Flowers Foods, Inc. (FLO) Earnings Call Transcript & Summary

Thanks, Cheryl, and good morning to all of you. We put out our fourth quarter results last night. You can find the earnings release and the quarterly slide presentation posted on the Flowers Foods website in the Investors section. We expect to file our 10-K with the SEC on February 19th. Before we get into our discussion, please keep in mind that it may contain forward-looking statements regarding the company's performance. While we consider those statements reasonable, they carry risks and uncertainties that might make actual results come in materially different; beyond the items we'll cover on the call, key factors concerning Flowers Foods' business are described in full in our SEC filings. Joining us this morning are Ryals McMullian, our CEO, and Steve Kinsey, our CFO. Rya, over to you.

All right, thank you, J.T., and good morning, everyone. We appreciate you being on the call. Before we dive into the quarter's specifics, I'd like to briefly remind everyone of the four strategic priorities that guide our value creation. Those are: concentrating on our brands, putting margins first, pursuing smart M&A, and developing our team. Delivering on each one is how we plan to hit our long-term objectives of growing sales 2% — 4% and earnings 8% — 10%. Reaching those objectives requires that we execute on two foundational themes. First, we understand that lasting, profitable top-line growth is critical to creating long-term value. We absolutely must build a portfolio of brands and products that looks ahead to what consumers need and excites our customers. Second, to generate value from our portfolio, we have to consistently expand margins by controlling costs, cutting out valueless complexity, and pushing efficiencies throughout the supply chain. As you hear our remarks this morning, please keep in mind several proof points tied to those two foundational themes that we see as evidence we're making progress toward our goals. One: the investments we're making behind our key brands are producing solid top-line growth, especially from DKB, Canyon, and Nature's Own. Two: margin improvement efforts stemming from our portfolio and supply chain optimization program are now underway, and we're highly confident that once executed, these efforts will eliminate valueless complexity, boost our operational efficiency, and generate meaningful earnings growth; in fact, the fourth quarter gave us some early evidence of exactly that, with modest margin improvement. The third proof point is the investments we've made to strengthen our team's capabilities by giving them the tools and the motivation they need to make better-informed, quicker decisions on the key drivers of our business. Underpinning all of this is full buy-in from the senior leadership team, which operates against clear expectations and is committed to building a culture of action and accountability. With that, I'll hand things over to Steve to walk through the quarter's details and share our guidance for 2020, and then I'll return to go over our operational priorities before we take your questions. Steve?

