Meg Nollen - Vice President, Investor Relations
Bill Johnson - Chairman and CEO
Art Winkleblack - EVP and CFO
Ed McMenamin - Senior VP Finance and Corporate Controller
Terry Bivens – JP Morgan
Jonathan Feeney – Janney Montgomery Scott
Alexia Howard – Sanford Bernstein
Ed Aaron – RBC Capital
David Driscoll – Citi Investment
Chris Growe – Stifel Nicolaus
Rob Moskow – Credit Suisse
Eric Katzman – Deutsche Bank
Bryan Spillane – Bank of America
Andrew Lazar – Barclays Capital
H. J. Heinz Company (HNZ) F2Q10 Earnings Call November 24, 2009 8:30 AM ET
(Operator Instructions) Welcome everyone to the H.J. Heinz Company Fiscal Year 2010 Second Quarter Earnings Release Conference Call. I would now like to turn the call over to Meg Nollen, Vice President, Investor Relations.
I’d like to welcome everyone to our conference call and webcast. Copies of the slides used in today's presentation are available on our website at www.heinz.com. Joining me on today’s call are Bill Johnson, Chairman and CEO, Art Winkleblack, EVP and CFO, and Ed McMenamin, Senior VP Finance and Corporate Controller.
Before we begin with our prepared remarks, please refer to the forward looking statement currently displayed. This is also available in this morning's earnings release and in our most recent SEC filings.
To summarize, during our presentation we may make forward looking statements about our business that are intended to assist you in your understanding of the company and its results.
We ask you to refer to our April 29, 2009, Form 10-K, and today’s press release, which lists some of the factors that could cause actual results to differ materially from those in these statements. Heinz undertakes no obligation to update or revise any forward looking statement whether as a result of new information, future events or otherwise, except as required by securities law.
We may also use non-GAAP financial measures in our presentation as the company believes such measures allow for consistent period to period comparison of the business. The most directly comparable GAAP financial measures and reconciliations of these non-GAAP measures are available in the company’s earnings release as well as on our website at www.heinz.com.
Please note we plan to file our second quarter 10-Q by the end of the day today. Our related financial highlights pages or stat pages will then become available in the Investor Relations section of the website towards the bottom of the page.
During today’s call, Bill will review Heinz strong financial performance, our upgraded fiscal ’10 outlook and recent consumer trends. Art will then review the remaining 5 C’s, our financial performance during the quarter and a quick year to date update. Then of course we’ll all be available to take your questions. We’d like to request that you limit your questions during the Q&A session to one in order to ensure adequate time for all those who wish to participate.
Now with the formalities out of the way, let me turn the call over to Bill Johnson.
Its a pleasure to join you to discuss our solid second quarter financial results and our upgraded outlook for fiscal 2010. Additionally, I will share a few insights on how consumers seem to be adapting to the new economy and how their pursuit of value is shaping the competitive landscape in our industry.
Consumers are the fulcrum of the 5 C’s that we frequently refer to at Heinz and they are at the heart of our plans to drive our great brands and accelerate our growth in emerging markets. Consequently we are continuing to intensify our focus on delivering premium quality, innovation and new products that drive even better value for consumers.
Looking first at our results, on a continuing operations basis Heinz deliver 2.5% growth in reported sales, 6% growth in operating income, and earnings per share of $0.76. Total company EPS of $0.73 reflects the sales of a small non-core food service business in the quarter which Art will discuss when he covers discontinued operations.
Importantly, on a constant currency basis we grew sales by 3.5%, operating income by more then 10% and EPS from continuing operations by almost 16%, reflecting continued organic growth in our top 15 brands, the benefits of carry over pricing, improved productivity and strong performance in emerging markets.
Heinz also generated exceptionally strong operating free cash flow of $293 million, that more then doubled from a year ago. Our strong focus on cash continues to produce excellent results while providing Heinz with increased balance sheet flexibility. Importantly, it has also enabled Heinz to deliver dividend growth of almost 56% since fiscal 2004, a compound annual growth rate of almost 8%.
Emerging markets where we are well positioned, continued to be a primary growth engine for Heinz as our 12% organic sales growth in the second quarter confirms. India, one of our catalysts in emerging markets delivered 26% organic sales growth in the second quarter, led by strong sales of Complan and Glucon-D nutritional beverages, two great examples of our company’s health and wellness emphasis. We are opening a new factory next month in India to support the growth of these brands which is being fueled by product innovations and increased marketing focused on children’s health.
