Flowers Foods Inc

NYSE:FLO

Earnings Call Transcript 2023-Q2

[J. Rieck, executive]

Hello, everyone. This is J.T. Rieck, EVP of Finance and Investor Relations. Welcome to the prerecorded discussion of Flowers Foods Second Quarter 2023 results, which we announced in a press release on August 10, 2023. We will host a live Q&A session on Friday, August 11, at 8:30 a.m. Eastern Time. Further details about the live call, along with our earnings release, a transcript of these recorded remarks and a related slide presentation are posted on the Investors section of flowersfoods.com.

Before we get started, keep in mind that the information presented here may include forward-looking statements about the company's performance. Although we believe these statements to be reasonable, they are subject to risks and uncertainties that can cause actual results to differ materially. In addition to what you hear in these remarks, important factors relating to Flowers Foods business are fully detailed in our SEC filings. Providing remarks today are Ryals McMullian, Chairman, CEO and President; and Steve Kinsey, our CFO. Ryals, I'll turn it over to you.

[A. McMullian, executive]

Thanks, J.T. It's a pleasure to welcome everyone to our call. Following an unexpectedly slow start to the year, which we detailed on our first quarter call, we recovered nicely in the second quarter and delivered strong results despite a still somewhat uncertain macro environment.

I attribute our performance to the effectiveness of our strategies and the outstanding execution by our team. Sales growth was largely driven by solid brand performance and strategic pricing initiatives designed to mitigate the impact of inflationary pressures. Despite selective price increases, volume trends in our branded retail bread business improved significantly relative to recent quarters. The resulting top line strength translated into higher earnings, which is reflected in our updated 2023 guidance.

Consumers remain pressured by inflation, which has encouraged trade down in the retail category to private label products. Despite that pressure and price increases in the quarter on many of our branded products, we successfully maintained our branded retail unit share in tracked channels for the fresh packaged bread category.

Our performance was even stronger in the grocery channel, where we gained 20 basis points of unit share. We saw a particular strength in the organic, specialty loaf and breakfast categories, gaining 290, 160 and 60 basis points of unit share, respectively, reaching record levels in specialty loaf and breakfast. After analyzing the source of that organic growth, we found that sales metrics for Dave's Killer Bread among middle- and lower-income consumers improved compared to the prior year with increases in unit sales per buyer, product trips and repeat rates.

Furthermore, DKB grew overall units by 7% in tracked channels, which we believe is a decent barometer for consumer health given the brand's premium positioning. Branded retail unit share for the company was fairly consistent throughout the quarter. Combined with the strong DKB unit growth, these factors give us some confidence that consumer demand may be migrating back to pre-inflationary levels. These indications are encouraging, but we'll be watching how the trends play out in the third quarter before concluding that consumer health is on a sustainable upward trajectory.

Sales in our other category increased significantly, driven by pricing initiatives implemented earlier in the year. Those gains were partly offset by planned business rationalizations as we work to enhance profitability. The overwhelming majority of our company-wide volume decline was in our non-retail and cake businesses. This result is aligned with our portfolio strategy of shifting a greater portion of our sales to higher-margin branded retail products and improving the profitability of our other businesses. We expect volume declines related to these initiatives to moderate in the second half of 2023.

Now I'll provide an overview of our second quarter performance in the context of our 4 strategic priorities: developing our team, focusing on our brands, prioritizing margins and pursuing smart M&A. Following that, Steve will review our financial results, and I'll come back with a discussion on key themes moving forward and our plan to drive shareholder value in 2023 and beyond.

I'd like to start by recognizing the incredible contributions of our team whose passion and commitment are the key ingredients of our success. Their efforts were instrumental in our strong second quarter performance. Last quarter, I discussed the restructuring of operational responsibilities at our bakeries, shifting them from the sales function to the supply chain function. One of the primary objectives of this change was to free up our sales team to focus solely on bringing our lean products to as many customers as possible, and I'm happy to say that the restructuring is already bearing fruit.

The sales team delivered outstanding execution of the Memorial Day and 4th of July holidays, resulting in a company record for bun unit share, a key part of our portfolio strategy. That execution is critical during the all-important bun season, and we expect continued benefits from the restructuring. Similarly, we are seeing increased focus and better performance from our bakeries, owing to the direct line of accountability and clear KPIs established by supply chain leadership.

As we've discussed for many quarters, operational improvement is a major opportunity for us, and I'm pleased to see our investments in capabilities, systems and processes start to pay dividends.

Our second strategic priority is focusing on our brands. Our brands continue to outperform. Despite a difficult competitive environment in which private label products gained market share, though at a moderating pace, our leading brands more than held their own. Nature's Own and Canyon Bakehouse both held unit share flat in the fresh packaged bread category while Dave's Killer Bread gained 20 basis points.

Results benefited from our commitment to innovation as we initiated nationwide launches of Nature's Own Keto Net One loaf, Nature's Own Perfectly Crafted Everything buns and Wonder Hawaiian buns. And the nationwide rollout of our DKB snack bars continue. The bars are currently on the shelf at almost 12,000 stores, and we expect that number to grow to more than 13,000 by year-end, slightly more than originally planned.

