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Annie's, Inc. (NYSE:BNNY)

F3Q 2013 Earnings Call

February 12, 2013 05:00 PM ET

Executives

Erica Abrams - IR

John Foraker - CEO

Kelly Kennedy - CFO and Treasurer

Analysts

Robert Moskow - Credit Suisse

Ken Goldman - JPMorgan

Ed Aaron - RBC Capital Markets

Jon Andersen - William Blair & Company

Brian Holland - Janney Montgomery Scott

Chris Growe - Stifel Nicolaus

Scott Van Winkle - Canaccord Genuity

Michael Lavery - Sidoti & Company

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the Annie's Incorporated Third Quarter 2013 Earnings Conference Call.

During today's presentation, all participants will be in a listen only mode. Following the presentation, a conference will be open for questions. (Operator Instructions). This conference is being recorded today, February 11, 2013. And I would now like to turn the conference over to Erica Abrams of The Blueshirt Group. Please go ahead.

Erica Abrams

Thank you, thank you all for joining us. Joining me on the call today are John Foraker, CEO; and Kelly Kennedy, CFO of Annie's. Before we get started, let me remind you that certain statements in this conference call, including Annie's statements regarding robust consumption trends, strong outlook for natural and organic food, results of key growth strategies, momentum of the frozen pizza products initiative, continued improvements and further growth in the fourth quarter and throughout our next fiscal year, fiscal 2014, opportunities ahead and expectations for Q4 and full fiscal year financial results are forward looking statements, within the meaning of the State Harbor Provisions of the Private Securities Litigation Reform Act of 1995. Such forward looking statements may be identified by words like anticipate, assumes, belief, continue, could, estimate, expect, intend, may, plan, potential, predict, project, future, will, seek and similar terms or phrases. The forward-looking statements contained in this conference call are based on management's current expectations are subject to uncertainty and changes in circumstances and are subject to significant risk.

We cannot assure you that future developments affecting us will be those that we have anticipated. Actual results may differ materially from these expectations due to changes in global, national, regional or local economic business, competitive market, regulatory and other factors many of which are beyond our control.

We believe that these factors including those disclosed in risk factors in our Form 10-K for Fiscal 2012, filed with the US Securities and Exchange Commission on June 8, 2012. Should one or more of these risks or certainties materialized or should any of our assumptions prove incorrect, our actual results may vary in material respect from those projected in these forward-looking statements. And forward-looking statements made by us in this conference call, speak only as of the date hereof. Factors or events that could cost our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statements whether as a result of new information, future developments or otherwise, except as may be required by any applicable securities laws.

Now, I will turn the call over to John Foraker, CEO of Annie's. John, please go ahead.

John Foraker

Hello and thanks everyone for joining us today, as we report our fiscal 2013 third quarter financial results. I am pleased with the performance of the business this quarter. It reflects well upon the strength of our brand and growth strategies, increasing consumer interest in natural and organic foods, and solid execution across the organization. We delivered strong growth in the quarter as adjusted net revenues increased by 22.7% over prior year, before returns related to the recent pizza recall, which Kelly will cover in detail in a few minutes.

During the quarter, we continue to invest in and focus on our four strategic growth drivers; expanding mainstream distribution, improving placement locations in stores, increasing Annie's brand awareness and household penetration, and finally continuing to deliver exciting innovation. We made good progress during the quarter in each of these areas, our strategies are working.

Retail consumption trends across our business remained quite healthy during the quarter in the high-teens with robust and balanced growth coming from all of our important channels. The key components of our meals and snack franchises both continue to deliver strong growth. Interestingly, we are seeing particularly strong growth in certain types of products such as specialty dressings, certified organic and Deluxe format Mac & Cheese that tend to do better when consumers are feeling more optimistic about their own economic outlook. This is a good sign and suggests that consumer conditions are fertile for future natural and organic industry growth.

A few highlights from the quarter that will be of interest to our investors. In our main line initiative, we continue to move placement of our bestselling SKUs into the mainstream grocery aisle. The strength of the story is improving as we have more and more actual success stories from key retailers where we have already instituted these set changes over the past year. Grocery retailers who have placed Annie's in the mainstream aisles have been seen strong item performance, delivering to them incremental sales growth, stronger category profitability and increased consumer loyalty. We had a number of wins in mainstream grocery this quarter and expect these placements to accelerate in the fourth quarter and through next fiscal year as we come into the key category review windows for Mac & Cheese, crackers, grahams, fruit snacks, and specialty dressings. We remain in the early innings of this effort.

