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

Good morning, everyone. I'm J.T. Rieck, Executive Vice President of Finance and Investor Relations. Thank you for joining our discussion of Flowers Foods' third quarter 2023 results. Before we begin, please remember that what we present today 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 the comments you'll hear in this session, our SEC filings describe in full the important factors affecting Flowers Foods' business. Speaking today will be Ryals McMullian, our Chairman and CEO, along with Steve Kinsey, our CFO. Ryals, over to you.

Appreciate that, J.T., and hello everyone — glad you could all be with us today. Execution remains solid as we move through Q3. Despite a tough backdrop, we posted record sales, with gains coming from both our branded retail segment and our other categories. Pricing actions implemented earlier in the year contributed to that growth, though it's worth noting as well that branded retail volumes picked up on a sequential basis, slipping just 1.1% compared with the 6.3% and 1.5% decreases seen in Q1 and Q2, respectively. Volume performance in our other category likewise showed improvement as the effect of business rationalization — a move aimed at lifting profitability in that unit — became less pronounced. During the prior call, we said we expected those planned business rationalizations to ease up in the latter half of 2023; that pattern is now materializing, even if some business exits occurred ahead of schedule. Along with storm activity that was below typical levels, those exits pushed third quarter sales under what we had projected and prompted a revision to our 2023 sales and EBITDA guidance. While the timing wasn't planned, exits of this kind follow naturally from our portfolio strategy, and that strategy is producing substantial margin gains in our foodservice business. The headway we're making on boosting profitability in this category encourages me, and I anticipate further gains going forward. For a second quarter in a row, our unit share in tracked channels was unchanged from a year earlier. Dave's Killer Bread and Wonder were especially strong, each gaining 20 and 10 basis points of unit share, respectively, while Nature's Own gave up just 10 basis points. Specialty loaf, sandwich buns and rolls, and breakfast all reached record highs for the third quarter, with unit share in those subcategories rising 150, 40 and 20 basis points, respectively. Sandwich buns and rolls gained from excellent execution during bun season, a good deal of which reflects the sharper focus our new sales and supply chain structure has produced. What matters here is that our positive momentum has carried over into Q4: across each of the first three weeks, we picked up over 20 basis points of unit share in bread. With the economy still uncertain, shoppers keep trading down to private label and moving more purchases toward value channels — mass, club and dollar stores. In Q3, private label picked up 40 basis points of unit share. That growth, though, is moderating, and it's below the 70 and 50 basis point gains posted in Q1 and Q2. Private label gains also remain concentrated in mass, while grocery channel share dropped once more during the quarter. Next I’ll give a summary of how we performed in Q3, framed around the four strategic priorities we’ve set: building up our team, keeping our brands front and center, putting margin first, and making smart acquisitions. After that, Steve will walk through the financials, and then I’ll return to talk about the main themes ahead. First, though, I want to acknowledge how much our people have contributed. What we achieved in Q3 is a direct reflection of their commitment and hard work. A central responsibility for me is ensuring we have the right people in place—with the capabilities required—to meet our long-term goals. So with that in mind, in August we shared a number of leadership changes. Heeth Varnedoe now holds the President role in addition to his ongoing duties as Chief Operating Officer. As a member of our management team, Heeth has been invaluable, successfully driving a number of key initiatives. His promotion to president recognizes that contribution and what I expect from him going forward. Terry Thomas also joined the leadership team as Chief Growth Officer. Having previously served as a Board member, he knows the company well, and his experience at several leading CPG firms will bring fresh capabilities and perspectives to Flowers. He's already putting in significant effort to find fresh sources of revenue and to push forward our transformation into a business that puts consumers and brands at the center. We're also lucky to have 2 new members joining the board: Brigitte King, who serves as Global Chief Digital Officer at Colgate-Palmolive, and Joanne Smith, Executive Vice President and Chief People Officer at Delta Airlines. Brigitte and Joanne offer new viewpoints to our Board, and their backgrounds align perfectly with 2 of