Earnings Call Transcript - CLX Q4 2021

Operator, Operator

Good day, ladies and gentlemen, and welcome to The Clorox Company Fourth Quarter and Fiscal Year 2021 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. At the conclusion of our prepared remarks, we will conduct a question-and-answer session. As a reminder, this call is being recorded. I would now like to introduce your host for today’s call, Ms. Lisah Burhan, Vice President of Investor Relations for The Clorox Company. Ms. Burhan, you may begin.

Lisah Burhan, Vice President, Investor Relations

Thanks, Christy. Welcome, everyone, and thank you for joining us. We hope you and your families are continuing to stay safe and well. Before we get started, I want to let you know that we are making some changes to how we present our results. Today, Linda will start by providing some overall key takeaways for the year. Next, I’ll follow up with some highlights from each of our segments. Kevin will then address our financial results as well as our outlook for fiscal year 2022. And, finally, Linda will return to offer her perspective and we’ll close with Q&A. Now, a few reminders before we go into results. We’re broadcasting this call over the Internet and a replay of the call will be available for 7 days at our website, thecloroxcompany.com. Today’s discussion contains forward-looking statements, including statements related to the expected or potential impact of COVID-19. These statements are based on management’s current expectations but may differ from actual results or outcomes. In addition, we may refer to certain non-GAAP financial measures. Please refer to the forward-looking statement section, which identifies various factors that could affect such forward-looking statements and the non-GAAP financial information section, including the tables that reconcile non-GAAP financial measures to the most directly comparable GAAP measures, both of which are located at the end of today’s earnings release, which has also been posted on our website and filed with the SEC. Now, I’ll turn it over to Linda.

Linda Rendle, President and Chief Executive Officer (CEO)

Thank you, Lisah. Hello, everyone. Thank you for joining us. Fiscal 2021 was an extraordinary year for Clorox, with the pandemic putting us through the ultimate test of volatility, including rapid changes in consumer demand and significant cost inflation, which was reflected in our Q4 results. Despite the complexities we faced, we delivered 9% sales growth for the fiscal year on a reported and organic basis, reflecting growth in all 4 reportable segments. This was on top of the reported 8% increase we delivered in fiscal 2020. On a 2-year stack basis, we delivered 17% sales growth. With rising cost pressures, we experienced declines in gross margin, particularly in Q4, resulting in a decrease of 200 basis points for the fiscal year, which we will discuss in more detail. Fiscal year 2021 adjusted EPS decreased 2% to $7.25. Recognizing the immediate priorities before us, I’d like to reinforce what matters most: long-term profitable growth. With a business that’s significantly larger than before the pandemic and a portfolio of trusted brands exposed to more tailwinds, we have clarity in our strategic imperatives, and I have every confidence in our ability to continue delivering long-term value creation for our shareholders. When I look at fiscal 2021, our performance has shown the strength of our people, brands and products, as well as the resilience of our categories, as we work tirelessly to supply consumers with products across our portfolio. As a result, we experienced significant growth in demand and strengthened our position amongst global consumers, with strong household penetration supported by higher repeat rates across new and existing users. The last 12 months have also demonstrated the need to accelerate our IGNITE strategy, to address near-term headwinds and capitalize on long-term opportunities. The industry environment remains dynamic, with significant inflationary pressure and continuing uncertainty. In the face of these conditions, our top priority is strong execution, to mitigate the impact of elevated cost headwinds and continue to improve market share. The pandemic has also highlighted areas where additional investments can help us be as agile as possible in the future. We are clear on the opportunities ahead of us to differentiate Clorox and build a stronger, more resilient, and more profitable company. This includes driving our growth runways and making investments to enhance our digital capabilities and drive productivity improvements, which I will discuss shortly. We are confident that strong execution of our IGNITE strategy will enable us to achieve our 3% to 5% long-term sales target and deliver long-term shareholder value. Before I discuss Q4 and our progress against our strategy, I’d like to thank our Clorox teammates around the world for everything they’ve accomplished over the past year, as well as their commitment and dedication to serving people and communities around the world. For Q4, faster-than-expected moderating demand for cleaning and disinfecting products had a pronounced impact on sales growth, as we move through the peak of the pandemic and lapped the unprecedented demand we experienced last year. The magnitude of this quarter’s gross margin contraction was a result of faster-than-expected sales moderation, acceleration of inflationary headwinds and improvements in supply, which led to broader product assortment, including the reintroduction of value packs. I’ll discuss shortly the actions we’re taking to address these headwinds. Now, let me share a few highlights of our progress on our IGNITE strategy. First, with fuel growth being a critical focus to help address elevated cost pressures and ensure the long-term health of our brands, I’m pleased we delivered over $120 million in cost savings in the fiscal year, surpassing our annual target. Second, we made strong progress on our 2025 goal to know 100 million people, crossing the halfway mark to our goal this fiscal year. Our higher investment and personalization has led to