The Simply Good Foods Company (SMPL) Earnings Call Transcript & Summary

Greetings. Welcome to The Simply Foods Company's Fiscal Second Quarter 2023 Conference Call. [Operator Instructions] I'll now turn the conference over to Mark Pogharian, Vice President of Investor Relations. Mark, you may now begin.

Thank you, operator. Good morning. I am pleased to welcome you to The Simply Good Foods Company earnings call for the fiscal second quarter ended February 25, 2023. Joe Scalzo, Chief Executive Officer, Shaun Mara, CFO; and Geoff Tanner, President, COO and CEO-Elect are with me today. Joe and Shaun will provide you with an overview of results, which will then be followed by a Q&A session. The company issued its earnings release this morning at approximately 7:00 a.m. Eastern Time. A copy of the release and accompanying presentation are available under the Investors section of the company's website at www.thesimplygoodfoodscompany.com. This call is being webcast and an archive of today's remarks will be available. During the course of today's this call, management will make forward-looking statements that are subject to various risk and uncertainties that may cause actual results to differ materially. The company undertakes no obligation to update these statements based on subsequent events. A detailed listing of such risk and uncertainties can be found in today's press release and the company's SEC filings. Note that on today's call, we will refer to certain non-GAAP financial measures that we believe will provide useful information for investors. Due to the company's asset-light strong cash flow business model, we evaluate our performance on an adjusted basis as it relates to EBITDA and diluted EPS. We have included a detailed reconciliation from GAAP to adjusted items in today's press release. We believe these adjusted measures are a key indicator of the underlying performance of the business. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP. With that, I'll now turn the call over to Joe Scalzo, CEO.

Thank you, Mark. Good morning and thank you for joining us. Today, I'll recap Simply Good Foods second quarter and provide you with some perspective on the performance of our business. Then Shaun will discuss our financial results in a bit more detail before we wrap it up with a discussion of our outlook and take your questions. As most of you know, on January 30, we announced that Geoff Tanner will be joining us as President and CEO-Elect. Throughout his career, Geoff has been primarily focused on marketing, sales and innovation within the food sector. So he brings superior experience along with credentials as a terrific leader and as you'll learn, incredible passion to everything he does. The Board and I are confident that under his leadership, the company will continue its track record of growth and profitability. And I look forward to partnering with him to achieve a smooth transition. I'll now turn the call over to Geoff for some introductory remarks.

Thanks, Joe. I'm honored that on July 7, I'll become the next CEO of The Simply Good Foods Company. As you know, Simply Good Foods is a special company with 2 great brands, fueled by passionate employees and loyal consumers. These attributes have delivered top-tier sales and earnings growth and will continue to do so going forward. Although my official start day was 2 days ago, April 3, I was eager to get a running start to learn about the business and meet with many of the employees via Zoom and phone. I learned what many of you already know, we have a remarkable energized team who come to work every day with a strong sense of purpose. That purpose is to lead the nutritious snacking movement with trusted brands that offer a variety of convenient, innovative, great tasting, better-for-you snacks and meal replacements. I want to say a special thank you to The Simply Good Foods team, many of whom listen in to this call. It's clear their passion and dedication, along with our strong brands and growth investments will continue to contribute to our further success. Both Joe and I have worked with Jim Kilts earlier in our careers. So it's no surprise we have similar beliefs as to the drivers of growth and value creation. Therefore, as I transition to the CEO role, you'll continue to see a focus on the core drivers of brand growth, namely marketing and media, innovation, category management and fundamental sales execution. I call this approach the brand growth flywheel and it's all in service of expanding household penetration to accelerate growth. We participate in a unique fast-growing category, fueled by strong underlying consumer trends that show no sign of slowing. The statistic that perhaps excites me the most is that household penetration of this category is only about 50%, which is very low compared to most food and beverage categories in North America. Working with our talented team and partnering with retailers, we will continue to fuel the brand growth flywheel to increase household penetration and continue to drive growth. Also, following in the footsteps of Jim, Dave West, Joe and others, I will ensure a continuous improvement mindset across everything we do, to deliver results and provide the fuel we need to deliver the growth that's in front of us. I want to underscore my optimism about Simply Good's future. I couldn't be more excited to lead the Simply Goods company. While it's not prudent for me to participate in today's conference call Q&A, again, this being day 3 to me, please note that I look forward to working with all of you as we focus on building value for all Simply Good Foods stakeholders. I'll now turn it back over to Joe, who will provide details of our second quarter results.

