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

Good day, everyone. I'm J.T. Rieck, Executive Vice President of Finance and Investor Relations. Thank you for joining us to discuss Flowers Foods' second quarter 2023 results, which were announced in a press release dated August 10, 2023. Before we begin, please note that the information presented today may contain forward-looking statements regarding the company's performance. While we consider these statements reasonable, they are subject to risks and uncertainties that could cause actual results to differ materially. In addition to what you hear in these remarks, important factors concerning Flowers Foods' business are fully described in our SEC filings. Speaking today are Ryals McMullian, Chairman, CEO and President, and Steve Kinsey, our CFO. Ryals, I'll turn it over to you.

Thanks, J.T. It's a pleasure to have everyone join us on this call. After a start to the year that was slower than expected—something we went into detail on during our first quarter call—we bounced back well in the second quarter and posted strong results even with the macro environment still carrying a fair amount of uncertainty. I credit our performance to how effective our strategies have been and to the exceptional execution delivered by our team. Sales growth came mainly from solid brand performance and from strategic pricing moves we made to soften the hit from inflationary pressures. Even with selective price increases, volume trends in our branded retail bread business improved substantially versus recent quarters. The top line strength that came out of this fed through into higher earnings, and you can see that reflected in the 2023 guidance we've updated. Consumers are still feeling the squeeze from inflation, and that has encouraged trade down within the retail category toward private label products. Even with that pressure, and with price increases during the quarter on many of our branded products, we managed to hold our branded retail unit share in tracked channels for the fresh packaged bread category. We did even better in the grocery channel, where we picked up 20 basis points of unit share. Strength was particularly notable in the organic, specialty loaf and breakfast categories, where we gained 290, 160 and 60 basis points of unit share, respectively, hitting record levels in specialty loaf and breakfast. After digging into where that organic growth came from, we found that sales metrics for Dave's Killer Bread among middle- and lower-income consumers improved versus the prior year, with gains in unit sales per buyer, product trips and repeat rates. On top of that, DKB grew overall units by 7% in tracked channels, which we see as a reasonably good barometer of consumer health given how the brand is positioned at a premium. Branded retail unit share for the company stayed fairly consistent across the quarter. Taken together with the strong DKB unit growth, these factors give us some confidence that consumer demand may be shifting back toward pre-inflationary levels; these indications are encouraging, but we'll be watching how trends unfold in the third quarter before we conclude that consumer health is on a sustainable upward trajectory. Sales in our other category rose significantly, driven by pricing initiatives put in place earlier in the year; those gains were partly offset by planned business rationalizations as we work to improve profitability. The overwhelming majority of our company-wide volume decline came from our non-retail and cake businesses. This result is in line with our portfolio strategy of moving a greater portion of our sales toward higher-margin branded retail products and improving the profitability of our other businesses. We expect volume declines tied to these initiatives to moderate in the second half of 2023. Now I'll give an overview of our second quarter performance through the lens of our 4 strategic priorities: developing our team, focusing on our brands, prioritizing margins and pursuing smart M&A. After that, Steve will walk through our financial results, and I'll return with a discussion of key themes going forward and our plan to drive shareholder value in 2023 and beyond. First, I want to acknowledge what our team has accomplished — their enthusiasm and dedication are truly what drive our success. Those efforts played a big part in delivering a strong second quarter. During the last call, I talked about reorganizing operational duties at our bakeries, moving them out of the sales function and into supply chain. A main goal behind that shift was to let our sales group concentrate entirely on getting our lean products into the hands of as many customers as we can, and I'm glad to report that the reorganization is paying off already. Our sales team executed exceptionally well around the