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

Hi, everyone, and thanks for joining us to go over Flowers Foods' second quarter 2021 results. I'm J.T. Rieck, SVP of Finance and Investor Relations. Just to remind you, our second quarter results came out on August 12, 2021. You can find the earnings release and the related slide presentation, along with a transcript of these remarks from our CEO and CFO, in the Investors section of our website. Everything is posted in the Investors section of flowersfoods.com. Before we begin, please note that what is 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 make actual results differ materially. Beyond what you hear in these remarks, important factors concerning Flowers Foods' business are fully detailed in our SEC filings. Speaking today are Ryals McMullian, President and CEO, and Steve Kinsey, our CFO. Ryals, over to you.

Thanks, J.T. It's great to be here and walk you through what we delivered this quarter. Our view is that conditions around us are still supportive. The ongoing shift in mix toward branded retail keeps working in our favor, although there has been a bit of reversal as people head back out to restaurants and foodservice claws back some of the volume it lost. Rather than sit back and count on a healthy demand backdrop to fuel growth, we're continuing to advance the strategies aimed at lifting our performance further — portfolio strategy, portfolio optimization and our digital transformation. Those efforts are already paying off, and we anticipate they'll keep delivering gains going forward regardless of what the environment brings. Those efforts represent only a portion of the numerous actions we've undertaken during the past several years that we think will propel our growth at minimum consistent with our long-term financial targets. Included among those actions is the organizational realignment we carried out to back robust investment and concentrate on our top brands. Through that realignment, we've brought in many high-caliber individuals who have considerably reinforced our team, established a separate agile product innovation group to fuel upcoming sales, and formed our transformation office to steer our digital efforts, which we anticipate will help enable revenue growth and margin gains. Beyond that, we have a proven history and a continuing plan of making smart acquisitions, and the two latest deals are expected to bring in roughly $1 billion of retail sales during this year. Our investors, quite reasonably, expect us to hit our long-term financial targets, and we are doing everything required to deliver on that expectation. To make the opportunity a bit clearer, if we were to reach the midpoint of our long-term financial targets across the coming years, we would anticipate EPS rising from the adjusted $0.96 base we had in 2019 to considerably more than the adjusted $1.31 we posted in 2020, when the pandemic was at its peak. Our goal is generating profitable growth that benefits shareholders, and with solid execution across our four strategic priorities, we're confident the long-term financial targets we've set can be reached. For some background on our results, I'll cover the present business climate and what we're doing to thrive in it, viewed through those four priorities: building our team, concentrating on our brands, putting margins first, and pursuing smart M&A; so let me start with our team. First, I want to say again how sincerely grateful I am to the whole Flowers team for their ongoing dedication to making quality products for our consumers and faithfully serving our markets. Right now, the job market definitely brings some unusual difficulties, especially when it comes to finding workers and keeping them. In certain places, as is true for plenty of other businesses, bringing on new staff can be tough, and holding onto them is sometimes just as hard. Operating under such conditions pushes up expenses tied to recruiting, training, and overtime, so we're making moves to soften the impact of those pressures—taking a fresh look at pay and establishing quality of life initiatives, such as improved work schedules. Even with those difficulties, our people have stepped up wherever they were needed, without regard for themselves, to limit the impact of these headwinds, and the outcome of that effort shows in our financial results; we are delivering the products customers want, and doing it both effectively and efficiently. Priority two strategically is a focus on brands. The brands that lead for us are powering today’s performance and positioning us for growth ahead. In our view, the portfolio of brands we hold has never been stronger, which our ongoing gains in market share demonstrate. During 2021’s second quarter, our dollar share rose to 17.7%, versus 17.4% in the same period a year before and 16.7% in Q2 of 2019; we anticipate that the money we are putting into marketing and innovation will keep making our brands and our market share stronger. As an example, we just rolled out fresh advertising and media campaigns for Dave's Killer Bread and Nature's Own Perfectly Crafted, aimed at chosen markets. I’ll share more specifics later in this call about the benefits that come from our leading brands. Margins are our third strategic priority. And the second quarter’s results keep showing that we are succeeding there. Year-over-year comparisons are tough right now, given the exceptional demand during those periods that the pandemic created, yet we are comfortably ahead of where we stood in the second quarter of 2019; sales rose 4.3% against Q2 2019, adjusted EBITDA margins climbed 120 basis points to 12%, and that produced adjusted EBITDA growth of 15.4% versus 2019’s second quarter. The main force behind that margin gain is the mix shifting toward more branded retail products, though we are also working diligently to get the most out of our internal efficiencies. Our portfolio optimization effort remains on course to hit the savings target of $30 million to $40 million in this year, which brings the program’s total value across the last 2 years to nearly $60 million. We further anticipate that our digital transformation work will generate efficiencies well into the future, letting us hit or beat the long-term financial targets we’ve set. Smart M&A is priority four. Deal flow is picking up now that 2020’s pandemic-caused slowdown has passed, and we are actively looking into the options available to us. Our consistent free cash flow and a robust balance sheet give us room to move when our financial, commercial and operational conviction is strong; and we will always stay disciplined in how we approach it. I’ll now hand things to Steve for a review of the quarter’s details, and afterward I’ll return to talk about what we expect from the current business environment. Steve?

