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Edited Transcript of FLO earnings conference call or presentation 9-Aug-18 12:30pm GMT

Q2 2018 Flowers Foods Inc Earnings Call

THOMASVILLE Aug 28, 2018 (Thomson StreetEvents) -- Edited Transcript of Flowers Foods Inc earnings conference call or presentation Thursday, August 9, 2018 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* A. Ryals McMullian

Flowers Foods, Inc. - COO

* Allen L. Shiver

Flowers Foods, Inc. - President, CEO & Director

* J. T. Rieck

Flowers Foods, Inc. - Treasurer & VP of IR & Financial Analysis

* R. Steven Kinsey

Flowers Foods, Inc. - CFO & Chief Administrative Officer

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Conference Call Participants

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* Akshay S. Jagdale

Jefferies LLC, Research Division - Equity Analyst

* Amit Sharma

BMO Capital Markets Equity Research - Analyst

* Brett Michael Hundley

The Vertical Trading Group, LLC, Research Division - Research Analyst

* Brian Patrick Holland

Consumer Edge Research, LLC - Analyst of Small and Mid caps Staples & Protein and VP

* Farha Aslam

Stephens Inc., Research Division - MD

* Timothy Scott Ramey

Pivotal Research Group LLC - Co-Head of Consumer Research and Senior Analyst of Food, Beverage, and Nutrition

* William Bates Chappell

SunTrust Robinson Humphrey, Inc., Research Division - MD

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Presentation

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Operator [1]

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Welcome to the Flowers Foods Second Quarter 2018 Earnings Conference Call. My name is Paulette, and I will be your operator for today's call. (Operator Instructions) Please note that this conference is being recorded.

I will now turn the call over to J.T. Rieck, Treasurer and Vice President of Investor Relations. You may begin.

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J. T. Rieck, Flowers Foods, Inc. - Treasurer & VP of IR & Financial Analysis [2]

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Thank you, Paulette, and good morning, everyone. Our second 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. Our 10-Q was filed with the SEC yesterday evening.

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.

Now let's get started. Participating on the call today, we have Allen Shiver, our Chief Executive Officer; Steve Kinsey, our Chief Financial Officer; and Ryals McMullian, Chief Operating Officer.

Allen, I'll turn the call over to you.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [3]

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Thank you, J.T. Good morning, everyone, and thank you for joining us. I'll get started this morning with an update on our operations and results for the quarter. Ryals will then share the opportunities he sees to accelerate our transformation under Project Centennial. And Steve will wrap up with a financial review and our outlook for the remainder of the year. We'll then open the call for your questions.

Let's turn to the business review. Top line performance in the second quarter was solid. Total sales grew 1.6%. Our branded retail business contributed more than half of this growth, driven by share gains from 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.

Overall, consumer trends in the fresh packaged bread category are encouraging. Branded products continue to gain share within the category, with consumers showing a growing preference for organic products and indulgent white breads.

The fact that these branded products carry higher points -- higher price points is encouraging. Our recent introduction of Dave's Killer Bread and Nature's Own Perfectly Crafted products are right in line with these consumer trends.

The commercial cake category was down slightly, but our snack cake share has remained stable for the past 4 quarters. Our cake team continues to focus on improved profitability. Our product assortment is being streamlined through SKU rationalization, allowing manufacturing to improve capacity utilization.

While we are pleased with our top line performance this quarter, we are not satisfied with the results as gross margins were down. There were several factors that pressured gross margins this quarter. And because of them, we have reduced our financial outlook for the year.

First, planned point-of-sale investments. These marketing activities, like couponing and consumer promotions, are expected to accelerate the growth of our key brands. And during the quarter, they did. They drove trial of new Nature's Own Perfectly Crafted, Dave's Killer Bread and Cobblestone Bread Company products. A special consumer promotion also drove sales of Wonder Bread and buns.

Another factor impacting margins this quarter was the business disruption caused by inferior yeast received from an ingredient supplier. This disruption occurred right before the July 4 holiday, a holiday which drives a significant portion of our bun sales each year.

Once we determined the issue with the ingredient, our team worked around-the-clock to resolve the problem as quickly as possible. Affected product was removed from retail and food service accounts and replaced with product made with alternative yeast. This response required an extraordinary effort for manufacturing, distribution, sales and procurement. I am proud of how our team managed this situation, and our operations are back to normal.

I want to thank the team again for their tireless efforts.

That said, we are continuing to evaluate the financial impact of the yeast event and our options with regards to being made whole by the supplier.

Finally, like other food companies, our margins were impacted by inflationary pressures from higher transportation cost, a tight labor market and increasingly volatile commodity markets. To address these inflationary pressures, we are aggressively working to capture greater efficiencies and cost reductions within our business. This increased focus on operations can be seen in the appointment of Ryals McMullian as Chief Operating Officer.

