Good day, everyone. Thank you for standing by. Welcome to the Lamb Weston third quarter 2019 earnings call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Dexter Congbalay, VP Investor Relations of Lamb Weston. Please go ahead, sir.
Good morning. Thank you for joining us for Lamb Weston's third quarter 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 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 filings 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 McNutt, our Chief Financial Officer.
Tom will provide an overview of our performance and some updates on the operating environments in North America and Europe. Rob will provide the details on our third quarter results and our updated fiscal 2019 outlook. With that, let me now turn the call over to Tom.
Thank you, Dexter. Good morning, everyone. Thank you for joining our call today. I'm pleased to say that we're continuing to successfully execute on our strategies as we leverage our advantage global platform to serve our chain restaurant, food service, and retail customers. We have a good operating momentum in each of our channels and remain committed to investing back in our business to support long-term growth and create value for all our stakeholders. In the third quarter, we delivered solid results despite facing difficult year-ago comparisons and a challenging operating environment in Europe. Our top-line growth of 7% was driven by solid mix of volume and price mix in our global and food service segments. Adjusted EBITDA, including unconsolidated joint ventures, was also up 7%. Through the first nine months of the year, we generated about $445 million of cash flow from operations.
Because we delivered another solid quarter and have built good operating momentum, we've again raised our fiscal 2019 outlook. We now expect sales to increase high single digits and EBITDA, including unconsolidated joint ventures, to be $895 million to $905 million. Our third quarter results reflect the continued strong execution and focus by our commercial, supply chain, and functional teams. Our global team continued to work closely with our large chain customers to drive growth across our key markets. This included driving incremental growth from limited time offers both in the U.S. and Asia, winning new business from a fast-growing regional quick serve restaurant chain, and supporting customers affected by the short crop in Europe. Our food service direct sales team has been improving mix by increasing sales of Lamb Weston branded products.
As part of that, the team has been working with a number of small and regional chain customers on trials for Crispy on Delivery, a unique fry that we created specifically for restaurant delivery. Customer trials so far have been very successful, with sales volumes greater than expected, along with strong consumer response. We're looking to expand these trials and leverage our new direct sales force to broaden our Crispy on Delivery footprint. In fact, we're gaining traction on expanding our Crispy on Delivery customer base beyond traditional burger and chicken QSRs to include movie theaters and lodging for room service. Our retail team continued to build momentum with a strong increase in shipments of branded retail products, including Grown in Idaho . It continues to gain distribution, and we're increasing support with a national advertising campaign and targeted digital marketing efforts.
In supply chain, our teams overcame extreme weather challenges in the Pacific Northwest, as well as disruption to some key inputs. The teams delivered strong performances in our manufacturing plants and implemented transportation workarounds to minimize supply interruptions to customers, all while continuing to drive costs and productivity savings. In addition, the team has our new 300-million-pound production line in Hermiston, Oregon, on track to be operational this May. Our functional teams also continued to execute well. Our investments to upgrade our IT, sales, marketing, and operating capabilities also remain on schedule, as does the integration of Marvel Packers, the Australian potato processor we acquired in December. Now turning to our operating environment. In North America, we expect the environment to remain generally favorable through the rest of fiscal 2019 as demand growth continues to be solid.
In addition, as Rob will discuss later, despite higher potato costs, we expect inflation will remain modest as a result of lower than anticipated production and logistics costs. In Europe, the effect of the historically poor potato crop on the operating environment is playing out largely as we expected. The short crop has resulted in sharply higher potato costs for our Lamb-Weston/Meijer joint venture and for the industry, and that will persist through fiscal 2019 into the first half of fiscal 2020. While the effect of these higher potato costs was pronounced in Lamb-Weston/Meijer 's third quarter results, they were in line with our expectations.
