French fries remain an undisputed staple in the American eatery experience. They're ordered eight times as often as the next most popular side or appetizer in the United States. Despite the side's popularity, a product as common as french fries doesn't generally elicit thoughts of market-beating returns.
Nevertheless, Lamb Weston (LW 0.71%) aims to prove that this outperformance is possible thanks to its leadership position in the frozen potato products niche. In fact, between 2016 and 2023, Lamb Weston delivered a total return more than double that of the S&P 500 Index.
However, following a few quarters of less-than-appetizing earnings that saw the company's capital expenditures (capex) skyrocket, Lamb Weston's stock price has plunged by 30% from its highs.
So is Lamb Weston a "falling knife" that investors should avoid catching, with its capex spending spiraling out of control? Or is the french fry juggernaut a steady dividend grower available at a once-in-a-decade valuation? Here's why I'm thinking the latter.
Going global with America's favorite side dish
Building upon its leadership position in North America's frozen potato products industry, Lamb Weston is turning its attention to the international markets. Despite already being the second-largest business in the frozen potato category outside North America, Lamb Weston's international unit only accounted for 15% of the company's total sales in 2022.
On an adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) basis, this figure was an even lower 10% of the company's total EBITDA. However, management expects its newly formed international unit (all countries except the U.S., Canada, and Mexico) to account for roughly 34% of sales and 20% of adjusted EBITDA by the end of 2024, roughly doubling its 2022 totals.
These international growth ambitions are where the company's incredible ramp-up in capex over the last few quarters comes from.
LW Cash from Operations (TTM) data by YCharts
After the company expanded its manufacturing capacity at plants in the Netherlands and Argentina while building a new facility in China, Lamb Weston's capex has temporarily risen above its cash from operations, resulting in a negative free cash flow (FCF). While these expansion plans could pay huge future dividends by streamlining the company's global supply chain and allowing it to serve higher-growth markets better, this short-term pain creates a murkier investment thesis.
Making matters worse, the company is simultaneously transitioning to a new enterprise resource planning (ERP) system. And to be brutally honest, this switch hasn't gone well so far in North America. In the third quarter alone, this ERP transition affected sales volume by a negative 8% due to "reduced visibility into finished goods inventories at its distribution centers, resulting in a higher-than-expected effect on customer order fulfillment rates."
While management believes it has adjusted its deployment plans enough to avoid issues like this in the future (the transition is a multi-year process), investors will need to monitor for any further financial effects closely.
So why is now the time to buy Lamb Weston, you may be thinking? Let me explain.
Image source: Getty Images.
A buy at its once-in-a-decade valuation
Currently trading with a price-to-sales (P/S) ratio of just 1.8, Lamb Weston's valuation is the lowest it has been since it spun off from Conagra in 2016.
LW PS Ratio data by YCharts
If Lamb Weston returns to the 11% FCF margin it averaged in "normal" operating times between 2016 and 2022, it would be trading at a mere 16 times FCF. Using a reverse discounted cash flow model, we can find that a company trading at this valuation would only need to grow FCF by 4% annually to equal the market's historical growth rate of 10% annually (assuming a 3% terminal rate).
This ever-so-slightly above inflation 4% growth rate means the market expects Lamb Weston to see no further sales volume growth. Management, however, anticipates frozen potato demand to grow by 3% globally over the long term. This steady, albeit small, growth rate should help Lamb Weston soar past the market's meager expectations for the company, especially as it passes along gradual price increases similar to the inflation rate.
Best yet for investors? Lamb Weston's 1.5% dividend yield only uses 15% of the company's net income, leaving ample room for a seventh consecutive year of dividend increases and beyond.
With management projecting high-single-digit earnings growth rates over the long term -- while the market has the company priced for only 4% growth -- Lamb Weston looks like an undeniably steady operator with market-beating potential.
