Mccormick & Co Inc Q2 FY2022 Earnings Call

Good morning. This is Kasey Jenkins, Chief Strategy Officer and Senior Vice President of Investor Relations. Thank you for joining today's second quarter earnings call. To accompany this call, we posted a set of slides at ir.mccormick.com. With me this morning are Lawrence Kurzius, Chairman and CEO; Brendan Foley, President and Chief Operating Officer; and Mike Smith, Executive Vice President and CFO. During this call, we will refer to certain non-GAAP financial measures. The nature of those non-GAAP financial measures and the related reconciliations to the GAAP results are included in this morning's press release and slides. In our comments, certain percentages are rounded. Please refer to our presentation for complete information. Today's presentation contains projections and other forward-looking statements. Actual results could differ materially from those projected. The Company undertakes no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events or other factors. Please refer to our forward-looking statements on Slide 2 for more information. I will now turn the discussion over to Lawrence.

Good morning, everyone. Thanks for joining us. I'd like to start by welcoming Brendan to this morning's call. In addition to his continuing role as President of our Global Consumer business, Brendan now has responsibility for our business worldwide in his newly appointed role as President and COO. At the end of our prepared remarks, I may ask him to weigh in on some of your questions. McCormick's long-term performance, including through the pandemic and other volatility, has been industry-leading and met or exceeded our financial objectives. Broadly, our results in the second quarter were in line with our sales and profit expectations despite certain global challenges, including a greater-than-expected level of high cost inflation and supply chain challenges, significant disruption in China from COVID-related lockdowns and the conflict in Ukraine. As our second quarter progressed, the dynamics of these conditions intensified and negatively impacted our sales and profit results. Before discussing our second quarter results in more detail, I'd like to comment on each of these, starting on Page 5. Consistent with the rest of the industry, high cost inflation and supply chain are continuing challenges. To partially offset cost pressures, we've taken multiple pricing actions, and as planned, we are raising prices again. Inflation continued to escalate, and we've adjusted our upcoming pricing actions accordingly. We appreciate our customers working with us to navigate this environment. Additionally, our plans to mitigate cost pressures include our CCI-led cost savings, revenue management initiatives and reducing discretionary spend where possible. We expect our pricing actions and other levers to begin to outpace cost pressures late in the third quarter, with higher cost and higher offsetting pricing actions than we expected on our last call, which further weights our 2022 profit to the second half of the year. We plan to fully offset cost pressures over time. In China, during the second quarter, there was significant unanticipated disruption in consumption due to severe COVID-related lockdowns in Shanghai and other cities throughout China. China is our second biggest sales country, with operations in Shanghai, Guangzhou and Wuhan. Our Shanghai operation produces approximately 40% of our total China sales, which are distributed throughout the country and support both of our segments. And as a reminder, our branded food service demand is included in our Consumer segment in China. The lockdowns lasted roughly 75 days, with our Shanghai plant forced to close for two weeks at the onset, with employees living in the facility. Once we were able to reopen, we were impacted by lockdown-related labor shortages due to workers being quarantined. During April and May, we incurred significant incremental manufacturing and transportation costs to supply our customers. In addition, as restaurants largely closed and consumers were unable to shop for extended periods in our strongest geographies, we experienced significant demand softness as well. Market conditions in China have also allowed very little opportunity to increase prices. While we are currently experiencing the short-term pressure, we continue to believe in the long-term growth trajectory of our business in China, but we will not be able to recover the sales and profit impact we experienced in this fiscal year. Finally, regarding the conflict in Ukraine, in mid-March, we suspended operations in Russia, and our operations in Ukraine were paused. These countries account for less than 1% of our overall business. We have recently decided to exit our Consumer business in Russia. Now for more detail on our second quarter results, starting with sales on Slide 7. Sales declined 1% from the second quarter of last year, including an unfavorable impact from currency. Our constant currency sales were comparable to last year, with growth from pricing actions offset by a decline in volume and product mix. The volume decline was impacted unfavorably by several discrete items, including a 1% impact from the China consumption disruption and the conflict in Ukraine I just mentioned, a 1% impact from the exit of low-margin business in India and a 2% impact from lapping the U.S. trade inventory replenishment during last year's second quarter. Excluding these items, our sales performance would have been 4% growth, reflecting the strength of our broad global portfolio and effective execution of our strategies and pricing actions. While growth in both segments was impacted by the discrete items, they were more impactful to our Consumer segment. Notably, our growth in Flavor Solutions was outstanding. Comparisons to 2021 and 2020 remain difficult due to the dramatic shift in consumer consumption between at-home and away-from-home experienced in the second quarter of the last two years. Using 2019 as a pre-pandemic baseline, second quarter sales have grown at a constant currency compounded annual growth rate, or CAGR, of 6%. Moving to profit. Adjusted operating income was down 33% or 32% in constant currency, and adjusted earnings per share was down 30%. The adjusted operating income comparison includes a 7% unfavorable impact from the disruption to China's consumption and the conflict in Ukraine. Although we anticipated the profit driven by sales growth in the second quarter would be more than offset by higher inflation and broad-based supply chain challenges, the impact was greater than expected due to continuing cost escalation. While this pressured second quarter profit, we expect to mitigate this impact later this year. Now moving to second quarter business updates for each of our segments. Starting with our Consumer segment on Slide 9, our second quarter sales reflect the impact of our pricing actions in all three regions. In the Americas, our first wave of pricing was phased in during our fourth quarter of last year, the second wave during the second quarter in April, and the third wave will go into effect at the end of the third quarter. With the first wave, we saw a very low level of elasticity. With the second wave, we are seeing more price elasticity, although still below historical levels. While consumer spending has remained strong, consumers are now under significant pressure from broad-based inflation, notably fuel prices and other macro factors. As we look ahead and our additional pricing actions are phased in, the elasticity we experienced may change, but we still expect the impact to be lower than historical levels. Overall, our pricing actions in EMEA and APZ are on track and our elasticity impacts are similar to the Americas. In EMEA and APZ, pricing timing varies by market within each region. In some markets, particularly in EMEA, there are regulatory guidelines on when we take pricing, which generally creates a lag in the timing of pricing compared to the Americas. In this unprecedented environment, however, we are taking additional action in markets across the EMEA. Now for some further highlights by region, starting with the Americas. Our total U.S. branded portfolio consumption, as indicated by our IRI consumption data and combined with unmeasured channels, grew 1%. And over the last three years, since 2019, consumption has grown at a three-year CAGR of 7%, which highlights how the sustained shift in consumer consumption continues to drive increased demand for our products and outpace pre-pandemic levels. In the Americas, a sales decline in the second quarter included the impact of lapping a 4% over-shipment of consumption to replenish retailer inventories in the second quarter of last year. Our second quarter shipments this year were in line