Marzetti Co (MZTI) Q2 2023 Earnings Call Transcript

Good morning. My name is Anita, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Lancaster Colony Corporation Fiscal Year 2023 Second Quarter Conference Call. Conducting today's call will be David Ciesinski, President and CEO; and Tom Pigott, Chief Financial Officer. All lines have been placed on mute to prevent any background noise. After the speakers have completed their prepared remarks, there will be a question-and-answer period. Operator provided instructions. Thank you. And now to begin the conference call, here is Dale Ganobsik, Vice President of Corporate Finance and Investor Relations for Lancaster Colony Corporation.

Good morning, everyone, and thank you for joining us today for Lancaster Colony's Fiscal Year 2023 Second Quarter Conference Call. Our discussion this morning may include forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially, and the company undertakes no obligation to update these statements based upon subsequent events. A detailed discussion of these risks and uncertainties is contained in the company's filings with the SEC. Also note that the audio replay of this call will be archived and available on our company's website lancastercolony.com later this afternoon. For today's call, Dave Ciesinski, our President and Chief Executive Officer will begin with the business update and highlights for the quarter. Tom Pigott, our Chief Financial Officer, will then provide an overview of the financial results. Dave will then share some comments regarding our current strategy and outlook. At the conclusion of our prepared remarks, we'll be happy to respond to any of your questions. Once again, we appreciate your participation this morning. I'll now turn the call over to Lancaster Colony's President and Chief Executive Officer, Dave Ciesinski. Dave?

Thanks, Dale, and good morning, everyone. It's a pleasure to be here with you today as we review our second quarter results for fiscal year 2023. In our fiscal second quarter, which ended December 31, we were pleased to report both record sales and higher profits. Consolidated net sales increased 11.4% to $477 million, while consolidated gross profit improved 5.7% to $102.1 million, and operating income grew 13.3% to $51.3 million. The Retail segment's second quarter net sales reached $259 million, up 5.6%, including the favorable impact of the pricing actions we have taken to offset inflationary costs. Beyond pricing, sales gains were driven by New York Bakery frozen garlic bread, and the continued success of our licensing program. The growth of licensed sauces was led by Buffalo Wild Wings and incremental sales from the recently launched Arby's Horsey and Arby's Sauces. Retail segment sales volumes measured in pounds were up 3.8% in the period, due to price elasticity as anticipated, along with the impact of our decision to exit some less profitable product lines in fiscal 2022. IRI data for the second quarter showed very strong performance for our marquee retail brands. Sister Schubert's leading share of the frozen dinner roll category increased 140 basis points to 55.4%. Marzetti share of the refrigerated salad dressing category added 110 basis points to 23.7%. And New York Bakery's leading share of the frozen garlic bread category grew 90 basis points to 43.1%. In summary, the Q2 top-line results for our Retail segment reflect our pricing actions, strong share growth from our core retail brands, and contributions from our licensing program, which were partially offset by price elasticity and product line rationalizations. In our Foodservice segment, net sales grew over 19% driven by our pricing actions along with volume gains for select customers and our mix of national accounts. Foodservice volume was down 4.6% in the quarter, primarily driven by our decision to exit some less profitable product lines in fiscal 2022. During Q2, we continued to experience high levels of inflation for raw materials, packaging and freight. That said, we've made great progress through our pricing actions to where our PNOC, or pricing net of commodities, was favorable versus the prior year. This is a continuation of the trend that began in Q1 in which we are recovering some of the negative PNOC we experienced last year. In the quarters ahead, we intend to focus on productivity gains in our supply chain and revenue growth management to improve our financial performance. Before I turn it over to Tom, I would like to extend my sincere thanks to the entire Lancaster Colony team for all their ongoing commitment and contributions to our improved operational and financial performance. I'll now turn the call over to Tom, our Chief Financial Officer, for his commentary on our second quarter results. Tom?

