SunOpta Inc. Q3 FY2022 Earnings Call

Good afternoon, and welcome to SunOpta's Third Quarter 2022 Earnings Conference Call. By now, everyone should have access to the earnings press release that was issued this afternoon and is available on the Investor Relations page on SunOpta's website at www.sunopta.com. This call is being webcast, and its transcription will also be available on the company's website. As a reminder, please note that the prepared remarks which will follow contain forward-looking statements and management may make additional forward-looking statements in response to your questions. These statements do not guarantee future performance, and therefore, undue reliance should not be placed upon them. We refer you to all the risk factors contained in SunOpta's press release issued this afternoon, the company's annual report filed on Form 10-K, and other filings with the Securities and Exchange Commission for more detailed discussions of the factors that could cause actual results to differ materially from those projections and any forward-looking statements. The company undertakes no obligation to publicly correct or update the forward-looking statements made during the presentation to reflect future events or circumstances, except as may be required under applicable securities laws. Finally, we would like to remind listeners that the company may refer to certain non-GAAP financial measures during this teleconference. A reconciliation of these non-GAAP financial measures was included with the company's press release issued earlier today. Also, please note that unless otherwise stated, all figures discussed today are in U.S. dollars and are occasionally rounded to the nearest million. I'd like to now turn the conference over to the SunOpta CEO, Joe Ennen.

