Earnings Call Transcript - HNST Q1 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to The Honest Company First Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Steve Austenfeld. Please go ahead.

Steve Austenfeld, Speaker

Good morning, everyone. Thank you for joining our first quarter 2023 conference call. Joining me today are Carla Vernon, Chief Executive Officer; and Kelly Kennedy, our Chief Financial Officer. Before we start, I'd like to remind you that we will make 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 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 on the Investor Relations section of our website at investors.honest.com. With that, I will turn the call over to Carla.

Carla Vernon, CEO

Thanks, Steve. Good morning, everyone, and thanks for joining us today. Last quarter, I indicated that we were not satisfied with the recent performance of our business. I also assured you that we can and will drive shareholder value by bringing greater discipline to our cost structure and operating approach. It was also my first opportunity to share my confidence in the fundamental strength and growth potential of the Honest brand. With decades of experience as a CPG Brand Builder and more recent experience as a digital retailer, I was drawn to the company because of the quality of the product, the demonstrated strength across a broad set of categories and the way the modern mission of clean and sustainable product design has taken a strong place in consumers' homes and lives. Now, with my first 100 days behind me, my conviction about the growth potential of the Honest brand and the opportunity to transform our business model remains strong. The strength of our portfolio is reflected in the Q1 revenue growth we announced today, which exceeded our expectations. As a result, we are now raising our revenue outlook for the year. Over the last year, we've successfully executed our plan to expand retail distribution and drive greater growth in physical channels. While we are pleased with the roll of growth from the retail channel, our Q1 revenue performance was balanced evenly across retail and digital channels with both growing over 20%, illustrating the strength of our omnichannel approach. While we are pleased with our top line performance, as I emphasized with you last quarter, we are relentlessly focused on improving our cost structure and margin performance. I'm pleased to announce the launch of our transformation initiative in Q1, which will drive long-term profitability and sustained shareholder value. This transformation initiative encompasses three pillars: brand maximization, margin enhancement, and operating discipline. The workstreams across these pillars are expected to improve our margin structure, drive focus on the most productive areas of our business, reduce working capital, deliver greater impact of brand-building investments, and improve executional excellence across the enterprise. While some of this work builds on ongoing work streams, I'm pleased to share that in recent months our team has redoubled our efforts to identify a more robust set of strategies and initiatives to accelerate our path to achieve sustainable, profitable growth. Kelly, I'll turn it over to you to review the financials, including further details on our transformation initiative.

