Q3 2023 Honest Company Inc Earnings Call

Participants

Steve Austenfeld; IR; The Honest Company, Inc.

Carla Vernon; CEO; The Honest Company, Inc.

Dave Loretta; CFO; The Honest Company, Inc.

Laura Champine; Analyst; Loop Capital Markets LLC

Andrea Teixeira; Analyst; JPMorgan Chase & Co.

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to The Honest Company's third-quarter 2023 earnings call. (Operator Instructions) Please be advised that today's conference is being recorded. I would now like to hand the conference over to Mr. Steve Austenfeld, Vice President of Investor Relations of The Honest Company. Please go ahead, sir.

Steve Austenfeld

Good afternoon, everyone. And thank you for joining our third-quarter 2023 conference call. Joining me today are Carla Vernon, our Chief Executive Officer; and Dave Loretta, our Chief Financial Officer. Before we start, I'd like to remind you that we will be making certain statements today that are forward-looking within the meaning of the Federal Securities Laws, including statements about the outlook of our business and other matters referenced in our earnings release issued today.
These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our earnings release issued today as well as our SEC filings for a more detailed description of the risk factors that may affect our results.
Please also note that these forward-looking statements reflect our opinions only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events, except as required by law.
Also, during this call, we will discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in the financial results section of today's earnings release. A live broadcast of this call is also available on the Investor Relations section of our website at investors.honest.com. With that, I will turn the call over to Carla.

Carla Vernon

Thanks, Steve. Good afternoon, everyone, and thank you for joining us today. It's a pleasure to be with you to share our results for the third quarter of 2023. This is the third consecutive quarter we've increased our revenue outlook, and the second consecutive quarter we've improved our outlook for adjusted EBITDA. Earlier this year, we committed to transforming the financial and consumer health of the business. And I'm pleased with the meaningful progress we've made in a short period of time.
This is a result of our collaborative and hard working Honest team coming together to execute the transformation initiative, and the strength the Honest brand continues to show in market. Our focus is always to keep the Honest community of consumers at the heart of everything we do.
Even in these uncertain economic times, we see that consumers have high standards for the products they bring home for themselves and their families. And we're committed to providing a wide array of products from sustainably designed wipes, onesies, and diapers to cleanly formulated mama care, beauty, and household products.
Our community expects our product to live up to the unique and rigorous Honest standard for clean, effective, and trustworthy. And this year, we've done this while improving the efficiency of our business model.
Let's turn to our third-quarter results to see how this intentionality comes together, beginning with revenue. This quarter we delivered all-time record revenue with third-quarter revenue up 2%, and our year-to-date revenue up 10%. Revenue growth was led by strong track channel consumption, double digit growth in the digital channel, and the positive benefits of our recent pricing actions.
Our gross margin was 32% for the quarter, which is our highest in two years. This improved performance is an outcome of the three key pillars we introduced as we laid out our transformation initiative earlier this year. Each of the three pillars, brand maximization, margin enhancement, and operating discipline contributed to our improved performance, including successful execution of pricing actions to restore Honest to our traditional premium position across our categories.
Margin improvement through SKU rationalization, cost savings, and the prioritization of our higher margin hero items, and disciplined management of our working capital, leading to a second consecutive quarter of positive operating cash flow.
As we enter the fourth quarter and continue to advance our transformation initiative, we anticipate continued year-over-year revenue growth and margin improvement. In addition to sharing these promising results, I'm delighted to introduce Dave Loretta, who recently joined Honest as our CFO.
Dave brings a robust track record of driving financial strength. With his depth of experience, he is a strong addition to our management team. And I'm confident in Dave's ability to drive our transformation forward and help build a stronger Honest.