We continue to anticipate that higher prices and cost savings initiatives should steadily begin to offset the effect of higher potato costs over the next couple of quarters. In addition, our teams in Europe and the U.S. will continue to work closely to leverage our global capabilities to serve existing customers affected by the short crop, as well as to evaluate and support potential opportunities as they arise over the coming months. As you can see, we delivered another quarter of solid results by focusing on our strategies, executing well across the organization, and working through some near-term challenges. We feel good about our performance and the operating momentum we've built, and it has enabled us to once again raise our financial targets. Let me turn the call over to Rob to provide the details on our results and our updated outlook.
Thanks, Tom. Good morning, everyone. As Tom noted, we're pleased with our results for the quarter, as solid results in our base business more than offset softness in Europe. Specifically, in the quarter, net sales increased 7% to $927 million, driven by a good balance of favorable volume and price mix. Volume increased 4%, led by growth in our global segment. Price mix was up 3% due to both pricing actions and improved mix. Some of our growth reflects the impact of a new accounting standard that we adopted at the beginning of this fiscal year. Specifically, the new standard affects when we recognize sales of customized products, which we define as products that we manufacture using a customer's unique recipe, such as a McDonald's french fry or a limited time offering product that's made for a single customer.
Under the new standard, we recognize revenue for customized products at the time we have a legally enforceable right to payment, which is once we've manufactured the product and have received a customer purchase order. Since sales of customized products are generally recurring, there hasn't been much of an impact on a quarter-to-quarter basis. However, in the third quarter, we received a higher number of purchase orders for customized products. In short, the effect of the new standard is all timing, which may create incremental quarter-to-quarter volatility. Gross profit increased $31 million, or 13%, to $273 million. Overall higher prices, favorable mix from increased LTO activity, volume growth, and supply chain efficiency savings drove the increase, more than offsetting the impact of relatively modest material input, manufacturing, and transportation cost inflation. The increase in gross profit also reflects a $4 million gain in unrealized mark-to-market adjustments related to hedging contracts.
This compares to a $1.3 million loss in the prior year period. Our gross margin percentage expanded 140 basis points to more than 29%. Excluding the mark-to-market adjustments, gross margin expanded by 90 basis points. As you may recall, when we updated guidance after the second quarter, we indicated that there could be some pressure on gross margin percentage in the back half of this fiscal year, due in part to accelerating cost inflation coupled with more modest pricing. However, despite low-to-mid single-digit increase in raw potato cost, overall cost inflation was lower than we had anticipated in the third quarter. This was a result of very strong execution by our supply chain teams, coupled with prices of some key inputs breaking our way.
Specifically, we capitalized on contract structures for edible oils that allowed us to enjoy the benefits of falling prices during the quarter while limiting exposure to price increases. As oil prices dropped during the quarter, we realized the benefit, including the unrealized mark-to-market impact contracts that will settle in future periods. We mitigated transportation cost inflation in part by implementing new software tools that helped us more efficiently optimize the mix between rail and trucking. We continued to leverage our Lamb Weston operating culture to drive efficiencies at our manufacturing facilities. As a result of these supply chain initiatives, we expect cost inflation will remain relatively modest in the fourth quarter. SG&A expense, excluding items impacting comparability, increased about $8 million to $80 million. The increase in SG&A was due to investments in our sales, marketing, operating, and information technology capabilities to support growth and drive operating efficiencies.
In addition, advertising and promotional expense was up about $1 million. IT costs continued to build in the third quarter, and we expect them to rise further in the fourth quarter and into fiscal 2020 as we build and implement a new ERP system. Adjusted operating income increased $23 million, or 13%, to $194 million. As I've just outlined, this was driven by strong sales and gross profit growth. Equity method investment earnings from our unconsolidated joint ventures, which include Lamb-Weston/Meijer in Europe and Lamb- Weston/RDO Frozen in Minnesota, were $14 million. Excluding mark-to-market adjustments related to hedging contracts, equity earnings were down about $9 million, largely due to higher raw potato costs and lower sales volumes in Europe associated with the poor crop. Putting it all together, Adjusted EBITDA, including the proportional EBITDA from our two unconsolidated joint ventures, increased $16 million or 7% to $253 million.
