General Mills Inc Q4 FY2022 Earnings Call

Good morning. This is Jeff Siemon, Vice President of Investor Relations. Thank you for listening to General Mills' prepared remarks for our Fiscal 2023 Second Quarter Earnings. Later this morning we will hold a separate, live question-and-answer session on today's results, which you can hear via webcast on our Investor Relations website. Joining me for this morning's presentation are Jeff Harmening, our Chairman and CEO, and Kofi Bruce, our CFO. Before I hand things over to them, let me first touch on a few items. On our website, you will find our press release that posted this morning, along with a copy of the presentation and transcript of these remarks. Please note that today's remarks will include forward-looking statements that are based on management's current views and assumptions. The second slide in today's presentation lists several factors that could cause our future results to be different than our current estimates. And with that, I will turn it over to Jeff.

Thank you, Jeff, and good morning, everyone. Let me start by summarizing today's key messages. Building on a good start to the year in the first quarter, we delivered strong results in our second quarter, including double-digit growth in organic net sales and adjusted diluted earnings per share. We also achieved a second consecutive quarter of gross margin expansion, which shows continued progress toward restoring our pre-pandemic margin profile. The operating environment remains volatile. While we've seen some modest improvement in recent months, it is still far from pre-pandemic conditions, particularly at our upstream suppliers. In this context, our team continues to execute well, and we remain focused on advancing our Accelerate strategy and fulfilling our fiscal 2023 priorities. Given our strong first-half results and positive momentum in our business, we are raising our full-year guidance for organic net sales, adjusted operating profit, and adjusted diluted EPS growth. Our financial performance for the second quarter and the first half of fiscal '23 shows that we drove 11% organic net sales growth in the quarter, fueled by strong net price realization in response to significant levels of input cost inflation. Adjusted operating profit was up 7%, and adjusted diluted EPS was up 12%, each in constant currency. Our first-half results were also strong, with double-digit growth in organic net sales and adjusted diluted EPS. The operating environment in fiscal 2023 remains challenging and dynamic. On the cost side, we continue to forecast total input cost inflation of approximately 14% to 15% for the full year, with double-digit inflation expected in the second half. Volume elasticities remain below historical levels in the first half, especially in North America Retail. We are monitoring these trends closely, but we do not expect a return to pre-pandemic elasticity levels during fiscal 2023. We have seen some modest improvement in the supply chain environment in recent months, with logistics challenges easing and a slight reduction in the level of upstream supply disruptions. Consequently, our customer service levels reached the high 80% range in U.S. retail by the end of the quarter, an improvement from the mid-80s last quarter, although still below our normal range of 98% to 99%. Despite these improvements, supply disruptions remain significantly above historical averages, and we do not forecast returning to pre-pandemic levels of supply disruptions or customer service during this fiscal year. Finally, we continue to see the pandemic affecting consumers' health and mobility globally, particularly in China during the first half of this year. Overall, while it is encouraging to see some signs of supply chain improvement, we expect the pace of change in the operating environment to remain high for the foreseeable future. Our focus is not to predict the future better than our competition but to adapt to change and deliver winning results regardless of the environment. This approach has been our recipe for success in recent years, and we aim to continue this success in fiscal 2023 and beyond. We are executing our Accelerate strategy this year by focusing on the three priorities outlined in our presentation. We will continue to compete effectively by building our brands, innovating relentlessly, and providing excellent service. We will invest for the future by delivering Strategic Revenue Management to offset inflation, making strategic investments, and progressing against our ESG commitments. Additionally, we will reshape our portfolio by ensuring smooth transitions for our announced transactions and exploring opportunities for growth-enhancing acquisitions or divestitures. I am pleased to say that we are making progress against each of these priorities in the first half. We are competing effectively in fiscal 2023, building on four consecutive years of strong market share performance. We are holding or gaining share in 37% of our priority businesses, although this includes a share decline in Cereal due to comparisons with our unusually strong share gains a year ago when a competitor faced service challenges. On a two-year basis, our market share in Cereal is still up, and after adjustment, we are holding or gaining share in 54% of our priority businesses across various platforms in the U.S. and internationally. Alongside executing for today, we continue to make strategic investments to strengthen our brands and competitive advantages for the future. Our media investment was up double digits in the second quarter, and we anticipate it will grow by double digits for the full year as we launch compelling campaigns leveraging our digital capabilities to reach consumers. Our capability investments will increase again in Fiscal 2023, particularly in Digital and Technology. We have raised our investment in this area by over $100 million in recent years and expect another double-digit growth this year. We also plan to boost our growth capital investments by more than 50% in Fiscal '23 to increase internal manufacturing capacity in key growth areas like pet food and snacks. Another critical aspect of our future investment is our commitment to initiatives aimed at reducing hunger and food insecurity through grants, contributions, and donations. We partner with food banks globally to enhance food security, with notable contributions to organizations like Feeding America, which we helped establish over 40 years ago. Through our support, MealConnect has recovered over 3.5 billion meals since its launch in 2014. Standing for good underpins our Accelerate strategy and represents how we are investing in our company, planet, and communities. Moving on, I would like to highlight businesses where we are continuously competing effectively and investing for the future, particularly North America Retail. Our U.S. cereal business has seen a 20% increase in annual retail sales since fiscal 2018, holding a solid number one position in the category. We are excited about our new developments in fiscal 2023, such as our innovative Mini platform, which offers miniature versions of popular cereal brands. We have also experienced nearly 50% growth in our Pillsbury U.S. Refrigerated Dough business over the past five years, marking five consecutive years of market share gains. We are bringing Pillsbury into more consumers' everyday meals and using data-driven strategies to connect personally with them, such as targeting messages to air fryer users. Our Fruit Snacks platform has similarly seen significant success, with retail sales up nearly 70% since fiscal 2018. After expanding our capacity, we are now optimizing our supply and distribution. We are also focused on the Blue Buffalo pet food business, benefiting from trends toward high-quality, natural feeding. While we encountered unexpected inventory reductions in Q2, we anticipate returning to double-digit net sales growth in Pet with better customer service and innovative product offerings in the upcoming months. In concluding remarks, I’m pleased with our execution of the Accelerate strategy to drive profitable growth while reshaping our portfolio. Now I will turn it over to Kofi to provide more details on our second-quarter results and our increased guidance.

