The Clorox Company (CLX) Earnings Call Transcript & Summary

Perfect. I think we're good to go. So we're going to get started. I'm sure some more people will trickle in at the back. Good afternoon, everybody. I hope you enjoyed the lunch. Delighted to welcome you to this 38th Annual Strategic Decisions Conference. And this fireside chat here, we have Kevin Jacobsen from Clorox. We were meant to have Linda as well, but she's been taken ill. So I think we're in very good hands.

I do my best to stand in for Linda.

I think we're in very good hands with Kevin, one of the much more strategically focused of the CFOs amongst the group that I cover, that's for sure. So Kevin, thank you for joining us.

Yes. Thank you.

A lot of things we want to run through. I think we're going to start a little bit with some of the more shorter-term focused things and get them out of the way a bit first and then sort of move on to some of the more longer-term strategically focused things.

And as I'm sure you know and as I'm sure you've been hearing from investors, a lot of focus at the moment on the strength of the U.S. consumer. Some of the comments that we've heard from retailers in particular, over the course of the past couple of weeks. So question is, do you see a correlation between the strength of the economy and retailer receptivity to your pricing?

What I'd say is it's a great place to start on pricing. And maybe just a little background so you kind of understand where we're at in terms of pricing. We're in the process of executing 3 pricing actions over the course of this year. We took one in the fall, we take another round of pricing that went into effect in April, and then we're in the process of taking a third round of pricing that go in effect in July. So 3 pricing rounds. I'd say really only the first one has been in market long enough to get a decent read. And what we're seeing is elasticity is generally slightly better than what we saw before the pandemic, which is certainly a sign that we believe the consumer is holding up. Now what I'd tell you is, I think, Callum, to your question, I don't want to overread the elasticity performances on the first one, assuming that continues. I think we have to recognize as pricing builds, we'll have to see how the economy plays out. But I think it's something we're watching very closely to understand how is the consumer reacting to the level of pricing we're seeing. I talk about the price increases we're taking. This is fairly consistent with what we're seeing across our categories, similar levels of pricing. So the entire categories are moving up. And so far, the consumers held up well, but it's certainly something we're keeping a very close eye on.

When you say slightly better, I think one of your peers has quantified that slightly better as being about 20% to 30% improvement in elasticities relative to what you would have historically expected. Is that about the same as what you're seeing?

No, that's not been our experience. I would say ours is more modest in terms of the improvements versus pre-pandemic global elasticities but not in the 20% to 30% range.

And if I -- so I think your answer is mostly focused on consumer response to the price increases. If I can focus on the retailer angle, obviously, the retailers, up until the start of 2022, had enjoyed a period of some strength through the pandemic. It seems like that's starting to come to an end, and they're starting to come under more pressure, and you've seen the reaction in some of their share prices. Do you think that there might be more pushback from retailers going forward to incremental price increases beyond FY '22?

We haven't seen that yet. As I said, 3 rounds we're taking. The first 2 we've announced in our end market. We're in the process of communicating our third round, and we're fairly far along in that. To date, I would describe the discussions with retailers as fairly constructive. Maybe what's different than the pricing we've taken in the past is, in the past, you probably spent more time with retailers trying to understand and justify the commodity inflation we were dealing with that we needed to pass on through pricing. I think there's a much greater understanding for both manufacturers and retailers of the cost environment we're operating in. So I'd say there's less discussion on understanding the cost inflation. The conversation pivots pretty quickly to with this pricing, how are you going to help me grow my category. Let's talk about innovation. Let's talk about the things you're going to do to make sure we keep bringing consumers into my store. That tends to be where the discussion is right now. Look, for anyone who's taken pricing, pricing is never easy to take with a retailer. You never walk in there and say, great, thank you. I would say it's more constructive right now than I've seen historically because of the clear understanding of the extreme cost environment we're all working in. And then the conversation is pivoting to, let's talk innovation. Let's talk about plans to build this category over the long term. That's what we see to date. Again, we'll have to see how this plays out if there's more pricing going forward. But at least for these first 3 rounds, I'd say it's been fairly constructive conversations.

Okay. If you think beyond FY '22 and beyond those 3, the timing of the 3 price increases that you spoke about there, and obviously, I don't want you to talk about things that you're not allowed to talk about. But if you can think about in general terms, what are the variables that determine beyond FY '22, the pace at which you might consider further price increases going forwards?