Good afternoon, and thank you for joining us today. With me on the call is Scott Huckins, our Chief Financial Officer. Overall, we were very pleased with our Q3 results, revenue was up 16% with plant-based revenue up 20%. Profitability also rose significantly with a 42% increase in adjusted EBITDA. These results demonstrate the durability of our competitive advantages in plant-based and the traction of our turnaround strategies. Let me offer several key takeaways before we begin unpacking the results. Encouragingly, we continue to deliver both revenue and volume growth. We continue to cover almost all inflationary costs with customer pricing adjustments. Similar to Q2, we had approximately 95% coverage of cost inflation. We made progress in Q3 against one of our five strategic imperatives focused on portfolio evolution with the sale of our Sunflower business and an idle frozen fruit plant in California. The sale of the sunflower business will provide investors with a clearer view of the margins in our core plant-based milk segment as sunflower was significantly margin dilutive. Despite a choppy supply chain, we continue to service our customers at an exceptionally high level with case fill rates in the high 90s. Similar to last quarter, the growth in plant-based was broad-based with growth across channels, product types, customers, and go-to-market strategies. Growth in plant-based largely came from share gains from both new and existing customers, reflecting our competitive advantages and capacity additions we made in 2021 and 2022. Oat continues to fuel growth in our plant-based business unit, and we are far outpacing the oat segment growth rates. The oat milk segment growth and syndicated data for the quarter was up 29% in dollars, while our oat business grew by 68%. We saw significant improvement in fruit segment performance both from portfolio evolution and productivity gains in frozen fruit. Fruit snacks continue a very impressive growth pace at 52%, most of which is volume growth. Similar to almost all food and beverage categories, we're seeing some demand softness and what I would describe as an erratic demand signal from our customers. Recall less than a third of shelf-stable plant-based milks show up in tracked retail channel data, where we continue to significantly outpace category performance, and the foodservice channel remains strong. Innovation continues to power the business. New oat-based products like chocolate oat milk, high-protein oat milk, and even pumpkin oat milk, new fruit snacks, new value-added frozen fruit blends, and new plant-based bowls are all examples of our commitment to lead through innovation. Lastly, the construction and qualification of our Greenfield plant in Texas remains on budget and on track for an end-of-year startup. Net-net, as a result of continuing momentum in the business, we are increasing our 2022 guidance to reflect strong year-to-date results and continued confidence in our outlook. Scott will further break out the details later in the call. Third quarter revenues rose nearly 16% on a consolidated basis driven largely by pricing. We continue to see solid volume gains in our key growth categories of plant-based milks, especially oat milk and fruit snacks. We have three levers that drive volume growth: category growth, share growth, and TAM expansion. While we are seeing some short-term moderation in category growth, we are more than compensating for this by pulling harder on share gains via new and existing customers and TAM expansion. Gross margin of 13.7% was up 190 basis points versus last year, despite 140 basis points of pricing dilution headwind. While margins continue to benefit from broad efforts to optimize input costs and production levels, the year-over-year expansion in our fruit-based business was especially strong. This strength reflects the importance of earlier initiatives around SKU rationalization and consolidating our manufacturing footprint, coupled with robust growth in our fruit snacks business. Production output in our plants and service levels continue to be strong, and all of our capacity expansion projects are complete or on track. Inflation remains a significant headwind, but we've been able to mitigate much of the impact with earlier pricing actions. In the third quarter, we incurred approximately $25 million of increased costs. And similar to the past couple of quarters, we were able to recover the overwhelming majority of this with higher prices. At this point in time, we see some costs trending up and some trending down, which in aggregate suggests there will not be a need for broad price increases in 2023. Now we'll turn to our segment results, starting with plant-based, where we remain focused on three strategic priorities. First, strengthening and fortifying our competitive advantages. Second, winning in oat milk to capitalize on the consumer trend and increase our participation in refrigerated beverages. Third, building a balanced multi-prong go-to-market business that includes co-manufacturing, private label, and owned brands. In our plant-based business unit, revenues were up 20% to $138 million in the third quarter, our 16th consecutive quarter of revenue growth and very similar to the 22% growth we delivered in the first half. On a TTM basis, we have grown this business 50% in the last 24 months. These results benefit from our unique, agnostic approach to winning in the category. We have balanced across food service and retail. We have our own brands to bring innovation to market. We co-manufacture for major national brands, manufacture products for private label, and sell ingredients. We aren't just an almond milk company or an oat milk company; we manufacture almost every type of plant-based milk from oat and almond to soy and cashew milk. This approach combined with our competitive advantages continues to fuel growth. When we look at the core plant-based milk product group, stripping out tea, broth, and sunflower, revenues increased by 25%, and this part of the portfolio represents approximately 70% of our plant-based business unit. Our tea business also remains strong with growth of 50%, an acceleration from Q2 reflecting strong customer demand. We saw a single-digit decline in broth as we prioritized profitability and overlapped some non-repeating business from 2021. This 25% growth in plant-based milks was broad-based with four of our five product types experiencing growth. Oat was once again the largest contributor to growth, with revenue from all oat products up 68%. Oat is now the number one product type in our portfolio, passing almond milk for the top spot. Most of this increase was volume-driven, reflecting consumer growth and our strong partnership with the biggest, fastest-growing brands in the category. Our Oat Barista products in food service contributed significantly to the 68% growth. The growth of these Barista products is a testimony to our R&D capabilities, as we have quantitatively demonstrated for customers that our Oat Barista products are functionally superior to other products in the market. Coconut milk was up mid-30s percent versus last year, again fueled by food service with roughly half of the increase stemming from volume. Almond and soy grew low to mid single digits as higher price realization