Compared to its peers, Lancaster has been hit harder by commodity cost inflation due to its higher exposure to dressings, which we estimate account for at least one-third of sales.
Soybean oil is used in most salad dressings, and prices have surged this year due to drought conditions hurting crops and the Russian invasion of Ukraine, a leading exporter of certain edible oils.
The price of wheat, a key ingredient in Lancaster's bread products, also increased as much as 50% earlier this year as war-ravaged Ukraine is unable to deliver its historical 10% share of global exports for this essential commodity.
Overall, edible oils and wheat are driving about two-thirds of the total inflation Lancaster is seeing. Across raw materials, packaging, and freight, Lancaster experienced nearly 30% inflation last quarter, well ahead of management's expectations.
With margins under pressure, Lancaster's adjusted earnings per share have fallen roughly 20% over the past year despite 15% sales growth. The slump in profits has pushed Lancaster's payout ratio towards 80%, marking the company's highest level in at least a decade.
We expect Lancaster's profitability and dividend coverage to eventually return to historical levels. The majority of commodities used by the firm sit at or near 10-year highs, incentivizing more production and potentially marking a cyclical peak as harvests improve.
Meanwhile, management is implementing additional price increases, investing in cost efficiency projects such as more factory automation, and reducing dependence on higher-cost co-manufacturers, which have supported Lancaster's growing relationship with Chik-fil-A (21% of sales last year).
Lancaster's financial position will remain strong as it waits for profitability to improve. The company maintains a debt-free balance sheet and holds $67 million of cash – nearly enough on its own to cover the firm's roughly $90 million dividend for a year.
Overall, we expect Lancaster to remain a cash cow and defend its track record of paying higher dividends each year since 1963, a streak matched by only 12 other U.S. companies.
Trading at a relatively high dividend yield compared to its historical norm, Lancaster's stock may appeal to dividend growth investors looking for a well-run business that can endure the challenging inflationary environment with its long-term outlook intact.