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

Good day, everyone. I'm J.T. Rieck, Senior Vice President of Finance and Investor Relations at Flowers Foods. Just a quick note that Flowers Foods issued its third quarter results on November 5, 2020. The release, along with the related slide presentation, is available in the Investors section of our website. Our 10-Q has been filed as well and is accessible on the SEC website. This quarter, we've altered our typical earnings format. For the third quarter of 2020, this call takes place on Friday, November 6, at 8:30 a.m. Eastern. Details are posted in the Investors section of flowersfoods.com. Before we begin, please remember that what's presented here may contain forward-looking statements regarding the company's performance. While we consider these statements reasonable, they carry risks and uncertainties that might cause actual results to differ materially. Beyond what you hear in these remarks, key factors concerning Flowers Foods' business are fully described in our SEC filings. Speaking today are Ryals McMullian, President and CEO, and Steve Kinsey, our CFO. Ryals, over to you.

Thank you, J.T., and I appreciate everyone's interest in Flowers. We feel really good about how the third quarter turned out; those results are strong and they mirror the ongoing pattern of more in-home get-togethers that started when the pandemic hit. This year has presented plenty of difficulties on many fronts. Our daily routines and jobs have been affected in ways we could never have anticipated, yet through it all, the people on our Flowers team have shown an unwavering dedication to serving our markets. I appreciate their persistence. Their commitment makes me humble, especially that of our front-line employees. They've displayed enormous bravery and a commitment to making sure consumers get the products they require, and we're determined to do all we can to give them a work environment that's healthy and safe. What we achieved this quarter mirrors our 4 strategic priorities: building up our team, concentrating on our brands, putting margins first and making smart M&A moves. Delivering on every one of these priorities is how we plan to hit our long-term targets of growing sales 1% to 2%, EBITDA 4% to 6% and EPS of 7% to 9%; we keep investing in our team so we have the right capabilities in place to reach our goals; in earlier calls, we've talked about our efforts to optimize our portfolio and supply chain, and we've reorganized the company to achieve those aims. In the third quarter, we brought on a new Chief Supply Chain Officer and a Chief Procurement Officer, and they're deepening our expertise in those respective areas. Our focus on brands is moving forward too. New items like DKB buns and extensions of our Nature's Own Perfectly Crafted line are producing very good early results; we've advanced further in establishing our new innovation capabilities, and we're putting together plans to deliver more distinctive and differentiated products that address consumers' evolving needs and, building on our foundational consumer research, we're crafting a road map for profitable growth meant to optimize how we allocate resources. As part of that effort, we've sorted our portfolio into 4 distinct roles, spanning from high-growth brands to businesses with limited profitability. Dividing our portfolio this way gives clear roles to the brands and products we hold, which is meant to drive more targeted decision-making about brand investments so we get the highest return. I want to stress that although a portion of our private label and foodservice business does underperform when it comes to margin, both still play a key supporting role in the portfolio. We intend to make them perform better, collaborating with our customers. We think that can be done through pricing, certainly in some instances, but pricing isn't the sole route. As strategic partners to our customers, we're looking for ways to boost profitability on our end too. That may involve more efficient distribution, manufacturing, different formulation, packaging and other possibilities. There will probably be situations where we can't land on a solution both sides find acceptable for reaching the profitability levels we need, but our starting intention is to keep serving customers in a manner that benefits both parties. As for the portfolio and supply chain optimization work that we kicked off at the close of last year, we anticipate delivering no less than $20 million in savings from those efforts during 2020. Those savings stem from several distinct initiatives, among them procurement, overhead streamlining, network optimization and bakery operations improvement. As a reminder, our original projection for those savings this year was somewhere between $10 million and $20 million. So it's a pleasure to report that we are running ahead of what we previously expected. We also anticipate capturing further benefits from this work as we head into 2021. Information technology is another area we're focused on for margin improvement. As a lot of you are aware, we run in an SAP environment, and over the coming few years we'll need to move to a more robust platform, S/4HANA, as SAP phases out support for the platform we use now. We brought in SAP more than 20 years ago, and plenty of enhancements have happened in the time since. The upgrade should sharpen data management and efficiencies while automating a great many of our processes; yet instead of treating this as strictly an IT project, we started a digital strategy initiative back in August that is meant to transform the way our business operates. This new strategic initiative has 3 primary goals: one, to bring more agility into our business model by empowering the organization through a fundamental redesign of core business processes and how we work; two, to embed digital capabilities where they matter and transform how we engage with our consumers, our customers and our employees; and three, to modernize and simplify our application and configuration landscape so we can clear away existing roadblocks and support our new ways of working, with the new ERP system serving as a key enabler of our business strategies. We're in the middle of finishing the initial planning and road mapping work right now, but a great deal lies ahead as we move into 2021, and we expect to give you an update on our fourth quarter call in February. The present environment and the resulting mix shift toward branded retail products are plainly fueling margin improvement as well. As I've mentioned on prior calls, we started our portfolio strategy work before COVID arrived, and we're already progressing toward a more brand-centric focus; however, the mix shift we've seen this year has shown just how valuable our strategy is and has helped speed up our adoption of it. Even though total volumes are down in 2020, our profitability has improved noticeably, since we're now witnessing the real power of concentrating on our brands. As we work to seize the opportunities in front of us, we also know that we’re starting from a strong position thanks to our lineup of leading brands such as Nature’s Own, Dave’s Killer bread, Canyon Bakehouse and Wonder; our expectation is that this focus will let us keep many of our new consumers, even as demand conditions start to moderate. On M&A, we continue to be proactive in the deal space, while sticking with the disciplined approach we have long maintained. M&A has always been an important part of our growth story and will remain so. The criteria we use for M&A candidates are those that can strengthen our branded portfolio, expand our geographic presence, fit our culture strongly and bring added capabilities to our company. We think our strong balance sheet gives us the flexibility to pursue a wide range of deals; and when the right deal that meets these criteria comes along, we will be ready. Now I’ll hand it over to Steve to review the quarter’s details and update our guidance for 2020. And then I’ll return at the end to discuss the current business environment. Steve?