Sure. So what we're looking at, if you follow The Clorox Company at all, our intent is to maintain top line momentum while we rebuild gross margins. We've lost about 800 basis points of margin through this cycle, this inflationary cycle. Before the pandemic, we're about 44% gross margins. We're going to end this year somewhere around 36%, so 800 basis points. Our intent is to rebuild that margin. Now it's going to take some time to do that. And Callum, I'd say what's important for us is we don't think about margin isolation, but it's margin rebuilding in the context of maintaining top line momentum. That's what's important to us. That's how we maximize the value of this company, maintain top line and rebuild margin at an appropriate pace. And so as we build those plans, what we're looking at is what does the inflation environment look like? What pricing is required? Right now, our expectation is when we look at our fiscal year '23, which for us starts next month in July, our expectation is we're going to be operating in an ongoing inflationary environment. So we're not assuming cost deflation as a pathway to rebuilding margins, at least not for the next 12 months. And so we're really focused on 3 areas. The first is the pricing that we've talked about, the 3 rounds of pricing that we're in the process of taking. We're going to continue to pursue our cost savings program. And if you folks follow us, we have a very disciplined approach to cost savings, and we'll continue to drive that program. And then the third bucket for us and the opportunity is we have built up tens of millions of dollars of cost in our supply chain as we've tried to manage through this disruption we're all dealing with. There's an opportunity for us to go out and pull those costs back out as the supply chain disruptions moderate, and that's another source of margin recovery. And so right now, at least with what we can see, Callum, and I'll acknowledge it's a low-visibility environment. But at least what we're projecting, we think between the pricing actions we've announced, our cost savings program and our ability to take cost out of the supply chain, that's our pathway to making progress on margin recovery. Maybe last comment. If you look at the progress we made most recently, our last quarter, sequentially, we added about 300 basis points of margin. So a very good start. Our expectation with these plans is you'll continue to see margin expansion as we move into fiscal year '23. And it'll likely take longer beyond '23 to fully rebuild back to a pre-pandemic level. But again, it's that combination of rebuild margin while trying to maintain our top line momentum.

Okay. I want to come back to some of the cost pieces later on, but just sticking on the sort of consumer side of things for now. And one of the other angles around consumer receptivity to pricing is around private label. So can you give us a sense of what you're seeing from private label in your categories? Are they following the price increases that you yourselves and the other branded players have been taking? And maybe even because they typically have lower gross margins on those private-label brands, is there even a possibility that we might see a narrowing of percentage price gaps versus private label?

Yes, I would say what we're seeing to date is, and this is true for private label, it's frankly true for all the players in our categories. A pretty, I'd say, constructive environment. We're seeing everyone pricing to fairly similar degrees of what we're taking now. We don't know what our competition's plans are nor should we. But what we're seeing in the marketplace is a fairly consistent level of pricing. I think there's going to be a lot of noise for the next couple of quarters. I think, Callum, if I look forward, our intent is we want to get to a place once we get through all this pricing, price gap's generally in line with what we had before the pricing began. We think that allows us to continue to be competitive in our categories and be in a position where we can grow share. I think for the next several quarters, it's going to be noisy. Some brands are -- some companies are going before us, some are going after us. They're at different levels. It generally seems to be about the same amount, but the timing is different. And so I think scanner data is going to be hard to read for a while. In some cases, price gaps are widening. In other cases, they're narrowing. I think that's temporary. And I think when we get through this, ideally, we've retained the price gaps we had going into this round of pricing. Now having said that, having taken pricing for a long time, I don't think you ever get pricing completely right by category or by country, when you take pricing broadly across your portfolio. So I suspect we will have to go back and do some cleanup on the back end once we see where this all settles out. But again, our goal when we get through this is we are left in a position we can be very competitive in the categories we compete because we've generally maintained those price gaps.

And I guess the other side of private label is obviously through the pandemic, we saw those private-label manufacturers lose a lot of market share. I think it had been the expectation amongst most investors that some of that would start to rebound this year as the consumer started to come under pressure. But it's been much slower to materialize, those private-label share gains. How is that looking in your categories today? And would you say it's still something that you're watching very closely?

It is. And I'd say in our categories, it's very similar to what you described. If you look at private label share performance during the bulk of the pandemic, we saw private label losing share to our portfolio, our trusted brands, as we've said. That started to change a little bit. If I look at the most recent 13-week read, I saw private label ticked up about 10 basis points, so a very small increase in private label in the categories in which we compete. We grew 20 basis points during that same period of time. So we are seeing private label pick up a little bit of share, not coming from us, but certainly something you would expect. In a recession, that is a fairly typical trend that you see a little bit of pickup in private label share. I think what ultimately matters to the consumer is not just the price point. When you think about private label, you're certainly talking about opening price points usually being the lowest. Consumers always care about value. I would say they're even more focused on value when they feel stretched in their pocketbook. And so our focus has always been give the consumers value superiority, the price you charge, your product performance and the strength of your equity. And if you can provide value support, you can compete very effectively with private label. That's been our focus for the last number of years. Callum, if you look at our performance right now, as we test our portfolio, 75% our portfolio consumers would tell us they see us superior to competition. That's the highest number we've ever had. And so the investments we're making in advertising, the investments we're making in innovation, keeping a sharp eye on price points, when you do that well, you can compete very effectively in these categories regardless of the economic conditions.

Interested that you cited 13-week scanner data. I know that some of the big retailers, when they spoke 2 weeks ago, have said that it's really much more recent and maybe more like the past 4 weeks that they've started to see the more accelerated trade down. Do you see anything different if you try and segregate it into sort of a slightly shorter time period?

