Lamb Weston Holdings, Inc.

Good day and welcome to the Lamb Weston third quarter 2021 earnings call. Today's call is being recorded. At this time, I'd like to turn the call over to Dexter Congolet, VP Investor Relations of Lamb Weston. Please go ahead.

Good morning and thank you for joining us for Lamb Weston's third quarter 2021 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 Warner, our President and Chief Executive Officer, and Rob McNutt, our Chief Financial Officer. Tom will provide an overview of the current operating environment and our recently announced investment in China, while Rob will provide some details on our third quarter results, as well as some shipment trends for the fourth quarter. 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 delivered solid sales volumes in the third quarter as restaurant traffic and consumer demand improved as governments gradually eased social and on-premise dining restrictions in some markets. While still down year-over-year, the rate of volume decline improved sequentially in both the U.S. and in our key international markets from what we realized during the first half of our physical year. Again, this was largely in response to government's easing restrictions as the quarter progressed and demonstrates that consumers are ready to go out as restaurants expand dining capacity. Specifically, overall restaurant traffic in the U.S. was between 85 and 90 percent of pre-pandemic levels. Traffic at large quick-service chain restaurants continued at roughly prior-year levels as they leveraged drive-through, take-out, and delivery formats. After a slow start to the quarter, traffic at full-service restaurants recovered to 70% to 80% of prior year levels. Traffic began to pick up later in the quarter as some governments gradually lifted social and dining restrictions that were put in place due to the resurgence of COVID. And as a relatively mild winter weather provided more outdoor dining opportunities. While we expect this momentum will continue, we're mindful that some of this performance may be due to customers and distributors restocking inventories prior to an expected boom in restaurant traffic in coming months. In contrast, demand at non-commercial customers, which includes lodging and hospitality, healthcare, schools and university, sports and entertainment, and workplace environments, remain around 50% of prior levels for the entire quarter. We're confident that demand from these customers will return, but realize that recovery to pre-pandemic levels may take some time as governments slowly lift restrictions for larger gatherings. In retail, demand in the quarter was strong, with weekly category volume at 115% to 125% of prior year levels as consumers continue to eat more meals at home. Outside the U.S., restaurant traffic and fry demand has been mixed. In Europe, which is served by our Lamb, West, and Meyer joint venture, fry demand in the quarter was 80% to 85% of prior year levels. However, we believe that demand rate is likely to soften as governments reimpose severe social restrictions in response to the resurgence of COVID infections. Demand in most of our international markets in Asia, Oceania, and Latin America improved in the quarter. Our shipments in China were strong. Demand in our other key markets, in the aggregate, remain below prior year levels, but continue to improve sequentially versus the first half of the year, as well as in each month of the quarter. So while demand in Europe remains soft, we feel good about the demand trends in the U.S. and most of our key international markets, and we expect governments will continue to gradually roll back social restrictions in the months ahead as more of their citizens get access to vaccines. This should serve to unlock pent-up consumer demand to visit restaurants and other food service outlets and ultimately demand for fries. As a result, we remain optimistic that overall frozen potato demand will steadily approach pre-pandemic levels on a run rate basis by the end of calendar 2021. The progress we made on sales volume in the quarter was offset by the pandemic's continued effect on our supply chain operations. As Rob will discuss later, COVID-related disruptions significantly affected our production, transportation, and warehousing networks, leading to significantly higher costs as we focused on customer service while dealing with the pandemic's impact in some of our communities and workforce. In addition, decisions that we made in the first half of the year to defer certain capital repair and maintenance projects further reduced our flexibility to manage disruptions and drove incremental manufacturing and distribution costs. So in summary, in the third quarter, we delivered solid top-line results. Operating in a pandemic environment has been and will continue to be challenged, and we expect it will continue to incur higher costs across our supply chain in the near term. Before I turn the call over to Rob, let me review a couple of items. First, we'll provide our normal update for this year's potato crop when we report earnings in July and October. Second, as you may have seen a couple of weeks ago, we announced that we're building a new French fry processing facility in China at a total investment of around $250 million. This green-filled facility will complement our plant, Chengdu, and is expected to add about 250 million pounds of frozen potato product capacity. We anticipate starting up the plant sometime during the back half of calendar 2023. We chose to build this plant in China because it's a fast-growing 1 billion pound plus market and a key driver to our international growth. This new plant enables us to support customers in China using in-country supply, which is something that our larger customers there increasingly want as they continue to expand. In addition, our new facility will allow us to further diversify our manufacturing base and mitigate risks of potential trade disruptions as we look to drive international growth. So, in summary, in the third quarter, we delivered solid top-line results as demand continued to gradually recover, but incremental costs related to pandemic-related disruptions