J.T. Rieck - Flowers Foods, Inc. Allen L. Shiver - Flowers Foods, Inc. R. Steve Kinsey - Flowers Foods, Inc..

Timothy S. Ramey - Pivotal Research Group LLC Amit Sharma - BMO Capital Markets (United States) William B. Chappell - SunTrust Robinson Humphrey, Inc. Rob Dickerson - Deutsche Bank Securities, Inc..

Welcome to the Flowers Foods Third Quarter 2018 Earnings Conference Call and Webcast. My name is Elin, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to J.T.

Rieck, Vice President, Investor Relations and Treasurer. You may begin..

Allen Shiver, Flowers Foods' CEO; and Steve Kinsey, Flowers' CFO. Allen, I'll turn the call over to you..

First, reinvigorating our core brands through innovation and marketplace execution; second, extending our portfolio and growing adjacencies in the bakery category through organic growth and acquisitions; third, working to improve margins by reducing cost and optimizing our supply chain; and finally, making strategic investments in new capabilities.

This multi-year transformation is well underway. We are on track to hit the top end of our gross savings target for this year. The entire company is dedicated to delivering on our long-term targets. In finalizing our 2019 plan, we will be conservative about consumption trends so that we can right-size our cost structure accordingly.

In addition, we are taking pricing market-by-market as we manage rising production and distribution costs. Now for a closer look at our top line. Consolidated sales were down 1%. Approximately 80% of this decline was driven by the non-retail category, specifically vending and foodservice accounts.

We continue to see strong performance from Dave's Killer Bread. Also, we realized better pricing on our core bread brands and added store brand. However, we did see branded retail sales decline in the quarter. This was driven by lower cake sales and difficult comparisons in our core bread business.

As we said on the second quarter call, volume comparisons were difficult due to multiple hurricanes in the third quarter last year. Our competitive position remains strong. According to IRI, we gained share for the ninth quarter in a row in the fresh packaged breads category.

In the third quarter, Flowers achieved a record market share of 16.3%, and each of our top three brands, Nature's Own, Dave's Killer Bread and Wonder gained share. I'd like to circle back on how we are reinvigorating core brands through innovation and marketplace execution.

A recent innovation example is Nature's Own Perfectly Crafted, a line of artisan-style breads, launched in the second quarter. Perfectly Crafted has performed very well, reinvigorating the growth of our Nature's Own brand. Our marketplace execution is improving as well. Retailers are allocating more space to the strongest national brands.

The streamlined assortment we put in place last year is helping Flowers gain additional space and distribution. Given the inflationary pressures in commodities, wages, and freight, we're working to optimize our pricing architecture market by market, using new tools to guide trade promotion decisions and better allocate trade dollars.

We also are capitalizing on adjacencies by extending our portfolio into growing segments outside of our core product lines, including breakfast items and now Canyon's gluten-free products.

In the breakfast segment, we're pleased with the performance of DKB organic bagels and breakfast breads, and we are further extending our reach into breakfast with our recent licensing agreement to produce and market Sun-Maid Raisin bread. Disciplined M&A is an important part of our strategy to grow in product adjacencies.

To that end, we are excited about our pending acquisition of Canyon Bakehouse. Let me take a moment to introduce Canyon and provide some additional color on the pending acquisition. With Canyon, we are well-positioned to gain share in the important and growing gluten-free segment.

Canyon brings to Flowers a great line of 21 gluten-free products, a very talented team and a state-of-the-art gluten-free bakery, along with a brand with an enthusiastic consumer base. The Canyon Bakehouse brand is a top gluten-free loaf brand in natural and specialty food stores. It is the fastest-growing gluten-free loaf brand in the U.S.

and Canyon recently became the number-two brand in the overall gluten-free loaf category. We believe Flowers is uniquely positioned to create value and accelerate profitable growth of the Canyon Bakehouse brand.

