The Honest Company, Inc. (HNST) Earnings Call Transcript & Summary

All right. Well, thanks, everyone, for joining us today. I'm Dara Mohsenian, Morgan Stanley's household products and beverage analyst. Before we get started, I'll just give our research disclosures, which are, please see our website at www.morganstanley.com for any research disclosures. And with that, I'm very happy to have Honest here today with us, including Carla Vernon, CEO; and Dave Loretta, the CFO. So thanks for being here, guys, today. We appreciate it.

Thank you, Dara.

So you're both relatively new in your roles at the company. And we're on the cusp here of your reveal of Strategy 2027. So maybe, Carla, you can just level set us on your biggest priorities here, maybe your biggest opportunities as you think about the company over the next few years here? And some of the changes or areas of focus for the company that have evolved in recent quarters here?

Wonderful. First, I want to thank you and the team. This has been a really great conference. It's wonderful to be here. Thanks to anybody who's joining us virtually on the webcast. We appreciate you taking the time to learn more about me and Dave and Honest and our executive team. I joined Honest not quite a year ago, but that was not the first time I became deeply familiar with the brand. I actually joined Honest after being Vice President of Consumables categories at Amazon. And at Amazon, in my categories, Honest was one of my key vendors. So I already had a hint of how strong the brand and the portfolio was because I managed all of the categories for Amazon in which Honest competes. So I already had this sense that the brand was extremely important to a consumer base that was very viable and growing and that there was lots of opportunity and upside. And as I like to tell people, I'm also quite a nerdy brand builder. I've been building brands for about 25 years, beginning my career at General Mills. And so I know a good brand with high growth potential when I see it. When I stepped in as the CEO of Honest, I was excited about the untapped growth potential of the brand, still very small market share in many of our strongest categories. And we also have a lot of opportunity on the retail distribution growth side. I'm looking forward to talking about that more in our conversation. But I think the most important focus for me within my early days was when I announced that we were going to be committed to a transformation initiative. Within my first 90 days at Honest, I realized we had an opportunity to strengthen our financial foundation. So we rolled out the Transformation Initiative, and the Transformation Initiative is grounded in 3 pillars. The 3 pillars of Brand Maximization, which really taps into what I was saying about the great upside potential of the brand to drive more awareness and more availability; then Margin Enhancement, it's -- for people who've been studying the brand for a while, unfortunately we were kind of -- we had backtracked on our gross margin and so that was a humongous priority for me. Having improved margins a number of times in my various other P&L responsibility roles at CPG enterprises, I know where a lot of those levers are. I was excited to collaborate with the team on defining that initiative. That initiative is already bearing fruit for us in the year. We've hit our strongest gross margin in 2 years. We announced that in our third quarter earnings. So that is outstanding. And then the last pillar, Operating Discipline, is really the undergirding of those priorities of both growing top line and strengthening the financial strength of the business, is making sure that as an enterprise -- there are a lot of practices for young, new companies like Honest -- that we are still instilling practices, habits and disciplines to improve how we execute. And so together, those 3 really mark the top priorities. And I think we're already seeing great progress from that.

Great. That's very helpful. And Dave, maybe I'll throw it over to you. You can -- we heard from Carla and why she joined and the upside potential in the brand. Maybe you can talk about what attracted you to Honest and just your priorities here also from a CFO perspective.

Yes, absolutely. Similar to Carla, I was attracted to The Honest Company because of the great opportunity that this company has. My whole career -- and I'm fairly new, so I've been here a little over 2 months. My whole career has generally been on the retailer side of things, so consumer focused, understanding how to bring those brands to light in the consumer's eyes. Most recently from the Duluth Trading Company, prior to that at Nordstrom for over 13 years and Restoration Hardware. So my view is that The Honest Company has got that kind of outsized brand potential that retailers love to be able to sell. And I'm excited to be here to be with the team that Carla has assembled, deep experience in CPG, deep experience in building brands. And my priorities are to continue on this Transformation Initiative. The team has made so much progress already year-to-date. And I'm just going to build on that and continue with it for the foreseeable future, but lots of upside.

