Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following management’s discussion and analysis of our results of operations and financial condition, which we refer to in this filing as “MD&A,” should be read in conjunction with the audited financial statements and the notes thereto. Discussions of fiscal 2021 items and fiscal year comparisons between fiscal 2022 and 2021 that are not included in this Form 10-K can be found in “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended May 29, 2022, which we filed with the SEC on July 27, 2022. Results for the fiscal year ended May 28, 2023 are not necessarily indicative of results that may be attained in the future.
Our MD&A is based on financial data derived from the financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and certain other financial data (including product contribution margin on a consolidated basis, Adjusted earnings before interest, taxes, depreciation and amortization (“EBITDA”), Adjusted EBITDA including unconsolidated joint ventures, Adjusted Income from Operations, Adjusted Net Income, and Adjusted Diluted earnings per share (“EPS”)) that is prepared using non-GAAP financial measures. Refer to “Non-GAAP Financial Measures” below for the definitions of product contribution margin, Adjusted EBITDA, Adjusted EBITDA including unconsolidated joint ventures, Adjusted Income from Operations, Adjusted Net Income, and Adjusted Diluted EPS, and a reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures, gross profit, income from operations, net income, or diluted EPS, as applicable.
Acquisitions of Joint Venture Interests
In February 2023, we completed the acquisition of the remaining 50 percent equity interest in Lamb-Weston/Meijer v.o.f. (“LW EMEA”), and in July 2022, we acquired an additional 40 percent interest in Lamb Weston Alimentos Modernos S.A. (“LWAMSA”). With the completion of the transactions, we own 100 percent and 90 percent of the equity interests in LW EMEA and LWAMSA (the “Acquisitions”), respectively. We acquired the remaining interest in LW EMEA (the “LW EMEA Acquisition”) for consideration consisting of €531.6 million ($564.0 million) in cash, which excludes settlement of pre-existing relationships and cash held by LW EMEA, and 1,952,421 shares of our common stock. We used $42.3 million of cash to acquire the additional equity interest in LWAMSA. We began consolidating LW EMEA’s and LWAMSA’s results in our consolidated financial statements following the respective acquisitions. The results are included in our Global segment. We discuss the Acquisitions in more detail in Note 3, Acquisitions, in “Part II, Item 8. Financial Statements and Supplementary Data” of this Form 10-K. Changes in our fiscal 2023 financial results compared to fiscal 2022 were primarily driven by the consolidation of the financial results of LW EMEA in fiscal 2023.
Overview
Lamb Weston is a leading global producer, distributor, and marketer of value-added frozen potato products. We are the number one supplier of value-added frozen potato products in North America and are a leading supplier of value-added frozen potato products internationally, with a strong and growing presence in high-growth emerging markets. We offer a broad product portfolio to a diverse channel and customer base in over 100 countries. French fries represent most of our value-added frozen potato product portfolio.
During fiscal 2023, we operated our business in four reportable segments: Global, Foodservice, Retail, and Other. We report net sales and product contribution margin by segment and on a consolidated basis. Product contribution margin, when presented on a consolidated basis, is a non-GAAP financial measure. Product contribution margin represents net sales less cost of sales and advertising and promotion (“A&P”) expenses. Product contribution margin includes A&P expenses because those expenses are directly associated with the performance of our segments. Net sales and product contribution margin are the primary measures reported to our chief operating decision maker for purposes of allocating resources to our segments and assessing their performance. For additional information on our reportable segments and product contribution margin, see “Non-GAAP Financial Measures” below and Note 13, Segments, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” in this Form 10-K.
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Effective May 29, 2023, in connection with our recent acquisitions and to align with our expanded global footprint, our management, including our chief executive officer, who is our chief operating decision maker, began managing our operations as two business segments based on management’s change to the way it monitors performance, aligns strategies, and allocates resources. This resulted in a change from four reportable segments to two (North America and International), effective the beginning of fiscal 2024. All summary financial information on a prospective basis will be presented under the new reportable segments beginning with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ending August 27, 2023.
Executive Summary
The following highlights our financial results for fiscal 2023. For more information, refer to the “Results of Operations” and “Non-GAAP Financial Measures” sections below.
In fiscal 2023, we delivered record net sales and earnings through a combination of improved pricing and supply chain productivity savings, while we continued to operate in a significant input cost inflation environment. Our net sales growth was driven primarily by pricing actions across each of our core business segments, as well as incremental sales attributable to the acquisitions of additional equity interests in LW EMEA and LWAMSA. Sales volume declined, largely reflecting our efforts to strategically manage customer and product mix by exiting certain lower-priced and lower-margin business. To a lesser extent, sales volumes towards the end of fiscal 2023 were also negatively affected by softening traffic in casual dining and full-service restaurant channels (which largely impacted our Foodservice segment), certain international customers reverting to pre-Covid inventory practices (impacted our Global segment), and certain customers in select U.S. retail channels temporarily lowering prices to reduce private label inventories (impacted our Retail segment). Outside of North America, frozen potato demand varied, although restaurant traffic trends in our key markets, including Europe, generally softened as customers and consumers both faced similar or more severe macroeconomic environments, including persistent inflation and rising interest rates, than in the U.S.
