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

Good morning, everyone, and thank you for joining us to go over Flowers Foods' third-quarter 2021 results. I'm J.T. Rieck, Senior Vice President of Finance and Investor Relations. Just to remind you, the third-quarter numbers came out on November 11, 2021. The earnings release and the accompanying slide deck, plus a transcript of what our CEO and CFO will say today, are available in the Investors section of our website. You'll find those materials posted at flowersfoods.com under Investors. Before we begin, please note that what we present today may contain forward-looking statements regarding how the company will perform. While we consider those statements reasonable, risks and uncertainties surround them, and actual results could end up differing materially. Beyond what you'll hear in these remarks, our SEC filings lay out in full the important factors affecting Flowers Foods' business. Speaking today will be Ryals McMullian, our President and CEO, and Steve Kinsey, our CFO. Ryals, the floor is yours.

Thanks, J.T. It's great to have everyone with us for the third quarter call, and I'm glad to walk you through our record results for the quarter today. Flowers keeps delivering outstanding performance in an environment that's both dynamic and difficult. In fact, things have gone so well that we're raising our 2021 guidance for the third quarter in a row. When we first gave guidance back in February, we felt it was reasonable to expect that some of the pandemic's effects would fade as the year went on. Still, we're quite happy with how resilient demand has been for the branded products we sell at retail — in fact, our leading brands keep posting gains, and they've even exceeded the record figures we set in last year's third quarter. I'll get into those trends in greater depth later in this call. And as usual, to give you some context around our results, I'll walk through the current business climate and what we're doing to win in it, framed around our four strategic priorities: building our team; concentrating on our brands; putting margin first; and making smart acquisitions. Let's begin with the team. To start, I want to thank the whole Flowers team once more for their commitment to making high-quality products for our consumers and for serving our markets so reliably. Conditions in the labor market are still difficult. Jobless claims are going down, and available positions are at an all-time high. Even with these obstacles, our bakery crews are putting in tremendous effort, and I want to recognize their persistence. All those working on production lines and in shipping are stepping up wherever they're needed to complete the work. As a company, we're doing everything we can to staff vacant roles and keep our bakeries operating efficiently. In recognition of what our frontline employees have done, I'm happy to share that we will give them appreciation bonuses during this year's fourth quarter. Our second strategic priority centers on our brands. By putting money into marketing and advertising, innovation, and broader penetration, we're building demand for our top products. Those efforts lifted our market share to 18%, a gain of 50 basis points from a year earlier and 100 basis points above where it stood in the third quarter of 2019. Our leading brands are out in front: Dave's Killer Bread picked up 50 basis points of share, more than any other bread brand in the category, while Nature's Own and Canyon Bakehouse each rose 20 and 10 basis points, respectively. Shoppers keep showing they favor branded products that stand apart, and the shift toward premium items, which we have talked about before, is nothing new. IRI data shows branded fresh packaged bread has picked up 480 basis points of market share since 2017 and now sits at 80.6%. During that stretch, Flowers' share has grown 210 basis points, far outpacing every competitor. Branded share gains have sped up amid the pandemic, yet we think the forces behind them, namely innovation and differentiation, look sustainable. Whether inflation can keep running hot and what that does to premiumization is tough to predict. Still, our plan is to grow the brands by launching distinctive, great-tasting items, then supporting them with marketing and distribution that put them in front of many different shoppers. Margin improvement ranks third among our strategic priorities, and the third quarter once again demonstrates progress on that front. Our portfolio approach means branded retail sales now make up a larger portion of higher-margin business, and portfolio optimization remains on course to deliver this year's $30 million to $40 million in target savings, bringing the program's total value across the past 2 years to nearly $60 million. We think those steps have helped us hold EBITDA margin pressure to a floor. Margins did slip a bit versus last year's demanding comparison, but they remain 170 basis points above where they stood before the pandemic. Many of our digital transformation efforts — designed to improve data visibility and efficiency and to automate processes — are shifting from the design stage into the build stage; and a number of our key domains, among them e-commerce, autonomous planning and bakery the future, have moved into implementation, and we're eager about the benefits we anticipate from these investments. Smart M&A is our fourth priority. Deal flow is increasing, and as usual, we are actively examining our options. With consistent free cash flow and a solid balance sheet, we have the room to move when we hold financial, commercial and operational conviction. And as we always do, we'll stay disciplined. I'll now hand things to Steve for the quarter's details, and I'll return shortly to talk about our outlook for the current business environment. Steve?