significantly improved ROI. It has been one of the contributors to increasingly strong payouts, driving our confidence in continued investments in our brands. Third, with innovation at the heart of our strategy, we doubled our innovation investments in fiscal 2021. New products were a bigger contributor to our top line, which we expect to continue in fiscal 2022. Next, as consumers have increased their digital usage during the pandemic, we leaned into digital marketing and commerce, resulting in our e-commerce business nearly doubling in the last 2 years, which today represents about 13% of total company sales. Finally, we continue to make progress on our ESG goals. For example, we advanced our commitment to climate action and submitted our proposal on Science Based Targets for our operations and Scope 3 emissions to the Science Based Targets initiative in June. And as a people-centric company, we continue to focus on the wellbeing of our teammates, and our value-based inclusive culture. I’m particularly proud that during this trying year, we achieved our best safety score in recorded history, with a recordable incident rate of 0.26, significantly lower than the 3.3 industry average. I’m also pleased that in fiscal 2021, we continue to have high employee engagement of 87%, putting us at the top quartile of Fortune 500 companies. Now, let me turn to fiscal 2022. We expect inflationary pressure to persist along with continued moderating demand as we lap COVID-19-related demand surges in the first half of fiscal 2021. While this is reflected in our fiscal 2022 outlook, which Kevin will discuss, by the second half of the year, we expect to be within the lower end of the range of our long-term sales target. Like others in our industry and beyond, we are experiencing significant increases in input and transportation costs across all categories in our portfolio, which have accelerated since Q3, and we’re holistically and dynamically managing this with a laser-focus on rebuilding margin. We implemented pricing on Glad and announced actions on our food, cleaning and international businesses. This represents about 50% of our portfolio. We’re also pursuing pricing in additional parts of our portfolio, which we’ll communicate at the right time. Based on the constructive conversations we’re having with our retail partners, and importantly, the strength of our brands, we feel confident about our ability to execute our pricing plans. In addition, we will continue to drive our hallmark cost savings program. We expect sequential gross margin improvements as we progress through fiscal 2022, with our assumption for gross margin expansion by Q4. In terms of market share, as we’ve discussed previously, we have experienced some declines due to supply challenges, but we have made notable progress. With strong investments in internal and external production capacity, including additional manufacturing lines and a significant expansion of our production team, in June we achieved our highest case fill rate since the start of the pandemic. I’m pleased to see that in the latest 13-week data ending July 17, we saw market share gains in 7 out of 9 businesses. Certainly, we recognize there is more work to do in parts of the portfolio, such as Glad trash, and we have adjusted our plans to drive market share improvements over time. Despite these near-term headwinds, we remain focused on our long-term priorities, rooted in our IGNITE strategy, to deliver our long-term growth aspirations. While some pandemic-related behaviors may revert over the next 12 months, we continue to believe there’s been a shift in behaviors that will advantage Clorox longer-term, including a focus on health, wellness and hygiene, more time at home, as well as increased adoption of e-commerce and digital platforms. The pandemic also revealed the urgency to upgrade our digital infrastructure and capabilities. Last year, I brought in Chief Information and Enterprise Analytics Officer Chau Banks, who has extensive experience in business-driven digital transformation to conduct a fresh assessment of our own program that was already underway before the pandemic. With that assessment now complete, we are accelerating our transformation through planned investments of about $500 million over the next 5 years to enhance our digital capabilities and drive productivity improvements, including replacing our ERP. This will enhance our supply chain to better position Clorox to meet customer needs, yield efficiencies, and support our digital commerce, innovation and brand building efforts. Prior to the pandemic, we were already adapting our business to differentiate Clorox from a digital perspective. We’ll continue to invest in e-commerce and digital marketing across our portfolio, leveraging data-driven insights to engage with consumers in more relevant ways. Moving to innovation, innovation continues to be a key focus area for me and our new Chief Growth Officer Tony Matta, who joined last October. Tony has more than 20 years of brand building experience with leading consumer companies, ensuring we have stickier innovation delivering multi-year value. We’re driving lasting new product platforms, such as Fresh Step Clean Paws and Scentiva, which continue to grow. In addition, we’re extending innovation by leveraging external partners to create new revenue streams. We’re continuing to support our brands, especially margin accretive innovation with disciplined, high ROI advertising and sales promotion investments to build and strengthen consumer loyalty. We also remain very focused on driving our growth runways to build Clorox into a global cleaning and disinfecting brand. We are still in the early stages of a multi-year journey, but continue to believe they can become a meaningful contributor to growth longer-term. And as we execute on all these initiatives, we will continue to drive the strategic link between our societal impact and long-term value creation, as we live our purpose and keep our ESG commitments front and center in our decision making every day. With that, I’ll turn the call over to Lisah to review our business unit performance.

