Simply Good Foods Co Q2 FY2023 Earnings Call

Greetings. Welcome to The Simply Foods Company's Fiscal and Second Quarter 2023 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. At this time, I'll now turn the conference over to Mark Pogharian, Vice President of Investor Relations. Mark, you may now begin.

Thank you, operator. Good morning. I am pleased to welcome you to The Simply Good Foods Company earnings call for the fiscal second quarter ended February 25, 2023. Joe Scalzo, Chief Executive Officer; Shaun Mara, CFO; and Geoff Tanner, President, COO, and CEO Elect are with me today. Joe and Shaun will provide you with an overview of results, which will then be followed by a Q&A session. The company issued its earnings release this morning at approximately 07:00 AM Eastern Time. A copy of the release and accompanying presentation are available under the Investors section of the company's website. This call is being webcast and an archive of today's remarks will be available. During the course of today's call, management will make forward-looking statements that are subject to various risks and uncertainties that may cause actual results to differ materially. The company undertakes no obligation to update these statements based on subsequent events. A detailed listing of such risks and uncertainties can be found in today's press release and the company's SEC filings. Note that on today's call, we will refer to certain non-GAAP financial measures that we believe will provide useful information for investors. Due to the company's asset-light strong cash flow business model, we evaluate our performance on an adjusted basis as it relates to EBITDA and diluted EPS. We have included a detailed reconciliation from GAAP to adjusted items in today's press release. We believe these adjusted measures are a key indicator of the underlying performance of the business. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP. With that, I'll now turn the call over to Joe Scalzo, CEO.

Thank you, Mark. Good morning and thank you for joining us. Today, I'll recap Simply Good Foods' second quarter and provide you with some perspective on the performance of our business. Then Shaun will discuss our financial results in a bit more detail. Before we wrap it up with a discussion of our outlook and take your questions. As most of you know, on January 30th we announced that Geoff Tanner will be joining us as President and CEO Elect. Throughout his career, Geoff has been primarily focused on marketing, sales, and innovation within the food sector. So he brings superior experience along with credentials as a terrific leader and, as you'll learn, incredible passion to everything he does. The Board and I are confident that under his leadership, the company will continue its track record of growth and profitability and I look forward to partnering with him to achieve a smooth transition. I'll now turn the call over to Geoff for some introductory remarks.

Thanks, Joe. I'm excited that on July 7, I will become the next CEO of The Simply Good Foods Company. As you know, Simply Good Foods is a special company with two great brands, fueled by passionate employees and loyal consumers. These attributes have delivered top-tier sales and earnings growth and will continue to do so going forward. Although my official start date was two days ago, April 3, I was eager to get a running start to learn about the business and meet with many of the employees via Zoom and phone. I learned what many of you already know: we have a remarkable, energized team who come to work every day with a strong sense of purpose. That purpose is to lead the nutritious snacking movement with trusted brands that offer a variety of convenient, innovative, great tasting, better-for-you snacks and meal replacements. I want to say a special thank you to The Simply Good Foods team, many of whom are listening to this call. It’s clear their passion and dedication, along with our strong brands and growth investments, will continue to contribute to our further success. Both Joe and I have worked with Jim Kilts early in our careers, so it's no surprise we have similar beliefs about the drivers of growth and value creation. Therefore, as I transition to the CEO role, you will continue to see a focus on the core drivers of brand growth, namely marketing and media, innovation, category management, and fundamental sales execution. I call this approach the brand growth flywheel, and it's all in service of expanding household penetration to accelerate growth. We participate in a unique fast-growing category fueled by strong underlying consumer trends that show no signs of slowing. The statistic that perhaps excites me the most is that household penetration of this category is only about 50%, which is very low compared to most food and beverage categories in North America. Working with our talented team and partnering with retailers, we will continue to fuel the brand growth flywheel to increase household penetration and continue to drive growth. Also, following in the footsteps of Jim, Dave West, Joe, and others, I will ensure a continuous improvement mindset across everything we do to deliver results and provide the fuel we need to achieve the growth that's in front of us. I want to underscore my optimism about Simply Good's future. I couldn't be more excited to lead the Simply Good Company. While it's not prudent for me to participate in today's conference call Q&A—again, this being my third day—please note that I look forward to working with all of you as we focus on building value for all Simply Good Foods stakeholders. I'll now turn it back over to Joe to provide details of our second-quarter results.

