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

Hi, everybody. J.T. Rieck here, Executive Vice President of Finance and Investor Relations. Thanks for joining us as we discuss Flowers Foods' results for the fourth quarter and the full year 2022, which we announced via press release on February 9, 2023. Before we begin, please remember that what's presented today may contain forward-looking statements regarding the company's performance. While we consider those statements reasonable, risks and uncertainties apply that could make actual results differ materially; beyond what you hear in these remarks, the important factors concerning Flowers Foods' business appear in full detail 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 have everyone join us on this call. The sales we posted in fiscal 2022 were a record, and they show how well our leading brands performed and how excellently the Flowers team executed. We delivered those results even with high inflation, which is squeezing consumers and pushing them to trade down toward cheaper products. Confronted with these and other difficulties all year long, we kept moving our strategic plans forward, and we managed to post respectable performance on both the top and bottom lines. Looking toward 2023, we anticipate an environment of continued high inflation—though hopefully declining—along with the possibility of a recession. Despite those challenges, we intend to continue putting money into the business, delivering additional innovation to market as well as executing our digital transformation and supply chain efforts. Such investments are going to weigh on our near-term results and push us below algorithm mirror, yet I believe they will reinforce a foundation that is already solid and position us for growth down the road, once these headwinds fade; we are acting proactively not only to ease short-term inflationary pressures but also to restore our standing as a low-cost producer in the industry over the long pull. I've pushed our team to intensify what we're doing through concrete measures aimed at generating cost reductions and boosting efficiency, so we come out of this stretch in a stronger position; shortly, I'll share more specifics about certain steps we're taking to set ourselves up for lasting success over the long haul. Next, I'll walk through how we performed in 2022 against the backdrop of our four strategic priorities: building up our people, concentrating on our brands, putting margins first and making smart acquisitions. Following that, Steve will review the financial results for our fourth quarter along with our 2023 guidance, and then I'll come back to talk about the main themes ahead and how we intend to generate growth in 2023 and afterward. First, I'd like to recognize how much our team has given — their commitment and ability to bounce back in this tough environment is something that keeps inspiring me. Thanks to how they performed despite inflation, supply chain disruptions, labor shortages and severe weather, we were able to overcome those difficulties and turn in solid results. We've made headway in cutting the number of open positions at our bakeries, and conditions in the labor market appear to be getting better. Even with that, we’ll continue putting money into what I consider the industry’s strongest team, and we’re making a serious effort so Flowers keeps being seen as a place people want to work. Alongside rolling out programs for our existing employees to make sure the right individuals are in the right roles, we’re also taking action to highlight the appealing career opportunities that await new hires. A lot of these internal efforts are still very new, but we feel good about what they could do to improve recruiting and retention down the road. Our second strategic priority is a focus on our brands. Today’s inflationary conditions make it clear just how much strong brands matter. In Q4, Nature's Own, Dave's Killer Bread, and Canyon Bakehouse each held their unit share as shoppers keep recognizing what sets these brands apart. That happened even in a tough climate, with private label picking up 90 basis points of share, and our portfolio strategy is delivering as planned. Both portfolio roles we're concentrating on — Aggressive Growth and Learn and Prove — posted growth above the company average. On top of that, we're leveraging our strong brands to launch new and innovative products. After excellent results in test markets, we're taking DKB bars national. The rollout to retailers kicked off in January and will run through the rest of the year. Though it's too soon for initial results, we're enthusiastic about the potential, and feedback from retailers and consumers has been positive. To back what we see as the first step toward building a DKB snack portfolio, we're putting substantial marketing support behind the launch. That spending adds to the 2023 headwinds I mentioned earlier; beyond the bars, we have an exciting pipeline of other new products, such as DKB crunchy snack bites and Nature's Own breakfast pastries, which you can try on our site creations by flowersfoods.com. Margins are our third strategic priority, and they remain a key focus given inflation. We've offset much of the higher cost impact through price increases combined with efficiency efforts. Our cost reduction efforts generated $24 million of benefits during the year, and we anticipate an additional $20 million to $30 million in 2023. Despite a decline in our margin percentage for both Q4 and the fiscal year, adjusted EBITDA in dollars rose 8.5% and 2.3%, respectively. Going forward, we are focusing on additional initiatives aimed at enhancing margins. One program demonstrating progress is bakery of the future. It was rolled out in 14 bakeries during 2022, and we intend to add 18 more this year. Once bakery of the future achieves critical mass, we expect the advantages of real-time data to begin materializing. Crucially, in 2023 we are dedicated to increasing our investment in supply chain capabilities to support these and other initiatives. We anticipate that these new capabilities will place more focus on preventive maintenance, cutting waste, efficiencies in logistics, and overall equipment effectiveness. In addition, putting capital into equipment upgrades and increased automation ought to contribute to our gains. Past these particular programs, we are fostering a culture of ongoing productivity gains designed to endure beyond the current inflationary stretch. And looking further out, we anticipate that this cultural transformation, along with our portfolio strategy, will produce significant margin improvement. Smart M&A ranks as our fourth priority. In December, we announced an agreement to acquire Papa Pita Bakery, which manufactures and distributes premium bagels, tortillas, breads, buns, English muffins, and flatbreads. Papa Pita has acted as an important co-manufacturer of Flowers goods for quite some time, and we think acquiring this business will create further synergies across manufacturing and distribution. We anticipate closing this transaction in the first quarter of this year. We continually monitor the deal marketplace, as is our habit, and we are actively seeking potential acquisitions and investments that could add capabilities, brands or products to our already robust portfolio. Thanks to our solid balance sheet, we are well placed to act once we have financial, commercial and operational conviction. It's a pleasure to report that Flowers was just added to the S&P High Yield Dividend Aristocrats Index — a move in line with our track record of allocating capital in ways that benefit shareholders. That index is made up of businesses that have boosted their payout annually for a minimum of 20 years. Our robust free cash flow has allowed us to maintain a lengthy history of dividends, and we're proud of that. At this point I'll pass it to Steve, who will walk through the quarter's specifics, and afterward I'll come back to discuss how we see the present business climate shaping up. Steve?