Lisah Burhan, Vice President, Investor Relations

Thank you, Linda. Now turning to our segment results. In Health and Wellness, Q4 sales decreased 17% for the quarter, while full year sales were up 8% with growth across all businesses. On a two-year stack basis, Q4 sales grew 16% and full year sales grew 22%. In cleaning, sales were down by double-digits compared to double-digit growth in the year-ago quarter, primarily due to the deceleration of demand across various cleaning and disinfecting products. On a full year basis, cleaning sales grew behind a strong front-half performance. While demand fell faster than anticipated, it remains higher than it was pre-pandemic with strong repeat rates among new buyers. Importantly, our supply and product assortment are almost fully restored, which is reflected in our market share improvements, especially in wipes and sprays, as consumer demand migrated to more preferred forms and value packs. We also saw a negative impact to price mix, which we expect to continue over the next few quarters. Going forward, we’ll be focused on strengthening our merchandising activities, especially for the back-to-school period. Sales in professional products were down by double-digits versus the year-ago period when we experienced double-digit growth. For the full year, professional product sales were up by double-digits, fueled by an exceptional front-half performance. Demand started moderating in Q3, and continued into Q4 as customers worked through high inventory levels, especially of Clorox T-360 electrostatic sprayers. In the short term, we expect results will continue to be volatile as we lap periods with unprecedented demand. Longer-term, this business continues to be a strategic growth area for the company. As part of our initiative to expand into new channels, we continue to add to our roster of out-of-home partnerships, including Live Nation, the world’s leading live events company. Lastly, within the Health and Wellness segment, our vitamins, minerals and supplements business increased by double-digits this quarter after lapping a double-digit decrease caused by a supply disruption related to COVID-19. For the full year, sales were up as well. Sales growth for the quarter was driven by a strong performance in the food, drug and mass channel and e-commerce. Turning to the Household segment, Q4 sales were down 8%. Full year sales grew 10% with growth across all 3 businesses. On a two-year stack basis, Q4 sales grew 8% and full year sales grew 12%. Glad sales decreased by double-digits in Q4 lapping strong double-digit growth in the year-ago quarter, which was impacted by initial stockpiling. For the full year, sales were up. Our efforts going forward, our focus is on managing the strong inflationary headwinds we’re facing. And as Linda mentioned, we still have more work to do in this business to restore market share. Grilling sales decreased by double-digits in Q4 as demand started moderating after 4 consecutive quarters of strong double-digit growth. For the full year, sales grew by double-digits, fueled by very strong consumption overall. Our focus on expanding distribution of our latest innovation Kingsford pellets continued with a nationwide launch, building on the product's initial success, while we’re also introducing signature flavors made with 100% real spices that will be available in select retailers before Labor Day as we gear up for the 2022 grilling season. This innovation is intended to help our business continue building consumption among multicultural millennials and other heavy growers. Cat Litter sales grew by double-digits in Q4, driven by continued strong consumption. For the full year, litter sales also grew. The results reflected strengthened e-commerce with Fresh Step becoming the number one brand online for the first time and positive overall category trends boosted by record pet adoptions during the pandemic. Going forward, we’re excited about our latest innovation Fresh Step Outstretch litter, which lasts 50% longer than regular litter, thanks to patent-pending technology. In our Lifestyle segment, sales were down 3% and full year sales grew 6%. On a two-year stack basis, Q4 sales grew 13% and full year sales grew 16%. Brita sales were down as demand continued to moderate from an extended period of elevated consumption. Full year sales grew on top of double-digit growth in the prior year. Despite the deceleration in Q4, business fundamentals are strong, especially now that our supply is mostly restored. We’re excited about the strong merchandising program we put in place this year, including the largest back-to-college event ever for the brand. The food business was down primarily due to lower shipments of Hidden Valley Ranch bottle dressings, with consumption moderating as consumer mobility improved. Full year sales were up by double-digits, on top of double-digit growth in the prior year. The consumer fundamentals for this business are strong with the brand growing market share and household penetration. Burt’s Bees sales increased by double-digits this quarter as overall category consumption began to recover. Full year sales were down as category consumption was negatively impacted by store closures, mask mandates and stay-at-home measures. We expect this business to continue to recover as people begin returning to their pre-pandemic shopping patterns and consumer mobility keeps improving. We’ll build on that momentum with our new 'Lips to Love' campaign supported by a strong innovation pipeline. Lastly, turning to international, Q4 sales grew 5% reflecting the combined impact of the Saudi JV acquisition and benefit of price increases partially offset by lower shipments due to moderating demand after a period of elevated consumption. Extended lockdowns in Canada also contributed to the decrease in shipments. The results are on top of 12% growth in the year-ago period, when we saw elevated consumption across our portfolio during the early stages of the pandemic. Importantly, we continue to expand our global disinfecting wipes business building on the dedicated international supply chain that was developed in 5 months, and we are making progress launching our Clorox Expert disinfecting wipes in existing countries as well as new markets. For the full year, sales increased 14% reflecting very strong growth for the majority of the year before moderating in Q4. On a two-year stack basis, Q4 sales grew 17% and full year sales grew 19%. Now, I’ll turn it over to Kevin, who will discuss Q4 and full year financial results for FY 2021 as well as our outlook for FY 2022.

