Lancaster Colony: Keeping An Eye On The Promised Productive Improvement (NASDAQ:LANC)

My Thesis

Lancaster Colony Corporation (NASDAQ:LANC) is a Manufacturer and Marketer of Specialty Food Products that has been operating in the market since 1961, with a strong presence in the main lines of 18 of the 30 largest restaurant chains in the United States. Based on net sales reported over the last 12 months to June 2023, 21% were from branded products and other categories, while 79% were attributed to national accounts, including customers in the QSR segment.

In terms of retail sales, Lancaster Colony is predominantly positioned in three distinct segments:

• Refrigerated Dressings, Dips & Other
• Frozen Breads and Shelf-Stable
• Dressings, Sauces & Croutons

In 2023, the company continued its strategic emphasis on broadening its sales channels, particularly targeting the food service sector, while concurrently aiming to bolster its market presence in retail. Notably, the retail segment, despite exhibiting relatively lower performance compared to other channels, presents the most promising avenue for expansion. The performance of our licensed Chick-fil-A sauces and dressings, Buffalo Wild Wings sauces, Olive Garden dressings, and Arby’s sauces in the retail channel, as indicated by the combined sales totaling $418 million for the 52-week period ended October 1, 2023, has proven to be resilient. This trend suggests that we should closely monitor these products’ performance as we move into 2024.

I would be worried if the company were not aware and open when talking about its margins, which leave something to be desired (despite being one of the best companies compared in this analysis), especially the adequacy of its COGS cost to the marginal increase in revenue, so I ask: will Lancaster’s growth be healthy and turned into net profit without first being wasted by COGS and SG&A costs? However, Lancaster Colony seems to treat this as the main challenge for expanding its operations, and, therefore, is developing some very interesting initiatives that should be mentioned here.

The first deals with the use of Value Engineering to increase your margins and continuously improve production efficiency, through an approach that optimizes the use of your resources in the production chain. The company proposes the following implementations in the production process:

1. Use of low-cost packaging materials
2. Substitution for alternative/substitute ingredients
3. Coordinated/cross-functional initiative between R&D, Marketing, Procurement, Manufacturing/Engineering and Finance

Furthermore, Lancaster is seeking to improve its logistics operations through the T² project, implementing new transportation management systems, adopting the One-Touch Strategy to optimize transportation costs and simplify cargo management, among other strategies to optimize the operation as a whole.

The company is committed to sales growth through an expanded M&A strategy, bringing new brands to Lancaster’s product list, and this is safeguarded through a progressive accumulation of Retained Profits. As the company is highly financially healthy, having a capital structure that allows shareholders some peace of mind, Lancaster intends firstly to establish an ideal modeling of its processes, through the implementation of an ERP system that helps leverage processing capacity, internal improvement of production processes and constant monitoring of the production chain, so that only then can we start creating value, which was not specified in the report, but I imagine it will be through M&A.

Therefore, my “Hold” thesis is based on Lancaster’s financial strength and its safe and stable dividend. I do not recommend purchasing at this price level as we still cannot see whether Lancaster will be able to stabilize its margins, much less how its expansion program will proceed, but I consider it prudent to consider the ideal modeling of its processes before the expansion itself.

As the company has not lost its fundamentals but is at a price that I do not consider attractive, still has to resolve problems in its processes and has not clearly specified how it would “create value”, I still remain cautious about the stock. From now on, we want to see three things:

1. Continuous improvement of margins, concomitantly with the improvements produced and updates on the implementation of the ERP system
2. Maintaining financial strength and healthy capital structure, if there is leverage, we want to take a look at the debt structure and its terms
3. Maintenance of dividends and stability of Free Cash Flow for the peace of mind of holding the paper; After improving margins, we want to get some insight from Lancaster into how the expansion process will take place

Fundamental Assessment

To begin our fundamental analysis, let’s explore Lancaster Colony’s capital composition metrics, starting with an examination of the leverage ratio to assess Lancaster’s capital structure. Between 2016 and 2020, the leverage ratio hovered within a narrow range of 0.24 to 0.26. However, in 2021, the company began relying more on third-party capital, with the range expanding from 0.26 to 0.30. As of the latest available data, the leverage ratio stood at 0.29.

The leverage ratio provides valuable insights into Lancaster’s financial strategy. A higher ratio indicates a greater reliance on debt financing, potentially limiting the company’s flexibility in managing capital. In comparison, other companies in the same sector, such as McCormick & Company (MKC) and General Mills (GIS), have historically higher leverage ratios. For instance, in 2017, McCormick & Company had a leverage ratio of 3.05, gradually reducing to 1.53 in the latest financial statement. Similarly, General Mills has also seen a gradual reduction in its leverage ratio over time.