Latin America was another growth driver in the second quarter with 38% organic sales growth led by higher sales of Heinz Ketchup and baby food. I’m particularly encouraged by our trajectory in Mexico, a relatively new and promising geography for Heinz with more then 100 million consumers and the ninth largest ketchup market in the world. Our team in Mexico has achieved a record ketchup share of 12% according to Nielsen after a little more then a year on the market.
I’m also encouraged by the early success of our wet baby food launch in Mexico where we are growing share after investing in a new jarred baby food line in Guadalajara that began production in the first quarter. Heinz baby food and Heinz Ketchup have won the important exclusive endorsement of the Mexican Pediatric Association.
Turning to Europe, Russia continues to perform well with 16% organic sales growth in quarter two driven by a higher volume of ketchup and baby food. With expanding distribution in the world’s second largest ketchup market, our solid relationship with McDonald’s and aggressive marketing, the outlook for Heinz ketchup and sauces in this still largely untapped growth market is very encouraging.
We have recently added new ketchup capacity at our Otradnoe factory outside of St. Petersburg and are planning further investments in our Georgievsk baby food factory to sustain our rapid momentum in infant nutrition. Importantly, Russia delivered the highest ketchup value share growth in Europe, complementing Heinz ketchup sales growth in virtually all of our top European markets. Of note, our European ketchup sales grew more then 10% organically in the quarter.
Overall, emerging markets generated 15% of the company’s total sales in the second quarter as well as year to date and they remain well on track to deliver approximately 20% of our annual sales by 2013 more then double their contribution of five years ago. No one of Heinz size has the breadth or capabilities in emerging markets that we possess. We have proved our ability to growth both organically and through external investments in these markets using a buy and build strategy focused on expanded distribution, new product launches and strong local marketing expertise.
Turning now to our three global core categories; infant/nutrition delivered 8.7% organic sales growth in the quarter on a the strength of new products and innovation. Ketchup and sauces grew 3.7% and Heinz built share in a number of key markets. Today, Heinz ketchup’s strong number one positions in seven of the top 10 global markets including the US, Canada, and the UK. In our meals and snacks category, organic sales of Ambient meals like beans and soup increased 5.1% but frozen declined 9.7% reflecting a difficult year on year comparison and a global trend of consumers spending fewer dollars in the frozen category.
Our top 15 brands delivered almost 2% organic sales growth led by higher sales of our hallmark Heinz branded products and Complan which has grown so rapidly that has recently become the third emerging market brand in our top 15 list joining Pudliszki in Poland and ABC in Indonesia. Overall, Heinz delivered organic sales growth for the 18th consecutive quarter, led by our dynamic growth in emerging markets.
Across our portfolio, pricing up 4.6% offset lower volume of 4.1% in the second quarter, a subject I would like to address. The volume results, while not at all satisfying, did reflect a difficult comparison versus the second quarter fiscal 2009 when US retailers drove significant volume growth in North American consumer products behind the heavy buy in ahead of quarter end price increases. Volume in this year’s quarter also reflected the continuing decline in US restaurant traffic and its consequent impact on our food service business.
During the first half of the year we strategically focused the company on profit and cash to protect us from the credit crisis and the strains in the economy, as I said we would at both our Cagney and May year end updates. However, given the stabilizing consumer environment and the economy, we are modifying our plans in the second half to drive the volume and market shares of our leading brands in developed markets as well as continue our rapid growth in emerging markets.
Importantly, we expect meaningful volume growth in the third quarter supported by actions that are already underway. We are significantly increasing marketing investments in the second half of the year, particularly in North America and Europe, while accelerating new product activity as well. Globally, we anticipate marketing will increase at least 15% this year compared to fiscal 2009. to provide further perspective, this means that our marketing investments will have increased by more then $130 million over the last four years or almost 50%. Our increased investments underscore our commitment to driving profitable growth and volume.
We have launched several exciting new marketing initiatives to drive growth in the US and the UK for the second half. The US team, for example, has recently launched an aggressive consumer value program or CVP as we refer to it. The cornerstone to this program are coupons that reward loyalty to Heinz, selective price point adjustments that are more attractive to cost conscious consumers, targeted media, increased point of purchase and in store marketing, and increased new product activity, particularly in frozen. With this campaign underway we expect mid-single digit volume growth in our North American consumer products business in the back half of the fiscal year.