pressured earnings. We expect that the increasing availability of COVID vaccines and the easing of government-imposed social restrictions will allow restaurant traffic to gradually improve as the year progresses. And we remain optimistic that overall frozen potato demand will approach pre-pandemic levels on a run rate basis by the end of calendar 2021. Now let me turn the call over to Rob. Thanks, Tom. Good morning, everyone. As Tom noted, in the third quarter, we delivered solid sales results as overall demand continued to improve, but the pandemic's disruptive impact on our manufacturing and distribution operations significantly increased our costs. Specifically in the quarter, net sales declined 4% to $896 million. Sales volume was down 6%, largely due to the pandemic's impact on fry demand, but improved through the quarter after a slow start. Importantly, that rate of volume decline improved sequentially from the 14% decline that we realized during the first half of fiscal 2021. Most of the sequential improvement was within our global segment and largely reflects a steady recovery in shipments in our key international markets. Stronger sales of limited-time offering products in the U.S. also contributed to the global segment's recovery. In addition, we saw a sequential improvement in our food service segment led by casual dining, as well as continued strength by our branded offerings in our retail segment. Price mix increased 2%. Improved price in our retail and food service segments, as well as favorable mix in retail, drove the increase. Price was up in our global segment, although this was offset by negative mix. Gross profit declined $54 million as lower sales and higher manufacturing and distribution costs more than offset the benefit of favorable price mix and productivity savings. Let's focus on cost of goods sold. As Tom noted, the higher costs were largely a result of the pandemic's disruptive impact across our supply chain. The resurgence of COVID in many of the communities where our plants are located greatly affected our manufacturing workforce. At times, the combination of infected and quarantined employees significantly affected our ability to staff production lines and other key roles at a number of our facilities. The consequences were, first, we lost days of production, which resulted in a number of our plants operating well below normal utilization rates and reduced our ability to cover fixed overhead costs. In addition, Recall that a year ago, we decided to continue paying employees despite production lines being down due to COVID. While we believe that was the right thing to do to support our production teams, it has had an impact on our cost structure. Second, focusing on maintaining customer service levels required us to quickly adjust production schedules to accommodate workforce and manufacturing line availability. This drove incremental costs and inefficiencies. In many cases, we shifted production from one facility to another, even though the alternate facility may not be the most effective in terms of cost or throughput for that specific product. That negatively impacted line speeds, throughput, and raw potato recovery rates. And third, the number of effective employees and facilities meant that we incurred even more costs related to temporary shutdown and restart of manufacturing facilities. Compounding these disruptions in the quarters were our decisions to defer certain capital repair and maintenance projects on our production lines that were originally scheduled for the first half of fiscal 2021. We'd planned on undertaking these capital and maintenance projects once the demand environment and our operations were more stable during the second half of the year. While deferring these projects was prudent in light of the uncertainty surrounding COVID, Executing them that same time as another COVID wave impacted our plants led to additional disruption in our manufacturing capabilities and further limited our flexibility to adjust production schedules across our network. This drove additional costs and inefficiencies on top of the staffing-related issues I described. The pandemic-induced volatility of our production facilities also had a downstream impact on our transportation and warehousing operations. We generally prefer to rely on rail more than trucking to move product from our production facilities and warehouses to our distribution centers and customers across the country. However, late changes to production schedules required us to switch significant volume from rail to trucking. which is more flexible but also higher cost in an effort to maintain customer service levels. In addition, we typically employ trucks using contracted carrier rates as opposed to securing spot trucking, which tends to be higher cost. Spot trucking has also had significant rate increases over the past six months, but because of the disruption to our production schedules and, again, to prioritize customer service, we lean more on expensive spot trucking. So our transportation costs significantly increased because of an unfavorable mix of rail and trucking, as well as an unfavorable mix of contracted and spot trucking. As you would expect, our warehousing costs also increased with the additional handling required across our distribution network. Finally, while the pandemic-related effects on our supply chain were the primary drivers of our cost increases, We also realize higher costs due to input cost inflation in the low single digits. We expect that rate will begin to tick up in the coming quarters as edible oil and transportation costs continue to increase. While our costs were higher in the quarter, we are starting to see the benefits of our supply chain teams work around a series of initiatives we call Win as One. These initiatives build upon the land west and operating culture productivity programs that we have in place. Broadly speaking, Win as One seeks ways to reduce our variable and fixed cost, increase production throughput on existing assets, and improve working capital, especially inventories. In the couple of the plants where the team has implemented these new ways of working, asset utilization is at