Yet Another Value Podcast - AJ Secrist from Firstlight Management on Lamb Weston $LW

Episode Date: December 8, 2022

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.   Chapters  0:00 Intro  2:25 LW Overview  9:35 LW Valuation  13:00 Isn't LW fully valued at these prices?  19:25 Discussing the current potato crop  26:55 Global margin upside  28:35 Why is scale an advantage for LW?  31:45 Why will LW's margins accelerate now?  34:30 Industry demand and supply dynamics  37:20 Capital allocation and share buybacks  41:30 Management incentives and share price targets  45:00 Potential private equity or BRK end games  48:10 A little more discussion on LW's potential P/E multiple  51:10 What happens if we have a low carb craze again?

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or listening to it. With me today, I'm happy to have AJ C-C-C-C-C-C-C-Ris. A-J is the man managing partner at First Light Management. AJ, how's it going? Good, good, Andrew. Thanks for having me. Hey, thanks for coming on. Let me start this podcast the way to 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. And then second, a pitch for you, my guess, we've been trading DMs with each other for probably almost two years at this point. And then a couple months ago, we started hopping on the phone and stuff. He said, hey, I'm in the process of building my own thing, you know, the type of person I like to talk to, concentrated fundamental

deep work. And as soon as you did, I was 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, it's 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? Yeah, well, it's, it's probably the best company and the best industry you never knew existed up until this point operating in the very sexy industry of frozen french fry processing i'm laughing because i think event people knew this uh existed because this spun out in 2016 and it's been a fantastic stock since the spin out and they either knew it existed and invested or they knew it existed

and did invest and they're kicking themselves but neither here nor there i guess yeah i mean that's that's that's actually when i got to know the company it was in q4 of 2016 when it spun out of Canagra. And, you know, as a guy who's basically lived on both coasts my whole life, you know, I heard frozen and French fries and processing. And I just about grew up and thought, oh, my gosh, it's supposed to have the worst demand trends on the planet. And, you know, but I did some work anyway and quickly realize that this is actually

a really good business, a really good industry. And I own this stuff. at, you know, 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 100 bucks at one point, and I felt like an idiot. But continue to look for a chance to get back involved. But what's really interesting about the company is, you know, despite all those descriptors I used earlier, Frozen, French fries, and process, processing, processed, you know, despite what I thought, demand is actually really quite good.

In the U.S. and Europe, which are the most mature markets, demand grows 100 to 300 BIPs per year. In emerging markets, it's more like mid singles to high singles. So globally, demand grows, you know, 300 to 500 Bips 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 of capacity.

And that's really interesting for a lot of reasons, you know, 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, you know, the most prolific place to grow potatoes on planet Earth in terms of, um, crop consistency in terms of yield, in terms of potato quality, in terms of water availability, and so on. And so by virtue of that fact, and they're also close to the ports in Seattle, so they have an advantage in the expert markets. So they have a margin advantage versus the two private competitors supplot in McCain. And I've heard it's as large as 4 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 on capacity. The typical cadence is a manufacturer will put out a press release saying they're bringing on the 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. to have that plant up and going. And, you know, they'll put out the 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 six to 12 months before that plant is, you know, fully sold out.

And so where you're sitting, from where we're sitting today, you know, we can have a very clear picture three years into the future into what will supply looks like. And so you can have really high conviction in, you know, global capacity utilization and what's going to happen to pricing going forward. And so, you know, you put those two pieces together where demand is, you know, pretty consistent. Supply is pretty benign in general with rational players. And Lamb is uniquely consistent. competitively advantaged against those competitors. That's a pretty good setup. And why that's all ultimately important is this business has a lot of pricing power, right? By virtue of a number of