Thanks, Geoff and welcome to the team. We are pleased with our second quarter performance that was greater than our expectations. During the important New Year season, Simply Good Foods Q2 retail takeaway in the U.S. combined measured and unmeasured channels increased about 16%. As expected, U.S. retail takeaway growth outpaced the net sales change principally due to the significant prior year retail customer inventory build. Shaun will provide more details on the difference between net sales and POS growth in just a bit. POS growth was driven by both brands. Quest performance was solid across key forms, customers and channels. Atkins continues to show growth in both measured and unmeasured channels. Additionally, Atkins' e-commerce growth continues to be additive to measured channels. North America net sales performance was better than our expectations due to solid retail takeaway, although net sales were affected by some customer inventory reductions in the quarter. Additionally, international net sales were softer than our estimate due to the impact of the second price increase initiated earlier this year. Second quarter gross margin was 34.6% versus 36.6% in the year ago period. The 200 basis point decline was greater than expectations due to lower ingredients costs flowing through at a slower rate than anticipated and marginally higher other costs within our supply chain. Importantly, our supply chain team performed well with customer service near target levels. Adjusted EBITDA in the quarter was $50.9 million versus $54.2 million in the year ago period. The $3.3 million decline was better than our estimate due to North American sales performance greater than our expectations and solid SG&A cost control that was partially offset by supply chain cost inflation. International softness was greater than our forecast. Simply Good Foods retail takeaway in measured channels increased 14.2% with a good contribution from pricing and volume. Specifically, we estimate that Q2 measured channel POS was driven by about 9 points of price and 5 points of buy. Similar to the last few quarters, total unmeasured channel growth was additive to total company point of sale, resulting in combined measured and unmeasured channel growth of about 16%. In the second quarter, Atkins and Quest combined measured and unmeasured channel growth were about 6% and 26%, respectively, with performance top tier within the measured channel segments of weight management and active nutrition. Turning to Atkins second quarter performance. Atkins' second quarter retail takeaway in the combined measured and unmeasured channel sequentially improved versus the first quarter and increased about 6%. Atkins second quarter POS at Amazon increased 35%. We estimate total unmeasured channel retail takeaway increased more than 25% and is about 13% of total Atkins retail sales. The brand continues to benefit from shopper channels shifting to e-commerce as well as improved digital marketing initiatives. Brand relevance and loyal remained strong, supported by a growing base of new and total buyers. Buy rate was down slightly in Q2, although it improved from the first quarter. Moving on to measured channels. In the IRI MULO and C-store universe, Atkins' second quarter POS increased 3.3% and as expected, sequentially improved from the first quarter. Consistent with recessionary shopper channel shifting, performance was driven by solid trends in the mass channel, offset by softness in the food class-of-trade. By form, Q2 shakes retail takeaway increased 13.5%, driven by solid growth across all major channels. Total Atkins bars were off 3.9%, a 300-basis point improvement for the first quarter. Meal bars, about 2/3 of the bar business, increased 2.5% and were offset by snack bar distribution losses that we discussed last quarter and some pricing sensitivity from our July price increase. As expected, confection POS improved from the first quarter and Q2 confections retail takeaway was off 1.5% as we lapped the strong year-ago performance of our dessert bar innovation. Importantly, the commitment to our brands and nutritional snacking category by major retailers remains strong. Although in the third quarter, we expect POS to slow as we face tougher e-commerce comps on Atkins and anniversary promotions in the club channel that will not repeat. Let me now turn to Quest's second quarter retail takeaway where the combined measured and unmeasured channel growth was 26% and continues to outpace the nutritional snacking category. In the second quarter, we estimate total unmeasured channel retail takeaway increased 21% as e-commerce strength was partially offset by softness in specialty channels. Quest's second quarter POS at Amazon increased about 30%, driven by growth across all forms. For perspective, total unmeasured channels in the second quarter were about 24% of total Quest retail sales. In measured channels, Quest retail takeaway increased 27.2% in the IRI MULO and C-store universe. Growth was driven by solid performance across all major forms and retail channels as well as increases across all major metrics, specifically household penetration, base velocity, distribution and continued new product success. In the second quarter, Quest core bar business retail takeaway increased 24.1%. Growth was solid across original bars as well as the new minis. Consumer response to the new recipe that provides a much softer original bar is positive and driving growth. Additionally, the Hero bar is beginning to gain momentum driven by distribution gains and higher velocities. The snacking portion of Quest products, that's cookies, confections and salty snacks continue to do well with second quarter measured retail channel takeaway of 30%. Growth was strong across all snack forms as distribution gains and marketing investments continue to drive awareness and trial. Consumer response to the price increase initiated in late July is tracking mostly as expected, although elasticity on chips so far has been slightly greater than our estimates. The snacks portion represents nearly 45% of total Quest measured channel retail sales and is already roughly equal to Quest bars in household penetration. We expect Quest snacks to continue to be a driver of the brand's growth over the next few years driven by household penetration as well as a solid pipeline of innovation. However, given the meaningful size of this part of the business, we expect the rate of growth over the next few quarters to moderate from its current levels. In summary, the company is uniquely positioned as a U.S. leader in the fast-growing nutritional snacking category. We have 2 scaled lifestyle nutrition brands that are well developed across multiple forms and snacking occasions. Our brands are aligned with the consumer megatrends of healthy snacking with a nutritional profile that's protein-rich and low in carbs and sugar. This profile has broad appeal to consumers interested in health and wellness as a means to achieving their goals, whether they are at home, in the office or on the go. This category remains well under penetrated from a consumer standpoint, indicating a long runway for growth. This is evident in our second quarter retail takeaway of 16% that exceeded our forecast. However, as I mentioned earlier, net sales were affected by some retail customer inventory reductions. This is a watch out as we make our way through the third quarter. Our positive business momentum continued into the third quarter as March retail takeaway increased about 12%. We remain cautiously optimistic about our prospects over the remainder of the year. That said, we expect retail takeaway will moderate from current levels as we lap large year ago comps and continue in an uncertain economic environment. While we expect full year fiscal 2023 gross margins to be below last year, we anticipate an improving cost environment in the second half of the year, with sequentially improving margin from the second quarter to the fourth quarter. We will continue to execute against our priorities and remain committed to doing the right thing over the near and long term for our brands, our customers and our consumers. Now I'll turn the call over to Shaun, who will provide you with some greater financial details. Shaun?