Thank you, Ryals, and good morning to all of you. I want to join in what you said about this remarkable team of ours and offer my heartfelt appreciation for the tremendous work they've done. Now, on to the quarterly results. Given how unusual the year-over-year comparison is because of the pandemic, in certain cases we'll also present comparisons against pre-pandemic results from the third quarter of 2019. As Ryals noted, we're quite happy with how we performed in the third quarter. Total sales rose 3.9% versus the same period a year ago and were up 6.3% against the third quarter of 2019. Better price/mix fueled that year-over-year gain, rising 6.4%, with price carrying more weight than mix. The main drivers were price hikes aimed at offsetting inflationary pressure and growth in our higher-margin branded retail products. Partly countering that sales growth was a 2.5% decline in volume, caused by lower retail volumes that were somewhat balanced by gains in nonretail volumes. Now looking at sales by channel. Branded retail sales climbed $31.6 million versus the prior year, or 4.8%, reaching $689.1 million; price/mix drove that gain. Even with the tough comparisons, Flowers' fresh packaged bread sales picked up 50 basis points of market share in tracked channels, with Nature's Own sales up 4%, Dave's Killer Bread up 14%, and Canyon Bakehouse up 17%. Against the third quarter of 2019, branded retail sales rose 17.6%, exceeding the comparable second quarter '21 growth rate of 15.2%. Our leading brands keep benefiting from pandemic-related demand increases and from our initiatives aimed at driving further growth. And as Ryals said, our total market share climbed 100 basis points above pre-pandemic levels, reaching 18%. Store branded retail sales fell $11.5 million year-over-year, or 8.5%, to $124.6 million, as consumers kept showing a preference for more differentiated branded products. The store branded category overall shed 160 basis points of market share, dropping to 18.8%, a downward trend that has persisted for more than 5 years. Our consumer research makes clear that the bread category is going through a premiumization process, moving away from store brands, which Ryals discussed earlier. Our capacity to manage that demand shift underscores the flexibility of our bakery network; beyond the store brand category trends, moves such as our portfolio strategy, which seeks to shift more of our sales toward higher-margin branded products, and our effort to boost profitability in some underperforming accounts have also affected sales. Where we can't achieve satisfactory margins, we've exited some accounts. Versus the 2019 third quarter, Flowers' store branded sales dropped 17.5%. Non-retail and other sales grew $18.1 million, or 9.2%, year-over-year to $214.2 million, as we lapped substantial pandemic-induced declines from the prior year period. Non-retail results gained from better price/mix and higher volumes. Non-retail and other sales overall stayed below pre-pandemic levels, down 6.8% against the 2019 third quarter. But with non-retail sales still recovering, that segment is returning at stronger margins than previously, thanks to steps we've implemented to boost profitability there. During the quarter, gross margin as a share of sales—leaving out depreciation and amortization—rose 20 basis points, reaching 49.9%. The gross margin comparison got a lift from greater sales volume and from $1.9 million in start-up expenses incurred in the year-ago quarter tied to converting our Lynchburg, Virginia plant into an organic bakery. Better pricing and mix offset climbing commodity costs, though this was partly counterbalanced by fewer outside purchases. Selling, distribution and administrative costs climbed 240 basis points as a percentage of sales during the third quarter. If you set aside the items affecting comparability spelled out in the press release, adjusted SD&A expenses rose 40 basis points, hitting 38.4%, since greater logistics expenses and heavier marketing spending were partly offset by reduced distributor distribution fees. GAAP diluted EPS came in at $0.18 per share for the quarter, versus $0.21 a year earlier. Setting aside the items affecting comparability listed in the release, adjusted diluted EPS for the quarter was $0.30 per share, a $0.01 gain over the prior-year period. Moving on to our balance sheet, liquidity and cash flow. For the year to date, through the third quarter of fiscal 2021, cash flow from operating activities fell by $49.2 million, landing at $315.2 million, mainly because of larger boneless payments during this year's first quarter plus other working capital shifts. Capital expenditures grew $18.5 million to $86.7 million, while dividends paid rose $6.6 million to $131.5 million. Our financial position stays solid. At quarter end, net debt to trailing 12-month adjusted EBITDA was roughly 1.1x, lower than the 1.2x recorded at the close of the second quarter. At quarter end, we had about $308 million in cash and cash equivalents along with roughly $679 million still available under our credit facilities. Now shifting to our adjusted outlook for 2021. We project sales dropping 1% to 2% compared with 2020, better than our earlier guidance of a 2% to 3% decline. Measured against 2019 results, our guidance points to growth of 4.3% to 5.3%; on earnings, we're lifting our range to adjusted EPS of $1.22 to $1.26, versus our previous guidance of $1.17 to $1.22 and 2019 adjusted EPS of $0.96. The EPS guidance factors in a $0.01 impact during the fourth quarter for appreciation bonuses going to our frontline workers, which Ryals mentioned earlier. Our revised guidance range sits above our long-term financial targets of 1% to 2% sales growth and 7% to 9% EPS growth off the 2019 base, even after absorbing the $0.05 headwind from our digital ERP initiatives and with no M&A benefit. Keep in mind that 2021 reverts to 52 weeks, one week less than 2020. That extra week in 2020 added 1.8% to full-year sales and roughly $0.02 to EPS. We still anticipate robust free cash flow, and our capital allocation priorities and philosophy stay aligned with our emphasis on maximizing return on invested capital and increasing shareholder value. Among the factors we weighed when establishing guidance were the timing and magnitude of demand reversion along with inflationary pressures. The operating environment is still stronger than what we initially forecast. Branded retail, our most profitable segment, has for the most part held onto its elevated share of total sales despite the partial recovery in our non-retail and other business. The back-to-school season, which we are watching closely, so far has not produced significant shifts in demand. On inflation, there are 3 broad categories we are focused on: commodities; logistics and freight; and labor; we are doing everything within our power to offset higher commodity costs, looking ahead so we can proactively navigate this period successfully. Our hedging strategy, through which we try to lock in commodity prices 6 to 12 months out, gives us visibility into future inflation and lets us be proactive in offsetting potential cost increases. We've noted that if commodity prices stay at current market levels, we would expect more meaningful inflation in 2022; so far, we've succeeded in securing the higher prices needed to offset inflation in the current year, and we remain optimistic that, together with other internal actions, we should be able to leverage pricing to mitigate the impact of inflation into 2022, if necessary. Logistics and freight costs have risen as our contract carrier rates repriced. Our closed loop system stabilizes costs over the short term, but pricing over lower periods will adjust to market levels. On the positive side, the strong relationships we've built with our carriers have enabled us to maintain adequate capacity despite driver shortages and other challenges. Beyond higher prices on our inputs, availability also became more of a focus. Although sourcing items has been challenging, generally, we are not seeing significant supply chain disruptions. So far, we've been able to obtain what we need, and with the hard work of our procurement team, we expect to keep doing so going forward. Ryals addressed the labor situation earlier. But to date, we have been successfully navigating labor shortages and turnover, and mitigating the financial impact. Although the competitive labor market continues to affect our operations, and we expect this trend to continue, workforce-related costs are relatively unchanged as a percent of sales quarter-over-quarter. In a moment, Ryals will share more color on the factors we are watching in 2021. Thank you. And now I'll turn it back to Ryals.

