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Flowers Foods Inc  (NYSE:FLO)
Q4 2018 Earnings Conference Call
Feb. 07, 2019, 8:30 a.m. ET

Contents:

Prepared Remarks:

Operator

Welcome to the Flowers Foods Fourth Quarter and Full Year 2018 Results 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. (Operator Instructions) 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. Mr. Rieck you may begin.

J.T. Rieck -- Vice President of Investor Relations and Treasurer

Thank you and and good morning, everyone, Our fourth quarter results were released yesterday evening. The earnings release and our updated investor presentation is posted in the Investors section of the Flowers Foods website.

Before we begin please be aware that our presentation today may include forward-looking statements about our company's performance. Although, we believe those statements to be reasonable they are subject to risks and uncertainties that could cause actual results to differ materially. In addition to matters we'll discuss during the call important factors relating to Flowers Foods' business are fully detailed in our SEC filings.

With that, I'll make some introductions. Participating on the call today we have Allen Shiver, Flowers Foods' Chief Executive Officer; and Steve Kinsey Flowers' Chief Financial Officer. Allen, I'll turn the call over to you.

Allen L. Shiver -- President and Chief Executive Officer

Thank you J.T. and good morning. Before we begin our review this past quarter and year I want to take a moment to commend our Flowers' team for their hard work. 2018 was year two in our 5-year journey to reposition Flowers Foods as a national consumer-focused food company.

Substantial progress was made against our strategic priorities, even as the team navigated unexpected disruptions. I am confident Flowers is well positioned to drive shareholder value. We have leading brands and a national footprint in a large and stable category. Our scale and relevancy with our retail partners enables us to leverage our distribution platform to strategically add differentiated products to our portfolio and drive profitable growth.

Now turning to the quarter. Overall our fourth quarter performance was consistent with our expectations. Our brand portfolio is performing well. Once again, we achieved record market share for the quarter. We gained market share in both the loaf and breakfast segments. In each of our top three bread brands Nature's Own, Dave's Killer Bread and Wonder increased their share of the category.

I want to point out that we accomplished these share gains with less promotional activity this quarter compared with the year ago. I'm pleased with the top line. However, earnings growth remains a major focus for our team. Commodity and transportation costs have been stiff headwinds to margin over the past two years. We have been able to partially mitigate these headwinds through our savings initiatives, which have offset more than $80 million of these costs since 2016.

In addition to attacking our cost, we've taken pricing where appropriate. We continue to redo pricing market-by-market and we'll adjust when necessary. We made progress on our strategic goals last year and you'll see us continue to execute on our Centennial playbook.

In 2019, we will continue to drive focus on three main priorities: first reinvigorating our core brands to profitably drive share; capitalizing on adjacencies; and improving supply chain productivity to improve margins.

First, we were focused on profitably growing share by continuing to reinvigorate our core brands through innovation and marketplace execution. The renewed focus we have put on our highest potential brands have led to additional space and improved shelf position. This is helping us grow sales in expansion markets, as well as gain share in core markets.

We believe that as the retail landscape evolves and the omni-channel shopping increases, the strength of our leading national brands and our reputation for serving the market will only become more important. Today Nature's Own is the number one loaf bread brand in the category and strong consumer response to the recently introduced Nature's Own Perfectly Crafted is driving incremental market share for the brand.

DKB is the number one in the organic segment and is driving growth in the entire category. We have been pleased with the rollout of DKB breakfast items and Wonder's powerful brand recognition continues to be a driver of market share growth. We know our brands must continue to be market leaders. To help ensure that, we have significantly increased our investment in innovation and marketing. Our marketing team is focused on translating unique consumer insights into innovation and brand loyalty.

These efforts, combined with our continued excellence and service to the market, is how we intend to drive consumer demand and profitable growth. Our next strategic focus is capitalizing on adjacencies. The large size of the category over 30 billion will provide ample opportunities for substantial growth. We continue to look for strategic M&A prospects in underdeveloped product segments and geographies that leverage our competitive advantages and align with our value-creation strategies.

A recent focus has been extending our portfolio beyond traditional loaf breads. We have been very pleased with DKB's move into the breakfast segment. We're also growing share in this segment through the Sun-Maid license. It's only been eight weeks since the Canyon acquisition closed and the integration is going well. The rollout of the brand across our DSD network is already under way and will continue to ramp-up during 2019, as we increase capacity in the Canyon bakery.

Canyon Bakehouse demonstrates execution against our strategic priority to capitalize on adjacencies. We believe Canyon provides incremental growth and allows us to leverage our baking expertise through our distribution network and retail partnerships to reach more consumers and increase brand equity. And the final important strategic focus is increasing supply chain productivity to improve margins and drive earnings.

