Hillshire Brands Management Discusses Q3 2013 Results - Earnings Call Transcript

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 |  About: Hillshire Brands Co. (HSH)
by: SA Transcripts

Hillshire Brands (NYSE:HSH)

Q3 2013 Earnings Call

May 02, 2013 10:30 am ET

Executives

Melissa Napier - Senior Vice President of Investor Relations

Sean M. Connolly - Chief Executive Officer, Director, Member of Executive Committee and Chief Executive Officer of North American Retail & Food Service Business

Maria Henry - Chief Financial Officer and Executive Vice President

Analysts

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Jason English - Goldman Sachs Group Inc., Research Division

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Robert Moskow - Crédit Suisse AG, Research Division

Kenneth B. Zaslow - BMO Capital Markets U.S.

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

Robert Dickerson - Consumer Edge Research, LLC

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Kenneth Perkins - Morningstar Inc., Research Division

Filippe Goossens

Operator

Good morning, and welcome to the Third Quarter Fiscal '13 Earnings Conference Call for Hillshire Brands. [Operator Instructions] This call is being recorded. If you have any objections, please disconnect at this time. I would now like to turn the call over to Melissa Napier, Treasurer and Senior Vice President of Investor Relations for Hillshire Brands. Thank you, Melissa. You may begin.

Melissa Napier

Thank you. Good morning, everyone, and welcome to our third quarter earnings call. Our third quarter results were released at 6:30 a.m. Central Time this morning. You can find that release, along with the slides that we'll be reviewing today, posted to our website under the Investor Relations section. Our 10-Q will be filed with the SEC later this afternoon.

I'm joined today by Sean Connolly, our CEO; and Maria Henry, our CFO. Sean and Maria will provide their perspectives on the performance of the business during the quarter. We'll take your questions after management's prepared remarks conclude.

[Operator Instructions] I'd now like to refer you to the forward-looking statement currently displayed and remind you that during today's call, we may make forward-looking statements about future operations, financial performance and business conditions. Actual results may differ from those expressed or implied in these statements. Also during this presentation, we may refer to non-GAAP financial measures. Explanations of those non-GAAP financial measures are included in the release.

I'll now turn the call over to Sean.

Sean M. Connolly

Thanks, Melissa. Good morning, everyone, and thanks for joining us this morning. Before we jump into the details of our quarterly results, as I usually do, I want to outline the big picture for everyone. Hillshire Brands is a focused food company that is equally committed to delivering growth and profitability. We believe in a very disciplined approach to brand building and innovation across our core brands. We also believe in reducing costs to fuel our growth agenda. Three quarters of the way into our year, I feel very good about the progress we're making against our plan, and year 1 is on track.

Q3 was a mixed story for Hillshire with earnings coming in better than our expectations, helped by favorable input costs. Revenue declined slightly, driven by declines in Foodservice. That said, we were very pleased to see our brand building and innovation investments continue to strengthen our core brands.

With EPS coming in better than we anticipated, we can now say that we expect full year EPS to be at the high end of our guidance range. A quick word on costs, and I'll ask Maria to elaborate further on this in a few minutes. We continue to make progress on our cost efficiency efforts, and this year is firmly on track. Encouragingly, we have also identified the remaining $35 million of our F '15 cost program, as well as additional savings opportunities, some of which comes beyond fiscal '15. These new initiatives further strengthen our confidence in our F '15 targets, as well as our conviction that we're creating a company built for sustained long-term value creation. Again, more on this in a few minutes from Maria.

As you know, the economic engine of our company is the Retail segment. After 4 consecutive quarters of volume growth, the Retail segment turned in flat volume versus Q3 a year ago. As you can see on this chart and as I’ve pointed out previously, the Q3 comps were far more challenging than what we saw in the first half. In fact, this chart also implies this was the most solid volume quarter yet year-to-date versus fiscal '11, which is a way of looking past last year's lumpiness. But there was a lot going on underneath the flat volume performance in the Retail segment beyond the tougher comps that I want to share, so let me break that down for you.

First, we had strong growth where we increased MAP investment. Second, we planned a decline in Hillshire Farm lunchmeat to enable our supply chain transition to our new package structure. Third, we continue to pull low-margin, low-velocity items out of the market in advance of new innovations. And finally, our frozen bakery business declined more than we forecast, as competition did not follow our post-holiday season price increase. I'll cover most of these points in a bit more detail.

In fiscal '13, we've made good progress on our disciplined plan to increase MAP spend to 5% of revenue by the end of fiscal '15. Recall, our history has been a MAP rate of 3% to 3.5% annually. Year-to-date, we've been at 4.3%, with the increase focused in 2 areas: first, Jimmy Dean, where we have very strong confidence in the ROIs; and second, supporting new item innovation, because you can't generate new item trial without first generating awareness.

Frankly, the improvement in trends that we've seen overall is very encouraging. This chart compares our fiscal '12 trends in consumer takeaway versus our year-to-date fiscal '13 performance. And what you see is real improvement. Our strong brands have grown stronger, and the ones that were weak are in a better place year-to-date, and that is encouraging.

Our focused approach to deploying MAP increase was fully evident in quarter 3, where more than 100% of our total MAP increase came in support of 2 businesses: Jimmy Dean and Ball Park burgers. In total, MAP was up $8 million in quarter 3, or 24%. And as you can see, that added real firepower to both businesses.