Thank you, Joe. Good morning, everyone. I will begin with an overview of our net sales. Total Simply Good Foods second quarter net sales of $296.6 million was about the same as the year ago period. This resulted in year-to-date net sales of $597.5 million, an increase of 3.4% versus last year. Looking at the Q2 drivers of growth. Net price realization was about 8.2 percentage points and volume was off about 6.9 percentage points. The March 2022 agreement to license the Quest frozen pizza business was a headwind of 1.3 percentage points. As Joe stated earlier, retail takeaway growth outpaced the net sales change. On the bottom of this slide, we attempt to reconcile Q2 POS growth of 16% to Q2 North America net sales growth of 0.3%. The biggest driver of this difference is the impact of the year-ago period retail inventory build. As a reminder, in a typical year, we see retailers build inventory by 1 to 2 weeks in the first half of the year to support the New Year new use season. This build typically comes out in Q3. Last year was atypical, as most retail customers elected to build significantly higher inventory levels in the first half of fiscal 2022 and did not deplete it until the fourth quarter of 2022 due to their supply chain concerns last year. We estimate the impact of this change in retail inventory compared to last year to be about an 11percentage point headwind or about $30 million for the second quarter of fiscal 2023. Additionally, as Joe mentioned, the current period inventory reduction by some retailers was about a 3 percentage point impact or approximately $10 million. Lastly, the licensing of pizza was about a 1 percentage point drag. Moving on to other P&L items for Q2. Gross profit was $102.7 million, a decline of $5.8 million from the year ago period, resulting in gross margin of 34.6%. The 200 basis points decline versus the year ago period was primarily due to higher ingredient and packaging costs. Versus our forecast, gross margin was off by about 50 basis points or $1.5 million due to lower ingredient costs flowing through at a slower rate than anticipated and marginally higher other costs within our supply chain. Net income was $25.6 million versus $18.5 million last year. The year-ago period was impacted by the fair value change of private warrant liabilities of $12.7 million. Adjusted EBITDA was $50.9 million, a decline of $3.3 million from the year-ago period. Selling and marketing expenses were $29.9 million versus $32 million last year, a decline of 6.3%, largely due to the timing of spend within the year. GAAP G&A expense was $25.9 million and declined 1.3% versus last year. Excluding stock-based compensation, executive transition costs, restructuring and integration expenses, G&A declined 1.8% to $22.5 million. The $400,000 decline versus last year was primarily due to lower employee-related costs. For the full fiscal year 2023, we expect selling, marketing and G&A expense to be slightly down versus the year ago period. Moving to other items in the P&L. Net interest income and interest expense increased $3 million to $8.3 million due to higher variable interest rates related to the term loan and our tax rate in Q2 was about 24.7%, about the same as last year. The tax rate in the year ago period excludes the impact of a change related to the warrant liability. Year-to-date results are as follows. Gross profit was $213.7 million, a decline of 5%. Gross margin of 35.8% declined 310 basis points versus the year ago period. The decline was primarily due to higher ingredient and packaging costs. Net income was $61.5 million versus $39.6 million in the year ago period. The year ago period was impacted by the fair value change of private warrant liabilities of $30.1 million. Adjusted EBITDA declined 6.8% to $111.7 million, primarily due to lower gross profit. Selling and marketing expenses were $58.5 million versus $62.5 million, a decline of 6.4% due to timing of spend within the year. G&A expenses increased 2.1% or $0.9 million. This excludes charges of $6.8 million related to stock-based compensation, executive transition costs, integration and restructuring expenses. Moving to other items in the P&L. Net interest income and interest expense increased $3.7 million to $15.3 million due to higher variable interest rates related to the term loan. Our year-to-date tax rate was about 22.7% versus 24.9% in the year ago period. The tax rate in the year ago period excludes the impact of the charge related to the warrant liability. We anticipate the full year fiscal 2023 tax rate to be about 25%. Turning to EPS. Second quarter reported EPS was $0.25 per share diluted compared to $0.18 per share diluted for the comparable period of 2022. In fiscal Q2 2023, depreciation and amortization expense was $5 million and similar to the year ago period and stock-based compensation of $3 million was about the same as last year. Adjusted diluted EPS, which excludes these items, was $0.32 compared to $0.36 for the year ago period. Note that we calculated adjusted diluted EPS as adjusted EBITDA less interest income, interest expense and income taxes. Year-to-date second quarter reported EPS was $0.61 and adjusted diluted EPS was $0.73. Please refer to today's press release for an explanation and reconciliation of non-GAAP financial measures. Moving to the balance sheet and cash flow. As of February 25, 2023, the company had cash of $63.2 million. Year-to-date cash flow from operations was $53.3 million. In Q2, the company paid down $35 million of its term loan debt. And at the end of the second quarter, the outstanding principal balance was $365 million, resulting in a trailing 12-month net debt-to-adjusted EBITDA ratio of 1.3x. Note, subsequent to the end of the quarter, we paid down an additional $15 million, so the current outstanding balance is $350 million. We anticipate net interest expense for the year to be about $28 million to $30 million, including noncash amortization expense related to the deferred financing fees. Year-to-date capital expenditures were $1.7 million. I would now like to turn the call back to Joe for closing remarks.