In the UK meanwhile, Heinz has launched our largest marketing campaign in that key market in five years. The campaign is called “It Has To Be Heinz” and it is designed to efficiently and effectively support the entire Heinz family of products. This comprehensive focused initiative is off to a very strong start and the early results are indicating significant volume and share lift in the Heinz basket, including ketchup, soup and beans.
New Zealand has just completed the most successful marketing initiative in its history of partnership with one of the countries two largest customers. The joint promotion featured over 400 Wattie’s products and drove not only our share but our customer’s business as well. Innovation that delivers quality and value will be key to growth in this changing environment.
Heinz introduced new products like our value sized 44oz jars of classical pasta sauces in the second quarter and we have a robust pipeline of new products including value size packages of Ore-Ida french fries and our projected launch of Ore-Ida sweet potato french fries planned for early next year. We will discuss specifics on these and other initiatives at Cagney.
Overall, our goal continues to be to strike an optimal balance between pricing, promotion, productivity, profit, and volume, with increased marketing support and investments, stronger commercial plans and a heightened focus on value oriented innovation for consumers.
Based on our strong financial results to date, the improving currency climate, our continued momentum in emerging markets, and the benefits we expect from our second half marketing activity, we are increasing our full year earnings per share outlook to a range of $2.72 to $2.82 from continuing operations versus our original target of $2.60 to $2.70.
We are also significantly increasing our outlook for operating free cash flow to approximately $1 billion versus our original target of $850 to $900 million, and we still expect constant currency sales growth of 4% to 6%.
Please note that our increased outlook for the full year is for continuing operations which excluding the divestiture of a small non-core business in the second quarter as well as other potential small non-core divestitures this year, like the sale of our private label frozen desserts business in the UK which we completed yesterday.
Now that I’ve shared a brief overview of the second quarter and our outlook I want to spend a few minutes on the consumer environment. The prolonged recession has clearly affected consumer behavior particularly in North America and Europe. High unemployment and the specter of further job losses continues to negatively impact consumer confidence and purchasing patterns.
For example, US unemployment in October, as all of you are well aware, climbed above 10% for the first time since 1983 and the jobless rate in many European nations remains very steep as well. Even though the global recession appears to be abating there’s no question that consumer and customers remain intensely focused on value which they are more often defining as price. Consumers in particular are looking for bargains wherever they shop for food and household items.
From my perspective, several trends in the competitive landscape are worth noting. First, retailers have clearly felt this pressure as well as benefits from some softening in the commodity environment. In response they have sought to entice thrifty consumers with a broader array of private label offerings and low prices. They have also seized on the growing trend of at home dining by expanding their focus on the deli and chilled departments as well as prepared take home foods.
These areas are growing rapidly which is why we have increased our presence in the chilled category in a few select markets with products like Renee’s Dressing in Canada, La Bonne Cuisine Dips in New Zealand and Arthur’s a small chilled smoothies business in Canada which we acquired yesterday.
It is also clear, however, that the growth of private label is slowing as consumer confidence picks up, opening a window of opportunity for trusted brand name leaders like Heinz that are focused on quality and value. The private label trends also foster the emergence of more aggressive activity from second tier brands that have been chasing volume at the expense of category development. Strong brands like Heinz Wattie’s as we have just shown are adapting to this new environment in many ways, including partnering with major customers to drive category growth for Heinz in our retailers.
As I said earlier, we are nimbly adjusting our plans in response to the new consumer trends and changes in our markets and we are taking action to invigorate our categories and further enhance our strong brand equity. In the US I’m proud to say that Heinz once again ranked first in customer satisfaction among food manufacturers for the 10th consecutive year in the University of Michigan’s American Customer Satisfaction Index, which was announced last Tuesday.
Heinz has now achieved the highest customer satisfaction score in the food manufacturing sector every year since 2000 an accomplishment that reflects the consistently high quality and taste of our premium brands, our commitment to innovation and food safety and our strong insights into what consumers expect when they purchase Heinz products.
In the UK, Marketing Magazine recently reported that consumers ranked Heinz as the most loved food brand in that nation for our ketchup, beans, and soup sold strong number one share positions. Importantly, Heinz was among the very few brands ranked by consumers above store brands that also appeared in the top 10, affirming the consumers preference for our tradition of quality and value.