Similar to what we're seeing with MAP, innovation is starting to contribute. I'm proud of our team for getting after this with such vigor. Over the past 4 years, 9% of our annual revenue has come from items launched in the prior 3 years. Our goal is to get that number to 13% to 15% by the end of fiscal '15. So far this year, we're at 11%, which is solid progress, and frankly, we're just getting warmed up here with a lot more to come.

Without a doubt, Jimmy Dean has been our standout performer in fiscal '13 and in Q3. Year-to-date, we've seen our decision to ramp up brand building and innovation pay dividends. Volume and sales have been up meaningfully in our first 9 months. Contributing to that are the new innovations we introduced this year, and we've also improved upon an ad campaign that was already strong. Plus we've been very pleased with consumers' positive response to our new, more contemporary packaging.

If you look within Q3, the story is the same. Sustained strong sales growth as velocities continue to increase on key products. Driving that in Q3 was a MAP increase of over 38%. Finally, we introduced our new Flatbreads line, which is gaining distribution now and is truly an exceptional product.

We call Aidells and Gallo our artisanal brands because they're beloved by foodies. These businesses enjoy strong marketing support and continue to grow nicely in response. Year-to-date volume, sales and share are up meaningfully on both brands. Further, innovation is also moving full steam ahead. Aidells is particularly interesting because it demonstrates where we invest the highest MAP rate in our portfolio, we get the highest growth. In quarter 3, momentum continued, and this was encouraging as Aidells, in particular, had very tough comps in the quarter. New items like Aidells Salami and Gallo Peppered Salame helped overall.

You've heard me talk previously about our commitment to getting the hot dog category moving in the right direction, and overall, Ball Park is moving in the right direction. Year-to-date, our Ball Park Hot Dog business has increased its leading market share position, and this is particularly encouraging to us as our Ball Park Hot Dog business is one of the categories where we elected to discontinue some previous suboptimal line extensions.

In quarter 3, we focused on driving trial on our burger business, specifically our new frozen Flame Grilled Burgers, which are precooked and ready in 60 seconds from the microwave. We invested MAP to generate awareness in trial-on burgers, and the response was terrific. Sales in Q3 were more than twice that of the prior quarter, and repeat purchase has also been robust. Over 100% of our total MAP increase in Q3 went to this business and Jimmy Dean, and clearly, we're glad we made that decision.

Q3 was also an important quarter for our Hillshire Farm franchise, as it represented the start of a multi-phase restage in one of our billion-dollar brands. In the quarter, we began phasing in new smoked sausage varieties and improved sausage packaging. Our snackable sausage business, we call Cocktail Links, has had a strong season. And our presliced lunchmeat business transitioned to new improved product quality and a new package structure. And we call this Phase 1 because we expect innovation to play a critical role on this business well into the future.

Now let's talk a little bit about the Hillshire Farm lunchmeat transition. First, recall our Kansas City lunchmeat facility is a state-of-the-art, high-speed and highly automated operation. We anticipated a start-up curve as we transitioned to the new improved product and different package structure, and to avoid out-of-stocks, we pulled back on MAP and promotion in quarter 3 versus where we've been in quarter 2. In fact, we planned for an associated volume and sales decline as we navigated the transition, and you likely saw this in the scanner data. But as the quarter unfolded, we also determined that the transition would be more challenging than had originally been assessed, and that the packaging aesthetics we were seeing were not consistently up to our standards. While cosmetic, this was unacceptable to us, and we immediately mobilized to make several changes. Accordingly, we are refining our execution for more consistent packaging appearance, but at the end of the day, this is an excellent brand and now an even better product, so it's important we get the packaging right.

From the beginning, we've talked about the need to strengthen our soft spots and that the recovery timetable could be a bit choppy. In the first half, we made progress, and trends improved meaningfully on average. Q3 was a reminder that our work here is not done. On one hand, our Sara Lee Deli restage recently commenced, and we're hearing very positive customer feedback. On the other hand, Foodservice and Retail frozen bakery still need work. In Q3, our Foodservice/Other segment declined. This was a function of our commodities-synced pricing decline and soft bakery performance, as consumers continued their retreat from desserts amidst challenged household budgets.

On the Retail side, as I mentioned earlier, frozen bakery had a challenging quarter 3. Part of this was expected. In particular, we proactively discontinued several low-margin, low-velocity items from the lineup, despite knowing we had unusually tough comps where year-ago volume was up over 6%. The impact of this was then exacerbated by our competition not following our post-holiday price increase.

We remain very clear-eyed about the need to bolster the softer pieces of our portfolio. With a lot of core brand programs now in a good place, we're increasing our attention in making the necessary moves in other areas. In Foodservice, while we have the leading market share in pies, velocity growth on core SKUs has been elusive. However, we see a meaningful innovation opportunity in upscale desserts, which is nearly $1 billion category, growing, and we only have a 3% share.

C-stores are another opportunity, with meat-centric hand-holdable foods, and finally, we see additional opportunities to increase trade efficiency. As we pursue these initiatives, we'll also be focused on improving margins over time. On Retail frozen bakery, it starts with sharpening our price points. We simply can't let others take our consumers because price gaps remain too high. We're also improving our shelf presence and have several new items in development to add some interest to our lineup.