more than offset moderation in volume. Looking at the results by customer channel, retail was up 16%, reflecting strong growth in mass and club. Food service was especially strong in Q3 with revenues up 30%, driven as I mentioned by oat-based offerings. Looking at the business from a go-to-market standpoint, the fastest growth continued to be in our branded business, where revenues were up 41% versus a year ago, including volume gains of 33%. This growth was fueled by doubling of our Dream brand, which benefited from distribution gains from our top customers. The largest part of our business, our co-man business, grew a solid 16% in Q3. Innovation continues to be a key factor in our growth, and new products or new customers accounted for approximately 15% of our revenue increase in the third quarter, led by large CPGs. Next, I'll provide some context on the plant-based milk category and its recent performance based on retail scan data. We continue to see solid growth in the plant-based milk category. In the latest 13 weeks, total plant-based milk dollar sales grew 12% while units declined 2%. Private label units are flat, and dollars are growing by 7%, representing a 15% share of the category. Category growth continues to be driven by oat milk, with units growing 12% and dollars growing 29%. Oat milk is now 21% of the plant-based milk category. Almond milk remains the dominant market share leader in the category with a 61 share and saw dollar sales grow by 8%. We've remained confident in the long-term growth potential of plant-based milks. The plant-based milk category is a $3 billion category in the U.S. with a ten-year CAGR of approximately 8%, and the underlying drivers of sustained growth are incredibly durable. First, people who drink plant-based milks prefer the taste versus cow milk and won't switch back to cow milk if they don't like the taste just to save $0.10 a glass. It's far more likely that these consumers will switch within the plant-based milk category for value. Second, for the one-third of Americans who are lactose intolerant, switching from plant-based milk to cow milk will make them uncomfortable or sick, so that isn't an option for them. Third, plant-based milk consumers understand and value the health benefits of these products. When you think about these three category drivers from a consumer's point of view, you can understand the durability of the consumer demand drivers. While consumers will certainly find ways to save money, like changing where they shop, how often they eat out, or trading down to less expensive private label products, they're less likely to leave the plant-based milk category. Consistent with most food and beverage categories, we have seen consumers destocking their pantries as a result of the current economic environment, but we believe this is short term, and we are seeing unit trends improve in the latest data. New capacity projects continue to be on track with expectations relative to timing and budget. As we have outlined many times, there are six capital projects that produce the doubling of our capacity from 2020. Five of the six are complete and contributing to growth, the most recent of the five being an expansion in Modesto, which came online a month ago as expected. As it relates to Texas, we hosted our Board of Directors three weeks ago at our new plant, and everything is looking great. I will share a comment from one of our directors: “I've been in hundreds of food plants in my 30 plus years in the business, and this is the most impressive plant I've ever seen.” All of the equipment for the first line is installed, and we're in the process of running the equipment for qualification and validation. At this point, the second line is on or maybe even a bit ahead of schedule. As it relates to business development, we continue to feel good about 2023 utilization with more than 50% of the capacity planned. Obviously, this will benefit the back half of 2023 more than the front half. As a reminder, we will expand our TAM with the addition of the 330 milliliter production line that gets us into the protein shake category. This TAM expansion is one of our five strategic imperatives, and we are now under contract for five years with one of the leading brands in the category. The plant management team is in place. Training of new employees is underway, and we anticipate the first production run in the next seven weeks. Given a very challenging environment going from a dirt field to fully operational in roughly 15 months is an incredible achievement, something we are all very proud of. Moving on to our fruit-based segment, recall our three strategic priorities are: one, de-risking the business through geographic diversification, customer pricing programs, and better grower relations; two, becoming the low-cost operator in frozen fruit through automation, footprint reengineering, and aggressive cost takeout; and three, evolving the portfolio via mix shift and innovation towards more value-added offerings. In the third quarter, fruit-based revenues increased by 10% to $92 million, led by the continued strength of our margin-advantaged fruit snacks business as frozen was essentially flat with higher price realizations offsetting anticipated volume declines. We were very pleased with the Q3 gross margin of 12.3% as the strategies we have been focused on for the last several years are manifesting in the numbers. A year-over-year revenue growth rate of our fruit snack business was an impressive 52%, and the overwhelming majority of the revenue increase was driven by higher volumes. In roughly three years, we've grown our fruit snacks business, which includes our smoothie bowls, by 125% to around $100 million of annual revenue. We remain very positive on the outlook for 2023 and beyond, leveraging our innovation capabilities and expanding capacity. Growth in snacks is very reflective of our balanced customer portfolio, and we continue to see solid gains across large CPGs as well as large retail customers. In our frozen business, revenue was up fractionally versus a year ago as higher price realization served to offset the volume declines we expected. A significant portion of the overall fruit segment gross profit margin improvement came from frozen. This is a strong indication of the power of our profit recovery strategies. Our efforts to build a low-cost business model focused on top customers, de-risking the business, and building pricing credibility with our customers are paying dividends. The 12.3% gross margin in fruit is the highest margin we've seen in five years, and we are confident these strategies have created a more stable, profitable business unit. In summary, our passionate team continues to execute extremely well against our core strategic priorities and deliver solid results despite a challenging macro environment. Underlying demand remains solid, and we are well-positioned to continue driving revenue growth, improving profitability, and capturing additional share by leveraging the power of our platform to rapidly scale. We remain committed to our long-term growth algorithm of annual double-digit plant-based revenue and profit increases and increasing returns on invested capital. Now I'll turn the call over to Scott to take us through the rest of the financials.