Yes, it hasn't changed that much. And again, I would be careful in scanner data because there is so much noise right now based on where everyone is out on their pricing plans. Gaps are widening and narrowing, so I would be very cautious on 4-week scanner data. I think you have to look at a longer time period to get a better sense of how this is playing out. But here's maybe the other perspective I'd give you. If you think about how Clorox performs in a recessionary environment, and while this may not be a recession in a true sense of it, it's -- I think the element of consumers being under pressure is consistent with 2008, 2009. If you look at our performance back then during that period of time, we grew sales in 8 of our 10 business units. We grew sales overall about 4%. And what we saw is what mattered to consumers was value, not just the lowest price point, but who gives me the best value when I have to stretch my dollars even further. And so I would say our categories historically have been fairly resilient, and we found our brands during recessions have also been very resilient.

So one of the headwinds to doing the same through this period of pressure is that you're obviously lapping periods through the pandemic where your cleaning businesses, in particular, saw tailwinds from pandemic-related demand. When we spoke this time last year and last November, you've spoken about how you saw increased household penetration and you expected at least some portion of that to be sticky post pandemic. We're starting -- touch wood -- to get closer to the post-pandemic kind of era. Do you still believe that some of that demand will be sticky?

We do. And while we talk quite a bit about consumer behavior changes, including disinfecting, we're really seeing changes that we think benefit our portfolio broadly. In cleaning and disinfecting, we certainly believe consumers' awareness of the cleanliness and the hygiene of the spaces they occupy has been elevated through the pandemic, and that is a long-term trend we expect to continue. We saw increased household penetration when the pandemic began and a significant -- it has certainly come off those peaks, but we see the bulk of our portfolio has household penetration higher than what we had before the pandemic began. That's true for cleaning and disinfecting. But I would say it's also true when you think about the concerned behavior changes more broadly beyond just cleaning and disinfecting. If you think about things like consumers spending more time at home, no one I talked to, I think, believes anyone is going to go back into the office 5 days a week. When consumers spend more time with their homes, they generally consume more of our products. They create more trash, they eat more salad, drink more filtered water. That's a tailwind broadly to our portfolio. If you look at cat or pet adoption rates, I should say, across the U.S., they're up significantly. We're seeing the cat litter category continue to grow at a fairly elevated clip. And so we see a number of tailwinds that we believe will benefit our business over the long term. Now clearly, to your point, they're going to come off the extreme highs we saw during the pandemic, but we fully expect them to settle in at a level well above where they were before the pandemic began.

If I think about that and look at the sort of the quarterly cadence and focusing in particular on the cleaning business, even over the past 12 months, you have seen spikes in demand around some of the resurgence of COVID. So your fiscal Q3, for example, this year, a slight rebound sequentially that perhaps was related to Omicron. Do you agree? And so it might suggest that even over the next 12 months, there is still some element to give back?

Yes, it's hard to know for sure how that's going to play out because as you folks can imagine, we're moving from a pandemic environment to an endemic environment. And we're all trying to understand is that process for the consumer to adjust their behavior, how do they operate in an endemic environment? What's their purchasing behavior? I think it's going to be difficult, and we're going to have to watch how this plays out. Again, our belief is long term, that's going to settle out at a higher level. But the process of that change is underway right now. It's hard to read. Here's maybe some data I'd share with you that we look at that reinforces our belief. If you look at our Health and Wellness segment and you can look at this public data, that's primarily our cleaning business in the U.S. If you look at our sales before the pandemic, we averaged in fiscal year '18 and '19 about $575 million of sales every quarter. There'll be a few spikes for cold and flu season but fairly consistently in that range. During the pandemic, we were selling over $800 million a quarter in our Health and Wellness segment. Now actual demand was even higher, but we were limited by our ability to supply. We've seen that now settle down. If I look at the last 3 quarters, we're averaging closer to $675 million. When we had a Delta wave, it was up a little bit. When you get past Delta, it's down a little bit. But it seems to be settling into a pattern below the peak but well above where we were before the pandemic began. And I think we're just going to have to see how that plays out as we go through the next several quarters. I suspect we'll get in some more level state because we're still seeing some puts and takes based on variants. But I still expect it to end up higher than when we started, for sure.

Okay. I want to come back to the sort of increased household penetration. And I'm interested, do you have any -- have you done any work disaggregating how much of that is driven by lower-income households who maybe were big beneficiaries of some of the stimulus that went to the consumer in the U.S.?

Yes. What we're seeing right now, as we look through the household penetration, low-income consumers, we're seeing at or above in terms of the benefits of household penetration. So we are retaining households at all ends of the spectrum, including the low-income consumer.

Okay. I want to shift into the mix side of the equation that has been a pretty meaningful headwind over the course of the past 12 months. And starting at a high level, can you just -- and for the benefit of the audience, some of whom I think are generalists and portfolio managers who may not be familiar with what has driven that headwind, can you break down the drivers for us of what's driven that mix headwind over the past 12 months?