Velocities have been in line with some of the leading competitors, and our team is working hard to drive trial and repeat sales through a multifaceted marketing campaign. The DKB snack bars are just the first item in a deep pipeline of innovation that we expect to expand our addressable market and meaningfully grow sales outside the bread category. Our DKB Amped-Up Protein Bars are in test markets currently, with plans for a nationwide launch in 2024. And our DKB Crunchy Snack Bites are also in test markets.

As we've discussed, the financial benefit of these rollouts will be limited in the near term as we invest in a robust marketing plan, but we are encouraged by the preliminary results.

On the other end of the spectrum, although Canyon Bakehouse held unit share in the overall fresh packaged bread category, it lost 230 basis points of gluten-free unit share. Canyon has had a couple of quarters of uncharacteristic weakness in tracked channels, which was caused by 2 factors. First, a mix shift to channels that aren't comprehensively measured by syndicated data, and second, a shortage of gluten-free capacity that impacted our ability to meet consumer demand.

Additional capacity is expected to come online in the second half of this year, and we have aggressive plans to reaccelerate our growth. We remain optimistic about the potential for Canyon, which remains solidly in the #1 market share position. In addition to initiatives to grow its core products, we're also exploring plans to add new products through our agile innovation team.

Our third strategic priority is margins. An area where we saw progress in the second quarter. The combination of food service and private label price increases to start the year and selected branded retail pricing in May helped offset inflationary pressures and higher expenses related to our ERP implementation. Our margin improvement plan goes beyond price increases.

We are also focused on maximizing efficiencies, in part through our digital initiatives like bakery of the future, which continue to benefit operations. Cost savings initiatives are on track to meet our savings goal of $20 million to $30 million for 2023. And the Papa Pita acquisition also benefited margins as we brought more production in-house and expanded our sales footprint.

Lastly, we continue to execute on our portfolio strategy. Branded retail products increased to 64.1% of sales, up 30 basis points sequentially, despite continued pressure from private label. And that branded retail performance was particularly strong in the branded bread category.

Our fourth priority is smart M&A. M&A has been a key contributor to our growth for decades, expanding our geographic coverage and supplementing our brand lineup. Moving forward, we also expect M&A to help us move into faster-growing adjacent categories beyond bread. We continue to monitor the deal market, actively vetting potential acquisitions and investments that could add capabilities, brands or products to our robust existing lineup. Our strong balance sheet positions us well to act when we have financial, commercial and operational conviction.

Now I'll turn it over to Steve to review the details of the quarter, and then I'll come back a little bit later to discuss our outlook for the current business environment. Steve?

[R. Kinsey, executive]

Thank you, Ryals, and hello, everyone. Moving on to our results. Total sales in the second quarter increased 8.8% from the prior year period. Improved price/mix drove the adjusted year-over-year increase up 13.3%, primarily due to price increases to mitigate inflationary pressures. Volume decreased 6.1%, partly due to targeted sales rationalizations in cake and foodservice.

The Papa Pita acquisition added 1.6%. Gross margin as a percentage of sales, excluding depreciation and amortization, increased 90 basis points to 49%. Comparisons were impacted by inflation-driven pricing actions more than offsetting input cost inflation, lower production volumes, increased product returns and increased maintenance costs. Selling, distribution and administrative expenses as a percentage of sales were 38.8%, consistent with the prior year period. Lower consulting costs and distributor distribution fees as a percentage of sales were offset by greater marketing expenses, reduced scrap dough income and an insurance liability reserve.

Excluding matters affecting comparability, adjusted SD&A expenses increased 70 basis points to 38.2% due to the factors listed above with the exception of the consulting costs. GAAP diluted EPS for the quarter was $0.30 per share compared to $0.25 in the prior year period. Excluding the items affecting comparability detailed in the release, adjusted diluted EPS in the quarter was $0.33 per share, up $0.02 from the prior year period.

Turning now to our balance sheet, liquidity and cash flow. For the first half of fiscal 2023, cash flow from operating activities decreased by $54.9 million to $128.9 million, which included business process improvement costs of $12.8 million related to the ongoing transformation strategy initiatives. Cash flow from operating activities was affected by working capital increases of $47 million, largely due to decreased accounts payable resulting from higher ERP-related capital expenditures in the prior year.

Capital expenditures decreased $29.5 million to $68.4 million and included $19.1 million for the ongoing ERP upgrade. Dividends paid increased $4.7 million to $98.1 million.

Our financial position remains strong. At quarter end, net debt to trailing 12-month adjusted EBITDA stood at approximately 2.1x. At quarter end, we held approximately $12 million in cash and cash equivalents and had approximately $510 million of remaining availability on our credit facilities. As Ryals mentioned, we are adjusting our 2023 forecast to reflect the second quarter results.

We are raising the bottom end of our sales, adjusted EBITDA and adjusted diluted EPS guidance. Our updated expectation is for sales in the range of $5.095 billion to $5.141 billion, adjusted EBITDA in the range of $503 million to $528 million and adjusted diluted EPS in the range of $1.18 to $1.25.

