Good day, and welcome to the Lamb Weston Second Quarter Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Dexter Kambalai, Investor Relations of Lamb Weston. Please go ahead.
Good morning and thank you for joining us for our Q2 2017 earnings call. This morning, we issued our earnings release, which is available on our website, lambweston.com. Please note that our remarks 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. In addition, some of today's prepared 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 within our earnings release. With me today is Tom Werner, our President and CEO, who will provide an overview of our total company results as well as for each
of our reporting segments. Also joining us today
is John Goering, our Interim Chief Financial Officer, who will provide a brief review of the financial impacts related to our spin off from Conagra, some highlights on our quarter and year to date results and some comments on our debt profile and cash flow. Tom will then wrap up with our capital allocation priorities and our updated outlook for the year before opening it up for questions. Let me now turn the call over to Tom.
Thanks, Dexter, and good morning, everyone. I'd like to thank you for joining us today. We are excited to be here for our 1st Lam Weston earnings call as a standalone company. On today's call, I'm going to take a few minutes to provide some context on where we are and our expectations going forward. We made a tremendous amount of progress in a short period of time to prepare for life as a standalone public company.
As I stated at our Investor Day, Lamb Weston is well positioned in a category that is growing worldwide. We're in the process of adding capacity that will come online in the back half of calendar 2017, which is well ahead of recently announced capacity expansions in North America by our competitors. We expect this to provide us with the ability to gain share and support our customers' growth plans in the near term. Over the long term, we believe we are well positioned to grow through our strong customer relationships with our domestic and international customers, our innovation capabilities and our global footprint. I am confident in our future and while we are in the early stages of our journey as an independent public company, we are on track on building new capabilities and our business is off to a great start through the first half of fiscal 2017.
As you all know, on November 9, we were spun off from Conagra Foods. Since then, we've rounded out our senior management team with the addition of Rob McNutt as our Chief Financial Officer. I'm looking forward to working with Rob. He has a tremendous background of executive leadership and I'm confident he'll be a great addition to the Lam Weston leadership team. I'm sure that you'll be impressed with Rob as you get to meet him over the coming months.
I also want to thank John Gehring for serving as our Interim Chief Financial Officer. As you know, John postponed his retirement to guide us through a critical time of standalone activities. I thank John for his leadership over the past several months and his counsel throughout the spin of Lam Weston. I wish him all the best in his retirement. Now let's turn to our results by first putting them into context.
As we discussed at our Investor Day in October, we have been investing in our business over the past several years and those investments are driving growth. We are executing well across our business in this favorable operating environment. Our factories are running at a high level of capacity utilization. We continue to see strong demand in our North America business due to our customer mix and growth in our international business. And we expect our material costs to remain at or slightly below year ago levels for the balance of the year.
Our focus on execution is also an important factor driving our strong performance. We continue to execute against our product and customer mix initiatives to improve margins across the portfolio. We remain laser focused on driving supply chain efficiencies, specifically in our manufacturing footprint to maximize our throughput and drive operating leverage. And where appropriate, we have implemented pricing actions across our segments. Lamb Weston's employees in the Lamb Weston customer service culture is an important contributor to our success as we manage through this tight industry capacity environment.
I want to thank our entire Lamb Weston organization for their tireless efforts in providing continued customer service excellence during this time of tight supply. This is a hallmark of our company and a true differentiator. We are committed to meet our customers' needs and deliver great products on time, every time. So let's take a look at the details for the quarter. Net sales were up 7% to over $790,000,000 Volume grew 4 points, which was better than expected.
We expect our top line growth rate to moderate in the back half due to our capacity constraints and as we lap a strong performance in back half of last year. Our Global Foodservice and Retail segments all posted mid single digit volume gains. We continue to see strong demand in North America across our segments and our international business continues to post volume improvements across many markets. Price and mix added 3 points, reflecting the current favorable industry dynamics and execution focus that I described earlier. With our balanced sales growth profile and favorable cost environment, we delivered strong earnings growth.
Adjusted EBITDA, including the proportionate EBITDA from our unconsolidated joint ventures, Lamb Weston Meyer in Europe and Lamb Weston RDO in the U. S. Increased 19% to nearly $170,000,000 Much of the benefits of positive price mix and volume growth flow to the bottom line as total manufacturing costs on a rate basis declined modestly, largely due to supply chain efficiencies and operating leverage. SG and A increased as we began to incur incremental costs associated with being a standalone company. A portion of the increase was also from higher incentive compensation accruals due to the overall business performance.