Thanks, Ryals, and hello to all of you. I want to add my voice to what you said about our amazing team and offer my heartfelt appreciation for everything they accomplished in a tough environment. Before turning to the Q4 numbers, I want to call out one change in how we present sales. In line with our portfolio strategy of driving more sales of higher-margin branded retail products, starting with the fourth quarter and full year 2022 report, we're splitting our sales into 2 categories: branded retail and other. That second category covers what we used to call store-branded retail and non-retail and other. We'll also give price/mix and volume detail for both categories. Beyond better alignment with our strategy, we think this added detail will provide greater insight into the business. Turning now to the results: total sales in the fourth quarter increased 10.1% compared with the same period a year earlier. Improved price/mix drove the adjusted year-over-year increase, which came in at 16.7%, largely reflecting price increases implemented to counter inflationary pressures. Volume declined 6.6%, and a meaningful share of that decline resulted from deliberate sales rationalizations in cake and foodservice. Gross margin as a percentage of sales, excluding depreciation and amortization, declined 110 basis points to 46.8%. The comparisons were impacted by higher ingredient and packaging costs, partially offset by lower incentive compensation and decreased outside purchases of product. In the fourth quarter, selling, distribution and administrative expenses were 37.9% of sales, down 110 basis points. Several factors helped results: incentive compensation expense was lower, distributor distribution fees decreased as a percent of sales, rent expense came down because 27 leased warehouses were purchased in the prior year, and the gain on sale of assets was larger. These gains were partly offset by increased logistics and bad debt expense. On an adjusted basis, excluding matters affecting comparability, SD&A expenses declined 100 basis points to 37.9%. GAAP diluted EPS for the quarter was $0.23 per share, compared with $0.18 in the prior year period. Leaving aside the comparability-affected items laid out in the release, adjusted diluted EPS for the quarter came in at $0.23 per share, an increase of $0.03 versus the same period last year. Moving now to the balance sheet, liquidity and cash flow. Cash flow from operating activities for fiscal 2022 increased $16.3 million, reaching $360.9 million, and that figure included $33.2 million of business process improvement consulting costs associated with the transformation strategy initiatives currently underway. Capital expenditures climbed $33.1 million to $169.1 million, with $61.3 million of that amount going toward the ERP upgrade in progress. Dividends paid were up $10.6 million, totaling $186.5 million. During the second quarter, our Board of Directors increased the company's share repurchase authorization by 20 million shares. During fiscal 2022, we bought back $34.6 million in common stock, which leaves 24.4 million shares available for repurchase under the company's existing share repurchase plan. Our financial position is still strong. Net debt to trailing 12-month adjusted EBITDA was approximately 1.4x at the close of fiscal 2022. Cash and cash equivalents came to roughly $165 million when the fiscal year ended, and we had about $687 million remaining available under our credit facilities. Turning now to the 2023 outlook, which reflects significant investments in our strategic priorities as well as actions we've taken to counter the inflationary environment. Sales are expected to increase 7.7% to 9.1%. Adjusted EBITDA should land between $513 million and $543 million, while adjusted EPS is forecast at $1.20 to $1.30 per share. A large share of what we are investing in 2023 ties to the continuing upgrade of our ERP system. We anticipate those costs will reach their peak in 2023 as deployment of the system begins across our network. Our adjusted EBITDA guidance factors in roughly $26 million, or about $0.09 per share, of incremental costs tied to this project. We expect those costs to ease considerably by the time the project wraps up in 2026. Additionally, we anticipate a per-share impact of $0.08 to $0.10 stemming from increased interest, depreciation and amortization costs tied to the ERP rollout and the Papa Pita deal; for 2023, D&A is projected at $160 million to $165 million, compared with $142 million in 2022. Capex is expected to land between $140 million and $150 million, of which $20 million to $30 million relates to the ERP upgrade. Elements that may move results inside our guidance range include pricing, consumer resilience and ongoing inflationary pressure. We implemented significant price hikes during 2022, and a portion of those won't be cycled until roughly mid-2023; beyond that, we're implementing additional increases in 2023, especially aimed at improving margins in our foodservice and private label segments, which run at lower profitability, and at offsetting rising commodity expenses throughout our product range. Broadly speaking, demand elasticity has come in line with what we anticipated and has remained below historic norms. We anticipate meaningful inflation during 2023 across the full set of costs we face on inputs. While wheat futures have eased somewhat from peak levels, they remain high; apart from flour, inflationary pressure is evident in nearly every significant area of ingredients, packaging and natural gas. Because of the way inflation unfolded during 2022, a meaningful share of those elevated costs is going to land in the first half of 2023. Our approach to countering that pressure combines price increases with the efficiency efforts Ryals outlined. Roughly 60% of the key raw materials we rely on are secured for 2023. To keep volatility in check and preserve sufficient clarity on costs, we've stuck with our customary hedging approach of locking in prices 6 to 12 months out. For fiscal 2023, we anticipate the ERP upgrade will run about $80 million to $90 million, and $20 million to $30 million of that figure will be capitalized. We anticipate the total cost of the ERP upgrade will come to roughly $350 million, of which about 32% is expected to be capitalized. We anticipate finishing the upgrade during 2026; that figure is above our original projection of roughly $275 million. The main reasons are that the project's scope has grown as we enter the build phase, and we expect heavier dependence on outside resources for implementation and bakery deployments because of labor constraints. By December 31, 2022, we had incurred costs of about $153 million connected with the project. Our ERP program is still on schedule, and we feel confident we can carry it out as planned within the revised financial guidance. On the earnings cadence, the first quarter faces the toughest year-ago comparisons, given how strongly we started fiscal 2022. Thank you — I'll now hand it back to Ryals.