Thanks, Geoff, and welcome to the team. We are pleased with our second-quarter performance, which exceeded our expectations. During the important New Year, New You season, Simply Good Foods' Q2 retail takeaway in the US combined measured and unmeasured channels increased about 16%. As expected, US retail takeaway growth outpaced the net sales change principally due to the significant prior year retail customer inventory build. Shaun will provide more details on the difference between net sales and POS growth in just a bit. POS growth was driven by both brands. Quest's performance was solid across key forms, customers, and channels. Atkins continues to show growth in both measured and unmeasured channels. Additionally, Atkins' e-commerce growth continues to be additive to measured channels. North American net sales performance was better than our expectations due to solid retail takeaway, although net sales were affected by some customer inventory reductions in the quarter. Additionally, international net sales were softer than our estimates due to the impact of the second price increase initiated earlier this year. Second-quarter gross margin was 34.6% versus 36.6% in the year-ago period. The 200-basis point decline was greater than expectations due to lower ingredient costs flowing through at a slower rate than anticipated and marginally higher other costs within our supply chain. Importantly, our supply chain team performed well with customer service near target levels. Adjusted EBITDA in the quarter was $50.9 million versus $54.2 million in the year-ago period. The $3.3 million decline was better than our estimates due to North American sales performance greater than our expectations and solid SG&A cost control that was partially offset by supply chain cost inflation. Simply Good Foods' retail takeaway in measured channels increased 14.2% with a good contribution from pricing and volume. Specifically, we estimate that Q2 measured channel POS was driven by about 9 points of price and 5 points of volume. Similar to the last few quarters, total unmeasured channel growth was additive to total company point of sale, resulting in a combined measured and unmeasured channel growth of about 16%. In the second quarter, Atkins and Quest combined measured and unmeasured channel growth was about 6% and 26%, respectively, with performance top-tier within the measured channel segments of weight management and active nutrition. Turning to Atkins' second-quarter performance. Atkins' second-quarter retail takeaway in the combined measured and unmeasured channels sequentially improved versus the first quarter and increased about 6%. Atkins' second-quarter POS at Amazon increased 35%. We estimate total unmeasured channel retail takeaway increased more than 25% and is about 13% of total Atkins retail sales. The brand continues to benefit from shopper channel shifting to e-commerce, as well as improved digital marketing initiatives. Brand relevance and loyalty remain strong, supported by a growing base of new and total buyers. The buy rate was down slightly in Q2, although it improved from the first quarter. Moving on to measured channels in the IRI MULO and C-Store universe, Atkins' second-quarter POS increased 3.3% and as expected sequentially improved from the first quarter. Consistent with recessionary shopper channel shifting, performance was driven by solid trends in the mass channel offset by softness in the food class of trade. By form, Q2 shapes retail takeaway increased 13.5% driven by solid growth across all major channels. Total Atkins bars were down 3.9%, a 300-basis point improvement over the first quarter. Meal bars, which account for about two-thirds of the bar business, increased 2.5% and were offset by snack bar distribution losses that we discussed last quarter and some pricing sensitivity from our July price increase. As expected, the confection POS improved from the first quarter, and Q2 confections retail takeaway was down 1.5% as we lapped the strong year-ago performance of our dessert bar innovation. Importantly, the commitment to our brands in the nutritional snacking category by major retailers remains strong. Although in the third quarter, we expect POS to slow as we face tougher e-commerce comparisons on Atkins and anniversary promotions in the club channel that will not repeat. Let me now turn to Quest's second-quarter retail takeaway, where the combined measured and unmeasured channel growth was 26% and continues to outpace the nutritional snacking category. In the second quarter, we estimate total unmeasured channel retail takeaway increased 21% as e-commerce strength was partially offset by softness in specialty channels. Second-quarter POS at Amazon increased about 30% driven by growth across all forms. For perspective, total unmeasured channels in the second quarter were about 24% of total Quest retail sales. In measured channels, Quest's retail takeaway increased 27.2% in the IRI MULO and C-Store universe. Growth was driven by solid performance across all major forms and retail channels, as well as increases across all major metrics, specifically household penetration, base velocity, distribution, and continued new product success. In the second quarter, Quest's core bar business retail takeaway increased 24.1%. Growth was solid across original bars as well as the new minis. Consumer response to the new recipe that provides a much softer original bar has been positive and is driving growth. Additionally, the Hero bar is beginning to gain momentum, driven by distribution gains and higher velocities. The snackier portion of Quest products, which includes cookies, confections, and salty snacks, continued to perform well with second-quarter measured retail channel takeaway of 30%. Growth was strong across all snack forms as distribution gains and marketing investments continue to drive awareness and trial. Consumer response to the price increase initiated in late July is tracking mostly as expected, although elasticity on chips so far has been slightly greater than our estimates. The snacks portion represents nearly 45% of total Quest measured channel retail sales and is already roughly equal to Quest bars in household penetration. We expect Quest snacks to continue to be a driver of the brand's growth over the next few years, driven by household penetration as well as a solid pipeline of innovation. However, given the meaningful size of this part of the business, we expect the rate of growth over the next few quarters to moderate from its current levels. In summary, the company is uniquely positioned as a US leader in the fast-growing nutritional snacking category. We have two scale lifestyle nutrition brands that are well developed across multiple forms and snacking occasions. Our brands are aligned with the consumer mega trends of healthy snacking with a nutritional profile that's protein-rich and low in carbs and sugar. This profile has broad appeal to consumers interested in health and wellness as a means to achieving their goals, whether they're at home, in the office, or on the go. This category remains well under-penetrated from a consumer standpoint, indicating a long runway for growth. This is evident in our second-quarter retail takeaway of 16% that exceeded our forecast. However, as I mentioned earlier, net sales were affected by some retail customer inventory reductions. This is a watch out as we make our way through the third quarter. Our positive business momentum continued into the third quarter as March retail takeaway increased about 12%. We remain cautiously optimistic about our prospects over the remainder of the year. That said, we expect retail takeaway will moderate from current levels as we lap large year-ago comparisons and continue in an uncertain economic environment. While we expect full-year fiscal 2023 gross margins to be below last year, we anticipate an improving cost environment in the second half of the year, with sequentially improving margin from the second quarter to the fourth quarter. We will continue to execute against our priorities and remain committed to doing the right thing over the near and long term for our brands, our customers, and our consumers. Now I will turn the call over to Shaun, who will provide you with some greater financial details. Shaun?

