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Executives

Marta Turner - EVP Corporate Relations

George Deese - Chairman, President and CEO

R. Steve Kinsey - EVP and CFO

Analysts

Farha Aslam - Stephens Inc.

Mitch Pinheiro - Janney Montgomery Scott

Tim Ramey - D.A. Davidson

Eric Katzman - Deutsche Bank

Heather Jones - BB&T Capital Markets

Ann Gurkin - Davenport & Company

Bill Chappell - Suntrust Robinson Humphrey

Akshay Jagdale - KeyBanc Capital

David Leibowitz - Horizon Asset Management

Flowers Foods, Inc. (FLO) Q2 2009 Earnings Call August 18, 2009 8:30 AM ET

Operator

Welcome to the Flowers Foods second quarter 2009 Earnings Call and webcast. (Operator Instructions).

It is now my pleasure to introduce your host, Ms. Marta Jones Turner, Senior Vice President of Corporate Relations. Thank you, you Ms. Turner you may begin.

Marta Turner

Thank you, Claudia and good morning everyone. Our second quarter earnings released earlier today, if you don't have a copy of that release of course you can find it posted on our website. Before we start I also want to mention to you that we plan to host an Analyst meeting with our management team on December 1. We'll send details later on, but I wanted you to save that day, December 1, in New York.

Before we begin our discussion of second quarter results, you know that I must point out that our presentation today may include forward-looking statements about our company's performance. These comments could include discussions about future performance including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow and other such items.

The statements we make today are based on our view of things today, so they may contain some degree of uncertainty. But we believe our segments to be reasonable. They are subject to risks and uncertainties that could cause actual results to differ materially. In addition to the matters we'll discuss during the call, important factors relating to our business are detailed fully in our filings with the SEC.

Participating in our call today are George Deese, Chairman of the Board, Chief Executive Officer and President, and Steve Kinsey, Executive Vice President and Chief Financial Officer. George and Steve will discuss our results and then of course we'll open the call for your questions.

Now, I'm pleased to turn the call over to our Chairman, CEO and President, George Deese.

George Deese

Thank you, Marta. Good morning. Thank you for joining our call as we report our second quarter and first half results. Our results this quarter demonstrate our team's ability to balance top line growth with quality earnings to maintain and grow our market share and to grow our earnings per share.

I'm happy to report that in the first quarter, second quarter we were able to grow the top line by 13.6% and our operating earnings increased by double-digits. Steve Kinsey will report all the financials in a few minutes. These results are impressive given the economic headwinds we faced through the first half of the year, including higher commodity cost. I would like to thank our entire team for the superb efforts in executing our strategies and/or again delivering good results.

We continue making investments to improve the business. We are expanding into new markets and strengthening our position in existing markets. We continue to innovate and develop new products. We have invested our time and focus in staying close to the markets we serve.

We're using our increased investment in consumer and shopper data to provide our team with valuable insights that help us make the right decisions for the long-term, and we continue to drive improvements in our costs and efficiency structures to maximize the value we deliver to shareholders.

Now I want to give an update on our operations. First, looking at our DSD segment. We had strong performance, as these results show. We were able to balance the effect of the economic downturn and the competitive environment. We achieved good growth in the retail channel of DSD. The slight volume decline of four-tenths of 1% in DSD came from lower foodservice sales.

Looking more closely to Flowers retail sales results, our total branded market share continues to grow. In the quarter the total US segment category as reported by IRI was relatively flat in dollars with a slight increase in units compared to first quarter of 2009. IRI also reported that private label, our store brand which I know has been a lot of concerns to many of you, was actually down in units and dollars compared to the previous quarter.

The data from IRI shows that in our core markets Flowers brands increased 30 basis points from 24.4 to 24.7% share of dollars from the first quarter of 2009. As a reminder, IRI captures only about 48% of our sales.

Our internal data shows a more complete picture of the growing strength of our brands. Once again, across our product categories, white bread, a soft variety, buns and rolls and the breakfast category, our brand performed nicely. The only section was the premium white pan breads, which we did not promote as much as last year.

Our growth continues to come from our number one brand, Nature's Own. Whitewheat our healthy white bread from Nature's Own also continues to contribute to our growth.

Now turning to our Warehouse segment. We continue to post good sales and earnings increases in the segment. Volume in the quarter was down 4.5% primarily the result of an economic impact of the foodservice category and the vending business in our cake business. Our foodservice sales continued to perform in line with the market, but below our expected sales volume. As the economy improves we are poised to take advantage of opportunities in the foodservice business.

On a positive note from the warehouse segment, our Mrs. Freshley cake brand performed well during the quarter. I'm especially pleased with the progress we are making with the distribution and sales of Mrs. Freshley, in fact Mrs. Freshley is now Flowers Foods number two brand in sales and is outperforming the market.

A few other highlights of the quarter. We continue to strengthen our position in expansion markets. In the quarter these markets contributed just over 1% to DSD sales, which is in line with our goals for market expansion. I am pleased to report that we began distributing our Nature's Own brand in the Indianapolis market July 20th. This adds an additional million consumers who can now purchase Flowers products.

Our new Bardstown, Kentucky bakery is performing well and yields us bread capacity to expand our DSD [sales] further into adjoining states. As we have said previously, we will be adding a bun line in Bardstown early next year. The immigration of Wholesome and ButterKrust is right on schedule. The Phoenix bakeries and the Lakeland bakery are now fully integrated into our financial and operating systems. We're making good progress following the introduction of our Nature's Own brand in the western markets.

I am pleased with addition of our new mix plant in Cedar Rapids, which we acquired in May. This operation will be a good asset for product innovation, which remains one of the ways we set our brands apart in the marketplace. As you can see that, we had a busy and productive second quarter.

Now, Steve Kinsey will give you more detailed report of our financials. Steve?