We have aligned our business units, sales and supply chain functions under Ryals. Our objective is to make all areas of our company more effective and accountable for delivering against our strategic priorities. Throughout his 15-year tenure at Flowers, Ryals has developed a deep understanding of our business and operations. He played an important role in shaping Project Centennial. Over the last 2 years, Ryals has helped direct the company's transformation under this important initiative. This makes him uniquely qualified to lead our operations as we execute on our growth objectives and cost-savings initiatives.

Ryals, will you please share your perspective on the opportunities and operations?

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A. Ryals McMullian, Flowers Foods, Inc. - COO [4]

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Thank you, Allen, and good morning, everyone. I really appreciate the time to make a few brief comments to you this morning.

We really are going under a transformation at Flowers. We've got a lot of opportunity ahead of us, and we have a talented team eager to work together to achieve great things.

And we call Centennial a transformation. We do not use that word lightly. We have made massive changes to a 99-year-old company, with a deeply rooted culture and established ways of working. Moving from where we were in 2017 to where we are today has been a monumental undertaking. And our team members have worked extremely hard to get us here. I am tremendously proud of the progress we've made and how we've positioned ourselves for the future. But at the same time, all of us are keenly aware that we have not yet realized the full value promise of Project Centennial.

We have only been operating under our new org structure for about 7 months. And overall, it's worked quite well. Just as a few examples, our business units have helped deliver exciting new product innovations. Our more focused sales organization has translated those innovations into higher sales. Our new marketing group is actively developing a promising pipeline of innovation to help us truly differentiate our products and brands. And our PG&S team has delivered meaningful savings.

But because it's still relatively new to us, we are constantly monitoring the structure for improvement opportunities, because it's so vital to have the right leadership in place. In fact, we've recently tweaked a few reporting lines in a way that we expect will make us more effective from an operational standpoint. However, despite overall savings goals that are on target, we have not yet translated those savings into improved bottom line performance. To be sure, additional cost headwinds and operational disruptions, some of which Allen mentioned a moment ago, are partly to blame, but we also have more work to do to reduce our cost. So my immediate focus will be on generating additional cost savings, primarily by addressing inefficiencies in our supply chain.

Working closely with Allen and the leadership team, we intend to take decisive action to further improve our efficiency and profitability. Look, our business is changing, and we have to ensure that we have the right capabilities from a supply chain standpoint and otherwise to answer for those changes. We are working plant by plant, making certain that we're optimized for today's business realities and tomorrow's.

As I did well leading Project Centennial, I am comfortable challenging old ways of thinking, and I do intend to push our team to be creative about solving business challenges and capitalizing on new opportunities. We'll each take full ownership for our areas of responsibility, and there will be increased accountability and transparency around our results and how we track to our KPIs.

As a matter fact, we're already tracking our efforts internally with a rigor never before seen at Flowers. And I fully expect this disciplined approach to bear fruit. Despite the fact that we are navigating some near-term challenges, I hope you can tell how energized I am about where we're headed. And more importantly, our team is energized too.

We have so much untapped potential. Opportunities are bound for Flowers, from additional growth from our already strong brands to a robust M&A pipeline to help us achieve margin-accretive growth in adjacent categories.

We do understand the urgency, and our team knows what to do. I'm confident that working together, our team can deliver the results that our shareholders expect and that we most certainly expect of ourselves.

Thank you very much for your time today, and I'll turn it back to Allen.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [5]

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Thank you, Ryals. Accelerating the cost-savings initiatives that we have in place, that is our top priority. With the fresh perspective and accountability that Ryals brings to operations, our focus on margins and efficiencies has never been greater.

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

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [6]

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Thank you, Allen, and good morning, everyone. Let's start with items affecting comparability in the quarter, which amounted to approximately $0.04 per share.

The most significant items were: Project Centennial-related consulting and restructuring costs that total $3 million; we also recorded a pension settlement charge of approximately $1 million; legal settlements of $8.3 million; and currently identified costs relating to the inferior yeast of $3.9 million.

A few additional comments on the yeast issue and its impact on the quarter. As Allen mentioned, our operations were significantly disrupted just as we were preparing for the important July 4 bun season. We have captured what we believe to be the currently identifiable and measurable costs in the second quarter, but continue to monitor and assess the impact on brands, customers and consumers as we plan to pursue all avenues available for recovery.

Results in the quarter were mixed. Top line performance was strong, but margin performance declined year-over-year. Consolidated sales were up 1.6%, with price/mix contributing 0.4% and volume up 1.2%. As Allen stated, DKB continued to have solid performance, more than offsetting continued softness in other branded segments.