On the innovation front, in January, we began shipping Organic Cheddar Squares, Organic Brick Pack Grahams, and new Mac & Cheese items called Bernie's Farm, which are shaped Mac & Cheese with cute farm designs. We've placed Cheddar Squares in over 1,300 Target stores, and we've also received very strong interest in these extensions from key retailers in all of our channels. You'll see these items popping up in other retailers over the remainder of the fourth quarter and into next year. Now, I would like to provide you with an update on our pizza business which was the subject of a voluntary FDA recall we announced on Tuesday, January 22. Kelly will cover the financial impact of the recall in her comments on the quarter, and I'll focus on the consumer and retailer elements.

Today, we begin shipping new pizza production to key retailers. We expect to be on-shelf quickly in important retailers like Whole Foods Market, Target and our top grocery accounts. Our operations team has done a fantastic job getting us back into production on a timely fashion. The response from our key retailers has been favorable and supportive. They appreciate the proactive nature of our communication on the issue and the speed of our response. We are confident that we will regain the vast majority of our placements over the next few months. Once we return to shelf, our plans include aggressive support for trial, awareness and merchandizing tactics over the remainder of Q4 and into Q1 of 2014, so we can quickly regain our footing with consumers. Feedback from Annie's consumers on pizza is really positive. Consumers love these existing products, and we're just getting started. We're excited about the frozen opportunity for Annie's. We're actively developing new frozen products in categories beyond pizza, and we remain on track to bring these exciting new items to market in the second half of fiscal 2014.

On the bottom line, Q3 was quite solid as well. On an adjusted basis and before the impact of the recall, operating and net income both grew more than 20% despite plan investments in new products, new people, enhanced systems and organizational capabilities. Even with these investments, we started getting modest operating leverage this quarter compared to prior year. This speaks well to the strength of our business model and our prospects for driving strong EPS growth in the future.

In summary, we're pleased with the progress on our key growth strategy this quarter. Our organization responded well during the recent voluntary recall of frozen pizza products, and we're moving aggressively to regain momentum in this important growth initiative. Now, I'll turn the call over to Kelly Kennedy for more financial details about the quarter.

Kelly Kennedy

Thanks, John and thanks for joining us today as we report our third quarter financial results, which reflects results for the three months ended December 31, 2012. We are pleased with the financial results overall this quarter, and with the progress we are making on advancing our business model. Please note that we are discussing adjusted financial results in this call, which exclude the effect of the recall, as we believe it provides better visibility into our normal operating results.

As John highlighted, adjusted net sales were $37.9 million for the quarter, up 22.7% over the third quarter of fiscal 2012. Volume was the largest driver in our year-over-year growth with approximately 3% of growth coming from higher average selling prices. Adjusted net income for the quarter increased 23% to $2.7 million or $0.15 per diluted share as compared to $2.2 million and $0.14 per adjusted diluted share in the same period a year ago.

EPS in the third quarter was based on our diluted share count of $17.8 million as compared to an adjusted diluted share count of $16.3 million in the same period a year ago. The share count increase was primarily due to the shares issued in the IPO in April, combined with shares from our stock option exercises.

Our effective tax rate in Q3 was 39.6%. During the quarter, we were able to secure a California enterprise zone tax credit that benefited our effective tax rate. As a result, we now expect full fiscal year 2013 tax rates to be approximately [14.4%] [ph].

During the third quarter, we recorded approximately $2.3 million in charges related to the pizza recall that was announced on January 22. These charges include a $1.6 million reduction in net sales to reflect anticipated customer and consumer returns, and an approximate $700,000 increase in cost of sales to reflect the write-off of finished goods and raw materials inventory.

While we incurred the majority of direct costs associated with the recall in the third quarter, we expect to record additional costs in Q4, and future quarters as costs are incurred. Any future recovery from our insurance or the supplier would be recorded to offset charges taking a net sales, cost of sales and SG&A. Any such offset will be recorded once recovery is probable, possibly as early as the fourth quarter.

We expect the effects of the recovery to be reflected in our financial statements in the next several quarters, and will continue to provide those GAAP and adjusted results, to provide the most transparency.

Now turning back to highlights from our third quarter. We saw strong trends across all three of our product categories, with 25% growth in meals, 22% growth in snacks and 18% growth in dressings, condiments and other. Meals growth was predominantly driven by our Mac & Cheese line but also benefited from sales of organic and made with organic pizza. Snack growth reflects acceleration versus prior quarters driven by grahams, crackers, mix snacks and snack mix product lines.