Thanks, Dave. Overall, the results for the quarter reflected continued top- and bottom-line growth driven by pricing actions that offset inflationary costs, as well as improved fundamentals. Consolidated net sales increased by 11.4% to $477.4 million. This growth was driven by successfully implemented pricing actions in both segments. Decomposing the 11.4% revenue growth, 15.4 percentage points were driven by pricing; the impact of the volume decline Dave mentioned was four percentage points. Consolidated gross profit increased by $5.5 million or 5.7% to $102.1 million. Gross profit margin declined by 110 basis points, reflecting the dilutive impact of higher pricing and commodity costs on the percentage calculation. The increase in gross profit dollars reflects favorable pricing net of commodities, or PNOC, in both segments. If you recall, in Q2 of fiscal 2022, we had negative PNOC as we lagged the rapid run-up in costs. We continue to recover those losses. While our commodity inflation was approximately 24% this quarter, our pricing actions offset this increase and the majority of the prior year shortfall resulting in improved performance. Consistent with the first quarter, our results also reflected improved fundamentals in three areas. First, both of our segments have eliminated lower-profit businesses and SKUs. Second, through improved planning, scheduling and tactical execution, factory headcount was down for the quarter versus the prior year quarter. Third, inventory days on hand are down versus the prior year quarter and our mix of inventory is better aligned with demand trends. These items, along with a more stable and predictable operating environment, helped to improve gross profit and significantly improve our cash flow performance. Selling, general and administrative expenses declined 1.5% or $800,000. This decrease was primarily due to lower expenditures on Project Ascent. Expenditures for Project Ascent, our ERP initiative, totaled $7.5 million in the current year quarter versus $8.6 million in the prior year quarter. We also benefited from lower professional fees and timing-related changes in consumer spending. Consolidated operating income increased $6 million or 13.3% to $51.3 million, primarily due to the gross profit growth and the reduction in SG&A costs. In the prior year quarter, we had a change in contingent consideration and a restructuring charge. The net impact of these items was immaterial. Our tax rate for the quarter was 22.8% versus 24.3% in the prior year quarter. We estimate our tax rate for the remainder of fiscal year 2023 to be 23%. Second quarter diluted earnings per share increased $0.20 to $1.45. The increase was primarily driven by the growth in operating income. With regard to capital expenditures, payments for property additions in the second quarter totaled $31.9 million. For fiscal year 2023, we are forecasting total capital expenditures of approximately $100 million. This forecast includes approximately $50 million for the completion of the Horse Cave expansion project. In addition to investing in our business, we also returned funds to shareholders. Our quarterly cash dividend of $0.85 per share on December 30 represented a 6% increase from the prior year amount. Our enduring streak of annual dividend increases now stands at 60 years. Our financial position remains strong, as we're debt free with $95.5 million of cash on the balance sheet. To wrap up my commentary, our second quarter results reflect revenue growth driven by pricing that served to offset significant commodity inflation. In addition, the company continued to execute well on the fundamentals in a more stable operating environment. I'll now turn it back over to Dave for his closing remarks. Thank you.

Thanks, Tom. As we look ahead, Lancaster Colony will continue to leverage the combined strength of our team, our operating strategy and our balance sheet in support of the three simple pillars of our growth plan: one, accelerate core business growth; two, simplify our supply chain to reduce our cost and grow our margins; and three, expand our core with focused M&A and strategic licensing. In our fiscal third quarter, we expect Retail sales to benefit from our expanding licensing program while in the Foodservice segment we anticipate continued volume growth from some of our QSR customers. Cost inflation will remain a headwind for our financial results, but we expect our pricing actions and cost savings initiatives to offset the increased cost. During our fiscal third quarter, we will also continue to ramp up production in the newly expanded section of our dressing and sauce facility in Horse Cave, Kentucky. In the back half of our fiscal year, SG&A costs will reflect increased investments in our business including higher levels of spend on consumer promotions. We will also continue to monitor economic conditions for any potential impact on our Foodservice business. Finally, I'd like to provide you with an update on the implementation phase of our ERP initiative, Project Ascent. As we shared previously, this past July we successfully completed Wave 1 of the implementation. In October, we completed Wave 2. We are now in the early days of the third wave of implementation, which will add our dressing and sauce production facility in Horse Cave, Kentucky to the new system. As many of you are aware, this facility is the largest plant in our manufacturing network. All is proceeding as planned and we look forward to completing this important phase of Project Ascent. Note that during the implementation phase, we will have this facility down for four days as part of the cutover process. Our third quarter financial results will reflect the incremental costs associated with this temporary shutdown. I would like to extend my sincere thanks to my teammates for their ongoing efforts on this very important strategic initiative. This concludes our prepared remarks for today and we'd be happy to answer any questions that you might have. Operator?

Thank you. Operator provided instructions. Our first question today comes from Andrew Wolf with CL King. Please go ahead.

Thank you. Good morning. I wanted to ask about volumes. Volumes were still down, but they improved significantly for Retail. I also saw that your direct-to-consumer or consumer marketing was down, but how about promotions that are accounted for as a net reduction of sales, particularly trade spending or other items? Could you give us a little more detail on the evolution of the improvement in volume sequentially this quarter versus last quarter? Did that include promotions? And did that impact the gross margin?