Thank you, Ryals, and good morning to everyone. We were happy to report record sales and operating cash flow for the year. Solid top-line momentum carried on in the fourth quarter, driven mainly by sales growth in the retail channel and stabilization in the non-retail channels. Consolidated sales rose $37.1 million, or 4.2%, quarter-over-quarter. Canyon Bakehouse contributed roughly 3% of that increase; within the base business, better price mix drove 2.1% of the sales gain, while lower volumes cut the top line by 90 basis points. Price realizations improved across most of our channels and product classes, which helped address the inflationary headwinds we faced in recent quarters. The main reason volumes declined was less promotional activity around traditional loaf breads, along with business we lost in food service. Now looking at the sales channel, branded retail sales were up $29 million, or 5.5%. Over half of those incremental sales dollars came from Canyon Bakehouse's branded products. Continued growth from Dave's Killer Bread and Nature's Own Perfectly Crafted largely drove the rest, partly offset by lower sales of other traditional loaves. Store branded retail sales increased $9.8 million, or 7.5%. A significant portion of that gain is attributed to the Canyon Bakehouse store brand business we acquired. The remaining increase came from a mix of better pricing and higher volume driven by wider distribution among current customers, though that was partly offset by weaker sales of store-brand cake and breakfast products. Sales to food service and other non-retail channels declined $1.7 million, equal to 80 basis points. That drop was mostly attributable to lower volumes, partly because of business lost from the inferior yeast disruption in 2018, along with reduced institutional volumes. Gross margin for the quarter held steady at 47% of sales. Gains from improved pricing were offset by rising workforce costs and weaker manufacturing efficiencies measured as a percentage of sales. If you look past the comparability items laid out in the press release, adjusted SD&A expenses came in 20 basis points lower as a share of sales. That was mostly driven by reduced distributor distribution fees and logistics costs, partly offset by increased workforce and marketing expenses. GAAP diluted EPS for the quarter came to $0.01 per share. We did settle several IDP-related lawsuits, and because of that, reported EPS this quarter took a hit from a legal settlement charge of roughly $0.10 per share. Setting that aside, along with the other comparability items described in the release, adjusted diluted EPS for the quarter stood at $0.18 per share, which is $0.02 higher than the prior year. Canyon Bakehouse contributed positively to EBITDA and EPS for both the quarter and the full year. Now a few remarks about leverage and cash flow. So far this year, operating cash flows have reached $367 million, while capital expenditures totaled roughly $104 million. As a result, cash flows year-to-date have been strong. We returned $160 million to shareholders through dividends and cut our debt by $114 million. At the close of the quarter, net debt relative to trailing 12-month adjusted EBITDA came in at about 2 x. That leads us to our 2020 guidance. First, I'd like to note that 2020 includes 53 weeks. Our forecast for sales growth is between 2% and 4%. That range reflects the additional 53rd week, which is expected to contribute approximately 1.5%. The rest of our revenue outlook comes from continued expansion at DKB and Canyon Bakehouse, share gains for Nature's Own and Wonder, plus better cake and food service sales; across the wider category, we anticipate growth will come mainly from consumers moving toward differentiated products rather than from higher volumes. For 2020, our adjusted EPS target sits between $1 and $1.08 per share. The middle of that range implies growth of about 8.3% on top of 2019 adjusted earnings per share of $0.96. We expect earnings growth in 2020 to come from leveraging sales growth, along with carrying out our supply chain optimization initiatives and lifting manufacturing efficiencies. We've said for a number of quarters now that our biggest defined benefit plan should be fully terminated in the first quarter of 2020. In connection with that, we expect a cash contribution of about $17 million to $35 million during the first quarter, along with a non-cash settlement charge of approximately $125 million to $143 million. Our capital expenditures target for 2020 is $105 million to $115 million, and roughly $19 million of that relates to making our Lynchburg bakery an organic production facility. We expect free cash flow to keep being generated strongly, and our priorities for allocating capital remain the same as we concentrate on maximizing return on invested capital and building shareholder value. We'll continue putting money into our brands and bakeries, and into efforts that make our team more capable. Another key focus will be strategic purchases that broaden our portfolio and boost its profitability. We intend to pursue that while preserving an investment-grade balance sheet and still delivering value back to shareholders via dividends and share buybacks made when opportunities arise; at this point I'll return the call to Ryals.