with our consumption change. Demand has remained high, and we are realizing the benefit of the manufacturing capacity we added as well as our increased resilience. However, some products remain stressed by sustained high demand. Shelf conditions continue to improve, as seen in our recipe mix share performance of another quarter of share gain. Our spices and seasoning share was pressured during the quarter by the shortage of certain packaging materials as well as certain organic spices. Some of these have been resolved and some will remain ongoing. We continue to use our category and revenue management capability to strengthen our spices and seasoning portfolio and optimize the category performance for both McCormick and our retailers. The strength of our brands and our category leadership has recently won us new distribution which we will begin to realize later this year. In EMEA, we continue to have strong share performance in most categories and markets. During the second quarter, we lapped strong year-ago consumption, partially due to last year's COVID-related restrictions throughout EMEA, where restrictions extended longer than other regions. Our Vahine brand of homemade dessert products in France, a product line unique to our EMEA region, was most impacted as recently we've seen baking returned to a more pre-pandemic baseline level. In other categories in the region, we believe there has been a step-up in consumption. And in the Asia-Pacific region, in addition to the consumption disruption in China, second quarter growth was impacted by the exit of low-margin business in India. At the end of last year, we decided to exit our rice business, the Kohinoor brand, to enable the region to focus on our higher-margin core category. Turning to Flavor Solutions on Slide 10. Our sales performance for the quarter was outstanding, with both pricing and volume growth contributing. We drove double-digit growth in both the at-home and away-from-home parts of our portfolio. Looking at our Flavor Solutions growth over the past three years, since the COVID-19 restrictions caused dramatic second quarter comparisons in '20 and '21, our sales CAGR is 8%, largely driven by volumes. Our pricing actions increased sales in all three regions. Broadly, pricing actions in the branded foodservice part of our portfolio followed the same cadence as those in each region in Consumer business. In the rest of our Flavor Solutions business, pricing is based on contractual windows, with automatic price adjusters in many contracts and the timing is going to vary based on those windows. In this dynamic environment though, with costs escalating so quickly, we are having discussions outside of those windows and passing costs through faster than usual. Higher volumes also contributed to growth in the Americas and EMEA region. Demand has remained strong for certain parts of our business in these regions. Our supply chain is being pressured to meet this demand and we are still taking on some extraordinary costs to service our customers. We appreciate our customers working with us through this pressure. In the Americas, where our customer base is skewed more towards packaged food and beverage customers, our at-home customers, strong growth was driven by flavors for savory snacks as well as performance nutrition and health applications with these customers. In EMEA, our customer base is more skewed towards quick service restaurants or QSRs, and our strong QSR momentum contributed to growth in all markets, partially driven by expanded distribution. Branded foodservice growth was strong in both the Americas and EMEA regions, driven by restaurant and institutional food service customers. Demand continues to strengthen in this channel, particularly as travel accelerates and restaurants benefit from consumers shifting to take-away and delivery. Overall, our Flavor Solutions sales demand and growth momentum continues to be strong. Now let me expand on our growth platform and positioning in the current environment. Turning to Slide 11. Global demand for flavor remains the foundation of our sales growth, and we have intentionally focused on great fast-growing categories that will continue to differentiate our performance. We are capitalizing on the long-term consumer trends that accelerated during the pandemic: healthy and flavorful cooking, increased digital engagement, trusted brands, and purpose-minded practices. These long-term trends and the rising global demand for great taste are as relevant today as ever, but the younger generations are fueling them at a greater rate. McCormick is uniquely positioned to capitalize on this demand for great taste, with the breadth and reach of our global flavor portfolio we are delivering flavor experiences for every meal occasion through our products and our customers' products. We are end-to-end flavor. We continue to make investments to sustainably meet the growing demand and to fuel further growth. In our global supply chain, we increased our capacity with our recently opened U.K. Peterborough Flavor Solutions manufacturing facility and have begun our expansion of FONA's footprint to support future flavor growth. We are also increasing our capacity in the fast-growing hot sauce category and investing in seasoning capacity to support increased demand and strengthen resiliency. As we've said, with the sustained level of high consumer demand, we're benefiting from the manufacturing capacity we've added. While we still experienced disruptions in the supply chain, they are much more specific mainly from a transportation and packaging supply standpoint. We experienced the peak disruption in the third quarter of last year. And with every month, the supply chain continues to get better, and we feel good about the progress we're making. We are strategically investing behind our brands to drive growth, including in brand marketing, as we did throughout the pandemic with our three-year brand marketing CAGR approximating our consumer segment sales CAGR for the same period. We're pivoting our messaging to emphasize to consumers how our products help them stretch their grocery dollar. For instance, we're launching a digital messaging highlighting the value of our product by making a great flavorful meal economically. We add flavor for only pennies per serving, and recipes like our 30-minute Taco Casserole are family and budget-friendly answers to what's for dinner. We continue to invest in new products. In our Consumer segment, we are responding to new consumer behaviors, like increased at-home lunches. For instance, our new patent-pending French's Creamy Mustard is off to a great start. We're sensitive to the needs of price-conscious consumers, not just in these challenging economic times, but every day. Our portfolio includes branded items to accommodate consumers' needs and provide solutions for everyone at every price point as well as private label products. Our new product launches include additional entry-level price point products for affordability and larger sizes of key high-usage items for better value. While we are still seeing strong consumer spending, we know that inflation is a significant concern for consumers, more so than COVID. We're leveraging our proprietary research, which served us well during the pandemic, to monitor for any signals of changing behavior. Our research continues to indicate consumers are going to cook as much at home or more than they did during the pandemic for many reasons. One of them is that they find it more economical. To the extent there is a recession, it further reinforces cooking at home, and we know from our past sales performance that our categories and brands perform well during a recessionary period. Now for some summary comments on Slide 13 before turning it over to Mike. We remain focused on the long-term goals, strategies, and values that have made us so successful. We have grown and compounded that growth over the years regardless of the environment. The long-term fundamentals that drove our industry-leading historical performance remain strong. The strength of our business, the value of our products and capabilities, and the execution of our proven strategies by our experienced leaders while adapting to changes accordingly gives us confidence in our growth momentum and in our ability to navigate a challenging global environment. Despite the pressures we experienced in the second quarter, we are well positioned and confident in delivering strong performance in 2022 and beyond while driving sustainable long-term value for our shareholders. McCormick employees continue to do a great job navigating a dynamic environment. Their agility and their teamwork drive our momentum and success, and I want to thank them for their dedicated efforts and engagement. And now, I'll turn it over to Mike.