Simply put, about $26 million of our EBITDA growth was driven by operating gains in our base business, plus another $4 million from the acquisition of the remaining interest in our Lamb Weston BSW joint venture. This was partially offset by a $14 million decline in EBITDA from unconsolidated joint ventures. Moving down the income statement, interest expense was about $27 million, which is a decline of more than $1 million due to lower average total debt. Our effective tax rate, excluding the impact of comparability items, was about 22%, up from about 19% last year. As you may recall, our relatively low tax rate in Q3 last year was related to the timing of implementing U.S. tax reform. Turning to earnings per share, adjusted diluted EPS was up $0.04 to $0.95.
The increase was driven by operating gains in our base business, which included a $0.02 benefit related to additional sales of customized products under the new revenue standard, partially offset by lower equity earnings and higher taxes. Let's review the results for each of our business segments. Sales for our global segment, which includes the top 100 U.S.-based chains, as well as all sales outside of North America, were up 11%. Price mix rose 2%, primarily reflecting pricing adjustments associated with multi-year contracts. Volume grew 9%, with about four points related to the additional sales of customized products under the new revenue standard.
As Tom mentioned, we delivered the remaining five points of volume growth by driving increased sales of limited time product offerings in both Asia and the U.S., sales to new chain restaurant customers, and increased sales to strategic customers in the U.S. and key international markets, including to customers affected by the short crop in Europe. We're very pleased with Global's high-quality volume growth in the quarter, especially as we lapped the 6% volume growth that we delivered in the prior year. Global's product contribution margin, which is gross profit less advertising and promotional expense, increased $15 million or 13%. Its contribution margin percentage expanded by 50 basis points. Favorable price mix, volume growth, including the benefit of additional sales of customized products under the new revenue standard, as well as supply chain efficiency savings, drove the increase, which was partially offset by modest cost inflation.
Sales for our Food Service segment, which services North American food distributors and restaurant chains outside the top 100 North American restaurant customers, increased 5%. Price mix increased 4%, reflecting the benefit of pricing actions initiated in fall 2018, as well as improved mix. Volume increased 1%, led by growth of Lamb Weston branded products. Food Service's product contribution margin increased $5 million or 6%, and contribution margin percentage expanded by 40 basis points. The increases were driven by favorable price mix and supply chain efficiency savings and were partially offset by modest cost inflation. Sales in our Retail segment fell 1%. Price mix increased 1%, largely due to improved mix. As expected, volume declined 2% as we lapped the 22% volume growth that we delivered in the third quarter of fiscal 2018.
As you may recall, Q3 last year benefited from the timing of private label product shipments from the second quarter, as well as distribution gains of Grown in Idaho and other branded products. In the current quarter, we continue to improve mix by driving mid-teens growth in our branded products, led by Grown in Idaho . Retail's product contribution margin declined $1 million or 4% as input manufacturing, transportation cost inflation, along with lower volumes and modestly higher advertising and promotional expense, more than offset favorable price mix. As a result, product contribution margin percentage fell 70 basis points. Moving to our balance sheet and cash flow, our total debt at the end of the quarter was about $2.5 billion. This puts our net debt to adjusted EBITDA ratio at 3x.
We continue to target a leverage ratio of 3.5-4x and remain comfortable being below that range as we continue to explore potential acquisition opportunities. With respect to cash flow in the first nine months of the year, we generated about $445 million of cash from operations, which was driven by the strong earnings growth. That's up from $310 million during the first nine months of fiscal 2018. Our priorities in deploying that cash remain the same. Our top priority is to continue to invest in our business, and we've spent about $245 million so far this year on capital expenditures, including the construction of our new fry line in Hermiston, Oregon. As Tom mentioned, the Hermiston line is on track to be operational in May. Another top priority is acquisitions.