Thank you very much, Joe, and good afternoon, everyone. As Joe mentioned, third quarter revenues of $230 million were up 15.7% year-over-year, reflecting continued growth in both segments. In the plant-based segment, revenue increased 19.9%, with pricing up 16.2% driven by earlier actions to offset inflation, and volume growth was 3.7%. Importantly, within the segment, the product category of plant-based milks delivered 7% volume growth in the quarter. Fruit-based revenues increased by 10% as a 10.6% increase in pricing was partially offset by fractionally lower volumes. Gross profit was $31.4 million for the third quarter of 2022, an increase of $8 million or 34% compared to the third quarter of 2021. Consolidated gross margin was up 190 basis points to 13.7%. Despite approximately 140 basis points of headwind from the dilutive effect of passing through higher input costs to customers and 30 basis points of increased depreciation expense. In plant-based segment level gross profit increased $1.4 million to $20.1 million, while gross margin was down 170 basis points to 14.6%. The year-over-year decline in gross margin reflects a 225 basis point impact from the dilutive effect of pass-through pricing to recover cost inflation, along with 60 basis points of incremental depreciation expense and 40 basis points of startup costs in Texas. Combining these three factors, our comparable gross margin would have been 17.8%, up 150 basis points compared to last year, reflecting improved plant efficiencies. In fruit-based, segment level gross profit rose $6.6 million to $11.3 million, and gross margin increased 670 basis points to 12.3%, despite an approximately 50 basis point headwind stemming from the impact of pass-through pricing to recover commodity inflation. The year-over-year improvement in fruit-based gross margin was driven primarily in frozen by rationalizing our SKU portfolio and consolidating our processing facilities to lower manufacturing costs. The significant volume growth and plant efficiencies in our fruit snack operations also contributed to higher gross margins in fruit-based during the third quarter. Segment operating income was $7.6 million in the third quarter, compared to $3.9 million last year. The year-over-year growth was attributable to higher gross profit, partially offset by a $4.2 million increase in SG&A due to higher employee compensation costs, the majority of which was stock-based compensation, reflecting our strong performance in 2022. Loss from operations attributable to common shareholders for the third quarter was $13.4 million, or $0.12 per diluted share, compared to a loss of $3.8 million, or $0.04 per diluted share in the prior year period. The loss was inclusive of the $16.9 million loss on the sunflower business and a $2.7 million gain on the sale of one of our two Oxnard facilities. On an adjusted basis, we had earnings of $2 million, or $0.02 per diluted share in the third quarter of 2022 versus adjusted earnings of $1.1 million, or $0.01 per diluted share in the prior year period. In the third quarter, adjusted EBITDA was $22.1 million, or 42% higher than $15.6 million in the prior year. I'd like to remind listeners that adjusted EBITDA and adjusted earnings are non-GAAP measures, and a reconciliation of these measures to GAAP can be found toward the back of the press release issued earlier this afternoon. Turning to the balance sheet and cash flow. As of October 1, 2022, total debt was $306 million and reflects $191 million drawn on our asset-based credit facility, $112 million of capital leases, with a balance representing smaller credit facilities. Leverage stood at 4.3x at the end of the third quarter, just above our targeted range, reflecting the timing and scale of our planned investments in capacity expansion. Given the volatility in the capital markets, it's worth reminding that our debt doesn't mature until the end of 2025. As the new capacity ramps and generates revenue and cash flow, we expect our leverage to return within our target range in 2023. From a cash flow perspective, cash provided by operating activities during the third quarter of 2022 was $20 million, compared to cash provided of $5 million during the third quarter of 2021. Cash used in investing activities of continuing operations was $22 million compared with $17 million in last year's third quarter, primarily reflecting investments in capacity expansion projects, partially offset by proceeds from the recent sales of non-core assets. As a reminder, we expect material improvement in free cash flow in 2023 as we monetize the capacity expansion projects we invested in during 2021 and 2022. I'd also like to recap the two divestitures completed in the third quarter. First, we sold an idled frozen fruit plant in Oxnard, California for $16 million. We did not run this plant in 2022 and monetized this non-core asset. As a reminder, we continued to run a second plant in Oxnard, California. Second, we sold our sunflower business for $16 million. As we discussed at Investor Day on June 2nd, sunflower was a non-core business for perspective. In the last 12 months, the sunflower business delivered $70 million of revenue with only a 4% gross margin. Let me share the impact on gross margin from removing sunflower from our business. Third quarter consolidated gross margin would improve by 110 basis points to 14.8%, and plant-based margins would improve by 210 basis points to 16.7%. On a full-year basis, the divestiture adds 150 to 200 basis points to plant-based gross margins. In summary, we are following our strategic plan to shape the portfolio to more value-added manufacturing. Let me close with comments on our outlook for the balance of 2022, recognizing the environment is very fluid as it relates to inflation, supply chain, labor, raw materials, and the state of the consumer. We are increasing our 2022 guidance to reflect strong year-to-date Q3 results and continued confidence in our outlook. Given the sunflower divestiture, I'll do this in three steps to ensure clarity. First, a recap of the outlook as shared on the second-quarter call. Second, our improved outlook without considering the sunflower sale. Third, the outlook as adjusted for the sunflower sale. On the Q2 call, we shared estimated revenue in a range of $930 million to $960 million. With adjusted EBITDA estimated in a range of $72 million to $78 million. On an apples-to-apples basis, we are increasing our full-year outlook to revenue in a range of $940 million to $960 million, with adjusted EBITDA in a range of $76 million to $80 million. Now adjusting this outlook for the effect of the sunflower divestiture, we are removing $17 million of revenue in the fourth quarter and making no adjustment for adjusted EBITDA. This results in a full-year outlook of revenue in a range of $923 million to $943 million, and adjusted EBITDA in a range of $76 million to $80 million. This new range results in annual revenue growth of 14% to 16% and adjusted EBITDA growth of 25% to 32%. To assist with year-over-year analysis, Q4 2021 sunflower revenue was $15 million. Let me note that for clarity, the sunflower business is too small on its own to be removed from the financial statements, so we will see the historical results show up in the comps for 2022 and 2023. I'd also like to remind listeners about how we see the new plant-based facility in Midlothian, Texas affecting Q4 2022 gross profit and gross margin. As we have previously stated, we expect production to start at the very end of the year. We expect to incur approximately $5 million in startup costs in the fourth quarter of 2022. While these startup costs are added back to adjusted EBITDA, they will affect gross profit and gross margin rate as reported. Before opening the call for questions, just a reminder that for competitive reasons we do not provide detailed commentary regarding customer or SKU level activity.