Thank you, Steve. As you just heard, our financial results are still beating expectations. We're producing robust sales and margins, and we're transforming the company so we can sustain our growth over the long term. When we talk with the investment community, what worries them most is inflation and the possibility that demand reverts as the pandemic fades. Steve has already covered inflation and our confidence in being able to offset it, but I want to emphasize once more how much our brands count in this kind of environment. We believe that having strong leading brands makes consumers more inclined to pay a bit more for the distinctive features our products offer. So far this year, the pricing moves we've taken haven't led to any significant falloff in demand, and in my view the key reason demand has stayed relatively inelastic is the strength of our brands. That's why we continue putting money into them to grow our market share and household penetration. Looking forward, should the current inflationary conditions continue, we believe that further price increases, together with efficiency programs already underway and others planned, will counterbalance those pressures. Additionally, it's worth keeping in mind that inflation is cyclical. Although it could be a short-term headwind, we have confidence over the longer run in the transformational strategies we've implemented and in our capacity to reach or surpass our long-term objectives. Products emerging from our innovation efforts are contributing to our results. Dave's Killer Bread has been expanding quickly in the breakfast and buns categories, and we've introduced the popular Powerseed Thin-Sliced bread across the country. Canyon Bakehouse continues to pick up share, and it now accounts for nearly 32% of the gluten-free category, with a boost from strong performance of new items such as multigrain breads, sub rolls and Hawaiian bread. Meanwhile, Nature's Own is expanding through its Perfectly Crafted sub-brand, which has reached close to $150 million in retail sales. We're leveraging those leading brands to grow sales in markets that remain underpenetrated, such as the Northeast. We hope you've noticed our new advertising campaigns for Dave's Killer bread, Bread Amplified, and Nature's Own Perfectly Crafted, You're Fancy Now. These advertisements, together with various other efforts, are fueling regional sales; across the Northeast we picked up 110 basis points of share during the third quarter and 240 basis points across the past three years. Plus, our lately completed conversion of the Lynchburg bakery gave us the capacity needed to satisfy that fresh demand. Now I want to dig a bit deeper into what's happening on the demand side. As our raised 2021 guidance shows, the pandemic-related reversion has come in smaller than we anticipated. In fact, during the third quarter our branded retail sales rose versus elevated 2020 levels for the first time this year. We've observed a degree of recovery in our non-retail business. In Q3, our sales came in 7% below where they stood before the pandemic, which compares with the 15% drop we recorded in Q3 of 2020. Meanwhile, our store-branded segment has kept shrinking over multiple years, and the pandemic may have intensified that pattern. As we look forward, it's difficult to gauge how much reversion to expect. It seems sensible to assume some movement back toward earlier demand patterns as the economy reopens. That said, we believe a number of factors point to a lasting lift from eat-at-home demand—among them more flexible work-from-home policies, reduced travel, and consumers' demonstrated preference for differentiated branded products. At present, we're focused on what we can control. Whatever the demand environment looks like, our initiatives are designed to keep growing our top brands. To wrap up, I feel a great deal of pride in what we've achieved so far this year, and I have strong confidence in the steps we've put in motion to secure success going forward. A team that leads our industry, paired with our premier brands, sensible plans to keep pushing branded growth, spending on digital and other capabilities that will fuel future wins, and a spotless balance sheet letting us pursue intelligent M&A chances—all of this leaves us in a stronger position than at any prior point to produce outcomes consistent with our long-range financial goals. That brings our prepared comments to a close.