Gross profit in fiscal 2023 increased as favorable price/mix more than offset higher manufacturing costs on a per pound basis and the impact of lower sales volumes. Incremental earnings from the consolidation of the financial results of LW EMEA beginning in the fiscal fourth quarter also contributed to the increase. Increased gross profit was partially offset by higher selling, general and administrative (“SG&A”) expenses, resulting in the increase in income from operations. Higher income from operations drove the increase in net income and diluted EPS.
In fiscal 2023, we generated net cash from operating activities of $761.7 million, up $343.1 million versus the prior year, due to higher earnings, partially offset by increased working capital. We ended fiscal 2023 with $304.8 million of cash and cash equivalents and a $1.0 billion undrawn U.S. revolving credit facility. In addition, we returned $191.1 million to our stockholders, including $146.1 million in cash dividends and $45.0 million of share repurchases.
Outlook
In fiscal 2024, we expect to deliver net sales and earnings growth, and to benefit from incremental sales and earnings during the first three quarters of the fiscal year attributable to the consolidation of the financial results of LW EMEA, as compared to the first three quarters of fiscal 2023. In addition to the incremental sales for the consolidation of LW EMEA, we expect our net sales growth to be largely driven by pricing actions (which may be more modest than fiscal 2023) to counter input cost inflation, and expect sales volumes will be pressured by our continued efforts to strategically manage our customer and product mix by exiting certain lower-priced and lower-margin business. We also anticipate that demand for our products in the near term may be tempered by ongoing softening restaurant traffic trends in the U.S. and other key markets as our customers and consumers both respond to challenging macroeconomic environments.
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We expect our earnings growth to be largely driven by sales and gross profit growth, and that the rate of input cost inflation, driven largely by higher potato costs, will, in aggregate, moderate as compared to fiscal 2023 inflation rates. In addition, our expectation of gross profit growth presumes that the yield and quality of the potato crops in our growing regions will be largely consistent with historical averages. We anticipate that the increase in gross profit will be partially offset by higher SG&A, reflecting incremental expense attributable to the consolidation of the financial results of LW EMEA, increased investments to upgrade our information systems and enterprise resource planning (“ERP”) infrastructure, the non-cash amortization of intangible assets associated with the LW EMEA Acquisition as well as prior investments in our ERP infrastructure, and higher compensation and benefits expense due to increased headcount.
We believe in the long-term growth outlook for the frozen potato category and that Lamb Weston is well-positioned to drive sustainable, profitable growth, and to better serve customers around the world as we leverage the commercial and operational benefits of LW EMEA, as well as our previously announced capacity expansion investments in China, the U.S., Argentina, and the Netherlands.
Results of Operations
Fiscal Year Ended May 28, 2023 Compared to Fiscal Year Ended May 29, 2022
Net Sales, Gross Profit, and Product Contribution Margin
Year Ended
May 28,
May 29,
%
(in millions, except percentages)
2023
2022
Increase (Decrease)
Segment net sales
Global
$
2,934.4
$
2,064.2
42%
Foodservice
1,489.1
1,318.2
13%
Retail
797.7
594.6
34%
Other
129.4
121.9
6%
$
5,350.6
$
4,098.9
31%
Segment product contribution margin
Global
$
595.5
$
252.2
136%
Foodservice
551.0
449.3
23%
Retail
280.1
109.4
156%
Other
(28.9)
2.2
(1,414%)
1,397.7
813.1
72%
Add: Advertising and promotion expenses
34.4
18.9
82%
Gross profit
$
1,432.1
$
832.0
72%
Net Sales
Lamb Weston’s net sales for fiscal 2023 increased $1,251.7 million, or 31%, to $5,350.6 million, and included $421.0 million of incremental sales attributable to the consolidation of the financial results of LW EMEA and LWAMSA beginning in our fiscal fourth and first quarters, respectively. Net sales, excluding the incremental sales attributable to the Acquisitions, increased 20% versus the prior year. Price/mix increased 26%, reflecting the benefit of pricing actions across each of our core business segments to counter input and manufacturing cost inflation. Volume declined 6%, largely reflecting our efforts to exit certain lower-priced and lower-margin business as we continued to strategically manage customer and product mix, as well as softer demand due to a slowdown in casual and full-service restaurant traffic. To a lesser extent, in late fiscal 2023, inventory destocking by certain customers in international markets as well as in select U.S. retail channels contributed to the volume decline.