Your first question comes from Brian Holland with Cowan & Company.

I would like to start by discussing the guidance a bit more. Initially, it was expected that there would be around $10 million in startup costs for 2022. However, it seems only about $600,000 has been incurred this quarter. Are there changes regarding those startup costs, or is the timeline being adjusted? I’m trying to understand if the revised guidance is simply reflecting the timing of when these startup costs will be realized.

Two pieces. In retrospect, our estimate of startup costs in Q3 was too conservative, mainly centered around the timing of a bunch of the occupancy costs. Then part two would be because those costs are added back to EBITDA, those startup costs in no way affect the updated range.

Joe, you described in your prepared remarks, I think, erratic customer behavior. Just curious how that impacts your near and long-term visibility?

From a long-term standpoint, as I outlined, we're incredibly confident in the durability of the consumer demand. In the short term, what that looks like, Brian, and I'll just give you an example. I mean, in Q2, customers were saying, give us as much as you can, we'll take everything you can make. Then it's, well, well, well, our warehouse is full, hit the brakes, hit the brakes. And then two weeks later, it's like, well, we may have over-course corrected, let's get back on our normal pattern. So, I think everybody's working through the consumer is destocking their pantry; we see that across many food categories. I'm sure you've heard that as other CPG companies have reported. But don't forget, not only does the consumer have inventory, but the retailer has inventory on the shelf, they have inventory in their warehouses, and then our customers also have inventory, and we have inventory. So I think this is just the process of getting back to normal working through how the consumer is responding. And as we mentioned, I mean category was up 12 on a comparable basis, our business was up 25 and on a volume basis category was down 2, we were up 7. So 900 to 1300 basis points better performance versus the scan data. We are proud of the brands that we're partnered with, they continue to win in the marketplace, and food service was also particularly strong.

You mentioned your expectation that you do not foresee a significant rotation out of the plant-based beverage category. While we might see some switching within the category, can you explain how trade downs within plant-based beverages, whether from brands or private labels, could negatively affect your business?

