Earnings Call Transcript - FLO Q4 2021

Operator, Operator

Good day, and thank you for standing by. Welcome to the Flowers Foods Fourth Quarter and Fiscal Year 2021 Results Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Mr. J.T. Rieck, Senior Vice President of Finance and Investor Relations. The floor is yours.

J. T. Rieck, Senior Vice President of Finance and Investor Relations

Thank you, and good morning. I hope everyone had the opportunity to review our earnings release and listen to our prepared remarks and view the slide presentation that were all posted yesterday evening on our Investor Relations website. After today's Q&A session, we will also post an audio replay of this call. Please note that in this Q&A session, we may make forward-looking statements about the company's performance. Although we believe these statements to be reasonable, they are subject to risks and uncertainties that could cause actual results to differ materially. In addition to what you hear in these remarks, important factors relating to Flowers Foods business are fully detailed in our SEC filings. We also provide non-GAAP financial measures for which disclosure and reconciliations are provided in the earnings release and at the end of the slide presentation on our website. Joining me today are Ryals McMullian, President and CEO; and Steve Kinsey, our CFO. Operator, we're ready to start the Q&A, please.

Operator, Operator

Our first question comes from Ben Bienvenu of Stephens.

Jim Salera, Analyst

Jim Salera on for Ben. I wanted to ask a little bit about inflation moving into the new year. I guess, first of all, on the January 2022 price increase, how long do you think that will take to get fully implemented? And then maybe you can talk a little bit about the cadence expectations for inflation in the new year?

Ryals McMullian, President and CEO

Sure. Thanks for the question. Well, the January price increases are in large measure. There's a few small pieces of it that are just due to contracts rotating over, but the lion's share of the pricing for the January price increases is already in for the year.

Jim Salera, Analyst

Can you guys talk maybe a little bit about expectations kind of as the year progresses for inflation?

Steve Kinsey, CFO

Sure. I mean when you look at the overall inflationary environment, obviously, we were building in Q4. So in 2022, I mean 2022, as we said, we expect it to ramp throughout the year and then obviously Q4 comps. While we still don't have inflation, we'll pull back slightly. So you should see a ramp and then Q2, Q3 would probably be the highest cost, and then it pulls back slightly in Q4.

Jim Salera, Analyst

Okay. And if I could sneak in one more question. In regards to freight, do you guys have a hedging position on freight costs? Or do you have any visibility into what freight costs might do into 2022?

Steve Kinsey, CFO

Two things on freight. One, if you recall, our biggest transportation cost is around our DSD network. So we termed out a closed-loop network. We actually have three primary haulers who take product from the bakeries to the warehouses. So those contracts are usually a couple of years in advance. But we are seeing elevated costs for those as well. And then from an open market transaction on our warehouse business, we have to go to the market from time to time to provide delivery there, but we do not hedge any of that. So we try to buy it forward as much as we can. But the reality is, like most companies, we'll be in the current market on the 3PL situation.

Operator, Operator

Next, we have Bill Chappel of Truist Securities.

Unidentified Analyst, Analyst

This is Donald on for Bill. Just wanted to maybe ask a question on any color you could provide on your foodservice business versus 2019 levels. And also with regards to current inflation on the cost front, how much of that would you attribute towards labor? And do you believe there is a time where that could play in at some point?

Ryals McMullian, President and CEO

Sure. The foodservice business, as you saw, did recover some in the fourth quarter, and we saw that sort of through the second half of the year last year. It's still below 2019 levels, but there has been some recovery there. As you know, we've been doing a lot of work on our foodservice business to improve its profitability as it does come back because obviously, we've been expecting at least some amount of reversion as we hopefully start to exit this pandemic situation. But it does still remain below 2019 levels. Conversely, our branded retail business continues to hold up really well, given the continued at-home eating trends, our investments in our premium brands, et cetera, have all helped that business to maintain its place as part of the mix. You want to address inflation?

Steve Kinsey, CFO

When you look at, I think your question was around labor inflation, I mean, we're really no different than other companies. I mean, the labor market is really tight, as you know. So we're expecting mid to low to mid-single-digit labor inflation throughout the year depending on which market you're in.

Operator, Operator

Up next, we have Rob Dickerson of Jefferies.