or above pre-pandemic utilization rates. and we're seeing the benefit in the cost structures in those facilities. As the team continues to roll out these programs to the rest of the network, and as infection and quarantine rates decline through vaccination programs we're supporting for our production employees, we expect our cost structure and utilization rates will begin to normalize. Longer term, we expect these initiatives to enhance margins, drive cash flow, and strengthen our culture of continuous improvement. Since we only began to roll out Win as One at a couple of our plants a few months ago, we're not providing any specifics on activities or targets today. We anticipate giving investors more insight into this program as we gain more traction. Moving to the segments, moving on from cost of sales, excuse me, our SG&A increased $8 million in the quarter. The increase was largely due to investments we're making behind the Win as One initiatives I just described. Equity method earnings were $11 million. Excluding the impact of unrealized mark-to-market adjustments and a comparability item in the prior year quarter, equity earnings declined about $11 million. Two factors drove the decline. First, fry demand in Europe fell as much as the region remained in lockdown and as colder weather affected outdoor dining. Second, our joint ventures also realized higher production costs related to COVID disrupting their manufacturing and distribution operations. Adjusted EBITDA, including joint ventures, was $167 million, which is down $61 million. Lower income from operations drove the decline. Adjusted diluted EPS in the quarter was 45 cents, which is down 32 cents. mostly due to lower income from operations. EPS was also down due to higher interest expense reflecting our higher average total debt, resulting from actions we took in late fiscal 2020 and early fiscal 2021 to enhance our liquidity position. Now moving to our segments, sales for our global segment, which generally includes sales for the top 100 North American-based QSR and full-service restaurant chains, as well as all sales outside of North America, were down 2% in the quarter. Volume was down only 2%, which is much better than the minus 12% we realized during the first half of fiscal 2021. Shipments to large chain restaurant customers in the U.S., of which approximately 85% are to QSRs, increased nominally versus prior year. QSRs continued to perform well as they continued to leverage drive-through and delivery formats. As I mentioned earlier, US QSRs were also aided by the return of some noteworthy limited-time product offerings. International shipments, which historically comprise about 40% of the segment's volume, were about 95% of prior year levels in the aggregate. That's up from around 75% of prior year levels that we realized during the first half of fiscal 2021. In the third quarter, shipments in China were strong versus a prior year when demand was negatively impacted by COVID. Shipments to our other key markets strengthened as the quarter progressed and were generally stronger in developed markets than emerging ones. Price mix was flat, with positive price offset by unfavorable mix. Global's product contribution margin, which is gross profit less A&P expense, declined 27% to $79 million. Higher manufacturing and distribution costs, as well as unfavorable mix, drove the decline. Sales for our food service segment, which services North American food service distributors and restaurant chains generally outside the top 100 North American restaurant customers declined 22%. Volume declined 24%. After a slow start, shipments to smaller chain and independent full-service and quick-service restaurants recovered to about 90% of prior year levels for the entire quarter as governments gradually eased social and indoor dining restrictions. We believe that some of the sales volume strengthening during the last few weeks of the quarter may reflect distributors restocking inventory in anticipation of more governments lifting social restrictions in the spring. However, it's difficult to gauge the extent of that benefit. In contrast, shipments to noncommercial customers remained at around 50% of prior year levels, with continued strength in healthcare more than offset by weakness in other channels such as travel, hospitality, and education. Price mix increased 2% behind the carryover pricing benefit of pricing actions we took in the second half of fiscal 2020. This was partially offset by unfavorable mix versus a prior year due to lower sales of premium products. As we've discussed in previous earnings calls, We've regained much of this business since the pandemic first struck last spring, but on a year-over-year basis, it remained a mixed headwind for the quarter. Food services product contribution margin declined 30% to $70 million. Lower sales volumes, higher manufacturing and distribution costs, and unfavorable mix drove the decline and was partially offset by favorable price. Sales for our retail segment increased 23% with volume up 13%. Sales of our branded portfolio, which include Alexia, Grown in Idaho, and licensed restaurant trademarks, were up about 45%, continuing the strong growth trend we've seen since the start of the pandemic and well above category volume growth rates that have been between 15% and 25% in the quarter. The increase in our branded volume was partially offset by the loss of certain low-margin private label volume, which will continue to be a headwind on volume through the remainder of the fiscal year. Price mix increased 10%, primarily reflecting the favorable mix benefit of selling more of our higher-margin branded products. Retail's product contribution margin increased 15% to $33 million. The increase was driven by favorable mix and was partially offset by higher manufacturing and distribution costs, as well as a $1 million increase in advertising and promotional expense. Moving to our cash flow and liquidity position, we continue to be comfortable with our liquidity position and confident in our ability to continue to generate cash. At the end of the third quarter, we had nearly $715 million of cash on hand, and our revolver was undrawn. Our