Thanks, Steve. You've just gotten the specifics on our Q4 financial performance and what we expect financially for fiscal 2023. Now I want to talk through a few of the major forces shaping the present climate — macroeconomic strain, how shoppers are reacting to that strain, and the competitive dynamics at play in the bread segment. The macro picture is still difficult, since persistent inflation and worries about recession have weighed on consumer spending. And even though unemployment is still low, there are recent indications of rising layoffs, as elevated interest rates could be hurting economic growth. Conversely, as the Fed pointed out this week, job growth coming in above expectations might make inflation tougher to bring down. Some shoppers are responding by trading down to cheaper items and moving more of what they buy toward retailers that emphasize value; specialty premium bread, for instance, gave up 50 basis points of unit share during the quarter — a bigger loss than any other category in fresh packaged bread. Meanwhile, the more budget-friendly white and soft variety loaf segments ranked among the biggest share winners, climbing 40 and 30 basis points, respectively. The mass channel also picked up 130 basis points of unit share in the back half of 2022, whereas the grocery channel dropped 170 basis points. Mirroring those patterns, private label won market share in the second half of 2022, though those gains leveled off near the end of the year. In earlier quarters, we've talked about how results diverge between mass and grocery, and that trend has persisted. Private label is still considerably stronger in mass, where the price gap separating private label from branded goods is broader than in grocery but evened out late in the year; in grocery, private label's share gains are still modest and in fact fell off toward year-end. It's worth noting that starting in January, we've started seeing the mass channel raise prices on private label. Price gaps are still broader than in grocery, but we read that step as a constructive first move for the health of branded products. As we look toward 2023, beyond the impact of tough comparisons in the first quarter stemming from Omicron and winter storms a year ago, we anticipate the major swing factors in how we perform will be shifts in inflation, patterns in consumer spending, the competitive landscape, and how well we can offset inflation through price increases and cost-saving efforts. While these macro-level trends are mostly outside our control, we're concentrating on proactively fortifying the parts of our business we can control, both now and going forward. Concrete steps include executing our portfolio strategy of moving a larger proportion of sales toward higher-margin branded products through innovation and advertising, and putting money into capabilities such as supply chain, our agile innovation team, and digital and ERP initiatives. These investments across our business, innovation, marketing, supply chain, digital and ERP, are building the groundwork for our growth in the future. Like we've observed with our digital and ERP initiatives, you have to spend money upfront before any benefits materialize, yet our conviction stays firm that putting capital into this business will return substantial rewards down the road. Although we are dedicated to getting the most out of performance right now, creating value over the long haul is what we're focused on. Therefore, even though we anticipate the macro backdrop will stay difficult in 2023, the Flowers team remains determined to move forward aggressively and put ourselves in position to outperform going forward. Our 2022 achievements make me genuinely proud, and I want to express gratitude once more to the Flowers team for the effort they put in that made such performance achievable. Even with the tough macroeconomic conditions, we achieved record sales, moved our innovation pipeline forward, and made meaningful strides on our digital and supply chain efforts. And we intend to extend that momentum during 2023. Additional investment will go toward digital and supply chain, plus marketing backing for the DKB bar launch. Even though those investments, together with ongoing inflationary pressure, will weigh on near-term results, I have confidence that by strengthening the already solid foundation we have, we are setting the company up for long-term success in the future. So with that, Tanya, we're ready to take questions.