Thanks, Shaun. In a challenging economic environment, we are well positioned to maintain our marketplace momentum. Over the remainder of the year, there are solid plans in place for both of our brands that we believe will drive sales and earnings growth, particularly in the fourth quarter of the fiscal year. Therefore, we anticipate the following for fiscal 2023. We reaffirm a net sales increase slightly greater than our 4% to 6% long-term algorithm. We continue to expect fiscal 2023 gross margins to be lower than last year. However, the overall cost environment is improving, including ingredients in the second half of the year and, in particular, in the fourth quarter. However, full year fiscal 2023 gross margins will decline greater than our previous estimate due to the year-to-date gross margin performance and slightly higher costs within our supply chain over the remainder of the year, with most of this headwind in the third quarter. We have made significant marketing and organizational investments in the business over the past 3 years and believe it will result in the growth of our consumer base, distribution and market share. As such, we believe total SG&A expense will be slightly lower than last year. Full year fiscal 2023 adjusted EBITDA will increase but slightly less than the net sales growth rate. And adjusted diluted EPS will increase less than the adjusted EBITDA growth rate due to the company's expectation of higher interest expense from an increase in the variable interest rate related to its term loan debt. As we look to the third quarter of the fiscal year, retail takeaway is off to a good start, with March POS up about 12%. We have customer programming in place that should enable us to maintain marketplace momentum. We expect Q3 net sales to increase slightly versus last year due to the typical retail inventory drawdown related to the first half of the year inventory build and year ago promotions in the club channel that will not be repeated. Q3 gross margin is anticipated to decline around 100 basis points. And adjusted EBITDA is expected to be about the same as the year ago period due to lower ingredient costs flowing through slower than anticipated and slightly higher cost in other areas of our supply chain. Importantly, the retail takeaway growth in our category and our brands remain compelling. As such, we are excited about the near and long-term growth prospects and we'll continue to execute against our strategies as a path to increasing value for our shareholders. We appreciate everyone's interest in our company and are now available to take your questions. Operator?

We'll now be conducting a question-and-answer session. [Operator Instructions] First question is from the line of Cody Ross with UBS.

First question is just around your sales cadence for the rest of the year. We have a couple of moving pieces here. You previously noted that shipments should exceed takeaway in the back half given the unusual cadence last year. Can you remind us specifically how much you expect to ship above consumption in 3Q and 4Q? And can you also take into account the retailer inventory reductions. I think you said it was a 3% headwind or $10 million this quarter. How should we think about the retailer inventory reductions going forward?

Yes. Cody, this is Joe. I'll just step back because I think you summarized it well, but for those who may not as be familiar with kind of the cadence from last year, so I want to start with, just for perspective, I want to start with the overall health of our business from a demand standpoint, can be best seen in point of sale. So not nearly the noise that we're experiencing this year in net sales. So our POS, on our business, we finished the quarter plus 16%. We're one month into the quarter that we're in at plus 12%, our overall health of our business from a demand standpoint is very healthy. We're cautiously optimistic as we move through the second half of the year. We've been exceeding our own expectations on POS and we feel pretty good about the momentum that we've got as we move through the second half of the year. Now as it pertains to net sales, a lot of noise in the numbers and it has, much of it has to do with last year. So just to remind folks of what last year was like, customers having difficulty given customer service across basically the food space, they took positions in inventory that were very atypical. And in our case, big inventory build, as you saw in Shaun's comments about a 11-point differential relative POS to shipments from the inventory build last year. A typical year, we would see far less and that inventory would come up pretty quickly, normally in the third quarter. Last year, that inventory didn't pull down until the fourth quarter. So we have a very unusual pattern to our business, big inventory, 3x what would have been normal in some cases, 4x what would have been normal. None of it coming out in the third quarter. A good portion of it coming out in the fourth quarter. So the headwind that we're going to -- the headwind that we faced in the second quarter becomes a tailwind for us in the fourth quarter. And we would expect the 11 points that Shaun mentioned, a good portion of that will reverse out in the fourth quarter from a comparison standpoint. Look, inventory, there are many things that we, as a management team control, trade inventory flows is not one of them. So we just keep our eye on it, have conversations with customers about it but it's not something that we control. But I would expect a good portion of that reverse out that we -- the 11 point reverse out that we experienced last year that would be our tailwind. The -- as it pertains to the year that we're in, there was, we saw in the second quarter retailers running and not top retailers, so kind of second-tier retailers, there was a 3-point, there was a 3-point drag to shipments. And it's from retailers running less inventory in their systems, tended to be tier-2 customers, tended to be small regional groceries, some distributors that service our small format business, but we saw drawdowns below what was typical. So we're just going to keep our lag continue, hard to say, we're going to keep our eye on it. And obviously, it's one of the reasons that we're a little bit cautious about our business as we move through the second half of the year.