Thanks, Lawrence, and good morning, everyone. Starting on Slide 15. Our top line constant currency sales were comparable to the second quarter of last year, reflecting 7% growth from pricing actions, offset by a 7% decline in volume and product mix. Excluding the 4% impact of the discrete item Lawrence mentioned earlier, our sales performance would have reflected 4% growth. Consumer segment sales declined 7% in constant currency. The impact from lapping the U.S. trade inventory replenishment, the consumption disruption in China, the exit of low-margin business in India, and the conflict in Ukraine contributed 6% to that decline. The remaining 1% decline was due to lower volume, partially offset by pricing actions. On a three-year basis, our second quarter constant currency sales CAGR was 4%. On Slide 16, consumer sales in the Americas declined 4% in constant currency, driven by lower volume and mix, partially offset by pricing actions. This decline is attributable to lapping trade inventory replenishments in the second quarter of last year. Over the past three years, constant currency sales in the Americas grew at a CAGR of 7%. In EMEA, constant currency consumer sales declined 11%, primarily due to lapping high year-ago demand driven by COVID-related lockdowns, the most significant impact of which was lower sales of Vahine homemade dessert products. A 1% unfavorable impact from lower sales in Russia and Ukraine also contributed to the decline. Pricing actions in all markets partially offset the lower volume. Over the past three years, EMEA's constant currency sales grew at a 3% CAGR. Constant currency consumer sales in the Asia-Pacific region declined 18%, including a 20% unfavorable impact from the consumption disruption in China as well as the exit of low-margin business in India. Pricing actions in all markets across the region partially offset this unfavorable impact. On a three-year basis, APZ's second quarter constant currency sales CAGR was a 7% decline, driven by the China and India impact I just mentioned. Excluding this impact, sales grew at a 5% CAGR over the past three years. Turning to our Flavor Solutions segment in Slide 19. We grew second quarter constant currency sales 11% due to pricing actions as well as higher volume and mix. This growth was partially offset by a 1% decline in sales related to the combined impact of the China disruption and the conflict in Ukraine. Second quarter constant currency sales for the last three years grew at an 8% CAGR. In the Americas, Flavor Solutions' constant currency sales grew 12%, driven by both pricing and the combination of volume and mix. Higher sales to packaged food and beverage companies with particular strength in snack seasonings led the growth, with higher demand from branded foodservice customers also contributing to growth. Over the past three years, constant currency sales in the Americas grew at a CAGR of 8%. In EMEA, we drove 19% constant currency sales growth with a 14% increase in volume and mix and 5% related to pricing actions. EMEA's Flavor Solutions growth, excluding a 1% decline related to the conflict in Ukraine, was broad-based across its portfolio, led by strong growth with QSR and branded foodservice customers. Over the past three years, EMEA's constant currency sales grew at a 10% CAGR. In the Asia-Pacific region, Flavor Solutions sales declined 6% in constant currency. The decline was driven by a 7% impact from lower volume in China due to the COVID-related restrictions, partially offset by pricing actions in all markets across the region. APZ grew constant currency sales at a 3% CAGR over the past three years. As seen on Slide 23, adjusted gross profit margin declined 550 basis points in the second quarter versus the year-ago period. Realizing this is a sizable compression, I will spend a moment on the significant drivers. Let me start with the drivers we anticipated. First, nearly half of this decline, approximately 250 basis points, is due to the dilutive impact of pricing to offset our dollar cost increases. We focus on gross profit dollars. This impact was more significant than in the first quarter because of the higher level of pricing in the second quarter. Product mix was unfavorable as compared to the second quarter of last year. In our Consumer segment, as we mentioned earlier, we are lapping strong U.S. spices and seasonings growth related to the inventory replenishment. In our Flavor Solutions segment, sales growth in our away-from-home products was higher than our at-home products, and we are lapping strong sales of beverage flavors last year. A sales shift between our Consumer and Flavor Solutions segments also contributed to the unfavorable product mix. In our Flavor Solutions segment, as we mentioned in our last earnings call, gross margin was unfavorably impacted by start-up and dual running costs as we transitioned production to our new U.K. Peterborough manufacturing facility. Of note, CCI-led cost savings partially offset the impacts I just walked through, and we are on track to deliver our expected savings of $85 million for the full year. In addition to the net impact of the anticipated items I just detailed, gross margin was also unfavorably impacted by the following items: As Lawrence discussed, cost inflation and supply chain pressures escalated during the second quarter impacting our results more than expected, primarily related to transportation costs and faster-turning materials. While we have adjusted our upcoming pricing actions to reflect that escalation, and we plan to fully offset cost pressures over time, our second quarter gross margin compression reflects the usual lag associated with pricing. We expect pricing to begin outpacing the cost pressures later this year and continue into next year. Our cost recovery will vary by region and segment. Currently, our pricing lag is more significant in our Flavor Solutions segment. Lawrence