Ryals, can you share a bit more detail about the increased marketing push for the snack bars? My understanding is that they'd been growing, were in test market, and performing well, but we didn't really have a way to quantify how large it is or how large it's expected to be this year. And perhaps you could discuss what is being invested behind the brand and when, and what sort of effect that's having on gross margin or on earnings specifically, as opposed to just overall brand spend or the marketing step-up.

Sure; so Bill, as you're aware, we're starting the nationwide rollout right now as we speak. So it will ramp up as production increases and as we secure shelf space and retailers over the course of the year. So it'll be a build throughout the year. And the bulk of the support behind that is going to be marketing, support, digital spend, display execution, all those kinds of things, since you really need to activate a new product. DKB is a known quantity, but obviously, this is a new space for DKB. And so we're being very intentional about the investments we put behind the introduction of the new snack line; so mostly marketing support; and again, it will be a build throughout the year. As far as magnitude goes, we're not going to disclose that separately. But as we gain traction during the year, we can start to give you, guys, additional color on how the products are performing overall in the marketplace.

Understood; but I suppose if we look at that initial guidance, it's below roughly where we had been, and fair enough, you hadn't provided guidance previously — I mean, does this represent about a $0.05 hit to earnings? Or is it a $0.10 hit to earnings? I'm just trying to get a sense of how much of that, as opposed to other market dynamics, is feeding into the guidance.