By leveraging our baking expertise, distribution network and retail partnerships, we aim to bring Canyon's products to more consumers across the country. Co-founders Josh and Christi Skow and the Canyon team have passionately built a wonderful brand and we're excited to welcome them to Flowers Foods.

Turning to our other initiatives, we continue to work on unlocking the profitability and growth of our cake business. We're going back to the basics and taking actions to right-size this business. This year, the focus has been on product assortment, pricing, and quality to be sure we were offering items with clear consumer appeal.

With this work as the foundation, our plan is to build new innovation and packaging platforms starting next year.

While we're pleased with the progress being made to reinvigorate and diversify our brand portfolio, we recognize the challenges in the marketplace and we understand the importance of reducing cost and optimizing the supply chain to maximize profitability.

To drive bottom line improvement, we are aggressively reducing cost and holding our leadership team accountable for those results. Driving execution at the local level is key. That is why early in the fourth quarter, we adjusted leadership roles at our bakeries to amplify our P&L accountability and allow for quicker response to market conditions.

This adjustment is intended to improve operational efficiencies and assure actions are being taken both regionally and locally to fit with our strategic goals. To control cost, we have been taking actions to reduce purchased goods and services and streamline our organizational structure.

We are making substantial progress and now expect these initiatives to deliver gross savings at the upper end of our targets. The goal is to deliver these savings to the bottom line. We are working aggressively to counter the inflationary pressures we're experiencing and improve productivity.

One way that we're doing this is through supply chain optimization. We began this effort last year with the closing of the Winston-Salem facility. This week, we announced the closing of a bakery in Brattleboro, Vermont, and the start-up of a new high-speed bun line in our Oxford, Pennsylvania bakery.

We have plans in place to continue optimizing across the supply chain in 2019 and 2020. Thanks to new data capabilities, we are gaining enhanced insights into profitability at both the customer and the product level. These new insights give us the ability to better take advantage of margin opportunities where possible.

In some cases, to strategically exit low-margin or unprofitable business is appropriate. These actions are all designed to further our strategic aim to reorient the business around the higher-margin branded products. We are not satisfied with our current results. Let me repeat that. We are not satisfied with our current results.

But there is a transformation underway at Flowers Foods to enhance our shareholder returns. We recognize the challenges that are facing the food industry and we are executing on priorities that we are confident will drive sustainable, profitable growth and value creation.

Now, I'll ask Steve to review the financials and provide our outlook for the rest of the year.

Steve?.

Thank you, Allen, and good morning, everyone. As Allen stated, it was a challenging quarter. We continued to experience some of the trends we saw coming out of the second quarter. Both top line and margins were challenged during the quarter.

We believe the yeast issue that hit at the end of the second quarter carried over into the third quarter, impacting the marketplace as well as bakery efficiency. Transportation, workforce, and higher ingredient costs continue to negatively impact profitability.

The pricing actions we took earlier did partially offset these inflationary pressures and we have taken additional pricing actions to further offset them in the back half. Turning now to our third quarter financial performance, consolidated sales were down 1%. Volume was down 3.5%, while price/mix was up 2.5%.

The volume decline was partially offset by strong volume growth in Dave's Killer Bread and growth in expansion markets. Pricing actions across many product lines and growing sales of DKB primarily drove the increase in price/mix. Several factors have contributed to the overall volume declines.

First, volume was impacted by significant prior-year period hurricane activity in our core markets. Second, consumption of variety breads and sandwich buns and rolls was soft. And third, we experienced lower volume across our foodservice, vending and cake businesses.

This was due to pricing actions and taking a more selective approach with low-margin high-volume business. Consolidated margins declined 150 basis points as a percentage of sales. This was primarily due to higher outside purchases and ingredient costs and lower manufacturing efficiencies.

As we noted in the second quarter, the labor environment remains very challenging. We are seeing both higher wages and increased turnover, which have contributed to higher manufacturing workforce-related costs. Adjusted selling, distribution and administrative expenses declined 10 basis points as a percentage of sales.