Sure. And what Callum is referring to, if you follow the company, we've had a negative price mix for a number of quarters now. And the phenomenon we're dealing with is we had a temporary benefit during the pandemic for 2 reasons. The first was because of our lack of ability to fully supply demand, we chose to significantly simplify our portfolio. And for the most part, that meant we started producing single-count items, not multipacks. I'll give you the best example. Before the pandemic, we probably had 100 different SKUs of wipes in all different configurations. During the pandemic, we got down to about 10 or 15 different configurations, mostly just the 30 count, the small container, because we could run that the fastest in our facilities. And so we significantly simplified our product offerings to get the most capacity of our plants to meet this elevated demand. That generated favorable mix. Additionally, because there's a lack of product on shelf, in many of our categories, there's almost no promotional activity going on, and so we had lower trade spending. And so when you look at our price mix during the pandemic, we had about a 4-point benefit pretty consistently every quarter because this was a temporary benefit of a simplified portfolio and a lack of merchandising activity. We knew that had to unwind. We knew at some point when we caught up with demand, we get back to more fully producing our full set of products, and we get back to a more normalized merchandising level. And so that's been unwinding for the last 4 quarters. And you've been seeing negative price mix. We've now lapped that in our most recent quarter we just completed. We've lapped that issue. And then going forward, what you should see in the future now is the benefit of pricing more fully flowing through without this drag of negative mix and negative trade spending. And the best example, if you look at our most recent quarter, we had 4 points of favorable price from the pricing action we're taking, offset by 4 points of unfavorable mix and increased trade spending as we lap that issue. Now behind us, so I expect going forward, you'll see more benefit from price mix, which is really the pricing actions we're taking.

Can you -- is it possible to disaggregate for us of the minus 4, how much was the mix issue and how much is the trade spend?

We have not separated that out and we don't look at that. We don't spend a lot of time separating those out. I would say in total, that was about 4-point hit to top line, the combination of those 2 issues, but they were both meaningful contributors to the hit to the top line.

And when you look at promotional spending now relative to pre-pandemic, is it back close to or at where it was pre-pandemic? Or we're still at slightly reduced levels?

I would say, slightly reduced, although almost back to a normalized environment. If you look at Clorox before the pandemic, our merchandising activity, about low to mid-20% of our volume would be sold on some form of merchandising before the pandemic. During the pandemic, because of the lack of ability to supply, our merchandising levels are probably in the high single digits, low double digits. So a significant drop off. The most recent quarter, we're back in the low 20s. So it's almost back to a normalized level of merchandising activity. Now for us, just last comment on that. When you think about merchandising at Clorox, we don't do a lot of what I describe as price merchandising, buying down the price. Most of ours is feature and display because we see value in that. If I can create awareness for products, if I can drive trial, that creates real value. We're not big fans of just buying down price on the shelf because in many cases, that doesn't build categories on everyday essential categories. Like trash bags, you don't buy more trash bags or use more trash because the bag costs less. And so we tend not to do a lot of price discounting but we tend to focus on feature and display, and that's now coming back to a more normalized level we're seeing.

Okay. I want to move on to gross margins. Before I do, I have a question from the audience. And just a reminder, if you scan the QR codes, you can submit questions that will appear on this iPad that I will put to Kevin as well. So the question from the audience is you have some segments with high private-label exposure. Does your pricing strategy depend on the competitive subset? And is it different in those segments with high private-level exposure?

Yes. And thank you for the question on private label. There's really 3 categories where we have the biggest private-label exposure. It's our bags and wraps category with our Glad equity. It's our bleach category, and that's our grilling category with our Kingsford equity, which the primary competitor is private label. I would say what we're seeing broadly, this includes those 3 categories, but it's a comment that's true across all our categories is we're seeing everyone move, private label included. Again, we compete very effectively against private label. We sell at a higher price point, but in many cases, we provide more value to consumers because they care not just about price, but they care about product performance as well as the strength of the equity. And so we're seeing private label in all categories, including the 3 I mentioned. They're moving, in most cases, in a similar fashion to our movements. In some cases, we've even seen private label go first on pricing. But we're not seeing any scenarios where gaps are widening, what we think as a permanent widening of price gaps with private label. What's maybe unique about this environment is everyone is facing the same cost situation. So every competitor is trying to figure out how do they recover the cost inflation they're dealing with. And that's why maybe more so than what I've ever seen before is everyone in a very similar fashion is moving on price, including private label. And that's why our expectation is as we get through this round of pricing, we expect price gaps to generally be in line with where they were before we started, so that includes private label. And if that's the case, I would expect to be very competitive in those categories as we've been today.

Okay. That's a perfect segue into my next question because I think you just said everybody is impacted by inflation in the same way. And obviously, your gross margins have been hit quite a bit harder than pretty much all of your CPG peers over the past 18 months. Historically, through previous inflationary cycles, that hasn't been the case. And do you have a sense of why this time has been different?