All right, thanks, Steve. As I mentioned when the call began, please remember those three proof points: growth in branded sales, optimizing both portfolio and supply chain to expand margins, and the investments we're making in our team. Beginning with sales growth, during Q4 our top-line momentum carried on as consumers moved toward differentiated, on-trend brands such as Dave's Killer Bread, Canyon Bakehouse, and Nature's Own Perfectly Crafted. Per IRI, those three brands combined saw strong double-digit growth in Q4 versus the fresh packaged bread category, which rose only 30 basis points. Canyon Bakehouse's integration has proceeded extremely well. Canyon didn't just move from the country's number three gluten-free bread brand to number one — we also beat our sales targets and our earnings contribution goals for the year. Canyon has a creative, entrepreneurial team located out in Colorado. I want to thank them for their hard work and for over-delivering in 2019. DKB remains a genuinely remarkable growth story. We bought DKB a little more than four years ago. Since that time, it has become our second-largest brand, with retail sales of roughly $581 million. Take a moment to consider that. At retail, that's over half of Nature's Own. Nature's Own launched more than 40 years ago; it's nearly equal to all of our white bread brands put together. Best of all, we still have ample room to grow, in some underdeveloped geographies and with additional customers who either don't stock DKB now or aren't yet inside our current DSD footprint. On top of that, household penetration for organic breads remains under-indexed compared with other organic products, which offers further opportunity. Given the brand loyalty consumers have shown, we believe DKB can also compete in other segments of the baked foods category. In fact, the success of our DKB breakfast products has already proven that. Going forward, we'll keep bringing innovative ideas to our passionate DKB consumers. In order to back DKB's impressive brand expansion and as part of how we're optimizing our supply chain, we shared in January that our bakery in Lynchburg, Virginia, is going to shift to organic production. The team we have at that Lynchburg facility is highly skilled. They are truly enthusiastic regarding this fresh growth assignment. By converting Lynchburg, we'll be able to reach East Coast markets with product that's fresher and costs less. We anticipate that the converted plant will be up and running in the fall of this year. In addition to DKB and Canyon, we posted strong share gains from Nature's Own Perfectly Crafted as well as Wonder. We're eager about what's planned for Tastykake and Mrs. Turning to Freshley's: we observed the business start to steady during the latter half of the year and actually record slight growth in Q4. Consequently, as you can see, the branded portfolio is producing robust results, and since that expansion stems from top brands and segments benefiting from strong consumer trends, we are confident the portfolio is positioned well for continued growth. Moving to proof point two, margin expansion: in Q4, I'm pleased to report that we achieved adjusted EBITDA margin expansion for the first time in eight quarters. We draw encouragement from stronger price realizations, tighter control of sale, and steadier performance in our cake and food service businesses. That said, there's still a lot to do before we reach our targets. We're concentrating on the three priorities I outlined for you last quarter. Executing on them is our path to steady margin improvement over the long run. The first priority is optimizing our portfolio and supply chain. A quarter ago, I told you about the rigorous review we had going to move the portfolio toward a growth profile that adds more margin, to simplify our supply chain so it supports a net-optimized portfolio, and to cut complexity from our operations. We completed that review just last week, and it involved creating a tool that gives us a fuller picture of customer and product profitability. With this tool, our understanding of product economics and cost to serve became much better informed. As a result of the review, we now possess actionable insights and are preparing concrete plans to do several things, including lowering some direct input costs, streamlining our distribution network, raising cube utilization for products with lower volume, and directing improvement work toward bakeries that are underperforming. Given the work done to date, we feel a high level of confidence that the initial savings from these projects can be captured this year. For that reason, we have built them into our 2020 guidance range. To ensure these various initiatives deliver results on time, we will bring in outside resources. The majority of those benefits should start showing up in the back half of the year, and our guidance already bakes in $10 million-$20 million of benefit for 2020. As we start executing on the projects and get a clearer picture of how much additional savings we'll pursue and when, we'll keep you posted. Getting the bakery improvements done is going to be essential for realizing savings and lifting margins. The tight labor market has hurt efficiency at just about every one of our plants, but the effect has been especially severe at six sites, and those are where we'll concentrate intensely first. As I said, we're engaging outside help, which I believe matters especially when it comes to improving operations and accountability; we're putting this money into our team so they get extra backing and we realize value faster. Now for our second priority: breathing new life into the cake business and putting money behind it. On that front, we're making several significant moves in both sales and operations. Back in January, we ran an intensive workshop designed to produce a comprehensive, detailed plan for upgrading our Navy Yard bakery, where efficiency has been running low and scrap rates are high. The team now has a clear set of specific actions centered on better processes, standards, and operational discipline. We also anticipate achieving higher efficiencies from the significant automation investments we're making at that bakery this year. On the overall cake sales side, our focus is on strategic volume growth to drive cost absorption, on cutting complexity through SKU rationalization, and on additional distribution opportunities plus innovation. Underpinning all of this is reinforcing a culture of excellence that consistently delivers high quality, service, and incremental innovation. Our cake business matters to us, and it's a key contributor to our bottom line. By providing focus and setting clear priorities, we intend to accelerate it toward its potential and drive meaningful earnings growth. Next is our third priority: getting our food service operation stable and expanding it. With yearly revenue near $1 billion, that business gives us operational scale and serves as an important generator of cash for Flowers. To improve profitability, the team relies on our product profitability tool so they can make smarter calls on pricing and on which product lines to expand; they're also working to land new business and deepen customer engagement as a way to fuel future growth. That leads to our last proof point, investments in the team. As I mentioned before, we're directing more investment toward the team, and that accomplishes a number of important objectives. We're putting in place stronger standards and processes, a higher degree of operational discipline, more structured ways of boosting efficiency, and faster delivery of value. The team is eager to get these investments, and they're ready to take on the challenges that lie ahead. Finally, we've made additional changes to our incentive structure, which worked quite well in many respects in 2019. I think the tweaks to our 2020 incentives will do even more to encourage the kind of effort and activity we need to move toward our goals. In closing, we're entering 2020 on the right path, with clear progress on our two key priorities: growing sales and expanding margins. Strong consumer trends are helping the top line, even though the broader category has shown some softness. In Q4, our margins improved somewhat, and we have pinpointed initiatives capable of producing substantial cost reductions and better operations down the road. Underpinning all of this is a skilled, committed workforce that plainly grasps our strategic priorities and concentrates on delivering against them. On that note, Cheryl, let's begin taking questions from the line.