things, right? Nobody's going to come in and undercut you on pricing because nobody has capacity. and french fries are an extremely critical component to a restaurant's menu it's typically the highest margin food product on the menu it's like 85 to 95% gross margins so operators love selling french fries and also in a you know inflationary environment pushing french fries is a way you can defend your margins too right um so it's they're sort of becoming increasingly important to a menu and also think about how critical it is to a global QSR, right? Can you imagine McDonald's without french fries? It would be not McDonald's. And, you know, 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 Macmill McDonald's, it's probably going to 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%. And, you know, we can get into the math, but suffice it to say, there's a load of latent pricing power here. So I've said a lot, you know, ultimately it's a good business, good industry, shockingly good industry, loads of pricing power. And, you know, that's the general idea no that that's fantastic uh look i do think i actually i think why don't we just dive into right into valuation because the two critical questions that i think stem off of everything you just said are going to be the pricing power discussion and especially the pricing

power with their global customers and we'll get into that and then just how good of a business it is because that will play into the valuation all the discussion so why don't we just go right into talking about valuation, then we can dive into those other areas. So valuation, you know, as you and I are talking, LW stock is trading for about $86 per share. That's about, I've got a 12.5 billion market cap after you adjust for a couple of shares they issue and that the most recent deal they did, which we'll probably talk about. But why don't we just talk 12.5 billion market cap-ish. What's the valuation look like there? Yeah, I mean, this year's a little bit wonky. You know, part of the thesis is,

This was a 27% 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% gross margin business this past year, at one point they were guiding as low is 17% gross margins. And 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

freight surcharges and so on. And so I don't really look at valuation this year because margins are still depressed. How I think about it is, you know, how long is it can 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, right? So this was pre-COVID post-spinoff very consistently 20 to 25 times P.E. And, you know, this is a, 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 it traded basically forever prior to COVID. And when you do that math,

kind of what target share prices that come out with for you? Yeah. Yeah. I mean, so to give you context, you know, like I said, this was 27% gross margins in 2019. I think they can get to the low 30s gross margins by fiscal 25. This is a May fiscal year in. So we're talking. in May 25 and that would get me to almost seven bucks of EPS adjusted for some share-based comp stuff that will roll off so seven times seven bucks on you know 22 times gets you into the 150 ballpark and it's fixed today so exactly from 86 you're talking about almost a double you know 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, you know, a lot of their sit-down

customers where they're doing French fries 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 have into more pieces of that, but let's just take a step back, right? You've just painted a business. You've just painted a picture. Good business.

Margins are going to expand as things normalized. But I could also paint the picture of, hey, this is trading at $86 per share. The guidance for 2023 is the midpoint is. is $2.65, $2.65 in EPS, I believe the guidance is. That's about 32 times this year's price to earn P.E. Yes, there's going to be margin expansion. But, you know, if I went back to fiscal 2019, which ends May 2019, they've got an all fiscal year, 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 a good business.

but it seems like the market's got this priced as a pretty good business you know it does feel like you're getting a pretty full multiple like what's the real edge here that's going to give you like i don't disagree this is a nice opportunity but where's the real juice that gives you like the alpha here you know yeah well i think it's um you know if you look at the sell side numbers um they never have margins getting above the prior high water mark right so they did 27 percent gross margins in 2019. The Southside never has them breaking 27% even in the out years. And that doesn't make sense, right? And yes, they did 322 in fiscal 19. But between fiscal 19 and 24, your top line has exploded because they brought on a bunch of new capacity and now pricing is going

veneers, right? So you're going to get higher margins on a much larger base. And there's there's all kinds of data points to suggest margins are going to break the prior all-time high waterwork of 27%. And, you know, I can go through a laundry list of them. For instance, you know, we haven't really talked about the segmentation of the business, but, you know, one third of the business, well, half the business is QSR, global QSR that operates on multi-year contracts. Those are slowly reprice. But about, you know, 35% of this business is food service, which is selling into the food service 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. Right. And so that's indicative of where the rest of this business goes as things reprice. So that's number one. You know, number two, just mathematically, if you just run through the price that they've taken in the most recent quarter in food service. Just say they've, you know, it was up 26% I think in the last quarter. And, you know, 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%, you know, mathematically, you're going to get margin expansion in food service. And 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 percent from what I understand on contract renewals. Those are typically three-year contracts. So one 30-year business is repricing higher at somewhere around 30 percent.