R. Steve Kinsey

Thank you, George and good morning. Sales in the quarter increased 13.6% compared to last year's second quarter. While the sales growth was driven by positive price and mix of 4.7% and acquisitions contributed about 10.6%. As George said, volume was down in the quarter about 1.7% and this decline came primarily in the non-retail channel in our foodservice and vending segment. Overall, we did maintain our share in our core retail markets.

The GAAP earnings per share in the quarter were $0.33 compared to $0.26 per share in the second quarter last year, and this was a 27% improvement year-over-year. As you will see included in our second quarter EPS is an approximately $0.02 gain related to the acquisition of Cedar Rapids mix plant.

The fair value of the assets acquired exceeded the purchase price, so under recently inactive accounting rules we had a gain on the acquisition as a result of recording the assets at fair value. Also, last year's second quarter did include about $0.01 related to the closure and sale of Atlanta snack facility and the receipt of some insurance proceeds. Excluding these items in both years, earnings per share grew about 24%.

Operating income in the quarter increased approximately $12.5 million or 34.4% over last year's second quarter. As a percent of sales the operating margin was up 130 basis points at 8% compared to 6.7% last year. Excluding the gain from the acquisition operating income would have been approximately $45 million - $46 million or up some 26% over the second quarter last year and as a percent of sales would have been roughly 7.5%. Acquisitions excluding the debt service costs and related amortization were accretive in the quarter about $0.01.

Gross margin was up in dollars $34 million or 13.7% over last year's second quarter. However, the gross margin percent as a percent of sales at 45.7% was flat. As we have said, the margin was negatively affected in the quarter by higher ingredient costs. We achieved approximately a 130 basis point improvement in selling, distribution and admin expenses in the quarter as a percent of sales compared to the same quarter last year. This improvement continues to be driven by distribution and administrative efficiencies quarter-over-quarter.

Net interest income in the quarter did decline approximately $2.50 million and this was due to higher interest expense resulting from the debt related to last year’s acquisition. You will note the effective tax rate for the quarter was 36.6% as compared to last years 35.7%. This increase is primarily due to the result of having favorable discrete items in last year’s second quarter that were not present this year. The second quarter rate, however, is tracking with our forecasted full year rate.

Now let's take a look at our segment. DSD had a strong quarter. Sales in the DSD division increased 15.1% driven by increases in price and mix of 3.4% and acquisitions of 12.1%. As George stated volume was down approximately four-tenth or 1% in the quarter primarily due to the economic impact on our foodservice business.

Branded sales in the quarter however were up as a result of good growth in our soft variety and branded white bread categories as well as our acquisitions. Private label increases in the quarter were primarily due to the 2008 acquisition, which as you may recall had a larger share of private label sales.

Our operating margin in the DSD business was up 70 basis points in the quarter at 9% compared to 8.3% a year ago. The DSD operating margin improved approximately 26% and the gross margin for DSD was down in the quarter about 70 basis points, again related to the impact of the higher ingredient cost.

Our Warehouse group posted sales increase of 7.1% driven by pricing mix of 7.8% and acquisition growth of 3.8%. As George mentioned there was an acquisition of a mix plant during the quarter. Volume in the quarter was down 4.5% primarily the result of declines in foodservice and vending.

The operating margin for the Warehouse group in the quarter was up 480 basis points on a GAAP basis. If you exclude the gain on acquisition the operating margin would have been up approximately 200 basis points. Our gross margin in the warehouse segment also was up some 200 basis points as well, moving from 25.6% to 27.7%.

Moving now to our balance sheet. We believe our balance sheet continues to remain strong. Our operating cash flow in the quarter was also very strong at $55.6 million. Our uses of cash remain consistent from quarter-to-quarter and during the second quarter of 2009 we spent $13.3 million on capital expenditures, $8.8 million on asset acquisition, paid dividends of $16.1 million and repurchased approximately 285,000 shares at $6 million under our share repurchase program.

Now, turning to our updated 2009 guidance. Taking into consideration considering pressure on the economy, the consumer and the competitive landscape, we did adjust our 2009 sales forecast, and just as a reminder of 2009 is a 52-week year versus 53 weeks in 2008. We will also lap the 2008 acquisition early in the third quarter and also lap a significant portion of our 2008 pricing initiatives late in the third quarter and some into the fourth quarter.

Sales are now expected to grow at a rate between 9.7% and 11%. Based on these growth rates sales should be $2.65 billion to $2.68 billion. Acquisitions will account for 6.5% to 7% of the growth with organic growth contributing 3.2% to 4%. For the year, net income excluding the gain on the acquisition is expected to be 4.8% to 5.1% of sales.

Earnings per share also excluding the gain on the acquisition should be $1.37 to $1.48, an increase of 7% to 15.6% over 2008. The EPS number is calculated using an average of 93 million shares outstanding. Included in our earnings assumption is an additional $7 million or so an improvement in input costs in 2009 over 2008.

This improvement is above what we had last forecasted in our last call. We are now forecasting input costs, ingredients packaging and natural gas to be up approximately $45 million to $46 million year-over-year, and just as a reminder these cost increases exclude the effect of the acquisition. We're still forecasting an improvement in gross margin in the back half, however we do anticipate pressure on the full-year gross margin year-over-year.

Now I'll turn it back to George.

George Deese

Thank you, Steve. I have total confidence in Flowers Foods ability to deliver good results in 2009, as our guidance indicates. The way I see it, we face tremendous headwinds in the first and second quarters due to input costs. Now in the third and fourth quarters we will have tailwinds as our input costs improve, and we should continue to benefit from those tailwinds as we enter 2010.

So looking at 2009 as a whole, when the year is complete, I feel that we will certainly be stronger operationally. Our DSD footprint will be larger. Our balance sheet will continue to be sound and strong, and we will deliver record sales and earnings is my belief.

Let me conclude my prepared remarks by reminding you that at Flowers we view business as a marathon, not as a sprint. Our bakeries are the most cost efficient in the industry. Our distribution network is the most efficient and the most effective. Looking back over time, we have proven that we take care of our customers with products, service, and value that help them meet their goals.