Quick clarification and then a follow-up. Is that retailer inventory reduction embedded in your guidance going forward, meaning it does not come back?

Yes.

Okay. And then just secondly, on the gross margin. I believe on the last earnings call, you talked about gross margin being down more than 100 basis points in the second quarter. It came down roughly 200 basis points this quarter. Can you help us understand the changes that you're making so that the cost surprises in gross margin don't happen as frequently? And can you just help us understand what your expectations were for gross margin going into the quarter?

Okay, Cody, I'll take that one. Thanks for the question. So let me take a step back for a second. A couple of context things for you. One, yes, the margin came in about 50 basis points, I'll say, worse than we thought it was going to be for the quarter. Just for context, that's about $1.5 million on about a $200 million COGS number. So I wouldn't say it's a huge thing. Really, 2 major themes as it relates to, I'd say, supply chain or cost of goods sold. The first is the commodity environment and the evolution of this. If you go back to last year, we were seeing significant commodity increases, double-digit inflation, obviously led to our pricing actions. That said, we hit an inflection point on this and we're seeing a general easing of the inflationary cost environment, specifically the softening of the spot markets in most commodities over the last 6 months and in particularly, dairy protein. That said, our comments still [indiscernible] have inventory value at higher price points and are burning through that slower than we anticipated. Savings are there that are flowing to the P&L at slower rate. That's the biggest change of our gross margin for the year. Second macro trend is really a shift in focus of prioritization of our supply chain. Last year, we were focused on improving fill rate, increasing capacity. Inventory levels was priority one to make sure we can get to a point where we filled our customer needs. Now we're trying to maximize working capital inventory levels, improving the efficiency of the supply chain, getting back to basics, in my words. So bumps and bruises along the way, working with the co-man to get to the right finished good inventory levels and settling into this environment. So we've estimated anticipated charges related to production runs, purchases and the overall operating environment. So all this is a transition issue and we're settling into where we want to be. We're carrying about 6 weeks of finished goods inventory on average, servicing our customers in the mid-90s. So not totally there yet, but really close, costs are coming down, savings are there, just a slower pace than we originally thought. As it relates to the processes we put in place, reminder, we don't own the ingredients at our co-mans. We just help them procure it overall. So we don't have the -- that on our balance sheet overall. So we're working with them now to get a better feel for what's out there. And we put in place -- processes in place in the second quarter to improve that going forward. So we think we have that in place right now.

Our next question is from the line of Steve Powers with Deutsche Bank.

Yes. Great. Maybe to follow up on that point. Can you just -- Shaun, can you just clarify if sales are coming in slightly ahead of your expectations? Can you just talk a little bit more about why the ingredient costs are flowing through slower than expected? There's just a disconnect there that, maybe I'm missing something.

Well, a couple of things, Steve. I would say, first of all, as we work through, again, the commodities that we have out there, the commodities are at different price point. I'll give you an example, one of the biggest pieces of our commodity favorability we're seeing is whey and whey protein is actually fairly down overall. The burn through of that from our co-mans is just coming at a slower rate than we originally had thought going forward. So even though we're selling product as we go through it, how we actually reduce the inventories to get to the point where we're actually recognizing that savings in our P&L has just come at a slower rate. I think the second piece is, yes, we're doing better from a POS standpoint. Obviously, volume is not increasing as much POS as obviously Joe talked you through. So we're not seeing the volume and we're basically adjusting that in a co-man environment as well, getting to lower volumes. That's what they're making, obviously, is volume, not necessarily the price piece of that. Does that help?

Yes. That does help. Okay.

Just so you understand, right? So you're -- we've come out of it -- we've come from an environment where you wanted as much inventory as you could have in your system at that point, right? So there is -- when you're -- you produce to a supply plan, not to a demand plan, so as you're bringing inventory levels down to more normal levels, your actual production levels come down. So units are running slower as we bring our inventory levels down against the same demand, right? The other context here is, we're talking about really small changes. Shaun said this, in the quarter, we're talking about $1.5 million on nearly $200 million in cost. And as you dig into the [ due tos ] of it, none of it is really big things. It's a smattering of small inflationary things, slightly worse than what we've anticipated. And if you just step back from all of this, we own contracts for lower ingredients. We can see the cost environment in our business changing fundamentally. It's just happening a little slower than what we anticipated.