So you're going to get low double-digit pricing in, you know, half of your business. And again, unless you think cogs per pound, which was already up a ton last year, right, is up another ton this year, you know, mathematically, you're going to get a ton of expansion over the next 12 months in that business as well. You know, so that's number two. Number three, you know, 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 being their best year ever. So there's this big discrepancy between what the private guys are saying and what the street expects for lamb. You know, I can I can go on and on and on. You know, another good data

point is management is guiding to the second and a half of this year looking like 2019. And if you go historically and say, you know, what does the second half of one fiscal year suggest for the next 12 marks, the subsequent fiscal year gross margins? And in every case, the subsequent fiscal year gross margins are higher than the second half that they printed subsequently. You know, so if this year and the second half, they're back at normalized margins and the following year, fiscal 24, if it follows a historical pattern, should be higher. And there's 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. And it's also really impressive that this year in Q1, the gross margin was only off about 100 bips from Q1 of 19. And again, this was worth with the worst crop year in the Columbia Basin, which annihilated margins. So, you know, I could still, I could, I could go on. Nope. Good, good.

Yeah, so I mean, just just an enormous, enormous amount of evidence to suggest margins will be at all time high this year, I think, and they're going to continue marching higher from there. And the south side thinks, you know, all time high and we're going to flatline from there, which doesn't make a lot sense to me. So let me just dive into a couple different things. So you mentioned a few times. Cogs was up about 20% last year. You mentioned how bad the crop was for last year. So I want to ask two questions, two kind of basic questions, but I think they're important both for listeners and for established thesis. Number one, why were cogs up 20% last year?

And then somewhat related, you know, why was the crop so bad last year? And the crop, for those you 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 check. 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? Like, 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.

Yeah, okay. If I lose track of that, 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 14.5% 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 were probably surprised by how little they get away with disclosing, right? Yep. They don't

give you ASPs. They don't give you volumes. They don't break out cogs for you. The stuff's kind of hard to, or at least, it's not hard to figure out, but they don't just hand it to you. And so, you know, why were cogs up so much? Well,

it's hard to tease out because they don't break down in a case, right? But if you think about, let's just talk qualitatively about what went wrong through 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. So the typical channel mix is 50% global QSRs, 35% food service, about 15% retail. Through COVID, obviously, your channel mix went totally wonky. because your channel mix was totally wonky, you were running different product lines at plants

that weren't 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 trucking, which is just much more expensive. And on top of that, you had absenteeism and your labor costs blew out as well. Right. So COGS was a disaster from those. And then you get into just the like-for-like increases from canola oils, edible oils, batters, grains, you know, 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-for-like cost increases as well. And then the cherry on top was just this Columbia Basin product disaster this past year. And that was, as I understand it, that was a function of all the heat in the summer of

21, I guess it was now, compounded by all the smokes. We had all these huge wildfires in Washington that year. And so what you need for potatoes to reach maturity is you need cool evenings. I've learned a lot about potatoes. You need evenings around like 60 degrees Fahrenheit. and I have I have a quick link on my on my browser to see the weather in Richland, Washington, you know, but you need evenings to be around 60 degrees and they weren't getting there because the smoke was trapping all the heat. And so there was this what is uniquely, historically uniquely competitive advantage at Lamb turned into a unique competitive disadvantage as the Columbia Basin was just socked in with heat and smoke in the summer of 21. And so what happened is typically, they contract for about 98% of their expected potato needs, 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% more expensive than the pricing they contract at. And then on top of that, the quality of the potatoes was just garbage as well. And so quality meaning you need more potatoes to create one pound of french fries, right, to process one pound of french fries. So the potatoes themselves were smaller, there were more defects. And so they ended up having to buy, you know, something like probably 15-ish percent of their potato volumes in the spot market. And what really hurts is the only place that had potatoes was Canada and the Midwest. in the Northeast, and so you're buying these potatoes, which are more expensive in the spot market,

