Lamb Weston Holdings, Inc.

Good day and welcome to the Lamb Weston Second Quarter 2020 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Dexter Congolet, VP Investor Relations of Lamb Weston. Please go ahead.

Good morning and thank you for joining us for Lamb Weston Second Quarter 2020 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 will make some forward-looking statements about the company's 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 violence with the SEC 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 Rob McNaught, our Chief Financial Officer. Tom will provide an overview of our performance, some recent capital allocation actions, and an update on the current operating environment. Rob will then provide the details on our second quarter results and our updated fiscal 2020 outlook. With that, let me now turn the call over to Tom. TOM HANKINS- Thank you, Dexter. Happy New Year, everyone, and thank you for joining our call today. We delivered another strong quarter as we continue to execute well. Specifically, sales increased 12% behind strong volume growth and favorable price mix in each of our core business segments. EBITDA, including unconsolidated joint ventures, increased 17%, while adjusted diluted earnings per share increased 19%. And in the first half of the year, we generated $345 million of cash flow from operations. Because of our strong year-to-date results and good operating momentum, we've raised our physical 2020 outlook for both sales and EBITDA. As Dexter mentioned, I'd like to update you on some capital allocation actions we've recently taken, as well as our thoughts on the potato crop in the current operating environment. On capital allocation, in October, we acquired a 50% ownership interest in a new joint venture in Argentina. This JV will provide us better access to a strategic and growing market where we have been underrepresented. Before this investment, our market share in South America was less than 2%. While the JV is a modest-sized operation today, it provides a good base for expansion to serve the broader South American market with a low-cost, high-quality product. This should enable us to drive faster share growth over the long term. We also remain committed to reinvesting capital back in this business to support customer growth. We have added three new French fry lines since 2014. And despite these additions, our current capacity utilization is above our targeted operating rates due to recent demand growth being faster than historical averages. While we are not prepared to announce any capacity expansion projects today, we are aggressively evaluating opportunities to expand production capacity inside and outside North America to support our customers' growth. We look forward to sharing our expansion plans with you soon. In the meantime, we're actively working to stretch existing capacity by de-bottlenecking lines and driving productivity. And finally, in addition to reinvesting back into the business, we remain committed to returning capital to shareholders. Last month, we announced a 15% increase in our quarterly dividend to $0.23 a share, or $0.92 on an annual basis. That puts our dividend payout ratio at about 27% on the latest 12-month basis. We will continue to supplement our dividends with share repurchases. In the second quarter, we bought back about $8.5 million of stock, which is largely consistent with our goal to at least offset equity compensation dilution. To do so, we estimate that we need to buy back around $40 million of stock annually. Now, switching to the potato crop. Recent press reports have led to market fears of raw potato and french fry shortages. As we discussed in our last earnings call, the crop in our growing areas in the Columbia Basin and Idaho will resource the vast majority of our raw potatoes and where we have most of our production facilities is consistent with historical averages in terms of both yield and quality. As a result, we expect to operate our plants there at normal utilization rates. In Alberta, Canada, where we have one plant, crop yields and quality are below average as a result of adverse weather conditions during the growing season and harvest periods. However, we've been able to secure enough potatoes to operate that plant at normal rates. Nonetheless, overall potato availability in Alberta is limited. In Minnesota, where we have a single plant through our joint venture, Lamb Weston RDO, crop yields and quality are below average. also due to poor weather conditions during the growing season and harvest periods. As a result, potato availability in the Upper Midwest will also be limited. However, our partner in that plant is a primary supplier of raw potatoes, and they expect to provide adequate supply for the plant to operate as planned. Also, we understand that the crops in other key growing regions such as Manitoba and Prince Edward Island are below average due to adverse weather. This limits the availability of potatoes in North America. It's important to note that we do not currently source raw potatoes from these regions. So let me be clear. Given our concentration of processing facilities in the Columbia Basin and Idaho, as well as our strong grower relationships in Alberta and the Midwest, and most importantly, our decision to source open potatoes several months