Thanks, Ryals, and good morning everyone. I want to second what you said and thank our amazing team—their work has truly been exceptional. Now to the quarter: COVID-19 is still shaping what we see, though there are some signs of mix reversion. Even so, we're happy with both total sales and mix for Q2 of 2021. Like last quarter, since the year-over-year comparisons are so unusual, in some cases we'll also give comparisons to pre-pandemic results from the second quarter of 2019. Total sales fell 0.8% versus the prior-year period, but rose 4.3% compared with the second fiscal quarter of 2019. Lower volumes drove the decline, falling 3.9% due to difficult year-ago comparisons across most channels outside foodservice. A 3.1% increase in price/mix—leaning more toward price than mix—partly offset that volume drop, helped by promotional efficiency. Results versus the prior year also improved as those comparisons became easier through the quarter. Against pre-pandemic 2019 levels, results stayed strong for the entire quarter. Turning now to sales by channel: branded retail sales declined $14.1 million, or 2%, from the prior year to $674.7 million. Even with those challenging year-over-year comparisons, Flowers gained 30 basis points of share in tracked channels for fresh packaged bread. Dave's Killer Bread posted a 9.4% sales increase, while Canyon Bakehouse rose 16.9%. Branded retail sales were up 15.2% versus the second quarter of 2019, topping the 13.7% growth we saw in the first quarter of '21, as pandemic-driven demand and our growth initiatives continue to lift our leading brands. Total market share climbed 100 basis points to 17.7% compared with pre-pandemic levels. New items such as Nature's Own Perfectly Crafted buns drove particularly strong growth, rising 75% year over year and contributing 60 basis points of market share. Sales of store-branded products fell $13.6 million compared with a year earlier — a 9.4% decline — landing at $131 million, since shoppers continue gravitating toward branded items that stand out more. Overall, the store-branded segment shed 90 basis points of market share, slipping to 19.5%, continuing a slide that has now lasted over 5 years. Measured against the second quarter of 2019, store-branded sales were off 19.5%. Nonretail and other sales climbed $19.1 million, up 9.9%, reaching $211.5 million, benefiting from an easy comparison against the steep pandemic-driven drop in the same period last year. Nonretail results were helped by better price/mix, due in part to internal efforts aimed at making this business more profitable. The recovery in foodservice stood out in particular. Sales to nonretail customers and other channels as a whole remained under where they stood before the pandemic, falling 6.8% versus the second quarter of 2019—except for fast-food and foodservice, which are above 2019 levels. With nonretail volume continuing to come back, that segment is returning at better margins than it had previously, reflecting the steps we have taken to make it more profitable. In the quarter, gross margin measured against sales—excluding depreciation and amortization—fell 20 basis points to 50.5%. Softer sales and more returns of unsold product weighed on that figure, offset in part by $1.5 million in start-up costs booked a year earlier related to turning our Lynchburg, Virginia plant into an organic bakery. Increased input costs for commodities were partially balanced out by advantageous pricing and product mix as well as more effective promotional spending. During Q2, selling, distribution and administrative expenses as a share of sales increased 140 basis points. Excluding the comparability-affected items outlined in the press release, adjusted SD&A expenses were up 30 basis points, reaching 38.4%, since elevated logistics costs and bigger marketing outlays were partially offset by lower distributor distribution fees driven by the mix shift, together with greater scrap income. For the quarter, GAAP diluted EPS was $0.26 per share, compared with $0.27 during the same period a year earlier. Excluding the comparability-related items outlined in the release, adjusted diluted EPS came in at $0.32 per share for the quarter, down $0.01 versus the same period last year. Turning to the balance sheet, liquidity and cash flow: for the first half of 2021, operating cash flow decreased $52.4 million to $223.4 million compared with the prior-year period, driven primarily by working capital movements. Capex increased $11.7 million to $58.3 million. Dividends paid were up $4.4 million, reaching $87 million. Our financial position continues to be strong. At the end of the quarter, net debt to trailing 12-month adjusted EBITDA came in at about 1.2x — in line with where leverage was at the close of Q1 and under the 1.3x figure we reported at the end of 2020. Cash and cash equivalents were roughly $292 million at quarter end, and about $663 million remained available to us under our credit facilities. Turning to the adjusted outlook for 2021: we anticipate sales declining 2% to 3% versus 2020, an improvement at the low end compared with our prior guidance. Compared with 2019 results, that guidance implies growth of 3.2% to 4.3%. Regarding earnings, we are raising our guidance to adjusted EPS between $1.17 and $1.22, which compares with the prior range of $1.10 to $1.17 we had given and with 2019 adjusted EPS of $0.96. That revised range falls within or exceeds our long-term financial targets — sales growth of 1% to 2% and EPS growth above the 7% to 9% range measured off the 2019 base — even after absorbing the $0.05 headwind from our digital ERP initiatives and with no contribution from M&A. As a reminder, 2021 returns to a 52-week year, one week fewer than 2020. That extra week in 2020 added 1.8% to full year sales and roughly $0.02 to EPS. Looking at how the first half of the year has gone, market conditions are holding up better than we originally projected. In fact, branded retail—our most profitable segment—accounted for 66.3% of total sales in Q2, versus 66.1% in Q1, 67.2% in last year's second quarter, and 60% in the second quarter of 2019 before the pandemic. Even with the partial rebound in our nonretail and other business, branded retail has mostly kept its larger share of total sales. Among the things we weighed when setting guidance were how the pandemic would affect the pace of reopening and inflationary commodity costs. So far, we've managed to offset a good deal of that inflationary pressure. How the back-to-school period plays out will matter more than anything else in determining our second-half 2021 results. When children are back in classrooms and parents can more easily return to the office, we ought to gain a better sense of how demand will look in the new normal. That said, the Delta variant's spike in COVID cases might prolong the pandemic's effects. So we are watching those trends carefully; in a moment, Ryals will walk through the specific factors we're monitoring for 2021 in greater detail. We anticipate robust free cash flow, and our priorities and philosophy for allocating capital remain unchanged, with our focus still on maximizing return on invested capital and building shareholder value. While our first half CapEx spend of $58 million is a bit under our full year run rate, we do expect the pace of investment to accelerate during the second half of 2021. We lowered our capital expenditure guidance to a range of $125 million to $135 million, from $140 million to $150 million for the year, mainly because of pandemic-related delays. As a reminder, that level was somewhat elevated relative to recent years, largely reflecting targeted investments supporting supply chain optimization and our digital transformation. Thank you; I'll now hand it back to Ryals.