Great. Thanks very much. Morning, all. I suppose my main general question concerns the timing of the internal study and portfolio optimization — the 3 pillars — versus what you think could involve some incremental expense this year, since what I'm picking up is that we've done a lot of work. Hopefully it all sounds — it's all clearly quite positive, and there's an outlook for Flowers potentially across the coming few years, because improving price mix and optimizing your plant network, whatever else, all of that takes time. Going back to just Project Centennial and the roadmap that was laid out, we were thinking 2017, 2018, then 2019 and beyond. We're now in 2020. Essentially, is what you're saying that we're now in this beyond phase? We have outlined the go forward of what all this might mean over the next few years. In the first year, which is 2020, there are going to be benefits, but there might be a few offsets just in terms of investment for those benefits. Then you'll tell us later what those benefits might mean to kind of a revisited margin outlook, potentially if in 2021 and 2022; that's it.

Okay. Well, first of all, Rob, welcome back. It's good to have you back in coverage.

It's great to be back with you. Thank you.

Yeah. Good. Yeah, we wrapped up the diagnostic just last week, so what we've presented today is the initial savings we have a high degree of confidence in for 2020. I mean, clearly, I said there's more coming on that front, but until we refine those figures — and it's really the timing of hitting those figures even more than the figures themselves — until we've refined that, I'm simply not ready to share it today; we'll keep you updated as things progress, and honestly, we should have it all finalized for you by our first quarter call. The $10 million to $20 million range is what we have high confidence in delivering during this year. You're correct that this includes elements spanning short, medium, and long timeframes. When it comes to the supply chain optimization work itself—starting with bakery optimization—that's the most intricate portion, and it's the one with the longest horizon. You need to factor in how your portfolio is composed, whether you might or might not intend to exit anything, and how that ripples through the bakery network; given all the reciprocal baking we do, that gets quite complicated. That said, on the optimization side, there are certain closer-in opportunities tied to the distribution network. A number of those items are ones we can address relatively fast. Thinking back to the Project Centennial period, a key step we took under Centennial involved bringing many functions together in one place. Depot procurement had previously been handled in a decentralized way — usually each bakery took care of it independently, more or less on its own. We have since brought that under one umbrella, yet certain problems inherited from the network stemming from those separate moves are still with us, and those are items we can address in the short term; on the investment side, we have discussed at length, in connection with Centennial, the cost savings achieved, the money put back into the operation through innovation teams, marketing teams, business units and similar efforts, and then clearly the inflation-related cost pressure that eroded part of those savings; as for this project, what I can say is that far less is reinvested into the operation, on a net basis after gross savings, if that makes sense. Most of our capabilities are now in place. A small amount will still be needed, though far less is required to hit the savings targets. Our spending on outside resources for this project is significantly below what we saw with Centennial. I hope that addresses most of what you were thinking about.

Yeah, no, that's great; it's very comprehensive, and it makes complete sense. Just looking forward to the update later this year. Thank you very much.