Thanks, Jeff, and hello everyone. Our second-quarter financial results are summarized on Slide 18. Note that there were a handful of events that impacted our year-over-year comparisons this quarter. These included the acquisition of TNT Crust, as well as the divestitures of our European yogurt business, our international dough businesses, and the Helper and Suddenly Salad businesses in North America. We also had an impact from the international Haagen-Dazs ice cream recall that we announced last quarter. We do not expect any further material impact from the recall in the remainder of the year. Now let's move on to our Q2 results. Reported net sales of $5.2 billion were up 4%, and organic net sales grew 11% in the quarter, reflecting continued positive price/mix in response to significant input cost inflation, partially offset by lower volume. Adjusted operating profit of $880 million was up 7% in constant currency, with benefits from positive price/mix partially offset by higher input costs, lower volume, and higher SG&A expenses, including a double-digit increase in media investment. Adjusted diluted earnings per share totaled $1.10 in the quarter and were up 12% in constant currency. Slide 19 summarizes the components of our net sales growth in the quarter. Organic net sales were up 11%, reflecting 17 points of positive organic price/mix, partially offset by a 6% decline in organic pound volume. Foreign exchange reduced net sales by one point, and the net impact of acquisitions and divestitures was a five-point headwind to second-quarter net sales. Now let's turn to our segment results, beginning with North America Retail on Slide 20. NAR continues to perform exceptionally well, with our brands delivering for consumers and the business executing successfully amid ongoing volatility in the operating environment. Organic net sales grew 13% in the quarter, driven by positive price/mix, partially offset by lower volume. Despite elevated levels of inflation-driven pricing, elasticities continue to remain below historical benchmarks. Growth in NAR this quarter was broad-based, with double-digit net sales growth in U.S. Snacks, U.S. Meals and Baking Solutions, and U.S. Morning Foods, and mid-single-digit net sales growth in Canada in constant currency. We continue to compete effectively, with 67% of our North America Retail priority businesses holding or growing share so far this fiscal year when adjusting for Cereal on a two-year basis. Second-quarter constant-currency segment operating profit increased 24%, driven by positive price/mix and HMM cost savings, partially offset by high input cost inflation, lower volume, and higher SG&A expenses. Slide 21 summarizes our Pet segment results. As Jeff mentioned, Pet net sales in Q2 were negatively impacted by a reduction in retailer inventory. All-channel retail sales were up high-single digits in the quarter. We expect Pet net sales growth to accelerate in the second half behind increased capacity, improved customer service, strong innovation and renovation news, and increased brand-building investment. Additionally, we expect retailer inventory levels to remain stable in the back half of the year. On the bottom line, second-quarter segment operating profit totaled $87 million compared to $132 million a year ago, driven primarily by high-teens input cost inflation, a significant increase in costs related to capacity expansion and supply chain disruptions, and lower volume, including the impact of the retailer inventory reduction. These headwinds were partially offset by positive price/mix. We expect to deliver profit growth on Pet in the back half with stronger volume performance, less headwind from capacity and supply disruption costs, and better alignment between price/mix and inflation.