previously mentioned we have incremental costs to meet strong demand for certain parts of our Flavor Solutions business, thus impacting our gross margin. And finally, as already mentioned, significant cost due to the COVID-related restrictions in China had an unfavorable impact on profit. Moving to Slide 24. Selling, general and administrative expenses were lower than the second quarter of last year, and as a percentage of net sales declined 20 basis points. The decline was driven by lower employee benefit and brand marketing expenses as well as discretionary spending reductions, partially offset by higher distribution costs. The decline in brand marketing investments was driven by China and Russia reductions. Importantly, across our other markets, we invested in brand marketing at a comparable level to last year. The net impact of the factors I just mentioned resulted in a decline in adjusted operating income, which excludes special charges, of 33% compared to the second quarter of 2021. In the Consumer segment, adjusted operating income declined 29%. And in the Flavor Solutions segment, it declined 40%. A 1% unfavorable impact from currency is included in each of these declines. Turning to income taxes on Slide 25. Our second quarter adjusted effective tax rate was 18.6% compared to 22.2% in the year-ago period, driven by a higher level of discrete tax items this year. At the bottom line, please turn to Slide 26; second quarter 2022 adjusted earnings per share was $0.48 as compared to $0.69 for the year-ago period. The decrease was driven by our lower adjusted operating income. On Slide 27, we summarize highlights for cash flow and the quarter-end balance sheet. Our cash flow from operations was $154 million through the second quarter of 2022 compared to $229 million through the second quarter of 2021. This decrease was primarily driven by lower net income. Cash flow from operations will be weighted to the second half of the year, similar to our profit growth. We returned $198 million of cash to our shareholders through dividends and used $102 million for capital expenditures through the second quarter. We expect 2022 to be a year of strong cash flow driven by profit and working capital initiatives. Our priority is to continue to have a balanced use of cash, funding investments to drive growth, returning a significant portion to our shareholders through dividends, and paying down debt. Now turning to our 2022 financial outlook on Slide 28. As a reminder, last quarter, the conditions in Russia, Ukraine, and China were just unfolding, and cost inflation and supply chain challenges remain dynamic and fast-moving. Today, we have a better view of the macro environment, and our guidance for the full year considers the greater impact from these items. In addition, and as noted previously, we have always expected our profit growth to be weighted to the second half of the year. We now expect it to be even more so. We are projecting strong top-line growth with profit impacted by the global challenges I just mentioned. We also expect there will be an estimated two-percentage point unfavorable impact of currency rates on sales, adjusted operating income, and adjusted earnings per share, an increase from our previous estimate of one-percentage point unfavorable. On the top line, we now expect to grow constant currency sales 5% to 7%. We expect sales to be driven primarily by pricing, which will accelerate significantly in the second half versus the first half. While we anticipate volume and product mix to be impacted by increasing elasticity, we expect elasticity to remain at a lower rate than historical levels. Our volume and product mix will also continue to be impacted by the pruning of lower-margin business from our portfolio as well as the impact of demand disruptions in China and Ukraine. We plan to drive continued growth through the strength of our brands as well as our category management, brand marketing, new product and customer engagement growth plans. We are now projecting our 2022 adjusted gross profit margin to be 200 basis points to 150 basis points lower than 2021. Given the rapidly escalating cost environment, cost pressures have outpaced our pricing, and future actions have been adjusted to reflect the higher cost level. This adjusted gross margin compression reflects the impact of a high teens increase in cost inflation, an unfavorable impact of sales mix between segments, and favorable impacts from pricing and CCI-led cost savings. As a reminder, we price to offset dollar cost increases. We focus on gross profit dollars. This has a dilutive impact on our adjusted gross margin and is the primary driver of our projected compression. We now expect to grow our adjusted operating income 2% to 4% in constant currency. In addition to the gross margin impacts I just mentioned, this projection also includes our CCI-led cost savings target of approximately $85 million and brand marketing investments comparable to 2021, which reflects reductions in China and Russia. Considering the year-to-date impact from discrete items as well as our estimated mix of earnings by geography, we now project our 2022 adjusted effective income tax rate to be approximately 22%. This outlook is expected to be a year-over-year headwind to our 2022 adjusted earnings per share of approximately 2%. We are lowering our 2022 adjusted earnings per share expectations to a range of $3.03 to $3.08. This compares to $3.05 of adjusted earnings per share in 2021 and represents a decline of 1% to an increase of 1% or, in constant currency, growth of 1% to 3%. This reflects our lower adjusted operating profit outlook and an expected $15 million benefit from the impact of optimizing our debt portfolio. In addition, we are well positioned with our broad and advantaged flavor portfolio and effective growth strategies to continue our operating momentum and drive another year of strong performance.

