Earnings Call Transcript - MZTI Q2 2024

Operator, Operator

Good morning. My name is Diade, 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 2024 Second Quarter Conference Call. Conducting today's call will be Dave Ciesinski, President and CEO; and Tom Pigott, CFO. 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. The operator will now provide instructions for the question-and-answer session. And now to begin the conference call, here is Dale Ganobsik, Vice President of Corporate Finance and Investor Relations for Lancaster Colony Corporation.

Dale Ganobsik, Vice President of Corporate Finance and Investor Relations

Good morning everyone, and thank you for joining us today for Lancaster Colony's fiscal year 2024 second quarter conference call. Our discussion this morning may include forward 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 at our company's website lancastercolony.com later this afternoon. For today's call, Dave Ciesinski, our President and CEO will begin with the business update and highlights for the quarter. Tom Pigott, our CFO 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 CEO, Dave Ciesinski. Dave?

Dave Ciesinski, President and CEO

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 2024. In our fiscal second quarter, which ended December 31, we are pleased to report record financial results, as consolidated net sales increased 1.8% to $485.9 million. Gross profit grew 19% to $121.5 million and operating income increased 28.1% to $65.8 million. I'm very thankful for the effort and commitment by all of our teammates throughout Lancaster Colony that enabled us to deliver these strong results. In our retail segment, net sales growth of 2% was driven by carryover pricing, volume gains for our successful licensing program, continued strong performance for our New York Bakery frozen garlic bread, and increased demand for our Reames frozen egg noodles. Retail segment sales volume measured in pounds shipped declined 1.9%. Excluding the impact of a product down-weighting initiative and our reduced commitment to private label bread, retail sales volume increased 1.2%. Specific to our licensed product, retail scanner data for the quarter showed Chick-fil-A sauces up 6% to $38.7 million and Olive Garden dressings up 2.1% to $34.4 million. Buffalo Wild Wings sauces were about flat at $19.3 million, which compares to a strong quarter last year when sales increased over 26%. Our category-leading New York Bakery frozen garlic bread saw sales growth of 4% to $88.7 million for a share of 43.1. Sales of our Reames frozen egg noodles increased 17.9% to $16.5 million to capture a 70.3 share of the frozen pasta noodle category. I'm also happy to report that Chick-fil-A refrigerated salad dressings, which we launched nationally last May are also performing well, with scanner data showing $9.4 million in sales during the quarter. When combined with the sales of our Marzetti brand dressings, our refrigerated dressing sales have grown to represent a category-leading 27.7%. In the food service segment, sales growth of 1.5% was led higher by demand from several of our national chain restaurant accounts along with volume growth for our brand and foodservice products. Foodservice sales volume measured in pounds shipped increased 4.6%. During the period, Foodservice segment net sales were adversely impacted by pass-through price decreases, which resulted from commodity deflation. During Q2, we were pleased to deliver gross profit of $121.5 million and a gross margin of 25%, an increase of 360 basis points versus last year. This increase was driven by favorability in our pricing net of commodities, or PNOC, following two years of unprecedented inflation, along with beneficial impacts of our cost savings initiatives. Our focus on supply chain productivity, value engineering and revenue management remain core elements to further improve our financial performance. I'll now turn the call over to Tom Pigott, our CFO for his commentary on our second quarter results. Tom?

