Flowers snack cake share gains rapidly dissipating

by Josh Sosland
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Double-digit declines in the company’s snack cake sales were a significant factor in lower second-quarter sales and earnings at Flowers.

THOMASVILLE, GA. — After Hostess Brands, Inc. in November 2012 abruptly halted operations and shipments of all its products, including Twinkies and Hostess Cupcakes, Flowers Foods, Inc. stepped into the void and rapidly raised its share of the snack cake market by 50% over the course of a only few months. When an investment group purchased the Hostess snack cake assets and resumed shipments in July 2013, Flowers was optimistic it would “weather the reintroduction very well.” Less than a year later, though, most of the Flowers market share gains have been lost.

Double-digit declines in the company’s snack cake sales were a significant factor in lower second-quarter sales and earnings at Flowers.

Net income at Flowers Foods in the second quarter ended July 12 was $42,064,000, equal to 20c per share on the common stock, down 9% from $46,460,000, or 22c per share, in the second quarter of 2013. Sales were $877,378,000, down 2.3% from $898,153,000.

Updating its financial guidance for 2014, the company has significantly reduced its earnings growth forecast for the full year — to a range of 1.1% to 7.7%. Three months earlier, the company had forecast full-year growth of 7.7% to 15.4%. Sales growth for the year was tightened to a range of 3.5% to 5%, from 6% to 10%.

Investors were disappointed by the results. In New York Stock Exchange trading Aug. 12, Flowers Foods shares slumped as much as 7.5% in early trading, before settling for the day at $19.10, down 91c, or 4.6%.

Results in the second quarter were adversely affected by a charge of $4,489,000 in connection with the pending sale of the company’s Leo’s tortilla plant in Texas. The company is moving its tortilla production to other Flowers plants.

Many other baking market dynamics, positive and negative, factored into the Flowers results, including aggressive promotional activity in bread and across the entire packaged foods industry, Flowers said. Additionally, the company’s results were helped by impressive growth in sales of newly acquired brands and in new geographic markets.

“We are particularly encouraged by the traction we are continuing to see in our new markets, where sales doubled since last year,” said Allen L.  Shiver, president and chief executive officer. “We also are seeing strong sequential growth in our acquired bread brands. As a team, we are working to control those issues within our reach while maintaining a strong, flexible, financial position to weather near-term storms.”

In addition to doubling sales in new markets since last year, Mr. Shiver said in an Aug. 12 conference call with investment analysts that sales of the acquired Wonder, Home Pride, Butternut and Merita brands were up about 35% from the first quarter of 2013.

“Also, with the successful reintroduction of our acquired brands behind us, we are focused on the distribution fundamentals necessary to improve top-line growth while maximizing our earnings opportunity,” he said.

Consumer spending remained under pressure during the second quarter, Mr. Shiver said. As a result, promotional spending is significantly elevated across all food categories, including bread.

“Promotional activity in fresh bread was high in the quarter,” Mr. Shiver said. “Our percentage of products sold on promotion was higher than normal, reducing our average price per unit. In recent weeks we have made progress reducing the number and depth of our promotions. Our goal is to return to a more normalized level of promotional activity by quarter four of this year.”

Also down during the quarter were Flowers’ sales of store brand and food service bread sales. Mr. Shiver observed that the decline in private label sales was related to the stepped-up promotional activity.

“I.R.I. shows that store brand lost unit and dollar shares in the quarter,” he said. “That category shift accounts for part of the decline in our store brand business. And we also gave up some unprofitable store brand volume during the quarter and exited some low margin food service business.”

Longer term the decline of private label and the exit from less profitable business should help Flowers results, Mr. Shiver said.

“However, these events are painful in the near term,” he added.

The company’s share of packaged bread continues to grow, Mr. Shiver said. At 14%, the company’s market share is up from 13.3% in the second quarter of 2013 and 10.7% in the second quarter of 2012.

New markets accounted for 5.9% of total direct-store delivery bread sales during the quarter, a figure described as “strong” by Mr. Shiver. He noted the company has garnered a 10% market share in Kansas City in just a year and has had good results in Cincinnati, Pittsburgh, New York and California.

Mr. Shiver attributed weak snack cake sales to “Hostess Cake and their growing penetration in the market.”