our strategic imperatives — growing our brands and developing our team. Their expertise and experience ought to benefit us greatly as we pursue deeper expansion into digital commerce and work to reinforce our programs for recruitment, retention and talent development. I'm really enthusiastic about the improvements we anticipate these new appointments will bring. Focusing on our brands is our second strategic priority, and despite a consumer under pressure, they continue to deliver strong results. DKB really stood out, outperforming the overall bread category as well as the organic subcategory. Even in today's economic climate, the brand keeps demonstrating that shoppers are willing to pay a premium for something differentiated, with better quality and taste. While the broader bread segment saw tracked-channel volumes decline 2.2%, DKB posted a 5.6% rise in total units, with gains in every business cell — loaf, buns and breakfast; that result drove meaningful share gains, including a 20 basis point lift in unit share of fresh packaged bread, 160 basis points in the specialty loaf category and 290 basis points in the organic category. A further standout was Nature's Own Keto bread, which demonstrates our capacity to respond to evolving consumer preferences. Since launching in Q2, this new item has resonated strongly with shoppers and picked up share quickly — unit share climbed 440 basis points during the quarter — and those gains are mostly incremental, since most of the volume is coming from people who hadn't previously bought Nature's Own or Flowers. On the innovation front, our DKB snack bars keep rolling out at a solid clip, finishing the quarter in roughly 14,000 stores. In addition to our core customer store base, we're going after small format locations too, which adds meaningful growth potential via new points of distribution. ACV on average has climbed each week, and our velocity is beating a number of top brands in the category. We're investing in that momentum via shopper marketing and e-commerce initiatives designed to encourage trial and conversion among current DKB consumers. In addition, we're preparing for the nationwide rollouts of DKB protein bars in the spring and DKB snack bites in the second half of 2024. Our teams are working hard to expand the roster of retailers that have already greenlit these promising new products. We're excited about how they could build on the initial snack bar launch. During the prior quarter, we talked about certain short-term challenges and monitored sales channels for products under our Canyon brand. Two things brought those about: first, a shift in mix toward channels that syndicated data doesn't fully capture; and second, insufficient gluten-free capacity, which limited how well we could satisfy consumer demand. I'm glad to say the capacity problem is now fixed, and we have ambitious plans in place to get growth accelerating again. We are bringing promotions back, resuming output of SKUs we had discontinued, and breathing new life into our innovation pipeline. Even though unit volumes were lower year over year in the quarter because we added new capacity, sales rose in each successive period during the third quarter, and the timing of that push worked out perfectly since October was gluten-free awareness month. We stay optimistic about what Canyon can achieve, and it continues to hold the #1 market share position firmly. Margins are our third strategic priority. Although price increases implemented earlier this year and moderating commodity costs helped margins, we keep investing in growth—for example, marketing behind the snack bar launch and the rollout of our digital initiatives, including our new ERP system. To help counterbalance what those investments cost us, our attention is on carrying out our portfolio strategy and getting the most out of our efficiencies. As a share of sales, branded retail products rose to 64.3%, a sequential gain of 20 basis points, even as private label kept up its pressure. We are also ahead of schedule on our 2023 savings target, with $25 million in savings already achieved against the original goal of $20 million to $30 million. Given that progress, we are revising the goal upward to a range of $30 million to $35 million. Smart M&A is our fourth priority. For decades, M&A has contributed significantly to our growth by widening our geographic reach and adding to our brand lineup. Looking ahead, we also anticipate that M&A will assist us in expanding into adjacent categories with faster growth that lie outside bread. We keep watching the deal market, actively evaluating possible acquisitions and investments that might bring capabilities, brands, or products to our already strong lineup. Our solid balance sheet puts us in a good position to act once we have financial, commercial and operational conviction. Now I’ll hand it over to Steve to go over the quarter’s details, and then I’ll return a bit later to talk about our outlook for the current business environment. Steve?