Are you referring to the marketing support for the bars themselves — what sort of headwinds does that create?

That's right. That's right.

I mean, possibly $0.02 or $0.03, most likely $0.02, $0.03.

Okay, now that helps.

Yes.

Then, quickly, regarding the private label trends you mentioned in your prepared remarks: is it now expected that pricing has normalized for private label at the one mass customer, and that it stays stable as we go through this year? Or does it actually get better? I mean, in the sense that branded share improves. What's your rough outlook for share over the coming couple of quarters?

Yes. So the pricing dynamics have begun — I should say the retail pricing dynamics — for private label and mass have started to tick up somewhat, which is a positive development. I think it's too soon to say how private label overall will perform in '23. Late last year, as we saw private label build and gain share in the second half, it did sort of level off at the end of the year. And through our first period just completed this year, that same dynamic is at play. So it's kind of to be determined. And of course, that's factored into our guidance range. That's one of our watchouts for the year — yes, how the consumer overall is doing and how that translates into private label performance. The divergence between mass and grocery does continue, though. In the first period, private label was up pretty significantly, in line with what it had been in the last couple of periods of last year, but from a unit share standpoint it was actually down in the grocery segment; so that's — if that continues, that's obviously an encouraging trend in and of itself.

I have quite a few questions, though I'll do my best to keep this short. Ryals, and perhaps Steve as well, I'm just wondering: when it comes to the top line guidance, that figure of about 8% to 9% year-over-year, does a large portion of that stem from — it sounds like there's some additional pricing in foodservice and private label; and the reason I ask is that, clearly, some pricing has already been implemented on the branded side, which in my view would slow as the year goes on, and volumes for the business as a whole were still somewhat lower. That feels a bit elevated to me, though perhaps the bar rollout is providing some extra lift as well; more detail on that would be great.

Yeah. So yes, we do expect some lift from the bar launch, but the bigger factor—keep in mind, Rob, that we have about five months of wrap-around pricing from last year. That may be what you're overlooking, and on top of it we've returned with further pricing this year. So much of the top-line guidance range reflects additional price as we keep facing elevated costs.

All right, understood. And regarding gross margin, Q1 sounds like a hard comparison. You've got some pricing in place. It sounds like perhaps some costs could ease as the year progresses, specifically around the hedging strategy. How would you sum up the year on the gross margin side? Is it likely roughly flat? Perhaps down slightly? Perhaps the second half is a bit stronger than the first half? Again, any additional detail would be helpful.

Well, Rob, looking at the full year, I think what you'll see is likely fairly flat. As we mentioned, we expect meaningful inflation to persist through 2023. And despite the extra pricing Ryals just covered, from an overall margin standpoint, I'd describe it as fairly flat and fairly consistent across the year, with some pressure obviously arriving in Q1. Because if you look back, Q1 was a very strong beginning last year.

All right, that's great — no problem at all. So my final point is this, Ryals: your prepared remarks included a fair amount of discussion and commentary about spending — spending aimed at future benefits — and also some remarks about what those benefits might deliver over the longer term. I believe the wording used was meaningful margin expansion potential. Clearly, you're investing to strengthen the business. And ideally, that strength, combined with some mix benefits, would create margin expansion potential down the road. I guess I'm just wondering — if we look at timing, part of that outlay is going to keep going through '23, then presumably '24, and after that it might begin slowing in '25 and '26, though some will still be there. So if we simply keep, say, the commodities cost center steady and assume nothing else changes — which is hard to do, but just as a concept — how do you see that carrying through to the benefit? Is it — again, this is fairly broad-based. Is it more the case that, yes, we do need to — our spending is rising in '23, and we'll continue spending in '24 as well, but as those benefits come through, we'd expect to see that margin expansion perhaps materialize by year 3 or 4, something like that; so that's the picture.