It does not, Brian. As you know, we are a manufacturer of private label products. And so, assuming the consumer trades down in a retailer where we are the manufacturer of that private label product, we would stand to be kind of a net-neutral recipient of that volume. It's also worth noting, we don't have material differences in our margin structure between co-manufacturing and private label. So there is not really a gross profit trade down to worry about if that were to happen.

Your next question is from the line of Andrew Strelzik with BMO. Your line is open.

Hey, good afternoon. My first question is on the cost backdrop, and you noted you are not expecting any broad price increases in 2023. There is some good guys and bad guys. Could you just elaborate a little bit on the puts and takes there? Where you see maybe the most risk or concern just as we watch that unfold?

Yes. We are seeing packaging continue to trend up, and some of the energy inputs like natural gas. And then on the downside on some of the core agricultural inputs, oats, for example, we are definitely seeing the market come back to where it was in 2020. So that's why we entered, that's why we kind of said, 'hey, we don't see broad brush pricing changes.' But obviously, where those are impacting a particular product for a particular customer, we may need to take pricing, but we don't see the aggregation of all of those input costs being something that we are going to need to make wholesale pricing changes on.

Okay, great. And last quarter you gave a fair amount of detail on productivity and capacity increases, just given kind of the evolution of the labor environment. Can you give us a little bit of an update there as well, please?

Yes. So capacity, we are in great shape. Texas will come online at the very end of this year, which we are excited about, huge accomplishment for the entire organization. The other capital expansion projects that we have been executing in 2021 and earlier this year, those are all complete, online and contributing to growth. So overall, we are feeling very good about that, and we look forward to bringing on new customers and new business.

Okay. And the last one for me. I know when we talked about the fruit-based segment margins, you noted some of the mix benefits and kind of maybe a wait-and-see approach. Now that we have got a couple of quarters in a row of these stronger margins, I guess I'm just curious how you are thinking about the trajectory here moving forward or the margin potential of that business. Does it change the way you are thinking about it at all, or is this kind of more in line with what you would have anticipated? Thanks.

Yes. Thanks, Andrew. It's Scott. So one, I think we're pretty pleased with the performance of both of the fruit businesses, both the frozen fruit business on an absolute basis, expanding margin and two, really, really nice growth in fruit snacks. I think Q2, Q3, if you'll recall, get us in the sphere of what our intermediate-term margin targets are. So I think the takeaway would be that's what we are capable of delivering. I don't know that I'd say you can pencil in that number for every single quarter because at the heart of it, as you point out, there's certainly a considerable amount of mixed benefit from fruit snacks, but it doesn't really change the way we're thinking about it. I think it gives us confidence that we're on the right track.

Your next question comes from the line of Bobby Burleson with Canaccord.

So I guess just trying to understand maybe some of your expansion categories in plant-based refrigerated milk, ice cream, and yogurt. Are there synergies there? Like do you guys anticipate margin benefits or some additional structural benefit as you stand out into additional categories and may use some of the bases that you produce?

Yeah, absolutely. So there are two steps to manufacturing plant-based anything — plant-based milk, plant-based yogurt, plant-based ice cream. The first step is converting that ingredient into a liquid or a powder. That step is called extraction. And so it is a very transferable end product. In terms of that end product, the oat base, if you will, that comes out of the extraction process is very usable in a yogurt environment and in an ice cream environment and for plant-based milks or creamers, etc. So it definitely opens the aperture for us to be an ingredient supplier, a value-added premium bespoke ingredients supplier into those categories, opens up the TAM for us and leverages our fixed asset investments around extraction, and specifically oat extraction.

And you've managed to do a pretty fantastic job in terms of picking your partners and how you've kind of aligned yourself with certain customers that are taking share. And I'm wondering, are there best practices there that you're looking at as you figure out who you're partnering with in these expansion categories? Are you taking some learnings there to help you kind of place your bets? Is there any overlap in your customer base with those product categories?

There's some overlap at a kind of the highest corporate level, but not necessarily at a brand level if that makes sense. You know, when you're talking about customers who are 20 billion, 30 billion, sometimes there are opportunities to serve multiple brands in that environment. So, definitely something we're looking to leverage and continue to build on.

And then maybe the last one, it seems like everybody's kind of capitulating to plant-based milk and kind of it's getting much greater adoption than what we're seeing in plant-based meat. And I'm wondering, does that extend maybe into younger demographics, like people that are younger than 18? Is this becoming potentially a substitute at the breakfast table for kids? Like, how far can we expand the category, just demographically in your minds?