Over the past two years, our team has done a great job realizing significant savings from various initiatives under Project Centennial. As part of this, we have developed better methods to identify savings opportunities and track our progress. These new processes are now a core capability and will help drive our ongoing productivity programs.

We're also working on a multiyear supply chain optimization project to address our fixed cost structure. This initiative is essential to achieving our long-term margin targets and enhancing returns on our capital investments. One important aspect of this project is taking a sharper look at contribution margins across different channels and product lines. In many of our bakeries, a single production line can produce a variety of products for branded, store-branded and non-retail segments. Our objective is to take advantage of this flexibility and optimize for higher-value production visions.

One example of this is a high-speed bun line we installed in our Oxford, Pennsylvania bakery. This allowed us to better utilize the infrastructure of the Oxford bakery and to close a low sufficient bakery in Brattleboro, Vermont.

Another example is we are adding organic production capabilities to one of our bakeries in the Northeast. When this project is completed, we can improve service to the Northeast market, while also lowering transportation cost.

In summary, our supply chain optimization project is a major opportunity for the company and we believe the steps that we are taking will drive significant productivity improvements as we work toward our 2021 margin targets.

I do want to give you a brief update on our snack cake business. Improving this business will continue to be a major initiative in 2019. We're already making significant progress, streamlining the product assortment, improving price/mix and exiting low-margin business. Now it's about driving profitable growth. We have a solid pipeline of new cake products and we look forward to improved results in 2019.

To recap, we've made important progress in 2018. We have reinvigorated the company and we are laying the foundation for sustainable, profitable growth. We have reduced cost and added new capabilities that have helped to partially mitigate inflationary pressures.

Our team continues to work toward our long-term goals and deliver shareholder value. As we enter 2019, our 100th year we have confidence in Flowers Foods' continued growth. The bedrock of our business is our portfolio of leading fresh bakery brands headlined by Nature's Own the number one loaf bread in the U.S.

By reducing fixed cost and improving productivity in our bakeries, we believe our team is taking the right steps to drive free cash flow from our business. With this cash flow we can invest in growing segments and leverage our distribution capabilities, our manufacturing scale and retail relationships to grow earnings and shareholder value.

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

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Thank you Allen, and good morning everyone. As Allen stated, the quarter was in line with our expectations. Good top line performance, although, it was offset by continuing margin pressure from cost inflation primarily in commodities and transportation.

Lower volumes in our core product lines continued to put pressure on manufacturing efficiencies. We did close the acquisition of Canyon Bakehouse on December 14. Due to immateriality, Canyon's results for the last two weeks in the quarter were excluded from the fourth quarter and will be reported in our first quarter of fiscal 2019.

Turning to the details of our fourth quarter financial performance. Consolidated sales were up 80 basis points. Volume was down 1.8%, while price/mix increased 2.6%. We continue to experience strong volume growth in DKB and growth in our expansion markets. Pricing action across many product lines and growing sales of DKB primarily drove the increase in price/mix. We did experience lower volumes in the quarter in our food service, vending and cake businesses.

As I mentioned last quarter, we are working to improve price realizations in these areas. And so we are taking a more selective approach with low-margin high-volume business. Consolidated gross margins declined 70 basis points as a percentage of sales. This was primarily due to higher outside purchases and ingredient costs and lower manufacturing efficiencies.

Excluding items affecting the variability detailed in the press release, adjusted SD&A expenses increased 50 basis points as a percentage of sales. Overall, workforce-related costs were lower due to the organizational changes and lower incentive compensation. These decreases were more than offset by increased distributor discounts, marketing costs and shipping and hauling costs.

The higher distributor discount as a percent of sales is generally attributable to the sales of company-owned territories. Higher production costs and higher adjusted SD&A, as a percentage of sales, resulted in adjusted EBITDA margin decreasing 150 basis points for the quarter to 8.9%. GAAP diluted earnings per share for the quarter was $0.10 per share. Excluding the items affecting comparability detailed in the release, adjusted diluted EPS in the quarter was $0.16 per share.

Two items below the operating line did influence adjusted EPS relative to our forecast. First, our effective tax rate was lower than we forecasted. This added approximately $0.01 to EPS. Second, as part of our pension derisking process, we had stopped at a more conservative asset allocation in line with our path to plan termination. This reduced adjusted EPS by approximately $0.01 in the quarter, offsetting the benefit from the lower effective tax rate.