Before I turn it over to Maria, I want to close with our overall outlook. Moving forward, we will continue to invest in a disciplined way behind our core brands. At the same time, we are in a good position to increase our attention on the remaining soft spots, and we're very pleased to be mobilized against a new, even more robust cost savings program and strengthening our capabilities for sustained performance. We also see opportunity to create additional value through disciplined capital deployment. Put it all together, and we remain very confident in both our original 3-year plan and our conviction that we are creating a company built for sustained long-term value creation.

That's it for me. Maria, over to you.

Maria Henry

Thanks, Sean. Good morning, everyone. Thanks for joining us. As you've seen in our numbers and just heard from Sean's comments, we posted solid earnings for the quarter, strong results for the first 9 months of the fiscal year, and we're on track to deliver the updated guidance we provided on the last call. We continue to execute our plan, and we're making progress.

Before I dive into the numbers, let me make some overview comments. For the quarter, we had favorable input costs, which offset lower sales and enabled us to deliver higher gross profit year-over-year. We continue to invest in MAP and innovation, and our SG&A expense was higher as planned and previously communicated. Through a lot of work over the last few months, we've identified the specific opportunities to deliver committed savings and additional efficiencies. We ended the quarter with a very strong cash balance, and overall, we're on track to deliver a solid year 1 of our plan.

Now let's take a look at the quarter's financial results. Our adjusted net sales declined 1% behind a 0.4% increase in volume. If you exclude commodity meat sales, our volume declined approximately 0.5%. Lower sales were primarily driven by Foodservice/Other segment. Gross profit was up 3% versus last year and benefited from favorable input costs in the quarter.

While our input costs were favorable for the quarter, the level of favorability was substantially lower than what we experienced in the first 2 quarters. Consistent with our strategy and our intent to invest some of the first half favorability into our business in the second half, we continued to invest in MAP in the quarter, and our MAP spend was 4.2% of sales. As Sean discussed, we're diligent in our analysis of expected returns on MAP and we only deploy it when and where we believe we'll get an appropriate return.

Our SG&A, excluding MAP, was up 7% from last year as expected behind 3 things: our workforce ramping to more normalized levels; stranded costs coming into our P&L as our Transition Services Agreements continue to ramp down; and certain investments that we made in the business. Adjusted operating income of $72 million is down 13% versus last year, and adjusted diluted EPS of $0.35 was down 15%. As you can see, year-to-date, our adjusted EPS of $1.46 is up 28% versus last year.

Now let's look at those segments. Retail segment sales and volume were flat, reflecting strength in many of our brands being offset by planned decreases associated with our Hillshire Farm lunchmeat transition, product discontinuations, as well as consumption weakness in frozen bakery. The 3% decrease in Retail adjusted operating profit reflected planned increases in SG&A, which were primarily the result of stranded costs coming into the segment from previously divested businesses.

Moving on to Foodservice/Other. Overall, this segment had a challenging quarter, and you see that in the numbers. Volume grew 1.3%, but 3 points of that growth was from commodity meat sales. Excluding sales of commodity meat, Foodservice volume declined 2%.

A number of factors contributed to the sales decline. First, macroeconomic conditions were very challenging for restaurant traffic early in the calendar year. And as we've discussed, the dessert area of Foodservice, where we have a large business, is heavily impacted by consumers tightening their spend when they do decide to eat out.

Next, when we have deflationary input costs, our Foodservice sales are lower, as much of our business there is on pass-through pricing contracts. And finally, our Foodservice/Other segment also had negative mix for the quarter, depressing both sales and income. The unfavorable mix resulted from higher commodity meat sales, lower bakery and less favorable mix within the Foodservice meat area. All of this, plus the segment's portion of the higher SG&A from stranded costs, led to an adjusted operating segment income decline of 41.5% and an adjusted operating segment margin of 4.1% for the quarter.

Beyond the financial results for the quarter, we've completed another major milestone in our plans, which is identifying the specific opportunities and action plans to deliver the remaining $35 million of the $100 million cost-saving target we communicated in June. As you recall, at that time we said we had full line of sight into $65 million of that, and we had to find the remaining $35 million. We said we'd look to find it in our largest areas of spend: trade and supply chain, as well as general process efficiencies that would result from implementing a new culture and a new way of working.

The good news is that we now have full line of sight to the $35 million, and we found some more. As we work through our strategic planning process, which just wrapped up and which goes through fiscal '16, we are pleased that we've identified an additional $45 million of annual savings opportunity that we look to deliver by fiscal '16. The additional opportunities further de-risk achieving our midterm targets. We expect to spend $80 million to $100 million of new cash charges to achieve the $80 million in ongoing benefits. To be clear, the $80 million of benefits includes the $35 million, plus the incremental $45 million.

There may also be some noncash charges, and we'll have more to say about that as we move forward. The projects we've identified have outstanding financial returns, with less than a 3-year payback in total. In addition to further strengthening our confidence in the midterm targets, the investments we are making and capabilities will position the company for sustainable growth and profitability well into the future.

Our balance sheet and cash flow remain strong. We received approximately $80 million of cash proceeds from the sale of our Australian Bakery business in the third quarter, helping to bring our cash balance at the end of the quarter to $416 million. Excluding significant items, the business generated $242 million of cash and $407 million in adjusted EBITDA during the first 9 months of the fiscal year. With $533 million of net debt, we remain conservatively leveraged.

As we said, our priority is investing in our business. We're doing that through our investments in brand building and innovation, and we'll now be deploying some of our capital against our capability developments and efficiency programs, as I discussed a moment ago.