McCormick spends an average of 13% of its Operating Profit paying interest expenses, and General Mills 12%. Both multiples are well within the benchmark that I usually use for my stock picking, which is 15%. Lancaster, due to its almost zero degree of leverage, only started paying interest expenses in 2019, and even then, in tiny amounts compared to its Operating Profit (less than 1%). This suggests that McCormick and General Mills have effectively managed their debt structures, taking advantage of favorable macroeconomic conditions to leverage themselves, aligning with the assessment of the cost of equity capital alongside the low cost of debt. Lancaster, in turn, chose not to leverage itself when rates were appropriate, only using third-party capital in 2019.

Lancaster’s debt profile is quite healthy – around 18% of its debt is short-term. The equity immobilization ratio is 0.81 and, consequently, its Own Circulating Capital represents 19% of its Equity. The idea here is for the company to have its own resources to cover the Long-Term Assets and still have enough left over (where the figure of Own Working Capital appears) to finance the Current Assets, that is, to use in its day-to-day operations. Therefore, in my analysis, Lancaster has a very interesting margin for mobilizing its own capital, maintaining a healthy margin for financing its daily operations in the form of more liquid assets. Our index of immobilization of non-current resources for Lancaster showed that the company allocated 75% of non-current resources to Non-Current Assets. It is important to highlight that, regardless of the sector we are analyzing, some amount of non-current resources is always necessary to be used as current assets. That said, Lancaster’s capital structure multiples are at healthy levels.

Therefore, the formatting of its capital structure allows the use of $243 million as working capital. This represents Lancaster’s financial “slack” in the short term, that is, financing that the company has for its operations and that will not be charged in the short term. The company enjoys a favorable equity position in the short term, this position can only be shaken if Lancaster experiences serious losses in subsequent years.

Lancaster’s General Liquidity ratio is 4.77, which highlights the participation of equity capital in the structure and formatting of the company’s assets and Lancaster’s habit of always using a much larger amount of equity capital than third-party capital in its operations. Lancaster’s General Liquidity Index is 4.77, which highlights the participation of equity capital in the structure and formatting of the company’s assets and Lancaster’s habit of always using a much larger amount of equity capital than third-party capital in its operations.

The Current Ratio complements the General Liquidity perspective, with Lancaster achieving a multiple of 2.48. This indicates that for every dollar of current liabilities, Lancaster has $2.48 of current assets available to cover these obligations. The remaining amount represents Net Working Capital, calculated as the difference between current assets and current liabilities. Net Working Capital provides the breathing space necessary to carry out operations in the short term. Over the past three years, this amount stood at $250 million (2021), $186 million (2022), and $206 million (2023). In comparison, McCormick’s Current Ratio is 0.64, and General Mills’ is 0.63.

This difference in debt management is explained by the fact that McCormick and General Mills maintain a completely different capital structure from Lancaster, opting for financing with third-party capital to leverage its operations, using the cash flow generated from its operations for the payment of these debts, therefore, do not require this parameterization. Lancaster is predominantly financed through its own resources, as we saw at the beginning of the analysis of the company’s capital structure.

Now, let’s apply a real strength test: acid-test ratio. Considering that only 50% of Lancaster’s credit sales could be considered highly liquid (I used an estimate to measure the ability to quickly convert credit sales into immediate liquidity), the acid-test ratio for Lancaster is 1.12.

Let’s start by examining the asset turnover ratio. In 2016, it stood at 1.87, declining to 1.67 in 2017, and further to 1.52 in 2018. Subsequently, it decreased to 1.44 in 2019, 1.34 in 2020, and 1.33 in 2021. However, there was a notable increase in 2022 and 2023, reaching 1.53 and 1.63, respectively. The decline in asset turnover was primarily attributed to the gradual rise in CAPEX expenditure, particularly in fixed assets. Consequently, we witnessed a significant expansion in Net Property, Plants, and Equipment over the years, experiencing a Compound Annual Growth Rate (CAGR) of 14.83%. We can state, however, that depreciation is controlled at levels that are accommodating to the gross profit of the operation (around 4.2% is used in the depreciation of fixed assets by Lancaster).

Still on operationality, from 2016 to 2023 the CAGR for Revenue growth was 5.12%, while for COGS it was 5.55%. This raises some doubts as to whether the COGS is healthily parameterized according to Revenue growth, and that there is still a large space for operational improvements with regard to the use of production factors more efficiently in the production process. As we can see in the graph below, there was a small deterioration in gross margins:

In our comparative analysis of SG&A expenses in perspective with Gross Profit, we noticed that Lancaster maintains its SG&A expenses in line with the sector, despite a marginal deterioration in recent years. I consider any company that can keep its SG&A/GP multiples regularly below 30% to be enjoying some competitive advantage in the long term. Lancaster, however, maintains its multiples between 37-58%, never below 30% and never above 60%, which I consider to be acceptable but in line with the industry standard. We need to pay attention to the next results, if this number is close to 80% these expenses will become dangerous for the profitability that we will see in Net Profit.