This year, we've expanded our global footprint with the acquisition of Marvel Packers for about $89 million, and completed the purchase of the remaining interest in Lamb Weston BSW for $78 million. Finally, we're returning cash to shareholders, including paying $84 million in dividends in the first nine months, and repurchasing nearly 110,000 shares for about $8 million. Turning to our updated fiscal 2019 outlook, we're confident in our ability to continue our good operating momentum as we close out the year. As a result, we've raised our sales and earnings outlook for fiscal 2019. After posting strong results in the third quarter, we now expect sales to grow at high single-digit rate up from our previous estimate of mid to high single digits. This implies mid to high single-digit sales growth in the fourth quarter.
For earnings, we've raised our target for adjusted EBITDA, including unconsolidated joint ventures, to a range of $895 million-$905 million, up from a range of $870 million-$880 million. Versus last year, that's an increase of about $80 million or nearly 10% at the midpoint of the new range. Sales and gross profit growth are driving the increase. For the full year, we're still targeting gross profit growing at least in line with sales, with favorable price mix and productivity more than offsetting higher transportation, input, and manufacturing cost inflation, as well as higher depreciation expense. Previously, we anticipated that gross profit growth may lag sales growth in the second half of the year due to increased inflation and the potential for unfavorable mix. However, as I described earlier, the impact of input and transportation inflation has been lighter than expected, and our manufacturing facilities have been performing well.
This, along with solid top-line growth, enabled us to drive strong gross margin expansion in the third quarter. For the fourth quarter, we expect inflation to remain relatively modest in our manufacturing facilities to continue to deliver operating efficiencies. As a result, we expect gross profit growth will likely be at least in line with sales growth, even after absorbing around $3 million of startup costs associated with our Hermiston production line. Regarding SG&A, in the fourth quarter, we anticipate investments in our sales, marketing, innovation, operations, and IT capabilities will continue to build, especially as we begin to step up spending behind our ERP system. As we've previously noted, we expect spending behind these investments will continue to be elevated for a couple of years.
We continue to target total SG&A, excluding advertising and promotional expense, to return to a range of 8%-8.5% of sales over the long term. For equity earnings, as Tom mentioned, the effect of the short crop in Europe is playing out largely as we had anticipated. In the fourth quarter, we expect equity earnings will decline versus the prior year, largely due to higher potato costs and lower sales volumes. Looking at our updated outlook at a high level, we're targeting high single-digit sales growth for the full year. In the fourth quarter, we expect to drive mid to high single-digit sales growth with a good overall balance of volume growth and improved price mix. For earnings, we expect to deliver adjusted EBITDA, including unconsolidated joint ventures, of $895 million-$905 million for the year.
In fourth quarter, sales and gross profit growth in our base business will drive the increase and will be tempered by higher investments in SG&A and softer results in Europe. We also expect to have about a $4 million benefit from the acquisition of the other half of our BSW joint venture. We also made changes to a couple of our other financial targets. For taxes, we now expect an effective tax rate for the full year of 22%-23%. That's down from our previous estimate of 23%. For the fourth quarter, we continue to anticipate it will be about 24%. For capital expenditures, we're now targeting it to be around $350 million, down slightly from our previous estimate of about $360 million.
Our other financial targets for the full year remain the same, including total interest expense of around $110 million, total depreciation and amortization expense of approximately $150 million. Let me turn the call back over to Tom for closing comments.
Thanks, Rob. Let me quickly sum up by saying we're pleased with our results in the quarter and are confident that we'll finish the year on a strong note. We're executing well across the organization and have built good operating momentum in each of our core segments. We remain laser-focused on executing on our strategies of investing to support long-term growth and create value for all our stakeholders. I want to thank you for your interest in Lamb Weston, and we're now happy to take your questions.
Thank you. If you would like to ask a question, please signal by pressing *1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press *1 to ask a question, and we'll pause for just a moment to allow everyone an opportunity to signal for questions.
We'll go first to Bryan Spillane with Bank of America.
Hey, good morning, everybody.
Good morning, Bryan.
Just two questions from me. I guess first, as we're kind of looking at the situation in Europe and thinking about it, I guess, for 2020, can you elaborate a little bit more on just how you see sort of the potential kind of crop conditions or plantings? Are there enough seed potatoes? Is there anything else that might sort of drag this supply issue into 2020? Then also, if you could talk a little bit about the opportunity to fill some of the supply gaps in Europe out of North America, how that's progressed.