total debt was more than $2.7 billion, and our net debt to EBITDA ratio was about 3.5 times. In the first three quarters of fiscal 2021, we generated nearly $375 million of cash from operations, which is down about $60 million versus last year due to lower sales and earnings. We spent $107 million in CapEx, and paid $101 million in dividends. In addition, in the third quarter, we resumed our share buyback program and bought back nearly $13 million worth of stock at an average price of just over $77 per share. Now turning to our current shipment trends. Please note that instead of providing a comparison to last fiscal year's fourth quarter, we're providing comparisons to the fourth quarter of fiscal 2019. We're doing this since fourth quarter fiscal 2020, which includes March, April, and May of 2020, includes the severe impact of government-imposed social restrictions at the beginning of the COVID pandemic. It was also the height of personal and economic uncertainty for many businesses and individuals. As such, we believe the fourth quarter of fiscal 2019 provides a more meaningful comparison for investors to understand the current condition of our business. Broadly speaking, we're optimistic about the recent restaurant traffic and shipment trends in the U.S. and many of our key international markets other than Europe. U.S. shipments in the four weeks ending March 28th were approximately 90% of levels during a similar period for the fourth quarter of fiscal 2019. In our global segment, shipments to our large QSR and full-service chain restaurant customers in the U.S. were more than 85% of fiscal 2019 levels, and we expect that rate will largely continue for the remainder of the fourth quarter. In our food service segment, shipments to our full-service restaurants, regional and small QSRs, and noncommercial customers in aggregate were approximately 90% of fiscal 2019 levels. We anticipate that shipments for these customers will largely continue at similar rate for the remainder of the fourth quarter. Shipments to non-commercial customers, which have historically comprised about 25% of this segment's volume, remain at around half of fiscal 2019 levels. We expect these shipment rates will likely remain soft for the rest of the quarter, and will likely take time to fully recover to pre-pandemic levels. In our retail segment, shipments were approximately 110% of fiscal 2019 levels, with strong volume growth of our branded products partially offset by a decline in shipments of private label products. We believe this rate may gradually decline during the remainder of the fourth quarter as consumers begin to shift purchases of fries to dining at restaurants as governments lift social restrictions. Outside the U.S., overall demand varies by market. In Europe, shipments by our Lamb, West, and Meyer joint venture were about 85% of fiscal 2019 levels. Demand has softened over the past few months as governments in some of our larger markets, such as Italy and France, reimposed stricter social restrictions to combat a resurgence in COVID infections. In addition, other than in the UK, vaccination efforts across Europe have lagged well behind rates in the US. As a result, we anticipate shipments may slow during the remainder of the fourth quarter. Shipments to our other international markets, which primarily include Asia, Oceania, and Latin America, were approximately 75% of fiscal 2019 levels in aggregate. As I discussed earlier, international shipment rates have steadily improved over the past few months, and we expect that will continue during the remainder of the fourth quarter as governments slowly ease social restrictions and as the current congestion at shipping ports begins to clear up. For those markets that are currently already operating under more lenient social restrictions, we anticipate that current shipment rates for those countries will largely remain at current levels. In short, although Europe is challenging, we believe overall shipment and restaurant trends in the U.S. and most of our international markets will remain favorable as governments continue to roll back social restrictions and vaccine becomes more widely available. These trends will keep us on a path of steady progress in restaurant traffic, which we believe will lead to overall frozen potato demand approaching pre-pandemic levels on a run rate basis by the end of calendar 2021. With respect to costs, in the fourth quarter, we expect to incur a similar level of incremental pandemic-related manufacturing distribution costs as we did in the third quarter. We experienced significant disruption in our production facilities transportation warehousing networks in January and February and this continued into March. We will realize some of the costs related to these disruptions in the fourth quarter as we ship finished goods inventory produced during these months. Now here's Tom for closing comments. Thanks Rob. Let me just quickly sum up by saying We continue to prioritize ensuring the health and safety of our employees during these challenging times by adhering to strict COVID protocols in all of our manufacturing locations and encouraging all our workers and their families to get vaccinated as soon as possible. We're confident that the near-term pandemic-related pressures on our manufacturing and distribution networks are temporary and that our cost structure will normalize once we get past COVID. In addition, we believe that the investments we're making in our supply chain will improve our cost structure over the long term. We feel good about the trends in restaurant traffic and frozen potato demand in the U.S. and most of our key international markets. and remain optimistic that overall frozen potato demand will approach pre-pandemic levels on a run rate basis by the end of calendar 2021. And finally, as shown with our investments for a new facility in China and to expand chopped and formed capacity in Idaho, we're focusing on the right strategic and operating priorities to serve our customers and build upon the long-term health of the category in order to create value for all our stakeholders. Thank you for joining us today. Now we're ready to take your questions.