Rob Dickerson, Analyst

Great. Just a couple of questions. I guess, first one, I missed the probably first minute of the call, so sorry if you already spoke to this. Just in terms of the gross margin EPS potential cadence for the year? I know in the prepared remarks, you're just kind of speaking to kind of first half, back half-ish with some moving pieces, obviously, in the back half. With kind of given what we saw in Q4, should the market kind of be expecting, let's say, similar year-over-year gross margin that kind of plays out in Q1 despite the higher pricing? And then just kind of in earnings, we kind of implied kind of flattish in Q1, just whatever you're willing to disclose, would be great.

Steve Kinsey, CFO

Yes, we don't provide specific guidance on gross margin or on a quarterly basis. However, we do expect some pressure on gross margins, leading to a decline year-over-year for the full year. As for the timing, our inflationary costs will increase throughout the year, but based on our experience in Q4, we anticipate some reduction later on. Additionally, we have implemented our January price increase and expect further price adjustments in certain categories and distribution segments during the first half. While we are about 70% hedged for the year, we still have some coverage that is open for the latter half, which means prices might not stabilize as expected. We may need to consider additional pricing strategies if that happens. Moreover, as we indicated in our release, the expected improvements in our margins will develop over time, with a significant contribution from our savings initiatives anticipated in Q3, leading to an overall enhancement in margins for the year.

Rob Dickerson, Analyst

Okay. Perfect. That was helpful. And then kind of simplistically, again, probably for you, Steve, and then I have one for Ryals. Just on the top line guide for the year, I'm assuming kind of what we're seeing is maybe all of that is driven by pricing, maybe volumes you've kind of implied or maybe down low single digit. I'm just kind of basing this off of kind of the level of pricing we saw in Q4, but then also kind of what we already see in the January data set on the track side. So just kind of any kind of perspective on kind of that rate of pricing as of now, excluding any additional pricing? It sounds like you're kind of talking high single-digit-ish. Is that fair?

Steve Kinsey, CFO

When you look at the tracked channel data, I mean, we're still seeing some positive mix. So that's also helping drive. But obviously, in Q4, pricing is a big driver of that. So I would expect you would see that development throughout most of the year.

Ryals McMullian, President and CEO

Rob, I want to add to that. We're feeling quite positive about elasticities so far. According to the syndicated data from IRI for the first period, which is essentially January of this year and follows the significant price increase in January, we’ve seen a 15.3% increase in dollar sales. Additionally, unit sales are up 5.3%, both of which surpass the category average. The early results from the price increases are holding, especially for branded retail, and the maintenance of those volumes is quite encouraging. This gives us confidence as we move forward into the year. We will need to keep monitoring consumer behavior and their ability to absorb these changes, but the initial data looks promising.

Rob Dickerson, Analyst

Yes, I think your volumes were actually up year-over-year sequentially relative to December despite the price increase. So it's a good sign, so there's a lot to still play out. All right, cool. And then just, Ryals for you, bakeries of the future, right? You've been speaking about this for some time. It sounds like given your prepared remarks that you have a number of pilots that will be in the market across a lot of your bakeries by the end of this year. The savings you're speaking to kind of so far and then through '22 doesn't seem like it's really contingent on bakery of the future, but obviously, bakery of the future would provide, I would think, some material savings in the out year. So is that something that kind of starts to kind of go into your network this year and that's kind of more of a '23 and forward optimization upside potential piece? Just anything you have there?

Ryals McMullian, President and CEO

Yes, we expect to start seeing benefits from Bakery of the Future this year. As mentioned in the prepared remarks, we will roll it out to half of the bakeries this year following the three or four pilots conducted over the past several months. We anticipate the savings to begin this year, and as you noted, we expect it to increase in 2023 and 2024.

Operator, Operator

Next, we have Mitch Pinheiro of Sturdivant & Company.

Mitch Pinheiro, Analyst

I’d like to follow up on Bakery of the Future. How significant is the transition to shift a bakery from its current setup to the bakery of the future? Are we just rearranging some servers and adding more computer screens, or does it involve shutting down production lines? Could you clarify this for me?

Ryals McMullian, President and CEO

Yes, from an operational perspective, it isn’t disruptive, and we don’t need to shut things down. Currently, this process is largely data-driven. We are implementing some automation and robotics, which is a separate aspect. As you know, we initiated that at Navy Yard, but the key focus for our bakery of the future is primarily on improving data, accessing better and more real-time information, eliminating inefficiencies, and reducing scrap costs. Operationally, it is hardly disruptive at all. The more challenging aspect is changing the mindset of the bakers, which does require some time. These individuals have been working in the same manner for a long time, and introducing advanced digital equipment while highlighting its potential benefits takes time. We need to educate them on how these changes can enhance their workflows and improve bakery performance. Therefore, it is as much a change management task as anything else. However, we have been very encouraged by the positive response from the bakeries so far.

