Lancaster Colony (LANC): A Small Cap Dividend King Worth Reviewing

Despite growing its dividend every year since 1963, Lancaster Colony (LANC) is a relatively unknown company with most income investors.

 

Lancaster Colony is one of the dividend kings here thanks to its 50+ consecutive years of payout growth, but it is unlike many of the other kings, which are generally large and relatively slow-growing companies.

 

Let’s take a closer look at one of the rare small cap dividend kings, Lancaster Colony, which just raised its dividend for the 54th straight year, a feat matched by just 14 other U.S. corporations.

 

Specifically, learn why this specialty food maker deserves to be on your radar and if its valuation is attractive for investors who are building a dividend portfolio the responsible way.

 

Business Overview

Founded in 1961 in Columbus, Ohio, Lancaster Colony is a specialty food maker that owns several niche dip, garlic bread, frozen roll, croutons, caviar, and flat bread brands, including Marzetti, New York Bakery, Sister Schubert’s, Flatout, Aunt Vi’s, Reames, Mamma Bella’s, Romanoff, and Chatham Lodge.

 

In addition, Lancaster makes licensed products including Olive Garden dressing, Jack Daniel’s mustard, and Hungry Girl Flatbreads.

 

 

Lancaster’s products are distributed through both retail grocery channels, as well as to 18 of America’s 25 most popular national restaurant chains.

 

 

Business Analysis

The key to any dividend growth stock includes a steady business model, with highly predictable and growing cash flow with which it can fund a secure and rising payout.

 

Over the past half century, Lancaster has managed to achieve impressive growth thanks to its disciplined approach to acquiring small, niche specialty products food companies that fit well into its existing business model and supply chain.

 

You can see that the company’s sales have grown by 12% per year since 1971, largely driven by acquisitions.

 

 

However, what truly sets the company apart from most of its rivals is that rather than attempt to grow for growth’s sake, management has remained steadfast in its approach to buying only the most popular names in its niche industries.

 

These are brands that have been benefitting from major demographic trends, such as the continued rise of the Millenial generation, and the changes in consumer tastes that come with them.

 

 

Specifically, the maturing of the Millennial generation, the largest in U.S. history, has resulted in consumers shifting their food dollars away from pre-packaged products found in the center of the grocery store, and towards the periphery to things like fresh foods, meats, and specialty products.

 

 

Over time Lancaster has evolved its business model to successfully tailor its product offerings towards these shifting consumer trends, including an increasing focus on expanding its produce and deli offerings, which now account for close to 40% of its retail sales mix.

 

 

Of course, even poorly run companies can grow strongly for a time through acquisition. However, Lancaster’s quality stems from its multi-pronged approach to long-term growth.

 

The company’s approach includes disciplined and well executed acquisitions (including premium whole grain bakery products maker Angelic Bakehouse in November of 2016), streamlining the supply chain to maximize economies of scale, and launching new products within its dominant brands.

 

 

For example, while Lancaster’s brands may not be household names to most American’s, they do boast dominant market share positions in their respective niches.

 

And while Lancaster may not be a large food company (sales of just $1.2 billion in the last twelve months), it has done an admirable job of streamlining its supply chain and manufacturing process.

 

That, combined with an increased focus on higher margin specialty foods, has resulted in relatively stable and improving margins and returns on shareholder capital over time.

 

 

This strong, and steady improvement in profitability has resulted in Lancaster Colony boasting some of of the best profitability in the industry, including a double-digit free cash flow (FCF) margin that helps it to maintain a highly secure and steadily-growing dividend.

 

 

The bottom line is that, in a highly competitive industry, Lancaster Colony has managed to generate a modest moat, driven by its disciplined focus on acquiring top brands that successfully cater to shifting consumer tastes, as well as consistent cost-cutting efforts.

 

As a result, Lancaster Colony has delivered impressive payout growth and decades of market-beating total returns (15% annual returns vs 10% for S&P 500 over the last 30 years).

 

Key Risks

While Lancaster’s success over the last 56 years has been impressive, there are several risks to consider before investing in the company.

 

Most notably, the food business in particular is a slow-growing one, which means that even with popular niche products, the majority of Lancaster’s sales, earnings, and cash flow growth stems from acquisitions.

 

This is a fact that you can see in recent years, where the top line growth has lagged the company’s impressive results in previous decades.

 

This brings us to the second risk, which is that Lancaster’s growing scale means that finding new needle-moving acquisitions that fit its disciplined approach and business model could be harder to come by.

 

For example, the company’s most recent purchase, Angelic Bakehouse, which the company paid $12 million for, is expected to provide only a 2% boost to the retail sales channel.

 

Or to put it another way, in the most recent quarter, this brand would have boosted the company’s retail sales growth from 2% to 3%.

 

Finally, the third and longest-term risk is that consumer spending habits change over time and the company can’t keep up.

 

While Lancaster has successfully navigated these trends in the past, there is no guarantee that it will always be able to do so.