Thanks, Ryals, and good morning, everyone. Net sales for the third quarter rose 3.5% versus the same period a year ago. The year-over-year gain came from better price/mix, which was up 6.3%, mainly reflecting price increases taken to offset inflationary pressures. Volume fell 4.1%, driven in part by targeted sales rationalizations in foodservice. The Papa Pita acquisition contributed 1.3%. Gross margin as a percentage of sales, excluding depreciation and amortization, rose 170 basis points to 48.5%. The comparison benefited from inflation-driven pricing actions that more than offset input cost inflation, lower production volumes, higher product returns, and increased maintenance and labor costs. SG&A — selling, distribution and administrative costs — represented 50.4% of sales. That's a big jump from the same period a year earlier. What pushed it up? More spending on legal settlements, employee-related costs, marketing investments, and technology amortization. Some of that was offset by distributor distribution fees being a smaller share of sales, plus acquisition costs that were booked in the prior-year period. If you strip out items affecting comparability, adjusted SG&A stood at 38.4% of sales, a rise of 200 basis points, and that reflects the same factors I just listed — except for the legal settlement expense and the prior-year acquisition costs. As we've said before, we announced on August 29, 2023 that we had agreed to settle the distributor-related class action litigation in California. The agreement includes a $55 million common fund, which will cover settlement payments to a class of roughly 475 plaintiffs, attorney's fees, and other payments and expenses. It also provides for a phased repurchase of about 350 distribution rights in California. Once that's finished, the company plans to serve its California market through an employment model. We anticipate wrapping up the buyback of distribution rights by Q4 of fiscal 2024. We peg the net cost of that repurchase at roughly $65 million. That number exceeds what we had announced earlier, since it takes in about 50 extra distribution rights outside the settlement. We booked these amounts in SG&A in Q3 of fiscal 2023. Keep in mind that the settlement terms call for court approval, which we expect in early 2024. For the quarter, GAAP diluted EPS came in at a loss of $0.22 per share, versus income of $0.19 a year earlier. Leaving out the comparability items spelled out in the release, adjusted diluted EPS came to $0.29 per share for the quarter, a drop of $0.01 versus the same period last year. Turning to the balance sheet, liquidity and cash flow: so far this year, operating cash flow fell $34.2 million, landing at $257.3 million. That operating cash flow figure reflected lower net income along with reduced deferred income taxes, partially offset by working capital reductions tied mostly to higher legal settlement accruals. Capital expenditures were down $31.4 million to $97 million, including $24 million tied to the ERP upgrade now underway. Dividend payments rose $6.7 million to $146.7 million. Our financial position remains strong. At quarter end, net debt to trailing 12-month adjusted EBITDA stood at approximately 2x. We finished with roughly $15 million in cash and cash equivalents, and about $547 million remained available under our credit facilities. To reflect the third quarter results, we're revising the sales and EBITDA outlook in our 2023 guidance. Our updated expectation calls for sales between $5.085 billion and $5.104 billion, with adjusted EBITDA between $495 million and $515 million, versus the earlier ranges of $5.095 billion to $5.141 billion and $503 million to $528 million, respectively. Our EPS target stays the same at $1.18 to $1.25 per share. In Q3, earnings per share landed about where we had projected, though revenue was somewhat below our target. Per Ryals, the primary drivers of that gap were business rationalizations materializing earlier than we had forecast and storm activity being unusually quiet. Looking ahead to Q4 2023, we expect a quarterly pattern similar to what we've seen historically. Items that might shift results inside our guidance range include demand reversion, price elasticities, consumer resilience, when business exits occur, and ongoing inflationary pressure. Broadly speaking, demand elasticity has behaved as we anticipated, remaining under historical norms. Just to remind everyone, our adjusted EBITDA guidance included $17 million, or $0.06 per share, of incremental cost compared with the prior year related to the ERP project; those incremental costs totaled $2.7 million, or $0.01 per share, in the third quarter; we anticipate these costs will decline substantially by the time the project is completed in 2026. Also, our 2023 adjusted EPS guidance includes an impact of $0.08 to $0.10 per share from higher interest, depreciation and amortization expense related to the ERP implementation and the Papa Pita acquisition. The ERP system went live during Q2, and implementation work is still advancing. For fiscal 2023, we anticipate the ERP upgrade will cost roughly $70 million to $80 million, with $25 million to $35 million of that expected to be capitalized. Through October 7, 2023, project-related costs incurred total about $201 million, and $108 million of that has been capitalized. When the quarter closed, we had coverage on approximately 96% of key raw materials for 2023. In order to reduce volatility and ensure we have sufficient visibility into costs, we aim to stick with our traditional hedging approach, through which we seek to boost certainty around our main commodity expenses looking 6 to 12 months ahead. Given our present coverage, the guidance we've provided factors in a modest decrease in commodity costs during the fourth quarter of 2023 compared with what we originally anticipated. Commodity prices are still volatile, and we keep watching them carefully, looking for chances to extend coverage at lower values that might help our future results. Thank you; and now I'll hand it back to Ryals.