Now turning to segment level financial results: DSD segment revenue was up 1.2% in the fourth quarter. Price/mix increased 2%, while volume decreased 0.8%. Our price/mix this quarter was driven by the growth of DKB and the pricing actions we implemented during the year to address input cost inflation. Volumes were impacted by lower food service volumes.

Adjusted operating margin in our DSD segment was down 170 basis points as a percent of sales versus the prior year. We continue to experience lower manufacturing efficiencies as well as higher input costs and distribution costs. Warehouse segment revenue was down 1.5% in the quarter. Price/mix increased 3.1% while volume decreased 4.6%. Price/mix was driven by pricing actions.

Volume declines incurred primarily in our cake and vending businesses. Adjusted warehouse operating margin improved 20 basis points as a percentage of sales, primarily due to improved price/mix.

Turning to cash flow for the year: Cash flow continues to be strong. Operating cash flow for the year was $296 million as compared to $297 million in the prior year. Keep in mind, in 2018, there were several discrete cash uses that totaled over $100 million. These investments allowed us to streamline our workforce, reduce risk associated with our pension liabilities and position the company for continued growth.

These cash uses were mostly offset by the cash generated from our payment terms extension initiative, a lower effective tax rate and bonus depreciation.

Capital expenditures were $99.4 million in 2018 as compared to $75.2 million in 2017. Dividends paid during the year totaled a record $150.2 million, a 6.5% increase year-over-year. We ended the year with $976.2 million in net debt. At quarter end, our net debt to trailing 12-month adjusted EBITDA was 2.4 times. Our financial position remains solid. As of quarter end, we had approximately $492.9 million of liquidity available on our credit facilities.

Now turning to guidance. For 2019, we expect sales growth in the range of 2% to 4%. This includes Canyon sales expected to be in the range of $70 million to $80 million accounting for approximately 1.8% to 2% of the total sales growth. The balance of our top line outlook is driven by price/mix partially offset by a conservative view on volumes. For 2019, we are targeting adjusted EPS in the range of $0.94 to $1.02 per share.

In 2019, we expect continued inflationary pressures in commodity transportation and labor of approximately 150 basis points as a percentage of sales. We intend to mitigate these costs through comprehensive cost-savings and productivity initiatives. These initiatives are being supported by new capabilities that enable improved tracking and enhance accountability. As Allen mentioned, improving price will also be used to offset cost pressures from inflation.

We continue to expect Canyon to be accretive to EBITDA in 2019, but it will be slightly dilutive to overall EPS. As stated in the release we expect depreciation and amortization of $150 million to $155 million other pension expense of $2.5 million to $3 million, net interest expense of approximately $12 million. We expect our effective tax rate to be in the range of 24% to 25% before discrete items. And we're also forecasting weighted average shares outstanding of approximately 212 million.

Capital expenditures are expected to be between $110 million and $120 million. We expect robust free cash flow generation in 2019. Our long-term capital allocation priorities remain consistent with our focus on maximizing return on invested capital and growing shareholder value.

We will continue to invest in our brand and bakeries as well in the ways that strengthen the capabilities of our team strategic acquisition that diversify and enhance the profitability of our portfolio will also be a priority. We will do this while maintaining an investment-grade financial position and continuing to return values to shareholders through dividends and opportunistic share repurchases.

Now, let's open the line for questions.

Questions and Answers:

Operator

Thank you. (Operator Instructions) Our first question is from Amit Sharma from BMO. Please go ahead.

Drew Levine -- BMO -- Analyst

Hi, there. This is Drew Levine on for Amit. Thanks for taking the questions. I just want to first start out with the incremental pricing from commodity inflation. Can you talk about the elasticities that you've seen thus far from the incremental pricing and if that's within your expectations?

Allen L. Shiver -- President and Chief Executive Officer

The pricing that we've taken, again it is in the marketplace. And we're encouraged with the overall consumer reaction. Pricing varies by market. It varies by brand and product line. But overall, the pricing that has been taken is encouraging. I think the real key here is having products that have a meaningful point of difference. And the consumer understands that the costs are going up. And the pricing that we've taken, it's encouraging to see the reaction so far.

As we look forward again, pricing will continue to be an opportunity for us to address issues as costs continue to run up. So pricing will -- as in the past, it will continue to be very much of a priority for us.

Drew Levine -- BMO -- Analyst

And then kind of transitioning from the guidance, can you talk about anything differently that you've done this year as -- in regards to the plan? We had two guidance because of last year or one the year before that. So can you just talk about maybe any different controls that are in place for this year?