Tom Pigott, Chief Financial Officer

Thanks, Dave. This quarter featured continued top line growth, improved gross margin performance and higher operating income. The gross profit and operating income results exceeded our expectations and set a second quarter record for the company. Second quarter consolidated net sales increased by 1.8% to $485.9 million, decomposing the revenue performance approximately 1.5 percentage points was driven by volume mix and the remainder was driven by pricing. Pricing was favorable in the retail segment, but deflationary in the Foodservice segment due to lower commodity prices. Consolidated gross profit increased by $19.4 million or 19% versus the prior year quarter to $121.5 million. Gross margins expanded by 360 basis points to 25%. The gross profit growth was primarily driven by favorable PNOC performance and the company's cost-saving initiatives. Commodity costs were deflationary versus the prior year, but remained elevated versus historical levels. Selling, general and administrative expenses increased 9.7% or $4.9 million. The increase reflects investments to support the growth of the business including higher consumer spending and increased brokerage costs. Consumer spending increased versus a low comparative period to support retail segment growth initiatives. Reduced expenditures for Project Ascent, our ERP initiative, partially offset these increases. Costs related to the project continued to wind down, totaling $2 million in the current year quarter versus $7.5 million in the prior year quarter. Consolidated operating income increased $14.4 million or 28.1%, due to the gross profit improvement, partially offset by the higher SG&A expenses I mentioned. Our tax rate for the quarter was 23.4%. We estimate our tax rate for the remainder of fiscal '24 to be 23%. Second quarter diluted earnings per share increased $0.42 or 29% to $1.87. The net impact of the reduction in Project Ascent expenses was favorable by $0.15 versus the prior year. With regard to capital expenditures, our year-to-date payments for property additions totaled $37.1 million. For fiscal '24, our forecasted total capital expenditures remain at $70 million to $80 million. The forecast reflects a decline versus the prior year spending with the Horse Cave expansion project now substantially complete. In addition to investing in our business, we also returned funds to shareholders. Our quarterly cash dividend of $0.90 per share paid on December 29 represented a 6% increase from the prior year's amount. Our enduring streak of annual dividend increases stands at 61 years. Net cash provided by operating activities for the second quarter was a robust $105.9 million, driven by the higher net income and reduced working capital. Our financial position remained strong with a debt-free balance sheet and $133.8 million in cash. So to wrap up my commentary, our second quarter results reflected continued top line increases, record gross profit and operating income performance and investments to support further growth. I will now turn it back over to Dave for his closing remarks. Thank you.

Dave Ciesinski, President and CEO

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. Number one, accelerate core business growth; number two, simplify our supply chain to reduce our cost and grow our margins; and number three, expand our core with focused M&A and strategic licensing. Looking ahead to our fiscal third quarter, we project retail sales will continue to benefit from our expanding licensing program that will include contributions from the launch of Texas Roadhouse steak sauces. I am also excited to share that we have added Subway as a new partner to our retail licensing program with an initial offering of four different Subway sandwich sauces including their most popular Sweet Onion Teriyaki. Both Texas Roadhouse steak sauces and Subway sandwich sauces will begin shipping to retailers later this month. In the Foodservice segment, we expect sustained volume growth from select quick service restaurant customers. Deflationary pricing is expected to remain a headwind for Foodservice segment net sales in the coming quarter. With respect to our gross profit, we anticipate some continued favorability in our PNOC, but at a sequentially lower level compared to our fiscal second quarter. With respect to our ERP initiative Project Ascent, following the successful completion of the implementation phase during our fiscal first quarter, we are devoting our attention to leveraging the capabilities of this system to strengthen our execution and support our continued growth. Finally, as we announced in December, we had a change in our Board of Directors effective January 1st of this year with the appointment of Alan Harris as our Chairman replacing Jay Gerlach. Alan has served as a Director on the Lancaster Colony Board since 2008 and was appointed lead Independent Director in 2018. While Jay is stepping down from his role as Executive Chairman, he will remain actively engaged as a Director. I would like to extend my deepest gratitude to Jay for his leadership and many years of dedication to Lancaster Colony both as an Executive and as the Chair of our Board. Jay was appointed to Lancaster Colony's Board of Directors in 1985 and is the corporation's longest serving director. I would also like to congratulate Alan on his new appointment. Both Jay and Alan bring extensive leadership experience and strategic oversight to our Board, which will continue to benefit our company and our shareholders going forward. This concludes our prepared remarks for today and we'd be happy to answer any questions you might have.

Operator, Operator

Your first question comes from Jim Salera of Stephens.

Jim Salera, Analyst (Stephens)

Hi, good morning guys. Congrats on a nice quarter. I wanted to start with the inflationary headwind on Foodservice. I think if we back in it's like a 300 basis point headwind in the quarter. If we think about the back half of the year is that 300 basis point number a good sticking point to think about? Or is it going to increase, decrease as we progress through the year?