For the past three quarters, our dressings, condiments and other category has been either flat or slightly down. This is primarily driven by the discontinuation of our cereal line. Despite still comping over some cereal sales from Q3 last year, this category saw impressive growth in the third quarter driven primarily by the growth of our natural dressings line. You can find historical quarterly net sales by product category on our website, in the investor relations section. Now moving to margins.

Adjusted gross margin for the third quarter was 40.4%, while gross margin was 30 basis points lower than the prior year third quarter due to higher commodity cost, it was slightly favorable to our expectations due to favorable product mix. We expect to see slightly higher commodity cost in the fourth quarter versus our year-to-date results driven by higher dairy cost. We also expect to invest in incremental trade promotions beyond our original plans to support pizza in the quarter. As a result, we expect fourth gross margins in the low to mid-39 with a full year margin in the mid-39.

Now turning to selling, general and administrative expenses. In the third quarter, SG&A increased $1.9 million over the prior year's third quarter to $10.7 million. This increased SG&A spending reflects planned investments in people, infrastructure, our brands and innovation. SG&A as a percent of adjusted net sales decreased by 50 basis points from prior year to 28.7%. While leveraging in the second half of the year, we expect SG&A as a percent of sales for the year to be on par with prior year. Adjusted operating income for the third quarter was $4.6 million, up 23.5% over the prior year. As we enter in to our largest quarter of the year, we expect to achieve quarter-over-quarter operating leverage as we begin to lap investments made in Q4 last year as we prepare to go public.

Turning to our cash flow, we generated 10.2% million in free cash flow year-to-date, while taking a conservative position building inventory a month earlier than typical in advance of largest sales quarter. This will position us to satisfy retailer demand during our busiest season of the year. We expect to close the fiscal year with significantly lower inventory balances versus the Q3 ending balance.

Our balance sheet continuous to be strong with $30 million in cash and no debt. On a 12 months trailing and adjusted basis, return on invested capital was approximately 19%, up 1% from the prior year. We continue to believe our hybrid supply chain model provide significant operational flexibility for us while maximizing the return we can generate for shareholders.

In regards to our Q4 results, we understand there are a lot of questions regarding the impact of the recall. On an initial estimate is that we will incur up to $1 million in additional charges related to the recall, this is inclusive of customer and consumer returns for pizza sales in January, the write-off of Q4 pizza production and legal and other SG&A expense incurred in Q4. These costs may be partially or fully offset by insurance recoveries. We expect that we will be able to cover substantially all of the recall costs through insurance or from the flour supplier.

As we highlighted in our January 22 conference call, we expect overall pizza sales in Q4 to be slightly less than would have been without the recall. On an adjusted basis, we expect revenue for the fourth quarter in the high-teens which is slightly lower than our year-to-date trends. We plan to make incremental investments in trade spending and promotions in the fourth quarter to support pizza as it hits the shelves.

While we still expect to be in the range of previously provided guidance for revenue and EPS when excluding the impact of the recall related expenses, given the incremental spendings to support the pizza, we could be at the lower end of our original ranges. Over the coming months, we plan to focus on our core growth strategies and regaining our momentum in the pizza rollout. We are highly confident in our ability to continue to drive our business and build a strong foundation for fiscal 2014.

Now I'll turn it back over to John for closing remarks.

John Foraker

Thank you Kelly. Overall I am very pleased with where we are in the industry, as well as where we are internally as we approach our one year anniversary as a public company. Our market opportunity continues to increase as all the key macro drivers we spoke about in the IPO process remain in place and our important growth strategies are continuing to deliver solid results. Our recent consumption trends bear this out and remain among the highest of any company in our space.

Organizationally we're continuing to improve as well. Better systems, better and deeper people and key additions to the organization have been made and are being made that will support future growth and scalability in our business. We're well positioned going in to Q4 and look forward to a strong finish to the year. While it’s a little early for us to give specific guidance for fiscal '14, we remain very confident in our ability to grow the business in the future. Strong consumption trends, significant distribution whitespace, increasing brand awareness and deep innovation pipelines and a favorable macro environment for natural organic industry growth are all factors working in our favor. We're excited about the year ahead.

Thank you. Operator, you may now open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from the line of Robert Moskow from Credit Suisse, please go ahead.

Robert Moskow - Credit Suisse

I wanted to know about the guidance coming down has to do with fourth quarter. You mentioned that there is incremental trade spending that has to go into place. Is that the main reason for the guide down? Or is it also from a volume perspective, you expect to sell just less pizza overall? Thanks.