Thank you, Mike. Now that Mike has shared our financial results and outlook in more detail, I'd like to recap the key takeaways, as seen on Slide 29. Our long-term performance has been industry-leading and met or exceeded our objectives, including through volatile environments. The long-term fundamentals that drove this historical performance remain strong. Several discrete items unfavorably impact our sales comparison to the second quarter of last year. Excluding these impacts, our sales performance reflects the strength of our broad global portfolio, the effective execution of our strategies, and our pricing actions. Our sales growth momentum is strong. Persistent high cost inflation and supply chain challenges intensified as the second quarter progressed and unfavorably impacted our profit. Importantly, we expect to mitigate this impact in the second half of the year. We're confident that with our broad and advantaged flavor portfolio, effective growth strategies, and our ability to navigate challenging environments, we will drive another year of strong performance in 2022 and build value for our shareholders. Now, let's turn to your questions.

Thank you. At this time, we will be conducting a question-and-answer session. Our first question comes from the line of Andrew Lazar with Barclays. Please proceed with your question.

I guess, first off, as you talked about, organic sales came in below where the market was looking for it, though you raised the outlook for organic for the full year. And I appreciate some of the items in the second quarter you highlighted were discrete. But maybe you could talk a little bit about what gives you the confidence in raising the organic guidance for the full year? Are you expecting headwinds in the second quarter to become tailwinds in the second half or better momentum in the underlying business? The scanner data has not necessarily shown any meaningful inflection yet that I can see at least on a year-over-year basis. I appreciate the multiyear CAGR of organic sales. So I'm trying to get a better sense for the underlying confidence in raising the full-year organic to start with.

Sure, Andrew. Our strategy has always been to have a stronger performance in the second half of the year compared to the first half, as we previously mentioned in our calls and conferences. A key factor contributing to this is the frequency of our pricing actions, with the second half of the year experiencing double the effective pricing compared to the first half. Currently, our pricing contribution to sales for the quarter is around 7%, and it will be significantly higher in the second half, driving total sales growth for both the third and fourth quarters. This pricing momentum also positively impacts our operating profit, earnings per share, and other metrics as we progress. Additionally, we did not anticipate the level of disruption caused by the lockdowns in China during the second quarter, which took us—and likely everyone—by surprise. China is a major contributor to our business, and we anticipate a return to normal operations there during the second half of the year, expecting a full normalization by the fourth quarter. Our past experiences with the initial COVID lockdowns indicate that once normalcy is restored, we typically see a significant increase in restocking from both consumers and trade channels, which should enhance our performance in the second half. Moreover, our U.S. and EMEA regions face easier comparisons in the second half than they did in the first half, as they won't be dealing with the inventory replenishment challenges we discussed last year or the COVID lockdowns that affected us, especially in the second quarter. Lastly, we are confident in the strong underlying demand from our consumers and customers that we are currently observing. Mike, do you have anything to add?

Yes. I think I'd add that we see a lot of strength in our Flavor Solutions business. We saw that in the second quarter, and we know that will continue in the second half. So we certainly think that's going to support, I think, really our outlook for the second half overall. But also we're seeing a lot of new business come through in the back half of the year in both segments. And so we see a lot of strength coming through on that, too. So, the growth again does look even stronger as we move towards the back half.

Great. And then just a quick follow-up. I don't think you mentioned it; I know you did last quarter when you were talking about in the core consumer business, private label had not yet really had much of a move one way or the other. I don't think you mentioned it this time around. I'm just curious what you're seeing there. Anything of note that we should be aware of?