Overall, workforce-related costs were lower due to organizational changes and lower incentive compensation. This more than offset increased distributor discounts, marketing costs and shipping and hauling costs. The higher distributor discounts as a percent of sales is generally attributable to recent sales of company-operated territories.

Reflecting the net of higher production costs and lower SD&A as a percentage of sales, adjusted EBITDA margin decreased 140 basis points to 10.6%. Adjusted EBITDA in the quarter was $97.5 million, down $14.8 million compared to the prior year quarter.

Higher input costs, manufacturing, workforce cost, freight cost and increased marketing spend drove most of this decrease. GAAP diluted earnings per share for the quarter was $0.19 per share.

Excluding the items affecting comparability detailed in the press release, adjusted diluted EPS in the quarter was $0.23 per share, or equal to the prior-year quarter. The effect of the new tax law accounted for approximately $0.03 of the increase in adjusted diluted EPS.

Now turning to segment-level financial results, the DSD Segment revenue was down 90 basis points in the third quarter. Price/mix increased 2.1%, while volume decreased 3%. Our price/mix in the quarter was driven by the growth of DKB in our sales mix and the pricing actions we implemented in the first quarter to address input cost inflation.

Volumes were impacted by cycling prior-year hurricanes, as well as lower foodservice volumes. Adjusted operating margin in our DSD Segment was down 140 basis points as a percent of sales versus the prior year. We continued to experience lower manufacturing efficiencies as well as higher input cost and labor inflation on lower sales.

Warehouse Segment revenue was down 1.6% in the quarter. Price/mix increased 3.3%, while volume decreased 4.9%. Price/mix was driven by pricing actions. Volume declines occurred primarily in our cake and vending businesses.

Adjusted Warehouse operating margin was down 190 basis points as a percent of sales, impacted by lower volumes as well as higher distribution costs. These were partially offset by lower SD&A costs. Now, turning to cash flow, cash flow continues to be strong. Operating cash flow year-to-date was $232.1 million, up $8.1 million from the prior year.

This increase was achieved even with several discrete cash uses totaling over $100 million. These include voluntary pension contributions associated with our pension de-risking strategy, Project Centennial-relating consulting and restructuring payments, multi-employer pension plan withdrawal liability payments and legal settlements paid.

These cash uses were more than offset by cash generated from our payment terms extension initiative under Project Centennial and a lower effective tax rate. Capital expenditures were $75 million year-to-date as compared to $51.2 million a year ago.

Dividends paid year-to-date total $112.2 million, a 6.7% increase over the first three quarters of last year. We ended the quarter with $775.6 million in net debt. At quarter end, our net debt to trailing 12-month adjusted EBITDA was 1.8 times. Our financial position remains strong.

As of quarter end, we had approximately $685.9 million of liquidity available on our credit facilities. This availability plus cash on hand allows us to comfortably fund the Canyon Bakehouse acquisition and continue to maintain a conservative financial position.

Now, turning to guidance, for 2018, we continue to expect sales to be in the range of flat to up 1.6%. As noted in the second quarter call, back half sales trends are expected to be below the first half, with third quarter comparisons being the most difficult due to the impact of prior-year hurricanes.

Sales in core markets in the snack cake business were softer than expected and we have adjusted our forecast for the remainder of the year. We're now expecting adjusted EPS to be in the range of $0.90 to $0.95 per share. In addition, we expect inflationary headwinds for commodities, wages, and freight to carry through for the rest of 2018.

We continue to expect approximately $40 million of input cost inflation in 2018, which we have partially addressed by taking pricing actions and are focused on cost savings initiatives. Tight labor market continues to pressure cost as well as higher workforce-related costs and lower manufacturing efficiencies.

We also see increasing logistics costs due to the driver shortage. We are working to mitigate these inflationary pressures through cost reductions. We expect the targeted gross savings from Project Centennial to be in the upper end of our $38 million to $48 million range we identified earlier this year.

