Earnings Call Transcript - HNST Q3 2022

Steve Austenfeld, Vice President, Investor Relations

Good morning, everyone. Thank you for joining our third quarter 2022 conference call. Joining me today are Nick Vlahos, Chief Executive Officer; and Kelly Kennedy, our Chief Financial Officer. Before we start, I’d like to remind you that we will be making certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook of our business and other matters referenced in our earnings release issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our earnings release issued today as well as our SEC filings for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events, except as required by law. Also, during this call, we will discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in the financial results section of today’s earnings release. A live broadcast of this call is also available in the Investor Relations section of our website at investors.honest.com. With that, I’ll turn the call over to Nick.

Nick Vlahos, CEO

Thanks, Steve. Good morning, everyone, and thanks for joining us today. As noted in today’s earnings release, we delivered revenue of $85 million, the largest single quarter in our 10-year history. This strong performance reflected our focus on three strategic growth priorities: marketing, innovation, and distribution expansion. Highlights in the quarter included our performance in retail where Honest growth in tracked channels continues to outpace the category, significant distribution expansion that will continue into the fourth quarter, and the broadening of the Honest lifestyle brand through the integration of our rapidly growing baby clothing business. That said, we recognize the headwinds in the marketplace, inflationary pressures across the supply chain remain an issue. Customer acquisition costs remain elevated, the digital channel remains challenged, and retailers are increasingly focused on managing their working capital by reducing weeks of supply. Despite these challenges and an uncertain macroeconomic environment, we continue to see a resilient consumer in our categories. Consumers are as value-conscious as ever, so we’re meeting their needs through tailored product offerings, pack sizes, and promotions. Because Honest is a lifestyle brand that spans categories, consumers will be able to create value-oriented bundled solutions across diapers, wipes, personal care, beauty, household products, and now our curated collection of baby clothing. Based on consumption trends in the quarter, it’s clear that the Honest brand continues to resonate with a clean conscious consumer. Looking at 12-week tracked channel data ending October 2, Honest is gaining market share as our growth equals or outpaces the category where we compete. Our unit velocities remain healthy following first half pricing actions as both volume and pricing are fueling our top line growth. This indicates the brand has pricing power even in this challenging economic environment. The overall category growth in tracked channels for diapers and wipes was 3%, coming almost exclusively from pricing. Honest diapers and wipes grew 6%, balanced between volume and pricing. In Baby Personal Care, the category declined 3%, while Honest grew 7%. And in Beauty, the category grew 9% and Honest grew 15% when including specialty retailers. As we execute against our key growth strategies, I wanted to provide an update on progress to date. Starting with marketing, which is the lever we pull to drive brand awareness, trial, and share of wallet. We continue to invest at a high level in our brand with marketing spend at 14% of sales in the third quarter. Recognizing the elevated cost of digital marketing as well as consumers' shift to in-store shopping, we continue to optimize our marketing investment, finding higher return opportunities in areas like retail marketing, where we can cost-effectively reach our consumers and support new distribution. In Q3, there were several marketing examples across our skin care business. We have national marketing and merchandising campaigns with Ulta to support our launch into over 600 stores. Additionally, we amplified the moment with a full exclusive launch of our new clearing collection, focused on acne, with a 360-degree marketing campaign partnering with 25 TikTok Gen Z creators and influencers while leveraging our influencer community as well. Overall, this full funnel campaign garnered over 30 million impressions and increased the share of our Gen Z consumer base by over 20% versus the prior year. We also launched our Extreme Volume Mascara, supported by a robust omnichannel marketing campaign, featuring our Founder and Mega influencer, Jessica Alba, and several other influencers generating over 40 million impressions. Turning to innovation, we’re pleased with the momentum behind our 2022 product launches. We continue to innovate our beauty portfolio by expanding our Extreme Length Mascara line, which ranks as the #1 clean mascara on Amazon by launching Extreme Volume Mascara on honest.com and with key retail partners. Initial demand has been strong, becoming one of our top five beauty items at Target and a top new release tag at Amazon based on its revenue and ratings performance. We also launched our new acne skin clearing line exclusively at Ulta and honest.com in a line of wellness supplements at GNC. Our Honest Beauty Fresh Flex Concealer earned a 2022 Allure Best of Beauty Award in the clean category, which is the ninth award Best of Beauty award win for the Honest brand. These are examples of our continued focus on Hero products within our three-year strategic product plan. In the fourth quarter, we look forward to our holiday gifting initiatives and the relaunch of our training pants to further drive revenue growth. On the distribution side, we’re now executing our launch into over 2,500 Walmart stores, following our launch into over 600 Ulta stores, over 1,400 GNC stores in all public locations. We are also expanding our partnership with Nordstrom, with the launch of skin and cosmetics into Nordstrom Rack chain-wide. The expansion into Walmart is expected to be highly incremental as over one-third of the locations will be where Honest will be introduced, particularly in the South and Southeast, where Honest has traditionally been underrepresented, in a part of the country that represents approximately 40% of U.S. suburbs. In store, you’ll find endcaps featuring 15 Honest items, including diapers, wipes, and personal care, featuring an exclusive new sweet cream scent. Although still early, we’re pleased with the incrementality of the business and look forward to acquiring new consumers and driving household penetration through this launch. In summary, we feel confident that continued focus on our key growth initiatives in marketing, innovation, and distribution will drive growth for the remainder of the year and into 2023. As we close out the year and look forward to 2023, we are closely watching a few areas. First, inflationary pressures remain high, particularly across the supply chain, digital advertising rates, and wages. In response, we focused on executing cost savings with continued pricing to offset some of the pressures, including increases in January and June across roughly two-thirds of the portfolio. Our elasticities have held as expected or better, and we continue to see volume growth across all categories. As we mentioned in our last call, we will be taking another round of pricing in mid-December that will impact roughly one-quarter of the company’s revenue. Second, our digital business remains soft as consumers have shifted back to purchasing in-store, and digital advertising costs remain elevated, impacting traffic and revenue online. Additionally, we see retailers managing their working capital and inventory amidst economic uncertainty, impacting shipments and creating volatility despite strong consumption trends. As we focus on delivering our Q4 targets, the Honest brand remains strong, and the benefit of our omnichannel strategy allows us to meet consumer demand regardless of where consumers want to shop. We have conviction behind our strategy as we continue to build the next modern CPG lifestyle brand and inspire consumers to love living consciously. Now I will turn it over to our CFO, Kelly Kennedy.