Our Warehouse snack cake business also had nice gains year-over-year as well. Though the category continues to see declines in store brand revenue, we had gains in store brand buns, breakfast and cake. Top line performance as well as growth margin was impacted by elevated promotional activity related primarily to the launch of Nature's Own Perfectly Crafted. We had heightened point-of-sale promotions related to the product launch that net out of sales and reduced gross margin. This was a significant part of the Q2 overall margin decline.

Consolidated gross margins declined 140 basis points as a percent of sales. Several factors contributing to this decline. As I mentioned, there was elevated promotional activity for new product launches and disruptions from the yeast issue. We also had higher outside purchases and ingredient costs and lower manufacturing efficiencies. The labor environment remains very challenging. We are seeing both higher wages and increased turnover, which has contributed to higher manufacturing workforce-related costs. We have initiatives underway to address these issues, but we expect these inflationary pressures will continue so long as the economy remains strong.

Adjusted SD&A expenses declined 20 basis points as a percent of sales. Lower workforce-related costs due to the organizational changes we made were partially offset by higher distributor discounts. Distributor discounts were higher as a percentage of sales due to recent sales of company-operated territories and promotional activity from new product launches.

SD&A expenses were also higher due to increased marketing cost and higher distribution cost. As we said on the last call, we expect below the line marketing cost to be elevated in Q2 and Q3.

Reflecting the net of higher production cost and lower SD&A as a percentage of sales, adjusted EBITDA margin decreased to 140 basis points to 10.9%.

Adjusted EBITDA in the quarter was $102.9 million, down $10.8 million compared to the year-ago quarter. Higher production costs and increased marketing spends drove the majority of the decrease.

GAAP earnings per share for the quarter was $0.21. Excluding the items affecting comparability mentioned earlier, adjusted EPS in the quarter was $0.25, up $0.01 compared to the prior year quarter. The effect of the new tax law accounted for approximately $0.02 of the increase in adjusted EPS.

Turning to segments. DSD segment revenue was up 0.5% in the second quarter, driven primarily by strong sales of DKB, mostly offset by lower sales of traditional bakery items. Price/mix increased 2%, while volume decreased 1.5%. Our price/mix this quarter was driven by the growth of DKB and our sales mix and the pricing actions we implemented in the first quarter to address input cost inflation.

Adjusted operating margin in our DSD segment was down 150 basis points as a percent of sales versus the prior year. Again, the biggest driver of these -- of this were increased promotional activity related to new product launches and the disruptions caused by the inferior yeast issue. Also, we continue to experience lower manufacturing efficiencies as well as higher input cost and labor inflation.

Warehouse segment revenue was up 8.2% in the quarter. Price/mix decreased 2%, while volume increased 10.2%. Most of this increase was driven by higher food service, store-branded retail and vending sales, partially offset by lower sales in our warehouse organic business and contract manufacturing.

Adjusted warehouse operating margin was down 100 basis points as a percent of sales, impacted primarily by a shift in mix from higher-margin branded bread items to lower-margin cake and food service items and higher distribution costs. These were offset somewhat by lower SD&A costs.

Turning to cash flow. Cash flow continues to be strong, driven by improved management of net working capital. Operating cash flow year-to-date was $148.6 million, down $24.3 million from the prior year. This decrease was driven by a significant number of discrete cash uses, including voluntary pension contributions year-to-date of $40 million associated with our pension derisking strategy. Project Centennial and VSIP-related payments of $27.2 million, $17.5 million of net withdrawal on payments and $8.9 million of legal settlement payments year-to-date. We were able to meaningfully offset these cash uses with a cash generator from our payment terms extension initiative under Project Centennial and a lower effective tax rate.

Capital expenditures were $49.5 million year-to-date as compared to $31.9 million a year ago.

Dividends paid year-to-date totaled $74.3 million, a 6.7% increase over the first 2 quarters of last year. We ended the quarter with $796.3 million in net debt. At quarter-end, our net debt to trailing 12-month adjusted EBITDA was 1.8x.

Our financial position is strong. At the quarter-end, we had approximately $677 million of liquidity available on our credit facilities.

Now let's take a look at guidance. For 2018, we continue to expect sales to be in the range of flat to up 1.6%. We are now expecting adjusted EPS to be in the range of $1 to $1.07 per share. This reduction in full year guidance is being driven primarily by the Q2 margin factors described earlier as well as expectations that we'll continue to see overall inflation in workforce and transportation.

Though our sales forecast is strong, we do also expect that mix will continue to impact overall margins. For the back half, we are expecting sales growth to be slightly below trends year-to-date, primarily because we are lapping prior year weather events in our core markets that may not repeat in the current year.

We continue to expect the top line to be driven primarily by incremental volumes from DKB, which is offsetting softer volumes for our core branded items. We expect approximately $40 million of input cost inflation in 2018, which we have partially addressed through pricing action and continued focus on improving manufacturing efficiencies.