I don't think that there's anything of special note there. We are seeing some trade held by consumers, not just in our category but in other categories that we track. It's no surprise that consumers at the lower end of the income scale particularly are feeling a bit of pressure from inflation, not ours, but inflation across everything. I mean, gas prices are $5 or $6 a gallon, depending on where you live, and that puts pressure on consumers' pocketbook. But I would say that it's still at a pretty low level, particularly when we look at our brands and the elasticity that we're experiencing, it's still significantly below historical levels and it's not a particular concern. I'd say also, I'll add to that, our sales with private label products are certainly an important part of our business but not particularly surging.

Thank you. Our next question comes from the line of Ken Goldman with JPMorgan.

I just wanted to make sure I heard your commentary about pricing correctly and then I'm doing some basic math right? You did about, I think, 6% pricing in the first half. You're saying that will double in the second half. And you also, I think, are implying that you need around 10% organic sales growth in the second half to hit your guide. Sorry to do the math on the call, I apologize for putting you on the spot, but are you effectively saying that it's reasonable for us to model maybe 12% pricing overall in the second half with volume maybe down around 2%? Is that?

Yes, let me begin with that. I will have Mike elaborate on it. However, I believe your calculations are on the right track. When considering the timing and impact of our price increases, you are correct to think about moving from 6% to 12% in the second half. Additionally, our next pricing action in the Americas, which is our largest region, is scheduled for August. Therefore, it's important to consider that timing as well.

I'd also just add, you're going to see it across both Consumer and Flavor Solutions pretty much at the same level.

Great. That's helpful. And then a quick follow-up. It sounds like you mentioned pricing will kind of phase in a little bit over the second half. In this context, and given some of the other factors you talked about, how do we think about the cadence of gross margin improvement in the back half? Should we expect a substantial improvement in 3Q? Is it more 4Q-weighted? Maybe any color you could provide there would be helpful as we think about modeling.

Ken, this is Mike. That's a great question. We anticipate that the highest costs compared to last year will occur in the third quarter, with some moderation in the fourth quarter. Pricing is expected to increase from the second to the third and then to the fourth quarter. Therefore, we may experience some challenges with gross margins in the third quarter. However, in the fourth quarter, we expect to see a positive impact from that pricing, along with the full benefits of the changes in costs. Additionally, we view the fourth quarter as our strongest in terms of volume. As Lawrence mentioned before, the recovery in areas like China, where we see significant margins, should also contribute positively to the fourth quarter.

Our next question comes from the line of Steve Powers with Deutsche Bank.

You provided a thorough explanation of the various challenges the business is facing. I understand that well. However, I want to summarize the situation from a higher perspective. Your overall sales forecast remains unchanged, even with the unfavorable currency conditions. You anticipate a slightly lower tax rate, a smaller share count, and reduced brand marketing efforts. Although the expected cost inflation is now projected to be in the high teens, it still aligns within the previous expectations. I would like to pinpoint what is specifically causing the decrease in operating profit and EPS outlook. It seems to me that the revised outlook regarding China, Russia, Ukraine, and supply issues, beyond the regular cost inflation, is contributing to this change. I would appreciate confirmation on that, and if possible, a way to quantify or prioritize these factors would be helpful.

Steve, this is Lawrence. I think we will want to revisit some of the minor adjustments you mentioned, but regarding the larger issue, you are exactly correct. This was part of the message we aimed to convey at your recent conference. The significant change comes from external factors that took us by surprise, and that is influencing our current situation. I'll let Mike explain the specific details on that.

Yes. Regarding our guidance, we are adjusting down by $0.14. From a perspective of China, Russia, and Ukraine, that accounts for $0.11. Additionally, with foreign exchange increasing by 1%, that adds another $0.03, totaling the $0.14. We acknowledge that cost inflation, which you mentioned, was originally in the mid to high double digits and has been moved to high double digits now. This translates to an increase of 1% to 2% in costs throughout the year, primarily due to transportation, packaging, and similar factors, which negatively impacted us in the second quarter. Nevertheless, while we are reducing some of those costs for the remainder of the year, we have pricing strategies in place to help alleviate the impact. Furthermore, some items you mentioned, like tax and interest expenses, will help mitigate this. One point of clarification about brand marketing: it is now flat, largely due to reductions in China, Russia, Ukraine, and foreign exchange. However, we are still investing in our major markets to drive growth.

Okay, that's helpful. Yes, that's perfect. Just a quick follow-up on Ken's question regarding the recovery of gross margins. Is there anything in the second quarter that you would identify as truly temporary? Were there any specific challenges in the second quarter that are unique to that period and won't affect future performance? I'm trying to understand if there's anything that you have already moved past.

The one thing I want to emphasize is that our business in China is very significant; it's our second largest market. We operate three large manufacturing facilities there, and the shutdown significantly increased our costs due to transportation and loss absorption among other factors. As that business recovers, these additional costs will diminish. Furthermore, we also faced rapid increases in costs related to transportation and packaging. For instance, fuel costs saw a 25% rise in gasoline prices since March, and such expenses quickly impact our profit and loss statements. While pricing will adjust to these costs, a one-month lag can result in a $30 million to $40 million impact, which amounts to about $0.10 per share. We are addressing this situation as swiftly as possible, and we are now seeing some stabilization. Looking ahead to the third and fourth quarters, we have a clearer outlook on our costs. To your question about what is temporary and what is not, I believe that covers most of it.

