Flowers Foods, Inc. (NYSE:FLO) Q3 2019 Earnings Conference Call November 7, 2019 8:30 AM ET
J.T. Rieck – Vice President of Investor Relations and Treasurer
Ryals McMullian – President and Chief Executive Officer
Steve Kinsey – Executive Vice President and Chief Financial Officer
Conference Call Participants
Mitch Penn Yarrow – Sturtevant Company
Welcome to the Flowers Foods Third Quarter 2019 Results Conference Call and Webcast. My name is Paulette and I will be your operator for today’s call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] Please note that this conference is being recorded.
I will now turn the call over to J.T. Rieck, Treasurer and Vice President of Investor Relations. You may begin.
Thank you, Paulette, and good morning, everyone. Our third quarter results were released yesterday evening. The earnings release and our updated investor presentation is posted in the Investors section of the Flowers Foods website. Our 10-Q was filed with the SEC yesterday evening as well. Before we begin please be aware that our presentation today may include forward-looking statements about our company’s performance. Although we believe those statements to be reasonable, they are subject to risks and uncertainties that could cause actual results to differ materially. In addition to matters, we’ll discuss during the call important factors relating to Flowers Foods business are fully detailed in our SEC filings.
With that I’ll make some introductions. Participating on the call today we have; Ryals McMullian, Flowers Foods President and Chief Executive Officer; and Steve Kinsey, our Executive Vice President and Chief Financial Officer.
Ryals, I will turn the call over to you.
Thanks J.T. Good morning and welcome to our third quarter call. We’re very happy today. We report record sales ahead of our forecast and reiterate our outlook for fiscal 2019 adjusted EPS. Regarding our four strategic pillars, focusing our brands, prioritizing margin, pursuing smart M&A and developing our team, we’re pleased to say good momentum in several of them.
We continue to make nice progress growing our portfolio of top brands, the DKB and Canyon acquisitions have been resounding successes. And although it’s harder to see from a quantitative standpoint, we are doing some great things for the development of our team. But as we said in yesterday’s release, we are still facing some margin headwinds.
Now for five months to see I’ve had the opportunity to assess where we are, and what we need to do to improve our profitability while maintaining the great top line momentum we’ve enjoyed this year. And I’m looking forward to sharing that with you on the call today.
However, before I do that and like we did last quarter. I want to call Steve Kinsey first to review the financial results and give our outlook for the remainder of the year and set the context for what we’ll talk about a few minutes. That of course will set the tone for your questions. Steve?
Thank you, Ryals and good morning everyone. For the third quarter, we continued to experience solid performance on the top line, driven primarily by sales and the retail channel. Validated sales increased 43.1 million or 4.7% year-over-year. Canyon Bakehouse, acquired in late 2018 contributed 2.2% and the baked business improved price mix drove 2.1% of the sales increase, while higher volumes benefited the top line by 40 basis points.
Price realizations improved across most of our channels and product classes, which has helped to partially offset the commodity, labor and transportation cost increases we’ve experienced in recent quarters. Overall, volume performance and our key brands and store brands was strong. However, we did see lower volumes of food service and store branded cake and breakfast items.
Looking at sales by channel, bread and retail sales increased 36.7 million or 6.7%. Canyon Bakehouse’s branded products accounted for less than half of these incremental sales dollars. The balance was largely driven by continued growth from Dave’s Killer Bread and Nature’s Own and Sun-Maid breakfast breads which were introduced in the third quarter of last year. Branded retail cake was flat as compared to the prior year.
Store branded retail sales increased 12.1 million or 8.7%, slightly less than half of the sales increase is attributed to the acquired Canyon Bakehouse store brand business. The balance of the growth was split between improved pricing mix and volume growth in store brand, buns and rolls due to increased distribution with the existing customers. All set to the lower volumes in our store branded breakfast business.
Food service and other non-retail sales decreased by 5.7 million or 2.4%. Lower volumes drove most of decline due in part to loss of business for the inferior yeast disruption in 2018 and volume offers in the vending channel of our non-retail cake business. As we lock these prior the orders, we expect our food service and non-retail business to stabilize.