and you're paying to have them shipped across the country. Exactly, yep. Your plants in the Columbia Basin. And as, you know, what I've really learned here is what really kills you is logistics costs in this business. It's, you know, when when logistics get messed up, that's when marginally 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. And so that's, you know, I think that was the biggest driver of the margin

decline from 27 to, you know, 20. They actually printed 20 last year, but they were guiding as low as 17%. And so that was the story with COGS and what happened last year. And, you know, now, now they're going back on offense where they're pushing price. They've implemented a bunch of freight surcharges. They've also got off-cycle price increases, as I understand it, from folks, from customer base, the customers, partly 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. And so anyway, that's the story of Cox.

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, all that. They've got it. But they almost have it on steroids because all of their contracted supply in their basin, they have an awful crop year. They have to import everything. So you get hit on the spot market. You get hit with extra import costs. Like your whole thing just isn't set up for this. So yeah, literally every, every item in the cost structure went the wrong way. And then I guess we could simply say for 2000. and obviously they've guided this and stuff like we've got early results it seems like the crop as I understand it is slightly below average but it's it's close enough to average where you know

last year's was historically bad and this is like a C minus so you know they they really start normalizing there tell me if I'm wrong on any of that though yeah no I this year's crop is 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, that offsets a little bit of that, but still, you know, it's still still not, not an average prop this year. So 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 margin normalization. I guess the best way to show this and kind of roll this in is, I think

when people look and people can DeLupa as a sponsor, I'll include a link to a DeLupa model, or you can just go look at the last two of the last four 10 case. I think the best way to show this is you go and look particularly at the global, 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. But global margins go from in fiscal 2019, global margins are 23%. And by fiscal 2020, 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 you want. But then let's talk about why is global the one that's getting this huge margin squeeze when they're managing to pass basically all this through on food service because 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 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 and so that's you know that that's part of the thesis right margins cracked. And, you know, my view is that's temporary because they can finally start going on offense

and pushing price on those big customers. And as you said, contract renegotiations 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've got lots of extra. They're the largest player here, all that sort of stuff. Okay.

Let me ask you a couple 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 10% of your sales, like they can go to someone else. I want to talk about these guys have big share. Why is scale such an advantage here? And then I want to dive a little bit more into the supply rationalization, not rationalization,

the rational supply come online that you talked about earlier. But why is scale such a big advantage here? Well, I mean, the way it typically, the way you fill a plant is you typically want some really high volume skews to take a big chunk of your capacity, right? That's going to be your anchor volume. And so McDonald's fries aren't the highest margin fries for you. Yep. They might be the lowest margin. But they're important for your throughput and your, you're not.

processing efficiency, and to even, you know, 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. And 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. And if you don't have those billions of pounds of, you know, foundational capacity, it's going to be really hard to compete for those lower volume skews with higher margins because you won't have the same efficiency. Is 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 selling to McDonald's. You're selling to your Chifle. That's just kind of covering the baseline fixed costs. And then where you really make your profit is on the food service side,

everything outside of the top 100 where you're selling small customers. Is that kind of the way to think about it? I mean, it's certainly lower margin. I mean, I'm sure it's economic. You want to, you make money on your fries. that you're selling McDonald's for sure. And I actually think that, you know, roughly, I think food service, the price point is probably two to two and a half X what McDonald's pays.

And, you know, I sort of have a view that the big guys could actually pay a lot more or should pay a lot more because French fries are so much more important to the value prop at a McDonald's or a Burger King than it is at, you know, big, diner or something like that. And so I think going forward, I think there's a lot more pricing power that could be flexed at the global customers. Aren't you making, like I do hear you. McDonald's is making, everybody remembers when they were taking like business 101 and somebody 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 they're bolting on. So I do hear you on that.

but at the same time, like, McDonald's has been doing that for 50 years. Like, what has, 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. Yeah, I mean, I think it's, uh, it's just capacity utilization. Like literally no one has capacity. And because we can, we can map out global supply looking out for years. you know, a very good view that there's not going to be excess capacity going forward. And so the industry, you know, it has consolidated.

