Earnings Call Transcript - FLO Q4 2023

Operator, Operator

Good morning, and thank you for standing by. Welcome to the Flowers Foods Fourth Quarter and Full Year 2023 Results Conference Call. Please be advised that today's event is being recorded. I would now like to hand the conference over to your opening speaker today, J.T. Rieck, Executive Vice President of Finance and Investor Relations. Please go ahead, sir.

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

Thank you, Norva, and good morning. I hope everyone had the opportunity to review our earnings release, 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 Riyals McMullian, Chairman and CEO; and Steve Kinsey, our CFO. Riyals, I'll turn it over to you.

Riyals McMullian, Chairman and CEO

Okay. Thanks, J.T. Good morning, everybody. Thanks for joining the fourth quarter call. We're proud of our team's accomplishments in the challenging consumer environment we're facing. Our brands performed very well, gaining unit and dollar share for the first time since the first quarter of 2022. Dave's Killer Bread was a particular standout, reaching $1 billion in retail sales and growing unit volume 10%, while the overall bread category declined 2.6%. We're excited about the multitude of future growth prospects for Dave's and our other brands, and we are investing in marketing and innovation to capitalize on that potential. Our 2024 forecast calls for continued solid results despite these category headwinds. We expect these results to be first half weighted, benefiting from wraparound pricing and branded retail, new pricing for selected food service accounts, and moderating commodity costs. Our second half forecast incorporates more caution due to the uncertain consumer and promotional environment. We remain focused on the significant longer-term opportunities we see ahead of us, filling in white space in geographic and product adjacencies while leveraging innovation to push into new categories. I've never been more confident in our long-term potential, and I look forward to building on our strong base throughout 2024. So with that, Norma, we can open it up for questions.

Operator, Operator

Our first question comes from Robert Dickerson with Jefferies.

Robert Dickerson, Analyst

I have a couple of quick questions. First, this might be more for Steve. As we look at the year, particularly the first and second halves, how do you view gross margin progression, especially considering the pullback in your inputs and the potential for ongoing promotional reinvestment?

Riyals McMullian, Chairman and CEO

Yes, Rob, let me start, and Steve can certainly fill in. So from a gross margin standpoint, we expect better results. We saw a nice gross margin increase in the fourth quarter, and we expect that to continue. A couple of other factors, though, to think about impacting bottom line performance. One, we are investing in the business. So whether that's ERP or our marketing investments, etc., behind Dave's and Nature's Own and the new bar launches and everything, we are spending more marketing dollars to invest in the business. So that will somewhat pressure margins from an EBITDA or bottom line standpoint. But obviously, those were intended to fuel future growth and our investments we're happy to make. But we would expect some improvement in gross margin. But one other thing to note, somewhat offsetting that, we talked in the prepared remarks about stranded overhead from the strategic exits. That does, particularly from a labor standpoint, affect those margins somewhat. However, the exciting thing about that for us is the opportunity we have ahead to refill that capacity with higher margin volume, which was the intention all along. Now obviously, that will come all at once. It will take a little bit of patience. But we've got a really significant opportunity ahead of us to refill that extremely low margin business that we've exited with much more profitable business. Steve, do you want to add?

Steve Kinsey, CFO

Yes. I mean, as Riyal commented and as you saw in the script too, we are being a little more cautious on the consumer in the back half. So when you think about overall cadence currently kind of in the guidance range, we do see stronger performance in the first half. A lot of that, as Riyal said, will be driven by some positives and negatives, specifically to some of the I'd say, commodity moderation pressure. If you think about last year, the first half was tougher than the back. So from an overall comp perspective, that will be driving some of the improvement in the first half as we've seen things pull back somewhat. We do expect the first half of 2024 to benefit more than the back half with regard to overall commodity inputs.

Robert Dickerson, Analyst

All right. And I guess just secondly, I think inherent in the guide is potential for ongoing volume declines. Clearly, I understand little pressure consumer backdrop, clearly, a decent amount of pricing going through. Dave's is doing well, but I guess that's a little different. So I'm just curious like if we listen to a number of other companies that are all kind of going through some form of volume pressure, there is kind of this expectation, so to speak, that as we get through the back half of '24, the probability should increase that volumes actually start to grow again, partially just driven by lower base and easier comp in the back half of '23. So I mean it sounds like you're being a little bit more cautious and maybe you're a bit more rational than others. So kind of the straight question is just kind of why not you do forecast a little bit more on the positive volume side as you get through the year? Or maybe that could play out. It's just you don't really know if it does, and that's probably realistic.