In the quarter, gross margin decreased 10 basis points to 47.3% of sales. Improved profit realizations somewhat helped to offset the cost inflation to some extent. However, the benefit of these pricing actions was offset by higher workforce cost and lower manufacturing efficiencies. Third quarter gross margins were also temporarily impacted by startup costs related to the introduction of a new product line at one of our bakeries.
Excluding the items affecting comparability detailed in the press release, adjusted SD&A expenses increased 60 basis points as a percentage of sales, primarily due to the timing of employees and an increased marketing cost. These items were partially offset by lower distributor distribution fees, which decreased 30 basis points as a percentage of sales and stabilizing logistic cost as percentage of sales.
GAAP diluted EPS for the quarter was $0.20 per share. Excluding the items affecting comparability detailed in the release, adjusted diluted EPS in the quarter was $0.22 per share, down $0.01 compared to the prior year. Higher sales were largely offset by elevated labor costs, higher marketing expenses and reduced manufacturing efficiencies. Canyon Bakehouse was the accretive go both EBITDA and EPS in the quarter.
Shifting to leverage and cash flow, just a few comments, looking year-to-date we’ve generated operating cash flow of 278.1 million, and a capital expenditure of 70.6 million. Accordingly, cash flows year-to-date have been solid, and we paid 119.8 million in dividends to shareholders and reduced our total indebtedness by 102.5 million. At quarter end our net debt, a trailing 12 month adjusted EBITDA stood at approximately 2.1 times.
Now turning to guidance, for the remainder of fiscal 2019 we expect good top line momentum. So we are increasing our outlook for full year sales growth to be in the range of 4% to 4.5%. This includes sales from the acquisition of Canyon Bakehouse, which is now anticipated to be in the range of 75 million to 80 million, accounting for approximately 2% of the total 2019 sales growth. We expect baked business growth to be driven by improvement the price mix, partially offset by conservative view on volumes due to broader category softness.
We continue to expect adjusted EPS in the range of $0.94 to $0.99 per share. The pricing actions we’ve taken has helped to mitigate input cost inflation, but we expect the margins will continue to be pressured as we work through manufacturing and efficiency and higher workforce costs because of the tight labor market. We are pleased that Canyon Bakehouse is performing at the upper end of our plan, and we now see it being slightly accretive to full year EPS.
Now, I’ll turn the call back to Ryals.
Thank you, Steve. So look, although there were some issues that affected the quarter. The underlying fundamentals of the business were strong. We’ve got a solid foundation to build upon. And while there are certainly areas for improvement, I believe the trajectory of the business is quite positive. Our branded retail business is thriving, and we believe this is largely attributable to the order changes put in place a couple of years ago and the resulting focus and higher marketing support for our high potential national brands.
Nature’s Own, Dave’s Killer Bread, Wonder all are significantly driving our top line and all three gained unit dollar share in the quarter as they have each quarter this year. Also in the third quarter DKB became the number two specialty loaf in retail dollars, and Canyon Bakehouse became the number one gluten free bread brand in the country, and it continues to grow in distribution and velocity.
Furthermore, our focus on omni channel is starting to pay off. In fact, syndicated data shows us that ecommerce sales of fresh packets, breads, buns and rolls have almost doubled in the last year, and our branded sales have increased by 55%. That’s still relatively small base, but establishing a presence for our brands on the digital shelf is critical for growth in the future as more households buy groceries online and home delivery expands. Having said that, we recognize there’s room for improvement and we still have work to do to improve our margin performance.
Over the past several months I have taken the time to evaluate our current situation and challenge our senior leadership team, working collaboratively, we’ve honed our focus around the issues we face, we better frame the questions we need to be asking ourselves and focused on the development of a solid plan of action, all within the context of our four strategic pillars. So we’ve identified the three primary areas that we believe will drive and most meaningful margin improvement.
One is portfolio and supply chain optimization; we need to identify the optimal mix of products for Flowers so we can drive out complexity and determine the most efficient bakery logistics footprint. Now, the other two areas I’ll talk about in a minute certainly have independent scopes of opportunity, but they too will be informed by the halo of this portfolio and supply chain initiative.