Kelly Kennedy, CFO

Thank you, Carla, and welcome everyone. Our performance in the quarter reflected strong top line results, as well as continued cost inflation and costs associated with our transformation initiatives. Starting first with revenue performance. First quarter revenue was $83 million, which was up 21% versus a year ago with comparable growth rates in both our digital and retail channels. Growth in the quarter was driven by healthy consumption trends, expanded distribution, prior year pricing actions, and healthy orders from a key digital retailer. Honest consumption in track channels, which now represents roughly half of our revenue, was up 30% in the first quarter with half reflecting organic growth and half coming from incremental distribution. Honest is gaining market share as our growth continues to outpace the categories where we compete. For example, in our largest category, diapers and wipes, Honest consumption growth in Q1 was over 40%, significantly outpacing the overall category growth of 7%. Reflecting on price increases taken in 2022, we are pleased to see consistent volume growth, indicating the value of our brands and the resiliency of our consumers. As we are poised to take additional pricing actions in 2023, we are confident in our ability to achieve price premiums that are aligned with our premium brands. Turning to key drivers by product category: first, diapers and wipes. Our diapers and wipes business represented nearly 65% of our revenue this quarter and was up 23% with consumption significantly outpacing the category. Growth reflected the benefit of price increases, retail distribution expansion, and increased assortment. In particular, we've seen growth in wipes as we have capitalized on uses beyond diapering, with recent campaigns focused on multiple uses in the household. Skin and personal care, which represented over 25% of total revenue this quarter, increased 7% due to retail consumption gain, a more focused assortment on best-selling items, and innovation, including Daily Green Juice Antioxidant Super Serum, which launched in the first quarter. We're seeing particular strength in our beauty business with consumption up double digits, driven by over 20% growth at Target. Our household and wellness business represented nearly 10% of revenue this quarter and increased 81% due to the benefit of integrating the baby clothing business. Now turning to results by channel. Digital channel revenue increased 22% while retail increased by 21%. Revenue in Q1 was equally split 50% retail and 50% digital, reflecting recent retail distribution wins, robust track channel consumption, as well as strong purchases by our key digital retailers. Some highlights included: continued strong performance at Target, our largest customer, where we saw all-time record consumption during the quarter; continued strength at Walmart behind new distribution secured last year, which we believe is highly incremental to our existing business; and double-digit point of sales growth across diapers, wipes, and beauty items at our key digital retail customer. Before I cover the rest of the income statement, I want to share further details on our transformation initiatives, recognizing their impact on reported results in the first quarter, as well as key actions we're taking to drive margin expansion through the three key pillars of our transformation initiative: brand maximization, margin enhancement, and operating discipline. First, to drive brand maximization, we plan to leverage the strength of the Honest brand to deliver growth through new innovation and a focus on core items. Specifically, we will grow distribution and drive higher velocities of margin and creative products in our portfolio. Something as simple as elevating the benefits, claims, and imagery of our products in our marketing and packaging can make an impact quickly and drive revenue growth within our existing products. Another critical component of our brand maximization strategy is pricing. We're taking significant pricing actions in 2023 to return to historical premiums that align with our brand positioning. Results of recent pricing actions indicate that consumers believe our value proposition is strong. The second pillar in our transformation initiative is margin enhancement. We've taken decisive actions this quarter to transform our cost structure. From a portfolio standpoint, we are aligning our focus where we can lead and win, including two immediate actions that can drive improved margins and profitability. First, we will focus on North America where we have scale and the ability to most cost-efficiently drive growth. This impacts our international business where we are exiting Asia and Europe. This decision will reduce complexity, inventory levels and associated costs, and give us greater focus on how we deploy our resources. We are also exiting portions of the household category as we contract our product line in the face of waning demand and look for opportunities to rationalize SKUs across the portfolio to drive higher margin and meaningfully reduce inventory. Costs associated with these structural changes are reflected in today's earnings release. Exiting SKUs is likely to impact offerings at certain retailers, which has been reflected in our revenue outlook for 2023 beginning in the second quarter. We are currently executing multiple supply chain and sourcing projects to reduce the landed cost of our products. Areas of focus include contract manufacturing strategies, reduced shipping and logistics costs, and product cost optimization. The third pillar of our initiative is operating discipline. This includes tightly managing our SG&A expenses and aligning our talent, resources, and skills to reflect the prioritization of higher margin opportunities and the exit of select low-priority businesses and products. Our operating discipline will extend beyond the P&L to ensure we're aggressively managing working capital, including the reduction of inventory, thereby reducing warehousing and fulfillment costs and generating cash we can invest to drive the business. In total, we anticipate the transformation initiative to incur $10 million to $15 million in costs with the majority being noncash. In the first quarter, we recognized $7 million of costs, which reflected noncash charges related to inventory and prepaid write-offs. Initiative costs impacted multiple parts of our income statement, including revenue, cost of revenue, SG&A, and also resulted in restructuring charges, which are reflected within operating expenses. We anticipate our transformation initiatives will generate an estimated $15 million to $20 million in annualized benefit starting in late 2023 as we monetize pricing, cost savings, and reduce operating expenses. Returning back to our Q1 financial results, gross margin was 24% in the first quarter of 2023 compared to 30% in the first quarter of 2022. This included nearly 400 basis points of transformation initiative costs, including reserving for inventory related to exiting our international business, portions of our sanitizing business, and from SKU rationalization as we pivot to higher margin parts of our portfolio. Excluding the charges related to our transformation initiative, our gross margin would have been 28%. Gross margin was also impacted by approximately 400 basis points of higher supply chain costs due in part to short-term inefficiencies driven by elevated levels of inventory. These costs are expected to sequentially improve throughout the year as inventory levels come down. Gross margin also reflected over 200 basis points of benefit from pricing and cost savings. Turning to operating costs and profitability. Operating expenses increased by $4 million in the first quarter of 2023 compared to the first quarter of 2022. Operating expenses included $6 million of nonrecurring expenses, including $4 million in restructuring and other transformation initiative-related expenses, $1 million in CEO transition costs, and $1 million in legal fees related to securities litigation expense. Marketing spend was 12% of sales, reflecting higher returns associated with greater support for our retail expansion. Adjusted EBITDA for the first quarter of 2023 was negative $10 million, including $6 million in costs related to the transformation initiative. Excluding the charges we recorded for the transformation initiatives, our adjusted EBITDA would have been negative $5 million. Turning to the balance sheet. We ended the quarter with $12 million in cash, cash equivalents, and short-term investments with no debt. Excluding items that we don't anticipate occurring again in 2023, such as CEO transition costs that were accrued in 2022 and paid in the first quarter, operating cash flow was positive in the first quarter. As mentioned earlier, the transformation initiative costs in the quarter were predominantly noncash. As we committed to last quarter, we made significant progress to reduce our inventory balance, which decreased by $17 million in the quarter. We now anticipate exceeding our initial goal of $20 million inventory reduction and continue to believe it will offset our operating loss for the year. As we mentioned in our March call, we entered into a $35 million asset-based credit facility in January to provide liquidity for future growth investments. We've not borrowed on this line to date and plan to aggressively manage working capital as we implement our transformation initiative and drive to profitability. Now turning to our outlook for 2023. Following strong consumption trends in the first quarter, we are increasing our full year 2023 revenue outlook to be up low single digits versus full year 2022. The company's full year 2023 revenue outlook reflects continued positive track channel consumption combined with the benefit of midyear pricing actions, offset by lower revenue related to the exit of low margin and low priority product lines beginning in the second quarter, and comparing against significant new distribution in the second half of 2022. Adjusted EBITDA is expected to be in the range of negative $25 million to negative $30 million, including $7 million to $10 million in costs and charges related to the transformation initiative that will impact adjusted EBITDA. With that, let me turn it back to Carla before we open it up for questions.

