Conagra Brands Inc (CAG) — Q2 2022 Earnings Call Transcript

Good morning, everyone. Thanks for joining us. I will remind you that we will be making some forward-looking statements today. While we are making those statements in good faith, we do not have any guarantee about the results we will achieve. Descriptions of the risk factors are included in the documents we filed with the SEC. Also, we will be discussing some non-GAAP financial measures. References to adjusted items, including organic net sales refer to measures that exclude items management believes impact the comparability for the period referenced. Please see the earnings release for additional information on our comparability items. The GAAP to non-GAAP reconciliations can be found in either the earnings press release or the earnings slides, both of which can be found in the Investor Relations section of our website, conagrabrands.com. With that, I will turn it over to Sean.

Thanks, Brian. Good morning, everyone, and thank you for joining our second quarter fiscal 2022 earnings call. Today, Dave and I will discuss our results for the quarter, our updated outlook for the remainder of the year and why we believe that Conagra continues to be well-positioned for the future. I like to start by giving you some context for the quarter. First, as you all know, the external environment has continued to be highly dynamic, but our team remained extremely agile in the quarter and executed the Conagra Way playbook. We navigated the ongoing complexity and delivered strong net sales growth anchored in elevated consumer demand that continued to exceed our ability to supply inflation-driven pricing actions and lower-than-expected elasticities. While our net sales exceeded our expectations, margin pressure in the second quarter was also higher than expected driven by three key factors. First, while we anticipated elevated inflation during the second quarter, it was higher than our forecast. Second, we experienced some additional transitory supply chain costs related to the current environment. And third, in the face of elevated consumer demand that continued to outpace our ability to supply, we elected to make investments to service orders and maximize product availability for our consumers. We expect margins to improve in the second half of the fiscal year as a result of the levers we pulled and continue to pull to manage the impact of inflation. We will always look to our cost savings programs to offset input cost inflation. However, given the magnitude of the cost increases, our actions also include additional inflation-driven pricing. We communicated pricing to customers again in December. For the year, we are once again reaffirming our adjusted EPS outlook, but our path to achieve that guidance has evolved. We are increasing our organic net sales guidance based on stronger-than-expected consumer demand and lower-than-anticipated elasticities. We are also updating our margin guidance given the increase in our gross inflation expectations for the year and the timing of the related pricing actions. Taken together, we continue to believe that elevated consumer demand, coupled with additional pricing and cost savings actions will enable us to deliver adjusted diluted EPS of about $2.50. So with that as the backdrop, let’s jump into the agenda for today’s call. We will start with an overview of the quarter before going into more detail on our outlook for the second half of the fiscal year. I will also share some of our thoughts on the structural changes we are seeing in consumer behavior, particularly with younger consumers. We believe these changes are further evidence in the long-term potential of Conagra Brands. Let’s dig into the quarter. As you can see on slide seven, our team delivered solid Q2 results. On a two-year CAGR basis, organic net sales for the second quarter increased by more than 5% and adjusted EPS grew by nearly 1%. As I noted earlier, we delivered these results in the face of a highly dynamic and challenging operating environment. Input cost inflation came in higher than expected in the quarter. In addition, we made some strategic decisions to service the heightened consumer demand we continue to experience. As the entire industry incurred transitory costs associated with labor shortages, supply issues on material and transportation costs and congestion challenges during our Q2, we chose to invest in our supply chain and service orders. This deliberate decision ensured we could deliver food to our customers and consumers, especially during the holiday season. Maintaining physical availability is an important part of building trust with customers and maintaining consumer loyalty. The bottom line is that amid the supply disruptions seen across the industry, we remain focused on building for the long-term. While the net result of these factors was a negative impact on our margins during the quarter, we are confident that our purposeful approach better positions our portfolio for the future. I want to take this opportunity to thank our tremendous supply chain team. They have been resilient in navigating this environment, allowing us to remain agile and deliver for our customers and consumers. I continue to be impressed by our team’s commitment and I am grateful for their ongoing dedication. Looking at slide 10, you can see that our strong performance in the second quarter was broad based. Total Conagra retail sales were up 14.8% on a two-year basis in the quarter, with double-digit growth in each of our domestic retail domains; frozen, snacks and staples. Household penetration was also up this quarter, building upon the significant number of new consumers we have acquired over the past two years. Total Conagra household penetration was up 59 basis points on a two-year basis and our category share increased 41 basis points. In addition to increasing household penetration and acquiring new consumers, we are retaining our existing consumers as demonstrated by our repeat rates. Shoppers continue to discover our incredible products and their tremendous value proposition. As the chart on the right of slide 11 shows, our consumers keep coming back for more. As we execute our Conagra Way playbook, innovation remains a key to our success across the portfolio in Q2. Slide 12 highlights the impact of our disciplined approach to delivering new products and modernizing our portfolio. During the second quarter, our innovation outperformed the strong results we delivered in the year-ago period. We continue to invest in new product quality and in supporting our innovation launches with deeper, more meaningful consumer connections. Once again, our innovation rose to the top of the pack in several key categories, including snacks, sweet treats, sauces and marinades, and frozen vegetables. Slide 13 demonstrates how our ongoing investments in e-commerce continued to yield strong results. We again delivered strong quarterly growth in our $1 billion e-commerce business and e-commerce accounted for a larger percentage of our overall retail sales than our peers. We outpaced the entire total edible category in terms of e-commerce retail sales growth during the second quarter, just as we did in the first quarter of 2022 and throughout fiscal 2021. As we mentioned earlier, our strong net sales