That helps. But also just capacity is just really, really tight. And it's going to get even tighter as global demand grows three to five percent. And I've got global supply growing it like, you know, out past this year, there's 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, you know, global QSR,

we're going to raise our prices on you by 5%. You know, 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 do. displace higher margin food service margin product somewhere. So that processor would lose the global business, but be able to pick and choose whatever higher margin food service stuff they want to take.

And to give you just one anecdote about how tight the industry is, one of the big, one of the private guys, private processors made quite a splash recently when they unilaterally voided all of their short-term food. service contracts. Is that everybody that is on a one year or two year contract, it's Nolan Boyd, we're moving everyone to spot. Like, good luck finding capacity elsewhere if you don't like it. So the processors have all of the leverage right now.

And, you know, barring some incredible disaster on demand, on the demand side, they're going to continue to have all power for at least the next three or four years. So in many ways, like a lot of. 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, you know, demand went down, which is probably one of the reasons supply wasn't getting invested in. And now that demand's starting to fully return. And I don't believe demand is fully, fully returned for these guys. But now that it's starting to fully return, you run in, you say, oh, our supply is still at 2019 levels. And

And demand is now at, you know, 2019 times 1.025 to the fifth to get to 2025 levels. And it takes two years, three years for supply to come online. So you're facing supply shortages. And that's why a lot of the demand, at least, especially in the near to medium term, shifts over here and why you can see expanding margins. Yeah, I don't, I don't think it's a function of underinvesting in supply, though. I don't think it was, you know, COVID hit and the industry just slamming the brakes on capacity engines. I think it was, they continued to bring on capacity. Lamb has continued to bring on capacity.

It's just the industry is pretty rational and pretty, pretty patient in how they bring on capacity. And so they just didn't, they consistently add a little bit less than the demand growth. What if, if I took the other side, right? So we've already got this year's fiscal crop. What is, this year's potato crop? If we had a unbelievable potato crop next year, year, right? Just potatoes out the wazoo. Would you run into an issue where, hey, you're,

you're oversupplied, right? Or is the limit really at the kind of French fry process, the frozen French dry processing manufacturing plant? So that would actually be great where your input cost, your supply is just getting crushed because there's so many potatoes, but there's still, you're still capacity constrained on the actual making of the French fry. Yeah, no, I think it's, uh, the, the plant is the bottleneck. I mean, these guys at least lamb is contracted, you know, like 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 volumes and your

price are what they are. That 2% that you need to buy in the spot market would be down, which is nice, but like, who really cares? And 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-a-vis the competition. But, you know, bumper crops, you don't really get the benefit of those, at least in North America, you would in their European business. but but north america it's not not not really windfall perfect that actually takes let's talk about capital allocation here right so obviously you think the stock is too cheap you think it's about uh kind of almost half of where it can trade in a year or two on the normalized earning numbers you talked about the multiple we've talked about all that type

type i want to talk capital allocation i mean the two places where they are putting their money are share they do have a small dividend but it's share repurchasees and M&A. I think they're definitely leaning on the M&A side. We saw that recently with the, they bought out their European JV, but they're under leverage. I think there's a lot of options going forward. But let's just talk about capital allocation.

You know, what makes sense to you going forward? Yeah. Well, I mean, I mean, I guess let's level set. The capital allocation policy is 30% of earning. It's a 30% payout ratio, right? So 30% of your earnings are going to dividends. And then after that, I think they have a strong reference for capacity ads. So I think for three or four months ago, they announced a new plant in Argentina.