Global net sales increased $870.2 million, or 42%, to $2,934.4 million, and included $421.0 million of incremental sales attributable to the consolidation of the financial results of LW EMEA and LWAMSA. Net sales, excluding the incremental sales attributable to the Acquisitions, grew 22%. The benefit of domestic and international
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pricing actions to counter multi-year inflationary pressures, as well as favorable mix, drove a 27% increase in price/mix. Volume declined 5%, largely reflecting our efforts to exit certain lower-priced and lower-margin business in international and domestic markets, and to a lesser extent, lower shipments in response to inventory destocking by certain customers in international markets late in fiscal 2023.
Foodservice net sales increased $170.9 million, or 13%, to $1,489.1 million, with price/mix up 22% and volume down 9%. The carryover benefits of pricing actions taken in the prior year, as well as actions taken in fiscal 2023, to counter inflationary pressures drove the increase in price/mix. The impact of our efforts to exit certain lower-priced and lower-margin business and a slowdown in casual dining and other full-service restaurant traffic drove the volume decline.
Retail net sales increased $203.1 million, or 34%, to $797.7 million. The carryover benefits of pricing actions taken in the prior year, as well as actions taken in fiscal 2023, across the branded and private label portfolios to counter inflationary pressures drove a 38% increase in price/mix. Volume fell 4%, largely driven by our efforts to exit certain low-margin, private label business, and to a lesser extent, the impact of certain customers in select retail channels taking actions to reduce private label inventories late in fiscal 2023.
Other net sales increased $7.5 million, or 6%, to $129.4 million, reflecting the benefit of pricing actions and volume growth in our vegetable business.
Gross Profit and Product Contribution Margin
Gross profit in fiscal 2023 increased $600.1 million, or 72%, to $1,432.1 million, and included $45.7 million ($33.9 million after-tax, or $0.23 per share) of costs impacting comparability in the fiscal fourth quarter, which included the sale of inventory stepped-up in the LW EMEA Acquisition and unrealized loss related to mark-to-market adjustments associated with natural gas and electricity hedging contracts at LW EMEA as the market experienced significant volatility.
Excluding these items, gross profit increased $645.8 million, or 78%, to $1,477.8 million driven primarily by the benefits from pricing actions more than offsetting the impacts of higher costs on a per pound basis and lower volumes. Incremental earnings from the consolidation of the financial results of LW EMEA beginning in the fiscal fourth quarter also contributed to the increase. The higher costs per pound primarily reflected double-digit cost inflation for key inputs, including: raw potatoes, edible oils, ingredients such as grains and starches used in product coatings, labor, and energy. The increase in gross profit was partially offset by a $29.0 million change in unrealized mark-to-market adjustments associated with commodity hedging contracts, reflecting a $38.5 million loss in the current year, compared with a $9.5 million loss related to these items in the prior year.
Lamb Weston’s overall product contribution margin in fiscal 2023 increased $584.6 million, or 72%, to $1,397.7 million. The increase was driven by higher gross profit (as described above), partially offset by a $15.5 million increase in advertising and promotion (“A&P”) expenses.
Global product contribution margin increased $343.3 million, or 136%, to $595.5 million, and included $27.0 million ($20.0 million after-tax, or $0.14 per share) of costs associated with the sale of inventory stepped-up in the LW EMEA Acquisition. Excluding this item, product contribution margin increased $370.3 million, or 147%, to $622.5 million. Pricing actions, incremental earnings from the consolidation of the financial results of LW EMEA, and favorable mix drove the increase, which was partially offset by higher costs per pound. Global cost of sales was $2,328.1 million, up 29%, primarily due to higher manufacturing costs.
Foodservice product contribution margin increased $101.7 million, or 23%, to $551.0 million. Pricing actions drove the increase, which was partially offset by higher costs per pound and the impact of lower sales volumes. Foodservice cost of sales was $930.8 million, up 8%, primarily due to higher manufacturing costs, partially offset by lower sales volumes.
Retail product contribution margin increased $170.7 million, or 156%, to $280.1 million in fiscal 2023. Pricing actions drove the increase, which was partially offset by higher costs per pound and a $7.6 million increase in A&P expenses. Retail cost of sales was $501.9 million, up 5%, primarily due to higher manufacturing costs, partially offset by lower sales volumes.
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Other product contribution margin decreased $31.1 million to a loss of $28.9 million in fiscal 2023, as compared to a $2.2 million gain in fiscal 2022. These amounts include a $48.4 million loss related to unrealized mark-to-market adjustments and realized settlements associated with commodity hedging contracts in fiscal 2023, and a $10.4 million loss related to contracts in fiscal 2022. Excluding these mark-to-market adjustments, product contribution margin increased $6.9 million, largely due to higher prices in our vegetable business.