Yeah. It's a great question, Andrew, and I'll take it head on. Our trade spending performance during the period was essentially flat versus the prior period. On volume, if you adjust for the fact that we had discontinuations in the prior period that we're continuing to work our way through, our volume on discontinued items was down 1.9%. When you pull it apart across Retail and Foodservice: our Retail business remains strong. The business continues to perform very much in line with our elasticities. We posted record shares in New York Texas Toast and we posted record shares in Sister Schubert's as well. Our Marzetti brand and refrigerated dressings continue to do well. And the licensed sauces, as we've told you before, are a bit unique in that they don't necessarily have direct competitors on the shelf. So with respect to the magnitude of the price increases, we feel very good about the volume that's in there and the performance. On Foodservice, we're optimistic about what we're seeing. Industry traffic was essentially flat in the period and that was marginally better than in the preceding quarter. Looking at our mix of customers, several were growing traffic: Chick-fil-A first among them, Taco Bell was also strong, and Olive Garden was strong. There were some others that were a little softer. What continues to give us a measure of optimism when we look at volume is that our elasticities in Retail are performing in line with our expectation. We have new items that are back-half loaded this fiscal year, and in Foodservice we remain cautiously optimistic about the consumer with LTO activity planned in the back half. Net-net, we think our volume is holding up in line to slightly better than our expectations at the beginning of the year.

Thank you. That was a pretty full explanation. On gross margin specifically, are there any items to call out with regard to getting Horse Cave up and running? When Horse Cave is running there will be an impact I'd like to know about. But particularly in the quarter, was there any disruption there?

No.

Go ahead.

So yeah, this is Tom. On the quarter and the margins, year-over-year we've got quite a bit of commodity inflation. When you put in $50 million of higher inflationary costs and $50 million of pricing, you get a natural dilution of over 200 basis points on our P&L year-over-year. Sequentially, we did see much higher egg costs and a couple of other commodities that resulted in some of the dilution you're seeing sequentially. But overall, despite those higher costs, we were able to offset them on a dollar basis and still grow our gross profit in this more challenging environment.

Andrew, if I can add on Horse Cave, the start-up has gone very much in line with our expectations, if not better. The factory has gone live; it's up and running in the new section. We're servicing customers out of that exactly as we had planned. In my prepared comments, I mentioned that we were going to be taking it down in this period for several days as part of the SAP cutover. I wanted to make sure you and others understand that. We intended to bring that facility up with the expansion and that team has done a fantastic job. They've brought it up. We've also seen a resurgence in demand on Buffalo Wild Wings and that new capacity has enabled us to keep up with that surge in demand.

Thank you. I'll get back in the queue and let some others ask questions. Thank you.

The next question comes from Brian Holland with Cowen. Please go ahead.

Thanks. Good morning, gentlemen. If I could start with the Retail segment top line. It strikes me that the tracked sales in Nielsen grew at about 2x your reported net sales. Curious where the delta comes from. I'm not sure if that's still a bit of byproduct of folks working off inventory from the pull-forward in demand or if there's SKU rationalization, which I understood to be more on the Foodservice side. Maybe you could aggregate the impact of SKU rationalizations on Retail, if there was any?

You're exactly right. If you look at scanner consumption, it was stronger than what we shipped in the period. We can't necessarily speak to whether it was a deload or something else, but generally we have been shipping to consumption. It's a timing thing. The discontinuations on Retail accounted for several points of growth in terms of shipments in the mix.

Brian, on Retail the impact was a little over 100 basis points. If you peel it back, where we saw the biggest disparity in terms of shipments versus consumption was in the licensed product, specifically Chick-fil-A, which has been doing extremely well. In the prior year period we were still building some inventory, so that may be what you're seeing.

What about anything in the non-tracked channels that would be a factor to explain the delta? Whether you might be lapping a program or anything like that?

Not really. No.

Okay. And then on gross margin, I understand gross profit dollar growth, PNOC going from negative to positive and some improved mix, but it didn't translate to gross margin improvement either sequentially or year-over-year. It doesn't sound like start-up costs for Horse Cave were material, but is there anything there to call out so we understand? I'd like to level set and think about the path forward based on what you are dealing with upstream and downstream.