Mitch Pinheiro, Analyst

How does that link to the new ERP program? I haven't personally looked for an ERP program, but I was surprised to see a $275 million cost over five years. Where is that money being allocated? Is it mostly for software with just a bit for hardware? That's a significant amount, or maybe it isn't?

Steve Kinsey, CFO

Yes. I mean when you look at these projects and you can look kind of across our peer set as well. I mean, these are not cheap projects, if you will. As we said in the release, about 40% to 50% of the costs will be capitalized. And the rest will be the cost of primarily implementing and rolling out the project itself. But when you look at the ERP itself, a lot of that is technology-driven and will be kind of a foundation or an enabler for Bakery of the Future. The majority of the costs running through ERP are not necessarily through kind of the digital work around Bakery of the Future. But to your point, it's not an insignificant cash flow item. A large part of the ERP costs from a capital standpoint will come this year. So you'll begin to see that tail off some over the next four years or so.

Mitch Pinheiro, Analyst

Okay. When you review some of the balance sheet numbers, like the fixed asset turns, they seem to have been stagnant. I was expecting that as we implement Bakery of the Future and adjust our capacity, we might see improvements in fixed asset turns going forward. I understand that baking is a regional business, and proximity to markets is important. However, will we be able to leverage efficiencies to avoid adding capacity for several years, or will our fixed asset turns remain fairly constant without much improvement? Can you elaborate on that, please?

Ryals McMullian, President and CEO

Well, a couple of things there, Mitch. One, obviously, our aim is to significantly improve the efficiency of the bakery. So that, in and of itself, will help us create some capacity. But also remember, we are doing some work via our customer strategy to over time, as we shift more of the mix to branded retail to convert some of that lower-margin business into our branded business. And you've seen examples of that in Tuscaloosa and Lynchburg with the organic conversions, and we'll continue to do that. But those customer strategies also open up opportunities for us to further optimize the network. You point out that, in a fresh business, we do need to be relatively close to the market, but we don't have to be as close as we used to be. With some of the technology that's out there now that we're already utilizing, that old 250-mile radius is not as relevant as it once was. So that opens up additional opportunities for us as well.

Mitch Pinheiro, Analyst

Moving on. As far as foodservice, what type of initiatives are you taking to improve profitability there? Can you give us some examples?

Ryals McMullian, President and CEO

Yes, sure. I mean, look, price is the most obvious one. And we've said many times that we do have some accounts that are underperforming. So we continue to work on those. Some of those are under contracts, so they do take some time. But price is certainly one lever. Our own efficiencies are another. This is not all about the customer. It's incumbent upon us to be as efficient as possible. So those are two things. But also method of delivery, too. Because some of these accounts are still DSD, which is a pretty expensive route to market, as you know. And converting them to a more optimized distribution model can help as well. So those are just a few of the levers we're pulling.

Mitch Pinheiro, Analyst

Okay. I have a final question regarding mergers and acquisitions. Your balance sheet looks excellent, and you have some low-cost fixed debt. You also have plenty of capacity on your revolving credit lines. Based on my estimates, you will generate significant free cash flow next year. I know you plan to remain disciplined in your approach and find the right opportunities, but how close are we to seeing some M&A activity this coming year? While I understand you can't predict timing, what is currently on your radar? Are there any developments in motion that could lead to opportunities in 2022?

Ryals McMullian, President and CEO

Yes, Mitch. We've been indicating for some time that our interest in M&A is quite strong. It has been a while since our last deal. We have a solid pipeline of opportunities that we are actively evaluating. For various reasons, we haven't proceeded with any because of alignment or pricing issues, or a mix of both. Nonetheless, we are engaged in the market, and while I can't forecast what will happen this year, I want to assure you that we remain active in this area.

Operator, Operator

Our next question comes from Ryan Bell of Consumer Edge Research.

Ryan Bell, Analyst

I just had a quick question about the ERP upgrade and sort of the efficiencies that would be provided by it. Is there sort of any savings number that you could talk to? We saw something on the cost side. Just to kind of understand exactly what you get out of that program.