Results in the second quarter were roughly in line with our expectations when we adjusted guidance last quarter. For the remainder of 2023, we expect a quarterly cadence similar to historic trends. Key factors that could shift results within our guidance range include demand reversion, price elasticities, consumer resilience and continued inflationary pressure. We are maintaining the top end of our guidance ranges as overall demand elasticity has been in line with our expectations, remaining below historical levels.

As a reminder, our adjusted EBITDA guidance incorporates approximately $26 million or $0.09 per share of incremental cost related to the ERP project. Those incremental costs were $2.5 million or $0.01 per share in the second quarter. We anticipate these costs to moderate substantially by project completion in 2026.

Additionally, we expect a 2023 impact of $0.08 to $0.10 per share from an increase in interest, depreciation and amortization expense associated with the ERP implementation and Papa Pita acquisition. Our ERP program, which went live in the second quarter remains on track, and we are confident in our ability to complete the project within the financial guidance.

In fiscal 2023, we expect costs from the upgrade of our ERP system to be approximately $95 million to $105 million, including $30 million to $40 million expected to be capitalized. As of July 15, 2023, we have incurred costs related to the project of approximately $190 million, of which $103 million has been capitalized. Approximately 93% of our key raw materials are covered in 2023. To minimize volatility and provide adequate visibility into costs, we strive to maintain our historical hedging strategy, in which we attempt to increase the certainty of our key commodity costs 6 to 12 months out. Based on current coverage, our guidance incorporates a moderate decline in commodity costs in the second half of 2023 relative to our initial expectations. However, inflation remains persistent, and we expect continued inflationary pressures into 2024.

We continue to monitor the commodity markets, exploring opportunities to extend coverage at lower values that could benefit our future results. Thank you. And now I'll turn it back to Ryals.

[A. McMullian, executive]

Thank you, Steve. Now I'd like to discuss some of the trends impacting our current performance and the steps we're taking to maximize our opportunities in this environment and beyond.

The 3 primary themes we've been watching are consumer health and behavior, inflationary impacts and the ability to take price to offset cost pressures. Consumers remain pressured from higher costs, and in response, they're trading down to lower-priced products and shifting more of their shopping trips to value-focused retailers.

Private label sales have benefited from this recent trend, gaining 50 basis points of fresh packaged bread unit share in the second quarter. However, those share gains were confined to loaf and traditional loaf products, the most commoditized part of the category. Private label lost unit share in specialty premium loaf, sandwich buns and rolls, breakfast and dinner breads and rolls, areas with greater product differentiation.

Importantly, those share gains continue to be largely concentrated in the mass channel. Private label products lost 40 basis points of unit share in the grocery channel, where Flowers' branded retail bread products gained 20 basis points. Perhaps most notable, private label share gains have slowed throughout 2023 and dropped to the lowest level of the year late in the second quarter.

Our leading brands fared well in this environment. Dave's Killer Bread's performance was noteworthy, gaining 290 basis points of unit share in the organic category and 20 basis points in the larger fresh packaged bread category as units grew 7%. As I mentioned earlier, Nature's Own and Canyon Bakehouse each held market share despite taking selective price increases in a tough competitive environment.

Earlier on the call, I highlighted data showing improved demand for DKB products among lower- and middle-income customers. Although it's too early to know whether that improvement will continue, these data may be signaling a trend reversal from the year ago quarter.

At that time, we noted lower-income consumers reducing their number of purchases and trading down to less expensive products. It's possible that consumers are acclimating the higher price levels and resuming prior purchasing behavior. Inflation has impacted both consumer demand, as I've just highlighted, and our cost structure. That cost pressure became acute following the start of the Ukraine war when commodity prices spiked.

While commodity prices, particularly wheat, have declined from those highs, they remain elevated relative to recent years. More recently, other commodities, most notably sugar, have seen rapid price increases. Given our consistent hedging policy, such increases are expected to have minimal impact on 2023 results. And we caution investors from expecting a downward step change if commodity prices remain at current levels.

I spoke earlier about initiatives we are taking to mitigate inflation, and pricing is one such measure. Our successful implementation of price increases in the second quarter, despite market concerns about increasing pressure from retailers and consumers, highlights our advantaged value proposition. We and our retail customers are particularly sensitive to affordability in the current environment, but we recognize that mitigating inflationary pressures is necessary to deliver a fair return to our shareholders.

I believe our leading brands provide significant differentiation, which, combined with the exceptional service we provide, including managing the shelf and retaining inventory risk, justifies margin expansion from current levels. The present environment is challenging with consumers shifting more to value and with volatile inflationary pressures.

However, we believe many of these headwinds are temporary and we expect to benefit over the long term from premiumization and the continuation of work from home. I'm confident that we're taking the necessary steps to thrive now and in the future.

Our team is the best in the industry, and we're enabling them to perform even better. Our leading brands are proving their value, holding their own in a tough consumer environment. We're implementing the right initiatives to improve our margin profile, and we will supplement those initiatives with shareholder-friendly capital allocation, including our long track record of successful M&A.

I remain extraordinarily confident in our ability to grow shareholder value far into the future. Thank you very much for your time. This concludes our prepared remarks.