When you lay in all the commodity inflation and keep in mind our inflation is a lot higher than peers due to our exposure to soybean oil, and this quarter in particular eggs were up quite dramatically, when you factor that in and you add $50 million of inflationary cost to the P&L and you price for it, you've got that natural dilution that occurs. Sequentially, the eggs and soybean oil were up sequentially and tomato costs were up sequentially, which is why you're seeing that dilution despite the positive PNOC. As we go forward, we feel like we'll definitely grow our gross margin percentages versus the prior year, certainly in Q3 and we're looking at Q4 now to try to make sure that we are successful there as well. But until we see stabilization of costs, there is this dilutionary impact. If some commodities moderate, that will alleviate the percentage dilution. We're focused on growing the penny profit and are happy with the quarter's performance.

If I could double-click on commodities. You said input cost inflation was about 24% this quarter. Was that an acceleration versus the magnitude of inflation you faced in Q1?

Yes, it was an acceleration. The unforeseen run-up in egg costs sequentially was a key driver.

Rolling forward, where are you from a hedging standpoint? Eggs are what they are right now. There's some discussion that flocks may improve in the second half of calendar 2023 and we might get cost relief, but I don't know if you're in a position to capture that based on forward buying. Also oils — we're hearing encouraging news on oil prices coming down. Do you have commentary on whether you expect inflation to moderate from here?

I'll jump in and then have Tom add color. On hedging eggs, it's difficult to hedge. For whole eggs we buy on grain-based agreements, so as grains move up and down so do egg costs. We've been able to take a more modest impact, but inflation is still present. We also buy yolks for some formulas and you cannot hedge yolks. We've been able to get forward protection with 90-day pricing protection, which helps. As eggs and oil move, we're continuing to hedge where we can and then price where we can to make sure we're passing costs along. For items where we saw exposure in this period, pricing actions have gone into effect, particularly for products that are heavy consumers of eggs in both Foodservice and Retail.

Appreciate the color. Last one for me: as you look at where you are today, do you expect further pricing is needed? Do you think you've got it all in? If more is needed, where would it be driven — Foodservice or Retail?

Brian, there are a number of pricing actions in flight. All of those have been successfully sold in. We continue to feel good about our ability to price to cover costs in both segments. So there's not a concern about retailer pushback at this stage; we're able to get the pricing in. With the more recent run-up there are additional actions in flight to help us.

To add, last year at this time our pricing was lagging inflation. In Q1 we were PNOC positive, and in this period we were PNOC positive again. We expect that trend to continue. Even where we're seeing short-term shifts like egg spikes, we are pricing for it. We feel that the pricing mechanism is fully developed and we're utilizing it.

Thank you. Good color.

The next question comes from Todd Brooks with The Benchmark Company. Please go ahead.

Hey. Good morning everybody. Hope you're well.

Good morning.

Good morning, Todd.

Following up on Brian's question: how does pricing vary by channel right now? How do you think about pricing in Retail, willingness to take it relative to the elasticity that you're seeing? Whole Foods tried to push back on suppliers; do you feel like pricing will be easier to get in Foodservice going forward if needed versus Retail?

Our conversations on pricing remain very constructive in both Retail and Foodservice. We have about a dozen discrete pricing actions going into effect at the end of Q2 and early in Q3, and these are all conversations that were had in Retail and have sold through. In Foodservice those conversations remain the same. Regarding Whole Foods' announcement on commodities, I don't know what data they're looking at but it doesn't necessarily line up with our data. Some commodity prices may have eased from their highs, but other categories continue to show inflation. For example, beans may have some board price pullback but delivered costs remain high. Net-net, we're not seeing broad relief on inflation. We don't intend to roll back prices because the economics of our market basket don't support that.

Can I ask about the magnitude of pricing for the year? Previously you were looking to be running high-single digit in Foodservice and mid-single digit in Retail. How does that change with the actions you're anticipating for the back half of the year?

We're now more high-single digit in Retail and very high single-digit in Foodservice. We're looking at more pricing than we initially anticipated based on recent commodity moves.

Okay. Great. A strategic question on Horse Cave: now that you're up and running, can you walk through a Horse Cave ramp timeline? How long does it take to ramp fully? Does this unlock Chick-fil-A expansion opportunities with larger pack sizes and additional flavors? How do you unlock other licensed programs with the capacity that's come online? And where in that process does co-pack volume come back in-house?

