Flowers Foods Inc
NYSE:FLO
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Flowers Foods Inc
Earnings Call Analysis
Q3-2023 Analysis
Flowers Foods Inc
The company made some planned exits from low-margin food service businesses, a strategic move to improve profit margins and align with full-year guidance. While these exits were anticipated to phase out by the end of 2023 or into 2024, their occurrence in the third quarter affected financial results for that period. However, management reassured investors that these exits were a part of a broader portfolio strategy aimed at either meeting margin targets or divesting from underperforming segments. This restructuring appears to be succeeding, suggesting a positive outlook for the company's profitability.
The company experienced an increase in unit share, especially notable with the Wonder Bread brand, as a result of focused marketing efforts and strategic partnerships. Highlighting their success, management mentioned the growth of the Wonder brand, which they acquired to enter the national sandwich bun and roll market. On the other hand, the Nature's Own brand, playing in the traditional loaf segment, saw a trade-down to private label products, which is attributed to its position as the least differentiated part of the portfolio. Despite this, management conveyed satisfaction with Nature's Own's relative performance and expects improvement as consumer spending pressures ease. The brand dynamics also reflect broader consumer trends, with private label products losing share in grocery stores as premium and differentiated products maintain appeal. Importantly, gains by private label brands in the mass channel are moderating, and the overall share gain trends indicate improving conditions.
The third quarter saw unusually limited storm activity, which contrasts with previous years that experienced higher levels of storms, affecting annual comparisons. Typically, storms can lead to a temporary surge in demand as consumers stockpile essentials, but this year's quiet storm season did not provide that temporary boost to the business.
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Hello, everyone. This is J.T. Rieck, EVP of Finance and Investor Relations. Welcome to the prerecorded discussion of Flowers Foods Third Quarter 2023 results. We will host a live Q&A session on Friday, November 10 at 8:30 a.m. Eastern. 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 could 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 and CEO; and Steve Kinsey, our CFO. Ryals, I'll turn it over to you.
Thanks, J.T. It's a pleasure to welcome everyone to our call. We continue to execute well in the third quarter. Despite the challenging environment, we achieved record sales driven by growth in both our branded retail and other categories. That growth benefited from pricing taken earlier this year, but it's also important to highlight that our branded retail volumes improved sequentially, down only 1.1% compared to the 6.3% and 1.5% declines in the first and second quarters, respectively.
Volume trends in our other category also improved as the impact of business rationalization is designed to improve the profitability of that business moderated. On our last call, we noted our expectation that these planned business rationalizations would moderate in the second half of 2023. And that trend is playing out, though the timing of certain business exits did come sooner than planned.
Combined with lower-than-normal storm activity, these business exits led to third quarter sales below our expectations and an adjustment in our 2023 sales and EBITDA guidance. Although the timing was unplanned, such exits are the natural result of our portfolio strategy, which is driving meaningful improvement in the margins of our foodservice business.
I'm encouraged by the progress we're making in enhancing the profitability of this category and expect continued improvement moving forward. For the second consecutive quarter, we held unit share flat in tracked channels versus the prior year. Dave's Killer Bread and Wonder showed particular strength, increasing unit share 20 and 10 basis points, respectively, while Nature's Own lost only 10 basis points of unit share.
Specialty loaf, sandwich buns and rolls and breakfast achieved historical highs for the third quarter with unit share in each of these subcategories, up a respective 150, 40 and 20 basis points. Sandwich buns and rolls benefited from outstanding bun season execution, much of which can be attributed to the improved focus resulting from our new sales and supply chain structure.
Importantly, we've maintained our positive momentum into the fourth quarter, gaining more than 20 basis points of unit share in the bread category in each of the first 3 weeks. The uncertain economic environment continue to encourage consumers to trade down to private label products and shift more of their purchases to value channels like mass, club and dollar stores. Private label products gained 40 basis points of unit share in the third quarter. However, that growth is moderating, and it's down from 70 and 50 basis point gains in the first and second quarters. And private label games remain centered in the mass channel, with share in the grocery channel falling again in the quarter.