Thanks, Steve. We've finished going over the quarter's financials, and I'm quite happy with how they came out. Now I want to discuss where things stand right now and what we're doing to win today and down the road. Our portfolio strategy — turning ourselves into a company with a stronger brand focus — is something we keep carrying out, and we set that plan in motion prior to the start of the pandemic. Difficulties have come with the pandemic, yet it has also shown plainly what our strategy can do. Because we moved our sales mix toward a bigger share of branded retail products that earn better profits, margins have grown despite volume being lower overall. We've talked about this portfolio strategy in the past, especially when discussing margin improvement, but in today's conditions it matters more than ever. At the pandemic’s high point, branded retail sales reached a peak they have since fallen from—yet they are still significantly higher than before the pandemic. Demand in foodservice is coming back, although it has not yet returned to where it stood in 2019, and private label has kept shrinking over multiple years as shoppers look for distinctive items that, in our category, brands typically are the only ones to provide. This drop in private label bread stands in sharp contrast with most other store categories, where private label’s market share is on the rise. One factor behind this shift is premiumization within the bread category, which brands such as Dave's Killer Bread, Canyon Bakehouse and Nature's Own Perfectly Crafted are driving, as consumers intentionally look for items and brands offering better health and indulgence qualities. We think this trend will continue and that it is a favorable sign for our leading differentiated brands. Thanks to our strengthened agile innovation capabilities, we anticipate continuing to launch new, exciting and differentiated products in the market under our leading brands, which we expect to drive future growth. While we anticipate that the pandemic may affect demand for food consumed at home over the longer term, it also appears reasonable to expect some return toward earlier levels; in that kind of setting, we believe our brands will enable us to gain additional market share from consumers who appreciate the distinctive quality and flavor characteristics of our products. And thus far, that is exactly what we have achieved. As Steve mentioned, during the second quarter, our market share in fresh packaged bread increased 30 basis points to 17.7% versus the prior year period and 100 basis points versus the same period in 2019, driven by continued growth of brands such as Dave's Killer Bread and Canyon Bakehouse. We're also seeing wins in the regions we've been focusing on. The Northeast, for instance, has proven to be a strong growth driver for us — we picked up 80 basis points of share there this quarter and 210 basis points across the past three years, and we're putting investment behind this key market to fuel even more progress. On top of that, we plan to keep capitalizing on what our innovation team has delivered, including the brioche buns and rolls, and we have a strong lineup of disruptive innovation in the works that we believe will support sales growth going forward. If you consider every new item IRI monitored in our category over the last two years, Nature's Own Perfectly Crafted brioche hamburger buns ranked first. Alongside the sales and share gains our top brands produce, today's inflationary environment reveals an additional advantage — the ability to raise prices as necessary so that increased costs are offset. Of course, pricing is only one lever we consider; we also evaluate factors such as operational efficiencies and internal cost savings. Even so, during periods like the present, when inflation is truly substantial, those other levers aren't always sufficient to offset the higher costs. In 2021, inflation was a modest headwind. As we mentioned last quarter, should commodity prices stay at their current levels, we expect inflation to become more significant in 2022. Our hedging strategy — through which we aim to secure commodity prices 6 to 9 months in advance — provides insight into the inflationary environment ahead and enables us to take proactive steps to counter possible cost rises; to date, we have managed to obtain the higher prices required to counter inflation this year; and we are hopeful that, along with other internal measures, we will be able to leverage pricing to lessen inflation's effect going into 2022 as well should that prove necessary. We think that because our top brands are strong and our market share is getting better, it's somewhat simpler to talk about pricing with customers, and consumers are a little more willing to pay extra to get the distinctive features our products offer. For some historical context, we experienced comparable inflation as we entered and went through the Great Recession of 2007 to 2009. Over that period, we were able to offset inflation through pricing, which is exactly what we're doing at present. The major distinction between the two periods is that at that time we had just one major brand, Nature's Own, while today we have a portfolio of leading brands. Additionally, in Q2 of 2009 our national market share was just about 8%, compared with 17.7% at present. To wrap up, I feel a great deal of pride in the way we did during the first half of this year, and I hold considerable optimism regarding the initiatives now in place to secure our success going forward. We are thriving in today's conditions, and with our best-in-class team and leading brands, we are positioned better than ever to produce results consistent with our long-term financial targets. So many thanks for spending your time with us; that brings our prepared remarks to a close. Thank you, and take care.