Okay. I mean that -- because that's going to -- that was sort of -- that's the crux of my question because there have been these slow kind of slices that have impact your forecast and costs -- results have come in slightly below external forecast. It's just been progressive. So the question, I guess, as you look forward, maybe you just answered it but do you have the visibility? And is there anything else you need to do? I mean we've been talking about sort of a climb back to that 40% objective over time. This quarter, we're a long way from it. So I'm just trying to get your...

We're not that far, frankly. We're not that far, for me, right? So the fundamental question you got to ask yourself, is the cost environment coming down? Is it going up, coming down? Or is it neutral? It's coming down. I own contracts for lower-cost ingredients, substantially on them. We got to get to them, right? So as units are a little bit slower, it takes a little bit longer to get to that. And then the cost environment in general, in the first half of the year, little bit through the third quarter has been inflationary, right? So every surprise is a cost surprise in the opposite direction, right? We're seeing that environment start to ease, right? So the question of, can you see everything? We're much better than we were at the beginning of the year and what we're seeing. But in general, the cost environment is coming down. So as we move through the second half of the year, if there are surprises, they're in all likelihood, going to be going in the other direction. Does that help with perspective, right? We're zooming in on a really small difference, right? And as Shaun said, no one thing. So we can't put our finger on it's this or it's that. What we're putting our finger on is, prices have been -- just costs have been a little stickier, higher than what we've anticipated and it just kind of pops up in a few places and you see them, right? That environment is changing. We can see it changing. It's just happening a little slower than what we thought.

Okay. Okay. And my last question real quick, just to round it out, is, it sounds -- just relative to what you said 3Q versus 4Q on the top line cadence, it feels like more is weighted to 4Q versus how at least our forecasts are structured, I think the Street's as well. And a lot of that's on the inventory catch up and rebuild lapping last year. But I'm just listening to that against the context of the smaller retailers already drawing down inventory. Is there, is there a risk that, as consumption slows, inventory exit -- inventory rates in the trade exit the year just at a structurally lower level and some of this margin benefit, therefore, slips into the subsequent year. Is that ring-fenced in your outlook? Or is that risk is something that we should be thinking about?

Yes. Look, I think that most of our major customers, the top 5 customers, 70% to 75% of our shipments are operating in normal inventory levels. So I -- we're keeping our eye on that factor. I don't -- it's -- we bake that into our estimates. I don't think it's a big issue. It's obviously was a 3-point issue in the quarter. It was a little bit of a surprise. I don't expect it to be an overhang. We're just being a little bit cautious. And again, just so for the quarters, the big driver of the difference in net sales performance, third quarter to fourth quarter was last year's inventory drawdown. So it's -- I know if you look at our shipments, it looks like a hockey stick in Q4, but the reality of it is the inventory came out in the fourth quarter last year. We will ship greater than consumption from a rate standpoint, just because last year's shipments were depressed in the fourth quarter.

Our next question is from the line of Alexia Howard with Bernstein.

So 2 questions. Firstly, honing in on Quest. Obviously, the pace of growth, the consumer takeaway is still very strong and has been for quite some time. I'm just wondering what innings are you in on the distribution gains? Is it new outlets? Or is it more the expansion of SKUs in certain channels? Presumably, velocity is improving over time as well. But I'm just trying to figure out, you mentioned the slowdown is expected as the business gets bigger but at what point does that happen? And what other levers can you pull? And then I have a follow-up.

I have the benefit of having watched Atkins for 10 years and watch the progress of distribution gains on average, I think Atkins MULO + C has 45 items in distribution, top retailers, 60 to 65. So Quest is in very early innings. And you have to remember, we bought a business that was principally a singles business. The team -- the Quest team prior to the acquisition started looking at multi-packs. So there is opportunity in the bar business alone for us to build out distribution and larger pack sizes. You then have the opportunity for us, as we've been innovating in other snacks to build out that platform over time. So very early innings in distribution gain. More importantly, on this business, lots of opportunity to drive brand awareness and trial. So relative to Atkins, everybody knows Atkins, high, high brand awareness. Quest is still relatively unknown as a brand. So the money that we've added and invested in this brand, I think when we took the brand over -- we were -- the team was spending about 4% of net sales and marketing. We're now up to close to 8%. We got to keep the pressure on there to keep the brand awareness and trial growing because it's still not particularly well known as a brand. And you can see the brand promise is big. This is a big business still with relatively low brand awareness and still growing with a lot of opportunity in trial. So that's the game and I'm really excited. Geoff is exactly the guy to make that happen.

Great. And as a quick follow-up, now that you can sort of see light at the end of the tunnel on the supply chain and the input cost pressures, are you beginning to see expectations that promotional activity will step up in retail? Or is that still on the back burner for now?