Allen L. Shiver -- President and Chief Executive Officer

I think as we've implemented kind of the early phases of Project Centennial, the organizational structure changes that we have are really settling down from an overall leadership standpoint. I'm very encouraged with the progress that's being made in organizational structure. Steve you may have other comments.

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Sure. I mean when you look at the guidance for 2019, we did do a couple of things I would say a little differently. When you look at the top line guidance as Allen mentioned price mix is a big driver of that. I would say, we also are taking somewhat of a conservative view on core volumes. We're looking at flat to down low single digits. The category had been down slightly.

And coming out of Q4 in 2018 even though we did take pricing actions, you could see some impact on overall volume. So on the top line, I feel like we've taken a conservative approach, while still being able to hit within our long-term guidance targets of 2% to 4% coming out of Project Centennial.

You may recall from a cadence perspective 2019 was when we thought we would begin to see things hit from a top line perspective. And we're still on that cadence with respect to growth. When you look at overall cost initiatives and from an overall earnings perspective, we did enhance capabilities throughout 2018 from an accountability and tracking perspective.

And I believe those went a long way as we pulled together the 2019 guidance. And from an accountability perspective, the granularity is pushed back down all the way through our bakeries. I would say, it was strengthened by the capabilities that we've put in place in 2019. So we feel fairly confident with the range that we've put forth.

Drew Levine -- BMO -- Analyst

Great and then just last one from me. You talked about 150 bps inflation from commodity transportation and labor. Can you just kind of maybe bucket those for us? Or any kind of relative commentary on which is the bigger buckets of those? Thanks.

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Sure. When you look at the commodity basket, I mean again 2018 was the first inflationary year, we had seen in some time. So it's fairly significant at high single-digit commodity inflation or input cost inflation for 2018. We do expect inflation to continue and we don't really see that turning in the near term. So in 2019 we're looking more at low single-digit inflation from a commodity perspective or input cost perspective. Transportation continues to be a challenge. When you look at the broader bucket that would include SD&A, again its overall low single digits and that would encompass transportation as well as labor.

Operator

Our next question is from Brian Holland with Consumer Edge. Please go ahead.

Brian Holland -- Consumer Edge Research -- Analyst

Yeah. Thanks. Good morning. Can we just --

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Hey, Brian.

Brian Holland -- Consumer Edge Research -- Analyst

...forgive me if -- good morning, forgive me if you guys touched on this and I missed it but have you laid out any growth savings targets specific to Centennial for 2019?

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

So when you look at what we said in the press release coming out of 2018, we did achieve and actually slightly exceed the targets we had laid out for the two-year period of $70 million to $80 million and then the $38 million to $48 million for 2018. We'll continue to focus on those cost savings. The next kind of leg of that stool will be network optimization. And as Allen mentioned, we have several projects going on from that perspective. We didn't give -- we didn't quantify an absolute dollar amount, but we -- again, we're still have insight the targets of the 13% to 14% EBITDA margin. And we still feel like currently based on the 2019 plan that those are still within reach.

Brian Holland -- Consumer Edge Research -- Analyst

Okay. Thanks. So it looks like the guidance would imply some margin expansion in 2019. So, maybe Steve this is for you. I'm curious, if you can help us understand maybe how that's balanced between gross margins and SD&A. Do we get some gross margin expansion off of a tough year last year? Or do we -- or do the majority of the cost savings still flow through SD&A? It sounds like based on Allen's comments it's a little more gross margin-based. And then maybe just to tack onto that you had some headwinds in 2018 labor capacity constraints on Dave's Killer Bread which you addressed earlier in the call. Freight sounds like it's probably an issue for you guys through maybe the first half at least of this year. I'm just wondering, if we think about the cadence as we go through the year maybe some of the puts and takes as you lap some of these external factors.

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Sure. When you look at the kind of the cost initiatives, I mean, you're correct. The majority of them are gross margin-driven. There are a lot of initiatives around operating efficiency. We did see our efficiency ratios fall-off in the quarter by about 100 basis points. And for our full year, we were down about 150 basis points. So this is fairly significant from an overall margin perspective. Some of the same initiatives, we've talked about in 2018 that are continuing in 2018, I mean, in 2019 we're looking at scale. We're looking at overall efficiency, volume impact efficiency pretty significantly. So we are looking in that and that kind of rolls into the network optimization projects that are going.

And then from a top line perspective there are initiatives that roll into the gross margin as well. So SD&A, I would say in 2018, we've done a great job. We're not abandoning any efforts in SD&A. We are looking at building on the $70 million to $80 million that was saved over the last two years. But the most significant savings now or the most significant improvement can be made in the gross margin line.