Thank you, Joe. Good morning, everyone. I will begin with an overview of our net sales. Total Simply Good Foods' second-quarter net sales of $296.6 million was about the same as the year-ago period. This resulted in year-to-date net sales of $597.5 million, an increase of 3.4% versus last year. Looking at the Q2 drivers of growth, net price realization was about 8.2 percentage points, and volume was off about 6.9 percentage points. The March 2022 agreement to license the Quest frozen pizza business was a headwind of 1.3 percentage points. As Joe stated earlier, retail takeaway growth outpaced the net sales change. On the bottom of this slide, we attempt to reconcile Q2 POS growth of 16% to Q2 North American net sales growth of 0.3%. The biggest driver of this difference is the impact of the year-ago period retail inventory build. As a reminder, in a typical year, we see retailers build inventory by one to two weeks in the first half of the year to support the New Year New You season. This build typically comes out in Q3. Last year was atypical as most retail customers elected to build significantly higher inventory levels in the first half of fiscal 2022 and did not deplete until the fourth quarter of 2022 due to their supply chain concerns last year. We estimate the impact of this change in retail inventory compared to last year to be about an 11 percentage points headwind or about $30 million for the second quarter of fiscal 2023. Additionally, as Joe mentioned, the current-period inventory reduction by some retailers was about a 3 percentage point impact or approximately $10 million. Lastly, the licensing of pizza was about a 1 percentage point drag. Moving on to other P&L items for Q2, gross profit was $102.7 million, a decline of $5.8 million from the year-ago period, resulting in gross margin of 34.6%. The 200-basis point decline versus the year-ago period was primarily due to higher ingredient and packaging costs. Versus our forecast, gross margin was off by about 50 basis points or $1.5 million due to lower ingredient costs flowing through at a slower rate than anticipated and marginally higher other costs within our supply chain. Net income was $25.6 million versus $18.5 million last year. The year-ago period was impacted by the fair value change of private warrant liabilities of $12.7 million. Adjusted EBITDA was $50.9 million, a decline of $3.3 million from the year-ago period. Selling and marketing expenses were $29.9 million versus $32 million last year, a decline of 6.3% largely due to the timing of spend within the year. GAAP G&A expense was $25.9 million and declined 1.3% versus last year. Excluding stock-based compensation, executive transition costs, restructuring, and integration expenses, G&A declined 1.8% to $22.5 million. The $400,000 decline versus last year was primarily due to lower employee-related costs. For the full fiscal year 2023, we expect selling, marketing, and G&A expense to be slightly down versus the year-ago period. Moving to other items in the P&L, net interest income and interest expense increased $3 million to $8.3 million due to higher variable interest rates related to the term loan, and our tax rate in Q2 was above 24.7%, about the same as last year. The tax rate in the year-ago period excludes the impact of the change related to the warrant liability. Year-to-date results are as follows. Gross profit was $213.7 million, a decline of 5%. Gross margin of 35.8% declined 310 basis points versus the year-ago period. The decline was primarily due to higher ingredient and packaging costs. Net income was $61.5 million versus $39.6 million in the year-ago period. The year-ago period was impacted by the fair value change of private warrant liabilities of $30.1 million. Adjusted EBITDA declined 6.8% to $111.7 million, primarily due to lower gross profit. Selling and marketing expenses were $58.5 million versus $62.5 million, a decline of 6.4% due to the timing of spend within the year. G&A expenses increased 2.1% or $0.9 million. This excludes charges of $6.8 million related to stock-based compensation, executive transition costs, integration, and restructuring expenses. Moving to other items in the P&L, net interest income and interest expense increased $3.7 million to $15.3 million due to higher variable interest rates related to the term loan. Our year-to-date tax rate was about 22.7% versus 24.9% in the year-ago period. The tax rate in the year-ago period excludes the impact of a charge related to the warrant liability. We anticipate full-year fiscal 2023 tax rate to be about 25%. Turning to EPS, second-quarter reported EPS was $0.25 per share diluted compared to $0.18 per share diluted for the comparable period of 2022. In fiscal Q2 2023, depreciation and amortization expense was $5 million and similar to the year-ago period, and stock-based compensation of $3 million was about the same as last year. Adjusted diluted EPS, which excludes these items, was $0.32 compared to $0.36 for the year-ago period. Note that we calculated adjusted diluted EPS as adjusted EBITDA, less interest income, interest expense, and income taxes. Year-to-date second-quarter reported EPS was $0.61 and adjusted diluted EPS was $0.73. Please refer to today's press release for an explanation and reconciliation of non-GAAP financial measures. Moving to the balance sheet and cash flow, as of February 25, 2023, the company had cash of $63.2 million. Year-to-date cash flow from operations was $53.3 million. In Q2, the company paid down $35 million of its term loan debt, and at the end of the second quarter, the outstanding principal balance was $365 million, resulting in a trailing 12-month net debt to adjusted EBITDA ratio of 1.3 times. Note, subsequent to the end of the quarter, we paid down an additional $15 million, so the current outstanding balance was $350 million. We anticipate net interest expense for the year to be about $28 million to $30 million, including non-cash amortization expense related to the deferred financing fees. Year-to-date capital expenditures were $1.7 million. I would now like to turn the call back to Joe for closing remarks.

