THOMASVILLE, GA. — A wide range of negative forces pressured profit margins at Flowers Foods, Inc. in the second quarter of 2018, prompting the company to cut its earnings guidance for the year. Factors Flowers said weighed on results included severe operational disruptions related to shipments of inferior yeast, increases in outside purchases of product due to strong demand for certain products, replacement product related to the faulty yeast, higher ingredient costs, decreases in manufacturing efficiencies and stepped-up promotional activity in connection with new product launches in the quarter.

Flowers net income in the quarter ended July 14 was $45,442,000, equal to 21c per share on the common stock, up 1.6% from $44,740,000, or 21c per share, in the second quarter last year. Sales were $941,283,000, up 1.6% from $926,639,000.

 “In the second quarter, we achieved solid sales growth and continued to execute on our initiatives under Project Centennial,” said Allen L. Shiver, president and chief executive officer of Flowers Foods. “While we were pleased with our sales growth, several factors impacted our gross margins during the quarter, including promotional investments we made to support new products and inflationary cost pressures from commodities, labor and transportation. In addition, we experienced widespread operational disruption caused by inferior yeast received from a supplier that impacted many of our bakeries. It took an extraordinary effort from our procurement, manufacturing, distribution and sales teams to address the situation, and return operations to normal. We are continuing to assess the potential impact of the issue and our options with regard to being made whole by the supplier.”

Flowers revised its guidance for the year, lowering projected earnings per share to $1 to $1.07 from the most recent guidance of $1.04 to $1.16. At the new levels, earnings for the year would be unchanged to 1.6% greater than in 2017. The sales forecast was left unchanged at $3,921 million to $3,982 million.

Flowers estimated the cost of the yeast-related disruption at $3.8 million in the second quarter. During an Aug. 9 call with investment analysts, Mr. Shiver added detail to the yeast issue.

“This disruption occurred right before the July 4 holiday, a holiday that drives a significant portion of our bun sales each year,” he said. “Once we determined the issue with the ingredient, our team worked round-the-clock to resolve the problem as quickly as possible. Affected product was removed from retail and food service accounts and replaced with a product made with alternative yeast. This response required an extraordinary effort for manufacturing, distribution, sales and procurement.”

Beyond the already estimated losses in the quarter, Mr. Shiver said Flowers was continuing to assess the financial impact of the yeast event and the company’s “options with regard to being made whole by the supplier.”

Flowers Foods said it expects to generate aggregate gross savings of $38 million to $48 million in fiscal 2018 from Project Centennial. Steps taken by the company this year in connection with the program include the naming of a chief operating officer, acceleration of supply chain optimization initiatives and substantial investments to support the launch of Nature’s Own Perfectly Crafted bread and Dave’s Killer Bread Boomin’ Berry bagels. Additionally, selling, distribution and administrative workforce-related expenses have been cut and working capital policies have been enhanced to improve the company’s cash conversion cycle.

“We are in the midst of a multi-year plan that is positioning Flowers for long-term success and value creation as a national branded baked foods company,” Mr. Shiver said. “We’ve been operating under our new organizational structure for seven months now and are fundamentally changing the way in which we work. The appointment of Ryals McMullian as chief operating officer is intended to enhance accountability as we optimize our supply chain, reduce costs and drive profitable growth. Through our transformation, I am confident we can overcome the current challenges and successfully position Flowers Foods to drive enhanced value for shareholders.”

Mr. McMullian participated in the call to discuss Project Centennial.

“We’ve only been operating under our new org structure for about seven months and overall it’s worked quite well,” he said.

With the new structure, he said the company has developed “exciting new product innovations” and has created a more focused sales organization that has delivered higher sales.

“Our new marketing group is actively developing a promising pipeline of innovation to help us truly differentiate our products and brands and constantly monitoring the structure for improvement opportunities,” Mr. McMullian said.

While the restructuring program has generated cost savings, Mr. McMullian acknowledged those savings have yet to translate into improved bottom-line results.

Later in the call Mr. Shiver said that fully capturing cost savings opportunities from Project Centennial will be Mr. McMullian’s top priority for the near term.