Tom Pigott, Chief Financial Officer

Hey, Jim. Yeah, it's Tom. We expect it to increase a little bit. We're in the 300 to 400 basis point range for the back half on Foodservice deflationary. And maybe Jim just a reminder that just as the way it went up when it goes down it's a mark-to-market pass-through. So it's a no-harm event on gross profit that also drives modest margin accretion as we talked to you about in the past. It's just one of the nuances of that business in our portfolio.

Jim Salera, Analyst (Stephens)

Right. Great. Yes, that's helpful. So that's broad-based across the portfolio. It's not just like a few key accounts, it's kind of the whole Foodservice?

Tom Pigott, Chief Financial Officer

No. And it's really driven by our basket of commodities, so soybean oil first among them on that part of the business.

Jim Salera, Analyst (Stephens)

Okay. Great. Maybe one other question. You guys got a nice lift from PNOC in the quarter obviously. Thinking about it stepping sequentially down, as we think about back half gross margins, should it be somewhere between kind of 1Q and 2Q's level? Or do we expect it to step down below what 1Q was as well? I think like 23 to 23.5 was first quarter.

Tom Pigott, Chief Financial Officer

So, yes Jim, I'll answer your question kind of as versus prior year. If you look at the first half, we were up 200 basis points versus prior year on gross margins. As we look at the back half, we expect it to moderate more in the 150 to 200 basis point range, but this is very much dependent on the commodity basket and how things play through. From a tailwind perspective, we are seeing some commodity deflation in our forecast and we're seeing some nice supply chain productivity results and those are baked into our outlook for the back half.

Jim Salera, Analyst (Stephens)

Okay. Great. Thanks, guys. I'll pass it on.

Tom Pigott, Chief Financial Officer

Thanks, Jim.

Operator, Operator

Your next question comes from Alton Stump of Loop Capital.

Alton Stump, Analyst (Loop Capital)

Great. Thank you. Good morning. I would also echo your comments Dave, as it pertains to Jay, having known him for almost 20 years. Great to hear that he is taking his next step, but will still be involved with the company and also congrats on the quarter of course as well.

Tom Pigott, Chief Financial Officer

Thank you.

Dave Ciesinski, President and CEO

Thank you. We'll pass your regards on to Jay.

Alton Stump, Analyst (Loop Capital)

Thanks so much. I want to ask about the Subway announcement, which you kind of slipped through there pretty quickly, Dave. That seems obviously pretty good news, if not huge news. You've had several major announcements over the last couple of years. I know you talked about this before, but how much of an impact do you think the huge success you've had over the last few years with Chick-fil-A is having on whether it's Texas Roadhouse, Subway, Arby's, et cetera? I would think that has led to an increased incentive for these guys to reach out to you and take something similar to what you're doing with Chick-fil-A. Can you give some color on the recent snowball of new sign-ups you've got and how much of that you think, if not directly, indirectly is a result of the big success you've had with Chick-fil-A?

Dave Ciesinski, President and CEO

Yes. I think as we've discussed previously, Olive Garden was our first foray into this space. Together with Darden Restaurants and Olive Garden, we learned our way through this. What we learned first and foremost is that the proposition in retail was relevant and second, that the proposition could actually be net accretive to the Foodservice business in terms of positive perception around the brand. Fast forward, as we've moved beyond Darden and continued to nourish that relationship but added Buffalo Wild Wings and Chick-fil-A, I think it's allowed us to demonstrate this proposition more broadly. Texas Roadhouse was a collaborative conversation; it was brokered by one of our big customers in retail. Subway was an inbound conversation as well. It's an interesting time, and I think it's a manifestation of the fact that the lines between retail and Foodservice are blending. We're seeing more occasions that are at-home, and our partners out there in Foodservice are becoming increasingly open to this idea. On the retail side, I think our important partners — be that Kroger, Walmart or other retailers — like the idea of bringing relevant new items to these categories. So it's nothing that grows to the moon, but our intention is to continue to work carefully to look for good partners where we align at the values level. We're looking for long-term relationships in this space, and we're going to try to see how far we can take this. We do have a pipeline of other folks that we're talking to, but we're not ready to share those at this time because these conversations take time. We're even starting to look at categories beyond things that are necessarily sold in the restaurant and maybe even other categories that we play in today. I would love to tell you we have another Chick-fil-A on the hook, but I think we all know there's just one Chick-fil-A out there. But in conjunction with how we're thinking about organic innovation and M&A into the future, hopefully this will give us a balanced set of sources of growth for our retail business that allows us to compete in the top quartile of our peer group, and that's really our long-term aspiration.