Thanks, Shaun. In a challenging economic environment, we are well positioned to maintain our marketplace momentum. Over the remainder of the year, there are solid plans in place for both of our brands that we believe will drive sales and earnings growth, particularly in the fourth quarter of the fiscal year. Therefore, we anticipate the following for fiscal 2023: We reaffirm net sales to increase slightly greater than our 4% to 6% long-term algorithm. We continue to expect fiscal 2023 gross margins to be lower than last year; however, the overall cost environment is improving, including ingredients in the second half of the year and particularly in the fourth quarter. However, full-year fiscal 2023 gross margins will decline greater than our previous estimate due to the year-to-date gross margin performance and slightly higher costs within our supply chain over the remainder of the year, with most of this headwind in the third quarter. We have made significant marketing and organizational investments in the business over the past three years and believe this will result in the growth of our consumer base, distribution, and market share. As such, we believe total SG&A expense will be slightly lower than last year. Full-year fiscal 2023 adjusted EBITDA will increase, but slightly less than the net sales growth rate, and adjusted diluted EPS will increase less than the adjusted EBITDA growth rate due to the company's expectation of higher interest expense from an increase in the variable interest rate related to its term loan debt. As we look to the third quarter of the fiscal year, retail takeaway is off to a good start with March POS up about 12%. We have customer programming in place that should enable us to maintain marketplace momentum. We expect Q3 net sales to increase slightly versus last year due to the typical retail inventory drawdown related to the first half of the year inventory build and year-ago promotions in the club channel that will not be repeated. Q3 gross margin is anticipated to decline around 100 basis points, and adjusted EBITDA is expected to be about the same as the year-ago period due to lower ingredient costs flowing through slower than anticipated and slightly higher costs in other areas of our supply chain. Importantly, the retail takeaway growth in our category and our brands remain compelling. As such, we are excited about the near- and long-term growth prospects and will continue to execute against our strategies as a path to increasing value for our shareholders. We appreciate everyone's interest in our company and are now available to take your questions. Operator?