Thank you, Steve. I'd now like to go over a few of the trends affecting how we're performing at present, along with the actions we're taking so we can make the most of our opportunities in this climate and going forward. First I'll cover how the consumer is doing, and after that I'll talk about the competitive landscape. As we mentioned earlier, the consumer is still under pressure. Higher food prices are weighing on category volumes; and while the data is uneven, tracked channel figures indicated that volume trends got better as the year went on, as those price hikes became less severe. That improvement in volume trends flipped direction near the close of the third quarter, mostly because of difficult comparisons stemming from Hurricane Ian a year earlier. Category volume went back to the favorable trend as we entered the fourth quarter; in reaction to elevated prices, shoppers have moved a larger portion of what they buy toward private label, which picked up 40 basis points of unit share during the third quarter; yet, much like the bread category overall, trends for branded bread products improved steadily across the year. Private label unit share growth accelerated near the end of the third quarter because of the storm comparisons year over year, but the moderation in its share growth picked back up in the early portion of the fourth quarter. The gap between mass and grocery also persisted, with private label giving up 30 basis points of unit share in grocery. Private label's unit share gains remain concentrated in traditional loaf, the subcategory that has the least differentiation. Subcategories with more product differentiation, like specialty premium, dinner breast and rolls and sandwich buns and rolls, saw private label share decline. And those are the subcategories where we picked up the most unit share in both the mass and grocery channels. Our grocery business stood out as an area of particular strength, as we picked up 10 basis points of unit share during the quarter; we keep a close watch on consumer trends, among them the possible effect of GLP-1 agonists; up to now, we have not seen any shift in consumer demand stemming from these drugs, while recognizing there are numerous unknowns, among them their effect on eating habits, long-term effectiveness and side effects. Even so, we believe our brand portfolio is well positioned to benefit if these drugs do gain traction. A number of our products, including those from our strongest brands like DKB and Canyon Bakehouse, carry health attributes that we think would complement the possible benefits of GLP-1s. Research appears to indicate that consumers on these drugs tend to look for healthier foods, which we believe could boost demand for certain of our breads and snacks. We intend to carry out research to gain a better understanding of the possible impact of these drugs and of how our products could meet consumer needs in this area. I'll now move to the competitive environment in the bread category, which continues to be rational even with the weakened consumer and declines in category volume. As you'd expect, promotions have risen compared with the unusually low rates of recent years. Even so, they are still under pre-pandemic levels. Promotional lifts are also below what we've seen historically, since inflation squeezing consumers means less discretionary spending. According to syndicated data, the entire grocery sector—the bread category included—remains mostly driven by base sales. In an environment like this, owning a portfolio of leading brands matters a great deal, and DKB's capacity to grow units even while shoppers try to stretch their dollars underscores the benefit of differentiated products. We're also innovating to bring our portfolio even more in line with what consumers want, as our Nature's Own Keto products and DKB stacking initiatives show. Whatever the environment, our 4 strategic pillars steer us toward maximizing shareholder value over the long term. We've brought substantial talent into our already strong team and refined our operating structure so we can concentrate more on key initiatives. Innovation continues, with new products added to our leading brands and pushed into adjacent categories to grow their market potential. We anticipate these efforts will enlarge the share of our higher-margin branded retail products and lift corporate profitability. On top of that organic growth, we intend to add new capabilities, brands and products via M&A. So our focus is on finishing the year strongly and carrying that momentum into 2024. My confidence in our long-term prospects remains extraordinary, and I look forward to updating you on our progress in the quarters ahead. We're very pleased with our strong third quarter results. We delivered record quarterly revenues and held our unit share despite inflationary pressures. Sales got a boost from strategic pricing initiatives aimed at mitigating inflation and improving volume trends. Our leading brands keep performing well. And we're putting money into innovation and marketing to sustain that momentum; we're also making continued progress on our digital and cost savings initiatives, which are helping us become more efficient. Even with those strong results, revenues came in a little bit below expectations because of business rationalizations that showed up sooner than we expected and a lower-than-normal amount of storm activity. It's important to note that while the timing can be unpredictable, these business exits are a core part of our portfolio strategy as we work to improve the profitability of our foodservice business; we've made great progress on that front, and we expect further improvement going forward. I remain extremely confident in our prospects, and I've never had more confidence in our ability to grow shareholder value over time. Before we move to questions, I also want to acknowledge that today is Veterans Day, and so we'd like to express our heartfelt gratitude to all the men and women in service who have chosen to risk their lives to protect our freedoms here at home. So thank you very much for your service. With that, Liz, we're ready to take questions.