What we did not anticipate is the level of tightness in the labor market, which continues to cause increased turnover at the bakeries and contributes to lower manufacturing efficiencies. In addition, the effects of the driver shortage are also increasing logistics costs. These along with the brand investments we planned have offset the $38 million to $48 million of gross savings from Project Centennial we targeted this year.

For 2018, we continue to expect a full year tax rate of approximately 25% to 26% before onetime costs. We believe our revised EPS guidance range appropriately balances the factors we are seeing in the marketplace, the disruptions related to the yeast issue and the progression of Project Centennial.

The upper end of the range assumes a rational competitive environment, steady growth from DKB and solid performance from our new product introductions for the remainder of the year. The lower end incorporates continued softness in core brands, a competitive marketplace and rising inflationary cost pressures.

Now I'll pass the call back to Allen.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [7]

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Thank you, Steve. I'm encouraged with our sales results in the second quarter and the strength of our brand performance in the marketplace. Our transformation is well underway and never in our history have we had this degree of change. The magnitude of this change is impacting every aspect of the business. We've built a hard-working team, and we're evolving our strong culture to become more proactive and more aggressive. This is essential. As I said at the start of the call, we have work to do on margins, and we are focused on addressing our challenges head on.

At the start of the third quarter, we began a range of additional cost-reduction actions, and we are working with urgency to execute on these throughout the balance of the year.

Thank you for your attention today, and we'll now open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Farha Aslam from Stephens.

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Farha Aslam, Stephens Inc., Research Division - MD [2]

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A question on Project Centennial. Could you just share with us how much of that $38 million to $48 million savings you've already realized, how much is in the second half and how much into 2019 we should expect?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [3]

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I mean, when you look -- that's our projection for the full year. We haven't -- we wouldn't disclose where we are today, but we are on track to hit the $38 million to $48 million.

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Farha Aslam, Stephens Inc., Research Division - MD [4]

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And your anticipation for 2019 savings?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [5]

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We -- at this point, Farha, we're -- I don't think we're ready to talk about 2019. I mean, we still believe in the 250 basis point margin improvement by 2021, so we're still focused on making sure we hit the targets that we've laid out from that perspective.

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Farha Aslam, Stephens Inc., Research Division - MD [6]

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Okay. And then could you just talk about your pricing and total inflation? Was that $40 million that you highlighted, Steve, just input cost inflation or is that the total inflation bucket you are seeing?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [7]

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$40 million was total input cost inflation, so there are -- there have been other inflationary pressures, primarily around labor as well as transportation costs.

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Farha Aslam, Stephens Inc., Research Division - MD [8]

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So as a percentage of cost of goods sold, are you using about 4% inflation? Just any color you can provide there. And then, how much pricing can be put in to offset that inflation?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [9]

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I mean, when you look basically at the pricing in place and you can see this somewhat an IRI data, it is basically offsetting a majority of the input cost inflation. So the remainder of margin has to be driven by cost savings in other areas.

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Operator [10]

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Our next question comes from Amit Sharma from BMO Capital Markets.

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Amit Sharma, BMO Capital Markets Equity Research - Analyst [11]

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Allen, the yeast recall, I appreciate your comments about. You're still evaluating the impact of it. Would you expect that to be a bigger impact in Q3 versus Q4 related to disruption and demand maybe?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [12]

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I feel like the majority of the disruption, the majority of the cost impact was in the current quarter. We are evaluating continued costs that may be still out there. But overall, the bulk of the costs is going to be within the quarter that we're talking about here today. But we continue to monitor concerns about our brands, which were impacted during this period of time and also some of our foodservice business. But all of that, we feel like is being addressed within the quarter and there may be some carry forward, and we'll identify that as we get further down the road.

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Amit Sharma, BMO Capital Markets Equity Research - Analyst [13]

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Got it. And then, if you talk about -- you talked about elevated promotional spending. Is that -- was it largely driven internally like you just wanted to do it or did you see something in the marketplace that made you increase that a little bit more than you might have planned going into the year?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [14]

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Yes. The bulk of the promotional activity was on our new Nature's Own Perfectly Crafted. A lot of excitement about that new item, and it's really -- even though it's in our Nature's Own brand, it's a product that was new and unique to our product line. So we did get -- we did a good job of introducing it to the marketplace. It is now doing extremely well. We've generated a lot of consumer trial. And that was really the reason behind the increase in the quarter. It was really focused on introducing that new item.

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Amit Sharma, BMO Capital Markets Equity Research - Analyst [15]

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So you would expect that trend or that spend to trend down from what it was in Q2?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [16]

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Yes. Yes, absolutely.