Yep. And these are big expensive plants. They're typically, you know, 300 to 500 million pounds of capacity at about $1.20 per pound in terms of CAPEX. So you're looking at like $300 to $400 million per plant. And they've spent a lot of money on building out capacity historically. And 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, well, I think three, buybacks in M&A are probably three and four. I think, you know, they just bought out the European JV for 700 million euros. I think that was a special case. I think they'd sure love to buy more players in Europe, but that's historically proven to be pretty slow going. And 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. 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, there'll be a decent little bit below 3X. You know, it does sound like they want to do more M&A. It does sound like Europe would be a nice area of focus for them. But, you know, given the stability, they're at three times EBITA, and that's without any of the margin benefit that you and I've talked about. given the stock, like, why not get more aggressive on capital returns in some form here? Yeah, I mean, I've, I agree. I mean, as like any good hedge fund, bro, I want them to lever up and buyback stock, right? I mean, and if your view is that the stock is going to be 2x in two years, then then you should be buying back as much as you possibly can.

And I've, you know, I've expressed that to them and, you know, they do what they, they they do with my opinions, which is probably throw them in the trash. But, you know, so yeah, I mean, I would be fully on board with them levering up, buying back more stock. I think that's a phenomenal use of capital if you think the stock's going to 2x. And, you know, implicit, you know, I guess, well, the smallest side, they had a new, they granted a new management of comp equity plan back in July. and this was largely, largely leveraged performance units with stock price vesting thresholds. Yep.

And the top two thresholds to keep in mind on the stock price is $140 and $212.12. I mean, that's where it caps out. I mean, that would be what. But let's say 140 bucks, which is where the CEO gets 300% of the target LPO's. So it maxes out of 300% of the target LPO's. And that's at 140 bucks. And that's by May of 25, right? So two and a half years, 140 bucks, basically overlaps with where I think the stock is going to be.

And that $140 target is, you know, it's not pulling a lot of, thin air, right? That's a function of the comp committee pulling, you know, presumably a budget and looking at historical multiples and saying, okay, 140 is a reasonable target for everybody involved. If I could just add something, I'm looking at that 8K, as you say it, and that 8K was filed July 26. The awards were granted July 20th. I could be slightly one or two days off on the timing here, but my overall conjecture is right, where they awarded that and then they announced really nice earnings and the stock went from 76 to 80 obviously 76 to 80 is not 120 140 but you know that's 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 full payout at 140 you get pay out at 200 like 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, what, $210 per share in earnings in two and a half years. They've probably got line of sight to a plan, like, especially when you see someone doing that right before the stock pops and earnings, like, there's, there's some gamesmanship playing and they've got an idea of how they're going to realize that. Yeah. Yes. Yeah. I mean, they're not just, they're not just pulling numbers out of a jump. 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. And 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 priced on July 29th. So they actually had incentive on earnings to be conservative, right, to not talk up the company, to not take up guidance. And this is a company that I think is, was conservative pre-COVID, you know, post-spinoff pre-COVID, this was just a routine beaten razor.

It was awesome. And through COVID, I think they've gotten quite shell-shocked. And I think they've become even more conservative after, you know, the debacle that they've had. and so I think they're they certainly want to get back on the beaten and raised trajectory what do you think to end games for them because look this is a as we talked about it's a 12 and a half billion company right but they're just in frozen franchise is is this long term they're they're just hey we're a public company we're you know right now we probably have line of sight to low to mid single digit growth plus margin expansion plus some pricing power but you know if if you and I are sitting here doing this podcast in five years are we talking about them and it's like like, hey, they're just a French fry, French fry company growing at kind of the rate, like, would anyone strategic ones to them? It does kind of seem like a private equity play in some safer form, but it's tough because what's the, there's no real, there's mom and pops to roll up, I guess, but there's no real

like angle of other things you're going to go get with this, you know? Yeah, I mean, it's, it would be challenging for private equity to do this because it's a giant company. I mean, it's a 12, 13 billion dollar cap plus some debt. It's like a 14 to 15 billion enterprise value. If the stock performs like I certainly hope it does, we're talking like, you know, 25 to 30 billion dollar enterprise value and then add a control premium on top of that. And like, we're talking like enormous, enormous equity check. Right. In a couple of years. You know, I think the end game is, you know, I'd be quite happy if they just, just continue to grind out mid-teens EPS growth forever and the consumer staple.