Dave Loretta

Thank you, Carla, and welcome, everyone. Let me start by saying how pleased I am to be on the call with you today. I joined Honest nearly two months ago with a strong belief in the potential of the Honest brand, the significant opportunities to drive margin improvement and our commitment to generate positive cash flow, and maintain a healthy balance sheet.
In the current dynamic consumer environment, Honest is well positioned to expand market presence, while solidifying our operating discipline, building on what the team has already demonstrated this year on improved financial results.
Turning to our performance this quarter, revenue was $86 million, an all-time record for the company. We grew 2% on top of a record quarter last year, when we saw a high level of pipeline shipments associated with significant retail expansion.
This top-line strength in the quarter reflects healthy track channel consumption trends in the retail channel, which continues to reflect more than 20% growth. Strong results in the digital channel, including robust consumption at Amazon, and pricing actions implemented over the course of 2023.
Looking at consumption, we continue to grow revenue through both volume and pricing with our elasticities remaining healthy. Having revenue exceed expectations underscores the deep trust and appreciation that our Honest community has for our clean and sustainably designed products.
Turning to key drivers by product category. First, our diapers and wipes business declined 5% due to comparisons against a year ago volume, which reflected pipeline shipments for expanded retail distribution. While shipments were down in the quarter, track channel consumption increased 32%, significantly outpacing the category growth rate of 4%. We're pleased Honest continues to lead growth in this category. Notably, our newly launched flushable wipes are already one of our top-selling items on Amazon.
Next, our skin and personal care business declined 4% as we scaled back low-margin products in the club channel, consistent with our focus on margin enhancement as part of our transformation initiatives. This club channel revenue will continue to unwind over the next two quarters, but will result in a significant margin improvement.
In the digital channel, skin and personal care grew strong double digits. And finally our household and wellness business increased 68%, reflecting both the underlying growth and expanded retail distribution of our baby clothing business.
Now turning to results by channel, digital channel revenue increased 19%, while retail decreased 9%. During the last year, our digital channel has experienced meaningful growth driven by strong performance with Amazon.
Looking at the retail channel, we continue to benefit from significantly expanded distribution reflected in higher ACV, which has increased from over 50% to over 80% versus the prior year. This was offset by exiting our low margin offerings in the club channel as well as lapping pipeline shipments in the year ago quarter to support expanded distribution.
Some highlights this quarter include continued strong consumption at Target, which saw a double digit growth versus last year. Double digit sales growth across diapers, wipes, skin, and personal care items at Amazon and Walmart consumption continues to remain strong throughout transition to inline shelf set.
Now turning to gross margin. Gross margin was 32% in the third quarter compared to 30% in the third quarter of 2022. Gross margin has improved during each quarter of the year, reflecting the discipline and focus driven by the transformation initiative.
Gross margin versus the year ago quarter reflects approximately 425 basis points of pricing benefit and trade promotion efficiencies, 125 basis points of cost savings and 100 basis points of favorable mix offset by roughly 450 basis points of higher input and supply chain costs, and 75 basis points of cost related to the transformation initiatives.
Operating expenses decreased $2 million in the third quarter of 2023 compared to the third quarter of last year, leveraging 330 basis points overall, reflecting improved marketing efficiency. Adjusted EBITDA for the third quarter of 2023 was negative $1 million, which included $2 million in costs related to the transformation initiatives.
Turning to the balance sheet, we ended the quarter with $23 million in cash and cash equivalents, an increase of $5 million versus last quarter. Our cash position improved from continued discipline in managing working capital, including our third consecutive quarter of reducing inventory levels.
Year to date, we've reduced inventory by 31% or $36 million, significantly exceeding our initial goal of reducing inventory by $20 million, while also supporting 10% year-to-date revenue growth. Our balance sheet remains strong as we've been increasing our cash balance and continue to carry no debt. This is an important consideration in today's bank loan market.
Now turning to our outlook for 2023. Behind strong Q3 results, we're increasing our full-year revenue outlook for the third consecutive quarter and our adjusted EBITDA outlook for the second consecutive quarter.
Looking solely at Q4, we now expect revenue to increase low single digits and expect adjusted EBITDA to be in a range of flat to down $3 million, which includes an expected $1 million to $2 million in transformation costs. Both our revenue and adjusted EBITDA outlook are better than earlier expectations, reflecting the strong momentum of the business. With that, let me turn it back to Carla before we open it up for questions.