For 2018, we expect a full-year tax rate of approximately 25% to 26%, before one-time costs. Looking at the benefits of the Canyon Bakehouse announcement, we expect 2019 sales of approximately $70 million to $80 million. Canyon has generated a compound annual net sales growth of approximately 45% since 2014.

We expect the transaction to be accretive to EBITDA in 2019 and accretive to EPS in 2020. We continue to expect the inflationary headwinds to continue. As Allen said, we're proactively addressing the inflationary cost environment with pricing actions and productivity initiatives.

As we usually do, we'll provide a full outlook for 2019 in our fourth quarter call in February. To sum up, this has been a challenging year in light of greater than expected inflationary pressures and a competitive marketplace. However, as Allen noted, we are making good progress to transform Flowers and overcome near-term headwinds.

The strength of our brands, along with our supply chain organization gives us confidence that we can expand our industry-leading margins over time.

In addition with strategic investments like Canyon Bakehouse, we are diversifying our portfolio into segments with above-category growth for our competitive advantages for the right opportunities for enhancing overall shareholder value. Now let's open the line for questions..

Thank you. We will now begin the question-and-answer session. And our first question is from Tim Ramey with Pivotal Research Group..

Good morning. Thanks for that. So, hate to bring it up, but this quarter looks like so many third quarters in recent years where we've set expectations relatively high, it was just in May we were looking at $1.04 to $1.16 and we're taking $0.12 to $0.14 off of that – $0.11 to $0.14 off of that six months later.

I get the challenging environment you're facing, but your ability to forecast really just has to be called into question. This pattern of dumping the guidance in the second half, we've seen it many times before, and looks to me like on your guidance, EBIT will be lower in 2018 than it was in 2013.

Can you comment on kind of your financial projections controls and how you're working to refine that and get that better?.

Sure, Tim. This is Steve. As you would recall, one of the aspects of Project Centennial was working on capabilities and driving better capabilities internally.

We did stand up a financial planning and analytics team in 2018 as part of Project Centennial, and the tools that we are implementing within that group should allow us to improve upon our forecasting ability going forward..

Okay. The area of concern, I guess, we've also seen pricing go up in the years past and volume fall fairly precipitously. I know you mentioned that your market share was up in the quarter. So, that's good.

But what do we think about the ability to actually realize those prices without exacerbating the negative spiral that you're seeing on input costs from lower volume?.

Yeah. Tim, this is Allen. We mentioned on the – that overall pricing continues to be a primary focus for us. We're adjusting pricing and have on a market by market basis. To speculate on the category and what might happen there, I don't think that would be appropriate.

But our – the marketplace is all dealing with the same type of cost increases that we are. And so you would expect the pricing in the category would continue to go up. I'm also very encouraged with our – what I would consider value-added brands that can support a higher price, and Dave's Killer Bread is a great example of that.

So as we look forward, this category is going to be about brands that can carry the type of margin that we're going to insist takes place..

Okay..

In the short term, we're in the transition mode right now..

Yeah. Thanks for your help..

Thank you..

The next question is from Amit Sharma with BMO Capital Markets..

Hi, good morning, everyone..

Good morning, Amit..

Allen, I'm sorry, I missed the first part of your prepared comments.

Can you talk about the Canyon Bakery (sic) [Canyon Bakehouse] (24:48)? Obviously, I heard about the growth, can you talk about the margin implication as well? And then as you think about synergies, obviously, we see some on the distribution side, but how do you think about the manufacturing side here?.

Yeah. So, we're – again, we're very excited about the addition of Canyon to our company, a very strong brand, excellent manufacturing facility, a very focused team on where the consumer is headed today and this whole gluten-free segment is growing significantly. And again, Canyon is positioned really as the number-two brand.

When we think of Canyon and expanding – from a distribution standpoint, expanding the Canyon brand onto our fresh DSD routes, again, many consumers across the country are going to have an opportunity to purchase Canyon. With frozen distribution, which is what they have now, they have limited distribution there.