So just to recap what you've said, and I want to check I've got this straight — would it be fair to say you feel the business's post-pandemic turbulence kind of hit its low point over the summer, and that while you haven't meaningfully changed anything since the third quarter, things are at least beginning to pick back up, and the only genuine shift was simply that some of your businesses exited a bit sooner than anticipated? Is that the best way to sum up the quarter?

Yes. That's a great summary. Honestly, we're very pleased with how the quarter came in. Sure, the foodservice business loss we referenced did affect the quarter and affect the guidance; but that was inevitable regardless. Those exits were planned. It's low-margin, highly complex business. In this instance, we're actually seeing some upside from lower transportation costs, since this was a somewhat difficult customer to serve. But the underlying business's strength is where attention belongs, at least as we see it. And on that front, we're genuinely pleased. I mean, you look at — Bill, you look at mix in the quarter, and it actually rose slightly on a branded mix basis; so that's a positive. Volume on the branded retail side keeps improving sequentially, and then naturally there's the share performance on top of that. So I think your framing is accurate. Things are beginning to stabilize. And I believe we also noted that even in the first few weeks of the fourth quarter, early as it is, we keep seeing that strong unit share performance carry on.

Great. No, that's helpful; and then perhaps a bit more detail on the California settlement, not the legal side necessarily, but the fact that you're moving it to an employee model. I guess I don't recall, or maybe you've said how large California is anyway, but does that change margins going forward? And could other states need to shift to an employee model later on?

Yes. So keep in mind that California is a unique legal environment, unfortunately; and so that legal environment is kind of what put us in this position; so it is unique. This isn't something I'd extrapolate across the whole country. We did have one other settlement in Maine. That was on a much smaller scale, but in that state we also switched to a company-owned model. As for California, you're correct — over roughly the next year, whenever the settlement comes through, and we're expecting it early next year, we'll move the independent model to a company-owned one in phases; so it does — and Steve can elaborate on this if you'd like, but it will move some costs around somewhat. And broadly speaking, clearly, we aren't giving any guidance for '24. We can probably sharpen this a bit more in February. Broadly, operating with company-owned locations costs somewhat more than using independent distributors. Still, there are benefits to regaining a degree of control—for want of a better term—over matters like service at the store level, how displays are executed, and service days, among others; we in fact anticipate a modest upside that should cover those added expenses.

Can you hear me?

Yes, Steve.