Riyals McMullian, Chairman and CEO

Yes. Look, it's a fair point. And it's clearly obvious the category continues to be under pressure and with private label trade down. But if you look at our market share performance, it's been quite admirable what we've been able to do even in this environment. Now certainly, we understand that market share performance in a declining category doesn't necessarily translate into bottom line profitability, but it does show the investments that we're making in our brands enable us to continue relatively strong performance in a pressured category. Now, as to the volume outlook for the year, I don't disagree with you. I mean there's certainly a possibility as the market adjusts to sort of post-pandemic reality that the category finds its equilibrium, which is what I think it's trying to do. And we could see more positive volume performance in the second half. But at the same time, part of our reason for caution is the offset of what a higher promotional environment could look like in that circumstance. I mean, if the category in order to drive unit volume decides it needs to become more promotional, then that could be an offset. The other thing that I would note, though, is our volume performance continued to improve throughout '23. And we finished the year with branded retail volume only down 30 basis points, which was a substantial improvement and overall volume improved. We were down, I think, 2.4% in the fourth quarter as opposed to 4.1% if you look back to the third quarter. So the sequence has been good, and so that's certainly a reason for optimism, which I think we're capturing at the upper end of guidance. But again, just given the uncertainty and the relative weakness of the category, we thought caution was prudent at least at this point.

Robert Dickerson, Analyst

All right. And then pardon me for asking a third quickly. Just the California legal decision, you had said in the prepared remarks, your decisions shouldn't be made any time sooner than March 1. Could you just maybe just add a little color as to kind of what that decision could imply like if decision goes one way, we likely would incur punitive damage or what have you, I'm not sure, or probably there's not some material impact. I'm just trying to understand kind of what that could mean relative to the current guide?

Riyals McMullian, Chairman and CEO

Yes. We have announced the cost of the settlement to the company. However, the more pertinent aspect of your question relates to what happens after March 1 if the settlement is approved. If that occurs, we will begin converting all distributors in California to an employee-based model. Initially, this is expected to have a negative impact on our results in California at least in the short term as we will need to train everyone and bring on the new employees. The positive news is that this will be done in phases, and we have 12 months from the date of the settlement to complete the process. We anticipate that the conversion should be finished by the first quarter of 2025.

Operator, Operator

Our next question comes from the line of Bill Chappell with Truist Securities.

William Chappell, Analyst

Just a little bit more maybe commentary on the foodservice, the cake business, kind of the thoughts there, in particular, kind of what initiatives we're looking at to kind of improve on the tasty cake side or just in cake in general and kind of how you see the trends play out for there versus the core?

Riyals McMullian, Chairman and CEO

Yes. So I think we've mentioned this a couple of times on prior quarter calls, but good question. I'd like to discuss it some more. So clearly, pricing has been important in both of those areas, all of those areas, private label food service and the cake business. And we've also, as you know, done some pretty significant SKU rationalization and strategic business exits, primarily in foodservice and cake, but also a little bit in private label. However, the profitability of all three of those businesses has improved markedly. So the strategy is working from that standpoint. And obviously, there are offsets in other parts of the business, the soft variety and white bread area, Bill, as you know, is the most susceptible to private label trade down. So obviously, that's a negative. And then offset by the DKB performance in terms of unit volume. But frankly, even DKB's profitability was down last year pretty significantly because we had substantially higher organic wheat costs last year. Now the margins are still very attractive for Dave's. I know we don't disclose particular numbers there, but still among the highest in the portfolio. But they were down roughly 500 basis points last year just because of the increased organic wheat costs, which this year will moderate somewhat. So we'll recapture some of that. So really good progress on those parts of the business, somewhat offset by category weakness in commodity costs and those effects on other parts of the business.

William Chappell, Analyst

Okay. And then a little bit on the commodity front. I guess, historically, you've just kind of said, hey, we hedged six to nine months out. I know it's most of the same thing, but this time, you're saying, hey, we're 70% locked on your input costs. So is there any change to how you're looking at things? Or we're just using percentages versus months?

Steve Kinsey, CFO

No, not really, Bill. We continue to look at our strategy to be about six to twelve months out, likely leaning more towards the shorter end in some cases. Last year, we entered with roughly 60% to 65% coverage, and we remain committed to our overall strategy. We have introduced some new tools to better manage volatility and improve training, but there are no changes to our approach regarding coverage or our planning horizon.

William Chappell, Analyst

Got it. Regarding the DKB bars, I apologize if this has already been addressed, but are you noticing repeat rates or any indicators that provide insight into the challenges of a competitive market? I understand DKB is a strong brand, but how do you distinguish yourself or secure additional shelf space among the many other bars available? What gives you confidence based on your observations from the last three to four months as you look to expand this year?