Alton Stump, Analyst (Loop Capital)

Great. Thanks for that color. As a follow-up, the Horse Cave facility is up and running now and it's your biggest facility. Is that playing a role in being able to be more aggressive and signing new partners? I believe you had meaningful capacity constraints prior to that facility opening.

Dave Ciesinski, President and CEO

That's correct. We were constrained on retail bottle capacity, and the SAP implementation created a lot of organizational noise. One of the things we've been happy to focus on in fiscal year 2024 is getting back to basics and focusing on good execution. The theme for this fiscal year is 'execute to grow.' That captures the essence of both elements: good execution in our plan, focusing on our GMPs, safety and quality, good execution in the plant around productivity, and making sure that we do this in a way that we can work through the external circumstances with where consumers are to achieve growth at the higher end of our peer group.

Alton Stump, Analyst (Loop Capital)

Great. And then one last one, probably for Tom. On your comments on the gross margin front, if you look at the first half of the year the bulk of that — as you mentioned 200-plus basis points — came in 2Q. So as you commented about 150 to 200 basis points, should we interpret that to mean the back half could be similar to maybe a bit lower year-over-year versus the first half of the year? Am I right on that?

Tom Pigott, Chief Financial Officer

That's correct. Part of the reason is that as you get into Q4, our expectations based on our commodity outlook and our pricing models suggest we don't expect the same level of PNOC performance year-over-year in Q4 versus Q3 and what we experienced in Q2.

Alton Stump, Analyst (Loop Capital)

Got it. Thank you so much Tom and Dave for your help.

Dave Ciesinski, President and CEO

Thanks.

Operator, Operator

Our next question comes from Robert Dickerson of Jefferies.

Robert Dickerson, Analyst (Jefferies)

Great. Thanks so much. Good morning everyone. Nice to hear from you. I've got a few questions, I'll try to keep them quick. First, on the back of your last comment on pricing in retail and how that rolls off, could there be some price deflation in retail in the back half? I'm thinking through maybe some incremental trade or promotional needs given the broader backdrop right now. Also, it seems like there's a more challenged comp in Q3 last year. That's the first question.

Dave Ciesinski, President and CEO

So, great question. What you're going to see is still some marginal pricing that plays through on the deflationary side of pricing. We started to see these trends of softness emerge in November and into December and at that point we started to put plans in action. For those tracking weekly data, we went out on Olive Garden for example and adjusted our entry price point size of 16-ounce where at one retailer it had floated above $4, and we supported the price down to $3.95 on shelf. We also made adjustments on Sister Schubert where we had planned to take our promoted price point from two for $7 up to two for $8, but predicated on the softness we're seeing in the consumer environment we communicated with retailers we wanted to roll back to two for $7 and they were happy to honor that. That would show up as a decrease versus the prior year, but it was a decrease versus our own algorithm internally. Those are examples of areas where we're selectively looking brand-by-brand at the entry price point that matters, whether it's the guaranteed advertised price or the promoted price point, and we're putting support in where appropriate. You're likely to see some marginal upticks in trade support, but you should also see some volume offsets on that. We're trying to orient toward household penetration, which we think is probably the more important metric to watch for the health of the business. We're focused on making investments that protect the business in both the short-term and long-term. On Sister Schubert specifically, we elected to take the promoted price point back down to two for $7. Parenthetically, we also implemented product down-weighting on that line where we went from 1.5 ounce per roll down to 1.25 ounce, which is consistent with what the industry is doing. We didn't receive complaints during the season, and we were able to address lagging margin issues on that business. So that's how we're handling it. But back to your original question: expect marginal upticks on trade. Given our categories, we don't see a wholesale reset. We're cautious about chasing profitless prosperity, so we'll be deliberate in how we invest.

Robert Dickerson, Analyst (Jefferies)

Yes. It's usually the other way around. I appreciate that. Okay. And then when I look at your dressings and sauces business, which clearly has higher margins and has been going well over time, it seems like recently maybe frozen breads are driving more of the growth than dressings and sauces. The licensing dynamic has been going great for you in retail, but have you seen any recent shifts in consumer behavior? I appreciate your earlier comments on price-pack architecture and household penetration, but with consumers being value-seeking, are they buying more frozen dinner rolls and less dressings and sauces? Any color would be helpful.