Bryan, it's Tom. In terms of potato seed and crop and planning, all those kind of things, it's no concern about seed. I would say, excuse me. We're early in the planning, we feel good about our growers and how that's progressing. As I do every year, further down the year, we'll give an update on how the crop's progressing, not only in Europe but across North America. I think your other question in terms of how this is going to play out, it's going to pressure the business, as we've stated. Obviously, you've seen the results in Q3. They're in line with our expectations. It's going to continue in Q4 through the first half, we'll progressively improve based on cost initiatives and pricing that'll start flowing through the P&L. It's definitely going to be impactful through the first half of 2020, as we've stated.
The last part to your question, we've got ourselves positioned with our book of business between Europe and U.S. supporting some of the European customers out of our U.S. operations. Right now, I've stated I think there's going to be some opportunities. It's still early. It still has to play out. I believe we may get some opportunities, right now, we've had nothing material that's been brought to our attention.
Okay. Thanks for that. Just as a follow-up, one of the questions we've got a lot in the last few weeks has been just concern with the capacity coming into North America that it is maybe going to put some pressure on prices and potentially margins. I guess as you're kind of looking at the landscape as it sits right now, is that something that you're concerned about at this point? Has anything really changed in terms of the environment?
As of right now, there's been some capacity come on. It has not materially impacted our business. We are obviously monitoring it. We've got capacity coming on in May. A part of this too, again, is going to normalize run rates back to a more sustainable level. I suspect this fall we may have pressure in pockets, we're going to continue to execute pricing discipline in the market and let things play out. I think it'll be immaterially impactful in the near term.
Okay, great. Thank you.
We'll go next to Chris Growe with Stifel.
Hi, good morning.
Chris. Morning, Chris.
Hi. Good morning. Just had a question for you. I wanted to better understand the limited time offering performance in the quarter and the mix effect. It sounds like that was positive year-over-year against exceptionally tough comparisons. I wanted just to understand kind of how that played out and what that meant to mix, maybe to a degree to margins. Can that continue in the fourth quarter? Are you seeing a continuation of the strong LTO performance you think continuing into Q4?
Chris, it's Tom. We had several LTOs that were planned in the quarter. As we always do, we take a conservative view of how those are going to perform. Had a couple domestically, an international LTO that exceeded our expectations. We won't get into how things are shaping up in the next quarter. Again, the LTOs performed better than we expected. Every year, we're going to have LTOs in our business periodically. We always take a conservative view.
Okay. Just a question for you on the gross margin, somewhat following on that question, I guess. The gross margin was much stronger than I expected in the quarter. You had a favorable mix performance as well. You indicated that you expected to be about or at least in line with sales growth for the year. Given the performance to date, is there anything unique to the fourth quarter we should be aware of or anything that could be pressuring the gross margin in the fourth quarter that could keep the expectation for the year down a bit?
Chris, it's Rob. Typically, as you know, that fourth quarter, the raw costs tend to be higher than in the third quarter. Third quarter tends to be the most attractive just because of storage cost and the aging of the raws. Beyond that normal seasonality, we don't see anything in the fourth quarter that's going to pressure margins.
Okay. Thank you for the time.
Hey, Chris, we said we're going to have about $3 million of start-up costs related to Hermiston in our prepared remarks, so something else just to remember.
Okay. That's helpful. Thank you, Dexter.
We'll go next to Adam Samuelson with Goldman Sachs.
Yes, thanks. Good morning, everyone.
Morning, Adam.
I was hoping to go back, Tom, to something you said in response to Bryan's question on the impact of capacity, I think your word was pockets of pressure. Just maybe elaborate on where and how that would really manifest itself based on your historical experience in the industry when you've had bigger increments of capacity come on, just category, customer type. Is it something that you would actually see in with your bigger global customers? Especially as we look to calendar 2020 when you've got a bigger part of that business up for renewal.
