensive to buy and less interesting to feature. I think CFRA is right to be cautious over the near term, but the longer-term picture still looks bright.
CFRA sums it all up well with this passage: “We expect growth to be driven by volumes, particularly in the second half of the fiscal year as [Lamb Weston] laps the disastrous ERP transition from the prior year. Price/mix will likely be soft due to increased price investments as [Lamb Weston] attempts to win back lost customers and utilize its excess capacity. The industry seems to be in a supply/demand imbalance, as restaurant traffic trends have recently been soft. This could take over a year, in our view, to balance out, and will likely happen as the industry rationalizes capacity.”
So that’s really it. If you’re looking for a quick buck on a short-term turnaround, this isn’t it. But as excess supply works off and Lamb Weston rights the ship from an operational standpoint, there could be a very significant bounce back in results (and the stock) over the next few years.
In the meantime, the payout ratio is so low (even on temporarily depressed results) that it offers a comfortable cushion in regard to the dividend. A 3% EPS CAGR over the near term isn’t something that can stop this train. While I would expect modest dividend growth over the next year or two, those who have the courage to buy the drop and the patience to stay with the business could be handsomely rewarded over the coming years with large dividend increases (in addition to lots of capital gain) once the storm has passed.
Financial Position
Moving over to the balance sheet, Lamb Weston has a decent financial position. The long-term debt/equity ratio is 1.9, while the interest coverage ratio is nearly 8. Also, cash on hand is minimal. This isn’t a bad balance sheet per se, but it is my least favorite aspect of this business.
Profitability, on the other hand, is robust. Return on equity has averaged 269% over the last five years, while net margin has averaged 10.8%. ROE has been juiced by the balance sheet, but the margins here are very respectable.
Furthermore, ROIC is routinely coming in at about 15% – a strong number. This simple-to-understand business has deceptively good fundamentals. And with economies of scale, entrenched customer relationships, and industry reputation, the company does benefit from durable competitive advantages.
Of course, there are risks to consider. Litigation, regulation, and competition are omnipresent risks in every industry. The company is concentrated on one particular type of product (frozen potato foods). There’s customer concentration risk here, as its largest customer is responsible for nearly 15% of revenue and commands a lot of sway over Lamb Weston.
Recent operational execution has been poor. Input costs can be highly volatile, especially since potatoes are naturally grown and dependent on crop conditions in any given year. Lamb Weston has exposure to the broader economy, as customers can easily pull back on discretionary restaurant spending during tough times (which would indirectly impact demand for the company’s products).
There are certainly some risks to consider here. But the ~50% drop in the stock’s price, which has created a much more appealing valuation than usual, should also be considered…
Valuation
The stock is trading hands for a P/E ratio of 12.4. To put that in perspective, it’s roughly half of its own five-year average of 23.4. The sales multiple of 1.4 is also nearly half of its own five-year average of 2.6. The price being cut in half has also cut the various multiples in half. And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%. Americans’ appetites for potato food products seems to have no limit, so it’s hard not to give Lamb Weston the benefit of the doubt.
It’s difficult to imagine a scenario in which this business doesn’t do at least moderately well over the long run. This long-term dividend growth expectation is lower than Lamb Weston’s dividend growth to date, and it’s downright conservative when put up against the size of recent dividend raises.
In addition, the payout ratio is very low. Now, near-term EPS growth is shaky, and the prospects for dividend raises over the next year or two are not great. But this is modeling in long-term growth, and the dividend was growing at well into the double digits before the ERP disaster (a one-time disaster that is temporary) – a double-digit rate that could soon return and more than make up for an upcoming lackluster year or two.
The DDM analysis gives me a fair value of $61.92. The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks. I see a stock that’s, at worst, fairly valued, and that’s after running it through what was, arguably, a conservative valuation model. But we’ll now compare that valuation with where two professional stock analysis firms have come out at. This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. Morningstar rates LW as a 4-star stock, with a fair value estimate of $95.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold. CFRA rates LW as a 4-star “buy”, with a 12-month target price of $70.00. I came out surprisingly low. Averaging the three numbers out gives us a final valuation of $75.64, which would indicate the stock is possibly 18% undervalued.
Bottom line: Lamb Weston Holdings Inc. has a simple-to-understand business that is busy selling basic food products that have enduring demand. A recent self-inflected wound has caused a massive selloff in the stock, creating what could be a rare opportunity to buy at a depressed valuation. With a market-beating yield, a low payout ratio, high-single-digit dividend growth, nearly 10 consecutive years of dividend increases, and the potential that shares are 18% undervalued, this could be one of the cheapest defensive ideas in the market for long-term dividend growth investors.
Note from D&I: How safe is LW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, LW’s dividend appears Safe with an unlikely risk of being cut.
Disclosure: I have no position in LW.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