Dave Ciesinski, President and CEO

I'll take that by category. New York Texas Toast is particularly relevant this season because the spaghetti and meat sauce meal occasion is a good value for consumers. Our team has used digital marketing with retailers to make sure we get into that basket. On rolls, it's relevant as well. Sister Schubert may not be as recession-sensitive as toast, but as consumers eat at home it rounds out the meal occasion. On sauces, we're seeing some trade patterns similar to the rest of the industry: consumers trading from traditional food channels into mass merchants, and in some cases down into discounters. Affluent consumers go to club. We're monitoring those shifts. For licensed sauces, Chick-fil-A sauce is continuing to grow in the mid-single digits albeit off the pace from prior peaks; it remains unique and consumers continue to support it. We saw some softness in Olive Garden as consumers traded down across sizes, which prompted our price point adjustment. Buffalo Wild Wings benefited from significant social media traction last year, which creates a tough comp for the next period; the business is still up more than 25% year-over-year. Arby's, which launched and was supported last year, had heavy retailer support then; without that support it's not selling as well off shelf this year. We look at velocities of the items and where they play in the greater condiment space — all of these are in the top quarter of the category in terms of velocity. Some are stars and some are position players, but they each have an important role with our retailers.

Robert Dickerson, Analyst (Jefferies)

No, that was even better than the last answer. I'll pass it on.

Operator, Operator

Our next question comes from Brian Holland of D.A. Davidson.

Brian Holland, Analyst (D.A. Davidson)

Thanks. Good morning. I wanted to ask about the PNOC trend. We didn't model this appropriately in Q2, and I want to make sure if we disaggregate the mix benefits flowing through in a normal year versus PNOC, is the PNOC spread widening and becoming increasingly favorable in recent quarters? And if we look to the back half, is Q2 a peak PNOC spread, or is the commentary more about mix impact where lower-margin Foodservice is a higher percentage of total net sales?

Dave Ciesinski, President and CEO

I'll take the first crack at this and then turn it to Tom. One of the hard things about the past six months has been forecasting where commodities would go. Soybean oil for example in September was around $0.60 and now it's trading around $0.45. Wheat was trading around 700 to 750 earlier and now is about 588. Corn has fallen off even more. Commodities have come off more aggressively than maybe anticipated, so we've been pleasantly surprised by that. Those movements impacted PNOC favorability in the quarter.

Tom Pigott, Chief Financial Officer

Brian, to build on Dave's point, versus the last time we spoke we saw favorability in soybean oil, flour and grain, and eggs — all contributed to favorable PNOC performance versus our expectations. We are mindful of making appropriate reinvestments to protect the business on trade and that will continue to evolve. In terms of the flow of PNOC, you have more carryover pricing in retail and commodity favorabilities accreted this quarter. As you progress further, there's less carryover pricing and a bit of need to reinvest. So Q2 is the strongest quarter of the year versus our PNOC projections. Q3 will be favorable and then less so in Q4, based on our commodity outlook and projections for trade reinvestment, which can change.

Dave Ciesinski, President and CEO

Modeling the business for Brian, if commodity deflation continues it will be a mark-to-market effect, particularly in Foodservice with modest margin improvement due to the math. We expect the majority of the deflation to stick in the Foodservice business. As commodities deflate, we should begin to see retail margins revert toward historical levels. The way PNOC manifests going forward will be different than in the past, because pricing carryover will be smaller.

Brian Holland, Analyst (D.A. Davidson)

Thanks Dave, that's helpful. Just to put a button on that — as we look to the second half, the PNOC spread tightening is more about pricing saving and potentially more trade reinvestment and assuming stable commodity prices, is that directionally the way to model it?

Tom Pigott, Chief Financial Officer

Yes. That's directionally how we're looking at it.

Brian Holland, Analyst (D.A. Davidson)

Okay. Great. Then SG&A was up more than I expected and was a source of deleverage. You called out consumer investment. Is the expectation in the second half that SG&A will need to increase further? Last year you were heavier in the back half on consumer marketing; is that happening this year or are you normalizing spend?