Moving on to our North America Foodservice segment results on Slide 22, organic net sales grew 17% in the quarter. As we expected, this quarter's performance included a greater price/mix benefit on our non-flour business compared to Q1, and less benefit from market index pricing on bakery flour, which is dollar profit neutral. Segment operating profit for the quarter was up 20%, driven by positive price/mix, partially offset by higher input costs and higher SG&A expenses. Second-quarter International segment results are summarized on Slide 23. Organic net sales were up 5% this quarter, driven by good growth in Brazil, our Distributor markets, and Europe & Australia, partially offset by a decline in China due to continued consumer mobility restrictions stemming from the government's COVID policy as well as the impact of the international ice cream recall. Second-quarter segment operating profit totaled $18 million compared to $59 million a year ago, driven by higher input costs and lower volume, including the impact of divestitures and the ice cream recall, partially offset by positive price/mix and lower SG&A expenses. With comparisons against the Yogurt divestiture and the Ice Cream recall now behind us, we expect to generate profit growth in International in the back half of fiscal 23.

Slide 24 summarizes our joint venture results in the second quarter. Cereal Partners Worldwide net sales were up 2% in constant currency, driven by favorable price/mix, partially offset by lower volume. Haagen-Dazs Japan net sales were down 10% in constant currency as the business lapped strong new product performance last year. Second-quarter combined after-tax earnings from joint ventures totaled $25 million compared to $33 million a year ago, primarily driven by unfavorable foreign currency exchange as well as lower constant-currency profit at Haagen-Dazs Japan, partially offset by favorable CPW price/mix. Turning to total company margin results on Slide 25, our second-quarter adjusted gross margin increased 100 basis points versus last year to 33.2%, driven by positive price/mix and HMM cost savings, partially offset by mid-teens input cost inflation, higher other cost of goods sold, and supply chain deleverage. While this is our second quarter of gross margin improvement, our adjusted gross margin is still below pre-pandemic levels, and we have more work to do to restore our historical margin profile. Adjusted operating profit margin increased 60 basis points in the quarter to 16.9%, driven by higher adjusted gross margin, partially offset by higher SG&A expenses. Slide 26 summarizes other noteworthy Q2 income statement items. Adjusted unallocated corporate expenses increased $30 million in the quarter, primarily reflecting increased capability investments this year and certain discrete favorable items a year ago. Net interest expense decreased $1 million, driven by lower average long-term debt balances, partially offset by higher rates. The adjusted effective tax rate for the quarter was 21.1% compared to 22.3% a year ago, driven by certain discrete tax benefits this year. And average diluted shares outstanding in the quarter were down 2% to 602 million, reflecting our net share repurchase activity. Our first-half fiscal 23 results are summarized on Slide 27. Net sales of $9.9 billion were up 4%, including a five-point headwind from net divestiture and acquisition activity and one point of unfavorable foreign currency exchange. Organic net sales increased 11%, driven by positive organic price/mix, partially offset by lower organic pound volume. Year-to-date adjusted operating profit of $1.8 billion increased 8% in constant currency. And adjusted diluted earnings per share of $2.21 were up 13% in constant currency. Turning to the balance sheet and cash flow on Slide 28. While we drove strong growth in adjusted net earnings in the first half, our operating cash flow was down from $1.5 billion a year ago to $1.2 billion in the first half of fiscal '23, driven primarily by an increase in inventory and higher cash tax payments. Year-to-date capital investments in the quarter totaled $227 million. We remain on track for capital investment to total roughly 4% of net sales for the full year. And we returned $1.4 billion in cash to shareholders in the first six months of the year through dividends and net share repurchases. On Slide 29, you can see our increased guidance for fiscal 2023. We now expect organic net sales to increase 8% to 9%, reflecting better volume performance and improved price/mix relative to our prior outlook. We continue to expect elasticities will remain below historical levels over the remainder of this fiscal year. We now expect adjusted operating profit to increase 3% to 5% in constant currency, reflecting stronger top-line performance. We continue to expect total input cost inflation of 14% to 15% of total cost of goods sold, as well as HMM cost savings of 3% to 4% of COGS, moderately lower supply chain disruptions versus last year, and increased investment in brand building and other growth-driving activities. Constant-currency adjusted diluted earnings per share are now expected to increase 4% to 6%. This updated outlook reflects stronger profit growth and higher net interest expense, which is now expected to total more than $400 million for the full year, reflecting rising interest rates. Our guidance for both adjusted operating profit and adjusted diluted EPS both include a three-point net headwind from divestitures and acquisitions and an estimated one-point headwind from the ice cream recall. Finally, we continue to expect free cash flow conversion will be at least 90% of adjusted after-tax earnings. Let me now turn it back to Jeff for some closing remarks.