Yeah, great question. I mean, we definitely see that there is a significant bias to younger consumers and younger households for plant-based milks. And I think it's one of the most powerful cohort effects in plant-based milks. And recall, this category has been around 30, 40 years, so you have consumers who grew up drinking plant-based products throughout their childhood, whether that was in breakfast cereal or used in baking applications, et cetera. For them, it's just a very natural continuation of what they grew up eating and drinking. So, demographics are definitely a huge propellant here. I would also underscore, we saw some data recently — plant-based milks has a 53% household penetration. So again, this isn't just a niche set of consumers who could wake up tomorrow and decide they're enthusiastic about something else. I mean, you have virtually 50% of American households having plant-based milk in them at some point during the year. So again, speaks to the durability, the breadth of adoption, and I think the power of that cohort in pulling their consumer behaviors along with them as they age and start their own households.

Your next question comes from Mark Smith with Lake Street Capital Markets.

First, certainly liked the consumer behavior data that you gave us early on. Can you just speak to food service? It certainly doesn't look like, from the growth that you put off, but have you historically seen any pullback there in tough economic times?

Good question, Mark, and I'll sort of pull a little bit on 30 plus years of my ancient time in the category. What you tend to see is, you might see consumers in broadly in food service trading down out of kind of fine dining. But if my memory serves me correctly, from the last economic downturn experiences, stopping for my morning latte and that $6 expense is something that consumers are loathed to give up. So you may be in a position financially where you're deferring buying a new car, or going on a vacation, or taking on a remodeling project because those are significant expenses, but consumers are very disinclined to giving up those small treats that things like a delicious oat milk or soy milk cappuccino represent for them.

And then within fruit snack, certainly like the growth that we're seeing there. I'm curious as we look at the margins within fruit snacks, and a lot of this is kind of newer products. Are there opportunities to expand the gross profit margin on that family of products as we move 12 plus months down the road?

I think with the expansion project that we have coming in the third quarter of next year, it definitely gives us an opportunity to better leverage the fixed cost structure of our plants. And so all things being equal, more volume through the same four walls should contribute a bit to EBITDA margin leverage.

As we consider the $5 million in plant expansion expense for Midlothian in Q4, will that entire amount appear in the cost of goods sold, or can we expect some of it to be reflected in SG&A?

It'll really be driven, Mark, in COGS. So the modeling would be, all of the factors being equal, an extra, if you will, $5 million in COGS so that affects gross profit and gross margin as reported. However, from an EBITDA standpoint, we add those costs back to have the effect on the P&L being net neutral. But again, the watch out is just that those flow through COGS.

Your next question comes from Alex Fuhrman with Craig Hallum. Your line is open.

Great. Thanks very much for taking my question and congratulations on a really strong quarter here. I wanted to ask about oat milk up 68% year-over-year and now your biggest plant-based milk, even though almond remains the biggest in the category here. Just curious how you have been able to grow your oat milk business so much faster than the overall market? And do you expect your oat milk business to continue to be your biggest plant-based milk going forward, considering almond is still the biggest in the category for now?

Alex, we saw the 68% growth that we outlined, which was driven both by foodservice and retail, and I think speaks to several things. One is the product quality that we are delivering. It speaks to our ability to continue to serve that category and produce and fill orders at exceptionally high rates — I mean, I'm talking 98%, 99% case fill rate for almost every one of our customers. So that then allows the retail customer the confidence to put that brand on the shelf, knowing they are going to be able to supply and keep the product on the shelf. I think we have identified and are working with some great partners. I would not underestimate the other component that I talked about on the call, which is we have a functionally outstanding product. It makes an amazing latte, the structure of the foam, the way again we formulate for foodservice coffee applications, and our oat milk is outstanding as a latte or in a cappuccino. It foams amazingly. It holds. We measure that over time. If you'll recall, when you had a chance to visit us, we showed you some of the technology and equipment we use to do that analysis, and it's certainly paying dividends for us.

Great. That's really helpful. Thanks, Joe. And then if I could ask just one question on the Midlothian project. You mentioned the second line; it sounds like that is now tracking perhaps a little bit ahead of schedule. Do you have an update on when you expect the second line of production to be operational?