I'd be okay with that. I think there are a couple of huge lovers that they have yet to pull. One is really pricing power. On my numbers, 1% to price all sequels, about 6% to EPS. So why couldn't you pull an extra 3% price per year and send your EPS growth into the stratosphere? and, you know, what's, what's a 20% EPS grower and consumer staple land worth? Like, it's a lot. It's a lot. So they could potentially pull that lever lightly but consistently. If they can't do that for whatever reason, you know, 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, you know, if they can't do that in public markets, you know, 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 strategics that might make sense, like I don't know, Cargill or Post actually bid for them pre-spin-off.

You know, now that you say that, I think that's sticking in the back of my mind. The other one who, this does kind of seem like a Warren Buffett business in some ways, right? Consistent. That was my punch line. We know the man loves potatoes. 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 getting him getting up on stage at his AGM with his like, you know, Coke and his French tracks? Yep. It's like perfect.

He can fund it with that insurance money. So he's funding it with, you know, negative cost flow. It sucks up, what, a month's worth of profit for him at this point. But yeah, it really does fit. Let me just go and do two more pushbacks. You know, a lot of the stuff we've said, we said, hey, $140, $150 price target is kind of 7x, 7x a year or two out EPS once they get the margin expansion times 20 to 25 times at PE, which is their kind of historical margins.

I know the company certainly thinks about those. historical margins. If you read through their, both the historical margins and historical multiple, if you read through the recent JV, they, they talked about that a lot. But I do want to put one pushback would be, hey, you guys are throwing out a 23 times historical multiple. That was the multiple in 2018, 2019. Interest rates were lower than. Inflation was lower than. The stock market had a better multiple then, right? 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, there's still pretty good upside there.

But, you know, it starts really cutting into that margin of safety. And then you say, oh, if the EPS is going to be six instead of seven and you're talking, let's say, 16 times instead of 22 times, like all of a sudden, all the upside has been captured there. So I just want to throw that back. It does come back to our valuation point. But I think that's the most fair pushback. And the thing, I think a lot of viewers will, listeners will have in their mind when

hearing this. Yeah, I mean, look, I mean, I wish I have a much better read on earnings than I do multiples, right? I mean, multiples will go or multiples will go. And my hope is that I'm sufficiently right on my earnings expectations that I don't get flown up by multiples going in reverse. But, you know, that said, you know, you can look at the universe of branded CPG guys who grow at fractions of the growth rate who trade 20 to 30 times PE. I just I just pulled up Coke because we were talking Buffett. I just pulled up Coke and you look at them and you say, oh, they're trading, 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. Yeah. And I mean, like there is no brand at Lamb. right really um but you know it's it's a consumer staple that that grows um people like that stuff um so you can look at the universe of branded cpg food or just branded cpg um and you know pretty consistently 20 to 25 30 times rings um and um you know that that gives me some comfort let me you know you actually and actually another good comp is probably is that

resource distributors, who Lamb is, I think, unequivocally a better business than, and those guys are mid-high teens to 20s. Cisco today is trading it 20 times. Yeah, no, no disagreement there. Just last one. You know, it's, this is always tough because one of the, one of Finchwick's favorite thing is never bet against the American eater, right? So it's always hard to say this. but I do look at this and look I certainly I always had a burger and fries for lunch day in preparation for this so but you know it does strike me like for years everyone said at some point the American diet has to change there's trends you know there's trends against sugar there's trends against potatoes there's trends again carbs honestly those trends I do think they're a little more I want to use the story I do think they're a little more kind of on the coast than versus the mom and pops like everybody always wants to be healthier but I don't think there's a way to but is there anything like i do remember back in like the late 90s or early 2000s i remember my dad was doing the sugar busters diet and i think i remember a lot of uh companies come on be like oh we sell sugar and we're having issues like sales are down because there's this low carb trend like