We have proven that we deliver quality products at a good value for consumers. Most importantly, our team understands this business and we have consistently demonstrated the organizational discipline that's so important for navigating through these very difficult times. We have proven over time that we deliver shareholder value through stock appreciation, dividends, share repurchases and capital investment.

Our growth strategy remains unchanged. We will continue to grow in our core markets and the expansion markets. We will build new bakeries to support that growth, and we continue to see opportunities for bolt-on acquisitions that fit strategically with Flowers Foods. Our Management team has the talent and ability to manage top line growth with quality earnings growth. We do all of this in a consistent and predictable manner, which we call "The Flowers way."

Before I open for Q&A, sometimes I'm asked, what is the most often question you're asked during the quarter, and I'll stop and name one or two. I always get questions about private label. Is private label taking over the bakery department like it is some other categories in the supermarket? And I've repeatedly said that private label units and dollars are pretty flat and I've always said for the past several years that it's a material category, and I do not see private label gaining that much more market share in the future.

I also believe that a lot of other categories have been underdeveloped and other categories are seeing big growth outside of the bakery category. I'd also say that due to competitive activity and more price promotions, that has probably been an effective tool. Yes private label of this form, and we did see that late in the first quarter and continuing into the second quarter and continuing to see that today.

I've been asked about the economy and how we think that will affect our business. The wonderful news is we're in the foods business, specifically we're in the bread business and bread seems to sell good times as well as bad times. Foodservice as you all know, people can eat at home and when tough economic time comes, when recessions hit seems like people do consume more food at home and buying direct from the supermarket.

Cake also can be impacted, even though we've not seen that much impact in the cake business. We have seen impact as I mentioned earlier on the vending business due to a lot less vending machines in the United States, which I believe is true. A lot of less vending machines in schools and of course factories, we certainly do not have [I mean] the factories today as we have had.

As far as the economy in our general market, I would say that all of you are aware that Florida and Arizona is one of the worst hit situations from housing equation and certainly foodservice business is off in those markets, because I feel that we didn't have the traffic that went into those markets this particular season. Hopefully we'll see that improve as we get through the year.

Those are some of the basic questions I get day in and day out and Claudia, I will now turn it over to you for questions from audience.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is coming from Farha Aslam with Stephens Inc. Please state your question.

Farha Aslam - Stephens Inc.

Congratulations on a good quarter.

George Deese

Thank you.

Farha Aslam - Stephens Inc.

George, you talked about promotional activity continuing, but could you just give us some more detail on how the depth of promotions progressed as the quarter went on versus last year?

George Deese

Sure. I'd also like to take just a minute to say from a more of historical viewpoint. Historically when the recessions do come, having been in the business 45 years, I've seen a few. And that's (inaudible) when the recessions come, a lot of times commodities do go down during recession. A lot of times not only bakers, but other food makers will promote their product because they are afraid they are going to lose volume during that recession.

So I think this time is no different. In the next recession you'll probably see the same thing. But in the first quarter, we did see [white] bread being promoted, we did see soft variety bread being promoted and the breakfast category being promoted, different [companies], different times. That pretty well, I did say, I saw a little heavier activity, maybe a little different deeper price cuts, heavier promotions at the end of the second quarter.

As we go into the third quarter, it looks like commodities are certainly leveling out of this period in time, but we need to remember commodities, and even though commodities are down, speaking specifically of wheat, from that 8 to 850 category, we will probably wait when it gets to 8 and 850. It's because most of the time we are not having a recession, the market is booming. The market is booming and then the food industry does not, will not promote as much during those boom times as they do in the tough times. I think that's what we are seeing. As we go through the rest of the year, I would think that we will continue to see price promotions until we see the economy begin to pick up and get stronger.

Farha Aslam - Stephens Inc.

Okay. And in terms of IDC's reentry into California, has that effected your growth in that market at all?

George Deese

I would say not.

Farha Aslam - Stephens Inc.

And so you continue to target sort of 10% of the market over the next three to five years?

George Deese

Farha, that is a big number. We will be gratified to get to that point. I would say in California we are putting on routes weekly and where expansions are going nicely, and we just have to see how the consumer and the retailer accepts our service quality and value.

Farha Aslam - Stephens Inc.

Okay.

George Deese

So I feel good about California.

Farha Aslam - Stephens Inc.

Perfect. In terms of your commodity hedges, they were adverse in the first half. Do you feel pretty good about your commodity position going into the second half versus the market?

George Deese

Steve, I'll let you handle that.

R. Steve Kinsey

Yes, [I think as far as alluded] to the back half. We are covered now for the rest of the year. All major input costs so we're very confident with our cost structure and that's why we're confident with the guidance we have out there and we will see as the hedges roll off, or roll into new hedges, we will see our costs begin to decline in the back half. So we won't disclose the level but as I said in my comments we did expect another $7 million or so improvement year-over-year in our input costs and a large part of that is coming in the back half so that gives a lot of confidence in the back half.

Farha Aslam - Stephens Inc

My final question, I'll pass it on is acquisitions. Kind of how robust is the acquisition pipeline and what's alluded in the M&A market?

George Deese

We're very excited and we have our line in the water and fishing real hard. I can say although that, lot of companies are waiting for the economy to pick back up before they might want to sell, because it has been a difficult situation and earnings may not be as strong so therefore they might not use much for the business, but we're very active. And historically we've grown by acquisition and we will continue to grow by acquisition and organically as well. So we're excited about the opportunities.

Operator

Our next question is coming from Mitch Pinheiro with Janney Montgomery Scott. Please state your question.

Mitch Pinheiro - Janney Montgomery Scott

Just sort of following from Farha's question on the West Coast, and you said you feel good about California, and 10% share is a big number. But let me just ask, isn't Baltimore, Washington which was a Greenfield market for you, you're in a double-digit share situation there. Is that correct?