Really early innings, right? So no, we're not seeing -- you're asking the question, as costs get better, so I appreciate that question. How do you see investing? How will you invest back? For us, we would be we would be looking to get marketing investment back to we feel like is at healthy level. So as gross margins approach 40%, we want to get the marketing spend up in the 9% to 10% range. Right? We will be spending back with customers on a tactical basis, especially we've seen some issues with pricing elasticity on some of our products, so you might start using temporary price reduction or base price reduction to get those more in line with where the consumers see the value. But those are decisions that Geoff and the team will start wrapping their mind around as we start thinking about the next fiscal year and where costs are going to come in and how we want to deploy those funds.

Next question come from the line of John Baumgartner with Mizuho Securities.

I wanted to ask about elasticity. You noted the downside to sales from international that was tied to the price increases. But I think elasticity isn't something we're really seeing in the U.S. up to this point, in the category at least. And I think we're also even seeing better lifts on promo relative to pre-COVID. So are there any -- would you say discrete factors impacting non-U.S. markets that are driving the volume pressure? Or is it just general headwinds that could hit the U.S. later in [indiscernible] '23? And I guess, I'm also thinking about...

John, are you talking about what are we seeing in New Zealand and Australia? Is that the question?

Exactly. Yes, the international markets, exactly. I guess looking at it in terms of the inventory reductions too, because it feels like based on sell-through, the environment in the U.S. would be better than retailers are hunkering down.

Yes. Let's start with our Australia and New Zealand business. We are the market leader there, Atkins is the #1 brand. #3 brand, Quest, quickly move -- kind of move into the #2, #1 position. So we have a very, very good business. We have a general manager there that has been leading that business for over a decade. We feel really good about the business. If you understand the business in Australia, and obviously, we're lucky with Geoff coming going forward. Geoff is a Kiwi. So he knows the markets pretty well. In fact, he just came back from a trip from New Zealand. It is a 2 retailer marketplace. Woolworths and Kohl's own the market. And we're not seeing in our category there, much pricing. So when we came in with a price increase, we got put our second one, we got put in the penalty box with 1 of the 2 retailers. So it's not a pricing elasticity as we get s*****d, right, lose distribution, lose promotion opportunities, right? So that's what's going on there. In the U.S., we're seeing elasticities for the most part on our 2 businesses like we would have expected with a little sensitivity in a few areas. So we're just keeping our eye on those, chips being one of them and our kind of confection snack bar business being the other ones. And we're just watching it and it's slightly elevated. Typically, what you see with the price increases, you see full elasticity early, you see a burn rate, so it starts declining over time. So in those products, we saw slightly elevated and we're just watching the decay rates now.

Okay. Okay. And just to build on that. From the category level at retail, just given the limited elasticity, the lifts on promo, are you seeing anything? Or do you expect to see any benefits for the category in terms of higher visibility, display in the store, maybe more momentum to be out of the HPC aisle? Anything coming out of COVID as retailers sort of reset these aisles and categories that you think could sustain growth for your areas going forward?

Yes. Look, it's a great question. So if you just step back and think about this from a category management story from a customer standpoint. So we're in the part of the store where most of the other categories, think cough, cold, oral care are infrequently -- less frequently purchased categories. So think center store, food, weekly shopping. The aisles that we're in, more like monthly shopping, right? And so one of the roles this -- the reason HPC loves this category, it is a foot traffic driver to the aisle. So we actually bring people to the aisle at a greater rate than their normal shopping patterns. So we serve a purpose for them in helping them build basket in a part of the store that's a higher-margin part of the store that are just a part of the store they want to build the business in. So as you think about out-of-aisle display, we're a really good category for those things because it then drives people down the aisle, get shoppers in there, builds their market basket. So that behavior was true through all COVID and we're seeing that behavior continue. In fact, it's part of our category management story. This is an important -- this is important category for you in this aisle. And we have 2 of the premier lifestyle brands that bring people to the aisle.

Appreciate it.

Our next question comes from the line of Pamela Kaufman with Morgan Stanley.

Good morning. Just a question on Atkins. You mentioned that the buy rates are down year-on-year. Given that mobility is improving -- has continued to improve and you're now comparing against periods of while -- where Atkins buy rates, why are they continuing to move down? And how are you thinking about stimulating Atkins purchasing going forward among [indiscernible]?

Right in my wheelhouse, I love these questions. So first and foremost, the overall health of the brand is strong. Our ability to grow buyers has -- continues to be simply outstanding. So we feel very comfortable, household penetration, total number of buyers, total number of new buyers, people are coming to the brand and that's really important. So during COVID, buy rate was driven by snacking behavior changes. And we've seen a rebound kind of from the worst part of those snacking behavior changes effect on buy rate to now where buy rate is almost flat. The driver of the buy rate -- and we've seen a rebound on bars. So it's -- we're not facing any of the not-working bar decline issues. We're seeing self-inflicted issues around the mix of our business. So if you look at what's growing on the brand right now, it's strong shake growth, strong chip growth. Relative to bars, those are all from a unit purchase standpoint, trade down in servings. So bar is a 5 pack or an 8 pack, a chip is a single, a shake is a 4 pack. So we're in -- we have a mix issue with the business. And it's around the pipeline of innovation that we've got. We've got to get back in the bar innovation business. We got to fill out our pipeline there. That work is underway. And as we move through the spring and the summer, we would expect those trends to improve as products hit the marketplace. But it's -- we don't have a COVID work issue anymore. We don't have a COVID issue. We don't have a bar issue driven by snacking behavior. We have an innovation pipeline mix issue in the business that we need to fix. And it's a good quality problem to have because we're bringing a lot of people to the brand right now. So we just got to get our mix better.