Dave Ciesinski, President and CEO

Good question. Last year we were light in the first half and heavy in the back half on consumer spending. This year we normalized that spend across both halves. So our year-over-year comparison will show elevated spending because we moved some of last year's back-half load earlier in the year. We don't have an intention to further elevate consumer support beyond the normalization. So on a full-year basis, the investment is being allocated differently across the halves.

Operator, Operator

Your next question comes from Andrew Wolf of CL King.

Andrew Wolf, Analyst (CL King)

Thank you. Good morning and congratulations as well. On PNOC and the 360 basis point expansion in gross margin year-over-year, can you give a sense of allocation between PNOC and value engineering? How much of the improvement was PNOC versus cost savings such as downsizing units, Horse Cave running better, and other initiatives?

Tom Pigott, Chief Financial Officer

The PNOC contribution was a little over 200 basis points and the cost savings initiatives were a little over 100 basis points. That's roughly how it played through the P&L.

Andrew Wolf, Analyst (CL King)

Got it. On that 100 basis points from value engineering and improvements like Horse Cave running better, is that fairly sustainable for a while? PNOC is market-determined, but how sustainable do you see those cost savings?

Dave Ciesinski, President and CEO

We've communicated that our target is roughly $20 million of cost out each year. This quarter's results were heavier on procurement and logistics, where we were able to use favorable line-haul and temperature-controlled trailer rates to generate savings. We had some manufacturing productivity benefit but less on that front this quarter. Going forward, we expect to lock in logistics savings where possible and pursue more savings from manufacturing and value engineering. An example is the down-weighting initiative where we felt it wouldn't diminish the consumer experience and it improved margins. So we expect ongoing programmatic savings from multiple levers.

Andrew Wolf, Analyst (CL King)

Thanks. On the PNOC comments that it will be less of a contribution going forward, are you speaking sequentially or year-over-year? Specifically, is the third quarter slower than the second quarter in PNOC contribution or are you referring to year-over-year moderation?

Tom Pigott, Chief Financial Officer

Year-over-year.

Dave Ciesinski, President and CEO

To clarify, over the last 18 months PNOC was driven largely by pricing and commodity mark-to-market effects. Going forward, the 'P' or pricing component will be smaller. The remaining PNOC will be driven more by commodity movements, and how much of that sticks depends on the commodity outlook. We've taken on two years of about 20% inflation and the recent deflation is still a small component of that overall increase. If commodity deflation persists, we could see more durable benefit, but it's uncertain and we pursue forward agreements opportunistically to lock in favorable pricing when available.

Andrew Wolf, Analyst (CL King)

On retail volumes you mentioned a product down-weighting and a reduced commitment to private label impacting pounds shipped. Can you disaggregate that? How much of the pound decline was down-weighting versus the private label reduction?

Dale Ganobsik, Vice President of Corporate Finance and Investor Relations

Andrew, the down-weighting accounted for about two-thirds of the decline and the private label reduction was about one-third.

Andrew Wolf, Analyst (CL King)

Is this kind of down-weighting widespread in the industry? You haven't led the industry down in most cases, right? So you don't think this puts you at a competitive disadvantage?

Dave Ciesinski, President and CEO

No, when we've made down-weighting changes in the past we've generally moved to industry standards rather than leading the industry down. We haven't done many of these, and we typically conform to the category. On Sister Schubert, after the change, recent period trends show it has continued to perform well. So we believe we're getting our fair share of any category-tailwind.

Andrew Wolf, Analyst (CL King)

Got it. One last question: better price points help units. How is per-unit profitability for you and for the retailer? Are retailers improving penny profit per item?

Dave Ciesinski, President and CEO

From our perspective, the margin story on retail is the important point. You can infer we are making more profit per unit because margins are improving. We are not seeing retailers meaningfully margin up on us broadly. In some categories where retailers compete with private label, they may attempt to margin up on a brand to drive trade down to private label, which is a watch for us. In most of our categories like sauces and licensing, it's not a major issue. In other categories like breads, it's more of a potential watch. Overall, we don't see a material shift in penny profit for retailers across our portfolio.