At the time of the reintroduction of Hostess cakes in July 2013, following an absence of about eight months, Mr. Shiver was hopeful Flowers’ would retain a large part of the business captured by Tastykake and Mrs. Freshley’s.

“We realize that Hostess cakes may have a place in the market, but we have confidence that our cake business will weather that reintroduction very well,” he said in August 2013.

Commenting on the second quarter, Steve Kinsey, Flowers’ executive vice-president and chief financial officer, said Flowers cake sales overall were down 12%, including a drop of about 11% in the company’s D.S.D. business and 13% in warehouse business.

Net-net, Flowers is still ahead, even after the tough second quarter, Mr. Shiver said.

“As a reminder, our market share of the cake category increased from 5.7% to 8.6% when Hostess exited the market,” he said. “Although we have maintained a good portion of our cake sales, in the second quarter we felt a stronger impact from Hostess cake as they increased distribution with several key customers. While our sales are under pressure due to the return of Hostess cake, it is important to note that our share of the cake category is still 6.7%, up a full point from 2012.

“This competitive pressure does not change our enthusiasm for the cake business. Since we acquired Tastykake in 2011, our cake sales have increased significantly. Tastykake retail sales are annualizing at $460 million, up $35 million from last year. Our strategy is solid. We will grow our Tastykake brand as we leverage the distribution strength of our D.S.D. route structure by offering outstanding customer service and exceptional product quality.”

Mr. Shiver identified a number of additional ways rapid changes in the baking market have been a drag on earnings that will not persist. For instance, he cited start-up costs associated with new production lines in Henderson, Nev.; Knoxville, Tenn.; and Modesto, Calif.

“It can take a year to 18 months to bring manufacturing efficiencies in line with our standards,” he said.

Without offering specifics, Mr. Shiver said Flowers has been hard at work toward improving results at the company’s Lepage operations.

Mr. Kinsey said issues related to the Lepage SAP conversion “are behind us,” but that operating earnings before tax at Lepage were down $4.7 million from the second quarter of 2013.

Prospects for the company’s revamped Cobblestone brand are encouraging, Mr. Shiver said.

“The introduction of Cobblestone Bread Company is a good example of our ongoing investment for the future,” he said. “After a successful test market period we are now in the process of introducing this new brand system wide.”

Mr. Shiver said the roll-out followed a three-month test period and said more extensive discussion of the brand was likely after the third quarter of 2014.

“We are excited because many of the categories the Cobblestone Bread Company addresses are categories where we are underdeveloped,” he said.

Still, even with Cobblestone, the investment in the new product introduction, together with other expansionary activities, was cited as a contributor to pressure on margins.

“Costs related to returned product, or what we term as stales, continue to run above historical averages,” Mr. Kinsey said. “Driving this is the introduction of the acquired brands, new products and accelerated pace for entry into new markets.”

To avoid ingredient market volatility, Flowers has booked flour somewhat deeper into the future than is typically the case, Mr. Kinsey said. He explained that slumping millfeed prices have been an offset to the beneficial effects of a weak wheat market.

“From an ingredient perspective, if we specifically isolate our last half 2014 flour, we expect to see only modest tailwinds compared to the last half of 2013 and the first half of the year,” he said. “It is important to note that wheat future prices have been moving lower; other key variables such as basis and meal feed have moved in a direction that has not been beneficial to flour prices. We expect those two variables to negatively affect our overall net flour cost by continuing to partially offset the benefits of the decline in wheat futures.

“In an effort to help mitigate price volatility we are on the long end of our four- to seven-month hedge guidance. We are beginning our 2015 planning efforts so it would be premature today to comment directly on 2015 costs.”

Mr. Kinsey said Flowers has contracts pending against three or four of the nine Hostess baking plants slated for sale and has sold about 11 warehouses, generating proceeds of about $5.5 million.

In the six months ended July 12, Flowers net income was $103,130,000, or 48c per share, down 35% from $158,486,000, or 75c, in the first half of 2013. Net sales were $2,037,138,000, up a fraction of one per cent.

First-half results in 2013 included a gain of $50,071,000 related to the company’s acquisition of the bread baking assets of Hostess Brands, Inc. 
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