Well, first off, I'd certainly be hoping this isn't the new normal where commodities are concerned; so hopefully some relief is on the way as we move through this year and into the next one. But no, that's a good question, Rob. And I think you've mostly got it. Obviously, the investment has to come ahead of the benefit, right? As we've explained, factors like inflation, the consumer, and other issues mean this will be a fairly tough year for us and for others in food. Even so, we're unwavering in our commitment to keep putting money into this business for the future. We aren't decelerating, and there's no reason we see to decelerate. So rolling out the bars will continue. We'll back that with marketing support. This year we're investing in supply chain. We've discussed at length the efficiency gains we need in the bakeries. Our view is that these investments will unlock those gains too. And then, of course, there's the digital ERP spending. My guess is this year marks the high point for that spending, and it should start easing over the next several years. On top of that, we'll have the benefits we expect to come in. So with investments declining and benefits rising, we believe both will drive a meaningful gain in margin.

This is Jim Salera, sitting in for Ben. I'd like to probe a bit on demand elasticity. In the prepared remarks, you noted that a big chunk of the volume drop came from SKU rationalization. Could you help us understand what branded volumes might have looked like without the cake SKU rationalization? My assumption is that on the other side — that basically all of the total volume decline is eliminated SKUs, but for branded, roughly half from SKU rationalization and half from demand elasticity?

We don't have that breakout to share with you today, I'm afraid. What I can say is that you're correct that the bulk of the volume decreases sit in cake and foodservice, and much of that is deliberate and strategic. So we cut back on quite a few underperforming SKUs. In cake, we reduced a lot of underperforming foodservice business. And we'll keep working to optimize that business, so to speak. So when you look at volume declines — and certainly, there — yes, there's been some softness on the branded side. With the mix shift toward private label that we've seen, I don't think anyone finds that surprising; but looking at the overall business, it's mostly — it's heavily concentrated in cake and foodservice.

Alright. So regarding 2023 pricing, is it roughly uniform throughout the portfolio? Or does it lean more toward foodservice and private label? My thinking is that since the value gap at mass is getting smaller, if you all implement pricing, does that risk widening that gap again? Or will it continue trending toward a tighter gap?

Yeah, I'd say the gap ought to — it should remain fairly consistent over the year. What I mean is, broadly speaking, there'll be a larger total dollar amount in private label and foodservice on the whole, but pricing applies across the whole business, though likely with somewhat more emphasis on private label and foodservice. Still, I'd anticipate the gaps to — assuming — this is our own view, depending on — sure, retailers may always act differently, but I'd anticipate the gaps to hold at their current levels.

All right. So perhaps just one additional question about that. Looking at it through the consumer's eyes, do you believe that after they've traded down — whether that's from a high premium product to merely a normal branded one, or from normal branded to private label — a promotion in the channel is needed to bring them back up the value chain? Or, as those gaps get narrower, do you figure they'll simply drift back on their own toward the more premium SKUs?

Yeah. I'd say my hope certainly is the second of those. It's just a matter of waiting to see how things play out. Up to now, the competitive environment has stayed — has carried on being stable, with no meaningful uptick that we've seen. And I'd certainly hope that any consumers who may have walked away from a Nature's’ Own or DKB in order to trade down will come back to something else. But also keep in mind why we're sticking with our marketing spend; we aren't slashing it for the year just because it's going to be a tough year. We keep investing in our brands. And once the time arrives, and some of that pressure lifts off the consumer, I believe they'll recognize the differentiated aspects of our top brands. And honestly, I think that on its own, together with the marketing support, will bring them back to us.

Yeah, it seems like you have a genuinely exciting set of innovations in the pipeline, from Dave bars and snack bites all the way to Nature's Own Breakfast Pastries. And obviously, the snack occasion is completely additive to what's already in the portfolio; but I suppose with the breakfast pastry, based on your research, do you see it cannibalizing your existing breakfast items such as bagels or English muffins? Or does it truly draw in a new customer or create a new occasion?

Yeah, Connor, we really believe it will be additive, which is quite an exciting prospect. Keep in mind, those breakfast pastries are only in test right now; but the thinking is that it delivers something differentiated on top. One noteworthy point about the breakfast pastries is that our plan is to actually merchandise them within the bread aisle. So in my view they function as an add-on alongside a bagel or an English muffin, that sort of product, and that sets them apart from the DKB bars, which are of course distributed through warehouse and sit in what you'd call the conventional bar section.