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Amit Sharma, BMO Capital Markets Equity Research - Analyst [17]

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Okay. And then just final one for me. Steve, look, I see that you did reduce guidance for full year. I mean, you still have a ton to make up in the back half, right? I mean, even with the gross margin expansion all the way down to EPS now looking to grow by 20-plus percent, what gives you confidence that given the first half performance and all this conversation about inflation still a factor that we can grow that much in the back half?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [18]

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When you look currently, Amit, we have a number of initiatives in place. I mean, we're still working on our supply chain initiative. Obviously, we need to get our production footprint in line with our overall volume and tonnage, so there continues to be a lot of work around that. We should expect to begin seeing some of that come to fruition in the back half. As we said, the elevated marketing expenses are primarily Q2 and Q3. Reality is Q2 is probably stronger than Q3 is going to actually in that being as well because now a lot of the promotion spend behind Perfectly Crafted is behind us. And that was basically a 50 to 100 basis point hit to margin -- gross margin, the fact that it's netted against the top line. So we will not have that -- necessarily that headwind in the back half as well. So just a combination of all the initiatives and strong focus on driving some of the cost savings. We know there are some headwinds on the top line. We know there are some fourth quarter headwinds because we did begin to implement some of the Project Centennial savings initiatives in Q4, but we feel like the initiatives we have identified will help us overcome that in the back half.

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Operator [19]

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Our next question comes from Akshay Jagdale from Jefferies.

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Akshay S. Jagdale, Jefferies LLC, Research Division - Equity Analyst [20]

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So I just wanted to follow-up on Amit's question a bit. So the second half, specifically on my math, implies 70 basis point or so margin expansion. And so far in the year, you've had 70 basis point decline in EBIT margins. So it's a pretty big turnaround. And it looks like the top line trends aren't going to materially change. So something on the cost side would have to be materially different, right? So clearly, we had this yeast issue that looks like it's behind us, but is that the main factor that's different first half versus second half or are there other factors that will allow the performance to be materially different in the first half from a margin perspective?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [21]

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I mean, again, the -- in Q2, the big -- the 2 biggest items impacting the gross margin were the elevated promotional activity, which again was about 50 to 100 basis points. We also had lower efficiencies, which could be some of the fallout from disruption around yeast. Also, the labor issue was roughly 30 to 40 basis points. So you can see those 2 items alone basically -- if you had not had that, you would have flat margins in -- roughly flat margins in Q2. So we believe that we have the initiatives in place to address the efficiency issues in the back half. And then also, you should see the overall marketing impact come down materially in the back half with regard to the impact on gross margin. I mean, realistically what it was there was a lot of couponing activity. That gets netted against sales. So that net top line from a cost and production impacted your overall gross margin. So that will be subsiding somewhat in the back half.

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Akshay S. Jagdale, Jefferies LLC, Research Division - Equity Analyst [22]

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Got it. And then one question just on the overall operations piece. So we appreciate the new position created and the comments made. But you guys have been known to be the best-in-class operators with the local model. So I know you're going to a more sort of consolidated model. But -- what's the main goal of this new position? I mean, is it -- are you structurally changing how the bakeries are being operated or this is just an enabler to Project Centennial?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [23]

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Akshay, the adjustments that we've made as far as organizational structure is not just the naming of our Chief Operating Officer. It really goes down into the organization providing more accountability at the lowest level. And really it's an enhancement to the organizational structure that we initiated 7 or 8 months ago. I'm excited because it's putting more decision-making authority and more responsibility, pushing it down to the lowest levels. And that is really the strength of our company. I mean, we have got the best team in the industry. And some of the adjustments we're making from an organizational structure is going to push that accountability down to lower levels. Again, also very excited about the naming of Ryals as Chief Operating Officer. Ryals' first position, first responsibility is to make sure that we achieve the cost reductions that we have projected. And we said in our earlier comments that we're not where we'd like to be from a cost standpoint and the impact on gross margin. Ryals will have a lot of responsibilities, but top on the list is making sure we capture the cost reductions that we have identified in Project Centennial. So I'm really excited about the changes that have been made. And Ryals as well as the changes that are being made in the field are going to be very important to take us to the next level.

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Akshay S. Jagdale, Jefferies LLC, Research Division - Equity Analyst [24]

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Great. And just one last one on promotional -- the promotional issue that you had, but it's more a broader question. I know you were in the process of implementing some new tools, et cetera, to manage the pricing strategy better. Can you give us a sense of where you are with that and how that might play a role in better execution on promotional programs going forward?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [25]

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Our TPM project is developing in a very positive manner. Looking back on this quarter, the way that we introduced Nature's Own Perfectly Crafted utilizing the coupon approach with an individual retailer, we had never done that before. And to be very honest, the redemption rate was extremely higher than what we had projected. So again, this is the first time we have participated in that type of an introduction. 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 will 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.

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [26]

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Akshay, with regard to TPM specifically, it is implemented and we continue to add customers to the software tool. So we are beginning to use that as we manage our overall trade promotion spend.

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Operator [27]

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Our next question comes from Bill Chappell from SunTrust.