Secondly, it’s no secret we’ve been challenged in the cake business. But I believe that with the right level of focus our cake brands plus investments and automation, we can turn this business and bring it to more attractive levels of margin contribution. And third stabilizing and growing our food service business. We’re one of the largest suppliers of food service bakery products in the US, and we need to better leverage that scale, rebuild our lost business and focus on our highest margin opportunities.
So with regard to portfolio and supply chain optimization, we’ve told you for a while now that the first stage of Centennial focused primarily on indirect costs, and org structure, and we’d be turning our attention to supply chain in the second stage. We’re now at that point. And so we’re asking ourselves two fundamental strategic questions. One, what’s the optimal portfolio for Flowers that can promote margin accretive growth and two, what’s the correct network and resources required to support and grow that portfolio going forward?
To answer these questions, we’re undertaking a complete portfolio profitability review, along with the development of tools and capabilities that will allow us to make more informed strategic choices around things like assortment, pricing, distribution, innovation. It’ll also help us more efficiently read our unprofitable products or unprofitable accounts that contribute nothing, but added cost and complexity. And it will generate opportunities for supply chain and overhead optimization. So the true crux of this effort is to drive out valueless complexity and improve our operational efficiencies.
Now, we’ve certainly taken advantage of the media opportunity to optimize our network. We’ve added organic capacity in the northeast this year. We announced the closing of our Opelika, Alabama bakery at the end of this year, and we installed a new high speed bun line in Suwanee, Georgia. We also have plans in place to convert another existing Flowers bakery to organic production to support the growth of DKB and that’ll happen next year. But I believe that a holistic approach that centers around the optimization of the portfolio would generate more meaningful improvements over time.
Before we formally launched this initiative, we did complete an internal review that began when I was COO. I wanted to be sure that we challenge at home the questions we were trying to answer so that when work began in earnest, we had a very tight focus scope of activities with clearly understood desired outcomes. The initial phase of this work has already begun. It will take several weeks to complete. It’s being directed by a dedicated internal team and we have support from outside resources. And it’s our intention to have an update for you on where we are by our earnings call next February.
With regard to the second area of focus, reinvigorating and investing in our cake business, look it’s become clear to me that we have under invested in our cake brands and operations for several years now. And the recent production difficulties we experienced with that new product launch, always serve to shot a brighter light on it. We believe in the potential of the iconic Tastykake brand, and we’ll be seeking to make smart investments to drive the brand forward. That means a renewed focus on consistent quality, service, distribution and innovation. It also means investing in robotics and other automation tools to drive efficiencies and improve our quality. Work on that initiative is already underway.
Food Service is our third area of focus. As you know, our food service business was challenged last year by the by the yeast disruption. We’re now cycling that, but more importantly, we need to get our food service business growing, yeah. It’s an important and scaled part of our business that I think that working to grow it smartly by winning good margin business, and seeking out attractive M&A candidates that offer margin accretive premium or orders and product lines will be beneficial. So within our four strategic pillars we’ll focus on these three years with intensity and I believe that over time, execution against all three will improve our bottom line performance.
So moving on, M&A, M&A remains a key strategic priority where we’ve had some recent success. As we mentioned earlier, since we closed the deal, last September Canyon’s grown from number three all the way to number one. On the top line it’s performing at the upper end of our expectations, and it’s beating our bottom line targets. But as the Canyon integration winds down, we’re continuing to proactively seek strategic opportunities and areas of the store outside of the traditional bread aisle, as well as different product segments where we believe we have the right to win. As you know, we play in a large category. So M&A is expected to be a key driver to grow our business and pivot to higher margin, and faster growing categories within baked foods.
And finally, I firmly believe our most important strategic priority is developing our team members, and making sure that our organization possesses the capabilities and tools to successfully execute on all the other priorities we’ve talked about today. So at all levels of the organization we’re increasing communication. We’re increasing engagement. We’re aligning work schedules to better fit today’s modern lifestyles, and we’re clarifying career path to attract the best candidates and improve retention. Also, we’re increasing accountability, and better aligning incentives to job responsibilities.
Today, almost 30% of our employees have incentives that are directly tied to their role. Two years ago that number was zero. So I firmly believe as we continue to link incentives with responsibilities at the functional level, execution against our priorities will improve. So in summary, despite some continuing margin headwinds in a few discrete areas, the fundamentals of the business were strong. The branded business continues to enjoy good growth.