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Thank you, Lisah, and thank you everyone for joining us today. As Linda mentioned, for fiscal year 2021, we delivered 9% sales growth on top of 8% sales growth in fiscal year 2020. While this is lower than we anticipated in our outlook, we feel good about delivering another strong sales year. Of course, we continue to manage an extremely challenging cost environment, which impacted our fiscal year margins and earnings. Importantly, we delivered another year of strong cash flow, which came in at $1.3 billion, compared to a record $1.5 billion for fiscal year 2020. I’m pleased our strong cash flow allowed us to return almost $1.5 billion to our shareholders through our dividend and share repurchase program, representing an increase of about 90% in cash returned to shareholders versus fiscal year 2020. Before reviewing our Q4 results, I wanted to highlight a $28 million non-cash charge we booked in Q4 related to a third-party supplier for our professional products business. As we have shared previously, during the height of the pandemic, we worked with a number of third-party suppliers to support us in addressing unprecedented demand in the consumer and professional spaces. We’re reducing our reliance on one of these suppliers. As a result, we took a charge in the fourth quarter. Important to note, this non-cash charge is included in our reported EPS and excluded from our Q4 adjusted EPS, as it represents a non-recurring item. Turning to our fourth quarter results, fourth quarter sales decreased 9% in comparison to a 22% increase in the year-ago quarter, delivering a two-year stack of 13% sales growth. Our sales results reflected an 8% decline in organic volume and two points of unfavorable price mix primarily in our Health and Wellness segment, as supply improvements resulted in a broader product assortment, including the reintroduction of value packs. On an organic basis, fourth quarter sales declined 10%. Fourth quarter sales were lower than expected primarily in our Health and Wellness segment, as demand for cleaning and disinfecting products moderated more rapidly than we had previously anticipated. While the cleaning and disinfecting category continues to moderate, we’re pleased to see improving share as we increased our ability to supply. Gross margin for the quarter decreased 970 basis points to 37.1% compared to 46.8% in the year-ago quarter. Gross margin results were lower than anticipated, largely driven by higher input costs and lower sales. The year-over-year change in Q4 gross margin was primarily driven by lower sales, resulting in lower manufacturing fixed-cost absorption as well as significant cost headwinds driving about 290 basis points of higher commodity costs, 180 basis points of increased transportation costs as well as 130 basis points of unfavorable mix. Our fourth quarter gross margin also includes about 70 basis points of negative impact from the non-cash charge just mentioned. These margin headwinds were partially offset by about 90 basis points of cost savings, and 50 basis points of benefit from our pricing actions in our international division. Selling and administrative expenses, as a percentage of sales, came in at 14.4% compared to 14.1% in the year-ago quarter. Advertising and sales promotion investment levels as a percentage of sales came in at about 12% with U.S. spending at about 14% of sales. Strong investments in Q4 supported our back-half innovation program and reflected our continued focus on building loyalty among new consumers. Our fourth quarter effective tax rate was 0%, primarily driven by a tax benefit from exiting a small foreign subsidiary, which was mostly offset by the charge we took to pre-tax book income associated with this decision, as well as favorable return-to-provision adjustments. On a full year basis, our effective tax rate was 20%. Net of all these factors, adjusted earnings per share for the fourth quarter came in at $0.95 versus $2.41 in the year-ago quarter, a decline of 61%. Before I review the details of our outlook, let me provide perspective on the strategic investment Linda discussed. We’re planning to invest about $500 million over the next 5 years to enhance our digital capabilities and drive productivity improvement, including the replacement of our ERP. In fiscal year 2022, we plan to invest about $90 million in operating and capital expenditures with about $55 million impacting our P&L, and the remainder reflected on our balance sheet. Beginning in Q1 and going forward, our adjusted EPS will exclude the portion of the $500 million investment that flows through our P&L to provide better insights into our underlying operating performance of our business. Now, turning to our fiscal year 2022 outlook. We anticipate fiscal year sales to be down 2% to 6%, reflecting ongoing demand moderation, primarily in our cleaning and disinfecting products in the front half of the fiscal year. In addition to the unfavorable mix and higher trade spending, as we move to a more normalized supply and promotional environment. We assume these factors will be partially offset by the pricing actions we’re taking broadly across our portfolio. Organic sales are expected to be down 2% to 6% as well. We expect front-half sales to decline high-single to low-double-digits as we lapped 27% growth in the front half of this year 2021 during the height of the pandemic. Additionally, we expect Q1 sales to decline low-double-digits. As we move to the back half of the year, we expect to return to the lower end of our long-term sales growth targets. Of course, we continue to operate in a dynamic and uncertain environment, which could impact our outlook. We anticipate fiscal year gross margin to be down 300 to 400 basis points, due to our assumption for significant ongoing headwinds from elevated commodity and transportation costs, which represent nearly $300 million in year-over-year cost increases. We expect these headwinds to be more pronounced in the front half of the year, particularly in Q1, as we expect key commodity cost increases to reduce gross margin by about 500 basis points, driving our assumption for Q1 gross margin to decline 1,100 to 1,300 basis points. For perspective, in Q1 we’re lapping a modern gross margin record of 48%, reflecting over 400 basis points of favorable operating leverage on 27% sales growth in the year-ago quarter. As we mentioned in our press release, we expect sequential improvement for gross margin over the course of fiscal year 2022, with the assumption for gross margin expansion in Q4. This is based on our assumption that cost inflation will begin to moderate, and then we’ll see the benefits from mitigating actions flow more fully through our P&L. We expect fiscal year selling and administrative expenses to be about 15% of sales, which includes about 1 point of impact related to our investment to enhance our digital capabilities. Additionally, we anticipate fiscal year advertising spending to be about 10% of sales, reflecting our ongoing commitment to invest behind our brands and build market share. We expect our fiscal year tax rate to be about 22% to 23%. The year-over-year increase primarily reflects lapping several one-time benefits in the prior fiscal year. Net of these factors, we anticipate fiscal year adjusted EPS to be between $5.40 to $5.70. As we start fiscal year 2022, I’d like to emphasize our priority to address elevated cost pressures from both commodities and transportation throughout the fiscal year. We are focused on executing the pricing actions we discussed today. We’ve implemented our announced price increase on our bags and wraps, and are taking pricing on our Food, Cleaning and International businesses. This represents about 50% of our portfolio. We’re also pursuing pricing in additional parts of our portfolio, which we’ll announce at a later date. While it’s still early, we are confident in our ability to price, given the strength of our brand and the constructive conversations we’re having with retailers. Consistent with our IGNITE strategy, we’re addressing short-term headwinds head on, with an eye on the long-term health of our business. We will continue to invest in our brands, including meaningful innovation to drive differentiation, which will help us continue to drive superior consumer value. We are leaning into our cost-savings program and productivity initiatives to help address ongoing cost pressures. And we’re accelerating investments in our digital transformation, to drive increased capabilities, lower costs across our supply chain, and improve innovation efforts and our brand engagement activities. And finally, as Linda mentioned, our business is significantly larger than before the pandemic and we’re well positioned for the future. Our global portfolio of trusted brands is more relevant than ever. And we’re positioning ourselves to make the most of the changing consumer trends we see. We have confidence in our strategic plans and our ability to execute, to enable us to continue to create long-term value for our shareholders. And with that, I’ll turn it back over to Linda.

Linda Rendle, President and Chief Executive Officer (CEO)

Thank you, Kevin. Before we open the line for questions, I wanted to take a moment to reiterate our commitment to and confidence in Clorox’ long-term growth and value-creation potential, which is fueled by our IGNITE strategy. We’re focused on strong execution in the face of dynamic conditions, including addressing significant cost headwinds and improving market share. In addition, we have clarity on the strategic imperative and executional mandate to differentiate Clorox and build a stronger, more resilient, and more profitable company. And as we accelerate and execute our IGNITE strategy, we’re confident that we’ll drive improved performance. Christy, you may now open the line for questions.

Operator, Operator

Thank you, Ms. Rendle. And your first question is from Dara Mohsenian of Morgan Stanley.