George Deese

Mitch, I can't specifically say that, because I don’t have the number before me, but we've been real pleased with our Northern Virginia and entry into to that market.

Mitch Pinheiro - Janney Montgomery Scott

So how big, have you looked at, what is the market size for fresh bread in the markets that you're in Southern California? Have you looked at that?

George Deese

Mitch, I don't have the number on top of my head though. But I can certainly give it to you offline, but it is a big number.

Mitch Pinheiro - Janney Montgomery Scott

Okay. Is there any competitive set or distinction between Baltimore, Washington, Northern Virginia market versus Southern California that would be anything different competitively?

George Deese

I'd say the biggest difference would be the retailers would produce more of their own product.

Mitch Pinheiro - Janney Montgomery Scott

In the Southern California market?

George Deese

Yes.

Mitch Pinheiro - Janney Montgomery Scott

Okay.

George Deese

As you well know basically in the South and North there's not many captive bakeries left, but there are still several in California.

Mitch Pinheiro - Janney Montgomery Scott

Okay. That's helpful. In terms of how many routes do you have out in Southern California now? You said you're putting them on weekly.

George Deese

Mitch, we don't give out that number for competitive reasons but we started this actually last September and it's been gradual ever since.

Mitch Pinheiro - Janney Montgomery Scott

Okay. And then in terms of your comments regarding competitive landscape, being part of the issue as far as staying somewhat conservative in your guidance for the second half. So it's clearly, private label you are not that concerned with, so what is it? Is it just, you just expect that the economic pressures to see your competitors staying aggressive on price or is there anything else that's out there?

George Deese

I think the number one thing that concerns me is the economy and specifically I think, I worry about foodservice and every article you read, not just our numbers but every article you read, people are not eating out as much as they were.

Mitch Pinheiro - Janney Montgomery Scott

So it's really a foodservice issue?

George Deese

It is a foodservice issue, but also from a competitive standpoint on retail. As I said earlier when the economy is tough, most time commodities go down and the food makers do not care for, not give away too much in that, but by the way there is a great article in the Wall Street Journal, I believe yesterday talking about when companies offer promotions, discounts, probably the promotions, they too often ignore the impact of the other products they sell, that can be true for the bacon industry or any other company and for the retailer.

There is always a warning for the retail side of the business just because I might have something on promotion and I'd say it's going to be a huge increase, that may be true but then we take that the resale will impact of the whole bakery category and what we might be having on the total margin consequences. And as a baker, when I promote, we look at it as the total category. What effect does this specially have on the total, not what effect it has on the one-item we're promoting. So, we all have to be intelligent, smart, study the facts, study the numbers and make our own individual decisions.

Mitch Pinheiro - Janney Montgomery Scott

Okay, George. Two more questions. In terms of I can't recall, you said I think your expansion markets were up 1%. Is that correct?

George Deese

Yes, that's correct.

Mitch Pinheiro - Janney Montgomery Scott

I mean, you don't include Southern California or Phoenix or anywhere else as an expansion market right now. Is that correct?

George Deese

Correct. If you'll recall in the last call we gave you, it was roughly up and slightly below a percent, although those markets in this quarter, Mitch is about six-tenth of a percent if you pull out the Nature's Own growth or what we would consider more organic growth.

Mitch Pinheiro - Janney Montgomery Scott

Okay, so …

George Deese

So, we're still turning nicely between 0.5% to 1%.

Mitch Pinheiro - Janney Montgomery Scott

Okay. The 1% is just sort of excludes that, correct? So we're going to see at some point those expansion markets, that the western markets be included in your organic growth numbers. Are you going to transition that somehow in August, when you do that?

George Deese

Right, that I will transition this quarter when we lap the acquisition.

Mitch Pinheiro - Janney Montgomery Scott

So, would you consider increasing your forecast on organic growth from expansion markets as a result of that or how do you view that?

George Deese

Mitch, we just have to analyze it as we go.

Mitch Pinheiro - Janney Montgomery Scott

Okay.

Mitch Pinheiro - Janney Montgomery Scott

If we don't have anymore markets that we speed up or slowdown that pattern, and have more success in California than less success of some of it will hinge on different factors.

Mitch Pinheiro - Janney Montgomery Scott

Okay. Last question is in your DSD operating margin, or your [secondary] operating margin was 9%, which gets you back to the same levels you had in the '05-'06 period, which was actually below some of your even your earlier 2000 second quarters. I think you did in the mid-to-high 9% earlier in the decade. I was curious how you view the 9% operating margin this quarter. Is that still below your potential due to, you still had higher costs in this last quarter, you're sort of back to normal almost. So how much more head room do you have?

George Deese

I'll let Steve answer specifically, but as we go into the future and its commodities do moderate which looks like they are. We'll certainly, we feel like hopefully as we go in the future not rest of the year as Steve indicated, but hopefully gross margins will improve and we do a great job continuing on [SD&A] which therefore yields a good result.

R. Steve Kinsey

Mitch, looking at the back half again, we do expect cost improvements, input costs and we're continuing to lever the [SD&A] line very nicely. I hope it continues the run rate we've experienced, but we do expect it to be strong for 2009 as well. And also like most companies we have some cost savings measures that we're working on and we're seeing those start to come to fruition and that will also benefit the back half and going forward, so we think we can continue to drive some improvement there.

Operator

Our next question is coming from Tim Ramey with D.A. Davidson. Please state your question.

Tim Ramey - D.A. Davidson

George and Steve, I'm just seeking some clarification. I think George you mentioned tailwinds in the second half and I think I just heard Steve say a minute ago that commodity prices might improve or maybe just overall costs. But earlier in the year, I think you did mention that the rate of commodity price increases in the second half would moderate but they would still be up. Could you clarify just isolating for the moment on commodity costs in the second half?