Thanks, Ryals, and good morning, everyone. I want to second what you said and give my heartfelt appreciation to our amazing team, whose work through this challenging period has been exceptional. Once more, thank you. Moving on to the quarter's results. COVID-19 is still exerting a significant influence on what we report, though that effect is easing a little. Sales for the quarter climbed 2.4%, which is lower than the 5.1% growth we posted in the second quarter. Price/mix accounted for 8.1% of the increase in sales, driven mainly by a shift in mix toward branded retail items, largely because consumers are preparing more meals at home. Volume subtracted 5.7% from overall sales, with notable softness in store branded and foodservice and other nonretail channels. On sales by channel, the trends largely mirrored what we saw in the second quarter, albeit more moderately. Branded retail sales grew $71.2 million, or 12.2%. Our leading brands keep propelling company performance, with standout strength from Nature's Own, Dave's Killer Bread and Wonder. As Ryals noted, new products including DKB bunds and extensions of our Nature's Own Perfectly Crafted line contributed meaningfully. Store branded retail sales fell $14.4 million, or 9.5%, with softness across the board as consumers moved toward branded products. Foodservice and other nonretail sales declined by $33.7 million, or 14.7%. Reduced volumes stemming from the COVID-19 pandemic accounted for most of that drop. These declines showed up across most categories of our nonretail business, especially food service, schools and other institutions. For the quarter, gross margin, excluding depreciation and amortization, rose 240 basis points as mix shifted toward higher-margin branded retail products. Partly offsetting that gain was $1.9 million in start-up cost tied to converting our Lindsborg, Virginia facility into an organic bakery. SD&A rose 160 basis points in the third quarter. Excluding the items affecting comparability detailed in the press release, adjusted SD&A expenses were up 50 basis points as a percentage of sales. A change in product mix pushed more sales through our DSD network, which led to higher independent distributor fees. Workforce-related costs rose mainly because of higher employee incentive costs tied to our improved financial performance. GAAP diluted EPS for the quarter came to $0.21 per share. Excluding the items affecting comparability detailed in the release, which are largely restructuring costs related to employee and lease terminations and impairments driven by our strategic initiatives, adjusted EPS for the quarter was $0.29 per share, up $0.07 from the prior year quarter. Now on to our balance sheet, liquidity and cash flow. Year-to-date cash flow from operating activities rose $86.3 to $364.4 million versus the year ago period. Capital expenditures totaled $68.3 million, and dividends paid amounted to $124.9 million. Our financial position remains strong. At quarter end, net debt to trailing 12-month adjusted EBITDA was approximately 1.4x, down from 2x at 2019 year-end. By the time the quarter closed, cash and cash equivalents stood at roughly $326 million, and we still had $478 million available under our credit facilities. Let me shift to what we expect for the rest of 2020. Since just one quarter is left in the year, we're lifting our 2020 guidance. Our forecast now calls for sales growth between 5.5% and 6%, and we're raising the earnings guidance range to $1.23 to $1.28, versus the earlier $1.15 to $1.25. Keep in mind that 2020 has an extra week, which we expect to add about 1.5% to annual sales growth. As we entered Q4, the operating environment has stayed fairly consistent with what we saw in the third quarter. That said, a few items factored into our guidance adjustment: higher incentive compensation, a holiday season that's uncertain and favors dinner rolls over Love Bread, and shifts in our scrap and still rates, which have been favorable so far this year. In a moment, Ryals will give more detail on the factors we weighed when looking ahead to 2021. We anticipate continued strong free cash flow generation, and our capital allocation priorities and philosophy are unchanged, with our focus on maximizing return on invested capital and growing shareholder value. For 2020, we're targeting capital expenditures of $85 million to $95 million, including about $19 million tied to converting our Lindsborg bakery to organic production. Thank you. And now I'll hand it back to Ryals. Ryals?