Kelly Kennedy

Yes, it's related to both. Overall, certainly on a gross basis, we'll be out of pizza for about three weeks. We do expect to fill the pipeline which will offset or offset the majority of those lost sales but the incremental spending, the two combined or both of those are leading to what I would say is a feeling that we could be at the lower end of our range.

John Foraker

Yes, Robert, I'd just like to build on that, the business has been growing roughly 20% all year, so fundamental momentum behind the business really hasn’t changed. We think it's just important to be a little cautious as we go into Q4, because we know we're going to want to invest behind pizzas, we get it back out there and we feel very solid about the quarter. It's definitely going to be a record quarter for us, the biggest quarter we've ever had and we think we're well positioned for that but we just want to make sure that we can guide it clearly as possible and let you know where we think we'll come in.

Robert Moskow - Credit Suisse

And just a follow-up. I was surprised to see that the dressings business strong in the quarter. You mentioned the easy comparison or easier comparison having to do with cereal. But are you doing anything with your dressings line or is that just a happy accident that dressings consumption is higher or have you done anything specifically with the trade to push dressings?

John Foraker

It's not a happy accident, but we haven't really done anything significantly different either. The way I think you should think about that is that we have very high quality products that are unique and differentiated in our categories. They tend to be premium. We've focused on merchandising assortment, pricing, getting the items in the right distribution and the right spot on the shelf, with the right retail price point, the right SKU mix. As we've been talking about over time, this is a segment of our business that overall has an inherently lower growth profile to total category that we haven't invested as strongly in this category for growth. This is an area, I've been involved with the business now for well over a decade, and when consumers are starting to feel pretty good about their own economic well-being and are willing to make little investments in their selves in healthier products, categories like this tend to do a little bit better. We've seen this before the last time I saw dressings with this kind of a profile would have been back in the '05, '06, '07 time frame before the economy really started to slowdown. So I think it's really just that. We're not investing anymore dollars in it. I do think though that the disciplines we're putting against merchandising assortment, pricing placement, to get it in the right spot and the right retailers to drive their results is definitely bearing fruit.

Operator

Thank you. And our next question comes from the line of Ken Goldman from JPMorgan. Please go ahead.

Ken Goldman - JPMorgan

I may have missed it, but did you give volume and pricing this quarter excluding the pizza recall?

Kelly Kennedy

So, the pricing has been pretty consistently all year about 3%.

Ken Goldman - JPMorgan

Got it. So I'll just subtract then. Okay, perfect. And then you mentioned consumption trends remain robust. Can you quantify that a little bit, how are consumption trends faring sequentially and year-on-year, for example? Just curious, because people in a high-growth business, they tend to look for acceleration or deceleration. I am just saying robust is a little more vague than I think what perhaps we could hope for. So, any color there would be helpful.

John Foraker

So, on prior calls and earlier this year, we talked about consumption growth kind of in the mid-teens range and we've seen that pretty much all year. Over the last quarter we did see those numbers pick up a little bit towards the high-teens and it was really a combination of continued strong growth in grocery in the other measured channels but also we were lapping over some mass channel business that had a been a little bit slower in the middle of the year and it started to reaccelerate towards the end of the third quarter and so in total, we're just seeing strength over all the channels that you guys can see but also the channels that are outside your vision, the natural channel, our business there, the club channel with Costco is outside and that’s doing well also. So, it's just a healthy environment right now for products like ours and we think we're well positioned and we don’t see anything in the forward view that would change that at this point. And so we're pretty optimistic about going into next year with that base two.

Ken Goldman - JPMorgan

As a general rule, do you think natural, and especially organic, trends are accelerating? Or are they really just staying at the same good level they've been in the past?

John Foraker

Yes, I wouldn’t say what we've seen in our business, would say that there is a massive acceleration. I would say that we've seen slightly stronger trends in our business through the year, that’s for sure. I would say, those trends are consistent with the thesis that we laid out in our prepared comments a little bit is that from the signs we see in our business, it looks like consumers are feeling better about investing in natural and organic and as a result, certain segments of our business that tend to pivot a little harder towards stronger growth when consumers are feeling better, we are definitely seeing that. So we haven't seen anything in any of the channels that we're doing business with that would tell us that there is anything that’s going south. If anything, we think that there is a little strengthening out there.