Carla Vernon, CEO

Happy to take it over from here. As Kelly indicated, in 2023, we will be relentlessly focused on delivering the goals of our transformation initiative. This foundation of improved brand maximization, margin enhancement, and operational discipline will set the path for more profitable growth in 2024 and beyond. Later this year, I will present the long-term strategic roadmap that will guide our ongoing growth. As we redefine our growth path, I'm pleased to announce that Kate Barton has joined the Honest management team in the new role of Chief Growth Officer. Kate brings a strong track record of brand building, innovation, and business management skills. Most recently, Kate was the Chief Brand Officer at an omnichannel founder-built lifestyle brand, and she also has a history of driving growth of both high-profile global beauty brands and category-leading food brands that you can read about in our press release issued earlier today. Kate's signature combination of heart and horsepower makes her the perfect leader to inspire the loyalty and imagination of our discerning and passionate Honest consumers. With that, I'll turn the call over to the operator, and we look forward to answering your questions.

Operator, Operator

Our first question comes from Laura Champine from Loop Capital.

Laura Champine, Analyst

It's a two-parter related to the outlook. First part, on the revenue guide, it doesn't seem like you've passed through the full amount of the Q1 beat. So I'm wondering whether you expect some retrenchment from a key digital customer in Q2 after this strong Q1? Second question is on the adjusted EBITDA guide. I'm a little confused about which costs from the transformation initiative stay in that number and which ones you'll pull out? So just looking for some more clarification on the guidance.