Thanks, Steve. The environment is still a favorable one for our branded business. Demand has softened a bit from the peak levels we witnessed in the first quarter, yet our strong brands and operational execution keep delivering appealing share gains and margin improvement. Unlike the strong branded retail sales, foodservice results are still under pressure, since many customer locations are running with capacity restrictions and lower demand. No one can say how long this environment will persist, but our aim is to get the most out of current performance while also getting ready for the point when demand normalizes. At a minimum, we believe the current climate validates our approach to the portfolio—pursuing better margins as we concentrate more on our branded retail offerings. Earlier I covered our plan for ongoing profitable expansion and the way we anticipate that plan will shape results ahead. Dividing the portfolio into distinct segments brings fresh, stronger discipline and sharper focus; we are fortunate to operate a business that generates substantial free cash flow. Meaningful returns for shareholders require us to direct our resources toward those areas offering the best risk-adjusted returns. This portfolio approach, together with the organizational restructuring we recently completed, will assist us in making those allocation choices as effectively as possible. Looking forward, we'll direct capital to various parts of the business so we can make our leading products even better and gain efficiencies that support margin improvement down the road. One clear example is what we've done at our Lindsborg bakery, where organic production began in March. I'm pleased to say that since early October that facility has been operating and producing high-quality DKB items for the market. This extra output should help us boost days of service and quality in the key Northeast markets, while also providing some welcome relief to our other bakeries that currently serve that region. DKB continues to grow quickly, and 2020 retail sales are now projected to exceed $800 million. Lindsborg really shows our strategy in action—shifting production toward the parts of the portfolio with the biggest margins and the most growth. In line with that effort to put margin first and keep costs in check, we're also directing capital toward better returns at our Navy Yard bakery, which has been underperforming. You'll remember that when we restructured the organization, we appointed David Roach as President of Cake Operations, and his single mandate is to turn around results at Navy Yard. For this situation, near-term expansion isn’t our main objective; instead, we’re focused on making operations better. We have automated production lines, strengthened the management team, and gained efficiency improvements. Much remains to be done, but I’m glad to say that following a fairly lengthy stretch of weak results, signs of progress are beginning to appear. I also anticipate those trend lines will continue getting better as we enter 2021. Bringing that bakery up to its full operational capability, as I’ve mentioned before, would deliver a substantial increase in profitability for the whole company. Finally, I realize that by this point in the year, many investors have shifted their attention to 2021 and later. We're developing our roadmap for next year, taking into account just how atypical 2020 has been and drawing on our best thinking as we attempt to forecast demand next year. As you surely appreciate, there are numerous factors to consider, including matters beyond our influence—such as the macroeconomy, commodity pricing, the next fiscal year having 1 fewer week, the political climate and, of course, the trajectory of COVID. Yet there are also elements we do control, among them new product launches and spending on talent, marketing, digital, as I noted earlier, and innovation; these investments, which are critical to hitting our long-term growth targets and boosting shareholder value, will start to accelerate in 2021. On the subject of long-term targets. As we laid out at our Investor Day in August, we stay committed to delivering performance consistent with those targets in fiscal 2022, using 2019 as the base year. We'll share more specifics about what we expect for 2021 when we report our fourth quarter earnings in February. At present, we are seeing continued strong branded retail performance, paired with softness in store brand products and foodservice. Branded retail remains above where it stood before COVID, even though it's plainly under its high point. As we move into 2021, the key issue is how long these patterns will last and what shape the return to normal will take; even so, whatever the operating environment turns out to be, we think our strategies are the right ones for prospering under any circumstances. Our portfolio consists of leading brands, and our attention goes to putting resources behind them. You can be certain that our skilled and committed team is putting in hard work to bring about positive change and get the most out of our performance. Our attention is fixed on the factors within our own command, while at the same time we prepare for a world after COVID, consider what the globe might resemble 2 to 3 years out, and strive to craft approaches that we feel will put our company in the strongest position for success down the road. Through ongoing execution of our 4 strategic priorities, we are confident that our long-term financial goals can be reached or surpassed. With that, I appreciate everyone joining us this morning; this concludes our prepared remarks.