One thing several food companies have told us over the last 1 month, 1.5 months is that there's been a meaningful trade up from private label to branded, for whatever reason. The thinking is stimulus checks or other issues, though nobody can quite figure it out; and clearly, that had some impact or continues to have some positive impact on your business. So I guess the question is whether you see this as a sustainable shift. Or do you think people will move back towards private label, which could put margin pressure as we move into the back half of this year or into next year?

Yes. Thanks, Bill. That's a good question. In our category, private label has historically been so overdeveloped that we were actually seeing declines in private label even before the pandemic. I think we've mentioned that on a couple of earlier calls. We've actually done quite a bit of research — consumer insights research — into why that trend is continuing and almost accelerating, really. And it really comes down to this: in our category, there's a distinct lack of differentiation in private label. It's basic white and wheat bread and buns, whereas in the category, Flowers has participated in this. Clearly, the new perfectly crafted brioche rolls give you a lot of differentiation, with items like Dave's Killer Bread and Canyon, and that has driven some premiumization—a shift from private label up to branded. As for whether that's sustainable, I actually believe it is. That's the reason we're putting all these investments behind our brands—the marketing support, et cetera. In a recessionary situation, you might see some movement back toward value. But even during the last recession we saw, around '08 and '09, we didn't see much of a shift back to private label even then.