Memorial Day and 4th of July holidays, which produced a company record for bun unit share — a crucial element of our portfolio strategy. That kind of execution matters a great deal during the all-important bun season, and we anticipate the restructuring will keep delivering benefits. In the same way, we're seeing sharper focus and improved results from our bakeries, thanks to the direct accountability line and clear KPIs that supply chain leadership put in place. As we've noted over many quarters, operational improvement represents a major opportunity for us, and it's a pleasure to watch our investments in capabilities, systems and processes begin to pay dividends. Our second strategic priority is a focus on our brands. Our brands keep outperforming. Even with a challenging competitive backdrop where private label picked up market share, albeit at a slowing rate, our leading brands more than held their ground. In the fresh packaged bread category, Nature's Own and Canyon Bakehouse each kept unit share flat, while Dave's Killer Bread picked up 20 basis points. Results got a boost from our dedication to innovation, as we kicked off nationwide launches of Nature's Own Keto Net One loaf, Nature's Own Perfectly Crafted Everything buns and Wonder Hawaiian buns. Meanwhile, the nationwide rollout of our DKB snack bars is ongoing. Those bars are now on shelves at close to 12,000 stores, and we anticipate that figure will reach beyond 13,000 by year-end — a bit higher than we originally planned. Velocities have matched some of the leading competitors, and our team is working diligently to build trial and repeat purchases via a multifaceted marketing campaign. The DKB snack bars represent only the first item in a deep innovation pipeline that we believe will widen our addressable market and meaningfully increase sales beyond the bread category. Our DKB Amped-Up Protein Bars are in test markets right now, with a nationwide launch planned for 2024; and our DKB Crunchy Snack Bites are in test markets as well. As we've said, the financial benefit from these rollouts will be limited near term while we invest in a robust marketing plan, but the preliminary results encourage us; at the other end, even though Canyon Bakehouse held unit share in the overall fresh packaged bread category, it gave up 230 basis points of gluten-free unit share. Canyon has experienced two quarters of weakness in tracked channels that isn't typical for the brand, and 2 factors caused this. The first was a mix shift toward channels that syndicated data doesn't measure comprehensively, and the second was a gluten-free capacity shortage that limited our ability to satisfy consumer demand. We expect additional capacity to become available in the second half of this year, and we have aggressive plans in place to reaccelerate our growth. We stay optimistic about the potential for Canyon, which continues to hold the #1 market share position solidly. Beyond initiatives to grow its core products, we are also exploring plans to add new products through our agile innovation team. Margins are our third strategic priority, an area where we saw progress in the second quarter. Price increases at the start of the year across food service and private label, plus selected branded retail pricing in May, together helped offset inflationary pressures and higher expenses tied to our ERP implementation. Our margin improvement plan extends beyond price increases. We are also focused on maximizing efficiencies, partly through digital initiatives such as bakery of the future, which keep benefiting operations. Cost savings initiatives remain on track to hit our savings goal of $20 million to $30 million for 2023; and the Papa Pita acquisition also helped margins as we moved more production in-house and broadened our sales footprint. Finally, we continue to execute our portfolio strategy. Branded retail products rose to 64.1% of sales, up 30 basis points sequentially, despite continued pressure from private label. And that branded retail performance was especially strong in the branded bread category. Smart M&A is our fourth priority. For decades, M&A has been a key contributor to our growth, expanding our geographic coverage and supplementing our brand lineup. Looking ahead, we also expect M&A to help us move into adjacent categories beyond bread that are growing faster. We keep monitoring the deal market, actively vetting potential acquisitions and investments that could add capabilities, brands or products to our robust existing lineup. Our strong balance sheet puts us in a good position to act when we have financial, commercial and operational conviction. Now I'll hand it over to Steve to review the details of the quarter, and then I'll return a little bit later to discuss our outlook for the current business environment. Steve?