Our recent M&A successes continue to bring meaningful returns. Our cash flow and our balance sheet are strong. And we’ve got a talented, loyal and dedicated team that executes with excellence. It will take some patience and some time for us to realize the full benefits of our initiatives. But if we can deliver against the three areas of focus, I summarize for you today, we believe that we can not only continue to drive the top line, but also deliver the improved margin performance of which we’re capable and then our shareholders expect.
So now we’ll turn to your questions.
Thank you. We will now begin the question-and-answer session. [Operator Instructions] And we have a question from Mitch Penn Yarrow from Sturtevant Company. Please go ahead, Mitch.
Mitch Penn Yarrow
Hi. Good morning.
Mitch Penn Yarrow
So first question is regarding stage two here, project Centennial and the supply chain optimization. I mean, I know you said something, but I missed it in your remarks. But how long is this review going to take? I would have thought that phase two would have been planned out as things wasn’t going along. But now it seems like it’s a discreet stop and then start and then you have this phase two analysis and then phase implementation. Like, what’s the timeline on it?
Yeah. So Mitch, I mean, the whole thing is kind of the next step in the evolution under Centennial right. I mean, we had a lot of order changes that came about in the first phase that we wanted to make sure we got bedded down and all in place, and all that frankly is settled out now. But I think more importantly, Mitch, we’ve been thinking about this for a long time. I mean, you know, this industry pretty well. And this is something you got to be pretty careful and deliberate about. And so we took a quite a bit of time to do our internal reviews, and frankly learned quite a bit. And I mentioned in my prepared remarks that one of the reasons we did that is we wanted to come out on the other side of that internal review with a very, very detailed and tight scope of work. Obviously, for economies we went through a lot of stuff with Centennial that won’t be repeated here. This is much a much smaller scale. But we wanted both our internal and our outside resources to be fully prepared going in on the front end, so that we could keep that scope really tight, clearly understand what outcomes we were after, and then perform the formal work.
Mitch Penn Yarrow
And when you look at this, is there – are you looking at your portfolio profitability optimization? I mean, is there any – are we going to see sales being cold in a material way? Or I mean would it be a drag on revenue growth in a material way I guess is the question?
Yeah. I mean, look, I mean, there’s an element of ski rationalization involved here. Obviously, I can’t quantify that for you today that’ll come later on, but it’s much more than that. I mean, this is a much more holistic approach that is rooted in portfolio optimization, but it’s also about the network right and making sure that we’re operating as efficiently as possible, and then we’ll have more details on it as we go through the process and not ready to answer that today. But there will be some element of ski rationalization involved and then that’s probably pretty obvious.
Mitch Penn Yarrow
Okay. And then when it comes to the tight labor as it affects efficiency, is that the inability to fill second ships or what would – can you talk about that a little bit?
Yeah. Mitch, it’s really turn over. The turnover has been the biggest problem and to address that we’re doing some short-term things and then obviously, the portfolio and supply chain network stuff is a little longer term. But we’re trying to do some accretive things with scheduling as a fresh perishable DSD business we basically run every day. And so we don’t have the luxury of building inventories and sort of having more predictable scheduling. So we’re doing some things with chefs to try to give people more certainty to their schedule, more instances of consecutive days off, which is historically a rarity in our industry, so overall trying to make it a more attractive place to work. And furthermore, we’re moving back away in some of our plants from outsourced labor back to permanent labor to create that more of that one team atmosphere. We’ve done that in a couple bakeries so far. And I can’t say that we’ve seen significant financial returns from that yet, but we have seen the turnover start to fall. Once that happens and takes hold. One would expect – once those folks are trained up for those manufacturing efficiencies to start coming back up the historical levels.
Mitch Penn Yarrow
Okay, I will thank you. I’ll get back in the queue.
Thank you, Mitch.
We have no further questions at this time. That concludes the Q&A session. And I will now turn the call over to Ryals McMullian for closing comments.
Well, we appreciate you joining our call today. Thanks for your interest in Flowers and we look forward to speaking again in February. Thank you.
Thank you, ladies and gentlemen. This concludes today’s conference. Thank you for participating and you may now disconnect.