What we had outlined at Investor Day was by the end of Q2, I believe, and we are certainly pressing as hard as we can to pull that forward. At this juncture, we are feeling good about it. And again, I think it speaks to the team's ability to execute in a complex environment. If we can pull that forward, even 30 days, that's fantastic for us because every dollar of revenue is 100% incremental to the business since we are not in that category. That's our 330ml line for protein shake capability. The faster we can get that stood up and contributing, the better it is for us. So as you might expect, we as a team are very focused on getting that production line up and contributing as fast as possible.

Your final question comes from the line of Jon Anderson with William Blair. Your line is open.

Guten Tag, gentlemen. What is the annualized impact of the sunflower divestiture on sales and EBITDA?

Yeah, John, two things. If you looked at the last 12 months, the revenue was about $70 million; call EBITDA on a standalone basis, roughly $3 million. What happens is for clarity is, we won't discontinue the reporting of the business. So as we see, for example, here in Q4 '22, we’ll be comping a Q4 '21 with call it, $15 million of revenue for modeling purposes. And then part two is we go to 2023, we'll have the three quarters of 2022 comp to compare against. So hopefully that's clear.

Yeah, that's helpful. Thanks. So with the strength in the oat milk business, and obviously strengthened food service, which I think is somewhat driven by a large customer you have in food service. You know, I was kind of fascinated by your comments that you've done quantitative testing on the performance of your product, proving it at parity or better to competing offerings in the market. I guess what I'm trying to figure out is does all of this suggest that the oatmeal business that you secured in food service with a large customer's business, would you expect to retain on a long-term basis?

We certainly expect to retain that. I mean, I think the product is performing exceptionally well; it is a superior product in their applications. We are servicing that business at an exceptionally high rate. Our partnerships with our top customers are in a great place as you might expect with those kinds of service levels. So it’s something we work at every day; we don't take it for granted, and we are incredibly focused on serving our customers. All indications we've received from them is they're very happy with us as a supplier.

Okay. And then the protein shakes, that's a large category, right, retail every bit as big as plant-based milks. So with your entry, and I think you've sold out your first line already, should we think about perhaps protein shakes being as big as plant-based milks a few years down the road for you? Is there any reason kind of, structurally or competitively why you couldn't kind of replicate to some extent your position in protein shakes?

So from a TAM standpoint, John, the protein shake category is actually twice as big as plant-based milks. The protein shake category is roughly $6 billion at retail, and plant-based milks is roughly $3 billion, so certainly a dramatic increase in our TAM. We're excited about the opportunity, and we certainly would anticipate and hope that we can demonstrate we're a great competitor and a great supplier in that space, and continue to add capacity to serve our customers. So, I think it would take quite a bit of work for it to be as big as our plant-based milks business in the short term, but certainly we see it as a significant growth driver for the planning horizon of 5 to 10 years. I mean, we absolutely are very bullish about this and think it's a great logical extension of our capabilities and competencies as a company. And so, we're excited to get into it and we believe it's a future growth lever.

As you continue to grow plant-based at a double-digit clip going forward, how important is Texas in allowing you to achieve that growth, specifically like in 2023? And the reason I'm asking that, I'm trying to understand how hard you're running your plants now to deliver the kind of growth you're delivering in plant-based? And how kind of Texas phases in and contributes to that sales growth during the course of 2023 and into 2024?

So at our Investor Day, we outlined a target for 2023 of $100 million of EBITDA. We need Texas to contribute, I would say, modestly to that number. But the core business, meaning the core asset base that we have right now, can pretty much deliver that with revenue growth and customer expansion, et cetera. In other words, 2023 is not completely dependent on Texas. Texas will contribute mightily to 2024 and 2025, and will certainly be a part of the growth algorithm for the back half of 2023. But we're just starting to ramp up, and all of these production lines have a startup ramp-up curve. And so Q1, for example, will be largely dependent upon the asset base that we have today.

There are no further questions at this time. I would like to turn the call back over to the CEO, Mr. Joe Ennen.

Great. Thank you, everyone for your interest and your time this evening. We appreciate it and look forward to speaking to all of you again soon.

Ladies and gentlemen, thank you for participating. This concludes today's conference call. You may now disconnect.