 

For example, while Millennials are big consumers of specialty foods, there is always a risk that the growing popularity of lower cost private label (i.e. store brands) could reduce Lancaster’s strong market share and profitability in the future.

 

Millennials are also dining out less at chain restaurants, and Lancaster supplies food to 18 of the top 25 restaurant chains in the country.

 

Lancaster Colony’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Lancaster Colony has a Dividend Safety Score of 99, indicating that it offers one of the safest dividends you can find on Wall Street. That isn’t a surprise given that the company has been growing its payout every year since 1963.

 

Note that Lancaster periodically pays out special dividends, which explains the spikes in 2012 and 2015.

 

 

This steady, half century of payout growth is courtesy of two main factors. The first is the company’s conservative dividend payout ratios, which allow it plenty of safety cushion during bad economic times, when sales of specialty foods and demand from restaurants can decrease, which happened during the financial crisis.

 

 

Lancaster Colony’s dividend usually only consumes 30% to 50% of its annual earnings and FCF, with rare exceptions, including during years with large special dividends when the company returns excess cash to shareholders. In fact, in the last 12 months the regular dividend EPS and FCF payout ratio were a very safe 50% and 48%, respectively.

 

Those periodic special dividends are feasible because of the firm’s immaculate balance sheet, which has almost no debt, relatively high cash levels (relative to the size of the company and its acquisitions), and a high current ratio (i.e. the company’s short-term assets cover its short-term liabilities by more than three-fold, thus protecting it from unexpected negative financial strains, such as during recessions when demand from restaurants can lead to declining sales, earnings, and cash flow).

 

 

 

Lancaster’s bulletproof balance sheet is even more impressive when we consider that food manufacturing is a rather capital-intensive industry. For example, compared to its peers, Lancaster’s leverage ratio (Debt/EBITDA) and debt/capital ratio are extremely low, and its interest coverage ratio is among the highest of any industry competitor.

 

 

In other words, despite its small size, Lancaster’s highly conservative management team has built a fortress-like balance sheet that ensures not just the survival of the company during periodic economic and industry downturns, but one that’s strong enough to continue growing through industry consolidation while still rewarding dividends investors with one of the market’s most impressive payout growth records.

 

Lancaster Colony’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Lancaster Colony’s Dividend Growth Score of 59 indicates investors can expect about average dividend growth going forward. That’s not a surprise given that Lancaster’s past growth, while highly regular, hasn’t been especially fast though it has beaten the S&P 500’s 20 year median dividend growth of 5.7%.

 

Note that the negative one-year growth rate below is due to the company’s 2015 special dividend. The most recent regular dividend increase was 10%.

 

 

 

That being said, given its small size and the still highly fragmented nature of the specialty food industry, Lancaster should be able to achieve organic sales growth of about 2% to 3%, with acquisitions potentially doubling the overall growth rate.

 

Factoring in future margin growth from ongoing cost cutting and improving economies of scale, Lancaster could achieve high single-digit growth in earnings per share over the coming years.

 

 

Since the current payout ratios are slightly higher than the company’s historical average, investors should probably expect annual dividend growth that’s slightly less than EPS and FCF growth, along the lines of 6% to 8% a year.

 

Valuation

Over the past year, Lancaster has underperformed the S&P 500 by about 20%. However, that doesn’t necessarily mean that it’s a great buy at current levels.

 

That’s because the forward P/E ratio of 23.9 is much higher than the S&P 500’s forward P/E ratio of 17.8, as well as the company’s long-term historical median value of 21.5.

 

Meanwhile, the low dividend yield of 1.8% is slightly lower than the market’s 1.9% payout, as well as the 2.1% that Lancaster has typically offered over the last 13 years.

 

In other words, shares appear to be slightly overvalued at this time relative to history, meaning that Lancaster Colony might be better off on a watchlist to wait for a better price.

 

That’s because at current price levels and valuation multiples, LANC’s long-term annual total return potential is only about 8.8% to 10.8% (1.8% yield + 7% to 9% earnings growth).

 

While that’s not a terrible expected return, it’s also far lower than this high-quality small cap dividend growth stock can return and has in the past, when purchased at more attractive valuations.

 

A 10% pullback would drop LANC’s price to about $110 per share and put its P/E ratio and dividend yield in line with their long-term averages.

 

Conclusion

Lancaster Colony is a rare breed – a small company, but with a nearly unbeatable track record of quality, long-term focused management, excellent dividend security, and an obvious dedication to consistent payout growth.

 

While the packaged food industry is experiencing a number of headwinds today and Lancaster is not immune, its more balanced sales mix (e.g. produce and deli, restaurants) and smaller, more nimble size position it fairly well to cope with the environment.

 

That being said, the slightly overvalued share price and low current dividend yield mean that this particular company isn’t for everyone, especially low-risk investors looking to live off dividends during retirement.

 

However, if you are patient and wait for the next market correction, when the share price should offer a more attractive valuation and larger margin of safety, and have a long time horizon to allow the company’s dividend compounding to work for you, than Lancaster Colony could be one of the more attractive small cap dividend growth stocks in the market.