Dara Mohsenian, Analyst (Morgan Stanley)

Hi, everyone. Two questions. First on the $500 million investment program on digital and productivity, could you just give us a better sense for why the program is necessary now? We’ve heard the IGNITE strategy has been working the last couple of years. Historically you’ve been ahead of the curve on e-commerce and we’ve been happy with innovation progress. So it sounds like there was a review when you took over, and obviously Chau Banks’ appointment. But I’m sure you were focused on these areas before also. So was this a surprise? How did it develop, particularly given it’s such a large amount? And then, as we think about the payback, is this what’s necessary to get back to long-term goals that at some point, in theory, sometimes a big spending program can yield payback above and beyond prior goals? I’m assuming at this point, it’s more to help return to prior long-term goals. Second, Kevin, on gross margins, when you include the guidance for fiscal 2022, you’re obviously experiencing a lot of gross margin depression over a 2-year period, probably a record amount of compression. So I’m just trying to understand your focus on pricing. It seems like the magnitude and timing of the pricing is less than what we’ve seen in the past versus these unprecedented cost pressures. So I just want to understand why we’re not seeing a greater offset through pricing. Is pricing more difficult in this environment from a retailer or competitive perspective? Is some of the pressure unexpected? Are there other pressure points on gross margin? How do you think about and help us understand why we’re not seeing more of an offset to those outsized cost pressures like we’re seeing with some of your peers?

Linda Rendle, President and Chief Executive Officer (CEO)

Sure, Dara. Thank you. On why it’s necessary now: the pandemic has accelerated consumer digital behaviors in a way we hadn’t contemplated when we penned IGNITE. We saw rapid movement online in both e-commerce and marketing consumption that required us to step back and assess our program. Our challenges in fiscal 2021 managing the volatility underscored the urgency to upgrade digital infrastructure and capabilities. This is not about today — it’s about maintaining momentum as we come out of our IGNITE strategy period. The bulk of the value from this comes after the IGNITE period, so 2025 and beyond. This will allow us real-time access to data and information to help our entire operation move more efficiently and better serve consumer and customer needs. The first investment is in our ERP, which is the foundation of these changes. We’ll gain better supply chain visibility across procurement and supply planning, further enhance digital and e-commerce capability, improve personalization and innovation. This decision was driven by rapid changes in consumer behavior and the need to build a stronger company with more momentum coming out of the strategy period.

Dara Mohsenian, Analyst (Morgan Stanley)

Okay. And could you talk a little about the yield from this, how we should think about timing and magnitude over time? And then second, Kevin, on gross margins, when you include the guidance for fiscal 2022, you’re obviously experiencing a lot of gross margin depression over a 2-year period, probably record amount of compression. So I’m just trying to understand your focus on pricing. It seems like the magnitude and timing of the pricing is less than what we’ve seen in the past versus these unprecedented cost pressures. So I’m just trying to understand that.

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Yeah, Dara, thanks for the question. Let me share our perspective on gross margin. Before the pandemic, our gross margin was just below 44%, about 43.9%. As we moved through the pandemic over the last couple of years, we ended this year about 43.6%, so just a little below where we were before the pandemic began. As we go forward, we are facing what we’re describing as an unprecedented cost environment in terms of inflation. For perspective, we expect about $300 million of cost increases this year between commodities and transportation, roughly a 400 basis point hit to gross margin this year. From the pricing actions we’ve taken, we think we can offset about two-thirds of those this year with the pricing actions we’ve announced plus more to come. We expect to fully offset the cost increase over time, but that will extend beyond fiscal year 2022 based on the phasing of pricing. Two other items to be aware of: we had temporary benefits during the pandemic related to mix and lower trade spending due to lack of supply. We expect promotional activity to normalize and reverse, which creates about 50 basis points of headwind from higher trade spending and roughly another 100 basis points hit from mix as larger sizes and multi-packs re-enter assortments. Both of those are temporary. The biggest challenge is the front half of fiscal 2022; we expect about 75% of the cost increases in the front half. You’ll see sequential improvements through the year, and by Q4 we expect margins back in the low 40%s. We’re committed to rebuilding them to pre-pandemic levels.

Dara Mohsenian, Analyst (Morgan Stanley)

Yeah, just on the timing of pricing, it does seem like it’s taking longer than it has previously. Obviously, a lot of compression year-over-year in Q4, almost 1,000 basis points. And we’re not expecting positive gross margins until you get to Q4 of next year. So I’d be curious for your thoughts specifically around the pricing offset. I understand there are issues like mix and some of the other issues you mentioned. But it does seem like it’s taking a long period of time to get pricing in relative to history. So just trying to understand that.

Linda Rendle, President and Chief Executive Officer (CEO)

Timing is related to the commitment we made at the beginning of the pandemic, which remains our absolute number one priority: to supply as much of the demand as we possibly could. That continued to be our priority through Q4. We made the immediate call to price on Glad given what we were seeing in resin. We were doing the work behind the scenes to ready pricing across the rest of the portfolio as needed. Clearly, we’re going to need to pull that lever and we are — about 50% announced to date with plans to take additional pricing that we will communicate as details are finalized. The priority was meeting demand first; now that supply is improving, we have been working with retail partners to implement pricing.

Dara Mohsenian, Analyst (Morgan Stanley)

Great. Thanks, guys.

Operator, Operator

Thank you. Next question is from Peter Grom of UBS.

Peter Grom, Analyst (UBS)

Hey, good afternoon, everyone. My question is on conservatism and the guidance. I know there are a lot of moving parts here. But I think a lot of investors are asking, is the company being prudent and conservative? Or have you embedded flex so that even if trends deteriorate from here, this guidance range is still achievable? I know the operating environment is very different. I’m not sure I’d call this a rebase versus what we’ve seen in the past. But it would be helpful to get your view on how much flex there is in this guidance should inflation rise or consumer demand fall more from here. Thanks.