Kelly Kennedy, CFO

Thank you, Nick, and welcome, everyone. I’ll start by highlighting our top line performance in the quarter, where revenue was up 2% versus a year ago on top of our highest single revenue quarter last year, slightly ahead of our expectations. Revenue was up 10%, excluding the impact of a prior year rotational club channel program that didn’t repeat this year. While we remain cautious as inflation continues to weigh on costs and impact our margins, we are taking action to mitigate higher input costs, including pricing actions, cost savings initiatives, and a focus on margin-enhancing innovation. Starting with the key driver by product category. First, Diapers & Wipes. Our diapers and life business represented 65% of revenue this quarter and was up 3%, following 9% growth in the second quarter. Growth was balanced with positive trends in both volume and pricing and positive year-over-year trends across all of our key retail customers. This quarter, we also shipped initial orders to support the rollout into Walmart retail stores. In the Diapers & Wipes, we are seeing acceleration, particularly in larger-sized offerings, which provide the best value to a consumer on a per-unit cost basis. I also wanted to highlight the momentum in our baby wipe, which grew at more than double the rate of the overall category, driven by alternate uses of wipes beyond diapers. In Q3, we relaunched our training camp, which completes our clean conscious cipher portfolio. During the quarter, we leveraged a multi-tier strategy of marketing, packaging improvement, expanded shelf placement, and stronger price positioning as we increased our assortment from 450 to 1,500 Target stores. Skin and Personal Care represented our Health & Wellness business saw a big step-up in revenue versus recent trends, increasing 115% and representing nearly 10% of revenue. Growth in the quarter was driven by our baby clothing business, which converted from a royalty arrangement into a conventional supply arrangement in the third quarter, which allows us to recognize the full revenue and associated costs. This new arrangement was almost a year in the making, as we recognized the growth potential of this business and ability to cross-merchandise and leverage our existing consumers and customers. We expect to scale on a state clothing within our retail footprint in 2023 and, over time, benefit from scale and operational efficiency. A great example of the growing demand for our Honest pajamas made for family and baby made from organic cotton is the recent feature for the second year in a row as one of Oprah’s favorite things for the 2022 holidays. Combined with new gifting collections launching in Q4 and the sanitizing business, which has stabilized, we expect to build household and wellness revenue back to expected levels over time. Now, turning to results by channel. Revenue in Q3 was split roughly 60% retail and 40% digital. This quarter, our business skewed more heavily towards the retail channel as we ship new distribution and continue to face softness in the digital channel. Digital channel revenue declined 14%, driven by an inventory adjustment at a key digital customer and a reduced digital marketing spend in the face of elevated advertising costs. As we’ve noted in the past, order patterns from retailers can vary, often driven by algorithms either outpacing or trailing consumer demand. In this case, consumption of this online retailer remains strong, up 20% in the quarter, while revenue was down over 20%. As more and more retailers are focusing on working capital, we expect further impacts from inventory reduction in Q4 despite solid underlying consumption trends. Over the coming months, we will be working closely with retailers to ensure they maintain adequate supply to meet consumer demand. As highlighted on previous calls, we have strategically shifted our marketing spend to invest in higher-return programs such as shopper marketing, which is reflected in our double-digit retailer growth in the quarter. Despite near-term challenges for our digital business, we continue to believe it will drive meaningful growth in the future and are investing to support the honest.com experience. During the year, we invested in site speed improvements, a modernized site layout, and dynamic content tailored to consumer brand interest. These investments are delivering as we meaningfully improve the quality of our subscriber base this quarter and achieved a click-through rate that exceeds industry benchmarks. We look forward to sharing further developments with you in 2023, including the rollout of the new rewards program. Turning now to retail, where revenue increased 17%, including double-digit growth at our five largest customers in the retail channel. Highlights included a 16% increase at Target supported by our 83rd consecutive week of year-over-year point-of-sale growth, our participation in the 30th exclusive seasonal diaper program, and an 8-foot natural shelf rack as part of the new baby planogram. The rollout of our hero skin care products in the acne line in over 600 Ulta stores, with 10 skin care items in-store and a broader assortment online, including cosmetics, with velocity to date exceeding expectations. 50% year-over-year growth at Kroger since launching Clubbox Diapers earlier in the year, which has led to Honest being the #1 clean and natural brand in their stores. And our launch in public, a leading grocery chain in the Southeast where our personal care items are already achieving top velocities in the category. Retail growth was also driven by the launch of diapers, wipes, and personal care items into over 2,500 Walmart stores, which offset the revenue generated last year in the club rotational program. Now turning to gross margin. Gross margin was 30.3% in the third quarter of 2022, a 30 basis point sequential improvement versus the second quarter as compared to 36% in the third quarter of 2021. This reflects approximately 825 basis points of higher supply chain costs versus the prior year, negative 170 basis points from mix and trade spending, offset by roughly 425 basis points from pricing and cost savings. The biggest impact came from higher product costs, including inbound freight, which increased approximately 510 basis points versus a year ago. This increase was generally in line with our forecast. In addition, fulfillment costs increased approximately 315 basis points