Lancaster’s Net Margin, averaging 8.5%, has been on a downward trend, declining at a CAGR of 3.89%. However, it still stands above the industry average. Despite this, Lancaster’s Net Profit isn’t showing an upward trajectory, and its net margin doesn’t meet our reasonable rating criteria. How will Lancaster increase its Net Margin under current conditions? As the company maintains a healthy capital structure and a very controlled debt profile, Lancaster will need to parameterize its COGS and control its Gross Margin – this is the main challenge for Lancaster if it intends to be more profitable.

As Lancaster has nearly tripled its fixed assets in recent years, we observed that its ROA ranged from 19% in 2016 to 11% today. This indicates that the investment in assets did not yield the expected return in terms of net profit. Despite the growth in assets resulting from equity investment, the net profit did not keep pace, leading to a decrease in Lancaster’s ROA over the years. While it’s understood that investment plans take time to generate profits, the data suggests that despite revenue growth, this hasn’t translated into increased net profit, which is crucial for shareholders.

Having Lancaster’s ROE (to establish the ROE I used the average Shareholders’ Equity) and knowing that it demonstrates the profitability of the company’s equity, we can use several benchmarks to compare the profitability of the asset with other alternatives on the market. Here we will compare it with the return of the S&P 500:

Risk to the thesis

Lancaster has positive points, and the biggest one is the company’s capital structure. The company, despite having tight margins, lack of COGS parameters in relation to marginal Revenue growth (taking into account the investments made in CAPEX in recent years), maintains its SG&A expenses at healthy levels, and therefore, there is not a company here which is at risk of going bankrupt like many others in the sector, I can base myself on quantitative models that have stable forecasts based on financial statements:

Using the Kanitz Thermometer and imputing Lancaster’s data, we can infer that there are practically no scenarios for Lancaster’s bankruptcy and, therefore, there are no risks of bankruptcy in the short/medium term.

However, when we blend financial stability with security and a steady, albeit slow, growth in dividends, we can deduce that Lancaster is a secure investment. My thesis, as previously stated, suggests an excessive overvaluation considering the company’s potential for profitability, which, in my view, is limited and has consistently shown to be so based on all the parameters we’ve examined.

The main risk associated with this thesis revolves around the assumption that Lancaster may struggle to significantly enhance its margins. Essentially, the concern lies in the challenge of boosting Lancaster’s productivity without expanding its capacity for assimilation and operational efficiency, which could potentially lead to adverse outcomes. Moreover, if the implementation of the ERP system is subpar and results in high costs for Lancaster, it could pose a significant problem. Additionally, there’s a more distant risk related to potential issues arising from Lancaster’s M&A activities, such as integration challenges, financial hurdles, regulatory complications, and notably, the risk of diluting shareholder equity in certain scenarios.

And, as we can see macroeconomically, the cost of loans is rising along with the long-term interest rate curve – “higher for longer”. As a result, the cost of third-party capital is unfavorable for Lancaster’s leverage, which in my opinion is unlikely to happen anytime soon.

Valuation

To begin applying our quantitative methods to define the intrinsic value of Lancaster Colony, we will use the well-known Discounted Cash Flow (DCF). Lancaster Colony’s Unlevered Free Cash Flow is $101.7 billion. Lancaster WACC is calculated as the weighted average of its cost of equity capital and cost of debt capital, adjusted for taxes. The WACC is at 7.43%. This includes the cost of equity at 7.43%, calculated as Risk Free Rate + Beta x ERP, and the cost of debt capital at 5.28%, reflecting the interest rate on Lancaster debt adjusted for the tax benefits. The weight of debt in the capital structure is 0%.

Analysts appear to expect growth of approximately 3% on average for Lancaster’s next five years. Considering this growth, we obtained an intrinsic value of $80.92. The current price of $192.89 is obtained if we use a growth rate of approximately 15.5%, this indicates a dissonance between the current share price and the growth expected by analysts. In other words, the share is being priced using the Discounted Cash Flow method, taking into account growth approximately five times greater than that projected by exogenous estimates.

When we use the Benjamin Graham Valuation Model and consider a growth of 3% we obtain an intrinsic value of $58.37 for Lancaster.

Using different growth scenarios, we obtained the following results:

When we use the discounted dividend method, modeling from a sustainable dividend growth of 5%, we obtain an intrinsic value of $155.56.

Conclusion

Based on our analysis, Lancaster Colony appears to be in a solid financial position, maintaining stable dividend payments despite small fluctuations. The company demonstrates adeptness in managing its liquidity and seems well-prepared for potential decreases in sales, likely stemming from weakened consumer spending. As the valuation remains stretched, and we still do not have information about the implementation of the ERP system and the actual reduction in margins, I maintain an optimistic stance for Lancaster Colony and, when I see signs of improvement in the production chain, I will not be reluctant to raise my rating. If the company manages to combine production efficiency with the financial strength it already has, the company will stand out in the sector.

Despite this, I still felt the lack of an expansion strategy, but this is still secondary when we put it into perspective with the creation of a culture of efficiency in the company as a whole. Many companies have failed because they took a step too far.