ago We're confident that we have raw potatoes to deliver our volume growth targets for the remainder of our fiscal year. However, potato supply in North America is tight, and this may pressure our ability to pursue incremental volume growth opportunities both domestically and internationally for this crop year. Accordingly, we will continue to evaluate opportunities to improve price and mix in each of our business segments. Now turning to Europe, the potato supply there is also expected to be challenging due to quality and late harvest weather conditions. Compared to last year's historically poor harvests, the potato crops in the Netherlands and Belgium this year are better but still below average. The crops in Germany, Poland, and the U.K. are more challenged. As a result, raw potato prices in Europe remain elevated versus historical averages but are below prices that we experienced last year. So we expect that land west of Myers performance will continue to improve compared to last year as cost pressures ease in the second half of our physical year as a result of the new crop. With respect to the operating environment, we believe that industry capacity utilization rates in North America remain elevated during the second quarter, and they will likely remain so for the remainder of our physical year subject to raw potato availability. We believe global demand growth for frozen potato products is generally favorable and will remain so through fiscal 2020. Similar to what we saw earlier in the year, U.S. demand in the second quarter continued to be underpinned by positive restaurant traffic trends, and quick service traffic growth was strong, again led by growth at chicken-based outlets. Demand in our key international markets, as well as in Europe, continues to grow in line with recent trends. Together, these factors help drive our strong volume growth in the quarter, especially in our global segment. So, in summary, we delivered a strong second quarter and first half results. We expect the overall operating environment to remain generally favorable for the balance of the year, underpinned by solid demand growth. We are well positioned with raw potatoes to deliver our volume targets. And finally, our successful execution of our strategy is generating strong cash flows, which allows us to continue to reinvest in the business to support growth and step up cash return to shareholders. Now let me turn the call over to Rob to provide the details on our second quarter results and our updated outlook. Thanks, Tom. Good morning, everyone. As Tom noted, we delivered another strong performance in the quarter and for the first half of the year. Specifically in the quarter, net sales increased 12% to $1,019,000,000, with volume growth and favorable price mix in each of our core business segments. Volume increased 10%, led by growth in our global and food service segments. Our two acquisitions in Australia, Marvel Packers and Ready Meals, added about a point and a half of volume growth. In addition, we had a couple of extra shipping days than we had in the second quarter of fiscal 2019 due to the timing of Thanksgiving. These extra couple of days contribute about another point of volume growth. As a result, this will pose a headwind to our Q3 results on a year-over-year basis. Price Mix was up 2% due to pricing actions and favorable mix. Our strong sales growth drove a $36 million, or 14%, increase in gross profit. Favorable price mix, volume growth, along with lower transportation costs drove the increase, more than offsetting the impact of higher manufacturing costs due to inefficiencies and higher depreciation expense associated with our new production line in Hermiston. In addition, the increase in gross profit included a $4 million benefit from unrealized market-to-market adjustments related to commodity hedging contracts. That's compared to a $2 million loss in the prior year period. Our gross margin percentage increased about 65 basis points to 28%. Excluding the market-to-market adjustments, it was up about 5 points. While we made a lot of progress improving our plant operating performance from the first quarter, in the second quarter we continued to incur higher than normal periods of unscheduled operating downtimes which affected our production levels. This impacted fixed cost absorption, raised overall maintenance costs, and lowered recovery rates. In addition, some of the costs that we realized in the second quarter was a carryover effect as we worked through finished goods inventories from the first quarter. Since our plants are now operating at more normal levels, we expect only a modest carryover effect from these manufacturing efficiencies in our fiscal third quarter results. SG&A expense was $92 million, an increase of about $17 million. About $6 million of this increase was related to higher incentive compensation accruals based primarily on our performance. About $4 million of the change reflects an insurance settlement that we had last year, but this was partially offset by a $2 million reduction in foreign exchange losses. About $7 million of the increase related to investments in our sales, marketing, and operating capabilities. Finally, more than $2 million of the increase was related to designing and implementing our new enterprise resource planning system. As we've