Beyond that, our strong cash position and the underlying earnings generation of the business provides flexibility for us to increase our dividend over time and actively consider M&A as a path to leverage our assets and capabilities to create shareholder value. We expect to have more to say on capital allocation as we give guidance for fiscal '14 on our next call in August.

With the first 9 months of the year behind us, we are refining our full year fiscal '13 guidance. We now expect to be at the high end of our EPS guidance range. Our previous sales guidance holds, and we still expect to be up slightly for the year on the top line. Our outlook incorporates our expectation of continued investment in MAP and innovation and takes into account the expected sales and earnings impact of the Hillshire Farm lunchmeat package transition. Clearly, that situation puts more variability into how we will end the year than we would normally have with 2 months to go, and it also influences the EPS guidance we are providing.

Let me make a few other comments related to guidance. We expect input costs to be unfavorable in the fourth quarter, which will be the first time we've seen that this year. We also still expect segment SG&A, excluding MAP, to be up for the year. Corporate expenses have continued to run favorably, and we now believe that we'll finish the year close to about $50 million in corporate expense.

So let me wrap it up. Overall for fiscal '13, I'm pleased with how our first year is unfolding. We're getting a lot of the heavy lifting done that needs to be done in our first year. The significant favorability we gained this year from lower input costs and expenses is enabling us to deliver higher earnings than originally anticipated. We have identified specific actions to improve the capabilities of our business and deliver committed savings. And finally, we're on track to deliver the high end of our updated guidance that we provided on the last call.

With that, I'll now open it up for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Akshay Jagdale.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

KeyBanc. So can you quantify what the impact of the Hillshire lunchmeat issue is on the fourth quarter earnings? I mean, it looks like you didn’t change your sales guidance. So the sales impact, if I understand it correctly, is not very different than what you thought previously. But if you could just help us understand what the earnings impact is in the fourth quarter, that would be great.

Sean M. Connolly

We're not going to get into specifics on the impact of working through the lunchmeat piece in the fourth quarter, Akshay because, quite frankly, we are getting the estimates to be more precise. I mean, the way I think about it overall after the last quarter, as you know, we raised our EPS guidance range to the current $1.60 to $1.70, and Q3's EPS came in a bit better than expected, which enables us to be able to say that we'll be at the high end of the range. We won't go further, though, as we have to take the actions necessary on lunchmeat, as we discussed in the call. And if that ends up costing us less than we estimated, it's possible we could do a bit better, but we don't want to convey false precision on those estimates at this point.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Okay, helpful. And then just the returns on MAP spending, so very encouraged to see continued spending on MAP. Any expectation to continue that trend in the fourth quarter? But obviously, there's a lot of moving parts on the volume side. So help me sort of grade yourself on how you did on your MAP spending so far.

Sean M. Connolly

I would give us an excellent grade on the MAP spend, and the simple way to think about it is, we are extremely focused in terms of how we deploy the MAP increase. Our historical MAP rates have been very light, as we've talked many times, and we needed to get them up. In fact, by fiscal '15, we need to get it probably to a full 5%. This year, we've increased it from about 3.5% a year ago, on average, to about 4.2%, 4.3%, and that increase has been extremely focused and where we've increased it, there's an outstanding return on investment. Jimmy Dean, really the key, and then from an innovation side, on our Ball Park burger business where we are -- we feel very good about the ROI because not only are we getting the trial response we want, but the product is delivering excellent repeat purchase. So it's one of the -- it's the gift that keeps on giving. The key, though, is that we focus our increased MAP in areas that we believe, as Maria said, are ready for the MAP and we have confidence we can get a good ROI on it. I'll also point out, too, that on lunchmeat, we can talk a little bit about lunchmeat, that's a business where we returned MAP to the portfolio in support of lunchmeat back in the second quarter. And we got the business going from a mid single-digit decline to growth, again, until we planned for the transition this quarter. So overall, I feel very good about the response we've seen on MAP.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

And one last one, just more on the category dynamics. Generally speaking, meat-centric snacks, if I may, but we cover a few companies that are lower on the sort of branded scale, if I may, and closer to the farm. And they have been talking more and more about becoming more branded and acquiring brands, et cetera. So you have some players who don't have a strong branded presence that are moving up the chain, perhaps in private label first and then with some smaller niche brands. So the first question is, have you seen that impact your categories, broadly speaking? Do you think that's a long-term risk? And then secondly, related to that, the reason these companies that I'm mentioning think this is a good strategy is because they feel like being closer or vertically integrated in some of these protein chains gives them a competitive cost advantage. So not being vertically integrated, is that another big -- is that a big risk in any way to your business model?

Sean M. Connolly

A couple of thoughts in response, Akshay. First of all, I won't comment on specific competitors, but I will say a couple of things. Number one, we do not believe vertical integration is an advantage to us at all. And the reason for that is because we like being a focused food company and specifically, a focused branded food company. We like management's attention on building great brands because great brands tend to translate to the ability to hold price and higher margins, and we like the ability to focus on things like the consumer and innovation, as opposed to the vertical integration side of it. So that is definitely not our philosophy. With respect to other companies or other companies wanting to be in the branded business, of course, people want to be in brands, but there's a difference between brands and iconic brands. And what we love about our portfolio is we believe we've got a portfolio of iconic brands. As we've talked before, some of them have been neglected, we clearly have been quite busy trying to get them up and running again to unleash their potential, and we feel like we're making tremendous progress in that regard.