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William Bates Chappell, SunTrust Robinson Humphrey, Inc., Research Division - MD [28]

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Allen and Steve, could you just, I guess, give me a little more explanation on just kind of the promotional environment? And instead of -- I would think as we go especially to the back half with rising costs and commodities affecting you and your competitors, I mean, that will be the time where the market gets a little more rational and especially as we go into next year. Is that the right way to look at it or are we seeing kind of, I guess, less rational promotional levels in this space and it probably doesn't expect to change anytime soon?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [29]

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Yes. Bill, if you look at the marketplace conditions, again, it is very different from one market to the next. You're aware that we took pricing earlier in the quarter in many markets that is doing well. There are isolated situations where we're having to take a look at our current everyday price. I do feel that -- and again, this is -- can't guesstimate on what is happening in the future. But with the commodity increases, the transportation increases, the other cost increases that are impacting the total category, you would expect pricing in general to improve as you go forward. Again, we will -- if you look at the IRI data, you can see that we're the price leader in just about every market that we compete in and that strategy will be -- we will continue. That's the way that we've always approached pricing. But with the category basically showing interest in products with a unique point of difference, whether it's Dave's Killer Bread or Nature's Own Perfectly Crafted, the point of difference that those products provide also provides a nice platform for improved pricing in the entire category. So again, we're encouraged with where we are from a product development standpoint. And we continue to focus on pricing every day.

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William Bates Chappell, SunTrust Robinson Humphrey, Inc., Research Division - MD [30]

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But just again going back to the promotion, you're not seeing anything from competitors that looks more rational at this point? I understand you're taking pricing and trying to do the right things, but it doesn't sound like the competitive landscape has changed in terms of promotional levels.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [31]

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Bill, it's very much of a market-by-market story.

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William Bates Chappell, SunTrust Robinson Humphrey, Inc., Research Division - MD [32]

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Okay. And in terms of transportation costs, we've just heard from others, didn't know if there's especially for the Warehouse business, if there are some incremental costs there just because of the availability of trucks or refrigerated trucks or anything from that standpoint that gives you -- makes it a little more pressure. Is that the -- just trying to understand the transportation kind of inflation you're expecting over the next few months.

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [33]

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Sure. I mean, we actually, Bill, are seeing cost increases in both the DSD and the Warehouse segment. As you know, the DSD segment is, what we call, a little more of a closed-loop system, but we are starting to see the driver shortage impact our carriers within that segment. The Warehouse segment actually typically has to buy more on the spot market, so they are also being impacted by the transportation cost increases going forward as well.

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Operator [34]

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Our next question comes from Brett Hundley from Vertical Group.

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Brett Michael Hundley, The Vertical Trading Group, LLC, Research Division - Research Analyst [35]

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Just as a point of clarification. As you guys respond to cost challenges in the marketplace, Allen, did I hear you correctly say that you are accelerating your cost saving program or that you are going after additional supply chain savings?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [36]

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Yes. The -- we -- the cost savings initiatives that we've identified in Project Centennial, we are accelerating our commitment to generate those cost savings now. And there's tremendous urgency with our entire leadership team to capture the cost savings that is a critical part of our Project Centennial. Again, other cost-savings initiatives are throughout the organization, looking at individual manufacturing situations, looking at markets that may be new markets that have not contributed to our profitability. So looking at the entire organization in terms of what additional cost savings are there. But again, there is an urgency commitment specifically on the cost savings that we've identified in Project Centennial. So it's a little bit of both.

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Brett Michael Hundley, The Vertical Trading Group, LLC, Research Division - Research Analyst [37]

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Okay. That makes sense. And then, I just wanted to ask you guys -- Steve, you're usually the resident expert on this. I just wanted to ask you about the wheat market, hear out your hedges. Just given what's happening across the world right now from a supply standpoint, can you talk about your wheat hedges, your expectations into 2019? Just -- it feels like at this point, we're setting up for another pretty material cost headwind into 2019. But I just wanted to get your thoughts on what that market looks like and your ability to continue to offset that.

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [38]

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Sure. I mean, generally, for just 2018, we are covered. We typically hedge 4 to 7 months, and we're on the long end of that most of the time. So for 2018, we feel good about the costs that we've said are there. Just kind of -- looking out for 2019, it does appear based on what's happening really in the U.S. and across the world, we're anticipating a generally higher prices in 2019. Typically, higher prices will bring more planning acres, so that will be remained to be seen in the U.S. as well. But right now, our expectations are that for 2019, you will see higher overall wheat prices.