R. Steve Kinsey

Yes, if you look at our, at the full-year, Tim, we had said costs will be up roughly now, and the number is 45 or 46 million. Majority of that has and has come to fruition in the first half. So as we move into the back half it will begin to decline. So we are expecting improvement in the back half.

Tim Ramey - D.A. Davidson

But it still is up year-over-year?

R. Steve Kinsey

Our year-over-year costs will still be up. But the magnitude will not be as dramatic in the back half as the first.

Tim Ramey - D.A. Davidson

And the SG&A trends have been really good. How do you feel about that going forward? I think it was in the third or fourth quarter last year where you started to see some improvements there related to new distribution centers and so on.

George Deese

Tim, I'll start out and Steve, you can follow it up. Part of our goal as we build these new plants, new bakeries was to really get them focused on where the people are, and we've been successful in doing that. When you do that naturally you take out an awful lot of tractor trailer expense in miles and fuel, et cetera.

Also though, [our barb], I give credit to our independent distributors and the great job they are doing in the marketplace. It continues to be a wonderful strategy. And Steve did mention that, we are down like we've had great improvements last two years. Can we get some more next year? We haven't given any guidance on that yet, but we continue to get more efficient as we go. As we know retailers nor consumers will pay us for inefficiencies. So we're striving to daily take out the cost out of that distribution system and the manufacturing process, not quality again increase productivity.

Tim Ramey - D.A. Davidson

So, George, when you mentioned there were tailwinds in the second half, where you thinking about more internally generated things or externally things the external items that we may not be thinking about?

George Deese

Well, Tim, you've been in this business. The reason I said we had the headwinds going to the first half of the year, I think the whole world knew our commodity costs were too heavy, so I felt all, I was pedaling upstream. We all were pedaling upstream, but doing it, we navigated that so good I think and I want to give our management team credit for navigating a tough situation.

So, as we're now on the other side of that, so he did indicate commodity is still up year-over-year but it's such a better picture on the back half that's what I mean by tailwinds. I don't feel like I'm swimming upstream anymore, I'm beginning to swim downstream.

Tim Ramey - D.A. Davidson

Got you. And just a clarification for Steve, did you say that the acquisitions were accretive before financing costs or did I get that wrong?

R. Steve Kinsey

Excluding the debt service and the intangible amortization they were accretive about a penny, that really on that kind of an operating.

Tim Ramey - D.A. Davidson

Is that the way you look at acquisitions excluding debt costs?

R. Steve Kinsey

Yes.

Tim Ramey - D.A. Davidson

Okay. Do you know what they would be if you put a cost to capital on them?

R. Steve Kinsey

Would be slightly dilutive.

Operator

Our next question is coming from Eric Katzman with Deutsche Bank. Please state your question.

Eric Katzman - Deutsche Bank

I guess a couple of questions. The first one is I think George, you referenced that IRI showed the category as flat in I think unit and dollar terms but that only measures about half. Can you give a little bit more clarification on what you think the category was doing including the non-measured outlook?

George Deese

To make a most accurate measure of Flowers would be our internal numbers. We feel that our packaged bread [wins] actually went up 4.5% in our core markets. So I think overall, the dollars were flat to up slightly. There was not enough unit volume increase to in my mind as a total, all companies competing, even though units did go up some dollars did not offset those reductions is the best way to say that I guess.

Eric Katzman - Deutsche Bank

So, basically, you're saying that including the alternative outlets, so looking at the whole category, volumes were kind of flat, dollars were flat because promotion was up and offsetting the prices that the category had put in, but your dollar sales were up like 4.5% so you gained share in dollar terms.

George Deese

Right.

Eric Katzman - Deutsche Bank

And in unit terms you also feel like you've gained share?

George Deese

No. We were off slightly on unit shares.

Eric Katzman - Deutsche Bank

But that includes the foodservice?

George Deese

No, I'm looking strictly at retail.

Eric Katzman - Deutsche Bank

Okay.

Marta Turner

Very slight.

George Deese

Very slight decrease.

Eric Katzman - Deutsche Bank

Okay.

George Deese

So I feel like the overall category, when your all out is involved and that's a guess, that probably units like say it could be up 1% to 1.5%.

Eric Katzman - Deutsche Bank

Okay.

George Deese

The dollar is flat to up very slightly. That would be my best guess.

Eric Katzman - Deutsche Bank

And on the last Sara Lee call, Brenda Barnes was talking about irrational promotion in the category and I think, you know, I don't know whether it's just interstate bakeries now out of bankruptcy, or if it's some of the captives also let's say behaving badly. But just specifically on IBC, it seems like their effort to put the Nature's Pride brand out there hasn't met with success. They've lost some distribution in private label. So what do you think is kind of their staying power to continue to be as aggressive if they're the primary driver of the more aggressive promotional environment?

George Deese

Eric, when they were public you could see all the numbers. Obviously we see zero numbers today, because they're private. I really, I can't answer that. I said all the time they are a tough competitor, and only they could determine what the cost and price and earnings should be, but as I look at the last quarter our overall price was up as you know and we lead that market I guess last October. So, we know where we are but I just can't predict how they're doing.

Eric Katzman - Deutsche Bank

Okay. And then I guess, looking out in terms of the input cost environment, you know where you are for '09, but I think you said that you're likely to see lower input costs into 2010, and I guess is that just because you're already hedged a bit or is it because you just think that the wheat market primarily is going to remain low because of good supply relative to demand or what have you?

George Deese

Eric let me say it this way. If you look at the cost of wheat today as compared to last Summer's activity and today is down considerably, still not anywhere close back to norms, and there is a lot of wheat, every forecast we see there is a lot of wheat. So there's no reason unless funds take over or something else takes over that we see that wheat should stay in this moderate level.

We have not decided, one we're not giving guidance for next year. Number two, I've not decided because it seems like when we signal what our hedges and costs are that too many people know it, and seems like it might have been taken advantage of a little but we will address that as we get closer into the year and start giving guidance, but I just feel like commodities will moderate and we'll have a good headwind continuing through the year next year.