Operator

The next question comes from Jason English.

Jason English - Goldman Sachs Group Inc., Research Division

Jason English here, Goldman Sachs. Maria, can you comment on, or try to help us quantify the magnitude of deflation, and then on the flip side, what the potential inflation may be for the next quarter?

Maria Henry

Let me give you a little bit of color there. On the deflation that we saw in the third quarter, that was the most significant driver of what you saw happen on our gross margin line. So I won't give you a specific quantification on it. But you kind of know what the normalized gross margin rate of the business is and the help from the input costs was the key driver on our gross margin rate in the third quarter. Going forward, in the fourth quarter, we expect commodity costs to be a hurt, and we expect commodity costs to be inflationary in fiscal '14. Now if I compare the expectations on that to what I thought 3 months ago, it has become less inflationary. But we still expect it to be inflationary in the fourth quarter and as we move through '14.

Jason English - Goldman Sachs Group Inc., Research Division

Great. One quick follow-up. Sean, yesterday, we saw Clarks report earnings, and they got buffeted on the charcoal side of their business with a really weak start to grilling season. Have you seen any headwinds related to that in your business?

Sean M. Connolly

Last year was my first winter in Chicago. When I got here, we had 5 days in a row of 80-degree weather. So it was an unusual wrap, but quite frankly, I don't like talking about the impact of weather on the business because to me that's a timing thing. Weather always comes. Grilling season, I expect will be robust, and we expect to be full participants in it.

Operator

The next question comes from Ken Goldman.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

JPMorgan. I have a question -- Maria, you guys now have, if my calculations are right, more cash on your balance sheet as a percent of enterprise value of pretty much every packaged food company out there. So I guess my question is, what are you waiting for, right? You have a dividend yield that you've talked about increasing. Maybe you're keeping your powder dry for some acquisitions that you see out there, but I'm just curious, why not raise your payout ratio now, please some investors who are obviously looking for yield in this kind of environment and perhaps, get your stock up that way rather than sit on cash that's not earning much interest?

Maria Henry

Sure, Ken. I agree that we've got a very nice cash balance at the end of the third quarter, and we talked a lot about how we think about capital allocation, with the first priority being internal investment in our business. We continue to invest in our business in brand building through innovation and MAP. And as I talked about today, we'll be investing some capital against capabilities development and some new projects to unlock some further efficiencies. Beyond that, we do intend to take up the dividend, and I'll have more to say about that on the call in August. We do see M&A as a way to create significant shareholder value. As I've talked about, we think we've got assets and capabilities that can be leveraged. We'll have a disciplined approach to M&A, clearly, and we're looking for acquisitions that align with our strategic vision and have smart financials. So we do see M&A as a good way to create value, and we want to allow ourselves flexibility to be able to act on that. You know as well as I do, one of the factors with M&A is that we don't control availability or timing of when deals can happen. So we'll keep you updated moving forward. But we are actively looking at that.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Would you say, though, just as a follow-up, that one of the reasons you're keeping cash on your balance sheet is to keep your powder dry for a potential acquisition? And if so, why would you do that given how low interest rates are? Right? You could always raise your dividend now, and if a deal comes, lever up, and then I'm sure the market would be more than happy to see you do that.

Maria Henry

Yes. I clearly understand where you're coming from and your point of view on that, but I'll have more to say about the dividend come August.

Operator

The next question comes from Rob Moskow.

Robert Moskow - Crédit Suisse AG, Research Division

It's Rob Moskow, Crédit Suisse. I guess I wanted to know more about the packaging switch in Hillshire, the Hillshire Brand. And maybe more broadly, Sean, the Sara Lee business, before you got there, had a kind of reputation for uneven performance and some supply chain hiccups. So I wanted to know if you think that this latest issue is just kind of a onetime event, or as you look at how the business is performing right now, do you feel like the supply chain is -- it needs more investment in order to avoid future issues?

Sean M. Connolly

Good question. I feel great about our supply chain. The team on the supply chain side has made great strides this year in a number of areas. This is a issue specific to lunchmeat, and quite frankly, the majority of the lunchmeat decline, in terms of net sales on the quarter, was planned because we -- keep in mind as per my comments earlier, Kansas City is a very automated, amazing plant, but when you transition to a new physical structure, you basically ramp down your throughput to start the thing up and get used to the new structure. And that means that our typical merchandising, which was fairly robust in the year-ago period, we would -- we expected not to be able to fulfill. So we chose to manage the demand side of it down by pulling back on our MAP expense and our merchandising versus where we were in Q2. So that's the bulk -- the bulk of what we saw there was planned. What was not planned was that as we went through the quarter and we started getting products out on the shelf, simply put, it didn't look right consistently. The product was great, but the appearance wasn't consistently up to our expectations, and we noticed it, and so did our consumers toward the end of the quarter because if you'd looked in fine detail at the scanner data, what you would have seen is the promoted volume was down throughout the quarter as we planned. The baseline volume was down a bit because we pulled MAP down, but then it dipped a bit further when some of these inconsistent products made its way on to the shelf. What we were expecting, quite frankly, was nicely layered, beautiful meat in an overall appearance that lived up to the product's strong taste credentials. And in some instances, the presentation didn't meet our standards. So we'll address it in Q4 head on, and we'll move forward with our other restaged products -- projects. But the bottom line is, we're committed to doing things right on Hillshire Farm, and we expect big things from this. It's one of our billion-dollar brands, and recall, before the transition, we had gotten the brand growing again when we activated MAP in quarter 2. So it is -- it's an executional challenge that we'll work our way through. I don't view it as a big deal, but in no way do I view it as a statement around our supply chain capabilities, which I think are excellent.