previously discussed, we expect to spend about $10 to $20 million of one-time costs this year on implementing a new ERP system. To date, we've spent about $4 million, so we expect spending to ramp up in the second half of the year. Income from operations increased about $20 million, or 11% to $194 million. This reflected solid sales and gross profit growth. Equity method investment earnings from our unconsolidated joint ventures, which include Lamb, Weston, Meyer in Europe, Lamb, Weston, RDO in Minnesota, and our new joint venture in Argentina, were $15 million in the quarter. Excluding mark-to-market adjustments, equity earnings increased $6 million. largely reflecting lower raw potato prices in Europe. So putting it all together, EBITDA, including joint ventures, increased $38 million, or 17% to $261 million. Operating gains by our base business, along with contributions from the BSW consolidation and the Australian acquisitions, drove about $32 million of EBITDA growth. Our unconsolidated joint ventures added about $6 million. Moving down the income statement, interest expense was about $25 million, which is about a million below last year. Our effective tax rate was more than 23%, or about two points higher than last year due to discrete items. Turning to earnings per share, Adjusted diluted EPS was up 15 cents or 19% to 95 cents. Operating gains in our base business and higher equity earnings drove the increase. We also had an approximately 4 cent benefit from the BSW consolidation. Now let's review the results for each of our business segments. Sales for our global segment, which includes the top 100 U.S.-based change, as well as all sales outside of North America were up 15%. Volume grew 14%. The increase was driven by higher sales including increased sales of limited time offerings to strategic customers in the U.S. and key international markets. It also includes a three-point benefit from the acquisitions in Australia and a one-point benefit from the additional shipping days related to the timing of Thanksgiving. Price mix rose 1%, primarily reflecting pricing adjustments associated with multi-year contracts. Global product contribution margin, which is gross profit, less advertising and promotion expense, increased $17 million, or 15%. Volume growth, favorable price mix, and lower transportation costs drove the increase, which was partially offset by higher manufacturing costs and higher depreciation expense associated with the Hermiston line. Sales for our food service segment, which services North American food service distributors and restaurant chains outside the top 100 North American restaurant customers, increased 9%. Volume increased 5%, led by growth of distributor private label and Lamb Weston branded products. About half of the volume increase was due to the additional shipping days in the quarter. Even after adjusting for the Thanksgiving shift, we delivered our fourth consecutive quarter of volume growth as our direct sales force continued to strengthen customer relationships. Price mix increased 4%, primarily reflecting pricing actions taken in October. Food services product contribution margin increased $14 million, or 14%. Favorable price mix, volume growth, and lower transportation costs more than offset higher manufacturing costs and depreciation expense. Sales in our retail segment increased 7% driven by four points of volume growth behind increased sales of branded and private label products. About two points of the volume growth was due to the additional shipping days in the quarter. Price mix increased 3%, largely due to favorable mix and pricing actions. Retail's product contribution margin increased $3 million, or 10%. Favorable price mix and volume growth drove the increase and was partially offset by higher manufacturing costs, depreciation expense, and A&P spending. Moving to our balance sheet and cash flow, Our total debt at the end of the quarter was about $2.2 billion. This puts our net debt to EBITDA ratio at 2.6 times. With respect to cash flow, we generated nearly $345 million of cash from operations in the first half of the year. That's up about 9% versus last year, driven by earnings growth. We used about $135 million towards acquisitions, including a $17 million initial payment for our half of the new joint venture in Argentina. We also invested nearly $110 million combined in capital expenditures and IT-related projects. In addition, we bought back more than $13 million of stock and paid $59 million in dividends to our shareholders. Turning to our updated fiscal 2020 outlook, as Tom noted, because of our strong first half performance, we've raised our sales and earnings outlook for the full year. As a reminder, our targets include the contribution of a 53rd week that will benefit the fourth quarter. Overall, we continue to be prudent when updating our annual outlook. For the full year, we're now targeting sales to grow at the high end of our original mid to high single digit rate range. We continue to expect that sales will be primarily driven by volume and it will deliver price mix increases to offset input cost inflation. As you know, we delivered 10% sales growth in the first half, including a 2% higher price mix and robust 8% volume growth. We expect our volume growth will moderate in the second half

for a number of reasons.