Selling, General and Administrative Expenses
SG&A expenses in fiscal 2023 increased $162.4 million, or 42%, to $550.0 million, and included a net $21.8 million gain ($12.2 million after-tax, or $0.08 per share) related to actions taken to mitigate the effect of changes in currency rates on the purchase price of LW EMEA, net of other acquisition-related costs. Excluding this net gain, SG&A increased $184.2 million to $571.8 million, primarily due to higher compensation and benefits expense, incremental expenses attributable to the consolidation of the financial results of LW EMEA in the fiscal fourth quarter, higher expenses related to improving our information systems and ERP infrastructure, and a $15.5 million increase in A&P expenses.
Interest Expense, Net
Interest expense, net in fiscal 2023 declined $51.8 million to $109.2 million. The decrease reflects a $53.3 million ($40.5 million after-tax, or $0.27 per share) loss on extinguishment of debt associated with the redemption of our previously outstanding senior notes due 2024 and 2026, which occurred in fiscal 2022. Excluding this loss, interest expense, net increased $1.5 million due primarily to additional interest expense associated with debt incurred for the LW EMEA Acquisition. For more information, see Note 8, Debt and Financing Obligations, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” in this Form 10-K.
Income Taxes
Our effective tax rate was 18.2% for fiscal 2023, compared to 26.3% in fiscal 2022. Excluding $34.3 million of net tax expense and a $4.6 million benefit from items impacting comparability in fiscal 2023 and 2022, respectively, our effective tax rate was 21.8% for fiscal 2023 and 21.4% in fiscal 2022. Our effective tax rate varies from the U.S. statutory tax rate of 21% principally due to the impact of U.S. state taxes, foreign taxes, permanent differences, and discrete items.
For further information on income taxes, see Note 5, Income Taxes, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” in this Form 10-K.
Equity Method Investment Earnings (Loss)
We conducted meaningful business through unconsolidated joint ventures until we acquired the remaining interest of LW EMEA in February 2023. In fiscal 2023 and 2022, our share of earnings (loss) from our equity method investments was $460.6 million of earnings and a $10.7 million loss, respectively. The fiscal 2023 results include a $425.8 million ($379.5 million after-tax, or $2.62 per share) non-cash gain related to remeasuring our initial 50 percent equity interests in LW EMEA and LWAMSA to fair value. Equity method earnings also includes a $31.1 million unrealized loss related to mark-to-market adjustments associated with currency and commodity hedging contracts, of which $37.8 million ($28.0 million after-tax, or $0.19 per share) related to losses in natural gas and electricity derivatives as commodity markets in Europe have experienced significant volatility. Equity method investment gains in fiscal 2022 included a $26.5 million unrealized gain related to mark-to-market adjustments associated with currency and commodity hedging contracts, of which $31.7 million ($23.5 million after-tax, or $0.16 per share) related to gains in natural gas and electricity derivatives . Equity method investment earnings in fiscal 2022 also included a $62.7 million (before and after-tax, or $0.43 per share) non-cash impairment charge to write-off our then-current portion of LW EMEA’s net investment in its former joint venture in Russia.
Excluding these items (non-cash acquisition gains and impairment charge, and mark-to-market adjustments related to natural gas and electricity derivatives) and the other mark-to-market adjustments, earnings from equity method investments increased $52.3 million compared to the prior year, reflecting the benefit of pricing actions, partially offset by higher costs per pound, in both Europe and the U.S.
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Fiscal 2023 Compared to Fiscal 2022 Balance Sheet Changes
The changes in our Consolidated Balance Sheet, compared with May 29, 2022, related primarily to the LW EMEA Acquisition and liabilities incurred to fund the LW EMEA Acquisition. We increased our assets approximately $1,896.8 million and our liabilities approximately $449.3 million in total based on the fair values of LW EMEA’s assets and liabilities, respectively, on the acquisition date. In addition, we incurred $450.0 million of new borrowings, which were used to fund a portion of the purchase price for the acquisition and for general corporate purposes, and also issued 1,952,421 million shares of our common stock as additional consideration for the acquisition. For more information about the LW EMEA Acquisition, see Note 3, Acquisitions, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
Liquidity and Capital Resources
We ended fiscal 2023 with $304.8 million of cash and cash equivalents and a $1.0 billion undrawn U.S. revolving credit facility. We believe we have sufficient liquidity to meet our business requirements for at least the next 12 months. Cash generated by operations, supplemented by our total cash and availability under our revolving credit facilities, is our primary source of liquidity for funding business requirements. Our funding requirements include capital expenditures for announced manufacturing expansions in China, Idaho, the Netherlands, and Argentina, as well as capital investments to upgrade information systems and ERP infrastructure, working capital requirements, and dividends. We expect capital investments in fiscal 2024 to be approximately $800 million to $900 million, depending on timing of projects and excluding acquisitions, if any. These expenditures could increase or decrease as a result of a number of factors, including our financial results, future economic conditions, supply chain constraints for equipment, and our regulatory compliance requirements. At May 28, 2023, we had commitments for capital expenditures of $623.9 million.