Ken Goldman - JPMorgan

And then one last one, on the pizza business, one of the issues you had early on, I think, is that you did not get quite the ideal space on the shelf that you were looking for. Right? Something closer to eye level. Before the recall, were you getting closer to resolving that? And does the recall impair your efforts to do that in any real way?

John Foraker

We were getting closer to resolving that. In fact, we had gone through areas of our business like the natural channel for example and have been really working with our brokers in getting a lot of improvement in the placements, spacing up the products so they are standing out, not on the bottom shelf. We were feeling really good about those efforts. We were seeing strong initial placements in retailers like Target with really good placement. We were improving some of our groceries placement as well and we don’t really see this as taking us off that track. The consumption trends that we were seeing and the retail performance trends that we were seeing in pizza right up to the point where we had to announce the recall were very encouraging for us. And so we're having to reboot or getting product back out into the chains. The retailers have been very, very supportive and have been really wanting to get the product back in as fast as possible. So we don’t see that changing. I think Ken, what we're going to do, is we're just going to be very focused once we get this back into distributors, is get our retail broker network out into the stores, make sure that we're cutting in the way we want but I think the way you should think about it is that the pizza recall definitely had us hit the pause button a little bit on this initiative, slowed us down a little but from everything we see now, a few weeks after the recall, getting feedback from consumers is that we should be able to get backup up and on track relatively quickly here and I don’t want to minimize the task, we know it’s a big task but we think it’s a fairly straight forward one and we're going to go after it and we think we'll be in pretty good shape.

Operator

Thank you. And our next question comes from the line of Ed Aaron from RBC Capital Markets. Please go ahead.

Ed Aaron - RBC Capital Markets

Kelly, I think you mentioned in your prepared remarks that the mix was a little bit more favorable than what you had expected going into the quarter. Can you just talk about what drove that?

Kelly Kennedy

Sure, as we spoke about in the past, we have some quarter to quarter variances and certainly as it relates to product mix, you'll know that we focused pretty heavily, we talked about the sort of three initiatives that we had. We had a lot of progress there, a lot of progress on the main line initiative and those are some of our key, you've heard of our key profitable skews. We don’t have a lot of variability. We don’t have any material variability across our major product categories, but from quarter to quarter we can see some slight product lend is favorable, not that we saw in Q3, it wasn't really material, but it drove us not even about 50 basis of interest of what we saw this quarter was going to look like in terms of margin.

Ed Aaron - RBC Capital Markets

Got it. I guess I was a little bit surprised, because I would have figured that the dressings business, which came in nicely ahead, would have been a little bit lower from a mix standpoint than the other pieces.

Kelly Kennedy

It's not materially different.

Ed Aaron - RBC Capital Markets

And then just my follow-up question, the snacks line actually showed some nice acceleration this quarter. I think that was before you really started rolling out the new products. Was there something in particular that drove that in the quarter? And is there any reason why we shouldn't see further acceleration in that part of the business in Q4, with the new products kind of getting out there?

Kelly Kennedy

We had a slightly stronger just channel mix. Snacks is a little more heavily focused on certain customers. So that was a little bit more just customer mix for the quarter. Year-to-date LTM is about 18%, it's been either plus or minus a couple percent on that. We did see a little bit of strength this quarter, so particularly on snacks and I just didn’t want to point out while we did begin shipping some of our new snacks, it wasn't material overall for the quarter and wasn't really material to the growth number.

John Foraker

Right and we mentioned on one of the prior conference calls to add that. In snacks we in some of the big retailers, we've been experimenting with some different price points and some different promotional price points and really trying to optimize those to deliver the best financial results combined with the best growth profile and so through the middle of last year, we were doing a little of that work and it caused a little bit of slowdown in a couple of those big accounts. But we've now got that right and we're comping over numbers from last year and so we see really strong growth there and expect strong growth in Q4 as well.

Operator

Thank you. And our next question comes from the line of Jon Andersen from William Blair. Please go ahead.

Jon Andersen - William Blair & Company

I guess I wanted to ask first about the main aisle or placements initiative. Thanks for the additional color there. That's helpful. Just wondering if you could quantify even a little bit more maybe where you sit today on that, in a couple of the major business lines. And you talked about some acceleration there in the fourth quarter and next fiscal year, in terms of the placements that you may be getting in the main aisle. A little bit more color there if possible, would be helpful.