In summary, Heinz delivered strong first half financial results and we are raising our full year outlook for EPS and cash. With our strength and faster growing emerging markets, substantially increased marketing and innovation in effect to consumer programs in place for the second half I’m confident that Heinz will deliver our key targets for the year and enhance our track record as one of the world’s best performing global food companies.
At this time I’m going to turn the presentation over to Art to provide you with more details on the second quarter.
We’re pleased with our second quarter performance and I’m happy to provide the detail behind Bill’s summary remarks. Given the changing environment in which we’re operating, I wanted to give you the three key perspectives on company performance for the quarter. These include:
Total Company reported results
Continuing Operations on a constant currency basis
Total company reported EPS was down $0.14 reflecting the $0.18 mark to market gain on currency hedges in Q2 last year and the impact of discontinued operations this year. Pealing back the onion, you can see that EPS from continuing operations was down $0.10 which again reflects the impact of currency changes and the hedge gains last year. We believe that the results from continuing operations on a constant currency basis are the best indicator of the health of our business and from this angle our results are up nearly 16%.
During the quarter we reported a $0.04 loss from the sale of Kabobs, a small non-core business from our US food service operation. We’re pleased to have completed this sales as we streamline the focus of our food service operations. We continue to assess opportunities to prune other small non-core businesses that could help us further simplify our global portfolio and in fact just yesterday, completed the sale of our private label frozen dessert business in the UK. These and other potential small divestitures are not expected to have a material impact on the ongoing profitability of Heinz.
Earlier, Bill mentioned the 5 C’s and now let’s take a look at one of them; currency. Currency continues to be very volatile but the good news is that most foreign currencies have rebounded from the low levels we were seeing back in March. The Euro and Aussie and Kiwi dollars are actually stronger in Q2 this year then they were in Q2 last year. While the UK pound, our most important foreign currency, is still weaker. As an aside, we see a similar story on some of our other currencies as well. The Canadian dollar is up year on year while the ruble, Polish vloty and Indonesian rupiah are still down from Q2 last year.
As you know, the cross-rate between the UK pound and the Euro has been a big factor in our UK results over the last 18 months or so with the unprecedented divergence of those two currencies. The good news is that the pound is improved from its intra-day low versus the Euro of .98 in December but the spot rate is still at about .89. Focusing in on the Heinz Effective Rate in Q2 which includes the impact of hedge positions, you can see from the stair step increases that this remains a headwind. For the quarter, this year on year pre-tax cost increase was about $13 million.
With that as a backdrop, let’s turn to our P&L scorecard. Focusing in on continuing operations we had a very strong quarter. On a reported basis sales were up 2.5%, gross margin increased 60 basis points, we increased consumer marketing at a double digit rate and operating income advanced 6%. Only EPS dropped, and again that reflects the overlap of last year’s currency hedge gains. On a constant currency basis the results are even better and particularly better at EPS. I’m pleased that we delivered these results while recently ramping up our marketing investments to help drive more top line growth in the second half of the fiscal year.
As we’ve done for the last few quarters, here we’ve laid out the dynamics of the currency changes as they rippled through our P&L. Overall, currency affected the year on year comparatives by $0.22. The impact of currency translation on current quarter results was small only $0.01 while the pound/Euro cross-rate hurt EPS by $0.03. The larger impact obviously relates to the prior year currency hedge gains of $0.18 which had been adjusted out of the prior year base here to get the two years on an apples to apples basis.
Turning to the P&L, I know this is a busy chart but there are a few items to note here. SG&A costs remained under tight control and in line with our plan up only 1% during the quarter. The net interest and other line included the $92 million mark to market gain on currency hedges last year and our tax rate was 300 basis points better then prior year reflecting tax planning and the settlement of tax audits during the quarter. Year on year this helped EPS for the quarter by $0.03. We now expect our full year tax rate to be at the low end of our previous estimate of 28% to 29%.
As Bill mentioned, in Q2 we delivered our 18th consecutive quarter of organic sales growth against a very tough comparison. Our volume growth was impacted by about two points from the timing of pricing taken in the US and UK at the end of the second quarter last year. Almost another point of our volume decline came from the US food service business which faces an environment of continued declines in restaurant foot traffic.
Offsetting the volume decline we’re still seeing the benefits of carry over pricing from last year. Acquisitions primarily reflect the addition of Golden Circle business in Australia and as discussed foreign exchange was slightly unfavorable.