Equity earnings declined due to our European joint venture, which is experiencing a significant increase in potato costs as a result of poor crop quality and reduced yields, which has driven overall raw costs higher. While the JV is taking actions to offset these higher costs, they are not fully expected to offset them in the near term. We expect the European joint ventures performance to be under pressure for the remainder of the fiscal year with the year over year impact more pronounced in the back half. Fortunately, as we've demonstrated in the first half, we expect to more than offset this impact with strong performances in other parts of our business. So now let's take a look at the results for each of our business segments.
First, our Global segment, which comprises a little more than half of our total sales and includes our top 100 North America based restaurant chain customers as well as our international business. Net sales for the segment were up 6% in the quarter, largely due to volume growth. This is a reflection of our faster growing domestic chain customer mix as well as export growth. Improved price mix also contributed to sales growth and the segment benefited from supply chain operating leverage. All these factors contributed to a 17% increase in product contribution margin.
And for clarity, product contribution margin is gross profit less advertising and promotional expense. Our next segment is foodservice, which comprises about a third of our total sales and serves North America foodservice distributors and restaurant chains outside our top 100 restaurant customers. Net sales for foodservice were up 11% with a balanced contribution from price mix and volume. Pricemix was up 6 points reflecting our product and customer mix initiatives as well as pricing actions across the segment. Volume was up 5 points with growth driven by small and medium sized chains as well as independent foodservice distributors.
Product contribution margin increased 39%, reflecting favorable price mix, supply chain operating leverage and volume growth. Next is our retail segment, which represents about 12% of our sales and includes sales of Alexia, licensed brand products as well as private label to grocery, mass merchant and club customers in North America. Net sales were up 5%. This was largely driven by volume growth of our licensed brands and private label. Price mix was also favorable.
Product contribution margin increased 36%, reflecting price mix, supply chain operating leverage, the timing of advertising expense and volume growth. So as you can see, we delivered a strong quarter and the management team is executing against our key strategies. We have committed significant capital investments that will position our business over the long term. Our supply chain footprint, innovation capabilities and relentless focus on customer service give me great confidence in our ability to deliver long term growth for all of our stakeholders. With that, let me turn it over to John for some additional details on
the quarter. Thanks, Tom, and good morning, everyone. Over the next few minutes, I'll address a number of topics, including the impact of the spin on our financial statements, a brief recap of our Q2 year to date results, including a review of the key drivers of our performance and our current debt profile and cash flow. Let's start with the spin. As Tom mentioned, our spin off from Conagra was effective on November 9, which is toward the end of our quarter.
Accordingly, fiscal second quarter financial statements reflect results on a carve out basis prior to the completion of the spin and on a stand alone basis for the balance of the quarter. Since we do not apply purchase accounting for the spin transaction, the changes to our financial results pre and post SPIN relate primarily to interest expense and selling, general and administrative expenses, including the ramp up of costs to operate as a standalone company and certain transaction related costs. We have treated the transaction related costs as items impacting comparability. And on a pre tax basis, we incurred about $9,000,000 of these costs in the 2nd quarter and $19,000,000 in the first half. In addition, our balance sheet reflects the various debt and shareholders' equity transactions necessary to affect the spin and to establish our new capital structure.
We've also recognized certain other assets and liabilities on our balance sheet in connection with the Spin transaction. Now let's take a look at our second quarter and first half results. As Tom described, we're pleased with our performance so far this year. We delivered strong net sales growth driven by both volume and price mix gains. And through the first half, sales are up more than 5% with volume up 3 points and price mix up 2.
Gross profit was up 23% for the quarter and 25% in the first half. Raw material costs, including potatoes, were essentially flat, allowing the benefits of favorable price mix, volume growth, supply chain productivity and operating leverage to flow through to gross profit. Adjusted operating income was up 23% for the quarter and 39% in the first half, driven primarily by the increase in gross profit. Reported SG and A expense increased in the 2nd fiscal quarter. While we have begun to incur some additional standalone costs, the increase this quarter is driven principally by costs related to the spin, which we treat as comparability items and higher incentives based on the strong performance.