versus a year ago, which was higher than expected due to labor warehousing costs. These higher costs were due to a combination of the timing of inventory receipts in shipments to support new retail distribution as well as the impact of the consolidation of our Fontana warehouse into Las Vegas causing short-term operational inefficiencies. We expect these costs to remain elevated through the end of the year. While some spot rates for inbound ocean freight and U.S. trucking have come down, any benefit would take some time to be seen in our margins as we capitalize inbound costs into inventory. Also, we’re mindful that the decrease in rates earlier in the year quickly reversed, eliminating any upside so the sustainability of any cost decreases remains uncertain. During the quarter, we reflected the full benefit of pricing taken earlier in the year, which enhanced margin by 375 basis points. As Nick noted, we are pleased with the execution at retail stores as our price gaps versus conventional products remain in line, and consumer reaction to pricing has been in line or better than anticipated. In tracked channel data for the quarter, we have seen increases in both volumes and sales in our category. In the third quarter, we announced additional pricing to retailers on a select number of diapers, wipes, and personal care items, taking effect mid-December with price increases in the mid- to high single-digit range. Given the continued cost pressures facing all companies and price points currently in the market, we believe taking pricing now on select items will be successful in the market and further help to offset cost pressures in 2023. Regarding input cost pressures, we are facing continued inflation impact on key commodities. We are currently evaluating options for offsetting these cost pressures, which may require a combination of additional pricing, pack size optimization, and other cost initiatives to deliver margin targets as we move into 2023. Turning to operating costs and profitability. Operating expenses increased $3 million this quarter, but were flat excluding costs attributed to a $1.5 million donation of sanitizing products and $1.6 million in litigation expense. As we work to align inventory to demand, we have looked to various strategies to address excess inventory in sanitizing products, which includes leveraging our partnerships to support charitable programs with Honest products. The donation reflects our commitment to social responsibility and builds on our long history of product donations to benefit those in need. Marketing spend was 14% of sales, in line with our planned support for the Honest brand and reflected a higher level of retail marketing support versus a year ago. Adjusted EBITDA for the third quarter of 2022 was negative $5.6 million. Excluding the product donation, adjusted EBITDA was negative $4 million. We ended the third quarter with $41 million in cash, cash equivalents, and short-term investments with no debt. This quarter, we invested $15 million of our cash in higher inventory and accounts receivable as we executed our Walmart launch into over 2,500 stores nationally and brought our baby clothing business in-house. Both of these initiatives will materially boost our revenue growth in 2023. Going forward, while we expect our absolute levels of inventory to increase as our business grows, we expect our inventory turnover ratio to improve as we gain greater understanding of consumption patterns with our customers and recognize the benefit of our warehouse consolidation executed earlier in the year. We believe the company’s increased investment in working capital supports the growth of the business and don’t anticipate it having a material impact on the company’s cash position going forward. Turning to our fiscal year 2022 outlook. We are updating our full year revenue outlook to be in the range of $310 million to $315 million, reflecting inventory adjustments at a key digital customer who reduced its weeks of supply. Our consumption remains strong, so we are working closely with all retailers to ensure they are able to meet consumer demand. We expect full year gross margin to be between 30% and 31%, reflecting approximately 600 basis points of higher supply chain costs versus 2021 and 100 basis points in incremental trade investments supporting new distribution, offset by roughly 350 basis points from pricing and cost savings. We continue to expect full year adjusted EBITDA to be in the range of negative $10 million to negative $20 million, but narrowing closer to negative $20 million. This reflects positive adjusted EBITDA in the fourth quarter, which assumes sequential gross margin improvement, lower seasonal marketing spend, and aggressive management of controllable costs. It also assumes no further material increases in product and fulfillment costs. Before we open it up for questions, I’d like to share our preliminary view on revenue for the first half of 2023. Our first half revenue outlook for 2023 is for revenue growth in the range of 7% to 10%. This contemplates the retail distribution expansion in the second half of 2022, a new round of price increases on select diapers, wipes, and personal care items effective the middle of next month, balanced by uncertainty in U.S. consumer spending and continued tight inventory management by retailers. As the year progresses, we will be lapping two significant events, the benefits of material 2022 retail expansion and back half revenue from baby clothing. We will provide a more detailed 2023 outlook on our fourth quarter earnings call in March 2023, including gross margin and adjusted EBITDA outlook. In conclusion, I’m pleased with the momentum of the business as we expand our omnichannel footprint and make Honest products more accessible to consumers in the U.S. and abroad. As we bring 2022 to a close, we are pleased that a number of factors that created volatility in our results over the last year will largely be behind us, including COVID impacts on our household and wellness business, digital demand volatility, one-time rotational program, inventory retailer rebalancing, and unprecedented inflationary pressures. We have set a solid foundation for growth in 2023 and are confident in our ability to deliver more consistent top and bottom line performance in the coming year. With that, I’ll turn the call over to the operator, and we look forward to answering any questions.