Great. Carla, you recently launched into Walmart. A, can you just take us through how that's gone, as you look back at that launch, B, maybe talk about incremental opportunities from here, and maybe, C, most importantly, just put that in the broader perspective of developing household penetration for the brand, so really Part C is sort of a broader perspective beyond just Walmart, but maybe first to start with, how Walmart sort of gives you some acceleration in the opportunities there and then broader household penetration in general?

We are so pleased with how our rollout has gone at Walmart. We launched into our first Walmart stores about a year ago right now. So we're anniversarying that launch. And our retailer partnerships, I love them. We're going to talk about that more. They're each marked by the way in which we collaborate with each retailer uniquely. And that is true for our launch into Walmart. We identified that Walmart was a strong growth footprint for us because of the strong south and southeast geography of the brand, and as many people know, Diapers and Wipes currently make up 63% of our portfolio's revenue. And the lion's share of new baby births are happening in the South and Southeast. So given that we, up until that launch, had smaller availability and smaller visibility in that region, we knew that appealing to those Walmart households was important. That was coupled with Walmart's own expression of their growth strategy and their intention to grow with upper income households, who already come into the stores and want to see the brands that they recognize and that they value and that offer the features and benefits that those households are looking for, those $100,000-plus households. So it was a great fit as an initial concept. Fortunately, and I'd say enthusiastically, the concept has been more than just a strong idea. It's proving to have really good results in market. So when we launched into Walmart, we did it by using something we've learned very well at 1 of our other brick-and-mortar retailers where we have a much older footprint. We've been in Target for more than 5 years, and we learned the way in which you want to build the brand awareness, so that the consumer knows that the brand is there, knows how to find you. So when we launched into Walmart, we launched with a portfolio of 15 of our strongest items across a broad set of our diapers, baby care, wipes and personal care category. And we did it on these end caps that were so cool. These end caps look like a house, to really demonstrate the utility that the Honest brand provides. And those end caps and such a strong display really launched the brand very well into the 50% of stores where we initially rolled out as sort of a test and learn and experiment as you go. That went so well that we have now moved the -- all of the diaper products from the end cap features to the in-line features, which is a very strong place to play for the way Walmart's supply chain strategy works. You want to be in line in the aisles. And then we also now expanded our personal care and wipes set to 100% of the Walmart stores. So that is a great sign of how well the portfolio is working at Walmart. Our newest launch, which has only happened in the recent couple of months, is that -- you may know we also have an apparel and layette side of our business with Honest Baby. Honest Baby is now rolling out our apparel and layette line into 1,000 Walmart stores with a very unique display. So the Walmart launch is going well. It's being embraced by the Walmart consumer. We are excited to build and grow. We've in fact created some products that are unique at Walmart, as we do with many of our retailers, allow something that can be developed specifically for their consumer base to really attract them into our set and into the aisle. And that builds off of the lessons we've learned with Honest being such a strong omnichannel performer. We were born in the digital space. Honest was launched first as a DTC brand, and many brands struggled to make that leap from DTC to brick-and-mortar, but as we built that strong partnership with Target as our really first foray into a deep brick-and-mortar relationship, we are so pleased that that continues to be our largest retailer. We have now more than 20 consecutive quarters of year-over-year growth at Target. And that's uninterrupted even following our launch into Walmart. So we're feeling great.

Great. And maybe just talk about the broader household penetration expansion opportunity. Walmart may tie into that, but really broader strategies in general and how that's proceeding over time.