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Brett Michael Hundley, The Vertical Trading Group, LLC, Research Division - Research Analyst [39]

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Okay. And then just my last question. I just had a question on Project Centennial, and maybe Ryals can kick in on this, just given how important he has been in shaping the program itself. But when I think about your margin targets, you've had EBITDA margin targets of 12% to 13% for '17 and '18. Your -- it appears that 2018 is going to fall shy of that target. And again, to the point that Ryals brought up, there has been some extraneous factors that have come up this year, but I would also expect that the management team there would leave some headroom in your margin targets for challenges that arise year-to-year. And so can you just talk about your comfort or confidence in leaving EBITDA margin targets of 13% to 14% out there for fiscal '19 and beyond, just given some of the labor challenges, transport, raw materials that we just talked about, wheat, et cetera.

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [40]

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Sure. Brett, this is Steve. I mean -- no -- when you look at the project, it's a 5-year -- it was a 5-year project. And from a time perspective, we are only in year 2. And we still feel like there's time to mitigate and make changes to the overall cost structure, where we need to, to stay on track to hit our 2021 margin target of 13% to 14%, which is basically another $100 million of EBITDA. Also built into that target is M&A. And we've had a pretty dry run here, with the exception of the organic businesses from an M&A perspective. We do expect to see M&A in the next 3 to 4 years as well. So we still feel comfortable with the target that we have out there from that perspective.

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A. Ryals McMullian, Flowers Foods, Inc. - COO [41]

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And Brett, just to follow-up. This is Ryals. There's a cadence of savings initiatives that were always planned under Centennial. And I think we mentioned last quarter, the initial focus was largely on SD&A and now turns to supply chain. So we feel really good about where we are. We know what we need to do, the initiatives that we have underway. In supply chain, we expected to yield incremental savings opportunities for us. And as Allen said, we're actually accelerating those efforts as well. So all of those things combined give us confidence that we can still reach our long-term targets.

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Operator [42]

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Our next question comes from Tim Ramey from Pivotal Research Group.

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Timothy Scott Ramey, Pivotal Research Group LLC - Co-Head of Consumer Research and Senior Analyst of Food, Beverage, and Nutrition [43]

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Ryals, I think this is your first call. Welcome, and I'd love to hear a little bit more about the kind of the macro shape of Project Centennial. To date, we've really heard you talk about incremental cost savings. I guess, I had in the back of my mind that there would be some more profound structural changes, maybe volume shifting out of DSD and to Warehouse Delivery, so things like that. Do you think you basically got the go-to-market strategies set right now or should we still expect more change?

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A. Ryals McMullian, Flowers Foods, Inc. - COO [44]

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Thanks, Tim. Yes, let me -- look, we're always looking at the best way to get our products to market most efficiently. And those were some initiatives that were targeted under Centennial. From a macro standpoint, our focus has been on pivoting our company to be more consumer-focused, more brand-oriented, and that in and of itself has resulted in some significant changes in the organizational structure. I mean, if you look at a lot of the capabilities we've stood up from marketing to innovation, some -- and some of those things we're starting to see those bear fruit now is a testament to the project itself. Over the longer term, as we look at our operating model, where we make products, how we get those products to market, that is something that we continue to look at and continue to try to optimize.

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Timothy Scott Ramey, Pivotal Research Group LLC - Co-Head of Consumer Research and Senior Analyst of Food, Beverage, and Nutrition [45]

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So would it be a reasonable expectation that those changes are incremental or perhaps more revolutionary? If you -- let's look out 3 years, something like that.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [46]

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Tim -- go ahead, Steve.

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [47]

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Yes. I mean, I would say it's really more incremental, Tim. I mean, when you look at our business, obviously, today the vast majority of our business is DSD. We still believe with this category, DSD is the best way due to the freshness and the number of terms. So I don't see us changing from our traditional go-to-market strategy with regard to DSD. There may be more products that come online that could fit in Warehouse, but the fresh products still fit very nicely from a DSD perspective.

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A. Ryals McMullian, Flowers Foods, Inc. - COO [48]

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And Tim, when you think about adjacent categories, we talk about M&A a lot, we talk about investing in adjacent categories, some of those things may or may not fit within a DSD model. But with regard to fresh packaged bread and the high turn and the perishability of it, DSD will continue to be a core part of our business going forward. We believe that the merchandising we provide to the retailers and that brand support that the retailers enjoy is vital for our brands in that segment.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [49]

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Tim, our overall organizational structure, we are very confident that it's a solid structure. The urgency that you're hearing today is really a valuation of cost components and the commitments we've made to reduce costs in Project Centennial. Those are the commitments that have to be accelerated and that is what this team is committed to do.

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Timothy Scott Ramey, Pivotal Research Group LLC - Co-Head of Consumer Research and Senior Analyst of Food, Beverage, and Nutrition [50]

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Steve, it didn't look like share repurchase was much if anything in 2Q, maybe not year-to-date. I have to think back. And you've historically been pretty aggressive there. Is there something that is holding you back on capital allocation process, certainly not cash or cash flow, I wouldn't think.