Now I'll provide an overview of our third 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 then I'll come back with a discussion of key themes moving forward.
I'd like to start by recognizing the incredible contributions of our team. Our third quarter performance is a testament to their passion and effort. One of my most important jobs is ensuring that we have the right team with the necessary skills to achieve our long-term goals. To that end, we announced several leadership changes in August. Heeth Varnedoe has assumed the President title in addition to continuing as Chief Operating Officer. Heeth has proven to be an invaluable member of our management team, having successfully led a number of crucial initiatives. His promotion to president acknowledges that impact and what I expect him to contribute moving forward.
Additionally, Terry Thomas joined the leadership team as Chief Growth Officer. He knows the company well as a former Board member and his experience at several leading CPG firms will bring new capabilities and perspectives to Flowers. He's already working hard to uncover new revenue streams and further our transition to a more consumer and brand-centric company.
We're also fortunate to add 2 new board members: Brigitte King, the Global Chief Digital Officer at Colgate-Palmolive and Joanne Smith, Executive Vice President and Chief People Officer at Delta Airlines. Brigitte and Joanne bring new perspectives to our Board and experience that aligns perfectly with 2 of our strategic imperatives, growing our brands and developing our team. Their knowledge and experience should benefit us as we look to expand more into digital commerce and enhance our recruitment, retention and talent development programs. I couldn't be more excited about the positive changes we expect these appointments to bring.
Our second strategic priority is focusing on our brands, and they continue to perform well despite a pressured consumer. DKB was a particular standout, outpacing both the bread category overall and the organic subcategory. The brand to continues to prove that consumers are willing to pay premium prices for differentiation and superior quality and taste, even in the current economic environment.
In contrast to the overall bread category where units in tracked channels declined 2.2%, DKB grew overall units 5.6%, with units up in each business cell -- loaf, buns and breakfast. That performance resulted in noteworthy share gains with a 20 basis point improvement in unit share of fresh packaged bread 160 basis points in the specialty loaf category and 290 basis points in the organic category.
Another highlight was Nature's Own Keto bread, which demonstrates our ability to meet changing consumer preferences. This newly introduced product has been a hit with consumers since its rollout in the second quarter and has been gaining share rapidly with unit share up 440 basis points in the quarter, and those share gains are largely incremental with the majority of sales coming from consumers who are new to Nature's Own and Flowers. Speaking of innovation, the rollout of our DKB snack bars continues at strong pace, ending the quarter with distribution in almost 14,000 stores. In addition to our traditional customer store base, we're also targeting small format locations, adding significant growth potential via new points of distribution. Average ACV has been improving weekly and velocities are ahead of some of the leading brands in the category. We're investing to continue that growth with shopper marketing and e-commerce programs designed to drive trial and conversion with existing DKB consumers.
We're also preparing for the national launches of DKB protein bars and DKB snack bites in the spring and second half of 2024, respectively. Our teams are working hard to add to the list of retailers who have already approved these promising new products. We're excited about their potential to supplement the initial snack bar launch.
Last quarter, we discussed some near-term headwinds and tracked channels for our Canyon-branded products, which were 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.
I'm happy to report that we have resolved the capacity issue, and we've got aggressive plans to reaccelerate growth. We're resuming promotions, restarting production of discontinued SKUs and reinvigorating our innovation pipeline. Although units declined in the quarter versus the prior year as we brought on new capacity, sales improved in each consecutive period in the third quarter and the timing of this push couldn't have been better as October was gluten-free awareness month. We remain optimistic about the potential for Canyon, which remains solidly in the #1 market share position.
Our third strategic priority is margins. While margins benefited from price increases taken earlier this year and moderating commodity costs, we are continuing to invest in growth, such as marketing to support the snack bar launch and the rollout of our digital initiatives, including our new ERP system. To help offset the impact of those investments, we are focused on executing our portfolio strategy and maximizing efficiencies. Branded retail products increased to 64.3% of sales, up 20 basis points sequentially despite continued pressure from private label. And our progress toward our 2023 savings goal is ahead of schedule, having already achieved $25 million in savings compared to the original $20 million to $30 million goal.