I want to emphasize the timing aspect. If there had been a one-month difference in the effective date of our price increase, we would be discussing a different outcome, resulting in an increase of $0.11 or $0.12 in EPS for the quarter. Those price increases are already in effect, so having them one month earlier would have made a significant difference. This is one reason we're confident that we'll catch up with the costs.

Understood. I want to quickly reiterate Mike's point about China. I understand that China had a significant negative impact in the second quarter, but I don't believe you're suggesting that this situation is entirely temporary. As of June 1, that challenge isn't fully resolved, right? It is improving, but it's not completely behind us.

So that's why I mentioned that it will really assist us more in the fourth quarter. There are still various levels of openings occurring now and expected throughout the quarter.

Our next question comes from the line of Robert Moskow with Credit Suisse.

Lawrence, you mentioned in your opening comments that your research indicates consumers will continue to cook at home as much as they did during the pandemic, if not more. However, from my observations this year, that doesn’t seem to be the case. People are becoming more mobile and returning to the workforce, which is reflected in your numbers as well. Do you have any real-time insights into consumer behavior this year, especially considering that your category in the U.S. appears to be underperforming compared to other packaged food categories?

Yes, Rob. In response to your comments, our research indicates that there is still a significant level of cooking at home. Whether through our own research or data from suppliers, we see ongoing strong at-home consumption. Overall, consumer behavior has remained relatively stable. In several categories, such as our recipe mix and hot sauces, we continue to experience notable growth. While there are some declines in categories like meat, our portfolio remains balanced, and we are still witnessing substantial at-home consumption.

And frankly, historically, you go back, Rob, a long way with us, if a recession does occur, that will drive more people cooking at home. So that bodes well, I think, for our broad portfolio.

Our research, I would say is recent in the last 30 days, is telling us that there is still a sustained level.

If we look at our Flavor Solutions business, it's evident that foodservice is performing well. Restaurants have reopened, and people are no longer compelled to cook at home. However, there remains a strong inclination towards home cooking. As we analyzed the first half of the year, we noticed macro data indicating a return to dining out and a decrease in home cooking. Recently, though, this trend has started to revert, likely due to economic pressures faced by consumers. Cooking at home has become a more cost-effective option. For various reasons, we remain quite optimistic about the ongoing retention of home cooking habits. Some areas differ, such as baking, which surged when kids were home from school, but those baking-related items have returned to pre-pandemic levels. This aspect is particularly relevant to our European market, with our Vahine brand playing a significant role. Overall, the trend of cooking at home continues, and the increasing number of home meal occasions, spurred by remote work, helps to maintain strong consumption levels.

Okay. And then maybe a follow-up for Brendan. As you're talking to the trade about the holiday seasons and the price increases and consumer behavior, what's the reception been like? Is the price increase well understood for the seasons, the reasons why? And are they eager to merchandise aggressively during the holiday season?

Yes, our discussions with customers and the outlook for the holiday season point towards an improvement in supply. This creates a sense of optimism and strength as we approach the latter half of the year, particularly during the holiday season. We are effectively communicating our capacity to supply and promote holiday displays. Customer conversations have been positive, and the overall outlook appears healthy, largely supported by supply. In relation to pricing, we work closely with our customers to ensure we are driving growth in our categories, and this has been a significant aspect of our discussions. We value our partnership with our customers, and overall, the outlook remains very promising.

And again, I'll just underscore that, well, we don't want to get too specific on discussions about pricing because there are customer or competitive considerations there and there's always some natural tension in those discussions. Our customers know that we've taken a long-term perspective on our relationship with them, that we are transparent in the reasons for pricing and they themselves are continuing to experience inflation. That's very broad based on some of the same factors that we are. And so those conversations have continued to be quite constructive.

Our next question comes from the line of Alexia Howard with Bernstein.

Can I ask about just the global supply chain dynamics? You obviously are sourcing ingredients from many different places around the world, probably more so than other large packaged food companies. I'd just be curious to hear sort of what you're seeing in terms of global supply chain, domestic supply chain. Where are the real pain points for you now? And is there any light at the end of the tunnel?

Sure, Alexia. Our most significant supply chain disruption was in the third quarter of last year, and it has gradually improved each month since then. We're not fully back to normal yet, but the major disruptions we faced a year ago are behind us, and the issues we encounter now are more specific. Our ability to source raw materials globally for our various markets has remained a strength throughout the pandemic and continues to be so. Our challenges mainly revolve around local packaging issues and specific materials from certain suppliers, which are still problematic. Additionally, there are some areas where, despite increasing our capacity, the demand remains extremely high, and we're struggling to meet customer needs in those specific regions.

And then just as a quick follow-up. There was a comment in the press release about unfavorable mix in Flavor Solutions. How important was that? Because obviously, the profit decline was very marked this quarter. And what drove that? And then I'll pass it on.

Yes, it's Mike. One of the factors was an unfavorable mix. If you look at a quarter-to-quarter perspective, there was really strong performance in some higher-margin categories, and this year, the best performance was in away-from-home products compared to at-home products. So, there was a slight shift between those two categories, but it's nothing to be overly concerned about. As we've mentioned, Flavor Solutions can be inconsistent based on the products we sell, and that's part of the reason.