Absolutely. We love to talk to our investors and partners about the fact that the launch into Walmart took our overall national ACV distribution from 50% to 80% of brick-and-mortar. But that doesn't really tell the detailed story if you double click down. One might hear, "Oh, you're already in 80% of brick-and-mortar, seems like you're running out of runway." But as you just heard me talk about the way the rollout has gone at Walmart, that's just a great example to say we may in fact be in that retailer, but we're still expanding the places, the locations, the items and the amount of items that we carry. So for example, our total item count in Walmart is significantly smaller than in our leading brick-and-mortar retailer. And yet we see those products are working. We just want the opportunity as we perfect the portfolio at each retailer to know which items are working. But we see the opportunity to grow on an item-by-item basis. I'm going to give you an example, because I love to talk about the Pareto principle. If there is one thing I talk about every time it's a CPG best practice of the Pareto principle, which says that, for businesses, especially consumer products businesses that are deeply consumer-centered, your portfolio will have a gravitational center at some point. And those items, which I like to call the hero items, tend to drive the most traction and tonnage in your portfolio because they are the items that are most strongly embraced by your consumers. But on our hero items, while we launched the DTC business, and 100% of our selection is available on our own website, and we have 300 items available on Amazon, our item count and our distribution at brick-and-mortar is much smaller. And in so many of our categories, our top items have less than 30% brick-and-mortar distribution. So my favorite -- for those of you that are on virtual, you won't be able to see my beautiful long eyelashes today, but 1 of our hero items is our Extreme Length Mascara. It is the leading Climate Pledge Friendly mascara on Amazon. I mean this thing sells like hotcakes. The people in the back of the room can witness that my eyelashes are looking long and healthy. And yet, this item is only in 30% ACV at brick-and-mortar, the #1 Climate Pledge Friendly mascara on Amazon. You can see, we already know it's a proven hero. It's a proven hit. That story is true for so much of our portfolio. Even in our diaper business. We only have a 5% market share on diapers. So between growing the shoulders -- meaning where we are, we could still have more items, but also where we are, this brand, and I know we'll talk about this, but this brand has such great shoulders. It plays very well because we bring consistent benefits to every category where we play. Consumers are looking for purpose-driven brands that they trust, and that's true with our brand. And there are so many categories where we have not yet deployed the brand. So I see us growing both where we are, in expanded breadth, but I also see that there are places in retailers we currently are in that we haven't yet dipped our toe in that section of the store, and I'm confident that that's going to be a way we will grow.

Okay. Great. And taking a step back, looking at long-term revenue growth from here, how would you break down the key drivers, whatever way you want to sort of dimensionalize it or the way you guys think about the business? What are the key drivers? How do you think about sustainability over time? How might they be different than recent history, looking back at the last couple of years here, more longer-term development of the company?

One of the reasons why, we have really brought in so much, what I'd just like to say, blue-chip talent on to our executive team. Dave has told you about the talent that he brings and the experience he brings from premium retailing and understanding how that works. We also have a really strong group of leaders inside of our organization. We've balanced leaders who bring the history of the Honest brand and who have been there a long time and really know how it works with new leaders from, for example, our Chief Growth Officer that we just brought in, she has joined us most recently from Chip and Joanna Gaines' Magnolia brand, another omnichannel, founder-built, strong, modern brand, deeply loyal consumers. But before that, she brought experience from J&J, where she worked on Neutrogena and Clean & Clear. And also, she worked at Estee Lauder, where she worked on the Aveda brand and other purpose-driven beauty and skin care brands. And we are taking the best practices that we know from our deep experience of what makes brands and portfolios healthy, thriving, driving awareness and driving trial. We're going to do that by using the best practices. So the magic for us is that we've got an incredible brand and incredible products, but we want to make sure we leverage the pillars in our transformation of brand maximization, in order to make sure distribution is a large opportunity for us to drive growth, because, again, as I've said, our brick-and-mortar distribution on our top items is still relatively small. We also want to make sure that we drive strong best marketing practices. We love social -- we were built by a millennial. So our brand has no excuse other than to be modern and relevant in today's times. And so we're one of the leading baby brands on TikTok, as an example. So we love dialing into all the best practices of marketing to make sure we'll have strong velocities. So I see that our brand and portfolio growth will be undergirded strongly by driving distribution expansion, making sure that wherever that distribution is, it works and it drives awareness and trial. And then our business model will be driven strongly by continuing to strengthen the financial foundation at the top, both by pricing, which we executed this year very successfully, I might say. We realized we've lagged behind on driving our top line revenue by keeping up with category pricing. We took pricing for the first time in 10 years last year as a brand, and we have managed to maintain both dollar growth and unit growth at the same time in a market where we know brands are challenged to do both at the same time. So our top line strategy will be important, and we will add to that the discipline of managing our portfolio tightly on a cost and expense basis.