As Tom mentioned earlier, equity method investment earnings were down largely related to significantly higher potato costs in our European joint venture. So putting it all together, total adjusted EBITDA, including the proportional EBITDA from our 2 unconsolidated joint ventures, increased 19% in the quarter and 29% in the first half. Adjusted EPS growth was also strong, up 26% for the quarter and 32% in the first half, driven by adjusted operating income growth. Interest expense was up, reflecting the additional $2,400,000,000 of debt that we incurred as part of the spin. As the spin happened near the end of the quarter, the increase only reflects about 3 weeks of interest expense on this new debt.
Income tax expense increased in the first half as a result of our higher earnings. For the first half, our effective tax rate was approximately 33%. And for the 2nd quarter, our effective tax rate was about 27% due to the impact of some favorable changes in estimates. Switching now to our balance sheet and cash flow. As I just mentioned, in conjunction with the spin, we took on an additional $2,400,000,000 of debt, which includes a $675,000,000 5 year floating rate term loan, dollars 833,000,000 of 8 year senior notes with a 4.5eight percent coupon, dollars 833,000,000 of 10 year senior notes with a 4.7eight percent coupon.
In addition, we entered into a $500,000,000 floating rate revolving credit facility, of which $80,000,000 was outstanding and drawn as of November 27. All in, our weighted average rate is currently a bit over 4%. From a leverage standpoint, we're comfortable with our current leverage and are making good progress towards our target range of 3.5 to 4 times adjusted EBITDA. With respect to cash flow, in the first half, we generated about $162,000,000 of cash from operations. A few items to note.
1st, 2nd quarter raw material inventory levels are typically at their peak for the year, given the timing of the potato harvest in September October. 2nd, we've increased finished goods inventory levels due to some anticipated downtime related to several capital projects. Also, there are several year over year timing issues related to payables and compensation accruals. Overall, we're confident that our operating cash flows will remain strong, especially in the back half as inventory levels come down. In addition, at about $300,000,000 our capital expenditures this fiscal year are high as we're investing in additional capacity at our Boardman, Oregon and Richland, Washington facilities.
Together, these will add about £350,000,000 of capacity by late calendar 2017. So overall, we're off to a strong start in fiscal 2017 and we're well positioned to support future growth and value creation. With that, let me turn it now back over to Tom for some comments on our capital allocation priorities and our updated outlook. Tom?
Thanks, John. We believe our balance sheet and cash flow will support a balanced capital allocation policy based on returns and executed with discipline. As we outlined in our Investor Day, our priorities are: 1st, investment in growth, both organic and through M and A. Our current capacity expansion projects attest to our commitment to invest in and support growth. 2nd, we will return capital shareholders.
Last month, we declared our 1st quarterly dividend of 0.187 $5 per share or $0.75 on an annualized basis. And third, we will reduce debt to achieve our long term leverage target of 3.5x to 4x adjusted EBITDA. Given our high CapEx this year, we don't expect to pay down debt beyond what is required in the near term. Now with respect to our outlook. Our performance in the quarter year to date were better than expected due to all the operating factors mentioned.
As a result, we are raising our outlook for the year. While we delivered well above our center line profitability in the first half, we do expect our earnings growth to normalize in the back half of the year, and we've taken a prudent view in our revised guidance. We now expect net sales to grow in the mid single digits, up from our initial estimate of low single digits. In addition, on a full year basis, we expect sales growth to be relatively balanced between price mix and volume as we continue to stretch existing capacity to meet demand. For adjusted EBITDA, including unconsolidated joint ventures, we now expect it to grow at a rate in the mid teens, up from our previous estimate of high single digits.
This reflects strong adjusted operating income growth driven by sales growth and supply chain operating leverage, while our raw materials for the balance of the year will be essentially flat to year ago levels. We do expect SG and A for the second half and full year to be higher as a result of higher incentive compensation costs and approximately $10,000,000 to $15,000,000 of incremental standalone costs. These are consistent with the estimate provided during our Investor Day. Operating income is expected to be partially offset by a significantly lower contribution from our unconsolidated joint ventures. We expect adjusted diluted EPS to be in the range of $2.20 to $2.28 This includes total interest expense of about $60,000,000 and an effective tax rate of approximately 34%.
So to wrap it up, we are off to a great start and we have tremendous momentum in the business. We are on track in our transition activities and the organization is doing a terrific job executing against our initiatives. I want to thank you for your interest in Lamb Weston and we are now happy to take your questions.
Thank you. We'll take our first question from Andrew Lazar with Barclays.
Good morning, everybody.
Good morning, Andrew.