Laura Champine, Analyst

It’s Laura from Loop. My question is on the consolidation of the baby clothing line. What’s the strategic rationale? And could you be more specific on the contribution to revenues this quarter, next quarter, and the first half of next year since you’ve provided an initial revenue outlook? Also, I’d love to hear the impact on adjusted EBITDA?

Nick Vlahos, CEO

Yes. I’ll start off, Laura, and give you some context around the strategic rationale. When you think of this business, we’ve been involved with it through a licensing arrangement for a couple of years, so we’ve been monitoring it closely. What we like about the business is it has two main aspects. Number one, the digital component around acquisition and how we drive our average order value and monetize that honest consumer in that early life stage is really attractive because we’re talking about opportunities to drive gifting, which not only includes baby clothing but also our personal care business and diaper business, will start to offer more holistic solutions. The second attractive aspect is the overlap in consumer demographics; about 80% of the consumers overlap between the Target audience in relation to the Honest brand for personal care and diaper products. We believe the bundling solutions around this initiative are really appealing. This has been in the works for a little while. It also gives us the opportunity within our household and wellness category. From a volume dollar perspective, it’s also attractive. This initiative, along with Walmart, as we look at next year, will drive about 5% to 7% incremental growth on an annualized basis. So when you consider both the new business from a Walmart standpoint alongside baby clothing, we think the incrementality of this is promising. I’ll let Kelly provide more details about the financials.