Okay. Well, that's a great segue, pricing into profitability. So Dave, obviously, a lot of progress in Q3. You moved only a slight EBITDA loss. Can you talk about the path to profitability from here as you look going forward? And maybe both of you can just put in perspective, there's clearly been a shift to a greater emphasis on profitability, I think, broadly across CPG among smaller, younger companies in the last few years, and you guys have had your own evolution there, so maybe talk about that sort of broader shift. So A, the short-term improvements, how much more can we see? What's driving that? B, the longer-term focus of the company and what that means?

Yes, absolutely. Well, as you can see from the results that we posted after the third quarter, we are on the cusp of positive adjusted EBITDA, a loss of $1 million, but that included a little over $2 million of transformation costs that we're still going to work through this year, and our guide, which we increased the second consecutive time for fourth quarter, would be flat to a loss of $3 million, also including some transformation costs that are nonrecurring and onetime in nature. So we're virtually there on adjusted EBITDA positive growth. And that's just going to build as we look into 2024. Now we'll come back in the spring with guidance for that fiscal year and outline the timing of exactly when we'll be there, but it's -- but we're so close. And as soon as adjusted EBITDA positive is achieved, in our view, it's operating margin expansion and getting to operating income on a positive year-over-year basis. So we've done a number of things as part of the Transformation Initiative to route costs down within our product categories, within our fulfillment and logistics expenses, and we proved that we can grow revenues, year-to-date up 10%, while trimming back marketing. So making that more efficient is something that's a key enabler to expanding our margin growth over the coming years.

Great. And then you talked about some of the growth opportunities. Your balance sheet is in fairly good shape, presumably positive cash flow going forward. Just how do you think potentially about capital injections, maybe, to sort of go after the growth opportunity? Is that something that's on the radar screen or just not really on the radar screen? And how do you think about sort of the balance sheet, capital allocation, looking out longer term from here, understanding you're new in your role at the company?

Yes. No, absolutely. As part of the transformation initiative, getting our working capital rightsized relative to the business was an important aspect of that. And year-to-date, trimming inventories 31%, so almost close to $40 million of less inventory levels while still supporting the sales growth, is quite an achievement. But as we think about cash as we sit on the balance sheet today, we had $23 million in cash at the end of the third quarter. We are thinking that it's not about just growth, but growth from profitability longer term. And as I think about the balance sheet and the principles that we're going to use for managing that, it's, number one, be debt free. So we have 0 drawings on our line of credit. It's going to be maintaining our capital-light business model so the investments that we're going to make won't require significant capital outlays. And third, it's going to be building cash from positive earnings. And those are going to be the principles that we use to build the foundation and a strong financial footing. Lastly, I'll say we did renew our ABL facility earlier in the year. So that gives us a nice backstop to weather uncertain times, but we don't anticipate drawing on it. And so we are very comfortably in a good spot from a capital use standpoint and are focused on continuing to kind of build this cash balance, which, over time, just gives us more flexibility, more control of our own destiny and eventually builds dry powder for us to be strategic opportunistically, which is something down the road I think the company would be available to consider ideas like that.

Okay. Great. And Carla, 1 of the key pillars of your Transformation Initiative is Brand Maximization. I could visibly see your enthusiasm.

Look at it. I can't hold back. I love this...

So just help us understand what that means as you think about the top line trajectory over the next couple of years here, impact to the Honest brand, ability to execute that and drive yield from it. And maybe that's also sort of a good way to talk about top line progression over the next few quarters and how you see things sort of playing out from a sales growth perspective broadly.