Thank you. We'll now be conducting the question-and-answer session. Thank you. The first question is from the line of Cody Ross with UBS. Please proceed with your question.

Good morning. Thank you for taking our question. First question is just around your sales cadence for the rest of the year. We have a couple of moving pieces here. You previously noted that shipments should exceed takeaway in the back half given the unusual cadence last year. Can you remind us specifically how much you expect to ship above consumption in 3Q and 4Q? And can you also take into account the retailer inventory reductions? I think you said it was a 3% headwind or $10 million this quarter. How should we think about the retailer inventory reductions going forward?

Yes, good morning, Cody, this is Joe. I'll step back because I think you summarized it well, but for those who may not be as familiar with the cadence from last year. I want to start with, just for perspective, the overall health of our business from a demand standpoint can be best seen in point of sale. So not nearly the noise that we're experiencing this year in net sales. Our POS on our business finished the quarter plus 16%. We're one month into the quarter that we're in at plus 12%. The overall health of our business from a demand standpoint is very healthy. We're cautiously optimistic as we move through the second half of the year. We've been exceeding our own expectations on POS and we feel good about the momentum we have as we move through the second half of the year. Now, as it pertains to net sales, there's a lot of noise in the numbers, and much of it has to do with last year. Just to remind folks of what last year was like, customers had difficulty in customer service across basically the food space, and they took positions in inventory that were very atypical. In our case, big inventory build, as you saw in Shaun's comments, about an 11-point differential relative POS to shipments from the inventory build last year. In a typical year, we would see far less, and that inventory would come up pretty quickly, normally in the third quarter. Last year that inventory didn't pull down until the fourth quarter. So we have a very unusual pattern to our business, with big inventory, 3 to 4 times what would have been normal, and none of it coming out in the third quarter, with a good portion of it coming out in the fourth quarter. The headwind that we faced in the second quarter becomes a tailwind for us in the fourth quarter. And we would expect the 11 points that Shaun mentioned, a good portion of that to reverse out in the fourth quarter from a comparison standpoint. But inventory is something that we can't control as a management team. So we just keep our eye on it and have conversations with customers about it, but it's not something that we manage. However, I would expect a good portion of that reverse out that we experienced last year to become our tailwind.

Quick clarification and then a follow-up. Is that retailer inventory reduction embedded in your guidance going forward, meaning it does not come back?

Yes.

Okay. And then just secondly on the gross margin, I believe on the last earnings call, you talked about gross margin being down more than 100 basis points in the second quarter. It came down roughly 200 basis points this quarter. Can you help us understand the changes that you're making, so that the cost surprises in gross margin don't happen as frequently? And can you just help us understand what your expectations were for gross margin going into the quarter? Thank you, and I'll pass it on.

Okay, Cody, I'll take that one. Thanks for the question. So let me take a step back for a second— a couple of context things for you. One, yes, the margin came in about 50 basis points worse than we thought it was going to be for the quarter. Just for context, that's about $1.5 million on about a $200 million COGS number. So, I wouldn't say it's a huge thing. Really two major themes as it relates to our supply chain or cost of goods sold. The first is the commodity environment and the evolution of this. If you go back to last year, we were seeing significant commodity increases, double-digit inflation, which obviously led to our pricing actions. That said, we hit an inflection point on this, and we're seeing a general easing of the inflationary cost environment, specifically the softening of the spot markets in most commodities over the last six months and, in particular, dairy protein. That said, our inventory is valued at higher price points and burning through that slower than we anticipated. Savings are there, flowing through the P&L at a slower rate. That's the biggest change in our gross margin for the year. The second macro trend is really a shift in focus or prioritization of our supply chain. Last year, we were focused on improving fill rates and increasing capacity; inventory levels were priority one to make sure we could fill our customer needs. Now we're working on maximizing working capital inventory levels, improving supply chain efficiency, and getting back to basics, in my words. So bumps and bruises along the way while working with the co-man to get to the right finished goods inventory levels and settling into this environment. We have, however, experienced unanticipated charges related to production runs and operations overall. So all this is a transition issue, and we're settling into where we want to be. We're carrying about six weeks of finished goods inventory on average while servicing our customers in the mid-90s, so not totally there yet, but really close. Costs are coming down, savings are there, just at a slower pace than we originally thought. As it relates to the processes we have in place, remember, we don't own the ingredients at our co-mans; we just help them procure it overall. So we're working with them now to get a better feel for what's out there, and we put processes in place in the second quarter to improve that going forward. So we believe we have that in place.