Thanks, Kofi. Let me close with a few thoughts. I continue to be pleased with how we're executing our Accelerate strategy and driving profitable growth, including delivering strong results again in Q2. We're competing effectively, building on four consecutive years of positive market share performance, and we continue to invest for the future. While we have work to do to overcome some short-term headwinds in Pet and International, we've taken actions to drive stronger results in those segments in the second half of this year. I'm also pleased that we are once again raising our guidance for the full year, building on our strong first-half results and compelling plans for the back half. Thank you for your time this morning. This concludes our prepared remarks. I invite you to listen to our live question-and-answer webcast, which will begin at 8:00 a.m. Central time this morning and will be available for replay on our Investor Relations page at GeneralMills.com.

Greetings, and welcome to the General Mills second quarter fiscal 2023 earnings Q&A webcast. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. As a reminder, this conference is being recorded on Tuesday, December 20, 2022. I would now like to turn the conference over to Jeff Siemon, Vice President of Investor Relations. Please go ahead.

Thank you, Kelly, and good morning, everyone. Thanks for joining us today for the Q&A session on our Q2 fiscal '23 results. I hope you all had the time to review the press release, listen to our prepared remarks and view the presentation materials, which are made available this morning on our IR website. Please do note that in our Q&A session, we may make forward-looking statements that are based on our current views and assumptions. Please refer to this morning's press release for factors that could impact forward-looking statements and for reconciliations of non-GAAP information, which will be discussed on today's call. I'm here with Jeff Harmening, our Chairman and CEO; Kofi Bruce, our CFO; and Jon Nudi, Group President of our North America Retail segment. Let's get to the first question, Kelly. So please get us started. Thanks.

I think just to kick it off, I guess, I appreciate that capacity constraints can often lead to a gap between shipments and retail takeaway, but obviously, the differential in Pet was far greater than anticipated. So, I'm trying to get a sense of why would retailers pull back on orders when capacity is constrained and demand remains so strong and does this pose any risk ultimately to the demand side of the equation? And then I've just got a quick follow-up.

Yes, sure, Andrew. Thanks for the question. In the second quarter, much of what happened was anticipated, including retail sales and our capacity constraints. Looking ahead, we expect double-digit growth for the second half of the year starting in Q3, driven by strong innovation, increased capacity, and solid advertising and marketing support. One unexpected factor was the reduction in retail inventory that you mentioned. However, we don’t believe this is a long-term trend but rather a short-term occurrence. The primary reason for this is that retailers have generally been holding less inventory lately due to inflation concerns, as carrying excessive working capital is undesirable. However, this doesn’t fully explain the eight-point differential. Additionally, the capacity issues meant that in several categories, like treats, we could not merchandise as much as usual during this season. Typically, retailers increase inventory in anticipation of merchandising efforts, which further impacted our treats business. Lastly, some large retail customers, particularly those with a mass merchandising focus, did not stock up as they were filled with other items, which differs from our North America retail business. We have thoroughly analyzed inventory levels by customer and believe that this situation will not repeat in the third quarter. This is why we feel confident in projecting double-digit sales growth again.

And then, I think you were looking for flattish gross margins or so for the full year, if we were thinking about last quarter's conference call, obviously, with the upside to gross margins in this quarter despite the pet constraints on profitability. Could we see gross margins likely up year-over-year for the full year at this stage?

Sure. Andrew, it is Kofi. Thanks for the question. Certainly, as we look at our revised guidance, that's within the range of possibilities. And while we're not giving specific guidance on gross margin, we're very comfortable we're making good progress against our long-term goal of getting our margin back to pre-pandemic levels. We're still about 150 basis points back of there. So, we're going to continue to drive at the things that will help us improve the margin profile as we go forward.