I suppose I'd like to hear a bit more about what you're actually doing, or what you're observing, regarding price/mix as consumers shift toward branded products. And I'm trying to get at this, I guess, first from a manufacturing angle — I mean, have you begun altering your mix, so that you're actually producing less private label and more branded in order to cut back on sales? And then, at the same time, is this purely brand migration? Or does any pricing factor in?

Yes. So beginning with the manufacturing side, Bill, I mean, as you're aware, our manufacturing facilities are pretty flexible. So the same plant that produces brand often produces private label as well. So it's quite easy for us to ship, along with the consumer dynamics shifting from private label to brand. But adding on top of that, if you consider the Lynchburg bakery, that's probably a great example of moving up the mix chain, or up the margin chain, depending on how you want to look at it, toward our higher-margin products and adding production capacity to serve the market that way. From a pricing standpoint, not too much; we haven't seen too much pure pricing this year, but the promotional environment is certainly well beneath historical levels. So average base prices are, I guess, up some. We have seen that start to tick back up a little bit more recently, but still well off the historical levels.

Understood. And I suppose, just as I'm attempting to grasp how the brands are migrating — I mean, moving from private label up to Wonder offers one kind of benefit. Then there's another benefit in stepping up to Dave's Killer Bread. So which one drives things more? Or is it really all of them together?

Yeah, I'd say it's really the whole picture. What you're saying is right. I mean, the margins on DKB and the margins on Nature's Own, taken together, would come in higher than Wonder and certain other brands. Still, any move away from that lower-margin business toward higher-margin business, overall, is a boost to the bottom line. But DKB, clearly, is an enormous growth driver. Canyon has been a major growth driver this year, and yes, both of those carry very high margins.

Got it. So looking ahead to next year — I know you're not giving guidance — but I have a couple of questions. First, what kind of impact does it have on your business that 70% of U.S. school children are learning at home, virtually, or in a hybrid setup? And that could change, hopefully for many of us, at some point during 2021? Is that effect positive or negative? Then the same kind of question — Steve, I believe you said there's a variable comp element, and everyone is understandably having a good year. When you reset that to normal levels for next year, how does that shift turn into a tailwind?