Three, I suppose, somewhat brief questions. First, drawing on what you said in your prepared remarks. First, you mentioned that it's not really — it's too soon to say what sort of normal looks like when it comes to folks going back to work and to school and that kind of thing sort of after the Delta variant. But you have quite a lot of exposure in states such as Texas and Florida, where they've sort of returned to normal a bit quicker than the remainder of the country. So perhaps tell us what you're seeing in those places and sort of what that suggests to you as we look toward '22 in terms of sort of consumption.

Sure. I mean, Bill, it's really sort of widespread across the country; we've been quite pleased with how well things have held up, especially on the branded retail side; so there's nothing really specific to highlight by region, other than to say that overall, the brand investments we keep making, the innovation we keep launching have really helped us retain a lot of these consumers. And likewise, we're also seeing additional growth in household penetration, velocities are higher, repeat buyers are higher; so every signal points in a fairly optimistic direction when you consider what a return to normal ultimately looks like.

Got it. Now turning to costs, you said there might be additional pricing actions to counterbalance that expense. Could you remind us whether your goal is to protect margin or to protect profit dollars where gross margin is concerned going forward?

Certainly. Protecting both is clearly the ideal outcome. Ultimately, though, it's the consumer who determines the final results, correct? Consumers are dealing with very widespread inflation. We've all seen the coverage — 30-year highs, a full straight month above 5%, that kind of thing. So everything from gasoline to our products is climbing. So we'll just have to wait and see how consumers ultimately respond to that. Should we find ourselves facing a shift toward value offerings or a decline in units, it's certainly fair to expect a degree of margin pressure in the near term. Still, my broad take on inflation is this: regardless of whether you view it as transitory or expect it to persist somewhat longer, these challenges are ultimately temporary and largely beyond our control. That's why our attention stays on the things we can control. We'll keep investing in our brands. We'll keep investing in our digital capabilities, and so on, which in time should produce margin expansion.