Kelly Kennedy, CFO

I'm happy to start with the revenue question first, Laura. We are experiencing strong underlying consumption, which is about 30%, split evenly between organic growth and new distribution as we head into the second half of the year. We'll be facing an environment filled with new distribution in that period. The 21% growth in Q1 reflects that we were up against a weaker quarter last year. As we progress into the second half, we have significant pricing changes that we've carefully considered regarding their elasticities. Additionally, as we move into Q2 and beyond, we've excluded revenue related to SKU rationalization, the exit of international operations, and the product lines we're discontinuing, which were negatively impacting our margins. This allows us to reallocate resources toward future growth and to drive accretive growth. Those are the main points to consider as we look at the second half in comparison to Q1. We are being careful about our revenue outlook for the remainder of the year. While we did raise our projections, as you noted, some of that may not reflect new revenue coming in during the latter half. Regarding the digital channel, we saw excellent results in the quarter. In Q1, consumption aligned with shipments from our key digital partner, and we do not expect further fluctuations in the latter half of the year. Regarding adjusted EBITDA, the transformation initiative will impact the entire P&L, and we aim for adjusted EBITDA to range from $25 million to $30 million, excluding $7 million to $10 million related to restructuring. We anticipate the restructuring costs to be between $3 million to $5 million, primarily associated with exit costs like termination fees or contract liabilities as we phase out certain SKUs. This will cover severance, contract termination fees, and prepaid write-offs associated with restructuring. Inventory-related items are mostly noncash in nature, involving reserves and write-offs for inventory we won't pursue. These will affect the cost of revenue and adjusted EBITDA. Excluding the $7 million to $10 million in inventory reserves from costs will show a slight improvement in adjusted EBITDA. We did raise our revenue outlook, so the changes are not drastic compared to the guidance we provided in the fourth quarter.

Operator, Operator

Our next question comes from Andrea Teixeira from JP Morgan.

Andrea Teixeira, Analyst

Can you provide insights on the transformation process, particularly regarding the sales and margins of the products and regions that have been excluded? I would appreciate your perspective on how you envision the core business evolving as we move towards a new Honest Company. Additionally, I understand there is still work to be done on the underlying aspects. Can you share your thoughts on the recurring growth patterns and margins as we look beyond 2023?

Kelly Kennedy, CFO

I'll start, and Kelly, you can jump in. When you think about the transformation initiative, we talked about there being three big buckets that we are focused on. The first is really around brand maximization. This is driving pricing and getting back to our historical pricing premiums. Really focusing on our core and margin-enhancing products that we can support with marketing and packaging to drive better performance. So that's really around brand maximization. The margin expansion really is the area that generates the cost for the business, which was $7 million in Q1, and we anticipate some additional costs coming later in the year. I would break that into kind of three components. The first is really product exits and international. As we think about getting through that product, those were margin drags overall on the business. More importantly, as we think about the complexity of that piece of the business, whether it be international or some of these other category and lower volume, lower margin products, exiting those allows us to focus on better returns. We also did a SKU rationalization across all of our categories. This touched every part of our portfolio, which is just something the company has not done in many years, and we thought it was the right time to do this for the business. The last piece to think about in our transformation initiatives is around cost savings initiatives as we move to lower costs. There are some costs that we incur as we move to new packaging, based on the cost savings we can generate that we will also take. As you think about the revenue impact, we're not breaking down the specific impact on all the SKUs, but our smaller business segments have mostly been closed. International is a small percentage of our business, and the other product exits will not significantly impact revenue, but should help with our margin and cost structure.

Carla Vernon, CEO

I'll just build on a couple of additional themes because I know that at the heart of your question, you were asking about the underlying base of the business and the reasons to believe about where we are going in terms of growing our margins and driving value creation in the portfolio. Kelly did a great job of explaining the bridge. I want to make sure a couple of themes are made clear. First and foremost, we have redoubled our efforts to drive discipline in how we operationalize our approach here, as we've found that there are opportunities to improve the cost structure of items in our existing portfolio. So that's something we can begin to address in the near term and expand the margins of the items we already have that we like. Additionally, we believe there are great growth opportunities in some of our best items. Our distribution levels are very small against some of our most productive and highest velocity items that will remain in our core. We have an opportunity to really drive growth. I often refer to the Pareto principle, which is true for many CPG portfolios; the top items often drive the majority of the revenue and productivity of the portfolio. So it's important for us to be mindful of these top items as we drive our growth roadmap moving forward. Finally, I will be back later in the year to discuss my growth strategy. This strategy will highlight the importance of our core, as well as reimagining the mix of our portfolio so we understand the role of enhancing margins by improving the mix in the categories where we can lead and innovate.