Marta Turner

Tailwind.

George Deese

Tailwind, I am sorry. Yes and that’s for sure Marta. A tailwind going in to the year, because of the moderation of the commodities.

Operator

Our next question is coming from Heather Jones with BB&T Capital Markets. Please state your question.

Heather Jones - BB&T Capital Markets

Just wanted to follow up real quick on Eric's question, just further clarification on the input cost going into '10. I understand you don't want to talk about where you may or may not be hedged, but is it a fair point that given where wheat is currently that that would be if your costs were locked in around this level that would be a very good tailwind on a first half year-on-year comparisons in '010?

R. Steve Kinsey

You make it tough, Heather, because we haven't put any guidance out yet, but I would say if you look at where wheat is trading now and you look at what our costs were in the first half. So there, as George said there is a pretty big tailwind headed into next year.

Heather Jones - BB&T Capital Markets

Okay. And then I was wondering you'd mentioned the promotional environment in late Q1 across white, soft variety, breakfast breads et cetera. And then you had accelerated in late Q2. Is that in all those categories or has it become more concentrated in a certain category?

George Deese

I'd say it's still pretty well across the, of course during the summer you had more bun activity and there is less of that now because that season is basically over.

Heather Jones - BB&T Capital Markets

Okay.

George Deese

It's also based on maybe what season you're in or what holiday you are going into that would also help determine that, but I'd say basic white bread has probably been the most competitive.

Heather Jones - BB&T Capital Markets

Okay. And then finally on the foodservice commentary, just wondering, that's been weak for sometime, but have you seen further deterioration there? We're starting to arguably go against easier comps as far as the declines in casual, et cetera, but it sounds as if you're seeing further deterioration there. I was wondering if you could speak to that.

George Deese

Well I'll say one thing. For sure speaking of the Arizona market, of course we didn't have Arizona last year during the heat of the season. We of course we have been celebrating about a year now with the Phoenix operation, but we didn't see those numbers prior to the fact even though we had due diligence. But that market you can really see people did not go to Arizona like they did last year and just as season comes on this year, I be able to answer that better, as it gets cooler out there we'll have a better indication. And in Florida, we really didn't see the foot traffic in Florida and that's a big part of our foodservice as well and I think that had to do with the economy.

Heather Jones - BB&T Capital Markets

And what about, I understand those are two big foodservice markets, but what about your other markets, Mid-Atlantic, further North of Florida?

George Deese

I'd say it wasn’t drastic, but it still was not up to expectations.

Operator

Our next question is coming from Ann Gurkin with Davenport and Company. Please state your question.

Ann Gurkin - Davenport & Company

Just wanted to start with, if you could give us a picture of the back-to-school level promotions, market expectations?

George Deese

Back-to-school is almost a year around school it seems like now. Used to as well started Labor Day, Monday after Labor Day, but that’s starting here now basically around August 1st. So short summer season, but we did see people getting back on when they've been on vacation. I did tell our group as we talked yesterday, I feel a little more optimism, few more people seem to be shopping now, so little more activity. But as far as back-to-schools promotions per se, there’s already a lot of promotions out and we didn't do anything extra from that standpoint.

Ann Gurkin - Davenport & Company

Okay. And then within your, well kind of the year. Can you help me understand a little bit better what to expect for price mix in the second half versus the first half of the year? Are you little concerned that pricing is going to slow, or you have to give back pricing? Can I get a little bit more understanding of that component?

George Deese

Sure, just looking at kind of at the breakout, I really won't talk about it, half versus half but now looking at our projection for the full year. Price mix probably Ann will be 3% to 5%. We're targeting volume kind of flattish, because it will be the direction and then acquisitions as we said in the press release 6.5 to 7.

Ann Gurkin - Davenport & Company

Okay, that helps. Thank you. And then any update on the expected pace of innovation in the back half of the year?

George Deese

We're excited about the back half of the year on innovation. I can't comment beyond that, but we've got some new things coming.

Ann Gurkin - Davenport & Company

Right, that sounds great. Thank you very much.

Operator

Our next question is coming from Bill Chappell with Suntrust Robinson Humphrey. Please state your question.

Bill Chappell - Suntrust Robinson Humphrey

Just a clarification. On the full-year sales number or on the second half sales number is it largely being lowered just because higher promotional activity affecting the reported or the net sales or is it some change to volume?

R. Steve Kinsey

It's the combination. I'd say the promotional activity as George said was getting deeper as we move to the second quarter and we see that continuing through the back half and then because we are stuck with our pricing strategy in the first half we did have some slight volume declines, but most of the volume came from foodservice and we just see a lot of pressure continuing in that category. So it’s a combination of volume and some pricing, but probably more volume related to foodservice and vending than price.

Bill Chappell - Suntrust Robinson Humphrey

Okay.

Steve Kinsey

But you'll have to weight the two.

Bill Chappell - Suntrust Robinson Humphrey

You said you're going to lap the price increase in October. I assume that means you're not looking at any increases that you normally have going in for next year?

George Deese

We're continuing to look and the marketplace will decide that, Bill. Can't comment beyond that, but at this point I don't see a lot of activity on that. We'll just have to see. We had planed some increases for October, and small but in fact we still have some price increase that’s going on different contracts and different things that come up on occasions, but not an overall standpoint of which we had last year.

Bill Chappell - Suntrust Robinson Humphrey

Okay. Then one final kind of big picture question. As you look at the overall category and at private label with bread being a way to stretch your wallet and private label certainly seeing customers trade down. Are you surprised by the IRI numbers both for private label and the category not being faster growth or is this what you would have expected?

George Deese

See it's really what we expected, because there was already so much here. It already has 25%, 26% in dollars and I believe the number is probably 40%, 42% in units and it is material category. Whereas other categories might have a five share, that's where you'll see the growth, not bread in my opinion.