Cash Flows
Below is a summary table of our cash flows, followed by a discussion of the sources and uses of cash through operating, investing, and financing activities:
For the Fiscal Years Ended May
(in millions)
2023
2022
Net cash flows provided by (used for):
Operating activities
$
761.7
$
418.6
Investing activities
(1,340.9)
(310.5)
Financing activities
340.8
(363.4)
(238.4)
(255.3)
Effect of exchange rate changes on cash and cash equivalents
18.2
(3.2)
Net decrease in cash and cash equivalents
(220.2)
(258.5)
Cash and cash equivalents, beginning of period
525.0
783.5
Cash and cash equivalents, end of period
$
304.8
$
525.0
Operating Activities
During fiscal 2023, cash provided by operating activities increased $343.1 million to $761.7 million, compared to $418.6 million for fiscal 2022. The increase related to a $306.8 million increase in net income, adjusted for non-cash income and expenses, in addition to an increase of $36.3 million of cash provided by favorable changes in working capital. See “Results of Operations” in this MD&A for more information related to the increase in income from operations. Favorable changes in working capital primarily related to an increase in accounts payable due to timing, a decrease in receivables attributable to timing of collection, and an increase in accrued liabilities due to higher compensation and benefits accrued in fiscal 2023, compared with fiscal 2022. These favorable changes were offset by an unfavorable change in higher-cost finished goods inventories, due primarily to increased potato and input cost inflation.
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Investing Activities
Investing activities used $1,340.9 million of cash in fiscal 2023, compared with $310.5 million in fiscal 2022. The increase primarily relates to our investments in our chopped and formed capacity expansion and construction of our french fry processing line in Idaho and our greenfield french fry processing facility in China, and investments to upgrade our information systems and ERP infrastructure . In addition, in fiscal 2023, we used $610.4 million to purchase the remaining equity interest in LW EMEA and an additional 40 percent equity interest in LWAMSA.
Financing Activities
During fiscal 2023, financing activities provided net proceeds of $340.8 million, compared with $363.4 million used in during fiscal 2022. During fiscal 2023, financing activities included $529.5 million of proceeds from debt issuances including a new $450.0 million term loan facility to fund a portion of the LW EMEA Acquisition and $79.5 million of borrowings on other credit facilities. We also had proceeds of $41.4 million from short-term borrowings on other facilities. These activities were partially offset by the payment of $146.1 million of cash dividends to common stockholders and $32.6 million of debt and financing obligation repayments. In addition, we used $51.6 million of cash to repurchase 569,698 shares of our common stock at an average price of $78.99 per share and withheld 83,974 shares from employees to cover income and payroll taxes on equity awards that vested during the year. As of May 28, 2023, $223.9 million remained authorized for repurchase under our share repurchase program.
During fiscal 2022, financing activities primarily related to issuing U.S. dollar-denominated senior notes and a RMB-denominated loan facility for combined net proceeds of $1,676.1 million, offset by $1,698.1 million of debt and financing obligation repayments, including cash used to redeem our previously outstanding senior notes due 2024 and 2026 (including the payment of a call premium of $39.6 million), and the payment of $138.4 million of cash dividends to common stockholders. In addition, we used $158.4 million of cash to repurchase 2,407,184 shares of our common stock at an average price of $62.59 per share and withheld 118,204 shares from employees to cover income and payroll taxes on equity awards that vested during the year.
For more information about our debt, including among other items, interest rates, maturity dates, and covenants, see Note 8, Debt and Financing Obligations, of the Notes to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Form 10-K. At May 28, 2023, we were in compliance with all covenants contained in our credit agreements.
Obligations and Commitments
As part of our ongoing operations, we enter into arrangements that obligate us to make future payments under contracts such as debt agreements, lease agreements, potato supply agreements, and unconditional purchase obligations. The unconditional purchase obligation arrangements are entered into in the normal course of business to ensure adequate levels of sourced product are available.
A summary of our material cash requirements for our known contractual obligations as of May 28, 2023 are as follows:
(in millions)
Total
Payable within 12 Months
Short-term borrowings and long-term debt, including current portion (a)
$
3,479.8
$
214.4
Interest on long-term debt (b)
960.3
169.3
Leases (a)
200.5
34.8
Purchase obligations and capital commitments (a)
1,233.9
717.1
Total
$
5,874.5
$
1,135.6
(a) See the below Notes to the Consolidated Financial Statements included in “Part II, Item 8. Financial Statements and Supplementary Data” of this Form 10-K for more information.
● Short-term borrowings and long-term debt, including current portion . See Note 8, Debt and Financing Obligations, for more information on debt payments and the timing of expected future payments.