Carla Vernon

Thanks, Dave. Before I wrap up my remarks, I want to set the stage for what is ahead. In addition to strengthening our financial foundation, our Honest team has been engaged in the development of a long-term strategic plan to carry Honest forward into our next phase of growth. We look forward to sharing that vision with you all this spring.
As we round the corner on the close of 2023, I remain excited about the trajectory we are on. As evidenced by our improved revenue and adjusted EBITDA outlook, our transformation initiative continues to help us deliver improved business fundamentals. And while we continue to monitor the impacts of economic factors, such as sustained high interest rates and pressure on consumer spending, we are optimistic about the value the Honest brand provides.
Premium purpose led brands continued to hold up well despite economic pressures. And this has shown to be true for Honest. And as we look ahead, I remain confident in our path to make a larger, more vibrant, and more financially sound Honest. With that. I'll turn the call over to the Operator, and we look forward to answering your questions.

Question and Answer Session

Operator

(Operator Instructions) Laura Champine, Loop.

Laura Champine

Hi, and congratulations on being able to raise the guide for the full year. I did want a little more information about why the diaper business declined in Q3 and what the outlook is for that particular segment into Q4?

Carla Vernon

Hi, Laura. It's Carla; so good to hear your voice on the call. Thank you for joining us. Yes, the diaper business continues to have strong fundamentals. As you will remember from our messaging, our diapers and wipes, consumer movement or consumption data is up 32% in the quarter. What you're seeing is largely the impact of -- a onetime impact of us lapping the launch into a new retailer at this time last year.
As you may recall, last year at this time was our all-time highest revenue quarter until this year, which we have now bested our all-time revenue quarter. But we always expected this quarter to have a challenging year-over-year outlook related to the launch into Walmart with the diapers and wipes business. We don't see that as a concern going forward.

Laura Champine

Okay. And then you've done a good job pulling inventory down this year, would you expect that performance to continue in Q4?

Dave Loretta

Hi, Laura. This is Dave Loretta. The progress we've made on the inventory levels are certainly significant. And while we're at this point of the year, I don't think we're going to see the end of the fourth quarter be any further significant decline. We've largely claimed most of that improvement so far this year. So I wouldn't put any further reductions by end of year.

Laura Champine

Got it. Thank you and welcome, Dave.

Dave Loretta

Thank you.

Operator

Andrea Teixeira, JPMorgan.

Andrea Teixeira

Thank you. Thanks for taking my question. And good afternoon there. Carla, like, and obviously welcome, [Dave]. Good to hear from you already. Carla, I believe you mentioned strong 20% consumption just now to the prior question even stronger in diapers.
So I was wondering if you can perhaps parse out what we should expect into the fourth quarter. I understand that there was pipeline fuel in some of those retailers. So by the time you lap those, what is your -- what is the setup for probably 2024? Do you think that it's going to clear the pipeline or create the comps as you go into next year?
And then related to that, and you're doing a tremendous job keeping the lifestyle and the ecosystem of your brands intact, while you also do the hard job of keeping your heroes and cleaning up some of the SKUs that were not as successful, how should we think about that timeline and how we should expect that process to be complete? Thank you.