Steve, if you want to comment on any of the financials?.

Yeah. So, when you look at it from an overall margin profile, we're expecting their EBITDA margins to be in line with or slightly above our corporate average today coming into 2019 and to be able to grow for that as distribution of the brand continues to expand.

I mean, when you look at the opportunity compared to organics or Dave's Killer Bread, I'd say it's probably not the size of opportunity you see with organics, but we still believe there is great growth opportunities within the gluten-free category.

And we believe that what you saw with DKB and the strength of DSD that we will be able to do that as well in the gluten-free category..

Perfect. And then both for Steve and Allen as well, two things here from a cost perspective, because I see – you said you saw headwinds from third-party purchases and then at the same time inefficiencies in your bakeries.

Can you just unpack those like how are we facing those issues at the same time, right, both seem exclusive to each other? And then Allen, broadly speaking, Project Centennial seems to be going well, but the focus from the very beginning has been on gross cost savings.

And if what we are seeing that gross to net is where the disconnect seems to be, are we doing anything to maybe bridge that gap or maybe focus a little bit more on net savings versus gross savings?.

Again, the focus on overall cost reduction, I mean, it is across the entire organization. And we have – and as I said in my comments earlier, nothing is more important than the team implementing the cost saving strategies that is in place.

And so there is tremendous urgency and there is a much more intense level of accountability than there ever has been about achieving the cost savings commitments that we've made. And we've made those commitments as a team and we're going to achieve those commitments..

Amit, it was – your first part of your question was hard to hear. You might want to repeat that..

Yes. So Steve mentioned that third-party purchases and then bakery inefficiencies were both reasons for margin degradation, right.

I'm just trying to reconcile how do you face both those issues at the same time? And does that get better or structurally because of the way DKB is growing, it still remain a headwind for margins for some time?.

When you look at outside purchases, the main thing we continue to buy is Dave's Killer Bread breakfast items. So over time, as we add production – organic production, that should be more transitory and some of that cost should abate.

When you – as we've said, we're looking at production in the northeast quadrant of the country for our organic business. Currently, we're shipping most of that product out of southeast. So that should drive greater efficiencies. It should also give you fresher product in the marketplace, which typically will also drive some top line leverage as well.

So again, as we look at the supply chain footprint and continue to work on optimizing that, you should see some of these – some of those costs begin to abate, whether it's efficiency driven or whether it's outside purchases, right.

We also continue to accelerate our commitment to SKU rationalization, again really focusing on items that are low-margin or no margin. We talked earlier about the foodservice segment. We're also very much focused on our cake category. And those SKU rationalization changes will also impact our overall supply chain structure.

So we're addressing that as well..

Got it. Thank you so much..

The next question is from Bill Chappell with SunTrust..

Thanks. Good morning..

Good morning, Bill..

Hey.

Just following up on the Canyon questions, so I guess, historically, I think you've even talked about the problem with going into gluten-free and having it blacked it and in the fresh aisle is it doesn't turn fast enough as a category, it ends up having high fail rates and we've seen I think with Rudi's with – and Udi's and others and have somewhat failed attempts to try to do that.

So, like, what's changed or what gives you confidence that you can expand Canyon through the DSD network?.

Yeah. No, I think the – you're exactly right. Number one, the category continues to grow. So the turns on any given week will be increasing. We are looking and have implemented technology that extends shelf life somewhat, again I don't want to get into the details there, but both of those factors will help us as we expand Canyon to DSD.

Also, I think having our independent distributors basically in the stores five to six days a week will also be able to keep it merchandised properly. And I'm excited about having more visibility to the whole gluten-free category and Canyon will be very much in a position to grow..

Okay. And I guess just following up on that, I mean, if you look at the – what you're saying is – I know what you're saying is correct. It has similar or higher margins than the company average and that implies kind of a high-teens to 20 multiple on EBITDA for the business.