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● Leases . See Note 9, Leases, for more information on our operating and finance lease obligations and timing of expected future payments.
● Purchase obligations and capital commitments . See Note 14, Commitments, Contingencies, Guarantees, and Legal Proceedings, for more information on our purchase obligations and the timing of future payments and capital commitments in connection with the expansion and replacement of existing facilities and equipment.
(b) Amounts represent estimated future interest payments assuming our long-term debt is held to maturity and using interest rates in effect as of May 28, 2023.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements as of May 28, 2023 that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures, or capital resources.
Critical Accounting Estimates
Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to our trade promotions, income taxes, and impairment, among others. We base our estimates on historical experiences combined with management’s understanding of current facts and circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Critical accounting estimates are those that are most important to the portrayal of our financial condition and operating results. These estimates require management’s most difficult, subjective, or complex judgments. We review the development, selection, and disclosure of our critical accounting estimates with the Audit and Finance Committee of our Board of Directors.
We have made appropriate accounting estimates based on the facts and circumstances available as of the reporting date. To the extent there are differences between these estimates and actual results, our consolidated financial statements may be affected.
Acquisitions
From time to time, we may enter into business combinations. In July 2022 and February 2023, we acquired an additional 40 percent interest in LWAMSA and the remaining equity interest in LW EMEA, respectively. With the completion of the Acquisitions, we own 90 percent and 100 percent of the equity interests in LWAMSA and LW EMEA, respectively . We recorded the assets acquired and the liabilities assumed at their estimated acquisition date fair values with the excess purchase price recorded as goodwill. The acquisition method of accounting requires us to make significant estimates and assumptions regarding the fair values of the elements of a business combination as of the date of acquisition, including the fair values (fair value is determined using the income approach, cost approach and/or market approach) of inventory, property, plant and equipment, identifiable intangible assets, deferred tax asset valuation allowances, and liabilities related to uncertain tax positions, among others. Additionally, for acquisitions of previously held equity interests, we remeasure the previously held equity interest to fair value based on consideration at the acquisition date utilizing a market approach based on comparable control premiums within our industry. This method also requires us to refine these estimates over a measurement period not to exceed one year to reflect new information obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. If we are required to retroactively adjust provisional amounts that we have recorded for the fair values of assets and liabilities in connection with acquisitions, these adjustments could have a material impact on our financial condition and results of operations.
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Significant estimates and assumptions in determining the fair value of brands and other identifiable intangible assets include future cash flows that we expect to generate from the acquired assets. If the subsequent actual results and updated projections of the underlying business activity change compared with the assumptions and projections used to develop these values, we could record impairment charges. In addition, we have estimated the economic lives of certain acquired assets and these lives are used to calculate depreciation and amortization expense. If our estimates of the economic lives change, depreciation or amortization expenses could increase or decrease.
Sales Incentives and Trade Promotion Allowances
We promote our products with advertising, consumer incentives, and trade promotions. Sales promotions include, but are not limited to, discounts, coupons, rebates, and volume-based incentives. The estimates for sales incentives are based principally on historical sales and redemption rates, influenced by judgments about current market conditions such as competitive activity in specific product categories.
Trade promotion programs include introductory marketing funds such as slotting fees, cooperative marketing programs, temporary price reductions, and other activities conducted by our customers to promote our products. The costs of these programs are recognized as a reduction to revenue with a corresponding accrued liability. The estimate of trade promotions is inherently difficult due to information limitations as the products move beyond distributors and through the supply chain to operators. Estimates made by management in accounting for these costs are based primarily on our historical experience with marketing programs, with consideration given to current circumstances and industry trends and include the following: quantity of customer sales, timing of promotional activities, current and past trade-promotion spending patterns, the interpretation of historical spending trends by customer and category, and forecasted costs for activities within the promotional programs.
The determination of sales incentive and trade promotion costs requires judgment and may change in the future as a result of changes in customer demand for our products, promotion participation, particularly for new programs related to the introduction of new products. Final determination of the total cost of promotion is dependent upon customers providing information about proof of performance and other information related to the promotional event. Because of the complexity of some of these trade promotions, the ultimate resolution may result in payments that are different from our estimates. As additional information becomes known, we may change our estimates. At May 28, 2023 and May 29, 2022, we had $86.1 million and $41.2 million, respectively, of accrued trade promotions payable recorded in “Accrued liabilities” on our Consolidated Balance Sheets. The increase from May 29, 2022 is primarily due to the LW EMEA Acquisition.
Income Taxes
We compute the provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. We measure deferred tax assets and liabilities using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be realized or settled.
Inherent in determining the annual tax rate are judgments regarding business plans, planning opportunities, and expectations about future outcomes. Management judgments are required for the following items:
● Management reviews deferred tax assets for realizability. Valuation allowances are established when management believes that it is more likely than not that some portion of the deferred tax assets will not be realized. Changes in valuation allowances from period to period are included in the tax provision.