Two questions for you, if I could. I guess, first, with Street expectations, I think, clearly already looking for some upside to full year EBITDA estimates. Because I'm curious how fiscal 2Q came in really relative to your internal expectations and really what primarily drove that delta if one thing stood out more than some of the other operating factors that you mentioned? And then I've got a follow-up.
Sure, Andrew. This is Tom Werner. I would say internally, the biggest drivers on Q2 is our volume performance across all of our segments came in better than expected. So that was obviously a big contributor. I would say another contributor is we had strong price mix, which was also better than we expected, specifically across our foodservice segment.
So those two things, coupled with our plants are running really well right now as we start processing the new crop. So essentially, we had 3 areas that were better than expected and that's really what drove the over performance in Q2.
Thanks for that. And then it's a good lead into the question on foodservice. If we think about the year over year improvement in gross margin, we try and parse out a couple of other key factors. I guess how much of a factor was the faster growth that you saw in the foodservice segment, which clearly has much higher margins versus maybe some of the other drivers such as supply chain and things of that nature?
I would say, Andrew, we have a couple of initiatives in the organization. We are laser focused on our product mix and some of our lower end products getting them out of the system at this point. So we've been really focused on product mix. Obviously, there's some customer mix that plays into that well. And we are also driving our Lamb Weston brand in that space too.
So that certainly has driven to some of the performance in that segment in the quarter.
Thanks very much.
We'll go next to Chris Growe with Stifel.
Hi, good morning.
Hi, Chris. Good morning.
Hi. So I had two questions for you as well. A bit of a follow-up on the previous on Andrew's previous question. As you're looking at the mix improvement, I guess I'm curious in how you're achieving that. Is it also just new product innovation?
And then is it possible to tease out how much mix benefited the sales overall? And particularly I'm looking at the global division and how mix may have helped there in that division?
Yes. I think, again, within that segment, we continue to be focused on both our customer product mix. There is some innovation that we're driving, but it's largely our pricing actions that we've taken along with our customer product mix initiatives that we've been driving in that segment.
Can you say how much mix benefited the sales overall
in the
division? Sorry, for the overall company, is it possible to tease that out?
We yes, this is John, Chris. We really don't tease that out. And we don't to the extent we have any details on that, we're just we're not in a position to share them.
Okay. And then just another question on the global division. If you were to look at the just the breakdown of revenue growth between North America and international, I was just trying to get an understanding of how much of that growth is being driven by international and how much is coming from North America in rough terms if you can give that?
It's really pretty balanced across both segments. So there's not one market area that's outweighing another. I would say it's balanced and both are doing well. So as you as we look at North America and the International segment, things are balanced right now.
Okay. That would seem contrary to some of the kind of the QSR sales been a little softer overall. I guess you're seeing better growth there. That means you're likely taking market share, is that the way to look at that or?
No, I would point you towards as we look at it, we have a great customer mix in our portfolio. So we work at that extremely hard to be positioned with the growing customers in the marketplace. We've done a great job over that over the past years. So it's really attributed to our customer mix in North America.
Okay.
That's very helpful. Thank you.
We'll go next to Akshay Jagdale with Jefferies.
Hi, good morning. Congratulations on a solid quarter. Good morning. I wanted to ask about the tight industry capacity that you've talked about. So in relation to that, what we are hearing in the marketplace is that there's double digit price increases that are being realized by your competitors.
So how do I put that into context with sort of the price mix that you're reporting, which is high single digits? And then I was really surprised and it's a positive surprise that you were able to produce 4% more volume. It's from what I understand, your plants and the industry's plants in general are already operating at 100% capacity. So can you just help me with those two issues?
Sure, Akshay. I would say, first of all, we are squarely focused on our pricing and mix initiatives as I stated earlier. So we're happy with the progress we are making within our own portfolio. So that's number 1. I would say number 2, I would go back to the comment, our factories are running really efficient right now.
So we are gaining a lot of throughput. Everything is hitting on all positive cylinders in the factories. That said, they are running at levels that are not sustainable. And we expect that we're going to adjust that in the back half. We've got some capital things that are coming at us that we plan for.
So it's really a function of throughput efficiency right now in the plants and how they're operating. And the supply chain organization is doing a fantastic job getting that throughput to meet the demand that we're continuing to see in our business.
Okay. And then on the raw potato costs, first, I'm under the impression that none of the new crop potatoes really flowed through your COGS this quarter. But from what we understand, the cost of production for potatoes this crop season is down double digits. So when you say your raw material costs are going to be flattish for the year, Can you help me square that with sort of the industry data points, which are pointing to significant decreases year over year in the new crop potatoes?