Robert Moskow - Crédit Suisse AG, Research Division

Great. Maria, just a quick question about the cost savings that you found and you're going after. Of the cash that you're spending, where is it going to be spent on? Is it mostly on capital to improve efficiency, or is it also to, like, pay off pensions and maybe retirement acceleration?

Maria Henry

The $80 million to $100 million of cash charges that I talked about is not CapEx. Those are charges that will show up against the P&L, and the areas that we are going after for the savings are areas where we have the biggest spend on our P&L. So it's in the areas of trade and revenue management. It's in the area of supply chain efficiency. And beyond that, it's within our support processes in the company. So things like IT, finance procurement, those types of activities. And so, that's what that spend is focused on, and that's where we expect to realize the benefits.

Operator

The next question comes from Ken Zaslow.

Kenneth B. Zaslow - BMO Capital Markets U.S.

Bank of Montréal. Just following up on that question about the cost savings. How do you expect to use those cost savings? Are you going to put it back into the business? Are you prepping to basically offset greater commodity inflation? How do you think about that incremental cost savings? And how does that better prepare you for the future?

Maria Henry

Sure. Let me break down the cost savings that we talked about. We talked about a number of $85 million, and $35 million of that was just finding the specific opportunities to the $100 million that we had committed to. When we just completed our strategic planning process, which goes through fiscal '16, we were able to identify the incremental $40 million -- $45 million in savings. A lot of that comes closer to the -- or in fiscal '16, as our strategic planning process goes out an additional year. The way that we think about the savings is that it de-risks the achievement of the midterm guidance that we've given. It gives us some more flexibility around investing in innovation and for growth. And beyond '15, it gives us some further flexibility.

Kenneth B. Zaslow - BMO Capital Markets U.S.

And my -- just a follow-up is, the degree of outperformance that you had in the first half of the year, the reinvestments, does that give you -- achieves the confidence level to be able to offset the commodity exposure for 2014? Or -- because obviously, you've put a lot back into the EPS number. How do you balance that and kind of thinking about, more about 2014 with that?

Sean M. Connolly

Well, we're not going to speculate on how we think the commodity curve is going to unfold for fiscal '14 at this point. Certainly, we're not prepared to guide on fiscal '14 at this point. But I will say, the philosophy we've got is that if we find ourselves in any given fiscal year where we get material favorability to the bottom line because input costs break our way, our principle has always been to take some of that to the bottom line, but to take some of it and put it back into the business, so that we could strengthen our brands going into potentially headwind periods. And the whole reason for that is the way you manage for margin consistency on these businesses is by keeping your brands strong, and it's precisely the model that we followed this year as things broke our way. And it's given us the ability to put a little bit more into MAP in the back half. For example, you'll see MAP spend in quarter 4, where typically in the old days, our MAP spend at quarter 4 would drop precipitously as we were kind of sliding into home on the year. So we'll sustain that. We've also got more slotting in our back half this year for new items that are coming into the marketplace, following some of the weeding that I've talked about before, in terms of pulling out previously launched lower margin or low-velocity SKUs.

Operator

The next question comes from Alexia Howard.

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

Yes, it's Alexia Howard from Sanford Bernstein. Can I ask about -- coming back to the lunchmeat question, how soon do you expect to be back up to sort of full capacity, starting the marketing and merchandising again? Just want to get a sense for whether that's -- it's possible that it might persist into the next fiscal year. And secondly, just as a follow-up, do you have any ballpark estimate of what the unexpected lunchmeat transition issues might have cost you, either to the top line for the year or the EPS line?

Sean M. Connolly

Well, per the comments earlier on the precise cost of navigating through this lunchmeat bump, the way I think about it in the simplest terms is EPS came in a bit better than what we expected in quarter 3, but we're not going to take that to the year because we've got to use that to cover anticipated costs to navigate through this in quarter 4, which we really don't have a whole lot more precision on that to give you in terms of top line or bottom line. We're working through that as we speak. In terms of the conversion cost piece and the plant running, the plant has actually made tremendous progress in the typical startup that we were planning for, that we were working the plant through. And just in the last couple of weeks, the plant has really started to get its throughputs back up. Exactly where in quarter 4 we'll land that thing back to our typical run rate, I can't tell you, but my team's goal here is obviously to push this to get it right back to where it was as fast as possible.

Operator

The next question comes from John Baumgartner.

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

Wells Fargo. Sean, just in terms of pricing here at Retail, it seems as though the industry has been passing through lower input costs in sausage, lunchmeat prices have been declining a bit. So just wondering what your sense is as to the consumer's ability to absorb higher prices going forward, if the industry needs to pass through some of those re-inflationary input costs over the next few months.