Thanks, Ryals, and good morning, everyone. Now let's turn to the results. In the second quarter, total sales rose 8.8% year over year. Adjusted sales grew 13.3% versus a year ago, driven by better price/mix, mainly from price hikes aimed at offsetting inflationary pressure. Volume fell 6.1%, in part because of deliberate sales rationalizations in cake and foodservice. The Papa Pita acquisition contributed 1.6%. Gross margin as a share of sales, excluding depreciation and amortization, rose 90 basis points to 49%. The comparison reflected inflation-driven pricing actions that more than offset input cost inflation, lower production volumes, higher product returns and higher maintenance costs. Selling, distribution and administrative costs represented 38.8% of sales, matching the same period last year. As a proportion of sales, reduced consulting expenses and distributor distribution fees were offset by increased marketing costs, decreased scrap dough income, and an insurance liability reserve. When excluding items affecting comparability, adjusted SD&A expenses climbed 70 basis points to 38.2%, pushed by the factors I just mentioned, with the exception of consulting costs. GAAP diluted EPS for the quarter came to $0.30 per share, compared with $0.25 in the same period a year earlier. After excluding the items affecting comparability detailed in the release, adjusted diluted EPS for the quarter stood at $0.33 per share, which is $0.02 higher than the prior year period. Now on to the balance sheet, liquidity and cash flow: for the first half of fiscal 2023, cash flow from operating activities fell by $54.9 million to $128.9 million, a figure that included $12.8 million of business process improvement costs tied to the ongoing transformation strategy initiatives. Operating cash flow was affected by working capital increases of $47 million, largely because of lower accounts payable resulting from higher ERP-related capital expenditures in the prior year. Capital expenditures declined $29.5 million to $68.4 million and included $19.1 million for the ongoing ERP upgrade. Dividends paid rose $4.7 million to $98.1 million. Our financial position remains strong. At quarter end, net debt to trailing 12-month adjusted EBITDA was approximately 2.1x. When the quarter wrapped up, our cash and cash equivalents stood at approximately $12 million, and we still had roughly $510 million available under our credit facilities. As Ryals noted, we're revising our 2023 outlook to account for what we saw in the second quarter. We're lifting the low end of our guidance for sales, adjusted EBITDA, and adjusted diluted EPS. Our new expectations call for sales between $5.095 billion and $5.141 billion, adjusted EBITDA between $503 million and $528 million, and adjusted diluted EPS between $1.18 and $1.25. When we revised our guidance last quarter, we said the second quarter would come in about where we expected, and it did. For the rest of 2023, we're anticipating a quarterly pattern that looks like what we've seen historically. Among the things that could move results up or down inside our guidance range are demand returning to prior trends, price elasticities, how resilient consumers prove to be, and ongoing inflationary pressure. We've held on to the top end of our guidance ranges because overall demand elasticity has come in as we anticipated and remains under historical levels. As a reminder, our adjusted EBITDA guidance incorporates about $26 million, or $0.09 per share, of incremental costs related to the ERP project. Those incremental costs totaled $2.5 million, or $0.01 per share, in the second quarter. By the time this project wraps up in 2026, we expect those costs to come down significantly. On top of that, for 2023 we're anticipating an impact of $0.08 to $0.10 per share, driven by higher interest, depreciation and amortization expense tied to the ERP implementation and the Papa Pita acquisition. Our ERP program launched in the second quarter and remains on schedule, and we're confident the project can be completed within the financial guidance; for fiscal 2023, we expect the cost of upgrading our ERP system to land at roughly $95 million to $105 million, which includes $30 million to $40 million we expect to capitalize. By July 15, 2023, project-related expenses had reached approximately $190 million, with $103 million of that amount capitalized. In 2023, around 93% of our essential raw materials are secured. To reduce volatility and provide sufficient cost visibility, we aim to follow our established hedging approach, which seeks to improve certainty around key commodity costs 6 to 12 months ahead. Given existing coverage, our guidance reflects a modest decrease in commodity costs during the second half of 2023 relative to what we originally anticipated. That said, inflation is still persistent, and we foresee ongoing inflationary pressure carrying into 2024. We keep watching commodity markets and looking for chances to add hedges at cheaper levels that might help our results down the road. Thanks. Now I’ll hand things back to Ryals.