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● We establish accruals for unrecognized tax benefits when, despite the belief that our tax return positions are fully supported, we believe that an uncertain tax position does not meet the recognition threshold of Accounting Standards Codification (“ASC”) 740, Income Taxes . These contingency accruals are adjusted in light of changing facts and circumstances, such as the progress of tax audits, the expiration of the statute of limitations for the relevant taxing authority to examine a tax return, case law and emerging legislation. While it is difficult to predict the final outcome or timing of resolution for any particular matter, we believe that the accruals for unrecognized tax benefits at May 28, 2023, reflect the estimated outcome of known tax contingencies as of such date in accordance with accounting for uncertainty in income taxes under ASC 740.
● We recognize the tax impact of including certain foreign earnings in U.S. taxable income as a period cost. We have not recognized deferred income taxes for local country income and withholding taxes that could be incurred on distributions of certain non-U.S. earnings or for outside basis differences in our subsidiaries, because we plan to indefinitely reinvest such earnings and basis differences. Remittances of non-U.S. earnings are based on estimates and judgments of projected cash flow needs, as well as the working capital and investment requirements of our non-U.S. and U.S. operations. Material changes in our estimates of cash, working capital, and investment needs in various jurisdictions could require repatriation of indefinitely reinvested non-U.S. earnings, which could be subject to applicable non-U.S. income and withholding taxes. While we believe the judgments and estimates discussed above and made by management are appropriate and reasonable under the circumstances, actual resolution of these matters may differ from recorded estimated amounts. Further information on income taxes is provided in Note 5, Income Taxes, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
New and Recently Issued Accounting Standards
For a listing of new and recently issued accounting standards, see Note 1, Nature of Operations and Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
Non-GAAP Financial Measures
To supplement the financial information included in this report, we have presented product contribution margin on a consolidated basis, Adjusted EBITDA, Adjusted EBITDA including unconsolidated joint ventures, Adjusted Income from Operations, Adjusted Net Income, and Adjusted Diluted EPS, each of which is considered a non-GAAP financial measure.
Product contribution margin is one of the primary measures reported to our chief operating decision maker for purposes of allocating resources to our segments and assessing their performance. Product contribution margin represents net sales less cost of sales and A&P expenses. Product contribution margin includes A&P expenses because those expenses are directly associated with the performance of our segments. Product contribution margin, when presented on a consolidated basis, is a non-GAAP financial measure. Our management also uses Adjusted Income from Operations, Adjusted Net Income, Adjusted Diluted EPS, Adjusted EBITDA and Adjusted EBITDA including unconsolidated joint ventures. Management uses these non-GAAP financial measures to assist in analyzing what management views as our core operating performance for purposes of business decision making. Management believes that presenting these non-GAAP financial measures provides investors with useful supplemental information because they (i) provide meaningful supplemental information regarding financial performance by excluding certain items affecting comparability between periods, (ii) permit investors to view performance using the same tools that management uses to budget, make operating and strategic decisions, and evaluate historical performance, and (iii) otherwise provide supplemental information that may be useful to investors in evaluating our results. In addition, we believe that the presentation of these non-GAAP financial measures, when considered together with the most directly comparable GAAP financial measures and the reconciliations to those GAAP financial measures, provides investors with additional tools to understand the factors and trends affecting our underlying business than could be obtained absent these disclosures.
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The non-GAAP financial measures provided in this report should be viewed in addition to, and not as alternatives for, financial measures prepared in accordance with GAAP that are presented in this report. These measures are not substitutes for their comparable GAAP financial measures, such as gross profit, income from operations, net income, diluted earnings per share, or other measures prescribed by GAAP, and there are limitations to using non-GAAP financial measures. For example, the non-GAAP financial measures presented in this report may differ from similarly titled non-GAAP financial measures presented by other companies, and other companies may not define these non-GAAP financial measures the same way we do.
See “Results of Operations – Fiscal Year Ended May 28, 2023 Compared to Fiscal Year Ended May 29, 2022 – Net Sales, Gross Profit, and Product Contribution Margin” above for a reconciliation of product contribution margin on a consolidated basis to gross profit.
The following table reconciles net income to Adjusted EBITDA and Adjusted EBITDA including unconsolidated joint ventures.