Great. One of the reasons I was so confident about the Honest brand is that I have had the opportunity to build other purpose-driven brands. So when I was at General Mills, I was -- I had the great privilege of helping drive growth on several founder-built brands like LÄRABAR and Annie's Organic and Cascadian Farm. And those brands were a little bit older than Honest in many cases. And so I really understood what the architecture of the growth path involves, especially some of those brands are deployed in multiple categories just like Honest, especially the Annie's business. And I knew that there needs to be a combination. The products need to be available, they need to be widely distributed, and you need to pay great respect to the fact that consumers of every stripe are looking for purpose-driven brands. So we want to be very democratic in our availability of these products. And that's one thing that I think you have seen we are beginning to advance with Honest. We want to make sure that no matter where a consumer wants to shop and what time of day they want to shop and how they want to shop, they have easy access to our brands. That's why the omnichannel model is so important for us and why we love our partnerships across digital, e-tail as well as brick-and-mortar. The other thing about our brand is it's important that people understand what the brand stands for, so the brand can distinguish itself. In a sea of long established brands, we're only a little more than 10 years old. And yet our brand's 2 main benefits are now so cemented in the mind of consumers that we can see why often we are outperforming our categories despite our smaller marketing investments and our smaller size. The Honest brand -- I mean, the name -- I mean, you can't get -- listen, I've worked on a lot of brands. You can't get a better brand name than Honest. I mean -- that word. Let's think about the times we live in. Let's think about what everybody is just seeking, right? That just -- we want to always be a transparent company. We want to be a trustworthy company, and that is in our brand, and that centers how we build everything we build, who we hire, how we show up at work. We really don't just want to be a brand. We want to be a company that operates in a way that we say we believe there is value to consumers by being this kind of brand. But that's not just a philosophy. If you look at the trends, the consumer-driven data, it demonstrates that people are increasingly looking for brands that address some of the issues of the day. Environmental sensitivities are up, allergies are up. People are looking for products where they understand what the heck is going on. So at Honest, our products all deliver on what we call the Honest standard. And the brand must be strong in order to drive brand maximization and our Honest standard where we commit to taking 3,500 ingredients of concern out of our entire product portfolio. We do not use those ingredients. We commit to promising you will not find them in our items. That is a much higher standard than in most other brands marketing themselves as clean, and even in the government required standards here and in Europe. So we think it's important then to be more vocal in our marketing, so we distinguish ourselves from our competitive set and that people understand this is a brand like no other when you see it in the aisle. That's a key part of brand maximization. And frankly, we have an opportunity to improve how we execute that. One example that I'd love to talk to investors about -- my team doesn't love when I talk about it, because I'm very excited about it and I want to go fast, is that our packaging is our #1 marketing vehicle. For a consumer product, the one thing you're sure everybody who buys your product sees, uses, reads, touches, and at some point disposes of is your packaging. And our packaging needs to be the first place you understand deeply the commitment to the Honest standard and the truth of the product quality. So we will be improving our core fundamental marketing as we go. That is a key part of what will improve our velocities in our consumer trial and our loyalty. But as I said, distribution, we just brought on a sales leader who has relationships, deep embedded relationships with all the top retailers across CPG. He comes from 10 years more of sales at General Mills and has worked at all of the top leading brick-and-mortar retailers. And so we intend to be really having deep and 2-way partnering conversations with our retailers about how distribution is going to be a key lever to growth.

Great. And then maybe put your company in the context of the current macro environment. You talked about how your brands really from a consumer pull standpoint are purpose-driven brands, obviously high degrees of loyalty. But we certainly have a couple of years of unprecedented inflation here in the U.S., some stresses on the consumer, whether it be student loans or whatever it may be. So just -- and your products are at higher price points. So just context for how you think about your company's positioning within that macro environment? What are you seeing, are you seeing any impacts? And what do you expect going forward from here?

Well, I think we are in great company when we say that we are in unprecedented and uncertain economic times. That's not new. And we will keep our eye attuned sensitively to those dynamics and make sure that we earn our consumers' loyalty and trust. That's at the center for us. And what we have seen so far, even in these unprecedented times, our consumer movement and consumption is outpacing our categories in almost every instance. Our diaper business is up double digits, year-over-year growth. And our wipes business is really driving market share growth in the wipes category. And what that tells us about consumers when their budgets are under stress is that the decisions they make is: it has to be worth it. And it has to be worth it given all the choices that they make. So we hold ourselves to the standard to make sure that we understand if you're going to spend your precious dollars on products that you use in very intimate ways, right -- we are on those babies' booties, we are using our wipes products on the most sensitive parts of your family and your pets, we are providing skin care and lotion that you put directly on your skin -- it has to be worth it. And that's really what brought me to Honest was the product quality, the commitment to taking out these 3,500 ingredients of concern. Our consumers are demonstrating that, with our consumption and our revenue growth still strong, that in fact, in these unprecedented times, when they make a choice to spend at that premium tier, it's important, because these are products that are important in all the things that they use in their home, and this is a place where they want to make that choice. With that said, we want to always just stay very close to this and make sure that we are meeting those product consumer values at exactly that right intersection.