Our next question comes from the line of Adam Samuelson with Goldman Sachs.

I would like to understand the second half better, viewing it from a different perspective. It seems that the full year guidance indicates a rise in second half operating margins of about 250 basis points compared to last year. I acknowledge that there are additional pricing actions that will help, and that the price-cost balance is likely to improve, especially in the fourth quarter. However, this also has a dilutive effect on percentage margins. I’m trying to grasp how we can achieve the expected percentage margin improvement in the latter half, despite some specific challenges we faced in May, particularly regarding the impact in China. Additionally, it appears that demand elasticity suggests volumes may not improve, and between the segments, Flavor Solutions is anticipated to grow faster than Consumer, which presents a mix headwind at the corporate level.

Adam, I'll start and then Mike can take over. I want to emphasize that there is a significant shift in the relationship between pricing and cost as we progress through the year. In the second half, price increases will start to exceed cost increases, and instead of lagging at the beginning of the year, we will begin to recover those cost increases. This will be a crucial factor, as the strong demand combined with having twice the effective pricing in the second half compared to the first half will have a significant impact. Mike, would you like to add to that?

There's other factors to add. I mean we really talk about pricing as a way to offset cost, and we have other levers when we talk about revenue management, our CCI-led cost savings. So we continue to lean hard on driving additional cost savings in this inflationary environment. We see continued strong demand driving that. High-margin products helping us there. So there's a lot of reasons to believe. To your point, though, I mean, between third and fourth quarter, I mean, the fourth quarter is where a lot of this comes to fruition from getting to a positive margin change year-on-year.

Yes, I'll add that we do not anticipate COVID lockdowns to recur in China. While that remains a wildcard and we have been surprised in the past, we are not expecting such an occurrence. However, it was a significant unfavorable factor in the first half, especially in the second quarter, and we believe that will correct and normalize as we progress through the second half.

Okay. To clarify, regarding the performance year-to-date in the second quarter, what are the realized CCI savings thus far compared to the 85% you mentioned for the full year? I didn't catch a specific figure for the year-to-date cost inflation in relation to the high teens target you've set for the entire year. Additionally, could you provide more details on the brand marketing aspect and other SG&A, specifically the extent of the tightening and how much that might contribute in the second half?

This is weighted to the second half, and that's all I'm going to say.

Our next question comes from the line of Peter Galbo with Bank of America.

Lawrence, I just wanted to circle back actually to Andrew's question around private label. And going back to the slides, you do have a section here talking about more entry price points. And I'm just curious, is that a response to what you see as impending more share shifting to private label? And so you feel like you need more entry price points? Or is it something else? You talked about inflating cost baskets and maybe in other categories, like proteins. And I noticed here, you're talking about entry price points on things like Grill Mates and Lawry's, which tend to be more tied to protein. So just curious to kind of get the thoughts around that.

Yes, that really isn’t related to private label. The issue at hand is the concern that consumers may be feeling pressure, as we have noticed signs of this early on. It’s evident that costs, such as gas prices, are rising. Our retail customers are reporting that consumers are feeling this pressure. We are worried that, with the inflationary environment and the significant risk of recession as we move into the second half of the year and into 2023, we need to ensure that consumers, especially those in the lower income brackets, continue to have access to our products. Our aim is to offer products that cater to consumers at all price levels throughout the category. With our new product launches and brand marketing efforts, we are adopting a tone that addresses the pressures consumers are facing. I know we are running out of time, and General Mills might be speaking right now, but Brendan has a lot of insights he can share on this topic, and I’d like to give him the opportunity to do so.

Well, I think Lawrence Kurzius, you hit it largely right. We're trying to make sure that our portfolio and our assortment is really geared towards what consumers are starting to face. And it could very well be price points that are lower in terms of smaller sizes. I would say, though, also, there's another dynamic on the other end, which is happening, which is we actually see even more consumers switching to larger sizes, looking for more value. And so it's playing out really on both ends. And so those are things that we're reacting to and making sure that we drive even more distribution and items in our assortment that serve those needs and those price points that consumers are looking for.

I don't want to get too specific, but I also don’t want to call out our suppliers with whom we’re trying to maintain a constructive and cooperative environment. However, we encountered some issues with glass for our organic spices in our gourmet range, which we believe are resolved now. Additionally, we faced ongoing challenges with some other types of rigid packaging, primarily in the U.S.

Thank you. Ladies and gentlemen, that concludes our question-and-answer session. Mr. Kurzius, I'll turn the floor back to you for any final comments.

Thank you. McCormick's alignment with consumer trends and the rising demand for flavor, in combination with the breadth and reach of our global portfolio and our strategic investments, provide a strong foundation for sustainable growth. We're disciplined and are focused on the right opportunities and investing in our business. We're continuing to drive further growth as we successfully execute on our long-term strategy, actively respond to changing consumer behavior, and capitalize on opportunities from our relative strength. We are well positioned for continued success and remain committed to driving long-term value for our shareholders.

Thank you, Lawrence, and thank you to everybody joining today's call. I apologize for those that we didn't get to. If you have any further questions, please reach out to me today. And this concludes this morning's call. Thank you very much. And for those of you in the U.S., have a wonderful holiday weekend, grill a lot. And for those of you in Canada, happy Canada Day. And everybody else, have a great weekend.