Thank you, Steve. I'd now like to go over a few of the trends shaping how we're performing right now, along with the actions we're taking so we can make the most of our opportunities in this climate and going forward. Three main themes have held our attention: consumer health and behavior, the effects of inflation, and our capacity to raise prices in order to counterbalance cost pressures. Buyers are still feeling the squeeze from elevated costs, and as a result they are moving toward cheaper items and redirecting a larger portion of their shopping trips toward retailers that emphasize value. Store-brand products have gained from this recent shift, picking up 50 basis points of unit share in fresh packaged bread during the second quarter. Even so, those gains were limited to loaf and traditional loaf items — the most commoditized portion of the category. Store brands gave up unit share in specialty premium loaf, sandwich buns and rolls, and breakfast and dinner breads and rolls, segments where products are more differentiated. Crucially, those share gains remain mostly concentrated in the mass channel. Store-brand items surrendered 40 basis points of unit share in the grocery channel, where Flowers' branded retail bread products picked up 20 basis points. Maybe most striking, store-brand share gains have decelerated across 2023 and fell to their lowest point of the year late in the second quarter. Our leading brands performed well in this climate. Dave's Killer Bread stood out, adding 290 basis points of unit share in the organic category and 20 basis points in the larger fresh packaged bread category, with units up 7%. As I noted earlier, Nature's Own and Canyon Bakehouse both maintained market share even after taking selective price increases in a competitive environment that was tough. Earlier in the call, I pointed to data indicating stronger demand for DKB products among lower- and middle-income shoppers. While it's too soon to tell whether that improvement will persist, the data may be pointing to a reversal of the trend from the year-ago quarter. Back then, we observed lower-income consumers cutting back on the number of purchases and trading down to cheaper items; it's possible that shoppers are growing accustomed to higher price levels and returning to their earlier buying behavior. Inflation has affected consumer demand, as I just described, and also our cost structure. That cost pressure turned acute once the Ukraine war began and commodity prices surged. Although commodity prices — wheat especially — have come down from those peaks, they are still elevated compared with recent years. More recently, other commodities, sugar most notably, have risen sharply in price. Because of our consistent hedging policy, those increases should have minimal effect on 2023 results; and we urge investors not to expect a downward step change should commodity prices stay where they are now. I discussed earlier some initiatives we're pursuing to soften inflation, and pricing is one of them. Our successful execution of price increases in the second quarter, even amid market worries about mounting pressure from retailers and consumers, underscores our advantaged value proposition. Both our company and the shoppers who buy from our retail partners feel the pinch of affordability especially sharply right now, yet we understand that countering inflation's effects is essential if shareholders are to receive a fair return. In my view, the strength of our leading brands sets us apart in a meaningful way, and that advantage—paired with the outstanding service we deliver, such as shelf management and shouldering inventory risk—warrants higher margins than we see today. Conditions at present are difficult, with buyers gravitating toward value and inflation swinging unpredictably; even so, we see most of these headwinds as short-lived, and over time we anticipate gains from premiumization as well as from the ongoing shift to working from home. I have every confidence that the steps we are taking will let us prosper both now and later on. Our people are the finest in this industry, and we are helping them perform at an even higher level. Our leading brands keep demonstrating their worth, standing firm amid a demanding consumer climate. The initiatives we have in place are the right ones for enhancing our margin profile, and we will add to them with capital allocation that rewards shareholders, among them our long record of successful M&A. My confidence in our capacity to build shareholder value well into the future remains extraordinarily high. These strong quarterly results please me a great deal. After a sluggish beginning to the year, performance bounced back, aided by the competitive might of our leading brands even as we pursued strategic pricing moves meant to counter inflationary pressures. Volume trends did pick up in our branded retail business, which might be an early sign that demand is returning to where it stood before inflation took hold. That top-line momentum carried through to better margins and earnings, as our revised 2023 guidance shows. Store-brand products did pick up share, though that gain seems to be slowing. We therefore stay confident that the premiumization trend—fueled by what we invest in innovation and marketing—will prevail over the longer run. Our prospects excite me, and honestly my confidence in our ability to grow shareholder value over time has never been greater. So with that, we are ready to take your questions.