Andrea Teixeira, Analyst

And just to be super clear, when you say you're going to come back on the top line growth, and I think we all appreciate in CPG that you're being focused on the 80/20 rule and basically drive home the highest level of growth and return of the products and focus. But is that also given that we are all kind of burned by the rebase? Is that basically it in terms of rebasing? Should we tell investors how much visibility you have into the planograms of the large retailers, obviously, you come from one of them, on your key retail partner? Like to make sure that you have that visibility to the extent the selling and sell-out converge, that you were seeing some sort of confidence on the new number and that there will not be any further rebase at this point, at least on the margin front?

Carla Vernon, CEO

I want to start by really grounding us philosophically, and then I’ll have Kelly address some specific building blocks. But philosophically, I hope I’m conveying that we have great confidence in our ability to continue on a glide path toward margin expansion and value creation, evident from the early strategies we are identifying for our transformation initiative. Additionally, our growth strategy project lives on top of that, and that growth strategy is specifically designed to continue to strengthen the areas we already favor that are margin-accretive in our portfolio but are small and have significant growth potential. Thus, we believe that even if there are bumps in the road, the path we are on is toward greater value creation and margin expansion. I'll let Kelly provide details on structural building blocks.

Kelly Kennedy, CFO

As we consider implementing the growth plan, we recognize that investments will be necessary. This is the beauty of an asset-light model. While there can be advantages and disadvantages to not owning our manufacturing, it allows us to quickly advance into new products and invest in innovation. These investments will mostly come in the form of resources, as discussed in our transformation initiative, within the SG&A, realigning our headcount toward the areas we will be investing in, including innovation. Another aspect is that these working capital investments will be required when we launch those products. The growth plan is primarily focused on 2024 and beyond. Therefore, working capital investments will rely on liquidity we have available to support our initiatives and to strive towards profitability in 2024.

Operator, Operator

Our next question comes from Jon Andersen from William Blair.

Jon Andersen, Analyst

I was going to take one more stab at the prior question, just so I’m clear on it. The guidance for the year, as I understand it, takes the sales guidance into account regarding the pruning work in terms of SKU key exits, international, and some household. What can come later in the year then, Carla, would be the strategy to lay on top of that; there wouldn't be a further reset of the sales outlook or reset, it would be more of an opportunity to enhance the top line growth outlook relative to where we sit today. Is that fair?

Kelly Kennedy, CFO

I think that’s a really great way to capture what we have communicated. Thank you.

Jon Andersen, Analyst

I appreciate that. Thank you. I did want to ask on pricing, a lot of companies are not pricing as much this year as they did last. It sounds like you've done your homework to determine that your brand and the elasticities are such that a price increase makes sense. Could you provide more detail around what level of pricing we are discussing for what part of the portfolio? And again, what evidence do you have that you are confident you won't see greater elasticities moving forward?

Kelly Kennedy, CFO

Yes, happy to speak to the pricing and Carla, if you can speak a little, maybe to the brand component of it. When we looked at the data, Jon, and we talked about this in our last call, we felt that we left some money on the table by not taking pricing sooner. The positive takeaway is that we have continued to grow predominantly by volume and pricing as we highlighted earlier. We've only taken about half the pricing versus competitive products. We've even depressed the premium to where we would like to be. As we think about taking pricing, which will be staggered over the year, it covers roughly half of our revenue base and falls into the mid to high single-digit range. This will affect multiple product categories and in some cases, will take additional pricing atop pricing we've already taken in 2022.

Carla Vernon, CEO

Yes, I'd like to elaborate on why we feel this is not only the right move but why we're confident in estimating the impacts moving forward. There are several factors. Firstly, the Honest brand has historically had a 15% price premium over key branded competitors in each category. Retail partners recognize this pricing relationship, which is closely tied to the premium nature of our products and the quality of the inputs. We are currently engaging in discussions with our retailers about this pricing strategy, and so far, we have found alignment regarding reinstating our approximate 15% price premium. Additionally, we are still growing across all categories, giving us confidence that our brand is gaining market share among the consumers we serve. Thus, it is crucial to have a pricing structure that reflects our brand's quality and allows us to continue creating shareholder value through investment.

Operator, Operator

Thank you. I'm not showing any further questions in the queue. I would now like to turn the conference back to Carla for any closing remarks.

Carla Vernon, CEO

Wonderful. Thank you again, everyone, for joining us and for your interest and support for The Honest Company. We look forward to speaking with you next quarter.

Operator, Operator

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