You're welcome.

Yeah, thanks. Morning, everyone. Let me kick off with the first question. Pricing held pretty firm all through the year, obviously. We had price mix tailwinds. Volume came in a bit soft during Q4. Looking at scanner data, we're seeing somewhat more aggressive promotions in the fresh bread category. So I suppose this is a two-parter. First — and apologies if you covered this and I missed it in your prepared remarks — the volume decline in Q4, is that down to something strategic on your side, like SKU rationalization and so on, or could it be down to some competitive activity in the market? The second thing I'd like to ask is what you're observing in the marketplace, particularly since your presentation mentioned that ingredient costs declined in Q4?

Of course. Yes, we experienced somewhat softer volumes in the traditional loaf products during Q4 — and to respond to your question directly about whether that stemmed from market forces or from us, the answer is that our promotional activity was much lower in Q4, which led to some volume slippage. When we look at the full year overall, we felt quite good about the trade-off we achieved between reduced promotions and lower volumes across the year as a whole. Looking at the competitive landscape in general, things look much the same in Q4 of this year as they did in Q4 of last year. A few markets, and even certain individual retailers, have seen somewhat elevated competitive activity.

All right. So moving that forward, the year was clearly a strong one, and in Q4 volume came in a bit softer, as you pointed out, yet you maintained your approach on pricing and promotions. Do you feel confident that this approach can hold up given what you're observing in the market out there? Or do you anticipate some moderation, whether on the competitive front or because you may need to give back some of it?

What I'd tell you is that we examine things market by market, and as we've mentioned in earlier quarters, we now have a trade promotion management tool in place that has been quite useful in helping us be more targeted and sharper regarding promotions and the returns we generate from them. Naturally, we track competitive activity in each market, and we act where we deem appropriate on a market-by-market basis.

Fair enough. I'm just curious—as we, I suppose, begin to look ahead, one of the genuinely interesting opportunities for the business, I think, lies in some of those white space opportunities and adjacent categories. I know we've discussed that before. Thinking about breakfast and other occasions, maybe in-store bakery, et cetera—any sense, or any update, on the progress against those initiatives and how you're thinking about getting bigger or exploring those opportunities more actively going forward?

For sure. First off, there's innovation from within, correct? We entered the breakfast space with DKB; that's performed really well, and we'll continue developing new ideas around those. As we mentioned, this matters a great deal—especially when you consider the broader weakness in the traditional loaf category. It's more crucial than ever that we pursue innovation on two fronts: internally, as we did with Nature's Own Perfectly Crafted, and through acquisitions, as we've done with DKB and Canyon, since that's essentially where market growth is happening. As I noted in my prepared remarks, I definitely see opportunities for both of those brands, DKB and Canyon, to expand beyond their traditional segments; we're actively exploring those possibilities. And then, of course, just as we've always done, we seek out M&A opportunities that can address those gaps too.

Thank you. That's useful coverage. This is my final question. I'm just considering gross margin and how overall margins are structured for 2020. Clearly, you've got certain plans in place—better manufacturing efficiencies and so forth—that are built into those figures and appear likely to produce some margin expansion. Just so I follow, on ingredient cost, what trend should we anticipate across 2020? Clearly, the other pressure comes on the labor side, which has been with you folks for some time now. Freight has been there too. Should we expect those elements to hold roughly stable, or is any easing likely? If you could help us grasp that, I'll hand it over. Thank you.

Yeah, sure. I'll handle the labor and freight portion and let Steve speak to commodities. On the labor side, we experienced continued elevated labor costs during the fourth quarter, just as we did throughout 2019. Those same challenges remain. The labor market is still extremely tight. Turnover is a problem, and that consequently impacts bakery efficiency; now, as I said last quarter, we do have several initiatives underway aimed at improving quality of life in the bakeries—giving additional days off, consecutive days off, that type of thing. We're starting to see that turnover begin to decline. We haven't quite yet observed that flow through on the cost side, but it's still very early and training and similar matters do require some time to work through. Then, as you noted—even within your question—the supply chain optimization effort ought to help ease some of that cost going forward as well; we have observed the transportation market flatten out; it remains elevated, but it isn't climbing at the pace we witnessed across the prior year and a half or so. Steve, would you like to address the commodities portion?