Sure, Adam. The couple of things to your question is, we expect the category to have a 1.5%-2.5% growth. There's always going to be an organic component that's going to need capacity support. That's the first thing. The second thing that we'll have to monitor closely is some of the contracts that are coming up for renewal with a few bigger customers. That's where we may see some pressure on pricing. We'll deal with that as those contracts come up for bid.
Just on the performance in the quarter and just trying to think about the implications. Has your view of market growth changed in a material way? I think we've always been operating under the assumption this is a 2%, 2.5% growth business from the North American industry. Do you think that the market has been meaningfully outperforming that? If so, is that just new use occasions and different channels? Just elaborate on that, the Crispy on Delivery just being more incremental to demand than you might have thought, potentially.
Yeah. Right now, I don't have a different point of view on the overall category growth based on all the data on how we analyze not only North America, but international markets in total. I would say the 1.5%-2.5%, we feel pretty good about over the long term. That's where it's going to shake out at. Some of the incremental Crispy on Delivery, for example, I don't view it as a new occasion, but that's meeting an occasion with a better quality fry that travels better, and that's how I view that product.
Okay. Just lastly, just quickly, it seems like the potato crop in the Pacific Northwest, the planting might have gotten started a little bit later than normal. Is that something that would materially impact you as you move into the August through October timeframe or not enough deviation from history to matter?
Adam, right now the crop is two weeks late planting in the Pacific Northwest. We had a point of view of that 30, 45 days ago and took actions to ensure that we were balanced on our raw. Again, it's early planting. I've been around this business a long time to know that, at times, we always tend to catch up, but we got to let it play out, and we'll provide more context on crop in a couple of calls as we always do.
Okay. Really appreciate the color. I'll pass it on. Thanks.
We'll go next to David Mandel with Consumer Edge Research.
Hey, guys. Thanks for taking my question. First, how would you rate the state of your plants given the high utilization rates? Will they get the necessary rest with the oncoming capacity, or does the Europe shortage preclude that? How should we think about that?
Yeah. This is Rob. As you recall, we started up a new line in Richland here in the last year or so, and that's allowed us to take capacity to more normalized levels in our plants. We are able to get caught up on the maintenance that we may have deferred over the prior few years. We'll have the new line coming on in Hermiston, which will give us further capacity to help support the continued growth in the business.
My last question, we've covered a lot of ground, so I just want to ask a high-level question. The faster-growing markets, I assume that they're not all created equal. You have China, Mexico, Middle East, Russia. I assume some processing plants might be turnkey and some might be fixer-uppers. How can I think about that in terms of those four markets?
Well, I think that's exactly right, that the growth rates aren't all created equal, and you also have to think through the overall market size. Some of those markets are, I'll give you a directional, 500, 600 million pounds. Some of them are 1 billion pounds, which is very different than North America and Europe. They're not all created equal. In terms of your second question, capacity is not all created equal as well. As you look at capacity in China, those plants have different capabilities versus our plant, not only in China but in North America. You are right. They are not all created equal.
Great. Thank you very much.
We'll go next to Carla Casella with JP Morgan.
Hey, guys. This is Sarah on for Carla. We just wanted an update on your capital allocation priorities in regards to shareholder activities versus de-levering, and then also maybe an update on your M&A.
Okay, Sarah, it's Tom. Very consistent on our capital allocation. We're going to continue to invest in our business as we have in the past and this year and in the future to drive growth. We're going to support a dividend. We've implemented a share repurchase, which we've been active in the market recently. We're committed to, as we've been very consistent since the spin, that's our capital allocation strategy. In terms of M&A, that's part of the strategy as well. I can't get into specifics about where we're at and what we actually have going on, but we are committed to pursue targeted M&A where it makes sense for us.
Okay, great. Thanks.
There are no further questions. Thank you.
Thanks, everyone, for joining the call. I'll be available for any follow-up questions either via phone or via email, and look forward to speaking with you later. Thank you.
That concludes today's conference. Thank you for your participation. You may now disconnect.