Bill Chappell - Suntrust Robinson Humphrey

And also to take us through the total bread category, I mean, I've seen cereal, you’ve seen pasta, some of the other cheaper center of the plate items grow. You just think bread is just so mature, it doesn't have that incremental kick?

George Deese

I do believe that's true.

Operator

Our next question is coming from Akshay Jagdale with KeyBanc Capital. Please state your question.

Akshay Jagdale - KeyBanc Capital

Hey, so couple of questions. I'll start with your outlook and George, you talked about tailwinds. You lowered your cost guidance by about $7 million to $8 million and based on what we see, we don't know what your internal expectations were, but earnings were better than consensus estimates this quarter of about $0.02 or $3 million at the EBIT line. So, I see that you have this sort of $10 million to $11 million basket and then the headwind is lower sales, which is $70 million to $85 million you reduced your guidance by which if you assume like an EBIT margin of 7% that translates into $5 million to $6 million in a headwind for the back half.

So, I'm just trying to understand why you did not raise guidance for the full-year. So maybe help me understand that. I know there is a lot of uncertainty regarding promotional activity and volumes, but just help us understand that part, please?

R. Steve Kinsey

Sure, this is Steve. I think if you look at, we were comfortable leaving the guidance where it is, Akshay. I think there is still a lot of uncertainty in the market and the economy is still under a lot of pressure. We think we've taken the appropriate actions and we have our strategies in the back half for the category, which we think we know very well, that we think we can regain some volume, continue to build our share. But overall I think there is still a lot of volatility and uncertainty in the marketplace and until we get a little better sense on how that plays out, which I think we will by the end of the third quarter. We just felt it was best to leave the earnings guidance where it is.

Akshay Jagdale - KeyBanc Capital

Okay, that's helpful. And just to clarify on the reduction in your sales guidance, you reduced it by 2.4% to 3% from my estimates most of that, 1.5% to 2% is due to lower expectations on volume. So, I know you've been talking a lot about promotions, but it seems to me that the lower guidance for sales is more volume related than pricing. Can you just confirm that?

R. Steve Kinsey

Yes. Lot majority of the volume decreases came in the foodservice category as well as the vending channel. And I've said if you look at the new guidance roughly 3% to 5% is pricing flat volume, which can move in either direction depending on how some of our programs work and then acquisitions of 6.5 to 7. So, I think you're looking at it right that a big part of the change isn’t related to volume and primarily in the non-retail channel.

Akshay Jagdale - KeyBanc Capital

Okay, that's helpful. And then just going back to acquisitions, in your last earnings call, you said acquisitions were $0.02 accretive excluding debt. I know Tim asked you a question similarly, but I'm just trying to understand what the implications or the impact of your acquisitions have been on gross margin, because you have flat gross margins this quarter and since these acquisitions started to flow through on average your gross margins are down by about 60 basis points year-over-year.

I know that most of the times when you acquire these businesses, they have slightly lower gross margin profile especially given the mix of these two businesses that you bought. Can you just tell us year-to-date what these acquisitions have meant in terms of a direct (inaudible)?

George Deese

I will [start with that] let me go first and then Steve will follow it up. Number one, we're extremely pleased with these two acquisitions. Really excited about what they brought to us. On the specific question by gross margin Steve will have that, but you’ll recall that Lakeland was heavily weighted to private label and a different distribution system, which does change the gross margin somewhat, and also as we said early on that Phoenix had a heavier weight of foodservice and private label. The retail in our [instance] is certainly maintaining and growing the foodservice and private label out there, but really the big effort will be on the retail side so that we can improve the gross margins out there. So Steve, I don't know the exact number that…

R. Steve Kinsey

Okay. Yes Akshay, looking at gross margin we are pleased that incremental dollar improvement, but looking at from a percentage perspective I'd say it's probably about a 30 basis point drag on the margin or so, somewhere between 30 and 50 basis points.

Akshay Jagdale - KeyBanc Capital

On the consolidated margins?

R. Steve Kinsey

Yes.

Akshay Jagdale - KeyBanc Capital

Just this quarter or …

R. Steve Kinsey

Year-to-date.

Akshay Jagdale - KeyBanc Capital

Year-to-date since you acquired …

R. Steve Kinsey

And I think that's what we had forecasted and we might have even talked about that at some point when we made the acquisition.

Akshay Jagdale - KeyBanc Capital

Okay. That sounds a little lighter than what we had once discussed, but I know you've said that in the past. I'm just trying to get a sense of over time, you've been able to integrate these acquisitions very well, and I'm just trying to get a sense of this earnings stream that may be coming back, right?

R. Steve Kinsey

Right, and I don't think this is any different. We're very pleased with how the integrations are going, except for the blip in the economy here with the pressure on everyone. I think you can expect to see these acquisitions perform like what we've seen in the past as we finalize the integration and lapped it in August and move forward.

Akshay Jagdale - KeyBanc Capital

And then just lastly on SM&A, I think you surprised a lot of people with the leverage there, especially this quarter, you know its almost close to 35%, 35.3% if I'm not wrong as a percent of sales. When you look at that line longer-term, I mean, first off, this year you had said you are expecting about a 50 basis point improvement year-to-date you're up about 100 bips.

Can you just help me understand for this year, what do you expect on SM&A leverage going forward, and then longer-term if you look at your algorithm where you've said 12% EBITDA margins. If you assume that you can maintain that 35% SM&A to sales that implies gross margins of only 47%. So I'm just trying to get a sense of how much of sustainability is there in that SM&A number that came in this quarter.

R. Steve Kinsey

I think as the rest of the year plays out, I think we'll continue to lever on that and we might be a little heavier than what we've originally forecasted just because we've seen reasonably good improvement. And then also in fuel, fuel has come down quite a bit so the distribution costs were benefiting there as well. And then we continue to generally underestimate our ability of SAP and the administrative leverage that we get from that as we just continue to integrate the acquisitions there as well.