Riyals McMullian, Chairman and CEO

Yes. We are very happy with the results in 2023. We've opened more stores than we initially planned. Our product is exceptional, which sets us apart. The quality of our loaf items and breakfast items is superior. Our baked bars offer great flavor and texture, along with an impressive nutritional profile. Many bars in this category are cold-pressed, but ours have a fresh baked taste that you can really notice if you've tried them. You raise a valid point about shelf space; we currently have only three SKUs on the shelf, making positioning crucial. Where our positioning is strong, particularly at the middle-high shelf level, our standout packaging has proven effective at attracting both existing DKB shoppers and newcomers, which is a plus for our consumer base. I believe this will significantly benefit us as we launch three additional protein SKUs this year, increasing our visibility on the shelves. The protein bars we’ve tested in the market are performing well in addition to the first three SKUs, enabling us to engage a broader consumer base with our protein options. Our sales velocities match those of the category, which is encouraging. There’s always room for improvement, and we are committed to getting better. We approach this as a start-up and learn as we grow. So far, things look promising. We have a strong innovation pipeline coming up with snack bites in the latter half of the year and even more for 2025. We're making a strong start and building good momentum. The team and consumers are both excited, and we feel optimistic about our current position. It’s early, but we’re in a solid place.

Operator, Operator

Our next question comes from the line of Jim Salera with Stephens.

Jim Salera, Analyst

In your prepared remarks, you mentioned some uncertainty in 2024, obviously, around the consumer and promotions. I think we all get kind of the consumer piece of that. But to double-click on the promotion side, is the concern that some of the larger competitors in the category are going to maybe revert to how they behaved in the past where they really aggressively chase volume? Or is it more that retailers are going to come to you guys expecting price deflation and using promotion as a tool to achieve that?

Riyals McMullian, Chairman and CEO

Yes. Jim, definitely the former. We've seen this in our category before. We haven't seen it in a long time. And even though, as we noted in our remarks, we even promoted a bit more in the fourth quarter just because, as you know, there is seasonality in our business not being a big dinner roll supplier that the fourth quarter can be a little bit volatile. So we promoted a bit more to drive more unit volume, got good effectiveness out of those promotions, but we also didn't spend nearly as much in trade to get it and maintained one of the highest average price points in the category. But yes, the caution is much more around the other competitors in the space than it is pressure from retailers, which we really have not felt to date.

Jim Salera, Analyst

Great. Because it seems like and we've talked about this in the past, but part of the challenge is you have this channel shift dynamic that's going on and from the branded retailers' perspective or over the branded food company's perspective rather, if you're putting promo dollars in the channel, but the consumer is in the wrong channel, you're essentially just giving price away, at least that's kind of the way we viewed it. And so would we have to wait until the consumer shifts back to traditional grocery before we see those promotional increases be put into place? Or is it something that even with the consumers still in kind of value-oriented channels, competitors might just put promo in the channel anyway just to see what comes up on the other side?

Riyals McMullian, Chairman and CEO

Yes. I mean it could be either. I think that's just going to need to be a wait and see and monitor the environment and react accordingly.

Jim Salera, Analyst

Okay, great. And could I ask one more question? In the breakdown for the 2024 sales guide, you mentioned a wraparound pricing benefit in the first half and some business exits that negatively affect the volume. Considering there was a pull forward of business exits into 2023, this won't give you a more favorable comparison in the second half of 2024. Can you separate the volume decline and indicate how much of it you expect to come from business exits versus organic volume declines?

Riyals McMullian, Chairman and CEO

Yes. Most of it is still going to be in business exits. And I do want to note, if folks didn't pick up on it in the prepared remarks, barring something unforeseen, we do expect this to be the last year of strategic exits. I mean, we're done with what we wanted to do. And I mentioned earlier that what we're thrilled about is the opportunity we have in front of us and believe me, there is a lot of opportunity to go back and refill that capacity with higher-margin business, which will not only drive profitability but go a long way to help bring the unit volume back up. But you are correct, it is first half weighted. You'll see most of that effect in the first half. And then as we move into the back half, it would be much less significant. And then, again, that should be it.

Operator, Operator

Our next question comes from the line of Mitchell Pinheiro with Sturdivant and Company.

Mitchell Pinheiro, Analyst

I have a couple of questions. Regarding the gross margin in 2024, if we exclude your input and commodity costs, are we expecting gross margins to remain flat due to stranded fixed costs as you exit certain businesses, or is there something else we should be aware of? I would anticipate that some of your digital transformation efforts will begin to manifest in fiscal '24, leading to improved overall equipment effectiveness and related metrics. When can we realistically expect to see tangible improvements in gross margins, excluding commodity costs?

Riyals McMullian, Chairman and CEO

Yes, we anticipate gross margin improvement this year. Some of this will result from the moderation of commodity prices. While there are mixed factors, such as better flower costs and increases in other expense areas, we still expect overall gross margin improvement. This will also be supported by the advancements in our baker of the future initiative, which is yielding better overall equipment effectiveness results. However, we are currently experiencing some offset primarily due to labor costs and stranded overhead, which is causing some strain. I want to stress that this is temporary, as we will eventually refill that capacity and these costs will diminish. Additionally, as we assess the profit and loss statement, factors like marketing, ERP costs, and some labor expenses are contributing to pressure on the EBITDA margin at this time. Nevertheless, we expect improvements throughout the year, particularly into 2025, as we address these stranded costs and enhance our capacity.