Sean M. Connolly

Well, I think the consumer's willingness to pay higher prices depends upon the brand, and it depends upon the elasticity of the brand. And we have different elasticities as do all companies on different brands. It tends to be directly correlated with the strength of that brand. So our goal is to continue to strengthen our brand so that we can pass through pricing. And in deflationary times, we tend to hang on to that deflation, and it gives us the ability to drop it to the bottom line or invest it back in the business. In inflationary times, we look to hang on to as -- we look for our brand strength to be able to help us navigate inflation to the best of our ability. But as you can imagine, it varies by business. So businesses like Aidells, which ironically is our most expensive brand, and Jimmy Dean, have lower elasticities, but businesses, historically, that had either not innovated or competed based on price, have higher elasticities. Those businesses we're trying to move more toward advertising- and marketing-based competition and less based on price competition. So in terms of specific competitors and what they may do on price, sometimes if you don't have a brand equity, you resort to price-based competition as an alternative. That's one of the things that we see going on in the dessert category, which was challenging for us this particular quarter where there really hasn't been a lot of innovation and contemporarization in that category. And as a result, you see people competing on price, which really isn't good for the category overall. So we're going to stay to the high road here on this and continue to push on brand building and innovation because we're convinced that's ultimately the way to create the most value for our shareowners.

Operator

The next question comes from Rob Dickerson.

Robert Dickerson - Consumer Edge Research, LLC

Sure. Consumer Edge Research. Yes, I just had a question on Foodservice. No one really brought it up. It doesn't sound like so far at least. When you look at the operating profit decline year-over-year, it's about $10 million, it looks like, on the segment side, $7 million that came from Foodservice. So I'm just wondering, I guess one, can you just kind of walk through or discuss where you might foresee trends for modeling purposes, kind of heading into Q4, then really, for overall for '14? And then secondly, which is just kind of bigger picture is, how do you view the Foodservice business? I mean, like how much operating leverage are you able to get out of that business, actually make it worth your while to continue to work through the pressure that we've seen in the business, really for the past 3 to 4 years across the board for most companies that operate it in the area?

Sean M. Connolly

A couple of thoughts. So first of all, just about every company that I can think of in our space has a Foodservice division, and that's because it's practical to have a Foodservice division. You can create value with the Foodservice division, you can leverage your assets, so on and so forth. So it definitely plays a role not only in Hillshire, but in just about every company I can think of in the space. The industry, in general, had a tough quarter in Foodservice overall in the first quarter of the calendar year, as I'm sure everybody has seen, particularly in January for a variety of reasons. I won't get into macroeconomic. And we were no exception to that, and interestingly, recall, that's following a very solid quarter 2 where I think if memory serves me correctly, our OI was up 8% or so in the quarter. So it was an unusually challenging quarter in Foodservice, but Foodservice absolutely plays a role in our portfolio. Now we expect that the channel will remain challenging in the immediate future, but clearly, not to the same degree as this past quarter. And in part, that's because what we're doing -- part of that is the industry and bouncing back from the tax refund deal in January, so on and so forth. But a big part of it is because we're taking action to improve trends and mix over time in our portfolio, as we talked earlier in the call. I don't know, Maria, did you have anything to add to that?

Maria Henry

No.

Robert Dickerson - Consumer Edge Research, LLC

Okay. And then just a quick follow-up. Is -- this all goes back to Ken's questions around cash and the dividend increase. I know you're going to talk about this in August, but that said, like from the beginning of the year, EPS guidance has gone up. You now have a $400 million cash balance at the end of Q3. So obviously, your -- the cash expectations, the cash generation expectations of the business in year 1 have been a lot higher than you expected, or I would think so from where you started the year. So with that, outside of looking for M&A or looking to increase the dividend, I mean, how do you think that outsized cash generation has actually expanded your optionality to allocate capital or expanded your potential, or increase your potential, to potentially increase the dividend more so than you had originally planned? I'm just trying to get a sense of, you're in a better position now than you were on earnings but also in cash, as you were in the beginning of the year, and I know we keep kind of pushing that off, but the larger question is, with more cash, how could you potentially use the stepped-up cash level going into '14?

Maria Henry

Sure. We are very pleased with where we are on cash, both in terms of cash that we have on the balance sheet. As you know, it is higher than I expected it to be at this point, when we first came out in June of last year. So very happy with that cash balance, and also the underlying business has had very good cash generation this year because of a number of factors. How all that plays into how we think about capital allocation is that we still think about it in line with the priorities that I've talked about. When we look at our dividend, we've clearly started out at a conservative dividend payout level, and we've talked about taking that up over time. We've taken into account the higher cash balance that we have and also what we see in terms of the earnings generation of the business, coming out of having just worked through our new 3-year or updated 3-year strategic plan. So we'll take all of that into consideration, as we reset the dividends, which I'll talk about in a few months here on the August call. We also still consider share buybacks as a valid way to deploy capital. We evaluate the economics around share buybacks against what we think is in the best interest of the shareholders, from an increased dividend or M&A activity, and weigh all of those factors to come up with how we allocate capital. At the end of the day, we look to allocate it in a way that we think best creates shareholder value over the long run. So I agree with you that very happy with the cash balance and the cash flow generation of the business in the fiscal year, and that gives us a lot more flexibility on what we might do and the level we might do it to.

Operator

The next question comes from Ann Gurkin.

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Davenport & Company. I wanted to just touch a little bit on volume expectations for '14. As we've seen good response from the increased brand support behind Jimmy Dean and Ball Park, can you comment on volume expectations as we go into '14?

Sean M. Connolly

Ann, we're not going to comment on '14 now. We'll be in a position to talk more about what we expect in '14 on our next call.

Ann H. Gurkin - Davenport & Company, LLC, Research Division

But given the response you've seen right now from the increased MAP spending, is it fair to assume we could see upside to volumes going into '14? Is that a fair direction?