All right. Great. Apologies. The operator disconnected us for a moment there. I have two questions. First, regarding the ERP program currently underway and how matters have unfolded since that rollout began. If I recall correctly, in '23 the projected costs fell from roughly $100 million at the midpoint down to $75 million this quarter. Capitalized costs also came down, and the amount included in adjusted EBITDA declined from $26 million to $17 million quarter-over-quarter. So, first off, I hope those figures are accurate — let me know if they aren't. But assuming they are, does that represent savings you're realizing? Or does it reflect early delays in the rollout? And how should we think about that going forward?

Yes, Steve — it's really more a matter of a change in cadence. On the whole, the project's total cost is still projected within the range we disclosed in the Q, which I believe sits around $350 million — roughly $350 million on average — and the project's completion remains slated for 2026. So overall costs are unchanged, but you're correct that we did shift that. Part of it came from the fact that, as you may remember, we rolled ERP out to 2 bakeries. We're trying — we're quite close to getting through all of it — working through all the various bugs, so to speak, from the rollout. And we'll resume with additional bakeries beginning next year. We had some scheduled for the back half of this year, but we chose to adjust the cadence somewhat on that front. Then, returning to Bill's question about California, we've had to move a few IT and business resources over to working through the model we'll be using in California. So we felt it was more prudent to adjust the ERP cadence given that focus; that way, hopefully, we can execute both projects well.

All right. All right. That's clear to me. My second question, then, was really about Terry Thomas coming in as Chief Growth Officer last August. I realize Terry answers to you, Ryals, but I'd appreciate a bit more insight into how his team is structured and how he's settled into the wider scope of the role, or how the company has, within the broader business operations. In what way does the Chief Growth Officer connect with the rest of the business? And how does that shift planning along with everyday execution as the company moves ahead?

Yes. Fair question. We're genuinely thrilled about this position; it was a path I'd been wanting to move toward eventually; and honestly, luckily for us, the chance arrived somewhat earlier than I'd even expected. As for how Terry's team is put together, basically he oversees the — every brand team, marketing, consumer insights, innovation, revenue growth management. So in effect, all the growth levers at our disposal sit within Terry's remit. And then, naturally, Heeth as President and Chief Operating Officer keeps all the operations of the business squarely beneath his umbrella. And so those 2 gentlemen will clearly be collaborating extremely closely. You brought up planning processes. I don't believe anything will shift right away, but we're developing better processes around planning that I think can only benefit us, both from an overall sales execution angle and from a demand planning angle. And then lastly, naturally, Terry will be collaborating closely with me on uncovering new revenue streams, organically as well as through M&A. He's a highly accomplished executive, as his CV shows, and we couldn't be happier to have him with us.

So I have a couple of questions. First off, what's your take on why promotional activity is running below average? With consumers under pressure, I'd think grocery and retail would be a bit more eager to see volumes turn positive in the category. So why do you figure it's down, or below average? And wouldn't you expect that in a quarter or 2 down the road, we'd see somewhat heightened activity?

Well, Mitch, it actually is up a little bit. In the prepared remarks, I believe we noted that although < > rose for the category, it's still under the pre-pandemic level. So your point about it being below average certainly holds true. Based on our research, the main reason we see for that is simply that there isn't much lift to be gained. Historically, the category has mostly been driven by base sales; yet historically there was also some incrementality to be had through promotion. What we see now is that you really don't get much lift when you promote. And as I've said before, I think that, kind of to your point, that does somewhat signal a pressured consumer to the extent — to the extent that the opportunity for expandable consumption isn't really there at the moment. Consumers are buying what they need, and that's it. Now looking ahead, would I expect somewhat higher promotions perhaps as we look into next year? We'll have to see. It's a very tough thing to predict. I — just looking at the overall macro environment and the consumer, I would have thought we might have already seen a little bit more of an uptick, but we really haven't. And I think that's largely because there's just not a lot of return available right now on promotion.

And what is behind those elevated stale rates you brought up in connection with margins?