Yes. I think there's 2 issues for us. The first is this issue of supply. It wasn't that long ago, 12 months ago, half of our portfolio was on allocation. And when I say allocation, what that means is we can't fully ship the orders we're receiving from retailers. I can assure you, it's very hard to have a conversation about pricing when the first conversation retailers want to talk about is why aren't you fulfilling my orders. And so you have to fix supply first. And we spend -- Callum, you and I have talked quite a bit about this. We spent a lot of time and effort improving our supply capabilities to make sure we can fulfill orders. And for the most part, we've done that. We've got a few outages. But by and large, we're back to where we can supply demand. As we've gotten through that, then we switch gears to start taking pricing. So those discussions are now, as I've mentioned, they're all underway. I would say the other issue though is our portfolio. And you're right. In aggregate, when you compare us to other companies, our margins are down further. But category by category, I'm not sure it's that different. Anybody operating in the grilling category is dealing with the same transportation issues we are, but not everybody deals with grilling. So I think you have to look at every category and say, is our margin any different in the categories in which we compete versus the appropriate competition? I think at the enterprise level, it's just too hard to do that because portfolios are so different in terms of the categories you compete in and what the underlying inflationary issues are you're dealing with.

Okay. You touched there upon some of the things you've done to solve some of the supply chain issues. And earlier, you were talking about the -- I think you said tens of millions of incremental dollars that's sort of currently in the cost base through some of the probably transitive solutions you found to some of the supply chain issues. So can we talk about -- I think you're talking about the third-party manufacturers. Can we talk about that a little bit? They've, I think, always been part of your business model, but you've spoken about how the mix of third-party to in-house shifted through the pandemic. Again, maybe for the benefit of the audience, a little bit of background might be helpful. And maybe you can talk us through where we are today in terms of that mix.

And this issue with contract manufacturing, I'll touch on that certainly. What I'd tell you though is the issue is much broader than just the use of contract manufacturers. When we talk about cost of goods sold, internally, we have this very simple way to describe it: buy, make and ship. I buy materials. I transform those into finished goods and then ship them to customers. So buy, make, ship. If you think about just the make part, manufacturing product, before the pandemic, in our cleaning portfolio, about 80% of the product, we self-manufacture in our facilities. In about 20%, we use third-party contract manufacturers. Because of the significant increase in demand, we had to increase our manufacturing capacity fairly quickly, and so we went out and leveraged third-party manufacturers. During the pandemic, that 80-20 split looked closer to 50-50. So about half the product we are producing, about half the product was being produced by third-party manufacturers. And we did this for a couple of reasons. The first is you can get product in market much faster by using existing manufacturing capability with third parties versus having to go build your own plants, which can take years, in some cases, to bring online. So it allowed us to very quickly get more product in market during the height of the pandemic. The other reason we did this was we knew that this demand was temporary. It was going to moderate. And what we did not want to do is overbuild internal capacity and then as demand moderates, we are stuck with a lot of underutilized facilities. And so we knew we would temporarily pay higher cost for this third-party manufacturing but allow us to get out of those contracts. As demand moderates, we can step out of those agreements and bring that product back in line. And that's generally playing out as we expected. As I said, during the height of the pandemic, we were 50-50. We have exited most of those third-party agreements now. By the end of this quarter, we'll be out of all the ones we intend to exit. And I expect we'll be back closer to 80-20 in terms of the manufacturing split. So that's an example where we've accepted some near-term costs to get product out there, but to ensure we don't overbuild capacity and then rightsize that as demand moderates. But I'd say that's only a piece of what we're dealing with in the supply chain. Every aspect of the supply chain has been challenged over the last 2 years through all the disruptions we're dealing with. As a company, we probably had more than 200 force majeures declared on us by our suppliers for any number of reasons over the pandemic. They could not get access to materials because of port congestion. They couldn't run their plants because maybe they had a COVID outbreak and had to shut their facilities down. So we've had to build up a level of resiliency into our supply chain that comes at a cost. I have qualified hundreds of additional suppliers to make sure I have resiliency. If a supplier goes down, I'm going to have backups now. And in some cases, those backups, they may be in Asia. And I've got to import goods through ocean freight, I've got to get it through our ports. It comes at a higher cost. I'm carrying more inventory level. If you look at my inventory balances, they're up significantly versus where we were before the pandemic began because we had to be prepared for a disruption. It wasn't that long ago, maybe 5, 6 months ago, we had one of our major manufacturers declare a force majeure for 30 days. They didn't ship us any product. We had prepared for that. We had extra inventory at our plants. We had finished goods at our warehouses, so we are able to ship product in spite of one of our largest suppliers not sending product to our facilities. That's what we've had to deal with for the last 2 years. And so as the supply chain disruption starts to moderate, we're going to be able to step out of these agreements. I can pull back from this extended supply chain of contract manufacturers, additional material suppliers. I can lower my inventory levels. There's tens of millions of dollars tied up in the choices we've had to make to supply product that we'll ultimately be able to step out of over time. And I think between our pricing actions, between our ongoing cost savings program and our ability to step out of these costs, that's the path to us rebuilding margins over time.