growth was driven by elevated consumer demand, favorable elasticities, and inflation-driven pricing actions. On slide 14, you can see the extent of our pricing actions in the first half of the fiscal year. During this period, our on-shelf prices rose across all three domestic retail domains, and as Dave will discuss shortly, the pricing flows through the P&L. As you can see on slide 15, price elasticity has been fairly low. It’s been favorable to our expectations. Consumers continue to see the tremendous value of our products relative to other food options, a concept I will elaborate on in a few minutes. Now let’s turn to the path ahead. You can see on slide 17, we currently expect gross inflation to be approximately 14% for fiscal 2022, compared to the approximately 11% we anticipated at the time of our first quarter call. This is a large increase and we are taking actions to offset the increase, while still investing in the long-term health of our business. Help manage our increasing inflation, we are taking incremental pricing actions, including list price increases and modified merchandising plans. Many of these actions have already been announced to our customers. As a reminder, there is a lag in timing between the impact of inflation and our ability to execute pricing adjustments based on that inflation. As a result, the incremental price increases will go into effect in the second half of the year, with the most significant impact during the fourth quarter. While it’s easy to get caught up in the quarter-to-quarter impact of inflation and pricing, it’s important to keep focused on the big picture. The long-term success of our business is driven by how consumers, particularly younger consumers respond to our products. And when you take a step back to evaluate the broader environment and how our portfolio delivers against the needs of the modern consumer, we believe that Conagra is uniquely positioned for the future. As we have detailed many times before, Conagra’s on-trend portfolio filled with modern food attributes is winning with younger consumers and our confidence is underpinned by the many changes we are seeing in consumer behavior that are proving to be structural, especially given that these changes are driven by younger consumers that represent the most significant opportunity for long-term value creation. Younger consumers represent a large and growing part of the U.S. population, and they want to optimize the value that they get for the money they spend on food. A large part of optimizing their food spending includes shifting more dollars from eating away from home to eating at-home. As they make that trade, they are choosing national brands and we believe Conagra is ideally positioned to experience an outsized benefit from these behaviors, given the relationship our brands are forming with younger consumers. Overall, Conagra is delivering superior relative value to consumers compared to both away-from-home options and store brands. Let’s take a closer look at these trends, starting with the population changes. Slide 20 highlights the demographic shift underway in the U.S. Millennial and Gen Z consumers are a large and growing cohort. These consumers are starting to settle down, buy homes and start families. As we presented in the past, when people enter the family formation phase, they increase the amount of food they eat at-home with an outsized increase in the consumption of frozen foods. And what we find particularly important about reaching millennial and Gen Z consumers is that we believe they will remain more value focused than their predecessors. First, let’s talk about the near-term. As you can see in the chart on the left, millennial and Gen Z consumers are earlier in their careers and earning less than the older generations of working-age people. This is natural. But it bodes well for food at-home trends in the shorter term. We believe that even as food service bounces back, younger consumers will be value conscious in their food choices. Fewer younger consumers are expected to achieve the financial success of the generations before them. The data on the right suggests that millennials are more likely to earn less than their parents. We believe this means that these savvy consumers will look to stretch their food dollars further even as they age. The data also shows that younger consumers are already eating more at-home. Compared to the population as a whole, Gen Z and millennials have decreased restaurant visits more and sourced a larger percentage of their meals at-home. As these younger consumers have made the shift to at-home eating, the data shows that they are finding comfort in the quality, reliability and familiarity that national brands provide. We believe this makes a lot of sense. National brands provide value, while replicating many of the on-trend flavors and modern food attributes that consumers are used to experiencing in away-from-home dining. When consumers make trades like away-from-home to in-home eating trust is paramount. In short, national brands, particularly modernized brands, like those in our portfolio, deliver on this trust imperative and that’s because they offer superior relative value versus other food options. As consumers seek to stretch their household balance sheets in the face of broad-based inflation, one of the single largest levers available to them is the reduction in spending on food away-from-home, as food away-from-home prices are typically over 3.5 times more expensive than food at-home prices. This trade will likely become even more important for consumers as food away-from-home prices have already increased faster than at-home prices in calendar 2021 and they are expected to increase at nearly twice the rate as at-home prices in calendar year 2022. Our aggressive modernization of the Conagra portfolio over the past several years has put us in a strong position to capitalize on these structural shifts. Our portfolio has shown its competitive advantage, with excellent trial, depth of repeat and share gain performance. Overall, we believe Conagra is well-positioned to leverage these shifts to create meaningful value for shareholders. And slide 25 shows you the data to support our claim, Conagra is attracting more younger consumers than our peers and getting them to repeat at more attractive rates. By appealing to younger consumers now, we are building superior consumer lifetime value. Importantly, the data shows that these new younger buyers are stickier across our portfolio. We believe this comes back to the investments we have made and continue to make in our products and our brands. The Conagra Way has positioned us to win. As I discussed earlier, we are reaffirming our adjusted EPS guidance of approximately $2.50 for the full year, with a few updates on how we expect to get there. We are increasing our organic net sales guidance to be approximately plus 3%, up from approximately 1%. We are slightly adjusting our adjusted operating margin guidance to approximately 15.5%, down from approximately 16% and we are updating our gross inflation guidance to about 14%, up from approximately 11%. Now that I have highlighted our performance for the quarter and strong positioning for the future, I will turn it over to Dave to provide more detail on our financial performance.