Thank you very much. I'll pass it on.

Our next question is from the line of Steve Powers with Deutsche Bank. Please proceed with your question.

Yes, thanks. To follow up on that point, Shaun, could you clarify if sales are slightly exceeding your expectations? Could you also explain why the ingredient costs are taking longer to reflect than anticipated? Is there a disconnect, or am I missing something?

A couple of things, Steve. I would say first of all, as we've worked through, again, the commodities that we have out there, the commodities are at different price points. I'll give you an example: one of the biggest pieces of our commodity favorability we're seeing is whey. And whey protein is actually fairly down overall. The burn through that from our co-man is just coming at a slower rate than we originally had thought going forward. So even though we're selling product as we go through it, how we actually reduced the inventories to get to the point where we're actually recognizing those savings in our P&L is just taking a little longer. I think the second piece is, yes, we're doing better from a POS standpoint. Obviously, volume is not increasing as much as POS, as Joe talked to you about. So we're not seeing the volume increase, and we are adjusting that in a co-man environment as well, getting to lower volumes. That's what they're making, obviously, as volume, not necessarily the price piece of that. Does that help?

Yeah, that does help. Okay.

And Steve, just so you understand, we've come from an environment where you wanted as much inventory as you could have in your system backlog. So when you produce to a supply plan, not to a demand plan. So as you're bringing inventory levels down to more normal levels, your actual production levels come down. So units are running slower as we bring our inventory levels down against the same demand. The other context here is, we're talking about really small changes. Shaun said this in the quarter: we're talking about a $1.5 million or nearly $200 million of cost. As you dig into the details of it, none of it is really big things; it's a smattering of small inflationary impacts, slightly worse than what we anticipated. If you just step back from all of this, we own contracts for lower ingredients. We can see the cost environment in our business changing fundamentally; it's just happening a little slower than what we anticipated.

Okay. I mean, that was sort of that's the crux of my question, because there had been these slow kind of slices that impact your forecast and have come costs and results coming in slightly below external forecast as this has been progressive. So the question, I guess as you look forward, maybe you just answered it, but do you have the visibility and is there anything else you need to do? I mean, we've been talking about sort of a climb back to that 40% objective over time. And in this quarter, we're a long way from it. So I'm just trying to get your...

We're not that far from it, right. So the fundamental question you got to ask yourself is, is the cost environment coming down, going up, or neutral? It's coming down. I own contracts for lower cost ingredients, and we have to get to them. As units are a little bit slower, it takes a little bit longer to get to them. The cost environment in general in the first half of the year, and a little through the third quarter, has been inflationary, right? So every surprise is a cost surprise in the opposite direction. We're seeing that environment start to ease. So regarding visibility, we're in a much better position than we were at the beginning of the year regarding what we are seeing. But generally, the cost environment is coming down. So as we move through the second half of the year, if there are surprises, they are all in likelihood going to be in the other direction. Is that a helpful perspective?

Okay. That really gets to the heart of my question. There have been gradual changes that affect your forecast, resulting in costs and outcomes slightly below external expectations as this has progressed. As we look ahead, could you provide some insights on this? Specifically, we're interested in the second half of the year concerning costs and pricing. And then do you have any idea on the timing of some of these ingredient cost reductions to come through into the P&L, and is there anything you need to do operationally to facilitate that or simply just wait for it to flush through?

So just from a timing standpoint, we have visibility to the contract negotiations we have with suppliers, and so we have that base set of visibility for a few quarters out. We have seen some moderation in prices based on what we are seeing in the markets. So in short, we expect pricing and costs to moderate over the second half of this year.

Okay, that makes sense. Thanks so much.

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

Good morning, everyone.

Good morning.

Good morning, Alexia.

So two questions. Firstly, honing in on Quest, obviously, the pace of growth in consumer takeaway is still strong and has been for quite some time. I'm just wondering what innings are you in on the distribution gains? Is it new outlets or is it more of the expansion of SKUs in certain channels? Presumably, velocity is improving over time as well. But I'm just trying to figure out; you mentioned a slowdown is expected as the business gets bigger, but at what point does that happen and what are the levers can you pull? And then I have a follow-up.