Andrew Wolf, Analyst (CL King)

Okay. Well, it sounds like you guys are managing those category situations pretty well. Thank you.

Operator, Operator

Our next question comes from Todd Brooks of The Benchmark Company.

Todd Brooks, Analyst (The Benchmark Company)

Hey, thanks, and good morning to you all. First, thank you for highlighting that PNOC becomes more the 'C' than the 'P' going forward. If we look at retail pricing, Dave in the past you've talked about not necessarily chasing incremental volume by lowering pricing. Given the current elasticities in retail channel, how are you thinking about holding price versus supporting price points? Do you have confidence in holding pricing at retail going forward, or do you expect to make tactical price moves where it makes sense?

Dave Ciesinski, President and CEO

If you look at elasticities, you can see tension in the consumer environment. Our elasticities generally don't allow for dropping the list price and fully recapturing margin by volume alone. However, there are key price cliffs — for example at certain price points — where a small move can have a disproportionate volume response. We saw a pickup on Olive Garden when moving to a $3.95 entry price that was 2.5x to 3x our elasticity model's prediction, so in those cases it made sense to take a tactical price and work with retailers to gain promotional support such as in-cap or display. Those kinds of investments can deliver stronger performance than elasticities alone would predict. So we remain deliberate: hold price where prudent, and make targeted investments where they produce high returns and protect household penetration.

Todd Brooks, Analyst (The Benchmark Company)

Thanks. Second question: with the magnitude of the gross margin bounce back, you mentioned in the past that getting back to 26% to 27% gross margin without a meaningful correction in commodities would be difficult. Given we've seen commodity correction, what do you think gross margin potential is if this commodity environment persists? Can you get to those levels?

Dave Ciesinski, President and CEO

Our aspiration is to get the business to the midpoint of our peers, and we still think that's doable. For that to happen, we'd need to see structural reasons for certain commodity prices — for example soybean oil — to remain lower both on the board and on basis. Part of the earlier run-up was policy-driven demand for renewable diesel, which increased demand for soybean oil. If that dynamic relaxes and prices remain lower, combined with our structural cost-out programs, we could get closer to those margin targets. We also buy forward opportunistically to lock in favorable pricing when it makes sense because weather and crop outcomes can create volatility.

Tom Pigott, Chief Financial Officer

From our viewpoint, we expect deflation at similar levels in the second half with some moderation in the fourth quarter, but there are elements you can't forward cover like basis and some processing costs. There's inherent unpredictability, so we remain cautious.

Dave Ciesinski, President and CEO

Tom's right — there's unpredictability, and we continue to monitor avian flu in eggs and other supply-side risks as well.

Todd Brooks, Analyst (The Benchmark Company)

Okay. Great. Thank you all and congrats.

Operator, Operator

Our next question comes from Robert Dickerson of Jefferies.

Robert Dickerson, Analyst (Jefferies)

Hey, guys. Sorry, just a very quick follow-up on the balance sheet. You talked about cash balance and strong cash flow this quarter, and you remain debt-free. ERP costs are winding down. With margins up and cash flow improving, and given limited organic CapEx needs beyond the usual, how are you thinking about that cash — outside of dividends — particularly on M&A or other uses? You've been quiet on acquisitions for some time; any incremental color on how you think about that cash?

Tom Pigott, Chief Financial Officer

We still see opportunities to invest in the business. We've made the big investment in Horse Cave which helps capacity. Going forward we'll continue to invest in automation and other projects to address the tight labor market — these provide good returns. That's our priority one. Regarding M&A, our strategy is to focus on opportunities that leverage our core competencies in dressings and sauces. The sauce category continues to be a nice growing space, and we have strong culinary capabilities, retail execution capabilities and now high-speed production from Horse Cave. With Project Ascent behind us and Horse Cave substantially complete, we're more open to looking at opportunities to scale the business further.

Robert Dickerson, Analyst (Jefferies)

Perfect. Thank you.

Operator, Operator

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

Dave Ciesinski, President and CEO

Well, thank you, everyone. We really enjoyed meeting with you today. We look forward to being with you again in May when we report our next quarter's results. Have a good rest of the day.

Operator, Operator

This concludes today's conference call. Thank you for participating and you may now disconnect.