Steve Kinsey, CFO

Yes, Ryan. I think a couple of things on the ERP upgrade. One, SAP is our enterprise-wide ERP system. The reality is, one would say we're forced, but we had to make a move because SAP has been to their S/4HANA platform across the whole. So at some point, service for our ECC platform will drop off. So that's driving a portion of the move in the cost. Secondly, because we have to make that move and because of the digital initiatives, they were looking at things that will enable productivity needs or hopefully drive long-term efficiencies across the bakeries. So there will be efficiency gains that have come out of this initiative, but we're not disclosing those at this point.

Ryan Bell, Analyst

Okay. And then just a broader question about the evolution of your portfolio as we're seeing a bit more normalization of the environment. Obviously, the branded part of your business has been doing really well. Just trying to understand, how do you think about the shift in the migration towards branded? How much of that can continue? And then in terms of the private label trends, why do you think that they're actually so soft despite some of the pricing that's coming through from the industry standpoint?

Ryals McMullian, President and CEO

Sure. This is Ryals. On the private label side, we're continuing a trend that's been present for over five years, which accelerated during the pandemic. However, even as we approach the end of that period, similar trends are still evident. In the fourth quarter, we saw a significant decline in private label units, with a slight increase in dollar sales so far this year. Nevertheless, units are still down as we start the year. Our research indicates a premiumization trend in the category, with consumers gravitating toward more differentiated products. We've seen considerable benefits from this trend with our branded portfolio, especially with Dave's Killer Bread and Canyon. The Perfectly Crafted subline for Nature's Own has also performed exceptionally well. Both Canyon and Dave's experienced double-digit growth in the fourth quarter, and this trend has continued despite the price increase in January. This showcases consumers' preference for high-quality, differentiated products, which is less common with private labels in our category. This is the main driver. Looking ahead, our brand prospects are promising, particularly with the innovation we are introducing, such as the DKB snack bars. Early feedback has been excellent, demonstrating that our strong brands can succeed across various categories, offering us opportunities beyond our core market.

Steve Kinsey, CFO

Ryan, this is Steve. Just one quick follow-up on your benefit question around ERP plus. When we started this project, the discussion there was, and Ryals have said it many times as well, part of this initiative really is going to be an enabler to drive productivity that helps us hit the long-term targets we have out there. So we really expect, in those target ranges, to see the benefit from the digital and ERP initiative. And that, hopefully, will drive us somewhere to the upper end of our range. But that's really how we're looking at it more internally.

Ryan Bell, Analyst

Can you provide any insight into the pricing situation? I understand you are discussing the trend toward premium products in your category. How much of the pricing is influenced by the shift in product mix and increased demand for items like Canyon's and Dave's, compared to pricing for individual products?

Steve Kinsey, CFO

With the pricing adjustments we've made, which Ryals mentioned in relation to the current IRI data for period one, we're observing positive results across our entire branded portfolio. Naturally, the premium products are contributing more to any increases, but overall, we've implemented pricing changes across the board rather than focusing on a specific brand.

Operator, Operator

And we have a follow-up from Robert Dickerson of Jefferies.

Rob Dickerson, Analyst

Great. Just a clarification question, Steve, on cash flow in Q4. It was a little light. I'm assuming there were probably some working cap headwinds on the inventory side. So maybe just explain if that's right. And then the only other question I have was just on the purchase of the lease portfolio. I've rarely seen that line item pop up. I'm not sure if that's part of the bakery of the future optimization plans. Maybe just those two quick questions.

Steve Kinsey, CFO

Yes. I mean when you look at kind of the fourth quarter on the lease portfolio, there was an opportunity that came to us kind of mid-quarter with regard to that. It was a collection of several warehouses and it fits in with our warehouse optimization strategy. So it did give us the ability to take out some leases and now we have some flexibility to look at how we're going to utilize these warehouses or potentially combine some warehouses. So that does fit in with that long-term strategy. And then the remainder of the elevated CapEx in Q4 was primarily driven around some of the project work you've alluded to regarding working capital.

Operator, Operator

I'm seeing no further questions in the queue. I'll turn it back over to the speakers for closing comments.

Ryals McMullian, President and CEO

Well, thank you for your interest in Flowers Foods. Appreciate your time today. Goodbye, everybody. Have a good weekend. Thank you.

Operator, Operator

This concludes today's conference call. Thank you all for participating. You may now disconnect. Have a pleasant day, and enjoy your weekend.