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Hey, Peter. Thank you. On our outlook, I don’t view this as conservative; I view it as balanced. We’re operating in an environment of unprecedented volatility — changing consumer demand, macroeconomy and virus uncertainty — and we expect that to continue, certainly in the front half of 2022. We provided a wider range in our outlook than we normally would to account for this variability. We think that’s prudent, and this is a balanced forecast based on what we’re seeing today.

Peter Grom, Analyst (UBS)

Okay, super helpful. Quick clarification on margin: returning to the low 40% gross margin in Q4 — does that mean you don’t expect to be around 40% until Q4 next year? I want to be modeling this correctly.

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Sure. We expect Q1 to be down about 1,100 to 1,300 basis points, driven by the cost environment. Then we expect sequential improvements through the year and by Q4 we’ll turn to margin growth and get margins back into the low 40%s. Going into fiscal 2023 we expect to continue expanding margins, but it’s too early to provide guidance for that year.

Peter Grom, Analyst (UBS)

Thanks. Best of luck.

Operator, Operator

Thank you. Next question is from Wendy Nicholson of Citi.

Wendy Nicholson, Analyst (Citigroup)

Hi. A couple of questions. First, with the amount of money you’re spending on the new digital and ERP investments, what’s your expectation for capital allocation, potentially stepping in to support the stock and buy back stock here, because your leverage is still low compared to peers? And Linda, stepping back aside from near term, the guidance for 2022 gross margin — I’ve covered this for 20 years and I have to go back literally 20 years to find a 40% gross margin for the company. I get we’re in a weird period with COVID and you made a commitment not to raise prices early on, which I think was the right move. But is there something structural in the business that suggests mid-40s gross margin is the right number previously and this is a temporary blip? Or is this now a structurally lower gross margin business in the low-40s or high-30s? Sorry for the long question.

Linda Rendle, President and Chief Executive Officer (CEO)

Sure, Wendy. It’s an extraordinary environment — a perfect storm — where we’re lapping incredible sales growth and operating leverage and also lapping temporarily low promotional levels due to limited supply earlier in the pandemic. Promotional investment is strategic for us — like marketing, it builds trial and supports innovation — and we intend to reinvest to support innovation coming to market. Combined with industry-wide cost inflation, all of this is happening at once. We view this as a temporary issue, albeit an extraordinary one. We’re managing with discipline. We will take pricing where appropriate and put our cost-savings machine to work. I feel confident in our ability to get back to the margins Kevin spoke about; it just won’t happen this year. You’ll see improvement in Q4 and continued improvement in fiscal 2023. We view this as temporary, not structural.

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

And, Wendy, on capital allocation, there is no change in our priorities. Our first priority remains investing in the base business, which includes the digital investments Linda discussed. Last year we ramped up investments in innovation, brand building and production capacity. As we move into fiscal 2022, you should see capital spending return toward our normalized range of 3% to 4% of sales. We will deploy a portion toward the $500 million technology investment; about 60% of that will flow through the P&L and about 40% through the balance sheet. In fiscal 2022 we’ll invest about $90 million, with roughly $35 million on the balance sheet. After investing in the base business, we will continue to return excess cash to shareholders. Last year we returned almost $1.5 billion; this year, given the cost environment and reduced profitability, we expect to return closer to $700 million to $900 million via dividend and buybacks. Regarding dividends, we recently increased our dividend and have averaged about a 7% annual increase over the last 5 years.

Wendy Nicholson, Analyst (Citigroup)

Okay, that’s great. On the digital investment, what’s the payback timing? When should we start to see whether this investment was worth it to the bottom line?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

This is an investment in our future. You’ll start to see some payback late in our IGNITE strategy toward the tail end — late 2024, 2025 — and then accelerating beyond IGNITE. We’ll continue to update on progress, investments and returns.

Wendy Nicholson, Analyst (Citigroup)

Great. Thank you so much for the color.

Operator, Operator

Thank you. Your next question is from Chris Carey of Wells Fargo Securities.

Christopher Carey, Analyst (Wells Fargo Securities)

Hi, everyone. I want to understand: you mentioned Health and Wellness normalizing to something like a $700 million-or-below run rate, which could have played out this quarter. That business could grow from that over time. What’s the timeline of that trajectory from where we are today? What is going to develop over that time period — professional getting back in stock in some businesses, promotional spending, pricing? Also, the Household business has difficult comps and Grilling is normalizing. Just trying to get a sense of how this trajectory plays out and whether we need some improvement on a stacked basis. I have a quick follow-up.

Linda Rendle, President and Chief Executive Officer (CEO)

Sure, Chris. It’s a dynamic time for cleaning given volatility, but we still believe the change in consumer behavior is durable. Consumption remains significantly above pre-pandemic levels: our two-year stack in Q4 for the cleaning business was over 20%, and consumption has been up 25% to 30% versus pre-pandemic. We’re lapping incredible growth and earlier periods where demand exceeded supply. Normalization is occurring, but at a significantly higher run rate moving forward; this is part of the rationale for raising our long-term target to 3%–5%. We won’t expect to deliver accelerated results in the first half as we lap 27% growth in the prior year, but in the back half we expect to return to the lower end of our sales algorithm with cleaning and household contributing positively.