So, I do think you know we may come in a little higher than the original projection and then I think also as we move looking out into the future, I think we will continue to be able to lever that line some, it probably won't be at the level you've seen in the last year and this year, but I do think there's still room to lever that. I think a lot will depend on some things out of our control like fuel costs. As I said earlier, we do have cost savings measured like most companies that have kicked in because when you start seeing sales number come in like you expected then you start finding other ways to deliver your earnings. So I think you can expect to see us to continue to lever that line.

Operator

(Operator Instructions). Our next question is coming from David Leibowitz with Horizon Asset Management. Please state your question.

David Leibowitz - Horizon Asset Management

Few brief ones you mentioned there are potentially one million customers in the Indianapolis market. Given the capacities you have in place, how many of them can you actually serve?

George Deese

That was one million consumers in that metropolitan market David, that’s what I meant. As you know, we've got a new plant in Bardstown, Kentucky and I believe the distance is to get to that area is roughly 150 miles or so, so it's certainly within our 250 mile reach, we always talk about. So we do have capacity to serve that market and do a great job in it. And we're adding a bun line as we mentioned, we'll be installing that equipment late this fall and start-up manufacturing probably next April or so.

David Leibowitz - Horizon Asset Management

To enter that market given that there is some rather well established competition. Are you going to have to fight price and couponing or is there anything special or unique to this market that you're facing?

George Deese

David, I don't see anything unique or different. As we move further in those markets you have more independent bakers there, they do a good job and that would be the only thing different than we would see in the South and Southwest. And I think the competitive factors will have to be the same.

David Leibowitz - Horizon Asset Management

Okay. Turning to acquisitions, you indicated that you are in conversation. Can you give us some idea of the size of the companies you are speaking to or the size of the bakery units you might be acquiring if things go your way?

George Deese

David, from a competitive standpoint I can't tell you. But if you look at the landscape, and see that 250 miles, 300 miles that we keep talking about outside of our existing markets, you'd see the size of the companies and they are, we call them bolt-on but they would be more of the size of sale of ButterKrust in Florida to a Phoenix size.

David Leibowitz - Horizon Asset Management

Okay. And lastly as a follow-up, what sort of balance sheet would you like to have if in fact you can make these acquisitions? Where is your debt level satisfaction?

George Deese

Well, our Board, we are always looking at leverage on what we would be comfortable with. As you know, we're very conservative, and we wouldn't be comfortable with 3.5, 4, 5 times leverage. We’d be comfortable 1, 2.5 times or so. But, another thing we have here would be the real value of another currency called Flower stock and we've been able to use that in a good way to merge other companies in with Flowers, not using cash but using this currency.

David Leibowitz - Horizon Asset Management

So, then it would be a potential transaction were it large enough, you are willing to swap stock for their operations?

George Deese

I can't comment on that for the future. You just have to look back at what we've done in the past David and make your own assumption.

Operator

Our next question is coming from Tim Ramey with D.A. Davidson. Please state your question.

Tim Ramey - D.A. Davidson

Just a follow-up on the second half volume outlook. If I'm doing my math right it looks like over four quarters, you're averaging down a little bit less than half a percent on volume, just coming from the core business. It's a little bit more than that like 0.6% down first half. I know the quarters aren't created equal, but given that you have the 12-week versus 13-week situation in 4Q, so you are going to lose 7% or 8% volume there unless something is odd that I don't understand. How can you come up with, I mean what confidence do you have that says organic volume could be 3% or 4% in the second half if we are going to hit the targets of minus one to plus one on volumes?

R. Steve Kinsey

Well, I said volume could be on either side or flat. I didn't say that we're down about consolidated about four-tenths of a percent this quarter I believe. I mean 1.7%, so we had like I said we have programs in place that as they work with what we think, we should gain some of our volume back, but again that remains to be seen, but that's what's built into our guidance.

Tim Ramey - D.A. Davidson

Okay. So in essence, programs yet to be revealed that will offset the impact of the shorter year?

R. Steve Kinsey

Well, let me promise I wouldn't go into new programs per se.

Operator

The next question is coming from Eric Katzman with Deutsche Bank. Please state your question.

Eric Katzman - Deutsche Bank

Hi, I also want to ask a clarification on the second half, but the acquisition contribution, Steve that you have now incorporated, I think that that might be a little bit lower than what you were talking about earlier, maybe somebody asked this question, but is that the impact of foodservice in the new markets?

R. Steve Kinsey

Yes, you are correct Eric. The foodservice market has been soft in Arizona, as George said that's been the harder hit.

George Deese

In Florida as well.

R. Steve Kinsey

In Florida, so that's playing into our forecast for the back half.

Eric Katzman - Deutsche Bank

Okay. And then kind of as a follow-up to Tim's question, the 10% to 11% sales growth that you're now forecasting for the full year, that includes the 2% hit from the 53 versus the 52-week? Correct?

R. Steve Kinsey

Correct.

Eric Katzman - Deutsche Bank

So the volume number that you're talking about is exclusive of the volume of the 52 versus the 53-week. Like you're capturing that impact in the 2%?

R. Steve Kinsey

Yes.

Eric Katzman - Deutsche Bank

Okay. So that's why when he's asking, you know are volumes going to be, the comp is going to be down 7% in the quarter?

R. Steve Kinsey

[No]. Okay.

Operator

I'm showing we have no further questions at this time. I'd like to turn the floor back over to management for any closing comments.

George Deese

Thank you, Claudia, and to all of you on the phone thank you for joining our call today and for your continued interest in Flowers Foods. Our strategies are all working. We have been innovative with our products and brands and our team is experienced and determined to win everyday in the marketplace. Again thanks for your confidence in Flowers Foods. See you next quarter, thank you.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your line at this time and we thank you for your participation.

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Source: Flowers Foods, Inc. Q2 2009 Earnings Call Transcript
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