But I suppose, in this quarter that we're in right now, did you observe a step change? Or would you say it's more that the trend simply carried on?

What we're seeing is really the trend carrying on. Private label keeps declining, and branded retail keeps holding up extremely well.

Great. Then turning to the cost side, same question really. I've been hearing plenty of your competitors mention — particularly around freight and incremental costs — yet you appear able to lift full-year EPS guidance; it looks like the impact is smaller for you. Is that mostly because of how your supply chain distribution is set up? Or is there something else helping you offset those costs?

Yes. In part, that's — and Steve can chime in here as well. But yes, that's partly the DSD, though it functions somewhat more as a closed loop system. So our exposure to long-haul freight is lower. And then the other point I'd make is that our hedging strategy runs 4 to 7 months out, occasionally a bit longer, which gives us solid visibility ahead of time into what our costs will be. And we're able to act proactively to mitigate those costs. Steve, anything you'd add?

No, I mean, I think, like we mentioned earlier, Bill, during the year we had fairly solid visibility into our overall cost structure for this year. Clearly, inflation in the back half is somewhat heavier, but we believe we've taken the right steps to mitigate most of that; and as Ryals said, regarding transportation, we're not immune to the increases. But we feel like for 2021, our contracts have protected us as best they can.

I just want to piggyback on what Bill asked about private label. Are retailers also shifting how they think about their own private label lines — specifically when it comes to how much shelf space they give them? Do they want to move private label more upscale, or are they simply trying to hold onto it? Or is that not really part of their playbook at all, and they're content to let the market decide and then redistribute shelf space accordingly? Could you shed any light — give us some color on that?

Sure. I mean, we've discussed this in a few isolated instances, but there's nothing broad happening across the market. So far we aren't really hearing anything about a desire to premiumize private label or anything along those lines. The likely single exception on our end — the one private label segment that keeps performing well — is Canyon's private label gluten-free. That's probably the one private label bright spot actually delivering growth within our portfolio.

And — but I'd also like you to address this in your remarks: are they trying to cut back shelf space in favor of private label? I mean, obviously the dollar value and the gross margin contribution that brands deliver compared with private label would point toward, in my view, giving more of the shelf to branded products. But is any of that actually taking place, or...

Once more, I'd say it has occurred to a certain degree, yet we have not observed any wide, sort of across-the-market shifts to remove shelf space; still, a handful of individual customers have seen reductions. And then there's the labor situation affecting everyone, which constrains — to some degree constrains the capacity to supply every SKU. So I mean all through this pandemic and this entire labor situation, we've had to, in certain cases, cut back on some of our SKUs. And so that has influenced shelf space allocation somewhat. But when it comes to the overall private label allocation, there has really been no meaningful change.

Regarding private labels, have there been any adjustments to pricing? Is the decline in volume? Or are prices rising? Could you shed some light on that?

Right. What I'd say is that over the past several years, we have indeed implemented some price increases in private label.

Alright, so when it comes to your — this is part of the overall strategy, and some of what Flowers gains comes from picking up share in markets that are less penetrated and newer, newer to Flowers, that is; is there anything you'd highlight by region, either strengths or weak spots across your territories?

Yeah. What I'd say is we've flagged the Northeast over the past several quarters as a market we're focused on; we keep putting investments in up there. And the encouraging part is that share gains are showing up there; we had a solid quarter in the Northeast; we're also continuing to pick up share on the West Coast, which is another really strong market for us. Clearly, we're extremely strong in the South. Mitch, as you're aware, the big whole — or the opportunity for us is that entire upper Midwest quadrant.

All right. Then only a few more items. Regarding — what is the situation with snack cake, and Tastykake specifically? Are you — is any headway being made on profitability?

Yeah. Yeah. Appreciate the question. We've seen genuinely strong improvement at Navy Yard. Once again, I'd note we aren't — we still haven't reached the level we're aiming for, though the direction of travel looks quite favorable. The team up there has performed admirably. The money we've put into automation is delivering returns. Scrap rates are declining. Staffing in the cake markets — in the cake plants, I should say, remains somewhat difficult. That's simply how cake bakeries are, given that more employees work inside them; even so, we've handled it quite effectively overall. On the commercial front as well, Mitch, we've taken certain steps around price promotion so that we compete better in that area. So every indicator suggests we're heading the right way. As a matter of fact, measured against our own targets, we're in fact running ahead of schedule there.