For the Fiscal Years Ended May
(in millions)
2023
2022
Net income
$
1,008.9
$
200.9
Equity method investment (earnings) loss
(460.6)
10.7
Interest expense, net
109.2
161.0
Income tax expense
224.6
71.8
Income from operations
882.1
444.4
Depreciation and amortization
218.3
187.3
Items impacting comparability
Acquisition expenses, net (a)
(21.8)
—
LW EMEA derivative losses (gains) (a)
18.7
—
Inventory step-up (a)
27.0
—
Adjusted EBITDA
1,124.3
631.7
Unconsolidated Joint Ventures
Equity method investment earnings (loss)
460.6
(10.7)
Interest expense, income tax expense, and depreciation and
amortization included in equity method investment earnings
29.1
42.0
Items impacting comparability
LW EMEA derivative losses (gains) (b)
37.8
(31.7)
Gain on acquisitions (b)
(425.8)
—
Write-off of net investment in Russia (b)
—
62.7
Add: Adjusted EBITDA from unconsolidated joint ventures
101.7
62.3
Adjusted EBITDA including unconsolidated joint ventures
$
1,226.0
$
694.0
(a) I ncome from operations for fiscal 2023 included a net $21.8 million gain ($12.2 million after-tax, or $0.08 per share) related to actions taken to mitigate the effect of changes in currency rates on the purchase of the remaining equity interest in LW EMEA, net of other acquisition-related costs. Fiscal 2023 also includes an $18.7 million unrealized loss ($13.9 million after-tax, or $0.10 per share) related to mark-to-market adjustments associated with natural gas and electricity hedging contracts at our European operations as the market experienced significant volatility, and a $27.0 million ($20.0 million after-tax, or $0.14 per share) charge related to the step-up and sale of inventory acquired in the LW EMEA Acquisition.
(b) Equity method investment earnings for fiscal 2023 included $425.8 million ($379.5 million, or $2.62 per share) of non-cash gains related to the remeasurement of our initial equity interests to fair value, including a $410.7 million non-cash gain ($364.4 million after-tax, or $2.52 per share) for LW EMEA and a $15.1 million non-cash gain (before and after-tax, or $0.10 per share ) for LWAMSA. These gains were partially offset by a $37.8 million unrealized loss ($28.0 million after-tax, or $0.19 per share), related to mark-to-market adjustments associated with changes in natural gas and electricity derivatives as commodity markets in Europe have experienced significant volatility. Equity method investments earnings for fiscal 2022 included $31.7 million ($23.5 million after-tax, or $0.16 per share) of unrealized gains related to mark-to-market adjustments associated with changes in natural gas and electricity derivatives. Equity method investment earnings for fiscal 2022 included a non-cash impairment charge of $62.7 million (before and after-tax, or $0.43 per share) related to LW EMEA’s withdrawal from its joint venture in Russia.
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The following table reconciles income from operations to Adjusted Income from Operations, net income to Adjusted Net Income, and diluted EPS to Adjusted Diluted EPS:
For the Fiscal Years Ended May
2023
2022
2023
2022
2023 (a)
2022 (a)
(in millions, except per share amounts)
Income from Operations
Net Income
Diluted EPS
As reported
$
882.1
$
444.4
$
1,008.9
$
200.9
$
6.95
$
1.38
Items impacting comparability:
LW EMEA acquisition-related items:
Gain on acquisitions (b)
—
—
(364.4)
—
(2.52)
—
Inventory step-up (c)
27.0
—
20.0
—
0.14
—
Acquisition expenses, net (c)
(21.8)
—
(12.2)
—
(0.08)
—
Total LW EMEA acquisition-related items impacting comparability
5.2
—
(356.6)
—
(2.46)
—
Gain on acquisition of interest in LWAMSA (b)
—
—
(15.1)
—
(0.10)
—
Impact of LW EMEA natural gas and electricity derivatives (c)
18.7
—
41.9
(23.5)
0.29
(0.16)
Loss on extinguishment of debt (d)
—
—
—
40.5
—
0.27
Write-off of net investment in Russia (e)
—
—
—
62.7
—
0.43
Total items impacting comparability
23.9
—
(329.8)
79.7
(2.27)
0.54
Adjusted
$
906.0
$
444.4
$
679.1
$
280.6
$
4.68
$
1.92
(a) Diluted weighted average common shares were 145.2 million and 145.9 million in fiscal 2023 and 2022, respectively.
(b) See footnote (b) to the reconciliation of net income to Adjusted EBITDA and Adjusted EBITDA including unconsolidated joint ventures above for a discussion of the item impacting comparability.
(c) See footnote (a) to the reconciliation of net income to Adjusted EBITDA and Adjusted EBITDA including unconsolidated joint ventures above for a discussion of the item impacting comparability.
(d) The fiscal year ended May 29, 2022, includes a loss on the extinguishment of debt of $53.3 million ($40.5 million after-tax, or $0.27 per share), which consists of a call premium of $39.6 million related to the redemption of our senior notes due 2024 and 2026 and the write-off of $13.7 million of debt issuance costs associated with those notes.
(e) See footnote (b) to the reconciliation of net income to Adjusted EBITDA and Adjusted EBITDA including unconsolidated joint ventures above for a discussion of the item impacting comparability.
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