Absolutely. If you take a look at total input cost, Brian, we’re basically aligned with the strategy we’ve laid out of covering a six-to-nine-month horizon; honestly, we still have some coverage that isn’t locked in for the back half. With that in mind, our forecast includes a modest amount of improvement in total input cost. It isn’t significant. It’s very low single-digit gains compared with a year earlier. Again, that depends heavily on how we’re able to come in and complete our coverage during the back half of the year. We’ve observed a bit of an increase in certain commodities over the last few months; we’re monitoring that and working to make sure we offset it wherever possible.

That's really useful, and thanks once more. Good luck to you both.

Thanks.

Hello, and good morning. I'm sorry if I came onto the call a bit late. I had a few questions. I'm seeing that your bread share for the quarter fell to 16.5%. Do you have any thoughts on that?

Well, when it comes to total fresh packaged breads, our dollar share was up slightly per IRI. What are you referring to?

All right. I take it the decline happened sequentially?

Yes, sequentially. We discussed this somewhat earlier — perhaps you didn't catch it — that the fourth quarter saw some weakness in the traditional loaf segment, which probably explains that. Growth from Dave's, Canyon, and Nature's Own Perfectly Crafted, which keep performing strongly, offsets it.

All right. And then when we look at the 2020 guidance, the low end — if you make an adjustment for that extra week, there really isn't much growth in there. Which factors are weighing on the low end of your range?

If you think about the low end of the range from a top-line standpoint, clearly that additional week contributes roughly 1.5% to the top line. From an overall sales standpoint, it's typically a week with softer, lower volume. As for the remainder of the business, at the low end we're anticipating only nominal volume growth. To reach the upper end of the range, I believe Ryals may have mentioned this earlier, volume and mix contribute significantly at the upper end. We keep seeing solid growth in the brands we recently acquired, and those really help drive a solid mix improvement. From that standpoint, on the top line, it will be essential that we keep seeing strong growth from those brands. As for the earnings and margin standpoint, once again, we usually add roughly $0.01, perhaps $0.015, to overall earnings. Once again, when you look at the coverage there, it's a softer week. Once again, that is the main factor at the low end of the range. At the upper end of the range, Ryals spoke at length about our optimization efforts and reaching that $10 million-$20 million range we've laid out, which is mainly driven by the back half. It will be essential that we deliver on those items and projects so that we can land at the upper end of the range.

All right, that's useful. Just one last thing I want to ask about. What are your plans for food service this year, and QSR in particular? You ran into some trouble there because of those poorer-quality yeast issues, so how do you expect food service to perform?

Mitch, 2020 ought to be an improvement. We'll be cycling past all of that. I think the final piece of it gets cycled past during the first quarter of this year. Only a little bit is left, and that's purely on the comparison side, stemming from the yeast problem. We'll be able to close the book on that subject. And yes, we have firm plans to grow in food service. As I said during the prepared remarks, it's a crucial piece of our business — a billion-dollar business. That's a major contributor, and what the team is concentrating on right now is, first, leveraging our new product profitability tool, which gives us a clearer view of true unit economics and cost to serve—in case you missed that commentary, Mitch. That makes us much more intelligent about the kinds of business we pursue. They're focused on securing new business and, honestly, on recapturing some of the business we lost too. In fact, we'll see a portion of that return in the first quarter, which is encouraging as we steady food service and then expand it, as we've said.

All right, fine. Thanks for those questions.

Yes, thank you, Mitch.

Thanks. Good morning.

Morning.

Hey, could you expand a bit more, I suppose on both Canyon and DKB, and really the distribution opportunities that come with Canyon? I suppose this is the first spring, sort of, where you've got full ownership and can plan things a bit better. Just trying to get a sense — does that actually happen? Are there distribution gains you see in the spring, or with your DSD network, is it more sporadic across the year? And is the growth coming more from the flaked out side of the business, or are you still seeing growth in frozen?