Okay. I want to sort of drill into lots of different nuggets of information within that. And maybe we could start -- you report a manufacturing logistics line within your gross margin bridges. Are you able to help us understand of the things you just set out, and I probably sort of broadly categorize it into 2 buckets, the third-party manufacturing and other things, how important are those 2 buckets within the headwinds we've seen in that manufacturing logistics line?

If you look at our cost structure, while I've said we're seeing inflation in every aspect of our business, what is the most challenging is commodities and logistics. If you look at commodities and logistics, let's talk before the supply chain disruptions. $50 million to $60 million worth of inflation would be a normal year for us. This year, we're projecting $530 million of inflation in commodities and logistics. So that just dimensionalizes to some degree, the level of inflation we're dealing with, which is unprecedented. And not just the amount but how quickly it's occurred. It's probably been in an 18-month period that we've seen it run up to this degree. And so that's what we're dealing with. That's what we're attempting to recover through pricing and all the other actions. But it's really been commodities and logistics, the most acute. But I would say it's broadly impacting every aspect of our business: wage inflation, insurance costs, utility costs. Every part of our business, we're seeing inflation, but those are the 2 lines that I'd say represent the vast majority of the cost increases.

If I just stick on the third-party bit of the equation for now. So you said, I think, in the answer that by the end of this fiscal quarter to the end of this fiscal year, that you should be out all of the third-party agreements that you intend to exit.

Right.

Can you walk us through the cadence over the past few quarters? Is that all coming in this fiscal fourth quarter with those exits? Or are we already seeing some of them? Just trying to think about how we should think of the cadence of benefits that you're seeing.

I think the way you'll see this play out in our P&L is it will start with a reduction in inventory. So as we've gone out to all these third-party manufacturers, we have to build inventory at all these new nodes we're creating. And so as we start exiting those relationships, the first thing we'll do is sell through that inventory. So there'll be a little bit of a delay. You should start to see inventory levels come down as we start eliminating the inventory we've held at all these facilities. As we work through that inventory, we then start pulling production back into our facilities and producing at a lower cost, and then you start seeing that piece go through the P&L. So I expect the benefit of exiting these co-pack agreements mostly in our fiscal year '23, which for us, keep in mind, starts next month. In the very near term, you'll start to see inventory levels come down. You saw that start in our third quarter. I'd expect that to continue and then accelerate as we move into fiscal year '23.

Okay. Can you walk us through what is the sort of the magnitude of gross margin hit between using a co-packer and doing it yourself?

Yes. Usually for contract manufacturers, you look at 2 things. One, we believe in most of the categories where we produce, we're the lowest cost manufacturer because of the scale we have. And so when you go to a third party, typically, you have to -- they just have a higher cost structure than we do. They may pay more for materials because they don't buy as much as we do. They generally just have a higher cost structure. And then additionally, you have to pay them on profit margin. And profit margins in the contract manufacturing world tend to be maybe 10% to 20% of the cost of goods. So you're dealing with a profit margin to these suppliers plus their less efficient ability to acquire materials, that tends to be the cost increase we're dealing with. We don't break that out in terms of exactly what that is overall. But those are the elements we're able to eliminate as we bring that production back in house.

So just running through that math in my head, that's a pretty significant maybe ballpark 30% reduction in unit COGS.

Yes. Yes, Callum, I think where you'd see this flow through, if you look at our financial information, before we went to this higher cost model, if you looked in our P&L that we published, you look at the manufacturing logistics line. And you might see 150 to 175 basis points of cost inflation on any given quarter a year. Right now, we're running at close to 500 to 600 basis points a quarter in cost inflation in manufacturing and logistics. That's both the manufacturing upcharges plus the upcharges we're seeing in transportation. Collectively, that's adding 300 to 400 basis points of hit to margin every quarter, and we've seen that now for about 1.5 years. I expect to see that start improving as we start stepping out of this supply chain cost we've built up.

Okay. Perfect. And of the other market, the non-third-party bucket that you were talking about, which is supply chain robustness, are any of those changes that you've made permanent?

Yes, I think some will be. I think the days of how we ran the supply chain before the pandemic are over. We used to have this saying just in time. I had a supply chain that was incredibly reliable. I had a demand signal that was pretty consistent. And so the focus was how do I get a lower and lower unit cost? And I had very little concern about reliability of that supply chain. I think the world is different now. I think as we move into an endemic state going forward, I don't think we'll ever go back to that type of supply chain. I think you're going to have to have a greater, resilient supply chain going forward. Now not to the extremes we're managing now. I don't think you'll ever go back to sole-source materials. You're always going to have backups. You're going to think differently about inventory levels. And so I think there will be a change. It doesn't change my point of view that we have built up so many costs that we're going to get those out. But I don't ever think you go back to that environment. I think you're going to have to have a more resilient supply chain because I think you have to be prepared for more uncertainty and more variability than we've dealt with in the past.

So if I think about it as a spectrum of on one end where we were pre-pandemic, where it was just in time. At the other end, where you got to at the height of the pandemic, how far back do you think we can get?