I wanted to just ask, you seem confident understandably why, why the de-load won't happen again, and thank you for the clear explanation, Jeff, on what the drivers were. I'm just curious, as you progress into your third quarter, it might be a little early to ask because we're still not at Christmas. But are you seeing any refilling of inventory levels by retailers, if you addressed this already, forgive me, but just trying to get a sense of sort of more real-time data as to what's going on?

Yes. I think there are a couple of points, Ken. We are early in the quarter, but there are a few things that give us confidence in our forecast for the third quarter. First, I want to highlight the Life Protection Formula, which is our largest dry business. Over the past six weeks, we've seen a significant rebound in demand, which is important because this is the first business we can restore to appropriate service levels, giving us added confidence. Additionally, I mentioned we expect double-digit growth in the third quarter, and although we are only about three weeks into December, I can assure you that we are on track to meet our goals for the quarter. This further reinforces our confidence in our plans, and we have observed the inventory pipeline starting to refill, particularly in the treats category.

And Ken, I'd add just to put some numbers on it, this is Jeff Siemon. For Life Protection Formula, the movement in Nielsen measured channels in the last month is up almost 20% and volume has been positive and accelerating recently now that we've gotten service back in the 90s. So just to put some dimensions on it, it's been encouraging to see that business grow basically in line with or even ahead of where the category is growing overall.

And then a quick follow-up. Just how do we think about the impact of adding more production from co-manufacturers and maybe re-stepping on the marketing pedal, for your pet food business in the third and fourth quarters, obviously, hopefully, there will be a better volume turnaround, and that will help as well. I'm just trying to get a general sense of, I guess, how to model those margins given all the puts and takes.

So let me start and then Kofi can give you some more thoughts on the margin. I would say how to think about the whole basket. I would say, clearly, we anticipate our reported net sales to improve to double digits in the second half of the year behind all of the activity we talked about. Given that we've gone externally both in treats and more importantly, in dry dog food to get capacity sooner, that obviously helps our service levels, external capacity doesn't tend to be as profitable. So I wouldn't anticipate our gross margins to rise as proportionately as our sales would rise. But the benefit is that we're getting back, and we're satisfying pet parents sooner. The other thing I would say is that to the extent that we increase advertising in the third quarter, and I think we have some really nice advertising, we're going to increase that double digits in the third quarter. I wouldn't expect our operating profit margin to rise as fast as it should get better, a lot better, but it probably won't rise as fast as the sales growth in the near term, but that's a choice that we're making. And our choice is to get back to growth first and making sure we can get that flywheel going again. So Kofi, you want to add any color to that?

Yes. And that said, we do expect profit growth on our pet business in the back half of fiscal '23. Some of the key things you'll see is we'll expect price/mix to catch up with inflation. We've got another effectively round of pricing coming through at the beginning of calendar year '23. We don't expect the pressure on supply chain to be as acute. So we won't see as much sort of drag from other cost of goods sold. And of course, we're not expecting the inventory depletion and the pressure that and deleverage that comes with that headwind. So as a result, we would expect our second half top line growth should give us still a solid profit growth even if it's slightly behind the top line growth.

Thank you for your question, and happy holidays. You mentioned another round of pricing expected to take effect in calendar year '23, and there is speculation that the pet food industry in the U.S. might become more competitive due to possible supply and demand imbalances. Can you share any insights on what you are observing regarding this situation?

Yes, thanks for the question. First of all, I would say that this category is always competitive with many strong players. The essence of your question seems to relate to price competition. We continue to observe growth at the premium end of the category. Blue Buffalo's life protection formula is expected to accelerate once supply is restored, and overall, the premium segment is performing well. This category tends to be fairly inelastic, as pet owners are very particular about what they feed their pets. I don't foresee the pricing becoming more competitive in the short term, given the nature of the category and the ongoing inflation we're experiencing. For our company, inflation in the latter half of the year will rise by double digits, and we are still recovering our service levels. The supply chain is not currently in a state of overcapacity and still needs to catch up. So, taking into account inflation, consumer behaviors, and supply chain conditions, I don't expect pricing competition to intensify in the near future.

Great. And one follow-up. So you mentioned that you expect the price elasticities to remain below historical levels during the remainder of FY '23 and also that there are particularly benign in North America retail. I'm wondering what you're seeing on this front in your international businesses, particularly European Cereal as we've heard some commentary of a return to normal levels of elasticities in those markets from other industry participants.