Good questions. The start-up has gone very much in line with our plans. We're producing hundreds of thousands of cases out of the facility now. It's enabled us to keep up with a big spike in demand for Buffalo Wild Wings garlic parm sauce. For example, two TikTok videos combined have over 25 million views and that product has been on fire, resulting in a surge in demand well in excess of our forecast — and Horse Cave being up and running enabled us to meet that surge. It's running and it's meeting demand. In March we go into a full rollout in Retail of new items: the larger Chick-fil-A sauce sizes, barbecue and Sweet & Spicy Sriracha on Chick-fil-A, a Caesar item for Olive Garden, and more behind Buffalo Wild Wings. The plant is producing product for Retail as well. Regarding co-pack agreements, we are honoring them, but we expect those to wean down through the remainder of this year and early next year, and then bring virtually all of that volume back in-house.

As a follow-up, Tom, if you're bringing co-pack volume back in, what's the benefit to margin rate of in-house production versus co-pack production?

We talked about the dilutive impact being 100 to 200 basis points. Over time we'll get that dilution back, so bringing production in-house will be a catalyst as we go forward.

Okay. Great. Thanks, guys.

The next question comes from Connor Rattigan with Consumer Edge Research. Please go ahead.

Hey, good morning.

Good morning, Connor.

It seems like you're seeing greater elasticity at Retail versus Foodservice when adjusted for SKU rationalizations. Why do you think Foodservice volumes have remained so strong? It seems to run contrary to the view that consumers would cut back on meals out before cutting back on grocery baskets.

We're just not seeing that so far. If past is prologue, we might see consumers dial back meals out before grocery baskets, but so far consumers remain resilient. In Foodservice, traffic across the concepts we follow has remained quite resilient; overall industry traffic was flat for the period and sequentially stronger than the prior period. Our portfolio includes Chick-fil-A, which continues to drive traffic growth and supports our performance.

That helps a lot. Thanks, guys.

The next question is a follow-up from Andrew Wolf with CL King. Please go ahead.

On inventory being down, particularly finished goods inventory, down about 7% from the end of the last fiscal year, that includes inflation in producing it. On a case basis how much are cases down? Could I add 20% to that and say cases are down 25% using round numbers, or am I not thinking about it the right way?

You're close, not quite that much, but units of inventory are down sizably. Last year we had unstable demand and got long on some items, and this year, through better tactical planning and execution, we've been able to drive inventory down and improve cash flow performance.

Got it. That's part of your plan. Re-asking Brian's point: have you heard anything anecdotally that the retail trade may have destocked a little for the December quarter to shore up balance sheets or defer orders? Anything anecdotal to explain the consumption versus shipments delta?

No. We've stayed close to our sales teams on Retail and Foodservice and there haven't been conversations about destocking. We've seen improved on-time and in-full service levels in the period versus the prior year same period. We're continuing to see sequential improvements on operating metrics, including inventory, service levels, and safety. We've tightened up execution and end-to-end coordination over the last year.

Thanks.

The next question is a follow-up from Todd Brooks with The Benchmark Company. Please go ahead.

What's the timing on the Horse Cave cutover when that four-day shutdown will be?

This weekend.

So it's a mid-quarter shutdown. Should we model any impact to the quarter from the shutdown, assuming all goes well?

Yes. We're viewing it as a modest headwind. We lose production days, there is a factory absorption impact, costs for training and start-up. It should be a modest headwind in Q3. It's difficult to quantify until we're through it, but we'll keep you posted.

Part of it is the absorption hit because the factory will be down for four days and it's a factory that would be running 24/7. Rough math: 90 days in a period, four days down will drive a modest absorption impact on top of what Tom described.

My other follow-up was on G&A. If I back out Project Ascent costs, it looks like SG&A is running just north of 9%. What is the right level to put that at based on the commentary around increased consumer spend in the back half of the year?

We expect to spend more on consumer in the back half to drive volume. Project Ascent costs will come back to the business, about $5 million to $6 million incremental in the year, slightly back-half loaded. We also have additional other costs, including compensation expense, anticipated in the back half. When you take out Ascent costs, we're looking at more of a 3% to 4% increase in SG&A, with Ascent adding to that. There will be a fair amount of catch-up in SG&A in the back half, but the full-year profile will be in line with our initial expectations.

Okay, great. Thanks, Tom.

If there are no further questions, we will now turn the call back to Mr. Ciesinski for his concluding comments.

Thank you, Anita, and thank you everybody for joining our call today. We look forward to seeing you out on NDRS (phonetic) in the forthcoming period. If we don't see you sooner, we'll talk to you in May. Have a great rest of the day.

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.