I suppose we could begin with a bit more detail on Canyon. I didn't entirely grasp what caused the decline in, I guess, market share and margins across the last few months, and I'm just trying to figure out how that gets better going forward. Canyon seems to have been on quite a strong path for the last few years, and I just wasn't sure whether this is more a signal that we're reaching a plateau or whether there's another factor I'm not fully seeing.

Yes, of course. Happy to do that. I'd call it temporary, Bill. What I mean is that a lot of it relates to capacity. In certain ways it's a good problem to have, because, as you know, Canyon has followed a really nice path, but things got a bit tight for us; we've had to take some steps to restructure the Canyon portfolio and put more investment into the Canyon Bakery to help unlock extra capacity; so we've resolved that; it's coming online during the second half, and we have plans to reignite the growth. There are also some channel shifts taking place that the syndicated data doesn't capture. So what you're seeing differs somewhat from reality; but again, I'd place that in the temporary bucket. We'll get it back on track. Canyon still has a great future in front of it.

This is now the second or third time you've brought up your thinking about entering adjacent categories via M&A. At the same time, I believe you've mentioned launching Dave's Killer Bread bars at some point in '24 — and I wasn't sure whether those two things tie together, as in, would you want more expertise in the snack bar or adjacent space before taking that nationwide? Or any update on how it's progressing would be great.

That rollout is going really well. Those first 3 bar SKUs, Bill, are in the midst of a nationwide launch as we speak; I think we mentioned in the prepared remarks that we're in roughly 12,000 stores, we'll be in over 13,000 by year-end, and in fact we'll run slightly ahead of our own expectations on that launch. For 2024, 3 new bar SKUs are coming that are higher-protein based. They're the amped-up protein bars — a truly excellent product. They've spent a while in test market. They've performed extremely well there. And most promising, I'd say, is that they're proving incremental to the original 3 SKUs. So I think that higher protein offering reaches a different consumer segment. And then, of course, beyond that we have the snack bites; those remain in tests, they'll arrive a bit later, and there's an entire innovation pipeline even past that. So we're genuinely excited about what we're building on the innovation front with Dave's.

And I suppose, when you look at it from an M&A perspective, does that make the bars category more appealing as a way to move beyond just Street Bread while you're developing expertise and building something like a national following behind a brand?

Yes, it could. I mean, it would definitely come down to the brand and what that brand offers to the consumer. I mean, it's a crowded category. So we want to be careful that we're putting money into the right segments of that category. Yes, there are definitely opportunities out there that we'd be interested in.

So I have a few questions, I suppose. To begin with, you discussed this at length — you devoted part of your script to private label, and you're seeing what look like better trends, yet you remain cautious on it — you simply aren't certain where things are headed. And I'm wondering, are you observing the positive trend, or a shift back toward brands, even now in August? And what would you be watching for as signals of movement in one direction or the other?

Yes, absolutely. Excellent question; there are a few things to cover there. Private label continued to take share during the quarter. Still, I believe it matters to note that such growth is decelerating. And this was — near the close of the quarter was the smallest gain we have witnessed for private label so far this year. So that is certainly a favorable trend. Another point to keep in mind, and we have discussed it throughout this year. This private label phenomenon shows up more in mass than it does in grocery, and in fact it shed share in grocery. It keeps gaining in mass; we have mentioned there has been some channel movement as consumers hunt for deals in mass, club, dollar, that kind of thing. I also think it matters to note that private label's share gains are largely limited to that loaf category, the traditional products. Put differently, those offering the least differentiation. Private label gave up share in nearly every other category where you typically find greater differentiation, so particularly breakfast, sandwich buns and rolls, that kind of thing; so the push toward premiumization is certainly still present. Obviously, consumers continue to hunt for deals, but that trend is moving in the right direction from where we sit as we work to grow our branded business. Mitch, I would also highlight — and we did bring this up in the prepared commentary. Dave's had a strong quarter, up 7% in units in the syndicated data. That is a truly, truly encouraging signal. Especially considering its premium positioning. If you remember, roughly 20% of Dave's Killer Bread shoppers are low-income households. That was a surprising figure to me when I initially learned it. But that is where we had really begun losing a lot of the unit volume. And in fact, earlier in the year, Dave's units went negative. Well, at this point those low-income shoppers are returning to the brand and helping us deliver that nice unit growth in the second quarter and were positive for the year. We also picked up some penetration and higher income households that helped. So all these factors combined give us some confidence that consumer health is getting better. Now we did warn everyone that we aren't ready to call the play yet. We would like to see that trend persist well into the third quarter before we conclude that it is here to stay, but definitely some really encouraging early signs.

Now turning to your food service within the other category — I mean, how much pricing is left to take there? That's my first question. Second, have you encountered any customer pushback on pricing up to now? And when volumes decline like this, what effect does that have on your gross margins?