Yeah, absolutely, Bill. I'll take the part about school kids, and then Steve can cover incentive comp. I mean, there are upsides and downsides to having the kids at home, right? We kind of lost the back-to-school lift we'd typically see in the fall, since kids were either staying home or went back and then got pulled out again; but on the flip side, you get more eating at home when the children are there all day, which is exactly what we saw early on in this, right? I mean, everyone's at home—kids, parents—so you see more eating at home. So there's somewhat of a mix of positives and negatives there. It's a bit difficult to tease those apart and measure them. But yes, I suppose ultimately, I know there will likely be many questions about '21 this morning, so I may as well go ahead and offer a few remarks on that now. Obviously, as you might—as I'm sure you can understand, planning for next year is quite challenging, given how extraordinary 2020 has been. There are two ways to look at this. One option is to sit around and speculate about what demand will look like in 2021 and afterward. The other is to determine which strategies you need to have in place in order to drive that demand. That's the approach we're taking — through our portfolio strategy and through the brand support we keep ramping up and applying to grow our brands. So you can either accept whatever comes your way, or you can control what's within your control and try to drive that brand environment with solid innovation, excellent quality and brand support. That's roughly how we're thinking about next year. Steve, would you like to take the incentive compensation question?

Absolutely. Bill, you've clearly got the picture. Looking across the year, the commentary and the financials show it — plus the fact that we've lifted our guidance and raised the bottom end as the year went on — that performance has beaten what we expected when the year began. Naturally, that's coming through in the P&L this year. When we look ahead to next year and establish our objectives and targets, we receive details concerning incentive compensation; however, we do anticipate some degree of normalization, since we will, of course, align our goals with what we believe the expectations to be; and although there will be a modest tailwind carried over from this year, we anticipate incentive comp will be somewhat closer to normal as we head into 2021.

Nice work on the continued strong numbers. To start, I'd like to ask about the fourth quarter. You beat what was, at least in my model, a pretty high bar I'd set for you in Q3; and then when I look at the revised guidance, the low end is above what my model implies for Q4. Now of course, it could just be that I'm modeling Q4 differently here; but assuming nothing real is going on there, I'll go ahead and ask. Is something building incrementally stronger as we head into year-end? Because it really does feel like a pretty notable lift in guidance.

Yes. I'll have Steve weigh in on this too; but there's nothing specific I'd point to. As I mentioned before, we're still seeing fairly solid patterns on the branded retail side. You're looking at that data too, and it remains quite elevated. From what we can tell, we don't expect a meaningful pullback. The fourth-quarter headwinds are always the holidays for us — that's a really strong roll season, though it isn't a big piece of our portfolio — so it partly hinges on how the holidays turn out. At the high end of the range, though, branded retail keeps showing the same elevated level we've been observing. Over the past few weeks or so, it has more or less leveled off and held fairly consistent from one week to the next. So if that pattern keeps up, and we're feeling good about the high end, then clearly the low end would mirror a somewhat significant decline in the branded retail mix. Steve, is there anything else you'd like to add?

Not really—I think Ryals handled most of that. Just as a reminder, though: when you look across the year and how things unfold, Q4 tends to be the hardest one for us. And Ryals pointed out—we also noted it in the release, in the prepared remarks—that this year the fourth quarter actually contains 3 holidays, even with that extra week. That business was usually roll business, and we're stronger on the loaf side. So we're watching the holidays with a bit of caution; but like Ryals said, if this branded mix keeps performing the way it has, the quarter should come together quite well.

Yeah, just to be clear on my end — that additional week is included in my figures. For the branded retail segment in Q4, though, what I'm expecting is mid-single digits. The scanner data we've seen so far shows you're clearly performing above that level. So, right, anyway, I just wanted to make that clear from my side. Based on what some other food companies have reported this earnings season, there appear to be two dynamics coming up that have weighed on you before. First, we're hearing about tight labor markets and the costs tied to them. And then there's freight. Given how manual-intensive the manufacturing is, labor looks like a particularly acute problem for you guys. And regarding freight, back in 2017 and 2018 there was actually a lag effect, the way I recall it, because of how you account for it. But I'm just curious — clearly, do you have any thoughts about labor? How ought we to think about that going forward? Then on freight, I'm just thinking about how you handled what we saw in 2017 going into 2018, and how that impacted you. And perhaps what changes you made that could allow you to mitigate those factors in 2021, should this continue?