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [51]

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No. I mean, again, cash flow continues to be strong. Our philosophy on share repurchases has been to do that more opportunistic unless there were other uses of cash. So again, you can see there's a slightly heightened investment from a CapEx perspective. And then we believe there may be other opportunities coming out of Project Centennial. So it's not that we've changed philosophically on how we look at share repurchases, it's just -- it's typically done more opportunistically.

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Operator [52]

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Our next question comes from Brian Holland from Consumer Edge Research.

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Brian Patrick Holland, Consumer Edge Research, LLC - Analyst of Small and Mid caps Staples & Protein and VP [53]

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I wanted to try to unpack the guidance revision a little bit more, if I could. You mentioned a number of catalysts, the cost inflation pressures are fairly well understood and certainly not specific just to Flowers, so -- can -- and certainly, this earnings season, we're learning as a lot of folks are having to react to that, that's become an incremental headwind. But -- I guess, to the extent that you've referenced the yeast issue and also the price promotion component, I guess, the yeast issue -- and you guys can correct me or maybe steer me on how you did this. But it looks like you pulled yeast out of operating results, so that doesn't feel like that should be an operating non-GAAP headwind and -- not sure how that would factor into guidance. And then also, again, as you guys have said, you've talked about increasing the promotion, et cetera, behind new product launches and you said last quarter Q2 and Q3. So I guess, I'm trying to get a sense of is this largely just the cost inflationary pressures that are impacting your guidance? And if it's the other parts, how do they come into the play or how do they become a bigger impact than you were anticipating?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [54]

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Sure. I mean, obviously, a big part of it is the cost inflation from the transportation and the workforce that we've talked about. But when you look at the yeast issue, the costs we identified were kind of what you could call hard costs that we were able to actually tie to the specific event. But there was a lot of disruption across our DSD bakery network impacting the majority of our DSD bakeries. So there was also some missed opportunity in the quarter from that perspective. And that -- as we said earlier, we're continuing to assess and monitor the impact that may have on our brands or our customers going forward. So from that perspective, we did miss a significant part of the July 4 bun season, and that did impact us. So there are some soft costs that we couldn't capture, so we were not able to currently add those back, but that does -- that did impact the operations for 4 or 5 weeks. So there was a missed opportunity during that time period. So we do feel like that does impact us from a guidance perspective.

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Brian Patrick Holland, Consumer Edge Research, LLC - Analyst of Small and Mid caps Staples & Protein and VP [55]

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Okay. That's helpful. Interesting point with the 4th of July. Certainly, my channel checks around the Memorial Day holiday and given the weather-related issues suggested that it was a pretty soft Memorial Day. If I'm right about that, that should typically be a pretty meaningful impact. So is -- was the offset that you guys experienced from what I presume is a soft Memorial Day, is that promotion around the 4th of July, et cetera, to get it back or is that just -- do you think that's actually an offset to particularly strong volume strength and reaction to the new product launches that you talked about in Q2?

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R. Steven Kinsey, Flowers Foods, Inc. - CFO & Chief Administrative Officer [56]

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The majority of our promotional activity or the most impact came from the new product launches. I mean, we did have promotional activity related to buns specifically because of Memorial Day, July 4 and also because of Labor Day. So you typically see that within that segment. And that tends to subside once you get to the Labor Day holiday, but the biggest impact for us in the quarter from a promotion standpoint was product launches -- new product launches.

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Brian Patrick Holland, Consumer Edge Research, LLC - Analyst of Small and Mid caps Staples & Protein and VP [57]

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Okay. And then last one for me. You talked about the pricing. And obviously, there's a lot of moving parts in there with the promotion, the mix, all of which you've laid out. But I'm just curious about pure underlying price and the pricing that you've been able to take thus far. Because clearly, that is one of your biggest tools to offset the cost inflation and then the other pressures from a cost standpoint. How is that holding up so far? Have you -- is any of that promotion tied to having to promote against list price to support volume? Or is price holding up and all the other stuff is just mix in promotion that's just getting away of us being able to see the list price flow through?

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [58]

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No. Again, just in general terms, the pricing that we took earlier in the quarter and the majority of markets that pricing is holding. Again, there are selected markets where we've had to be more aggressive from a promotion standpoint simply to be competitive. But overall, I'm encouraged that the pricing that we took within the quarter overall is holding. And as we look forward with the cost increases that we've discussed this morning, we'll continue to evaluate price as we always do. But at this point, we're encouraged with the pricing that is holding in the market.

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Operator [59]

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That concludes the Q&A session. I'll now turn the call back to Allen Shiver for closing remarks.

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Allen L. Shiver, Flowers Foods, Inc. - President, CEO & Director [60]

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Thank you for joining our call today. We look forward to our next update on the work we're doing to drive growth as well as taking costs out of the organization, becoming more efficient. Thank you for your time. This ends our call.

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Operator [61]

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