Sean M. Connolly

Well, what I think we can say is that we are committed to growth, and we're committed to profitable growth. We believe that is the way to create value, and we'll do it through brand building and innovation, and we've given midterm guidance at this point, as you know for F '15, but nothing yet on F '14.

Operator

The next question comes from Ken Perkins.

Kenneth Perkins - Morningstar Inc., Research Division

With Morningstar. I'm just wondering, you pulled back on the MAP spend in the lunchmeats initially due to the packaging issues. So I'm just wondering, since you had some new innovations and flavors that you're planning to roll out in the fourth quarter, if any of those adjustments could impact the timing of the MAP spend to support the rollout.

Sean M. Connolly

A lot of the -- some of the launches here for the back half are really just ramping up. For example, Ball Park Lean hot dogs just now kind of flowing into the marketplace and achieving scale. The same thing with some of the new lunchmeat flavors. So typically, what we do is we'll work new products into the marketplace in the back quarter of the year, the back half of the year sometimes, and then really begin to support them once they achieve scale distribution, which really probably is more of a fiscal '14 concept.

Kenneth Perkins - Morningstar Inc., Research Division

Okay. Great. And then I just wanted to touch quickly on -- the gross margins were pretty strong. Clearly, commodity costs were the driver. I'm just wondering if you can give us a sense for how much innovation also seems to be playing a role, given that the volumes are strong, and how we should think about favorable mix from innovation versus pricing and the higher input cost going forward.

Sean M. Connolly

Well, innovation will clearly be ramping up as it has been this year. I showed you the 11% versus the 9%. We expect by the time we get to fiscal '15 that will be up farther as we talked. The gross margins on those innovations will depend upon the specific item. Some of the items, leverage assets that we are up and running on, and we've got them in-house, and we've got an excellent gross margin on. Some of the things that are newer to us we work through co-packers. We sell at a lower gross margin in the early days until we prove it, and then we repatriate it, we bring it back in-house, reinvest in capital, so on and so forth. So it's really a mix. Innovation will absolutely be more of a contributor overall though to the top line, as we proceed forward than it has been historically.

Operator

The next question comes from Filippe Goossens.

Filippe Goossens

Mitsubishi Securities. Maria, I wanted to kind of go back to the M&A topic that came up a couple of times, and I have kind of a 2-part question to that. First, from a portfolio perspective, can you point us to any potential holes that you would have for M&A activity, kind of what makes sense and then kind of related to that as well from a geographic perspective, obviously, focuses on the U.S., but do you see opportunities to add value also by looking outside of the U.S.? And then my second question is more from a credit perspective. Right now, you're a solid mid-BBB type company. When you look at M&A activity potentially down the road, can you share with us what your sensitivities are with regard to ratings? Is it critical for you to maintain that mid-BBB or you might be willing to go a little bit lower but still stay in that investment grade space?

Maria Henry

Certainly. Your first question is around M&A, and I'll take geography first. We -- our first priority is within the U.S. We think we've got ample opportunities right in front of us and the execution risk of staying within the U.S. geography is obviously lower. And so right now, that's where our efforts are focused, given the sizable opportunities that I think we see. In terms of the holes in the portfolio, here's how we think about M&A and the potential targets. We look for things that are in line with our strategic vision, clearly, that have smart financials to them. In terms of specifically what we look for is we look for properties that have meaningfully attractive top line growth trends. We look for things that are accretive to our margin structure and to our EPS. And ultimately, we look for places where we could structure deals that have economics that create shareholder value over time. In terms of the credit rating, we are a solid investment grade at this point. Our preference is to remain solid investment grade. That we think gives us just financial flexibility on a number of fronts, which we like. It doesn't mean that we absolutely wouldn't do something that might put a little bit of pressure on that. No, it doesn't mean that. But our preference is that we would like to maintain our investment grade rating for the flexibility it gives us.

Operator

The last question comes from John Baumgartner.

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

Wells Fargo. Maria, any update in terms of the legacy payments you still do, as an impact to cash on the balance sheet here?

Maria Henry

Sure. There's a couple of things that I've talked about on legacy payments. I've previously told you that we would have $65 million to $75 million in charges in our fiscal '13 P&L, related to what we're calling legacy actions. You can see in the tables that year-to-date, we have $52 million of significant items related to that. I think that it's likely going to be closer to the bottom end of that range, and some of it will materialize beyond fiscal '13. The other piece that I've talked about in terms of legacy items is that we expect $190 million to $210 million of legacy cash obligations, and I've said that the majority of that would be paid in fiscal '13. I expect some favorability on those costs as well, so the lower end of the range, and I'm going to provide more guidance on that, specifically, in August. And the reason I'm holding off until August is that I expect a significant amount of legacy cash to get paid out in the fourth quarter, and there's some timing issues around that. So I'd rather just get through the fourth quarter, see where we are, and then I'll give you a clearer picture of how I see the cash related to those legacy obligations, post-fiscal '13, when we're back on the phone in August.

Operator

At this time, there are no further questions. I'll turn the call back to the speakers for any closing remarks.

Sean M. Connolly

I just want to thank everybody for calling in. We covered a lot of ground this morning. Thanks for your continued interest in Hillshire, and we will be talking further soon. So long.

Operator

Thank you. That concludes today's conference. All lines may disconnect. Thank you for your participation.

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