Based on this progress, we're updating the goal to a range of $30 million to $35 million. 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?
Thank you, Ryals, and hello, everyone. Total sales in the third quarter increased 3.5% from the prior year period. Improved price/mix drove the year-over-year increase, up 6.3%, primarily due to price increases to mitigate inflationary pressures. Volume decreased 4.1%, partly due to targeted sales rationalizations in foodservice.
The Papa Pita acquisition added 1.3%. Gross margin as a percentage of sales, excluding depreciation and amortization, increased 170 basis points to 48.5%. Comparisons benefited from inflation-driven pricing actions more than offsetting input cost inflation, lower production volumes, increased product returns and higher maintenance and labor costs.
Selling, distribution and administrative expenses as a percentage of sales were 50.4%, a significant increase over the prior year period due to increased legal settlement expense, workforce-related costs, marketing investments and amortization of technology. Those costs were partly offset by lower distributor distribution fees as a percentage of sales and acquisition costs incurred in the prior year period. Excluding matters affecting comparability, adjusted SG&A expenses were 38.4% of sales, a 200 basis point increase due to the factors previously mentioned, with the exception of the legal settlement expense and prior year acquisition costs.
As we have previously disclosed, on August 29, 2023, we reached an agreement to settle distributor-related class action litigation in California. The settlement provides for a $55 million common fund to cover settlement payments to a class of approximately 475 plaintiffs and attorney's fees among other payments and expenses. The settlement also requires a phased repurchase of approximately 350 distribution rights in California. Once completed, the company plans to service its California market with an employment model.
The repurchase of distribution rights is anticipated to be completed by the fourth quarter of fiscal 2024. We estimate that net repurchase cost to be approximately $65 million. This amount is higher than the previously announced estimate due to the inclusion of approximately 50 additional distribution rights that are not part of the settlement. These amounts were recorded in SG&A during the third quarter of fiscal 2023. Please note that the terms of the settlement require court approval, which is expected in early 2024.
GAAP diluted EPS for the quarter was a loss of $0.22 per share compared to income of $0.19 in the prior year period. Excluding the items affecting comparability detailed in the release, adjusted diluted EPS in the quarter was $0.29 per share, down $0.01 from the prior year period.
Turning now to our balance sheet, liquidity and cash flow. Year-to-date, cash flow from operating activities decreased by $34.2 million to $257.3 million. Cash flow from operating activities was affected by lower net income and reduced deferred income taxes, partly offset by working capital decreases largely due to higher legal settlement accruals.
Capital expenditures decreased $31.4 million to $97 million and included $24 million for the ongoing ERP upgrade. Dividends paid increased $6.7 million to $146.7 million. Our financial position remains strong. At quarter end, net debt to trailing 12-month adjusted EBITDA stood at approximately 2x. We held approximately $15 million in cash and cash equivalents and had approximately $547 million of remaining availability on our credit facilities.
To reflect the third quarter results, we are adjusting the sales and EBITDA forecast for our 2023 guidance. Our updated expectation is for sales in the range of $5.085 billion to $5.104 billion and adjusted EBITDA in the range of $495 million to $515 million compared to the prior range of $5.095 billion to $5.141 billion and $503 million to $528 million, respectively. Our EPS target is unchanged at $1.18 to $1.25 per share.
While earnings per share were roughly in line with our expectations in the third quarter, sales were a bit less than planned. As Ryals mentioned, the primary drivers of that variance were business rationalizations that materialized sooner than expected and a lower-than-normal amount of storm activity.
For the fourth quarter 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, timing of business exits and continued inflationary pressure.
Overall, demand elasticity has been in line with our expectations, remaining below historical levels. As a reminder, our adjusted EBITDA guidance incorporated $17 million or $0.06 per share of incremental cost versus the prior year related to the ERP project. Those incremental costs were $2.7 million or $0.01 per share in the third quarter. We anticipate these costs to moderate substantially by project completion in 2026.