Yes. In general, the economic situation in Europe is more challenging than in the U.S., driven particularly by higher energy prices and unemployment rates. Additionally, elasticities in Europe are typically higher than in the U.S., and we are observing that trend in the current environment. This applies to various categories, whether it's cereal, bars, or ice cream. Overall, the situation in Europe is a bit more complicated than here, influenced by the macroeconomic context and generally higher elasticities. However, we are seeing similar trends in both regions.

You mentioned some new pricing actions in pet. Do you expect to take more pricing actions in North America retail as well? The public comments from the grocers sound increasingly concerned about higher pricing and the impact on their consumers. So, I wanted to know if there's any blowback on that. And then also, in the past, there's been unusual de-loading in January by some retailers to protect balance sheets. I think you mentioned it here today. Do you see any risk of that happening as well?

So Rob, regarding pricing, we've implemented some changes for the pet segment and notified our retail customers about these changes, which will take effect around February 1. Earlier this fiscal year, we indicated that we've already taken most of the necessary pricing adjustments for the market, and that remains accurate. Looking ahead to the second half of the year, we anticipate double-digit inflation. While it may slow down from current levels, it will still be significant. Even beyond the next six months, we expect to see an inflationary environment, influenced largely by wage increases. Therefore, it's difficult to envision a scenario without inflation, even if the levels may not mirror what we've experienced recently. We'll continue assessing our pricing strategies, focusing on ensuring that any price adjustments are justified based on the costs we are encountering. We've found that if we can explain these costs to our retail partners and show them that we are investing in category growth—backed by significant increases in consumer spending and innovations like minis, cereal, Pillsbury, and Blue Buffalo—the discussions become more productive. To address the concerns about retail inventories, we've noticed a slight decrease in inventory levels due to the inflationary climate. However, I don't view this as a risk for either Blue Buffalo or our broader business strategy moving forward. Jon Nudi, do you have anything to add?

No, I think you hit it. I would just say that our SRM capability is something I'd point to is much more sophisticated than it was a few years ago. So as inflation continues to come, we'll leverage the entire toolbox. So it's not just list pricing, it's promotional optimization and mix and pack price architecture. And by leveraging all those tools, we believe that we'll be able to combat inflation as we move forward as well. And in terms of retailers, as Jeff mentioned, I mean, is pricing has never been easy. And even over the last couple of years that we've seen significant inflation. But if we can bring in a strong market basket story, we have had success moving pricing through the market.

Can I ask a follow-up? In the past, have you been able to go to retailers and show labor inflation internally and use that as a rationale for raising price. It seems like that's something new.

Yes, Rob, I think the scale of the inflation is different today, right? So we're seeing a double-digit inflation. And historically, over the last decade or so, we haven't seen a lot of inflation has been low single digits. So it really hasn't been a conversation because there really hasn't been enough inflation to take significant action. I think with the scale of the inflation we're seeing today and the sophistication, as I mentioned as well, we're able to really break down where we're seeing inflation and some things are starting to moderate. But at the same time, you're seeing things like labor, certainly, sprout remains sticky, and it's in the equation. And we've gotten more sophisticated but our retailers have as well. So again, I think we have really good constructive conversations that are really based on facts at this point.

Rob, or where we see that impacting us is not so much our own labor, but it's the labor at our suppliers, which translates through their pricing to us. So yes, there's labor inflation in our own facilities, et cetera, but the much bigger aspect of labor is upstream at the supplier base.

I wanted to revisit the topic of elasticities and gain a clearer understanding. You mentioned that you don't expect a return to more normal levels during the second half of the year. Is that primarily because half the year has already passed? Or are there other structural factors influencing that expectation? Additionally, how would you define a more normal level?

What influences our expectation, Michael, is that we continue to see conditions for relative inelasticity in the marketplace, though not complete inelasticity. This is largely due to ongoing inflation, which, even if not as high as in the first half, remains in double digits. Additionally, we are still facing supply chain disruptions. Our service levels are in the high 80s, which is an improvement from the 70s last year, but still not at the desired 98%. Furthermore, consumers are likely to feel increased pressure in the coming months, which may lead them to opt for eating at home rather than dining out. As a result, we expect to see a continued shift towards food consumption at home. These are the factors influencing our view that there won't be a significant change in elasticities over the next six months. However, these are simply our assumptions based on current observations.