Thank you, Sean, and good morning, everybody. I will start by going over some highlights from the quarter shown on slide 28. As Sean mentioned earlier, there were a number of factors that influenced our results this quarter. First, we were encouraged to see that consumer demand for our products remain strong; and second, elasticities were better than anticipated. However, we also continued to see inflation rise across a number of key inputs and the dynamic macro environment created challenging conditions for the supply chain. The team remained agile in response to these dynamics, including the decision to make additional investments during the quarter to meet the elevated demand and maximize the food supply to our consumers. Overall, our actions favorably impacted our top line during the quarter, with organic net sales up 2.6% compared to the year ago period. An important part of the top line success we have realized throughout the pandemic is our ongoing commitment to the Conagra Way. We have remained focused on building and maintaining strong brands across the portfolio. We continue these efforts in the second quarter with continued product innovation and by further increasing our spending on advertising and promotion, primarily focusing on e-commerce investments. We show a breakdown of our net sales on slide 29. The 4.2% decline in volume was primarily due to the lapping of the prior year’s surge in demand during an earlier stage in the COVID-19 pandemic, as volume increased approximately 1% on a two-year CAGR. The second quarter volume decline was more than offset by the very favorable impact of brand mix and inflation-driven pricing actions we realized this quarter, driving an overall organic net sales growth of 2.6%. On last quarter’s call, we noted that the domestic retail pricing actions were just starting to be reflected on shelves at the end of the first quarter. Those increases were reflected in our P&L this quarter, driving the 6.8% increase in price mix. The divestitures of our H.K. Anderson business, the Peter Pan peanut butter business and the Egg Beaters business resulted in a 70-basis-point decline and foreign exchange drove a 20-basis-point benefit. Together, all these factors contributed to a 2.1% increase in total Conagra net sales for the quarter compared to a year ago. Slide 30 shows our net sales summary by segment both on a year-over-year and on a two-year compounded basis. As you can see, we continue to deliver strong two-year compounded net sales growth in each of our three retail segments, which resulted in a two-year compounded organic net sales growth of 5.3% for the total company. You can see the puts and takes of our operating margin on slide 31. We drove a 6.2-percentage-point benefit from improved price mix, supply chain realize productivity, cost synergies associated with the Pinnacle Foods acquisition and lower pandemic-related expenses. Netted within the 6.2% are the additional investments we made to service orders and maximize product availability. These investments reflect the dynamic environment and actions we have taken to respond to it. This includes decisions to utilize more third-party transportation and warehousing vendors for some of our frozen products, incurring incremental cost to move product around our distribution network to better align with customer order patterns and delaying a plant consolidation productivity program to maximize current production. The 6.2% also includes transitory supply chain costs, such as higher inventory write-offs and increased overtime to support operations. The 6.2-percentage-point benefit was more than offset by an inflation headwind of 11-percentage-points. The second quarter gross inflation rate of 16.4% of cost of goods sold was approximately 100 basis points or $20 million higher than expected, driven by higher than anticipated increases in proteins and transportation, which are both difficult to hedge. The combination of the favorable margin levers, our choice for supply chain investments and inflation headwinds resulted in adjusted gross margin declining by 483 basis points. Our operating margin was further impacted by 20 basis points due to our increased A&P investment during the quarter as I mentioned earlier. You can see how these elevated costs impacted each of our reporting segments on slide 32. While each segment was impacted, our Refrigerated & Frozen segment was impacted the most, with adjusted operating margin down 707 basis points, primarily due to outsized materials inflation and the additional investment incurred to service orders and get food delivered to consumers. We are confident that we will improve overall operating margins in the second half as we execute our additional pricing actions to offset the higher inflation rates. As you can see on slide 33, our second quarter adjusted EPS of $0.64 was heavily impacted by the input cost inflation across our portfolio. Even though the benefits of our first quarter pricing flowed through the P&L this quarter, the incremental inflation we incurred in the second quarter created an additional headwind. In response, we announced additional pricing to customers in early Q3 during December. Although we have yet another lag before this pricing benefits the P&L, we expect to realize benefits from these pricing actions in late Q3 with most of the impact in Q4. Also, our Ardent Mills joint venture had another good quarter and delivered EPS benefit versus the prior year. We realize lower net interest expense and a slightly lower average diluted share count due to our share repurchases in prior quarters. Turning to slide 34, I want to unpack how Q2 adjusted EPS landed versus our expectations. Our second quarter adjusted EPS came in lower than we originally had anticipated due to two main factors. First, as previously mentioned, inflation came in higher by approximately 100 basis points of cost of goods sold were approximately $0.02 to $0.03 of EPS. While we have announced additional pricing actions for the second half to offset the incremental inflation, the timing of these benefits is naturally lagging behind the higher inflation. Second, the cost we elected to incur to service orders, coupled with the additional transitory supply chain costs I described earlier, leads to another $0.02 to $0.03 impact on our adjusted EPS. We are forecasting these service and transitory cost dynamics to improve as the second half progresses. Looking at slide 35, we ended the quarter with a net debt-to-EBITDA ratio of 4.3 times, which is in line with the seasonal increase in leverage expected for the second quarter. We expect to generate strong free cash flow in the second half of the fiscal year and expect to end the year with a net leverage ratio of approximately 3.7 times to 3.8 times. We remain committed to a longer-term net leverage target of approximately 3.5 times and to maintaining an investment-grade credit rating. I want to close today by reviewing the factors driving the updated guidance we issued this morning, which is shown here on slide 36. I will start by saying that we remain confident in our ability to achieve approximately $2.50 in adjusted EPS for the full fiscal year. As the macro environment continues to be very dynamic, our expectations for the path to achieve that target have shifted. We are increasing our organic net sales growth guidance to approximately 3% to reflect our stronger than expected performance year-to-date, as well as our incremental pricing actions in the second half. We are lowering our adjusted operating margin guidance to approximately 15.5%. We expect the incremental sales and pricing actions in the second half to offset the dollar impact of the incremental net inflation and other supply chain costs. We have increased our gross inflation expectations to approximately 14%, largely driven by higher estimated costs versus the previous estimate for proteins, transportation, dairy and resin. We will continue to monitor these input costs closely and we will be quick to respond using all available margin levers. As Sean detailed, price elasticity has been favorable to our expectations so far. As we have explained previously, there is a lag in timing between when we experience inflation take actions including pricing to offset the dollar impact of the inflation and when we see those actions flow through our financial results. With respect to the additional pricing actions, we have announced for the second half of fiscal 2022, we expect to realize a small amount late in the third quarter and the full benefits from these price increases in the fourth quarter. We therefore expect our third quarter margins to be roughly in line with second quarter margins, with an increase in operating margins in Q4, as the pricing catches up with inflation and the impact of the lag is reduced. Our guidance also assumes that the end-to-end supply chain will continue to operate effectively as the COVID-19 pandemic continues to evolve. Before turning it over to the operator for Q&A, I would like to reiterate that our results this quarter and throughout the pandemic have reflected our ability to consistently deliver superior relative value to our consumers. Our confidence in our ability to reach our earnings goal is based on the strength of our business at its core to manufacture and deliver foods that people enjoy. That concludes my prepared remarks today. Thank you for listening. I will now hand it back to the Operator for questions.

Good morning and happy New Year everybody.

Good morning.

Hi, Andrew.

Hey. Two questions for me, if I could. First, maybe Sean, you mentioned several times that elasticities remain sort of below expectations than maybe what you have seen historically, and I realize there are a lot of dynamics at play that that lead to that. I am trying to get a sense of what you are building into sort of back half guidance along these lines in terms of elasticity, just given more pricing is obviously set to keep rolling in as you have talked about. And just some of your expectation taking into account the potential fading of some government stimulus and how does that play a role again and how you think about elasticity? And then I have just got a follow up for Dave.

Right. Sure, Andrew. Let me hit that elasticities and stimulus. I’d say, our year-to-go outlook takes into consideration everything that we have seen in the marketplace to-date as well as our planned pricing and merchandising actions in the year-to-go period. I will tell you that I see with respect to elasticities a major difference in the marketplace today in terms of how consumers are assessing value versus what I have historically seen in the past. Previously, a consumer’s comparison of choices was between close proximity items inside the grocery store. Today, due to the demographic dynamics I talked about around young consumers home nesting, as well as the huge move to working from home, the biggest comparison taking place from a value standpoint is between away-from-home choices and at-home choices. And as I said in my prepared remarks, the consumer is showing us that modernized national brands like ours are offering superior relative value and that’s having a positive impact on elasticities that we expect to continue, but we have factored in our year-to-go actions. In terms of reduced stimulus payments particularly SNAP, the short answer is we don’t believe that the eventual end to the emergency allotments in the SNAP program is going to create a material headwind to our business, and fundamentally it comes back to that superior relative value of our portfolio versus alternatives. But let me unpack this one a bit because I know it’s been kind of a hot topic. Since the start of the pandemic, consumers were actually able to reduce their overall food spending significantly and that reduction was driven by the mix shift from higher priced food away-from-home to lower priced food at-home, and at the same time, that consumers have been able to save money on food because of that shift to food at-home, many have also been receiving these COVID-related stimulus payments on multiple fronts, including for some higher SNAP benefits. Now as this one component of consumer cash flow changes, that is as the emergency allotments in the SNAP program sunset, we are not seeing and we don’t expect to see a meaningful shift away from the newly created behaviors we talked about around eating national brands at home. There are a few things that I think you need to keep in mind here. First, the reduction in SNAP dollars in the total ecosystem is already happening as a slow peeling back. It’s not a cliff. Now to that point, the number of individuals receiving any SNAP benefits today has been declining versus pandemic highs already and individual states are ending waivers and emergency allotments on their own schedules. It’s not a one-time event. Second, I’d say recent permanent changes to the SNAP program have actually raised core continuing SNAP benefits to a level that is higher than pre-pandemic. So the core SNAP consumer who has also benefited from other stimulus is going to have a higher SNAP budget coming out of the pandemic than they did pre-pandemic. And then, third, the USDA forecast that food away-from-home prices are going to rise faster than food at-home prices and that maintains the value proposition of food at-home for consumers. And then, finally, I’d just say, and perhaps, most importantly, the early data does not show that as SNAP benefits and consumer behavior changes relative to food at-home. We are, as you can imagine, closely watching the states where emergency allotments have already ended and we have not yet seen a significant change in consumers’ purchases of packaged foods. And that we believe is, because as I said, our brands are offering superior relative value versus both away-from-home alternatives and store brands, especially given the huge move to working from home.

Thank you for that helpful perspective. I have a quick question for Dave. Given your expectations for margins in the third quarter, it seems they are about 150 to 200 basis points lower than what consensus expected. I understand this is due to the timing of pricing changes impacting the fourth quarter more significantly, along with some incremental costs beginning to ease as the year progresses. This situation puts more pressure on the fourth quarter to meet expectations for the year. Are you factoring in some level of flexibility for that based on what is needed in the fourth quarter? What is your visibility on that at this stage, considering it appears to be more weighted toward the fourth quarter? Thank you.

Yeah. No. And you summarized it well, Andrew. Let me try to walk through it, so I can kind of hit the kind of the big puts and takes. So as I mentioned in my remarks, we expect Q3 operating margins to be roughly in line with Q2 margins and then Q4 margins up. If you look at the puts and takes from Q2 to Q3, we have increased our total inflation estimate for the year from 11% to 14%, so now we expect second half inflation to approximate 11.5%, and that’s off of a prior year inflation that was about 6.5%. We also expect that some of the additional costs we incurred in the second quarter to support shipments and getting product to consumers will continue into the third quarter given the continued challenges in supply chain. We are forecasting that this complexity will gradually improve as we approach Q4 and the March timeframe. The additional pricing actions, which are critical, we announced in December and they were accepted and we have a small impact in Q3 given the timing, but we will have a much bigger impact on Q4 from the pricing. So the pricing has been announced, it’s been accepted and we have very good visibility to that for forecasting purposes. So Q4 will benefit meaningfully from these pricing actions. We expect price/mix to approximate 10% in the fourth quarter as we will start to catch up with the inflation and the reduced pricing lag that impacted us through the first half and will impact Q3. Q4, as you mentioned, will also benefit from the decline in incremental cost to support shipments that I just referenced, as well as a decline in some of the transitory costs that hit us in Q2 as well. So it’s important to note that, although we expect meaningful improvement in Q4, we are still forecasting higher inflation, as I mentioned. So if you look at our cost per unit of volume, we expect that to continue to increase in H2 before being offset by the pricing in Q4.

Hi. Thanks so much. Dave, I just wanted to clarify, when you said to expect 3Q’s margin to be roughly in line with 2Q’s margin, is this comment solely about the operating margin or should that roughly apply to the gross margin as well?

I was commenting on the operating margin, but that’s driven by the gross margin.

Okay. Perfect. Thank you. And then I wanted to clarify, you mentioned inventory write-offs, I think, I heard and higher overtime expenses as maybe some of the examples of 2Q’s non-recurring challenges. I guess, number one, can you elaborate a bit, if I did hear that right, on what the write-offs were. And can you also talk a little bit about labor availability over the last couple of weeks, maybe as Omicron has started to affect more people and how much of that risk is baked into your guidance as well?

All right, Ken, it’s Sean. Let me start with the back piece, because I know that’s also a hot topic and you wrote about it the other day, which is absenteeism. And what I’d say there is, I told my team back in July, the word of the year this year is perseverance and that has certainly proven to be true. We faced a number of factors that have converged to create a persistently challenging operating environment, things like sustained elevated demand alongside a protracted pandemic and a strained supply chain and acute inflation. But against that backdrop, I’d say our team has done a remarkable job persevering and doing everything possible to keep our food in consumers’ hands, particularly in Q2, which is our largest volume quarter. But to your point, clearly, it’s not perfect yet, and I think it’s entirely reasonable for all of us to project that the next month or so could remain strained within the supply chain as Omicron runs its course. But I’d say we will persevere through that too, but as you saw in Q2 and you referenced some of the things, not at normal efficiency which is a factor as to why margins in Q3 are expected to be similar to what we put up in Q2. But we will persevere, because keep in mind, that Q3 is a smaller quarter volumetrically than Q2, call it, 5% to 10% less volume on average. We also have a geographically diversified manufacturing footprint across our plants and those of our co-packers. We don’t have like one big mega plant. And as we saw early in COVID, there are steps we can take to maximize line efficiencies and throughput, things like SKU simplification, et cetera. And as I mentioned earlier, we have already tightened up our merchandising activity in year-to-go period. So collectively, these things should help ease the impact of Omicron-driven absenteeism. And importantly, as you highlighted in your note from Tuesday, there’s good reason to believe that, that challenge will be short lived. So I’d say to sum up, the team is staying agile and as we move beyond Q3 and into Q4, clearly we see opportunity. We will begin to wrap the onset of input cost inflation, our most recent pricing actions will be rolling into market and Omicron-driven absenteeism should be diminished, and all of that positions us to deliver meaningful improvement in multiple metrics as we go into the final quarter.

Yeah. So let me get the first part of your question, Ken. So, yeah, we were impacted $0.02 to $0.03 in the quarter from incremental transitory costs and that included higher overtime across all of our supply chain operations, given the labor challenges and higher inventory write-offs. Regarding the inventory, in this environment, it’s no secret the end-to-end supply chain has been strained. We are moving fast to meet demand as are our suppliers. So our food safety and quality standards are the highest priority for this company and include product from suppliers that we use as well. We have thorough processes for ensuring that the raw materials and finished goods meet our standards before they are utilized, and if not, we write them off. And that’s what happened in Q2, we do believe that this impact is transitory in nature as we move into the third quarter. So we always have some level of inventory write-offs, but this was higher than we expected for those reasons.

And the messaging just to wrap it up is not a demand-driven write-off, it’s a supply chain driven issue?

Yeah. Absolutely…

Hey, thanks, Operator. Good morning, everyone. I have two quick questions. First, Dave, can you provide some insights on the items below the operating profit line for the remainder of the year or for the full year? I believe the consensus for interest expense is around $3.80. Regarding equity income with Ardent Mills, it seems like there are some positive trends, so that might increase. Also, could you offer some guidance on how we should view the tax rate for the full year?

Sure. I think on the interest expense, I think, that number is in line, the number that you quoted the $3.80. Ardent, we had benefit in the quarter, which you saw and we expect to continue to have benefits. So we see upside in Ardent and that contributes to our EPS, call it, $2.50. So we have upside in Ardent year-to-go. And the tax rate should be in line with the 23% guide that we have. We are a little favorable this quarter slightly, but that’s the right rate to use.

Thank you for that. Sean, during this period of inflation, you mentioned in response to a question about adjusting merchandising. Previously, there was a greater focus on spending more above the sales line because it provided significant returns. Now, it seems there isn't a strong incentive to continue that approach. Are you reallocating more of that spending to advertising and promotions, and will that trend continue, particularly in this inflationary environment?

I would not view it that way, Bryan. The funds allocated to brand building involve various investments, including traditional merchandising. My comments in the prepared remarks today largely addressed our less aggressive approach to typical in-store merchandising. We have maintained this strategy since the beginning of the pandemic, as it does not make sense to stimulate excess demand while already struggling to meet existing demand. Our other above-the-line investments have been strong for several years, and that will not change because that’s where we achieve some of the best returns on investment in brand building. These investments range from products and packaging innovations to collaborating with our customers for the right merchandise placement and support in-store, including sampling and in-store promotions. Those are solid brand-building investments that have remained strong. The aspect of above-the-line spending I mentioned relates specifically to merchandising. Regarding the increase in advertising and promotion expenses this quarter, as I noted previously, that can vary each quarter depending on our innovation agenda. If we have a new item launching that we want to promote, advertising and promotions become essential, especially in e-commerce, which we continue to emphasize. Therefore, this spending may fluctuate each quarter, but our overall spending philosophy remains unchanged.

Okay. Thanks for that Sean. Happy New Year, guys.

Yeah.

Thank you.

Thanks. Question on slide 31, you have that 620-basis-point benefit from productivity, hedging price, mix and other. I just would love to dig into that a little bit. You have pricing of 680 basis points and I would imagine you might have a few hundred basis points of productivity and some hedging benefits. So that number could be seen as low, but obviously, there’s some headwinds in there. Could you dig into that and maybe give a sense of the headwinds offsetting what might be significant benefits of pricing and productivity?

Sure. David, let me give you a kind of a high level bridge. So we clearly had the benefit of pricing. We always combine price/mix, right? So we did have unfavorable mix in the quarter. Primary driver of that is because our away-from-home segment was up 15% and that’s a lower margin segment. So you get the unfavorable segment mix there and there is some unfavorable brand mix embedded in the business, but away-from-home is the big driver there. You are right, we have productivity and sourcing combined. We had over 500 basis points of favorability there or improvement. But then the additional supply chain costs that we incurred that I went through plus absorption hit us because volumes were down. We had forecasted that, but that’s in those numbers. So that’s a high-level bridge to get you to the 620 basis points.

And then as you are looking through the rest of the year, can you give us a sense even directionally about some of those line items, how you are thinking about, I mean, it sounds like we are going to get some more pricing benefit, perhaps, how you are thinking about the cadence and the directions of those items on gross margins?

Yeah. So from a price/mix perspective, we are estimating price/mix now will be approximately 6% for the year. So Q3 should be in line with Q2, and as I mentioned, Q4 price/mix, we expect to be at about 10%. So, clearly, there’s a benefit there. We continue to expect our productivity to click along as it’s done both our core productivity and our sourcing benefit. So that will continue to track. We laid out the inflation and kind of what that looks like. So they are really the key drivers and then, as I mentioned, David, the cost we got hit with in Q2, the transitory costs, we really expect those to start to go down in Q3 and into Q4. And then some of the incremental cost to support selling and getting product on shelves, that will continue through Q3 and then we expect that to decline in Q4. So that’s a high level kind of bridge there.

And I will stop here, but the supply chain friction costs, whether those you are really calling them transitory or another, but you can see that during COVID there’s a lot of these costs. How much of that would you estimate is in the fiscal 2022 gross margins that you are anticipating overall? How much of the supply chain, you call it, COVID era friction costs, do you think are weighing on that 15.5% overall margin?

Yeah. David, let me get back to you on that, because there are so many different components of cost. I want to go through that to make sure that I classify it right.

Things are clearly progressing, David, and we can observe that. Recently, some aspects have begun to improve, but with the arrival of Omicron, things are still fluctuating in various directions. However, we do see some of the friction points improving based on our best available information as we transition from Q3 to Q4, which is significant since it contributes to the improvement of gross margins in Q4. Nonetheless, there is more to the gross margin recovery in the fourth quarter and beyond. Looking at the broader picture, navigating through these inflationary cycles relies on two main factors: having brands that resonate with consumers and perseverance. The first factor allows us to implement price increases driven by inflation, with a favorable consumer response to those prices; we have both of these factors in our favor, which is crucial for us. The second factor, perseverance, serves as a reminder that once inflation is addressed through pricing and there is strong demand, improvements can happen quickly. Sharp changes are common when effective pricing and a favorable consumer response are in place. All the data indicates that consumers, especially younger ones, perceive our products as offering good value between away-from-home options and store brands, influenced by demographic changes and the significant shift towards remote work. Overall, we feel we are nearing the end of this challenging period as we approach Q4, positioning us well for what lies ahead.

Thank you.

Thank you very much. I have a couple of questions. First, regarding the bridge between measured pricing, it seems you could weight the months differently. However, it looks like the pricing is around 9, and your realized price/mix is approximately 6 or 8. I understand that scanners don't cover everything, but Dave, could you comment on any major factors that may be causing that lag? I'm particularly interested in whether retailers are possibly increasing their margins in this pricing environment. Additionally, Sean, you mentioned several times that elasticities are low, which is clearly the case. Utilization is high, yet supply is not meeting the consumer demand that is evident. Big picture, what is preventing pricing from improving in the industry, and what details are you comfortable sharing on this issue? Any insights you have would be appreciated. Thank you.

I believe that our pricing is being effectively communicated. We have been transparent with our customers regarding the cost inflation we are facing and the necessary pricing actions we need to take. While we do not dictate how customers price their products, generally, they tend to pass on costs similarly to how we do. Some may increase their margins while others might lower prices to capture market share, resulting in a balance overall. I recommend keeping an eye on the scanner data, as we expect our pricing strategies to be reflected there. So far, the results have aligned with our expectations.

Yeah. Jon, I would just say to my previous point, mix does impact that 6, 8 number. So we had some negative mix in the quarter.

Hi everyone, Happy New Year. I have a couple of questions. Your forecast indicates that you expect these temporary costs to decrease in the second half of your fiscal year. Did you experience these costs in December and January during your fiscal third quarter? I assume absenteeism and related issues may still be present. Are you currently facing them in the third quarter? Additionally, I've noticed that you've raised your pricing guidance for the year without changing your volume guidance. You've mentioned your confidence in price elasticity, but with prices potentially reaching a 10% increase in the May quarter, this is a significant change for consumers. There’s also an Omicron wave that might come and go quickly. Consumers may be relieved it was mild and return to dining out sooner than expected. Am I right in noting that there are no changes to your volume estimates for the year regarding price?

I want to address the first point regarding Q3. As I mentioned earlier, we do not expect Q3 to function at what we would consider normal efficiency. Dave highlighted some of the temporary expenses in Q2 that we accepted because we aimed to deliver as many products as possible to consumers, which did create inefficiencies. We anticipate that some of these dynamics will carry into Q3. The impact may take on a different form, such as increased absenteeism due to Omicron during the initial weeks of Q3, while we have already observed improvements in other areas. This is what I was referencing earlier when I mentioned that some factors are improving, yet we are also facing challenges, like absenteeism due to Omicron. Overall, we believe we will continue to push for high volumes in Q3, even if it means lower efficiency than usual. As we transition from Q3 to Q4, we expect some of these challenges to ease, and we believe that once we finalize pricing, we will start to see notable margin growth. Regarding sales, I know Dave has some thoughts for Rob, but I want to emphasize the way consumers evaluate value today. Traditionally, consumers compared similar products directly, and a small price increase significantly influenced their decisions. Currently, consumers consider our product, which might have increased from $2.69 to $2.89, against alternatives like dining out, which has become much more expensive at $14.50. We offer a much better value, and many consumers are working from home, which adds another layer to consumer behavior. This context helps explain why we have experienced very little price sensitivity—some, but far less than in the past—and we don't foresee significant changes in that trend moving forward. Dave, would you like to add anything?

Yes. Regarding the transitory costs related to inventory that I mentioned earlier, we expect these to decrease as we move into the third quarter. Additionally, our internal forecast indicates a slight decline in volume. While it's not substantial, it is noticeable. As Sean pointed out, we analyze this situation by examining each brand and category individually, utilizing our demand science models to assess elasticity. Therefore, our volume forecast is built from the ground up based on pricing impacts for each brand and category, and we have observed a small drop in volume compared to our previous forecast.

Good morning, everyone, and thank you for the question. Happy New Year.

Happy New Year, Alexia.

I would like to focus on the e-commerce slide on page 13. You mentioned that there was an 80% growth over two years in fiscal 2021 and a 50% growth over two years in Q2. I take that to mean that year-on-year growth has significantly slowed. Is the current 9.4% primarily driven by click and collect? What e-commerce investments are you currently making, and does this signify a change in the profitability of the e-commerce channel compared to your brick-and-mortar operations? Thank you, and I have a quick follow-up.

We have made significant changes in our advertising and promotion spending over the past seven years. We are directing less of our budget toward traditional TV and other less effective channels, and instead, we are focusing on social and digital platforms, especially e-commerce. A few years ago, we decided to treat e-commerce as a startup and have invested heavily in it due to its greater potential for growth. We are seeing strong returns on our investments in e-commerce, which includes both pure online retailers and brick-and-mortar stores that have developed their online presence. These investments help us secure a place in consumers' online shopping habits, leading to repeat purchases. E-commerce has become a major marketing focus for us, and the results have been promising. While the percent comparisons can sometimes seem misleading due to varying base periods, we are focused on absolute growth. Overall, e-commerce is a priority for us, and we are pleasantly surprised by the success of various products, including frozen goods, which are performing well in this channel and contributing to profitable sales.

Very helpful. And just a quick follow-up. You mentioned that innovation is a key driver for you right now. Over the last few years, you have significantly increased the percentage of sales from new products. What level are you currently at, and are you satisfied with that level, or do you anticipate further increases in the future?

We refer to this as the renewal rate, which is the percentage of our annual sales derived from products launched in the past three years. We've increased this to approximately 15%, up from around 9% when we started. I'm pleased with this level, as it indicates consistent innovation. Consumers show interest in new benefit areas each year. For instance, last year we saw significant success with our Power Bowls, and we capitalized on the grain-free trend, which has been a major hit for us. We aim to stay ahead of the competition by leveraging our demand science team to identify emerging trends. Interestingly, when we introduce a new trend, competitors often just begin to catch up by releasing versions of last year’s products. Staying ahead of these trends is crucial for our innovation strategy.

Great. Thank you very much. I will pass it on.

Great. Thank you. So, as a reminder, this call has been recorded and will be archived on the web as detailed in our press release. The IR team is available for any follow-up calls that anyone may have. So feel free to reach out. Thank you for your interest in Conagra Brands.