Additionally, our 2023 adjusted EPS guidance incorporates an $0.08 to $0.10 per share impact from an increase in interest, depreciation and amortization expense associated with the ERP implementation and Papa Pita acquisition. Our ERP rollout went live in the second quarter, and we continue to make progress in that implementation.
In fiscal 2023, we expect cost for the upgrade of our ERP system to be approximately $70 million to $80 million, including $25 million to $35 million expected to be capitalized. As of October 7, 2023, we have incurred costs related to the project of approximately $201 million, of which $108 million has been capitalized.
At quarter end, approximately 96% of our key raw materials for 2023 were covered. To minimize volatility and provide adequate visibility into cost, 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 our current coverage, our guidance incorporates a moderate decline in commodity costs in the fourth quarter of 2023 relative to our initial expectations. Commodity prices remain volatile, and we continue to monitor them closely, 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.
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. I'll first touch on the health of the consumer and then address the competitive environment.
As we discussed earlier, the consumer remains pressured. Category volumes are being impacted by higher food prices. And though lumpy, tracked channel data showed volume trends improving throughout the year as the magnitude of those price increases waned. That volume trend improvement reversed toward the end of the third quarter, largely due to tough comparisons from Hurricane Ian in the prior year. Category volume resumed the favorable trend as we moved into the fourth quarter.
In response to higher prices, consumers have shifted more of their purchases to private label, which gained 40 basis points of unit share in the third quarter. However, similar to the overall bread category, branded bread product trends improved consistently throughout the year. Private label unit share growth picked up toward the end of the third quarter due to year-over-year storm comparisons, but its share growth moderation resumed in the early part of the fourth quarter.
The disparity between mass and grocery also continued with private label losing 30 basis points of unit share in grocery. Private label unit share gains continue to be concentrated in traditional loaf, the subcategory with the least differentiation. Areas with greater product differentiation, such as specialty premium, dinner breast and rolls and sandwich buns and rolls showed declines in private label share. And those subcategories were where we gained the most unit share in both the mass and grocery channels.
Our grocery business was a particular area of strength as we gained 10 basis points of unit share in the quarter. We continue to closely monitor consumer trends, including the potential impact of GLP-1 agonists. So far, we haven't detected any change to consumer demand as a result of these drugs, while acknowledging that there are many unknowns, including their impact on eating habits long-term effectiveness and side effects.
However, we think our brand portfolio is well positioned to benefit, should these drugs gain traction. Many of our products, including those of our strongest brands such as DKB and Canyon Bakehouse, have health attributes that we believe would complement the potential benefits of GLP-1s.
Research seems to show that consumers taking these drugs tend to seek out healthier foods, which we believe could drive demand for some of our breads and snacks. We plan to conduct research to better understand the potential impact of these drugs and how our products might satisfy consumer needs in this area.
I'll now turn to the competitive environment in the bread category, which remains rational despite the weakened consumer and category volume declines. As one would expect, promotions have increased relative to the abnormally low rates in recent years. However, they remain below pre-pandemic levels. Lifts from promotion are also lower than historic levels as inflationary pressure on consumers translates into reduced expandable consumption.
Syndicated data shows that all of grocery, including the bread category continues to be largely base sales driven. Having a portfolio of leading brands is crucial in such an environment, the ability of DKB to grow units even as consumers seek to stretch their spending highlights the advantage of differentiated products. And we're innovating to align our portfolio even closer to consumer demand as evidenced by our Nature's Own Keto products and DKB stacking initiatives.
No matter the environment, our 4 strategic pillars guide us on our path to maximize shareholder value over the long term. We've added significant talent to our already strong team and improved our operating structure to allow for greater focus on key initiatives. We continue to innovate, adding new products to our leading brands and pushing them into adjacent categories to increase their market potential. We expect these activities to expand the proportion of our higher-margin branded retail products and improve corporate profitability.
And we aim to supplement that organic growth by adding new capabilities, brands and products through M&A. So we're focused on finishing the year strongly and continuing that momentum into 2024. I remain extraordinarily confident in our long-term prospects, and I look forward to reporting on our progress over the coming quarters.
Thank you very much for your time, and that concludes our prepared remarks.