Okay, that's helpful. I know China is relatively small, but I would appreciate an update on what you're observing there. In the second quarter, there were certainly challenges related to food service due to lockdown restrictions. How is the situation evolving in China, and what insights can you share on that?

Well, there's been a fairly significant policy change by the Chinese government on COVID and zero COVID. And it's going to be a ride, I think, for the next few months because we've had a population that's gone from relatively no COVID to quite a bit of COVID in the marketplace. And so that now people don't lock down as much. But I think when you have as much COVID as they have, we'll see not as many people venturing out, which is very good for our Wanchai Ferry dumpling business, which is half of our business, and not as good for our Haagen-Dazs business. And so, I want to think about that business over the next few months, I think it's going to be a wild ride. But I would think that our dumpling business will do quite well. And our Haagen-Dazs business will maybe be a little bit more challenging over the next few months, but they're about equal in size.

Since they changed their policy, they have stopped providing updates on case counts. So, is it quite chaotic there? I guess we should expect a few months of uncertainty, but it seems like you are positioned well for this situation.

I wanted to come back to the Pet segment. And just to revisit what gives you confidence that you can return to double-digit growth in pet in the second half of the year? And can you decompose how you're thinking about the drivers of that growth? I mean, can you grow volumes with the capacity that you've secured? Or do you expect volumes to continue to decline with the growth driven predominantly by the pricing?

Pam, I have confidence due to several factors. The first is the restoration of our supply chain and capacity, which is crucial for our treats segment, as well as for dry dog and cat food. I would start with treats and then cover dry dog and cat food. We have gained enough capacity to grow volumes in the second half of the year for both areas. The second aspect is the need for solid marketing support. I'm optimistic about our innovation and the work we’re doing with the Wilderness brand, along with the enhancements to Tastefuls and our cat dry food. I'm also confident about our collaborations with retail partners to restart our treats business effectively. We've improved many products we acquired from Tyson, rebranding them to Blue Buffalo, which has strengthened our brand. We have strong programs with our retail customers, boosting my confidence in our treats business. Additionally, we plan to ramp up our brand building significantly. We have already observed a return to volume growth in our Life Protection Formula, despite lacking innovation or increased advertising there; this success came purely from supply enhancements. I believe that the combination of supply management, robust innovation, effective in-store execution on treats, and sound advertising will help us quickly turn around the Blue Buffalo business. Even though our second quarter did not meet our expectations, the brand remains strong, as confirmed by extensive brand testing. The trends towards humanization in pet products are favorable, indicating strong tailwinds in the category, supported by a solid brand and improved supply and marketing efforts.

That's helpful. And you pointed to a lot of innovation that's coming within the Pet segment. Is there anything in particular that prompted your plans to step up innovation or were these initiatives already in the works? And how should we think about the margin impact of the innovation? You mentioned you're adding more meat to Wilderness. How are you planning to offset these costs? And what is the margin profile versus the existing portfolio?

I would say that we have been ready to introduce innovation to the market for some time. However, we have not been able to supply our base business adequately, so adding innovation without addressing that issue might not be wise. I believe it's a positive sign for investors that we are confident in our ability to supply our business better as we bring this innovation to the market. We would not proceed with this if we didn’t believe we could manage it effectively. Regarding product renovations, Wilderness operates as a high-priced, high-margin business. Since pet owners are requesting more meat in the product, we are responding to that demand, which should greatly benefit our margin profile. The key to enhancing our margins in the pet segment is to increase volume. Therefore, with the right supply and the introduction of a high-priced, high-margin brand, we expect to see positive results for our pet business margins.

Good morning. I want to start first, if I could, with a question on the gross margin, perhaps for Kofi, but just to understand, the sequential change in the gross margin from 1Q. And again, your gross margin was up nicely year-over-year, and that's been quite unique in the industry. I just want to get a sense of any factors that are worth considering that occurred sequentially. And obviously, the one that stands out, I think, would be around Pet. Was that one of the sequential drivers of the softer gross margin absolute performance or any other factors that are worth noting there, if you could, please?

Sure, Chris. You have the plot. Certainly, Pet is a contributing factor, but there are also some other structural things around the mix of our business as we move from Q1 to Q2. We have a lot more volume from businesses such as soup and baking products, which is, as you know, are heavily merchandised in that seasonal window, so those tend to drive us to a structural step-down in margin as we move from Q1 to Q2. And the other factor, as you rightfully noted, was the acute pressure on Pet margins in this quarter.