I think you get pretty close. I think you have to be careful in some areas where we got to a single-sourcing product because we had a supplier that had incredible reliability, you could count on them. I think you're going to want to have redundancy in your supply chain on things like suppliers, contract manufacturers. That doesn't necessarily mean you're going to pay a higher cost. It means I may split my business between a few strategic suppliers versus I may have given all of it to one supplier in the past. So I wouldn't equate a more resilient supply chain to a higher cost. I think it's just a different way you're going to run that supply chain. Now you may have some more administrative costs because I'm going to manage more suppliers in the future. But I think that's just a smart way to run a supply chain now, that I think we've learned that lesson through the pandemic.

Okay. Probably a final question on this before we piece it all together. Can you walk us through how you contract for these commodities and these inputs? How quickly do -- should we expect the recent spikes, the continued spikes that we've continued to see versus other commodities maybe starting to roll over? How quickly should we expect those to flow through into the P&L? Is there any lag on hedging, fixed-price contracts?

Yes, there's a little bit of a lag, I would say, because it's a bit of all of the above. We do some hedging. So in that case, you expect there's a lag. Our hedging tends to go out about 12 months. And I wouldn't say we do a lot. But in some categories, soybean oil, some of the solvents we use are hedged. And so you get some price protection that can last anywhere from 9 to 12. In some cases, 18 months. That will delay when we see that flow through our P&L. There's a natural lag because of how we inventory materials. They come and they sit in inventory. It usually takes about 60 days if we're on what we call a FIFO accounting process before it flows through. And then in some cases, we have fixed-price contracts with our suppliers that they'll agree to pricing for some fixed period of time. So it's a little bit of all of the above. So there's typically some delay in aggregate before this all flows through our P&L. But generally, because we don't do a lot of hedging, I would say, for the most part, the cost environment that we're seeing generally flows through fairly quickly in aggregate. There's a few exceptions, but in aggregate, the cost environment fairly quickly within a quarter or so, we're seeing in our supply chain.

Okay. So if I piece it all together, can you walk us through your guidance for gross margin progression in the fourth fiscal quarter and then remind us of what you've said in terms of how you expect that recovery to progress over -- think at Q2 results, you described it as a several year process.

Right. We've been trying to be very clear with folks is we don't believe our path to recovering margin is a 1-year process. And there's a very specific reason. We look at not just margin isolation but margin in the context of top line momentum. As I said earlier, we want to maintain top line momentum while we rebuild margin, and we think that's how you maximize the value of the company. If someone said to me, "Kevin, just focus on margin recovery. That's all I care about." I can cut trade spending, I could take more pricing, I could cut investments in advertising innovation, and I guarantee I could make faster progress on EBIT margin expansion. I can also guarantee, if anyone doing business, that's the way to kill momentum and reduce the value of your company. And so for us, we're being very thoughtful about what is the right pace of margin recovery that allows us to continue to invest in our brands and continue to drive top line momentum. And we think if we do that well, that's how we maximize the value of the company. And so for us, what we try to be very clear with folks is that's what we're working towards. And what that means is we're not going to recover margins in 1 year. It's probably a couple of year process for us, and we think that's a smart choice to maximize the long-term value of the company.

Okay. Perfect. You mentioned the sort of the -- if you were only focused on margins, which you're not, then maybe cutting back on advertising could have been something you've chosen to do. And you've chosen to focus on the long term and keep advertising spend where it is. So maybe if we're moving on from gross margins, advertising is a [indiscernible]

Thank you for that. We've moved on from gross margins. I spent quite a bit of time talking about that.

So advertising spend, you kind of got to 10%. Part of the rationale, I think, for increasing up to 10% was increased advertising ROIs. And the flip side of that is, I think it's been very well documented some of the big digital ad players that some of those ROIs have come back a bit over the course of the past 6, 12 months with some of the privacy changes that we've seen. Does that change your thinking about the 10%?

It doesn't. Maybe I might correct you just a little bit, Callum. We have typically spent about 10%, advertising on percent of sales. What I would say is it varies quite a bit by brand, some much higher, some much lower. But in aggregate, about 10% spending we found allows us to be very competitive in the categories we compete. During the pandemic, we actually took it up to 11%. So we added almost $100 million in extra advertising investment. We felt that was a strategic investment for the company because at the time, if you folks remember in the pandemic, we had millions of additional consumers coming into our franchise for the first time. Household penetration was growing rapidly. We saw that as a unique opportunity to engage and build loyalty with new consumers. And as I said earlier, our household penetration across the bulk of our portfolio is higher now than it was before the pandemic. So we felt that was a good investment that's paid off by retaining consumers in our franchise. And that I can tell you folks, acquiring new consumers in your brands is one of the highest ROIs you can get. And so I felt very good about our choice to elevate spending during that year. To your point, Callum, we've come back down to a more normalized level 10% this year. What I can tell you is the data we've seen is our ROIs continue to go up. I just saw a report from our internal analytics group a few months ago. And we're seeing increasing ROIs in our spending. So we feel very good about the 10%. We're growing share broadly across our categories. So we feel like we're getting good returns for that investment. Ultimately, what I'd tell you though is -- I showed you sort of how we run Clorox. Linda and I don't have a number that we have to spend. We don't go out and say we are spending 10%. What we tell our general managers, we have 9 business units in the U.S. and our international business, the direction to our general managers, you need to improve ROI every year. And how you do that is your choice. You can decide where you spend the money, how you spend it, but we expect you to be able to increase ROIs every year. And they've been able to do that very consistently as they change the mix of how that money is deployed to get a better return on that. And we've seen that fairly consistently. And so right now, we think 10% is about right, but I am very open. If a general manager comes and makes a case for a good investment that generates a return, we would absolutely consider changing our investment levels beyond 10%. We just found right now 10% seems to work, but we could change that in the future if we thought we could generate a good return.