I had the benefit of having watched Atkins for 10 years and observe the progress of distribution gains on average. I think Atkins MULO + C has 45 items in distribution; top retailers have 60 to 65. So Quest is in very early innings. One must remember, we bought a business that was principally a singles business. The Quest team, prior to the acquisition, started looking at multi-packs. So there is opportunity in the bar business alone for us to build out distribution in larger pack sizes. You then have the opportunity for us, as we've been innovating in other snacks, to build out that platform over time. So we see it as very early innings in the distribution gain process. More importantly in this business, there are many opportunities to drive brand awareness and trial. Relative to Atkins, everyone knows Atkins, it has high brand awareness. Quest is still relatively unknown as a brand. So the money we've added and invested in this brand, I think when we took the brand over, the team was spending about 4% of net sales and marketing and we're now up to close to 8%. We need to maintain the pressure there to keep brand awareness and trial growing because it's still not particularly well known. The brand promise is big. This is a business with a broad consumer base that still needs validation and trial. I'm really excited about this opportunity to drive consumer awareness as we move forward.

Great. And as a quick follow-up now that you can sort of see light at the end of the tunnel on the supply chain and input cost pressures, are you beginning to see expectations that promotional activity will step up in retail, or is that still on the back burner for now? Thank you. And I’ll pass it on.

We're really early innings, right. So no, we're not seeing anything significant on that front. For us, we would be looking to get marketing investment back to where we feel like is a healthy level. So as gross margins approach 40%, we want to get the marketing spend up to the 9% to 10% range. We will be making that investment with customers on a tactical basis. We've seen some issues with pricing elasticity on some of our products. So you might see temporary price reduction or base price reduction to bring those more in line with what our consumers see as value. But those are decisions that Geoff and the team will start wrapping their minds around as we begin planning for the next fiscal year and where costs are going to land and how we want to allocate those funds.

Great, thank you very much. I'll pass it on.

Have a good day, Alexia.

Next question comes from the line of John Baumgartner with Mizuho Securities. Please proceed with your questions.

Good morning. Thanks for the question.

Hey, John.

Joe, I wanted to ask about elasticity. You noted the downside to sales from international that was tied to the price increases, but I think elasticity isn't something we're really seeing in the US up to this point in the category at least. And I think we're also seeing better lifts on promo relative to pre-COVID. So are there any discrete factors impacting non-US markets that are driving the volume pressure, or is it just general headwinds that could hit the US later in 2023? And I guess I'm also thinking about inventory reductions too, because it feels like based on sell-through, the environment in the US would be better than retailers are hunkering down.

Yes, let's start with our Australia and New Zealand business. We are the market leader there. Atkins is the number one brand, while Quest is moving quickly to become the number two or one local brand. We have a very strong business there, and our general manager has led that business for over a decade. We feel very confident about our operations. Understanding the dynamics in Australia: it's a two-retailer marketplace, Woolworths and Coles own the market. We haven’t seen much pricing in our category there. When we implemented a price increase, we experienced penalty effects with one of the two retailers. This reflects additional distribution losses and reduced promotion opportunities. In the US, we're seeing elasticities for the most part on our two businesses, as we would have expected, with slight sensitivity in a few areas. We're just keeping an eye on those effects, as we typically do with chips and the snack bar business. Watching it closely now.

Okay. And just to build on that, from a category-level at retail, just given the limited elasticity and lifts on promotion, are you seeing anything—or do you expect to see any benefits for the category in terms of higher visibility, displays in-store, or maybe more momentum on the aisle reset, anything coming out of COVID as retailers sort of reset these aisles and categories that you think had sustained growth for your areas moving forward? Thank you.

Yes, look, it's a great question. If you step back and think about this from a category management story from a customer standpoint, we're in the part of the store where most of the other categories think cough, cold, oral care are infrequently and less frequently purchased. For example, things like store food are typically bought weekly. The aisle that we're in, more often resembles a monthly shopping trip. One of the roles this category serves is driving foot traffic to that aisle; we actually bring people to the aisle at a greater rate than their normal shopping patterns. So we serve a purpose for them in helping them build up basket in a part of the store that typically results in higher-margin growth. This behavior was evident through all COVID, and we're seeing continued momentum. In fact, it's part of our category management strategy. This is an essential category for you in this aisle, and we have two of the premier lifestyle brands that can grow foot traffic.