Carla Vernon

Andrea, so wonderful to talk to you today. And yes, we're glad you have an opportunity to meet Dave. Looking forward to being with you together in the future. Thank you. I think your questions, I'm going to try to take them in two parts. I want to make sure I'm really answering the question as you intended.
So I think the first question you're asking is, given that we've said, our consumption remains strong, and has been particularly strong in the quarter overall, for the Honest brand in the quarter tracked channel consumption was up 27%. And then we broke that down and indicated that diapers and wipes consumption in the quarter was up 32%.
That strong double digit consumption really reflects what we see as the fundamental consumer -- continued consumer belief, affinity, and alignment for the Honest brand across our categories. As we look into the future, not only do we think that those fundamentals remain true, that we will still have strong consumer-driven consumption expectations in the future.
While I certainly don't want to predict them in particular because there are a lot of elements to consumer consumption that we all need to watch as we look at the levers in the future. I am optimistic we will remain in good strong double digit territory. As we look forward, I see no concerns there.
And as you know, that's really based on a number of levers of which we do control. We feel we remain feeling strong that while we've increased our distribution at many major retailers, in some of those retailers it's still a relatively small cross section of our portfolio.
And we're seeing that that portfolio performs well as an example, when we look at how Walmart has continued to expand from our initial launch into half of their stores to a broader footprint among our body care, body wash, and baby care portfolio now in 100% of the stores.
We continue to identify growth opportunities. And those will support the consumption outlook that we have going forward. I want to take your second question, but I want to make sure that I understand it. Would you be willing to just sort of frame it for me again, so I don't miss anything.

Andrea Teixeira

Thank you, Carla. That was super helpful. And I appreciate that you wanted to make sure that we hit the same ideas. I was just thinking, like this tremendous job that you're changing the tire as you are driving the car, and driving all this consumption precisely going through your hero products.
And then taking those hard decisions, right. Taking away some of the SKUs. And that cost you sales, right, that potentially, you have to basically replace with fast growing items. So I'm just asking, my question was more the SKU rationalization time period, right? Are we pretty much done with that process at this point, and from now on, you feel like the profitability and I know you have a tremendous experience in CPG to make sure that innovation brings the type of returns that you're intended to.
So we're just thinking how the setup, like how clean you're going to enter 2024 after this process? Or are you still going to have some cleaning up to do into the beginning of next year.

Carla Vernon

Wonderful. Can I just say thank you for recognizing what I consider to be the incredible coordinated work of this whole team. You are right, we've been doing whatever we want to say, chewing gum and walking at the same time, changing tires, driving cars, I love it.
And this team has done a great job of finding quick places to identify very clear opportunities for us to focus our work on the most important things in the highest return efforts. And for us to help over time, whittle away and prune the things that we don't think are going to drive our long-term strategy driver at long term scale. So we've done that. And the SKU rationalization is a great example of that.
As you know, this year while we reduced the number of SKUs, our revenues are actually up 10% overall fiscal year to date. So we've shown that thesis statement that I love to make, and I think is a true CPG truth, which is that you actually can do more with less, especially if you focus on your core.
So with that in mind, I would say that while our team will always have a healthy practice of evaluating which items on our shelf add enough value, add enough value to be meaningful in especially in a brick and mortar context, where we're trying to grow. I believe we've done -- made a big effort in that direction this year. And that what you'll see in the coming years is we're really focused on executing the best ways to bring to life our core hero items.
With that said, I think you said it better than I can, which is that it is a true CPG practice. You must always have that discipline of monitoring as you execute your portfolio year after year that you've got the emphasis or not on the items that can both drive the top-line growth as well as the improved mix and margin expansion. That is a component of our strategic imperatives. But I would say as I look ahead, I see us feeling a stronger declarative focus about growing and winning with our winners.

Andrea Teixeira

Great. Thank you so much. I'll pass it on.

Operator

(Operator Instructions) And I'm not showing any further question at this time, I'd like to turn the call back over to Carla.

Carla Vernon

Everyone, thank you so much for joining us today. Since there are no more questions, I just want to take this opportunity first and foremost, to thank the incredible team of Honest employees at this company. I want to thank the retail partners that help us have those strong results. And I want to thank our Honest community for how much they believe in our products. And as you can see, the Honest brand continues to remain healthy. We're committed to this transformation initiative, making us a stronger and more vibrant Honest.
I look forward to our next conversation with you as we come back in 2024 to give you a bigger picture of where we're going with our long term strategy. Thanks, and we look forward to talking again soon.

Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.