Discussing the company’s inability to translate cost savings into higher profits, R. Steve Kinsey, executive vice-president and chief financial officer, said Flowers did not adequately anticipate “the level of tightness and the labor market, which continues increased turnover in bakeries and contributes lower manufacturing efficiencies.“

“In addition, the effects of the driver shortages are also increasing logistics cost,” he said. “These, along with the brand investments we planned, have offset the $38 million to $48 million in gross savings from Project Centennial we targeted this year.”

Asked about Flowers’ wheat coverage in the face of surging prices, Mr. Kinsey did not answer directly. He said Flowers is usually hedged four to seven months, most often at the lower end. He said the company “feels good” about wheat cost prospects for the balance of 2018 but is projecting higher costs in 2019.

Earnings before interest and taxes for the Direct-Store-Delivery segment in the second quarter were $54,481,000, down 31% from $79,465,000 in the second quarter last year. Sales were $799,626,000, up 0.5% from $792,892,000.

Adding to other cost pressures weighing on EBIT were $8.3 million in legal settlements and the $3.9 million loss connected with defective yeast as well as restructuring charges of $694,000.

Sales of branded retail products rose 1.4% to $521.9 million during the quarter while store branded sales slumped 3.2% to $153.2 million.

“Branded retail sales increased due to significant sales growth for branded organic products, growth in our expansion markets, the launch of Nature’s Own Perfectly Crafted bread and improved price/mix,” Flowers said. “This increase was partially offset by costs related to increased promotional activity, decreased production capacity as a result of inferior yeast and softer volume for other branded items.”

Dave’s Killer Bread sales increased, boosted by volume gains and the addition of D.K.B. breakfast products in the second quarter of 2017.

“Volume losses in food service, partly due to the inferior yeast issue and the shift of certain food service business from the D.S.D. Segment to the Warehouse Segment, and decreased sales of products in our bakery outlet stores resulted in decreased non-retail and other sales,” Flowers said.

Breaking down the overall sales gain, Mr. Shiver said branded retail business accounted for more than half — particularly Dave’s Killer Bread, Wonder and Nature’s Own.

“For the eighth quarter in a row, our market share increased, driven by healthy growth in our base sales,” he said.

Mr. Shiver also was encouraged by consumer trends within the fresh packaged bread category.

Flowers’ recent new product introductions and its D.K.B. brand are “right in line with these consumer trends,” he added.

In terms of product promotion, Flowers introduced Nature’s Own Perfectly Crafted with a couponing approach with individual retailers the company has not used in the past.

“To be very honest, the redemption rate was extremely higher than what we had projected,” Mr. Shiver said. “The good news is we generated a lot of trial with consumers with a new loaf of bread that is unique to our product line. So now that the promotional activity is over, we’ve gotten our Nature’s Own Perfectly Crafted back to what we would consider everyday price. We’ve generated a lot of consumer loyalty in that process. But we will be very careful in pulling that trigger again with the same type of promotional activity.”

Discussion about the snack cake market was limited during the call, but Mr. Shiver said Flowers’ market share has held “remarkably stable” over the past four quarters. On the other hand, the overall market has been declining modestly, he said.

Warehouse Delivery segment EBIT was $11,135,000, down 3.9% from $11,589,000 in the second quarter last year. Sales were $144,657,000, up 8%.

Operating income slipped because of a shift to lower margin cake and food service items from higher margin branded bread, increased product purchases from the D.S.D. segment, increased outside purchases of product, deteriorating manufacturing efficiencies and higher distribution costs, partially offset by lower workforce-related costs.

Warehouse retail sales rose 2.3% to $35.8 million, store branded retail sales jumped 15% to $28.1 million and non-retail and other sales rose 9%, to $80.8 million.

“Branded retail sales increased mostly due to growth in branded cake, partially offset by volume declines in warehouse-delivered branded organic bread and negative pricing/mix,” Flowers said. “Sales of store branded retail items increased primarily due to volume increases in store branded cake. Non-retail and other sales, which include contract manufacturing, vending and food service, increased primarily from significant volume growth in food service and vending sales, and to a lesser extent the shift of certain food service business from the D.S.D. Segment to the Warehouse Segment in the current year, partially offset by declines in contract manufacturing.”