Understood; and then one more from me. In your remarks you made a comment about seeing M&A activity pick up. So I suppose the question is: why is that happening? I mean, my impression was that these are the same sort of keen key targets you've been discussing for years, maybe decades. So I wasn't sure why things would begin picking up at this point? Or — perhaps you could give a bit more color on that comment.

Sure. I mean, I think perhaps a bit earlier in the year, some tax issues may have been driving it; we'll ultimately see where that bill lands. It looks like some of that is not going to end up in the bill; so that could have been driving some of it; and you're right, we still keep talking to some of the same targets that we have for a number of years, but the activity has really picked up, Bill, more in the adjacent product category, so more in the snacking space, that kind of thing.

I'd like to ask about the ongoing momentum in branded retail—those results remain really strong. I'm certain mix continues to help gross margins, even with some cost pressures showing up. I'm curious whether you could speak to this: do you believe we've reached an equilibrium at this point? Is this an equilibrium from which we can grow? And how much do further pricing increases affect any shift away from branded retail toward store-branded products?

Yes, Ben. Excellent question. That's a crucial point, I think. As I said a moment ago when answering Bill, everything will hinge on the consumer. Up to this point, despite the price increases we implemented in July, branded retail units have proven quite resilient. In branded units, we've observed essentially no drop at all; going forward, when you think about next year amid all the inflation consumers are confronting and stimulus payments coming to an end, among other factors, how much the consumer will tolerate is still unclear, and that will be a major subject for next year, right? We've faced similar circumstances before, most recently in the '07, '09 timeframe. The business weathered it fairly well. Our lineup spans many price tiers, and that definitely works in our favor—starting with the super premium Dave's Killer Bread and going right down to private label, plus options in between such as Nature's Own and Wonder at 2, and similar items. That leaves us, in our view, extremely well placed to succeed whatever conditions we face. Naturally, we'd be happiest to see the patterns we're currently tracking persist, yet the real question, I believe, centers on how inflation hits shoppers and how much they can take on. Yet that is exactly why it matters more than ever for us to stay on top of things—to keep pushing ahead with innovation and to keep building our capabilities, so that in time this will fade. It always does. And once it does, we will be in an even stronger position.

Yes. Perfect. Understood. And regarding the cost side of things, what kind of visibility do you have into the remainder of this year and into early next year? And any thoughts on how that looks and where we stand in terms of the cost inflation curve? From your vantage point, how near do you think we might be to seeing a light at the end of the tunnel?

Sure. Obviously, especially given where we are in the year and the fact that we forward buy and hedge a lot of our commodity spend, we have full visibility for 2021. So from that perspective, we've been discussing the cadence of inflation for this year. The majority of it is coming in during the fourth quarter; so we'll start to see some of that ramp up, and all of that is placed into the guidance we gave yesterday when we released. Looking forward to 2022, we're not prepared to give guidance today, but obviously, when you can look at a forward curve, it's pretty significant inflation. And if things stay at the market levels we see today, as we said in our prepared remarks, we expect to see pretty meaningful inflation next year. But as Ryals has commented, we're looking at efforts to mitigate that through pricing as well as other cost initiatives. So we anticipate this to be at least another 1-year cycle. And as Ryals just said, depending on whether it's truly transitory or not, it could go slightly beyond a year; but right now, all indications are that the inflation will hold through most of 2022 as well on the cost side.

And I suppose, building on the discussion we've already had, your prepared remarks and a few of the conversations from this morning really highlight the uncertainty about how quickly demand shifts back toward pre-pandemic levels, along with inflation headwinds and other factors. On top of that, we know you're continuing to make strategic investments in technology, branding, and other areas. So in that light, I'm hoping you can go into more detail on the drivers that — at least as I read your presentation, the company's presentation slides in the prepared remarks — point to confidence and an expectation of reaching those long-term — that long-term algorithm in fiscal '22. So maybe — unless I misread that — what are the drivers that, despite all these uncertainties, give you the confidence and visibility to lock in those long-term growth targets next year?