Okay. We got about 5 minutes left. And we have a question from the audience on the international business that ties in as well with some of what's to come on my list. So maybe we can jump there. And you -- obviously, at the start of 2021, you lifted the longer-term growth targets, top line growth targets. And I think you described international as being a part of that increase. You've described in the past how that's going to be capital light for now. Is there an expectation that you need to shift ad spend and sort of brand marketing spend to build brands in those international markets?

Yes. If -- and thank you for the question on international. If I can just talk briefly about, I'd say -- 2 goals we have in international. When you look at our international performance in our previous strategy period, over a 5-year period, it averaged about 2% decline in sales. The biggest issue we're dealing with is I would describe us as having a geographically disadvantaged portfolio. About 50% of our sales in Latin America, about 50% of our sales are in rest of the world. If anyone has worked in the Latin American markets, that is a very difficult place because of currency devaluation over the last decade. 8% organic growth, 10 points of negative FX headwinds over that period, negative reported sales. Our strategy when we rolled out our IGNITE Strategy was we want to evolve our portfolio into more stable, profitable and growing markets away from Lat Am. And so our intent was to build our business outside of Latin America. Last year, as an example, we bought majority control of our business in Saudi Arabia. It's a terrific business. It's margin accretive to the company. It has a currency that's pegged to the dollar. There's no currency fluctuations. That's the path we've been going under to pursue growth in more attractive markets, Europe, Middle East, Asia, against those parts of our portfolio that we think have the most growth potential. Our litter business, our Burt's Bees business and our cleaning business. And so that's where we started with our IGNITE Strategy. And then the pandemic came along, and all we've seen is additional growth [ one raise ], as a result of the pandemic and the change in consumer behaviors, which is not just a U.S. phenomenon, that's a global phenomenon. And so we've seen even more opportunity to grow our cleaning business. Callum, your point on asset light, we have started out from a manufacturing perspective, choosing to work with contract manufacturers. We are growing our wipes business internationally. If you think about the wipes business, in the U.S., wipes has fairly developed household penetration. It's about 50% before the pandemic, not just Clorox, but half of all U.S. households were using wipes before the pandemic began. If you would look at international markets before the pandemic, household penetration was in the single digits. It was not a form that was used extensively. What we're seeing now from consumers is a greater understanding of the health and hygiene of the spaces they go into and a willingness to pay more for convenient solutions. And so for us, that means more opportunity to introduce wipes into new markets. And that's what we've been doing. We're now in about 35 countries, introducing wipes. That's a significant increase from where we were before the pandemic began. And as part of that, we've stood up a dedicated supply chain to support that business. We used to ship wipes from the U.S. because of a relatively small business for us into these international markets. But as that business has grown, and we think this is a multiyear runway, we're now trying to move supply closer to the market. We've started doing that through a contract manufacturer, and that's fairly typical for us. When we start new businesses, we tend to start in third-party manufacturing until we prove out the business, we scale the business, where it makes sense for us to invest capital. We're not at that point yet. Now I'd love to be at a point in a year or 2, you and I are sitting here saying we're building a new wipes plant internationally because the business is so large, it supports that. I would say we're a few years away from having that discussion.

What's the mindset? Are you like a digital disruptor?

As it relates to wipes, I'll talk about our cleaning business. For the most part, what we've done to date is in the countries where we currently operate, we're extending our offering in those countries where we already have capacity and capability. I think the longer-term opportunity is then to start looking at new geographies. And so the first opportunity for us is build out your portfolio with consumer-preferred solutions in the countries you operate and then look at new geographies to go into. I would say for other of our brands, we are certainly using digital as a way to enter markets. I would say Burt's Bees in Asia is a great example. That's a wonderful equity. We've been able to build that business in international markets, in many cases, through online. But we'll look at every aspect, either online or through more traditional brick-and-mortar. Whatever the right plan is for each market, we evaluate that with our GMs and then pursue that strategy.

Okay. Perfect. It looks like we're out of time. So I think that's a good place to stop. Kevin, thank you very much for your time, and thank you, everybody, for joining us today.

Yes. Thank you, everyone. I appreciate your time today.