Christopher Carey, Analyst (Wells Fargo Securities)

Thanks. Kevin, quick question on Health and Wellness margin in the quarter: I appreciate mix dynamics and volume deleverage, but it was well below model. Could you expand on what occurred in that business and how we should think about the margin trajectory into fiscal 2022 and why it will improve?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Sure, Chris. On Health and Wellness margin, we did take the $28 million charge related to the PPD supplier, which impacted the segment by about 11 points of margin in the quarter; that was non-cash and won’t continue going forward. We’re also lapping 85% growth in last year’s Q4 and dealing with increased costs. So margins were pressured in the near term, but we expect expansion in the back half of fiscal 2022 and into 2023 as cost pressures moderate and our mitigation actions take effect.

Christopher Carey, Analyst (Wells Fargo Securities)

Okay. Thanks so much.

Operator, Operator

Thank you. Next question is from Jason English of Goldman Sachs.

Jason English, Analyst (Goldman Sachs)

Good afternoon. First, on cash flow, have you given free cash flow guidance? If not, can you? You have a target for free cash flow conversion as a percentage of sales of 11% to 13%. As you migrate away from GAAP and start excluding certain items, should we expect that ratio to move lower or to the lower end of the range?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Jason, we target 11% to 13% cash conversion. In fiscal 2020 we delivered over 19% during the height of the pandemic, and in fiscal 2021 we ended at 12.9%. This year, given the challenging cost environment, I expect cash conversion to be at the low end of that range, closer to 11% if not slightly below. Long term, we’re confident in delivering 11%–13%.

Jason English, Analyst (Goldman Sachs)

That’s helpful. Linda, I know you’re pleased with market share progress, but versus pre-COVID levels, particularly in cleaning, you’re still well below where you were pre-COVID. For multipurpose spray and wipes, it’s only gotten worse versus 2019 for recent months. Is that why pricing progress is slow — to reset price gaps and become more competitive? Or is it due to service levels and the need to restore supply before pushing pricing with retailers?

Linda Rendle, President and Chief Executive Officer (CEO)

Jason, I’m pleased with our share results given the environment. We’re seeing significant increased competition and we had supply challenges, but we’re making strong progress — share up in 7 of 9 businesses in the latest 13 weeks, wipes regained double-digit share growth, and Kingsford continues to grow. We remain committed to growing share. Glad is an area where I’m not as happy and we have work to do there. Pricing is unrelated to the share recovery issue: pricing timing was tied to ensuring supply first and then working with retail partners to implement plans. We’re considering price gaps and will act where appropriate. Our brands are strong — we have record-high percent of portfolio deemed ‘superior’ by consumers at 70% — so we feel confident in taking pricing with the consumer, supported by marketing and innovation.

Jason English, Analyst (Goldman Sachs)

Thank you. I’ll pass it on.

Operator, Operator

Thank you. Next question is from Kevin Grundy of Jefferies.

Kevin Grundy, Analyst (Jefferies)

Thanks. From an organic sales perspective you expect down 2% to 6%. What portion of that assumes category growth or declines? You mentioned being pleased with market share improvement — is that reflected in this guidance? And longer term, I know you don’t see this as a structural margin decline, but it seems like a multi-year journey to restore margins. Would it be reasonable to expect margins to recover into fiscal 2023 and more fully in 2024–2025?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Kevin, on the organic sales outlook: our assumption is modest category decline as demand moderates, partially offset by share growth across the portfolio — that’s embedded in the minus 2% to minus 6% range. On margin restoration: we are committed to recovering the cost inflation we’re seeing. Between cost savings and pricing, we expect recovery to extend beyond fiscal 2022 due to phasing of pricing. We believe this is a short-term issue and expect margin rebuilding into fiscal 2023, with continued expansion thereafter. Historically we’ve rebounded after pricing actions — for example, in fiscal 2018 we had nine straight quarters of gross margin expansion following pricing.

Kevin Grundy, Analyst (Jefferies)

On the remaining 50% of the portfolio where you haven’t announced pricing, what’s the probability you take pricing? Are you limited by competitive dynamics, price gaps versus private label, or other considerations?

Linda Rendle, President and Chief Executive Officer (CEO)

We’ve announced pricing on about 50% of the portfolio and plan additional pricing that we’ll communicate once details are finalized. The approach was category-by-category: ensuring supply was in position, then evaluating category dynamics, our competitive position, innovation and marketing plans. We’re balancing restoring margins with protecting long-term profitable growth. You’ll see a prudent stance on pricing and it will be a meaningful contributor to margin expansion as we move through the year.

Kevin Grundy, Analyst (Jefferies)

Thanks. Good luck.

Operator, Operator

Thank you. Next question is from Lauren Lieberman of Barclays.

Lauren Lieberman, Analyst (Barclays)

Hi. Could you give color on where retailer inventories currently stand and the same for PPD? Any research on consumer pantries that were built and the category correction in the first half? Specifically, where do retail inventories and professional channel inventories stand?

Linda Rendle, President and Chief Executive Officer (CEO)

Broadly, retail inventories are largely restored across the bulk of our portfolio due to the supply progress we made in Q4. We do have additional work to do on broader assortment, a few packs in cleaning and disinfecting and some work on Kingsford and food. In the professional business, it’s different: in the front half of fiscal 2021 we had a 70% increase in professional products sales, and then a significant drop in the back half as customers worked through high inventories, especially distributors. There appears to be elevated inventory in the professional channel across manufacturers. As we read down that inventory, results will be bumpy in the short term, but we have confidence in the long-term growth opportunity for PPD. The two-year stack for PPD is 35% sales growth.

Lauren Lieberman, Analyst (Barclays)

Thanks. On assortment: did you consider using this as an opportunity to intentionally streamline mix and improve profitability through assortment optimization and revenue management?

Linda Rendle, President and Chief Executive Officer (CEO)

Yes. As we brought SKUs back into assortment we did not bring back the full assortment; we simplified where appropriate, which helps cost lines and the P&L and optimizes retailer shelf and online space. We intend to use net revenue management more aggressively, including assortment decisions and mix optimization to drive margin. All business units are developing plans to use that lever more broadly.