Kelly Kennedy, CFO

Laura, for the quarter, the Honest baby clothing generated just under $4 million. It tends to be a little more seasonal in nature, so Q3 is expected to be the largest quarter concerning revenue, as we ship products to retailers in advance of the holiday season. Although we only entered into the agreement roughly halfway through the year, it was anticipated and accounted for in our numbers. They are averaging about a $15 million business for the current year, with significant growth projected for the following year, and further opportunities as Nick mentioned, not only to leverage our distribution but also the margin and EBITDA structure, which is expected to be favorable as we consolidate within our warehouse facilities in 2023.

Unidentified Analyst, Analyst

This is John Keeper standing in for Bryan. Referring to the release, you mentioned an eight-point drag due to last year’s rotation program in Skin and Personal Care. If I adjust for that, does it suggest that there is a 16% to 17% growth otherwise? Would that be a more accurate reflection of the underlying momentum in that business?

Kelly Kennedy, CFO

Yes. I think if you look at the underlying, we would suggest you consider the recent consumption data. We highlighted in the release that our 12-week tracked data was up 6%. If you look at the most recent IRI data that just came out through October 30, our four-week data showed some acceleration with growth closer to 17% versus the category at 3%. So we’ve seen good underlying consumption trends within the tracked and retail channels. There were a lot of variables for Q3. We were up against the rotational program, and we also faced a drag due to destocking by one of our key digital partners that somewhat influenced Q3. However, we did ship a significant amount of pipeline through Walmart, which in essence, offset the loss from the rotational program. Also, we did observe some strength overall in our Honest Baby clothing segment, relative to what we had planned coming into the quarter. So considering all those elements, the 2% growth figure does suggest that excluding the one-time program, the growth in Q3 would have been closer to 10%, keeping in line with the consumption trends being reported and the IRI data.

Laura Champine, Analyst

And if I could have a follow-up: So Walmart is basically offsetting around the rotation program loss, which is about $6 million. Is there any public pipeline fill in the quarter as well?

Kelly Kennedy, CFO

No, we did expect that some of that Walmart Q3 shipment was pipeline. However, there was no other material pipeline fill for the quarter.

Unidentified Analyst, Analyst

This is Shabana Choudhary on behalf of Andrea. I just wanted to quickly ask about now that the retail channel makes up a bigger portion of your sales at 60% versus digital previously. Can you please go over like your margin dynamics, especially for retail versus digital? I mean you did elaborate on the marketing being lower for retail and you’re shifting towards retail more. But can you please elaborate on the other margin profile? Is it better? Or how do you see it going forward?

Nick Vlahos, CEO

Thanks for the question. I would first provide context regarding the 60-40 split. As an omnichannel business, what we’re driving that’s unique is providing accessibility in multiple market segments. We’ve seen digital soften over the past year because consumers have shifted back to in-store purchases in the post-COVID era. As we drive broader distribution with partners like Walmart and Publics, we’ll make our products more accessible, which will help mitigate volatility as digital sales soften, allowing us to offset overall revenue through alternative markets. On a margin basis, it’s almost equivalent. Looking at digital versus retail, we have reasonably equal margin structures between both channels. Kelly, do you want to add any additional context regarding fulfillment and overall footprint?

Kelly Kennedy, CFO

Yes. In terms of retailer margins, they're pretty much equivalent when factoring in fulfillment costs associated with both retail and digital. Although our retail growth has highlighted better marketing efficiency and returns, leading to a marketing spend of about 14% for the quarter, historically it’s been slightly higher. We believe we can reduce marketing spend as we see better returns, much of this driven by shopper marketing partnerships which amplify our marketing to retail partners. Additionally, there’s some slight trade efficiency regarding dilution spending linked to retailers. Over time, while highlighting the potential for digital channels to achieve better margins, the margins are currently closely aligned across both channels at this scale.

Nick Vlahos, CEO

I appreciate the participation today. I would just say from our standpoint, there are three main takeaways: number one, as you look at the underlying consumption of the business, it continues to be strong. As you eliminate some of the noise that has transpired this year, the second major takeaway as we enter next year is that many of the historical moving parts have stabilized regarding supply chain volatility, rotational club programs, retailer inventory destocking, and COVID impacts. We believe that’s behind us. The third key point is, as we enter 2023, this continues to be a growth story. We talk about 7% to 10% growth in the first half, and contributing 5 to 7 points of incremental growth moving forward through new developments in Walmart and baby clothing lines, combined with pipeline innovation, pricing benefits, and expected new distribution, give us confidence that 2023 will be a strong year for the Honest Company. We’ll return in our next earnings call to provide a full forecast regarding the top line, gross margin, and profitability. Wishing everyone a great holiday season and looking forward to our next call.

Operator, Operator

And this concludes today’s conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.