could there be something 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 supply is a little bit constrained demand's going through it if if demand comes back a little down you've got excess supply that's a disaster for anything that's for everything but especially anything's commodity like could you what happens if you get into a low car i i don't even know what i'm saying but there does there's like a the tickle of a risk in the back of my mind there i mean yeah i mean like consumer preferences matter right it's it's a risk um i mean the industry has lived through atkins it's lived through south beach it's lived through all this other stuff um and it's been pretty resilient do you know what demand

looked like kind of at the height of Atkins or was that just too long ago it's it's just too long ago yeah it's not good data for yeah we only have standalone financials for lamb going back to like 2014 obviously do a lot of international i think international man's better for a lot of reasons you know internationally yeah i mean that's what i was going to say i mean globally french French fry consumption. It's probably 50% U.S. and Europe and 50% rest of world. And that rest of world business is growing a lot faster than the U.S. and Europe. I mean, U.S. and Europe is like, you know, 100 to 300 BIFs per year. Yep. So, you know, if that, if that were to go negative five or something, that would be a big problem. But I guess it's a question of how severe consumer

preferences change and how quickly. What is a, what is emerging market growing? You said U.S. and Europe are kind of growing at the rate of GDP. What's emerging growing? I mean, it's like mid singles to high singles, depending on the market. How much of their sales are coming from? I know I did most of my work on U.S. and Europe, which is where basically all their earnings are coming from. But do they have kind of similarly good share in emerging markets? Well, it depends on the market.

You know, their 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, like, 19% share in Europe, and Europe serves a lot of Africa, a lot of the Middle East, and so on. I mean, all the, basically all the processors are based in North America and Europe, and they largely just export to the emerging markets. And that is why they were talking about, again, they just recently bought out their big European J.B, 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 Africa, Africa in particular, they said it's way under penetrated for French fry trends. So you're kind of getting that built in growth. 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. Well, one more point on the consumer preferences. One thing we didn't talk about, that's very important, is nacho fries. From Taco Bell? Yeah.

Yeah. So, I mean, so in fact, like, consumer preferences are going the other direction. Yep. Because Taco Bell has this really successful LTO that they offer periodically of nacho fries. So people love fries, man. Hey, I love French fries. Everybody loves French fries. I mean, operators also have big incentive to push fries, too, right?

I mean, through the years, we've seen the introduction of, like, sweet potato fries, which is... 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. Yeah, yeah, yeah. So, I mean, there are different, you know, variations on a 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, you know, making fries, the side dish of choice. I guess here's the question I didn't even thought about, right? I just thought these guys, they do French fries, they do frozen French fries by USR. You and I, we're LW hits 170 next year. We're celebrating by going to a steakhouse, right?

We order the steak fries on the site. I guess if you go to high-end places that are making their fries fresh, is that, that's not getting sourced by LW in any way, shape, or form, right? They're just ordering potatoes and do it. So this is more QSRs who are doing frozen franchise, dumping them in the fryer and popping them out. Yes, correct, correct. I mean, in and out, in and out isn't a customer, right?

In and out buys their potatoes and they chop them and they fry them in their units. But Chick-fil-A is, right? Because I think Chick-Lay does, yeah. Yeah, they do the waffle fries, and that's a good product for them. 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 a the higher end QS like fast casual type thing the Chipotle's and stuff obviously Chipotle doesn't have a potato product but you get the more hey we're going to make all our fries fresh in store I do think most places realize hey frozen fries tastes about as good as fresh 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 shake acts, the in and Alice who are just getting fresh fries. You had 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 a 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. That sounds delicious to me. To be honest. AJ, anything else we should be covering? I think we got it. This is great. Hey, AJ, this was great. really appreciate you coming on. I'm going to tag AJ's Twitter on 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 sexy one that has some interesting similarities to this one. But we'll probably have to wait until the new year for that one. But AJ, thanks for coming on and we'll chat soon, man.

Cool. Thanks, Andy. A quick disclaimer, nothing on this podcast should be considered an investment. Guests or the hosts may have positions in any of the stocks mentioned during this podcast. Please do your own work and consult a financial advisor. Thanks.