Okay. And I just had one more follow-up on the Pet profit. And you had indicated that the second quarter would be a little softer. You had some costs related to getting third parties and co-manufacturing ready, some inventory and warehousing costs. I guess I just want to get a sense of this second quarter Pet profit performance was unique. You plan on some of that occurring. So are a lot of those costs then sort of embedded in the business? Do you have any ongoing costs related to the co-manufacturing outside just that's a lower margin way to supply your business?

Sure. So I would expect some of those costs to be structural for sure as we go forward. We'll have external supply chain costs related to the step-up in volume that we're getting. But not all of those costs will carry forward. Some of these costs were related to disruption and enrollment of additional warehousing capacity in that window. So we would expect in aggregate that the drag from those costs will reduce as we step into Q3 and Q4 for this year, which is part of the reason why we also expect profit growth and profit margin improvement as we step into those quarters.

Just another angle on that gross margin question. If we look at this quarter, your gross margin is still down maybe 80 or 100 basis points from pre-COVID levels, with many factors at play. I'm curious about how you perceive that gap and your potential to return to pre-COVID gross margin levels. You mentioned the supply chain friction costs, but there might be some categories where you'll need to adjust pricing to maintain profit dollars. This presents some challenges. I'm also wondering if you anticipate seeing some relief in key commodities in specific categories. Additionally, you've experienced strong growth in some of your highest margin categories, so it seems plausible that you could exceed previous peaks as you move past these friction costs. Any insights on this would be appreciated.

I'll do my best to address your question. Looking ahead, one of the key factors will be a return to a more stable environment with supply chain disruptions closer to historical levels. Currently, disruptions are about twice our typical levels, down from the peak of six to seven times last year, but still significant. Once we move past the short supply situation, utilizing our higher margin methods will be more achievable, and we expect some pandemic-related costs to decrease as we stabilize. Ultimately, our goal is to recover around 150 basis points of margin compared to our levels before the pandemic. A stable supply chain will be crucial in this effort, along with a return to more typical inflation rates, although the timing of that is uncertain. We are actively positioning our business to reduce costs whenever possible. And just a separate follow-up. You talked about investments in your prepared remarks in digital and other capabilities. Could you just give us a sense about what you think the benefits will be from those investments and when and where we'll see that? Sure. So a lot of the focus of our investments in digital and technology to enable our marketing activity and as well our supply chain efficiency. So, we'll see benefits both in gross margins, and we would expect to see that deliver on growth. And then, I'll ask Jon if he wants to weigh in since we're seeing a lot of investment in our North America retail business.

Yes, absolutely. As Kofi mentioned, the supply chain is a major focus, presenting significant opportunities for efficiency. On the marketing side, we refer to it as connected commerce. The top of our funnel generates demand, and increasingly, our marketing is shifting towards digital, particularly performance-based marketing. We have made substantial investments in acquiring first-party data to strengthen our marketing engagement platform, which allows us to deliver relevant messaging at scale and customize it for our consumers, yielding impressive returns. Further down the funnel, we view transactions similarly whether they occur in-store or online, as the margins remain consistent. However, we have a stronger online market share. We have developed several digital tools to better understand the digital shelf. Our background is in a brick-and-mortar environment where we relied on Nielsen data to drive our business. However, digital operates differently, so we created dashboards for our team to analyze key metrics, ensure the digital shelf is accurate, and monitor search metrics. Much of this information is now digitized and available to our leaders daily in dashboard format, enabling them to make real-time adjustments. As a result, we are witnessing robust market performance today, and our capabilities will continue to evolve as we invest further in this area.

Can you just clarify or quantify how much the retailer inventory reduction was in Pet this quarter? And then also, I apologize if I missed it, which channels or retailers was the inventory reduction in?

I'll answer the first part of that question for you. As for the second part, I'll politely pass. Regarding the first part, our retail sales were up about 8% during the quarter, while our reported net sales remained flat. The difference of 8 percentage points was due to a reduction in retailer inventory for various reasons I've already mentioned. I won't go into a detailed analysis of inventory changes by customer or retailer.

Okay. I think that's all the time we have for this morning. So Kelly, I think we can go ahead and wrap up. Thanks, everyone, for the time and the good questions, and happy holidays to everyone.

Thank you. That does conclude the conference call for today. We thank you for your participation, and we ask that you please disconnect your lines.