Thank you, Joe. Appreciate it.

You're welcome. Have a good day.

Our next question comes from the line of Pamela Kaufman with Morgan Stanley. Please proceed with your question.

Hi, good morning.

Good morning.

Good morning.

Just a question on Atkins. You mentioned that the buy rates are down year-on-year. Given that mobility is improving and has continued to improve, and you are now comparing against periods of lower Atkins buy rates, why are they continuing to move down? How are you thinking about stimulating Atkins purchasing going forward?

That’s a good question. Thank you. It's right in my wheelhouse, and I love these types of questions! First and foremost, the overall health of the brand is strong. Our ability to grow buyers remains outstanding. We feel very confident in household penetration, our total number of buyers, and the total of new buyers. People are coming to the brand, and that remains important. During COVID, buy rate was driven by changes in snacking behavior. We've seen a rebound from the worst part of those effects on buy rates, and now our buy rate is almost flat. The driver of the buy rate has been issues surrounding our mix of products. If you look at what’s growing on the brand right now, it's strong shape growth and chip growth. Unfortunately, the bars have not seen the same level of growth. So if consumers come to the shelf and we don’t have the right offerings, that's where it affects our buy rates. We experienced significant losses on snack bar distributions recently. However, we have a robust innovation pipeline that’s just getting underway and should allow us to improve those dynamics through the spring and summer.

Got it. That makes sense. That's helpful. My second question is just on e-commerce and generally growth in unmeasured channels. You continued to see strong performance in e-commerce, particularly on Amazon. What's driving that, and how are you thinking about e-commerce growth in the second half given you have tougher comparisons in that channel?

Yes. First of all, a little background: Quest was an e-commerce startup brand, so it established a playbook focused on utilizing e-commerce effectively. When we acquired the brand, we gained a lot of expertise around e-commerce and a strong position on Amazon. If you look at the Quest business, our e-commerce plus specialty accounts for roughly 24% of the business today, while Atkins has also come a long way with about 13%. What we’ve learned about our Quest experience is to look at catalog expansion; we want the right items with fewer items in the catalog to encourage awareness and promotion opportunities. Getting the right items is also critical to Amazon’s profit mix. We're currently implementing that model; last year, we saw an uptick with Atkins after starting the catalog rollout with shakes, which has led to significant increases. As we continue that rollout with the remainder of the Atkins lineup, it’ll only help. I want to mention that Atkins' average price point on Amazon is around $10-$11, compared to $22-$24 for Quest. That means we have a lot of room to grow there. We expect strong growth in e-commerce, but when we wrap against last year’s numbers, we'll encounter some bigger challenges. Still, we feel very good about capturing market share as e-commerce continues to outpace brick-and-mortar growth.

Thank you.

You're welcome.

Thank you. Our last question comes from the line of Rob Dickerson with Jefferies. Please proceed with your question.

Great. Joe, I just wanted to circle back to the comment you made I guess from Pam's question on kind of shakes, bars, and what's going on with Atkins. So on the bar side, right, clearly you see it, and we see it in tracked channels; volumes are still somewhat pressured. You're basically saying that you're just in a bit of an absolute situation with price points to the consumer, given pack sizes, just a little too high. So like with all hands on deck, should we assume that we could see smaller pack sizes and kind of lower absolute price points to increase the velocity of purchasing? Is that what we're thinking?

No, it's actually simpler than that. When you bid, you need to consider Atkins, which is a high-consumption brand. A first-year buyer usually purchases about 35 servings, while a second or third-year buyer tends to buy close to 100 on average. Heavy buyers consume it daily. Therefore, how we innovate should offer consumers the variety that meets their needs depending on the amount they purchase. Last spring, we introduced new chips, cookies, and shakes, but our snack bar pipeline wasn't strong enough. Consequently, we faced significant distribution losses in snack bars, with double-digit declines; this needs to be addressed. This impacts the buy rate because when a consumer approaches the shelf to buy a unit, if they replace a snack bar with a chip, the purchase drops from five items to one. We are in a position where we must innovate more effectively with our bars to satisfy consumer demands. This is a quality issue for us.

Perfect. That's all I had. Thanks, guys.

All right. Have a good day.

Thank you. We've reached the end of the question-and-answer session, and I will turn the call over to Joe Scalzo for closing remarks.

Thank you for your participation on the call. We look forward to talking to you at the end of our third quarter. We hope you all have a good day. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.