Sure. Thanks, Brian. I'll cover the labor market part, and maybe let Steve speak to the transportation piece. So, I mean, finding workers remains somewhat difficult, and it really varies by location. It isn't severe in every place, though there are definitely regions where we're having a tougher time — mainly with retention and reducing turnover — and then COVID adds another layer on top of that. People end up missing work for various reasons, which creates some difficulties at the plants. Actually, even with the strong results we posted, there's still considerable room to improve at our facilities. Our efficiency has slipped somewhat, including compared with a year ago. Given the numbers we delivered, that might not seem to make sense. Still, you're dealing with lower volumes on top of elevated scrap rates and similar issues, and those tie straight back to how stable your workforce is. So there's a big push to get that settled down, especially in the areas where it's been worst, since we can make some real gains there. Past that, as we've mentioned before, it's about improving the work environment overall and confirming our pay levels are competitive — that's one piece — while also addressing things such as scheduling. Since we've observed—just like plenty of other businesses—that quality of life now carries enormous weight and frequently matters as much as, if not more than, pay, we're reworking our scheduling so frontline staff especially get clearer visibility into their time off, and we're trying to guarantee consecutive days off wherever we can, which is a big break from what's typical in our sector. Details like that truly count. That's the reason we keep investing effort there as well. Steve, anything to add regarding freight?

Okay, Bill. So this year we got some benefit from our mix being more DSD-driven. As you remember, we call that a closed-loop system. For our DSD products, we actually have 3 to 4 primary carriers that bring them to our DCs. Those contracts tend to be negotiated on a 12- or 24-month cycle. So we aren't really out in the true market purchasing as much freight as we typically do in our warehouse business, so we've seen some benefit from that. If this mix keeps going into 2021, we'd expect part of that to carry on until we start to lap some of it late in Q1. Also, as Ryals mentioned, on the labor side and being more efficient, I think we've become more efficient from a production standpoint, and on our runs we have better transportation run efficiency too, because we're sending fuller trucks to these DCs instead of sending half loads, so that has affected us as well. And again, that's mix — that's driven by mix. So if that continues through 2021, I'd expect to keep seeing somewhat stable transportation going into next year as well. And then, obviously, fuel costs will have an impact on that too. So I'd say those are probably the 3 or 4 factors that really affect transportation for us.

So if we just look at what's happening right now, I mean, how has foodservice been picking up for you? Could you split that out between QSR and casual?

Sure. On the QSR side, I believe we talked about this last quarter, so it's really a continuation of what we've been seeing. The foodservice — fast food, sorry — the QSR segment has recovered somewhat faster, simply given what it is, drive-throughs and all that. Yeah, the Chick-fil-As, the ones I pass, the lines wrap around the building twice. So they're performing quite well. The sit-down, fast-casual category is still behind. It, Mitch, is coming off the bottom, but remains well down. You can see it in the nonretail figures we reported, down about 14.5% or so. But that's off the lows from earlier in the year. So recovery there is slow. My personal opinion is it's going to take a long time. And you have to factor in, well, what happens with COVID. If there's another surge, it's really going to take a hit. You're seeing that beginning in Europe with new lockdowns; and will that make its way over here as we head into flu season? We'll have to see. So it's trying to come back, but it is slow; and I think it will be drawn out.

And has it bottomed out, so to speak, like it did in the third quarter? Now that we're sitting here in the fourth quarter, has it more or less leveled off? Is that what you're telling us?

Yes. In the second quarter, our nonretail business was down 15.8%. Then in the third quarter, it was down 14.7%. So an improvement, but not a dramatic one.

Okay. So looking ahead to '21, just in general terms, what kind of cost savings and supply chain savings — you know, part of that $20 million you had this year. I mean, are we talking roughly the same level of cost savings next year? Or does it taper off? Any color you can give on that?