John Foraker

So, what I'll say about that is, the Mac & Cheese business is a little more developed because we've been focusing on mainline initiative there for about a year longer. We saw solid gains across the whole portfolio in this initiative over the last quarter. We reported on our last second quarter call that we had picked up about 17,000 points of distribution, about two thirds of those were in mainlines. We saw a lower number in Q3 which is what you would expect at a seasonal time of the year and going into Christmas night where there is a lot less resets in our categories. We expect those numbers to accelerate into Q4 and into the reset periods in the first half of next year we expect really solid gains and one of the reasons Jon is because a year ago when we were going into retailers and making the presentation, we had a really solid fact based story. It was limited in certain retailers and certain categories. What we've been able to do since then though is we've been able to make a number of these placements and now we're going back into those same retailers and we're able to show them the success that we've had driving this strategy and so we think that the opportunity for us is going to get bigger in the future with these retailers as a result of that. We are in the process right now formulating from thinking on how we can communicate the metrics around our mainline initiative to our investors so they would be helpful for them to track our business and sometime around the time we introduced our Q4 numbers, or later this year, we'll be talking about what those metrics look like so that we can give the streets some really good measuring sticks to evaluate our progress against those goals not only where we are but how we're tracking going forward. We know that’s something that we can do a better job and we’re going to be focused on that.

Jon Andersen - William Blair & Company

In terms of innovation, you mentioned that Cheddar Squares, I think, were in 1,300 Target locations. What are the expectations for a broader rollout of Cheddar Squares? And I didn't hear you mention the Flat Grahams. Have the Flat Grahams begun shipping? And what are your expectations there?

John Foraker

Yes, all those items that we mentioned earlier had begun shipping and we've gotten strong pickup across channels for those. We thought calling up the Target placement was an important one but we've gotten a lot of distribution and a lot of distribution that’s coming, regional grocery chains, independent natural foods retailers, big supernatural retailers across those whole lines. So you'll see a lot of placements in Q4 and then I think when we get to the point where we talk about Q4 and into next year, at that point we'll have some real data on how those items are performing in terms of velocity at retail and we'll be able to give you a better idea how they are doing. We do see very strong retailer interest in them and we think that the products are very good tasting and priced and positioned right. So our expectations are that they should do very well but it’s a little early for us to call exactly how they are doing because they are just getting out there in retail right now.

Jon Andersen - William Blair & Company

Okay. And clearly, this isn't an approach where you incubate it first in the natural retailer channel. You go across channel right from the start?

John Foraker

Yes, these items have really strong mainstream appeal and we think that’s the right approach to take. We do have some versions of these products that we're doing in specific channels, organic items and the like but as a general rule we feel really good rolling going broadly with these right now.

Jon Andersen - William Blair & Company

Just on pizza, given the reboot that's going on right now, I know that you talked in the past about the March quarter being an important quarter in terms of adding new distribution, because the presentations are going on and the resets happen in the spring. How is it informing your opinion on your ability to go broader in the mass channel or traditional grocery channel, as you move forward from here?

John Foraker

To the extent that you got lucky in recall, we did get a little lucky. If this recall had happened 90 days later, I think it would have created a much bigger problem for us in expanding our distribution. Because we're getting back into distribution relatively quickly, because the items were performing well with these big retailers that we're targeting for expanded distribution coming into the next reset, we think it's going to have minimal impact and as well I can't guarantee you that we ought to get in, we got to do the reviews. I can't say that we think we're well positioned to do that.

Operator

Thank you. And our next question comes from the line of Jonathan Feeney from Janney Capital Markets, please go ahead

Brian Holland - Janney Montgomery Scott

This is Brian Holland filling in for Jon Feeney. Most of my questions have been answered, but if I could just ask one follow-up. If you could update us on what you're seeing in the frozen pizza category since the recall, with respect to competitive response, how that's measured up relative to maybe what your expectations were going in, and how that might impact your efforts going forward in the near and longer-term?

John Foraker

We haven't seen a lot of syndicated data because the data tends to lag. Our expectation would be that there would be some competitors out there that would try to take advantage of our (inaudible) from the shelf. I think that makes common sense. We have been talking very directly to all of our importantly retailers and we don’t expect that we're going to have any comparative issues that are going to prevent us from getting right back into the same footprint of distribution that we had before and I'll also say that the data that we received for how we were doing in retail stores right up to the point of the recall was actually very encouraging. So we think we're in a good place and the data tells a very strong story and we just need to get in, get the products back into distribution, fill the orders that these retailers are cutting us right now and then walk back in, tell a data story, make sure that they are lined up for the next category review so that we can drive the best possible result for next year.

Operator

Thank you. And our next question comes from the line of Bill Chappell from SunTrust. Please go ahead.