I mean, are you comfortable that you can get these, the revenue synergies to really justify kind of a normal multiple? And is that something possible over the next year or two or how long does it take to really expand something like that?.

I mean, when you look at the overall forecast on the financial performance, as we said, it would be accretive to EBITDA next year on a EBT basis basically slightly dilutive and then become accretive to earnings beginning in 2020.

So, we do believe that it's a two-year to three-year timeframe before you start seeing it contribute to earnings for the company..

Okay. Thanks so much..

Yeah. All I was going to add is that we're also encouraged that the sales of Canyon should be incremental. Many consumers that are gluten intolerant have exited the category and we feel like the Canyon – greater distribution of Canyon Bakehouse will bring many of those consumers back into the category..

Got it.

So – but your thought is that you could have it on the DSD network early next year?.

Yes..

Yes..

Perfect. Thank you..

The next question is from Rob Dickerson with Deutsche Bank..

Great. Thank you. Apologies if what I ask is a bit duplicative, I just stepped on a bit late. So, I guess, firstly, just in terms of Canyon and this might be an overly simplistic question, so again apologies, but it's frozen.

So, I'm just curious and maybe you've touched on this, just how that works with the DSD, because obviously it's in a different aisle, different category captains, different trucks, et cetera? Thanks..

We'll continue to distribute frozen Canyon as they do today. But we'll also be distributing fresh through our DSD system and that will be network-wide at some point. It won't happen at the very beginning of the year; it will be a transition through next year.

But our plan is to continue with frozen distribution, but the big growth that I'm looking for will be off our fresh, off our DSD routes..

Okay, great. Thank you. And then, again, I guess on 2019 and beyond, maybe somebody touched on this already, but I am curious to hear your thoughts, and just with respect to targets.

Obviously, there is a bit of margin compression or pressure in Q3, looks like Q4 it has similar trajectory so to speak and just given the cost savings initiatives and kind of the top line expectations, how should we be thinking about 2019 – you might not be giving guidance, but just kind of given where the implied Q4 is, any incremental color would be very helpful.

Thank you..

Sure, Rob. As we said, we typically give full-year guidance in February of 2019 on our fourth quarter call. But just looking ahead, we are expecting to see many of the inflationary cost headwinds that we saw in 2018, they will continue to increase at varying percentages. But we still expect headwinds with regard to input cost.

We still expect headwinds with regard to transportation and hauling cost. And we expect to continue to see labor inflation in a tight labor market.

So from that perspective – from a cost perspective, as Allen said, we're having to work really hard to look at other areas to try to take cost out of the business to offset and mitigate as much of those cost increases as we can.

We've also initiated in the back half additional pricing actions in the market – and they're already beginning to hit the marketplace to be in place at the beginning of the year to offset some of the cost inflation. And then we're trying to use innovation and marketing dollars to turn some of the volume trends we've seen.

The third quarter was probably one of the most significant down volume quarters we've had in a long time and you continue to see the category decline as well. So, we are looking in 2019 at ways to try to mitigate some of those headwinds around overall volume and category decline as well..

And just to touch quickly on the volume side, the retail takeaway data that we all look at seem to be tracking a little bit better relative to what you reported.

And so I'm just curious, was there – is it driven by tighter inventory management or I mean, obviously, there's some hurricane effect, but what would you kind of call the top two main drivers of that disconnect? Thanks..

I think the most significant item in the quarter would have been the impact of hurricanes year-over-year. And then secondly, we did – we had been seeing increases in our warehouse cake business. And in the third quarter, we actually had declines in overhaul business especially at retail as well as in vending.

And vending is not measured within the IRI data or Nielsen data..

Got it. Thank you so much..

Thank you..

And that concludes the question-and-answer session for today. I'd like to turn the call back to Allen Shiver for closing remarks..

Good. Thanks to each of you for joining our call today. We look forward to our next update that will be in February. We'll share with you at that point our fourth quarter results. Thank you for joining the call today. Goodbye..

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect..