Kraft Heinz Company (KHC) — Q4 2022 Earnings Call Transcript

Thank you, and hello, everyone. This is Anne-Marie Megela, Head of Global Investor Relations at The Kraft Heinz Company, and welcome to our Q&A session for our fourth quarter 2022 business update. During today's call, we may make forward-looking statements regarding our expectations for the future, including related to our business plans and expectations, strategy, efforts and investments and related timing and expected impacts. These statements are based on how we see things today, and actual results may differ materially due to risks and uncertainties. Please see the cautionary statements and risk factors contained in today's earnings release, which accompanies this call as well as our most recent 10-K, 10-Q and 8-K filings for more information regarding these risks and uncertainties. Additionally, we may refer to non-GAAP financial measures, which exclude certain items from our financial results reported in accordance with GAAP. Please refer to today's earnings release and the non-GAAP information available on our website at ir.kraftheinzcompany.com under News & Events for a discussion of our non-GAAP financial measures and reconciliations to the comparable GAAP financial measures. Before we begin, I'm now going to hand it over to CEO, Miguel Patricio, for some brief opening comments.

Thank you, Anne-Marie, and thank you, everyone, for joining us here today. Let me first take a moment to say how proud I am of the Kraft Heinz team. We have come so far on our transformation journey. It's quite amazing. And the fourth quarter was no exception. You can see the momentum building across our business; service levels and market share trends are improving. Base volumes are positive. We are outpacing the competition in foodservice and emerging markets significantly. Importantly, we continue to invest for growth. Once again, we have unlocked efficiencies over $400 million this year, which allows us to invest in new tools and capabilities for our teams and in new product innovation for our consumers. From a pricing perspective, 99% of all needed pricing has already been announced for 2023. As we look to the rest of the year, we have no current plan to announce new pricing in North America, Europe, Latin America and most of Asia. I am very optimistic and excited about how we are positioned to deliver long-term sustainable growth. With that, I’ll ask Andre, Carlos and Rafael to join me. So let's open the call for the Q&A.

Good morning, everyone. Your EBITDA guidance for fiscal '23, excluding the impact from the 53rd week, aligns well with your long-term expectations. When you discussed this at CAGNY last year, you mentioned it could take several years to achieve this level of growth. Are you ahead of schedule now? If so, what factors have contributed to this? What has performed better or faster than you expected? Most importantly, do you believe this level of growth is sustainable moving forward? Thank you.

Thank you, Andrew, for the question. Andre, could you answer this question?

Sure. Hi, Andrew. Good morning again. And thanks for the question and thanks a lot for noticing it. In fact, we feel very proud about what we have been achieving as a company. And I think in 2023, we will mark another step-up in our performance. And as we all notice, we are already on the long-term algorithm in net sales and also on EBITDA, if we remove the effects from currency and the 53rd week. I think this is the best way to show that transformation is working through results. It's good to see how 2022 that we finished with very strong momentum, how that's translating into a stronger performance in 2023. This is a consequence of our market share in the U.S. continuing to improve, still negative but improving, as foodservice continues to deliver at above 30%, with emerging markets growing at double digits. So all these factors in terms of growth are working in our favor. Supply chain efficiencies continue to happen, and in 2023, as you might have noticed in guidance, we are expanding gross margin and see our path to go back to 2019 levels, which is allowing us to continue to increase investment in the business for growth. So we feel good about where we are moving. We still want to do more, but we will.

Thanks, operator. Good morning, everyone. My question is about just the free cash flow, and I have a couple of questions related to that. I guess the first is just simply, Andre, can you give us a little bit more insight in terms of the inventory build? Is it finished goods inventory? Is it raw materials, the decision to do that? And I guess, in the prepared remarks, it's tied to service level. So are you going to need to carry elevated inventories through '23? Is my first question.

Sure. Thanks for the question. Look, as we said throughout 2022, we had to rebuild inventory. Our case fill rate at the end of '21 was in the low 80s, which was extremely low. So we had a lot of recovery to do. You have seen throughout the year the effect of us building inventory. Keep in mind that we finished 2022 in the low 90s, which is still not what retailers are expecting from us and what we expect ourselves to achieve. That said, we do have, compared to historical levels, higher inventory coverage on average in raw and packaged materials, which is normal because we're also trying to build buffers given all the volatility and uncertainty. So we expect that those raw and packaged materials should decline over time, including starting in 2023. In finished goods, even though we need to increase inventory in certain spots where the inventory service levels are still low, we still have a lot of opportunities to rebalance our inventory across the network. I think one of the consequences of the pandemic was demand volatility, which caused us to have inventory stranded in the wrong warehouses to meet the demand. And that takes time to sort itself out, because of the actual cost of products and shipping items across the network. So because of these effects and all the investments that we have made in the past two years to automate demand forecasting, we are investing a lot of resources in better supply planning. We have a big project that has already started, focusing on network simplification. So the combination of these investments, plus the rebalancing of the network, plus us going back to more historical levels of averages in raw and packaged materials should help us start recovering inventory starting in '23 and into the future.

So I guess this was kind of bridged to maybe how we should be thinking about free cash flow and free cash flow conversion for '23. Can you give us a little bit of perspective on, I guess, capital spending? Will inventory or working capital be a tailwind? Like can we get back to more normal free cash flow conversion in '23? Or is it still going to be somewhat subdued relative to previous years?

So free cash flow will be better than 2022. We are still not going to be in the long-term algorithm of 100%, and that's in great part because of CapEx investments. As we have said when we unveiled the long-term algorithm, we are investing for growth. We have stepped up investment in CapEx. In 2022, we spent a little more than $900 million, which is a significant increase compared to the $700 million to $750 million in previous years. We are ramping this up again in 2023 and 2024 as part of our long-term plan. Then we should go back down to closer to 3.5% of net sales starting in 2025. That's the current perspective. If you want to expect something this year, it should be about 80%, or so it will be more in line with the back.

I have a question regarding your promotional spending. Your data and charts indicated a decline since 2019, which is more than your branded competition. Are you planning to increase that spending? Is this related to improvements in service levels throughout the year? Additionally, what would you consider the right target for rebuilding that promotional spending? What part of the 5% decline shown in 2019 should be restored? You have valuable data and capabilities now. Can you enhance efficiency with your promotional spending? I believe the answer is yes, but I would appreciate further clarification on this.

Maybe, Andre, you can start and then Carlos comment specifically on the U.S.

Yes. Thanks for the question. We have increased trade investment in a very significant way from 2017 to '19, more than $1 billion in the United States alone. We restarted from a very high base and increased it in late 2019. We created a centralized revenue management organization with more than 50 people fully dedicated to that in North America alone, and we have started to leverage the power of our sales organization. We put a lot of discipline and science behind making promotional decisions that benefit us and retailers. You have seen a lot of that coming to fruition now in the results over the last three years. That is obviously impacted by service levels as well. If you look at Q4 volume sold on promotion, we had about 24% of volume sold on promotion in Q4 '22. That's higher than 2021 but remains below the 23% mark, a two percentage point drop from the past, still lower than branded competitors in our categories. In 2019, it was 34%. That's too much. In terms of promotional investments, we still have a significant amount of promotions that have negative ROIs. It’s not about cutting promotions; it’s about deploying them in a smarter way. We’re in this journey and have seen results, but there’s still a lot of opportunities ahead of us. We’ll deploy it and want to gradually increase it. It isn’t for me to give you a precise number of where this will land, but I can tell you with confidence that we won't get anywhere close to 2019 levels.

Yes. It's Carlos here, Chris. Just building on some of the comments that Andre just mentioned, as we think about promotional activity moving forward, it’s really about being strategic in how we invest those promotion dollars. We are focusing on event-based activity so that we are driving the best utilization of those investments versus price-based activity. This approach enables us to drive positive ROIs. As you heard from Andre, we have made tremendous strides from 2019, and we’re not going back. Regarding our focus on improving the ROI of our programs, in 2022 versus 2019, we’ve tripled the level of ROI returns from promotions three years ago. This demonstrates that all the investments we’re making in revenue management are still yielding results in better understanding how to read the data and utilize our funding for better results.

Just a quick question around your organic sales guidance. You guided 2023 organic sales growth of 4% to 6%. Based on wraparound pricing from 2022 and the incremental price that you discussed for 2023, we estimate that your volume growth assumption is flat to down low single digits. Is that correct? And then if so, what gives you the confidence that elasticity will remain so low as we move throughout the year?

Andre?

Yes. Hi, Cody, thanks for the question. As noted, we are finishing Q4 growing about 10%. The recent round of price increases has a positive effect in the first half of the year. We expect gradually throughout the year for our results to align more closely with our long-term growth algorithm. While volume is still negative, it should improve throughout the quarters as we start to lap the prices. But even at the end of the year, volume will still be negative. That's not the balance we want. We aim for a better balance between price and volume growth. We will discuss this in more detail at CAGNY. We have factored in the guidance with an increased level of elasticity compared to 2022, but still not at historical levels. Regarding what gives us confidence, the sell-out for the industry in Q4 was still very strong. In fact, if you look at sell-out elasticity based on price and volume, Q4 was better than any other quarter in the year. Of course, we need to keep monitoring, as consumer behavior may change.

The one thing I would add there, Cody, is the fact that we are also ensuring we continue to expand in terms of the number of formats and price points we select within our categories to maintain consumers who have been with us over the last couple of years. In Q4, consumers earning over $100,000 grew over 13% in terms of consumption. We’re also improving the number of offerings in clubs with items such as Mac & Cheese and JELL-O and in dollar stores, we’re increasing the number of SKUs available. This approach allows us to cater to consumers looking for value across various economic situations.

Just hoping to get a better sense of the magnitude of the gross margin improvement you're expecting this year. And besides the obvious ones in terms of the cadence of inflation, if there's any considerations we should have about maybe the timing from quarter-to-quarter of that improvement?

Andre, please?

Hi, Ken. Good morning, thanks for the question. In Q4, we provided guidance on a relevant sequential improvement, which positioned us in line with 2019 gross margins. We expect in Q1 for gross margin to go a little bit down as we have contracts being renewed, and some inflation that wasn't passed down last year will now affect us. We had that contemplated in our guidance. However, you should expect something close to flat in Q1 compared to the prior year, and from there, start to see expansion on a year-over-year basis. Ballpark, you should think about 50 basis points to 100 basis points in terms of the magnitude of gross margin expansion, which allows us to invest more in marketing, technology, and people, all critical aspects.

Can you talk about the competitive dynamics within your categories? In the prepared remarks, you indicated that private label share is increasing, but that is primarily coming from your branded competitors. So maybe if you could just elaborate on what you're seeing there? That would be helpful.

Maybe Andre and Carlos can comment on that.

Sure. Let me start. Thank you for the question. As you saw, when I speak for the North America business first, and then maybe Andre can give you his perspective on other markets. We do see the continued share improvements moving forward. In Q4, misadjusted share improved by 20 basis points. The market share in December remained flat. We’re seeing that the investments we continue to make in renovating our key products, innovation, and marketing are paying off. The specific platforms and brands that drive our growth are indeed seeing share improvements, whether it’s Lunchables, Kraft Cheese, Heinz Ketchup, or Mac & Cheese. It’s about continuing to support those investments. Meanwhile, we have some relative supply chain constraints in certain categories, so it’s about ensuring that we support those brands to unleash their continued growth in the retail environment.

Andre, do you want to add anything from an international standpoint?

The situation varies by region. In Europe, the private label situation is indeed tougher, as the price gap has widened. We are implementing a lot of initiatives like relaunching value brands where we had none, HP being a key example in the fast process category. We are doing a lot in price spec architecture, which keeps us strong against branded competition. In the rest of the world, particularly in emerging markets, the private label issue is not as present, and we continue to gain share.

To put it in perspective, retail in Europe is about 5% of our business, and that’s what Rafael was referring to. I want to add that two-thirds of our growth is from emerging markets and foodservice, and in those channels, we continue gaining share and growing positively, at double-digit rates.

Two questions. First, on service levels and fill rates. On Slide 16, you show how you’ve seen improvement in the fourth quarter, really every month within the fourth quarter. Has that improvement continued into '23 thus far? And what have you really assumed as the base case for '23 relative to the ultimate goal of getting back to the high 90s? Is that an assumption in the guidance? Or is that more of an aspiration to have some less than allowances in the outlook?

It's Carlos. To give you a perspective, the way we see it kind of in North America, as you said, we are seeing progress in our supply chain and service levels. In fact, the December numbers were the highest service levels we had across the entire year. However, there are still industry challenges, particularly upstream with ingredients and some packaging materials. Moving forward, our goal is to achieve the kind of service levels we saw toward the end of the year. We are still dealing with remnants of the avian flu and its impact on the industry, particularly in our cream cheese soft business, where some packaging materials have been a challenge. Although most things are beginning to stabilize, there are still areas where we are experiencing challenges. Our team is focused on adapting to situations as they arise. For example, we’ve adjusted products that rely heavily on eggs in response to rising prices. We aim for service levels approaching 98%, as that is our goal, while being agile enough to adapt to ingredients that may face short-term challenges but should see improvement as we exit 2023.

Great. If I could follow up as well, I apologize.

Go ahead.

I was just going to ask if I could follow up on the elasticity point that you've been discussing. You exited the year with elasticity at their most favorable levels. Based on the data on Slide 9, you've talked about the assumption of those elasticities potentially normalizing through '23. What’s your base case for the pacing of that normalization? And do we think about '23 as sort of a mirror image of '22 from an elasticity standpoint?

Andre?

Yes. As we have stated, we have factored the guidance with the expectation that elasticities gradually go back to historical levels, and we expect that process to unfold toward the end of the year. We anticipate Q1 to be slightly worse than it was in Q4, and anticipate a gradual return to historical levels by year-end. We keep a close eye on various factors, such as reductions in subsidies and are prepared for any changes that may arise. However, we believe elasticities will gradually return to historical norms.

We have seen this coming, so it's essential to provide great value to consumers regardless of their situation. We're expanding our range of price points and formats complemented by rigorous evaluation of promotion investments to ensure positive ROI. In North America, we've seen a mix that suggests a return to historical elasticity by the year-end, reflected in our guiding framework for 2023.

Operator, we will take one more question.

I just wanted to drill into your foodservice growth pillar a little bit more. In Slide 13 or 12, it’s interesting with some color here. Can you unpack a little how you're gaining share compared to competitors? Is it new items for existing customers? Are you broadening your distribution into new accounts? And are those customers gaining share? I’m sure there are components from a few different areas, but what’s the primary driver of your outperformance?

Michael, we are experiencing great momentum in foodservice globally, both in North America and internationally. I will ask Carlos and then Rafael to comment.

In North America, it’s all of the items you mentioned. We grew by over 20% in Q4 and gained share. The investments we’ve made are yielding results; we’ve adjusted our leadership structure, simplified our product portfolio by reducing SKUs nearly 50%, renovated our foodservice offerings, and strengthened our sales team to maximize distribution. Furthermore, we are investing in capacity to support the growing demand. We still only participate in 25 of the top 50 QSRs in the U.S., presenting ample opportunity for further growth. We're winning with distributors and expanding distribution across various foodservice segments, including non-commercial accounts. Our growth is evident in restaurants, with items being sold into Fast Casuals and QSRs like Papa John’s and Pollo Tropical. Overall, we remain optimistic about the outlook for foodservice growth.

Just to add to Carlos' point, one reason for our growth is the capacity investments we've made in foodservice. By May, we will have added an additional 25% capacity in the U.S. for pouches and 50% more for paper and squeeze bottles, which are critical for foodservice growth. Rafael, please go ahead.

Carlos has already highlighted areas of strength in foodservice. As we will explore in-depth next week during CAGNY, I’d like to point out two elements contributing to our success internationally. One is our global partnerships, which leverage our scale and capabilities to deliver customized solutions for our partners. This is especially important because we often compete with local players. Secondly, our chef-led model allows us to engage with customers collaboratively, enabling us to identify menu concepts that meet their specific needs. These might seem basic, but perfect execution is driving our foodservice success. Also, remember that while international foodservice is growing robustly, it still represents one-third less of the proportion of face attrition than in the U.S., meaning we have plenty of room for growth.

In summary, on foodservice, we believe we transitioned from a transactional approach to a strategic growth pillar, enhancing our investments in talent and technology, which is clearly paying off. We are very excited about the path ahead.

That will wrap up our Q&A session. Thank you all for your call. I am going to turn it over to Miguel for some closing comments.

I just want to express that we remain very excited about our progress. Our transformation continues to evolve; the journey is far from over, but we are growing every day. Why are we so excited? Each day we see momentum rising with service levels, market share, particularly in our growth platforms, gaining traction. Foodservice and emerging markets are expanding their market shares and showing great momentum. Additionally, our organization is much more agile than before, efficiently adapting and predicting changes. We're investing to support growth as gross margin expansion fuels investments in technology, people, marketing, and R&D. We’re thrilled to have anticipated pricing, with 99% of our pricing for 2023 already announced. Approximately 95% is accepted, and roughly 90% has been implemented. We see ourselves continually delivering quarter after quarter, year after year. Thank you for your attention, and I look forward to seeing you at CAGNY next week, where we have a lot of excitement to share.