Sure, Akshay. I'm not sure what data sources you're looking at for starters, but I will say that, as I've stated through our Investor Day, we contract a lot of our supply needs prior to our fiscal year. So we have a high level of contracted potatoes, which translate into contracted cost base for us. There is variability in our portfolio from a raw standpoint as it relates to overall crop yield and quality as we go through the growing season and the harvest. But as we take a look at the back half of the year, we're seeing it's a pretty known cost and we think things are going to be relatively flat to prior year.
So we feel comfortable with where our cost basis is.
And just one last one. This is more of a longer term question, but some of your competitors have recently announced some capacity expansion plans. Obviously, you're talking about capacity being tight right now. Can you give us your perspective? I mean, the expansion plans that have been announced are 2 years down the road, but they seem to be pretty unprecedented in terms of the absolute volume that's being announced.
So can you these expansion plans might do to the supply demand balance a couple of years down the road?
Sure, Akshay. I think, first of all, as we have anticipated this global expansion and added capacity several years ago, and as everybody knows, we're in the process right now of adding additional capacity that will be online in the back half of twenty seventeen. 2nd, I believe the category growth projections we talked about at Investor Day have not changed. And there is going to be a need to add capacity in addition to our capacity. Our competitors have announced that.
We believe that demand is still going to outpace supply over the long term. There may be some mismatches at times because of timing of the capacity add and the demand, but we're confident in our overall view of the category going forward and we feel we're positioned right now in the near term, the next couple of years as you stated that as our capacity comes online ahead of our competitors and we're making these investments to meet our customer needs. And we've been highly committed to that over the last couple of years and we'll continue to do that. But we think long term, demand is going to continue to outpace supply. We feel good about how we're positioned going forward.
Thank you. I'll get back in queue.
Our final question comes from Matthew Granger, Morgan Stanley.
Hi, good morning, everyone. Thanks for the question.
Good morning.
Just 2 from me, and I apologize, but I'm going to go back to price mix again just given the positive surprise there year to date. You've talked in the past about the company's ability to price through inflation when necessary and your confidence there. But in historical context, when we look back at the data that's available, your ability to realize pricing in a flat cost environment seems like a newer driver of the company's earnings growth. So I guess just to elaborate on that, is the industry just capacity constrained enough that the risk of pricing concessions coming back into play is really limited for the time being? And if that's the case, what's the risk of pricing normalizing a bit when we look out a year or 2 as that capacity does come online?
Yes, Matthew, I think there is certainly the operating environment we're in with capacity is driving us to evaluate our customer mix and our product mix. And certainly, we've taken pricing actions across the portfolio. It is a dynamic. And I would say, we're confident that we have the ability to carry that those actions forward. I would say as capacity comes online, specifically ours in the next year from now, we're going to have opportunities to gain additional volume.
It may be at some different margin levels, but we'll evaluate that as we go forward.
Okay. Thanks, Tom. And then just on the full year outlook, obviously very strong start to the year, 30% EBITDA growth and you're looking for mid teens for the full year. I guess as we think about the I guess one, as we think about the sustainability of the progress you've made this year and your ability to continue growing EBITDA high single digits off that higher base, are there any other factors that we should be thinking about looking ahead to fiscal 2018 beyond the incremental corporate costs that you would going back to your Q1 commentary, characterize as maybe being non recurring in terms of the benefit that they've provided to EBITDA this year? And the second piece is just on the tax rate.
What's driving the step up in the second half?
Yes. I would say in terms of FY 2018, we'll provide that guidance as we close out 2017 in Q4. So I'm not going to get into any outlook there. And as far as the tax rate, I'll throw it to John.
Yes. On the tax rate, I would emphasize the first half tax rate was around 33%. That's pretty close to the range we called for the year of 34%. So we're seeing maybe a little bit of pressure above 34% in the back half, but it's we expect it to be in the range.
Okay. Thanks. Thanks, both.
And that concludes our question and answer session. I would like to turn the conference back over to Mr. Kambalai for any additional or closing remarks.
Thank you for joining us for our Q2 call. Maybe you have any follow-up questions, I can be reached via email or via phone at any time over the next few days. And we look forward to your continued interest in the company. Thank you.
And that concludes today's conference. We thank you for your participation.