Great. And you're truly an omnichannel company. Can you talk a little bit about the growth opportunity in retail versus e-comm and how you think about that going forward? A, just sort of what should we expect in terms of mix shift over time, and B, strategically, how you think about managing that in the context of driving growth for the overall business?

Yes. As I mentioned earlier, it's a really cool origin story because -- I love the fact that our founders were so scrappy. They knew that the world needed this business. And if online was going to be the fastest and most effective way to get it to people, then online is what the times called for. So we began as a direct-to-consumer company. We were one of the first companies with that subscription model, demonstrating that if you have something people love, they also want to simplify and drive convenience in their life. They want to put that thing on autopilot. So we've learned a lot of practices by operating our own honest.com DTC channel, which we still have as a key part of our portfolio. And expanding that out even as e-commerce grew and as brick-and-mortar retailers increased the e-commerce footprint of their business, we could take many of what we know as best practices and, as a fairly young, digitally born company, how to continue to make that a balanced piece of our portfolio growth. And that's why today, digital sales are still about half of our portfolio's revenue come from digital. We're very well balanced. I think as I said, some companies really try to figure out exactly how -- what is the way to be effective in both places. And I'm very pleased with the way my team continues to refine and execute that model, so that we are effective with today's best practices and best shopping practices on digital and e-comm. At the same time, I know from my history that the lion's share of consumer grocery purchases still happen in store. And that's something we're excited about because that's where -- while 50% of our business is there, there is a great untapped opportunity for us in terms of number of doors, number of face-outs that we have in any given aisle where we are, and then expanding our products in the aisles where we aren't. So if you ask me where my growth is, I think there will be growth in both places, because we're a smaller brand no matter where we show up. But I am excited because I think there is great growth potential for us as we continue to successfully expand in brick-and-mortar.

Great. Maybe we can shift to the marketing line. That's come down a bit in recent quarters. Just how should we think about that? You guys have talked about driving greater efficacy. Is that playing out? Has that had any impact on your growth profile? And how do you sort of think about that line item as we look out longer term?

Well, you're right. We have found that line item being more efficient. Some of that spend was directed out of our honest.com channel and pushed into the retail channels to really support the hero items that is seeing some of the momentum. But with marketing, we're going to target long term an ad ratio, so to speak, that continues to drive efficiency, and every year that improves on itself as we take the learnings from the prior periods, as we think about the digital channels and the media that consumers consume, and it's always changing. But it will be an important line item that we'll maintain a high level of investment in to keep the business moving and find leverage within our operating expenses and other places. So I'd expect that to be somewhat consistent where it's at, but working harder a little bit every year to make it a smarter spend and really driving the categories that we're going to see the most volume in.

Yes. We love to use all of the modern practices. So we have a very strong program with influencers and associates that we leverage, whether those are the retailer-specific associates and influencer programs or whether those are some of our owned relationships. That's an area of best practice for us. As I mentioned, we're very strong in social media. We have a lot of great holiday-oriented ideas on your TikTok and Instagram. If you're not following Honest, get those gift ideas. Hannukah is getting ready to start, stocking stuffer time. So we love that kind of marketing. But as I said, all of the classic things are really still there for us to continue making more efficient. We already have packaging anyway. Our packaging might as well work harder for us, right? So we believe that there is growth by doing better at what we do and then also making sure that we are very visible and vocal in the categories where we play.

Okay. Great. Well, with that, we're running up on time here. So we're going to end things there, but really appreciate you both being here and thanks for the discussion.

Thank you for having us.

Thank you.

Thank you.