Lauren Lieberman, Analyst (Barclays)

Thanks. One more: could you expand on the $28 million charge related to the PPD supplier? Why was it excluded from adjusted EPS?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Happy to. Early in the pandemic, we invested to help scale a third-party supplier to meet unprecedented demand. Recently that supplier had challenges and we decided to reduce reliance on them and move business to other suppliers. The $28 million charge in Q4 reflects writing off investments made to scale that supplier. It’s non-cash, related to a one-time decision, and we excluded it from adjusted EPS as a non-recurring item.

Lauren Lieberman, Analyst (Barclays)

Okay, thanks so much.

Operator, Operator

Thank you. Next question is from Stephen Powers of Deutsche Bank.

Stephen Powers, Analyst (Deutsche Bank)

Hi, thanks. Regarding the $500 million investment and the decision to adjust out those investments from recurring EPS: why are these investments considered non-recurring? They sound like material, multi-year foundational investments in the business. Why treat them differently in adjusted EPS versus other recurring investments?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Steve, a couple points. The size is material — $500 million over 5 years — and the majority is for replacing our ERP, which is typically a once-in-decades type of investment. We want to isolate that to allow folks to see underlying operating performance, which has been volatile, versus the long-term investment we’re making to set up the company beyond 2025. This treatment helps investors see the business operating performance separate from a large one-time transformation investment.

Stephen Powers, Analyst (Deutsche Bank)

Okay, fair enough. Can you talk more about the bridge from Q1 to the back half and why you have confidence you’ll reach the low end of the long-term algorithm in the back half? What gives you conviction that this is achievable?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

Steve, the front half is challenged because we’re lapping 27% growth. We expect the business to be down high-single to low-double digits in the front half. By the back half we have normalized comps and expect to be in a more normalized operating environment; that’s when our assumptions for share gains, pricing and cost-savings can take effect and get us back toward the lower end of our long-term growth target. The front half volatility is temporary and we expect improvement as comps normalize.

Stephen Powers, Analyst (Deutsche Bank)

One quick clarifying point: you noted unfavorable price mix driven by supply improvements that led to reintroduction of value packs. Was that purely mix-driven, or was there also a price component?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

It was essentially mix. We had about a point benefit from pricing in international, and roughly three points of negative mix overall. The mix headwind was two-fold: reintroducing additional SKUs and consumers migrating to more convenient forms as wipes supply improved, which displaced some higher-margin, less convenient forms like bulk bleach. This conversion is good for consumers but is slightly lower margin for us. So it’s a combination of SKU reintroduction and shifting product form mix.

Stephen Powers, Analyst (Deutsche Bank)

Understood. Thanks very much.

Operator, Operator

Thank you. Next question is from Andrea Teixeira of JPMorgan.

Andrea Teixeira, Analyst (JPMorgan)

Thanks. Linda, on Glad bags: why is it taking so long to recover even after a main competitor has narrowed price gaps and led with price increases? Is it because innovation and private label caught up during COVID? Now that capacity is back and vaccinations are up, do you still think you need to narrow price gaps for the large-count bags? What do you need to see before you act on pricing more broadly for Glad?

Linda Rendle, President and Chief Executive Officer (CEO)

On Glad, Q4 sales were down double-digits versus a year-ago quarter with strong demand in the prior year. For the full year, Glad sales were up and our two-year stack shows growth. From a share perspective, we’re seeing improvement: down 0.9 points in the latest 52 weeks, down 0.5 points in the latest 13 and down 0.4 in the latest 4 — trending the right way with improving distribution and fundamentals. Pricing: we announced pricing on Glad earlier and it’s being implemented now; we took a larger first-round increase than others to account for resin cost changes and we’re evaluating the need for additional increases. Our focus is in-market execution: getting distribution right, implementing pricing flawlessly and strengthening merchandising. Innovation in Glad continues to work well and we’ll support pricing with merchandising and brand investment.

Andrea Teixeira, Analyst (JPMorgan)

Thanks. Kevin, on commodities and resin: are you assuming resin stays at spot, or are you using forward curves? If commodity costs get better and you take more pricing, is there upside to your guidance?

Kevin Jacobsen, Executive Vice President and Chief Financial Officer (CFO)

We project a commodity environment for the year based on forward-looking assumptions, not spot. We expect commodity costs to increase and peak this quarter and begin to moderate in late calendar year. We expect to see about 75% of the commodity cost increases in the front half of the year, which is why Q1 is the most extreme. For context, we’re projecting over a 100% increase in resin costs in the front half year-over-year. If commodity costs moderate faster than we assumed, or if pricing actions are accelerated or larger, there could be upside to our guidance, and we’ll update as we learn more.

Andrea Teixeira, Analyst (JPMorgan)

One last one: any evidence consumers built pantries of bleach and cleaning products leading to a drawdown now? Or is consumption still elevated and they’re simply shifting forms as supply is restored?

Linda Rendle, President and Chief Executive Officer (CEO)

We don’t see evidence of excess pantry inventory across our categories. Pantry loading earlier in the pandemic has reversed. Consumption in cleaning categories remains elevated compared to pre-pandemic levels, though lower than the peak. What we’re seeing is consumers shift back to preferred and more convenient forms as supply improves, not a systemic pantry overhang.

Andrea Teixeira, Analyst (JPMorgan)

Thank you so much, Linda.

Linda Rendle, President and Chief Executive Officer (CEO)

Thanks, Andrea. I believe that’s the end of Q&A. Thanks again, everyone, for joining us. We look forward to speaking with you again on our next call in November. Until then, please take good care.

Operator, Operator

Thank you. This does conclude today’s conference call. You may now disconnect.