Bill Chappell - SunTrust Robinson Humphrey

Just digging a little bit more into the trade promotion step-up in this quarter, maybe I missed it. Is it primarily that you need to step it up in order to backfill from the reboot? Or is it you're seeing so much opportunity in the marketplace, you felt like, hey, let's go ahead and bring some of this stuff forward to really drive the category?

John Foraker

It's a combination of factors. The way to think about it is really in two ways. One is, retailers tend to be six to nine months out on their major promotional windows. And so we had some standing promotions in the March timeframe and the late February and March and April timeframe that we want to get back into distribution quickly so that we can get into those programs and drive them. We've been really successful it looks like now with respect to the timing of those and so we're going to be very aggressively supporting those. But in addition, in the retailers in places where we didn’t have a program set to run say in March or April but we're coming back on to the shelf, we are going to the retailers and saying hey, let`s put an incremental promotion in this timeframe to just capture consumers eyes, remind them that we're there, give them a reason to just point to us in the box again. So it's really a combination of those two things. We think it’s a very smart thing to do coming back out and we think that given that we were starting to build some loyal consumer base that we'll have a good opportunity to bring consumers back into the product quickly if we can do that.

Bill Chappell - SunTrust Robinson Humphrey

Okay. And would you expect the trade promos to kind of stay at this level as we move into early next year, to support the brand? Or is this also, some of its just timing?

John Foraker

I think the way you should think about it is timing. This is a category where we'll be promoting it on a regular basis but probably three to four times a year and some retailers will go when we promote, we'll go deep. It depends on the retailers' strategy and what our total strategy is to drive trial and awareness in the category. I think we'll certainly be investing a little more money over next year just in trial and awareness but on the marketing side rather than in straight trade promotion, but we were expecting to do that anyways. So this puts that back just a little bit until we can get pizza back on the shelves.

Bill Chappell - SunTrust Robinson Humphrey

And I know you're not giving guidance at this point, but can you give us maybe an outlook from here, maybe the next six, seven months, what you're seeing on both the commodity front and commodity inflation front? And then also do you need to take another round of pricing to offset that?

Kelly Kennedy

So nothing really has changed since our Q2 outlook on commodities. We are seeing some commodity escalation going into next year. We tend to buy forward six to 12 months and we've already bought some of our commodity needs for next year already. We feel very confident that we will offset that we have in previous years, to hold and or gain some margins. With a combination of both pricing as well as efficiency projects. We tried to take a little bit of pricing, kind of each year and so we don’t have any exact outlook on when and or what pricing we would take next year. We're hoping to be able to take as we always do as little as we need to. But we feel right now the commodity outlook is pretty much where we expect it.

John Foraker

Over the last few years where we have been facing some pretty big commodity inflation and our competition has been as well. Typically we've been at around this time of the year facing a bigger obstacle that we've had to overcome in the following year with a combination of productivity and pricing. This year it looks like a much more benign situation relative to what we had to do with in the past. So we feel very good about where we are.

Operator

Thank you. And our next question comes from the line of Chris Growe with Stifel Nicolaus. Please go ahead.

Chris Growe - Stifel Nicolaus

Just to understand, in the fourth quarter, you have outlined another $1 million or so of cost. I want to understand what that would relate to. I think you mentioned certainly returns. I thought a lot of the returns that were captured as part of this quarter. So I wanted to understand that. And then, also, just the cost of producing pizza, is that going higher? Or is that a factor at all in your fourth-quarter expectation?

Kelly Kennedy

So the fourth quarter, up to $1 million that we mentioned, it actually reflects on customer returns associated with sales in the fourth quarter that we took in January up until the time of the recall, so that 400,000 of the $1 million is related to a reduction in sales that we could not accrue because it had not yet been incurred as of 12/31. And we ramped up production significantly in January so we were deep into our production run when this issue was discovered. So we have about 450,000 of costs associated with inventory write-offs. Again, as those production runs took place in Q4, they will be Q4 charges. And then we will have some nominal SG&A expenses, legal crisis kind of PR on costs that will go into SG&A. And of course it’s a very early estimate. The total cost as well as our estimate for Q3 will be revisited in Q4 and any adjustments that will need to be made as we refine our estimate would also be taken in Q4. So it’s a little early for us to judge exactly what that would look like. We may also have some insurance recoveries that will be far enough along in the adjustment process that we may be able to as early as Q4 offset some of those charges. So it’s a little hard to call exactly what Q4 total costs will look like as it relates to the recall.