Got it. That makes sense. That's helpful. And then my second question is just on e-commerce and just generally growth in unmeasured channels. You've continued to see strong performance in e-commerce and Amazon in particular. What's driving that? And how are you thinking about e-commerce growth in the second half, given you have tougher comparisons in that channel?

Yes. So first of all, just a little bit of the history, we -- Quest was a e-commerce start-up brand. So it was part of how the brand grew up. So when we bought the business, we bought a lot of institutional knowledge around e-commerce and a big seat at the table with Amazon. We've now -- and if you look at the Quest business, our e-commerce plus specialty is around 24% of the business today. So big portion of the business. Atkins has come a long way in a short period of time. It's about 13% of the Atkins business. So what we've learned from our Quest experience is, you got to get your catalog right. You got to get the right items. The right fewer items so that you bring consumers on the catalog to fewer items, more eyeballs that enable you to promote. And then getting the right items also, is important to Amazon's profit mix. So we're running that playbook. So last year, you saw Atkins spike. We started that catalog rollout with shakes, our shake business had a significant step up. We're now running that playbook through the rest of the Atkins lineup. And just to give you a little bit of a sense, the Atkins average price point on Amazon was somewhere around $10, $11, more like $22, $23, $24 on Quest. So we got room to go, right? There's -- and we need to continue to improve it. As it pertains to the second half of the year, while against much bigger numbers, right, so growth is still good. We still feel really confident about the growth but you start to -- you're going to come up against that 75%, 80% growth that we saw last year. And so the rate is going to come down a little bit. We would expect over the next few years, e-commerce, Amazon is going to outstrip brick-and-mortar growth and can become a larger portion of the business. At 20%, that should be a nice target for Atkins to get it there over time.

Our last question comes from Rob Dickerson with Jefferies.

Joe, I just wanted to circle back to the comment you made, I guess, from Pam's question on kind of shakes, bars and what's going on in Atkins. So on the bar side, right, I mean, clearly, you see it -- we see it in on track channels, volumes are still somewhat pressured. You're basically just saying, it's just a bit of the absolute price points of the consumer, given pack size is just kind of too high and too big. So like with all hands on deck, it's like, we should be assuming, I guess that we would see maybe some smaller pack sizes and kind of smaller absolute price point such that velocity would have a higher probability of improving? Is that just -- just trying to...

No. Actually, it's even simpler than that. The -- when we -- you have to step back on Atkins, right? Atkins is the high consumption brand. So -- and there are very few brands in the store like this, right? So if you're a first year buyer, you're buying about 35 servings, if you're a second, third year buyer, you're buying close to 100 servings on average. So if you're a heavy buyer, you're a daily eater and then some. So how you innovate, gives consumers the variety that they need, given the buy rate that they have, which are big buy rates in multiple years, heavier buyers, right? So how you innovate, determines how people purchase. Last spring, we innovated on chips and cookies and shakes. And our pipeline, in particular, on snack bars was not strong enough. So we saw significant distribution losses on snack bars. Double-digit distribution losses. We got to fix that. And the reason that affects buy rate is, just think -- I'll do this simple. I'll do the simple example. If I swapped out a weak snack bar for a chip and the consumer comes to the shelf to buy a unit, I just traded them from a 5-unit purchase or 5-item serving purchase to a 1. That affects your buy rate, right? So it was -- for us, we -- in allowing snack bars to lose distribution in favor of chips was a trade down and a buy rate issue, something we completely control and something that we're going to fix. Does that make sense?

Yes, that makes complete sense. And I mean, also just asking a question because I feel like it does kind of all flow through, right, just in terms of kind of the inventory or the inventory kind of [indiscernible] bars from last year, kind of on then what kind of reverses and flow through this year, but then in terms of -- if you're a retailer, you're saying, I'm getting higher velocity on these products and you bring me innovation. Yes, maybe I'll take a little bit more inventory, maybe not, bring me as much on bars, maybe I'm not as quick to get that inventory, then the buy rate is not as good and therefore, the costs don't flow through as much right, blah, blah, blah. So kind of a fully loaded question. Does that make sense?

I think if you -- clearly, if you don't have bar innovation, you're not going to have bar inventory and you're going to be in that situation, absolutely. But then, I mean, to be really clear, the fix here on buy rate, again, it's small numbers of decline. So we're not talking about big declines in buy rate. It is small, it's mix driven, it's innovation driven and we will fix it.

Perfect. That's all I had.

Have a good day.

We've reached the end of the question-and-answer session. And I'll turn the call over to Joe Scalzo for closing remarks.

Thank you for your participation on the call. We look forward to talking to you at the end of our third quarter. We hope you all have a good day. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.