From an overall cadence perspective, the big external factor I'd say in 2018 was transportation. We didn't expect to see the increases that we experienced. We thought we were a little more protected somewhat with our kind of closed-loop system. But they did began to pick up in the back half. So you'll see probably stronger transportation changes in the first half of the year with kind of flattish in the back half of the year. But we are still forecasting up transportation cost for 2019.

Brian Holland -- Consumer Edge Research -- Analyst

Okay. That's helpful. And last one from me, we're sort of seeing in the scanner some inflection in the cake segment for you guys, less negative sales. Obviously part of that is just lapping some sharp declines. But just wondering if we're starting to see some progress there with some of the initiatives you've talked about with respect to SKU optimization, et cetera. And maybe just an update on how that's progressing? And maybe to the extent you think about when we could see an inflection a sharper inflection in that segment?

Allen L. Shiver -- President and Chief Executive Officer

I think we look at our cake business today, I think you're exactly right. We are seeing some encouraging trends with the new products that we've introduced. We all know that cake is an impulse category. And our new products and bringing news to the retail environment with our Tastykake brand as well as Freshley's is something that the retailers are looking for as well.

So we have gone through some significant SKU rationalization in our cake business. And now as I mentioned earlier, the focus is on introducing new items that bring excitement back into the category and are making sure that our retailers are working with us with off-rack displays and other items to push sales. So we're focused on growing our cake business.

Brian Holland -- Consumer Edge Research -- Analyst

Okay. Thanks. Best of luck.

Allen L. Shiver -- President and Chief Executive Officer

Thank you.

Operator

The next question is from Bill Chapell from SunTrust Robinson. Please go ahead.

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

Thanks, good morning.

Allen L. Shiver -- President and Chief Executive Officer

Good morning, Bill.

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

Two questions, one on pricing. So are you done with the pricing actions for this year? Or does your forecast assumes there are additional pricing actions throughout the year?

Allen L. Shiver -- President and Chief Executive Officer

Our forecast assumes additional pricing throughout the year. Again, we did take pricing last quarter. But again pricing really is a constant opportunity. And again, as I mentioned earlier, it varies by market. It varies by brands. And -- but pricing will continue to be very much top priority. It's something that we evaluate week in, week out.

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

Okay. And in terms of the modest expectations for volumes with pricing being favorable. Is that -- are you assuming total volumes are actually down for this year?

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Our overall assumption in the assumption in guidance is to be flat to down potentially low single-digit.

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

Okay. And then back to the cake business and just kind of your outlook. Do you believe you can grow the business this year? And the reason I asked that is, I guess, historically or the past four years, five years it had been kind of Hostess with a different model taking share and really pushing back. But right now it seems like Bimbo with almost an identical distribution model and business and brands really having an outstanding passing quarters and momentum. Can you replicate that with Tastykake or Mrs. Freshley's? And can you drive the growth of the overall category with your system?

Allen L. Shiver -- President and Chief Executive Officer

We're confident that we can. If you look at our history, our Tastykake brand is, obviously, a very much high unaided awareness with consumers. As I mentioned earlier, I mean our focus is on developing new items that have exciting point of difference, making sure that our retailers understand that off-rack displays are the key to growing in this segment.

Our independent distributors are focused on growing their cake segment. And again there is an opportunity there because of the impulse nature of the category. And I'm really excited about some of the new items that we've got in the pipeline that will be introduced. So we're focused on building our cake business.

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

And the thought it can grow this year?

Allen L. Shiver -- President and Chief Executive Officer

Net sales maybe depending on the SKU rationalization that we've taken, offsetting some of the new items that we're introducing. We're not projecting tremendous growth in our cake business. But I want to make sure you understand it remains an important part of our overall product mix.

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

Got it. Thank you.

Operator

And we have no further questions at this time. I'd like to turn the call back to Allen Shiver for closing remarks.

Allen L. Shiver -- President and Chief Executive Officer

Thank you for your time this morning. Thanks for joining the call. We look forward to our next update in May and we'll share our first quarter results at that time. Thank you for your time and that concludes our call.

Operator

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

Duration: 34 minutes

Call participants:

J.T. Rieck -- Vice President of Investor Relations and Treasurer

Allen L. Shiver -- President and Chief Executive Officer

R. Steve Kinsey -- Chief Financial Officer and Chief Administrative Officer

Drew Levine -- BMO -- Analyst

Brian Holland -- Consumer Edge Research -- Analyst

Bill Chappell -- SunTrust Robinson Humphrey -- Analyst

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