John Foraker

And they are best estimates that we use of what's required although we certainly were cautiously. We want to be conservative in the way we call these numbers.

Chris Growe - Stifel Nicolaus

And, again, if I could just be clear on it, then the $400,000 and the $450,000, those two pieces, it sounds like you know those pretty well already, so the question is like above, if it goes above that. Is that really the question?

Kelly Kennedy

Well I think the important thing to know is the inventories, the cost of sales numbers that we disclosed, we know those with much more precision and we're going to know the reduction in sales. The reduction in sales reflect our best estimate of what is going to be returns by customers and consumers and we don’t have got numbers there so there is a lot more estimation required in the reduction in sales. So we tend to try to take a conservative approach when we come up with those estimates and we'll have a lot more information as we start to see deductions come in from our customers and actual data come in. very little information has come in so far.

John Foraker

Chris the last part of your question, the cost to get back into production for the products we're making are just slightly higher because of the seed and the change over and manufacturers but we expect we'll be able to overcome those and it's not material.

Chris Growe - Stifel Nicolaus

Okay. And then if I could ask also, last quarter, you had a little bit of a shortage of product, as demand really spiked up. Was that any factor in this quarter at all? Were you rebuilding inventories or that kind of thing that we should just be aware of?

Kelly Kennedy

Yes, the main impact is really on the inventory levels. You'll note that the strong customer demand, the peak demand that we saw in Q2, Q4 is our largest quarter and is a highly promotional quarter. Our consumer promotions happen in the fourth quarter. And so we have taken a very conservative approach and we backed up our typical inventory build by about 30 days. And you'll recall the inventory downs at the end of Q2 was actually slightly understated by a few million dollars from what would be an appropriate levels of inventory. Clearly we were shorting some customer's products. Q3 is probably just a couple million higher than would be typical based on our builds, but what it allows us to do is it provides significant flexibility in the fourth quarter if we need to quickly ramp up production as a result of seeing some stronger trends. In addition, all this inventory is not a risk because it's all in our very fastest moving skews and then they have a long shelf life. So we fast turns, it's not a particular risk, but that’s where you would see, it's on our balance sheet.

Operator

Thank you. And our next question comes from the line of Scott Van Winkle from Canaccord Genuity. Please go ahead.

Scott Van Winkle - Canaccord Genuity

You know, all my questions have really been answered. I guess the one I would ask here is, as you step back on the gas on pizza, how important is it over the next couple of quarters to build distribution, and kind of get back to where you were, ahead of launching further frozen items?

John Foraker

It’s a great question. We think it's important for us to get back on to the plane of success where the product was with retailers. We were starting to build some reasonable distribution levels. We had a pretty good idea of how the products were ranking in the overall categories. We had a pretty good idea about the incrementally of that business for the retailers and for the total category. So we wanted to get back into a place where we could continue building that data store because it will be very helpful for us as we walk in, present these view items, talk to retailers about why Annie should be in this segment of frozen, what we can do for the segment, for the total category as well for the retailer competitively. So I think it's important. I wouldn’t say, it’s the most important thing, but I do think it will be very helpful as we sell the new ideas.

Scott Van Winkle - Canaccord Genuity

Okay. And then maybe one just to make sure I got this correct. The expectation of kind of a low-to-mid-39's gross margin in the fourth quarter, that was before taking into account product returns impact, correct?

Kelly Kennedy

It's on an adjusted basis. But it does take into account incremental spends that we expect in the fourth quarter related to supporting pizza when it gets back on the shelf.

John Foraker

But not the recall.

Kelly Kennedy

But not the recall. It’s the impact of the projected returns.

Operator

Thank you. (Operator Instructions). And your next question comes from the line of Michael Lavery from Sidoti & Company. Please go ahead.

Michael Lavery - Sidoti & Company

John, with regard to your frozen initiative, you spoke to some products in the pipeline, I guess, for the second half of fiscal '14. Can you touch; is there anything in the innovation front in terms of the first half of '14?

John Foraker

In terms of other innovation?

Michael Lavery - Sidoti & Company

Yes, just other innovation in general, other product lines?

John Foraker

Yes, nothing that we're in the position to formally announce right now. There could be some, but we're not ready to announce any.

Operator

Thank you. And this does conclude our question and answer session for today. And ladies and gentlemen that does conclude our call as well. We thank you all for your participation. If you'd like to listen to a replay of today's conference you may do so by dialing 303-590-3030 or 1800-406-7325 and then entering the access code of 458-8179#. We thank you for your participation and at this time, you may disconnect.

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