Mitchell Pinheiro, Analyst

You're a little cautious on the second half. You just talked about it a question before about promotion, the potential for maybe a little more promotional environment. But you guys have invested in your promotional management tools. Can you talk about that as it might apply to the back half?

Riyals McMullian, Chairman and CEO

Yes. I think it's a great question. And it's timely because that really showed up in the fourth quarter. If you look at the syndicated data, you'll see, as I said, that we had among the highest average prices in the category. And yet our units on promotion were up a bit. We did promote more. But we did so much more effectively and with much less trade spend than we might have historically needed to use really good display execution in support of those promotions. And for the first time in a while, actually saw a nice lift and got a good return off of those promotions. And for the past few years, we've been talking about how promotions have not been very effective, not seeing a lot of lift from them. But in the fourth quarter, for the first time in a while we did. So that trade promotion management tool that you referenced is enabling us to be a lot more effective when we do promote.

Mitchell Pinheiro, Analyst

Okay. And then anything to call out from a geography performance point of view? Were there any geographies that were stronger than you expected or weaker in the last quarter?

Riyals McMullian, Chairman and CEO

Yes, not stronger and weaker than expected, but we continue to really do well in the Northeast. It's a great growth market for us. We've talked in the past, Mitch, about what a share point is worth up there, some $35 million or so at retail, and we still got a lot of room to grow. So when you think about opportunities for future growth, whether it's there, Pac Northwest, still on the West Coast, and in particularly the upper Midwest where we're really not present. We're excited about the prospects we have in front of us. Retailer excitement about having us move into those areas, etc., bringing Nature's Own, Dave's, and Canyon to those consumers. There's still quite a bit of headroom left for us.

Mitchell Pinheiro, Analyst

Are you at the stage where you can look beyond the ERP implementation and your general investments to consider a more significant acquisition beyond just the Papa Pita, or are we still some time away from making a larger commitment?

Riyals McMullian, Chairman and CEO

No, we're ready when the right opportunity comes along, and that's the key is what will that opportunity be? And when will it come? But when it does, we're absolutely ready to go. We've got plenty of dry powder despite all the things we have going on. We certainly have the capacity to do a meaningful acquisition. And as we said in the prepared remarks, we're very proactive. I'm more optimistic about M&A activity, seeing more founders and sellers that we talk to contemplating transactions. Don't know exactly when they'll come, but when they do, we'll be ready.

Operator, Operator

Our next question comes from the line of Connor Rattigan with Consumer Edge.

Connor Rattigan, Analyst

Yes. So we heard from other reporters so far this season that the breakfast occasion has remained remarkably resilient in food service channels and away from home with maybe some more weakness in the at home. I guess, have you guys seen any different levels of elasticity like Dave's part or product types across your portfolio? Or maybe within the category at large.

Riyals McMullian, Chairman and CEO

Connor, it was a little tough to hear you, breaking up a little bit, but I think I got the gist of it. But simply put, elasticities have remained below our forecast and below historic levels kind of across all those channels you mentioned.

Connor Rattigan, Analyst

Okay. Got it. Hopefully you can hear me a little bit better now. Also, so on Dave's Killer Bread, so it sounds like things are going great with the bars. I guess just my question is, on the 98,000 stores called out in the prepared remarks, could you maybe help us contextualize that number a little bit? I guess just how much more room is there to run on distribution or maybe a quarter of the way there? And are there maybe any channels lagging behind others that you view as an opportunity?

Riyals McMullian, Chairman and CEO

Yes. The ACV is still relatively low, so we have a lot of potential for growth. There are further opportunities in clubs and we haven't fully explored the convenience channel yet. We started in areas where we have strengths like mass and grocery, which means there's still much more ahead of us. I don't have the exact figure, but I believe the ACV is still in the 30s. I’ll confirm that, but I think it’s close. To give you a comparison, DKB has an ACV around the 75 range.

Operator, Operator

And I'm currently showing no further questions at this time. I'd like to hand the conference back over to Mr. Riyals McMullian, Chairman and Chief Executive Officer for closing remarks.

Riyals McMullian, Chairman and CEO

Okay. Norma, thank you. I just want to thank everybody for taking time today and joining us for questions. We very much appreciate your interest in our company. And as always, we look forward to speaking with you again next quarter. Everybody, take care.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.

Riyals McMullian, Chairman and CEO

Thanks, Norma.

Steve Kinsey, CFO

Thank you.