Organic and constant currency sales outside the US increased during the quarter while retail and food service sales in the US were down. North American consumer product sales would be nearly flat for the quarter excluding the sizeable impact from the buying ahead of pricing last year. US food service sales, while down slightly, are very favorable when compared to the rate of decline in restaurant traffic. We’re confident that our innovation pipeline, marketing initiatives, continuing momentum in emerging marketing, and better year on year comps will drive positive volume in the second half of the year.
Importantly, we expanded our constant currency gross margin by 100 basis points in Q2 which included more then 200 basis points of productivity savings. Overall, we’re making good progress on supply chain productivity through our global supply chain task force initiatives, project keystone and effective efforts across our business units. Notably, the first implementations of our global indirect procurement system went live this quarter in the US and we plan to keep rolling from there.
Another of the 5 C’s is Commodities. Net costs for these inputs were up 4% in Q2 a lower rate of increase then we’ve seen in recent quarters. Improved trend was driven by procurement productivity and lower costs in some commodity categories such as resin, oils, and dairy. Transaction cross-rates drove more then half of our total inflation, the remaining increase largely reflects higher costs on tomatoes, potatoes and tin plate.
We’re pleased with the performance of all of our segments from a profit and cash flow perspective. On a constant currency basis all reporting segments generated higher profits during the quarter. Reported results for continuing operations were also up for all segments with the exception of Europe which was about flat, but you can see that if you exclude the impact of currency translation and transaction Europe’s operating income was up almost 15%.
Of note, US food service posted another quarter of strong profit growth, as the team continues to drive simplification and process improvement while introducing new product and packaging innovation in the core business. This is a very healthy performance in an industry facing a tough economy and lower customer counts.
Our balance sheet performance was also strong this quarter. We continue to effectively manage capital spending which was below 2% for the quarter some of which reflects the timing of projects. We expect higher capital spending in the back half of the year but will continue to manage it closely. We generated a major improvement in our cash conversion cycle this quarter. CCC came down by seven days and I’m particularly encouraged by the six day improvement we achieved in inventory levels.
Our focus on cash this year has been very effective and we have more then doubled operating free cash flow this quarter. This primarily reflects improved working capital and lower capital spending which was only partially offset by higher net contributions to our pension plans.
Let’s take just a quick look at year to date results. For the first half of the fiscal year EPS on a like for like basis has grown by nearly 13% versus last year. This excellent start to the year has been driven by higher constant currency operating income and favorable interest and taxes.
Year to date P&L scorecard shows the broad based strength of our first half. On a constant currency basis sales are up more then 4%, gross margin is up, operating income has grown by almost 8% and EPS rose approximately 13%. This was accomplished while increasing our marketing investment by about 9%. I’m happy to say that so far this year we are meeting or beating our full year constant currency targets on the key lines of the P&L.
For the first half, the year over year currency impact has been $0.34. Adjustments for the year are comprised of $0.09 for the currency translation, $0.06 from UK transaction cross-rates, and $0.01 for currency translation hedges executed this year. Again, we have adjusted the prior year base by $0.18 to set aside the impact of currency hedges executed in FY09.
For the first six months of the fiscal year our balance sheet metrics are moving in the right direction as well. CapEx is running well under last year’s some of which is timing but it also reflects sound management. CCC is better by four days, importantly days in inventory has improved by five days. Operating free cash flow has more than quadrupled to over $400 million. Net debt to EBITDA is up slightly reflecting the overlap of the hedge gains in EBITDA last year. After tax ROIC is up 10 basis points to 17.6%.
As Bill said, today we’re updating our outlook for the full fiscal year that ends on April 28th. We’re increasing both ends of our EPS range by $0.12 or almost 5% to reflect our strong start for the year, improved foreign exchange, and good business momentum as we look to the back half. Importantly, while our increasing outlook we are also significantly increasing our marketing and brand support. Additionally, we are raising our cash flow target to approximately $1 billion. Expected increase from prior year primarily reflects improved working capital management.
We are holding to our constant currency continuing operations sales growth target. We believe we have strong programs in place that will drive volume growth in the back half and we believe that the most difficult comparison periods are behind us. We also expect quarterly EPS to be relatively balanced between the two remaining quarters.
In summary, we’re pleased with our strong performance this quarter and for the first half and are looking forward to continuing momentum in sales, cash, and earnings.
With that we’d like to take your questions.
(Operator Instructions) Your first question comes from Terry Bivens – JP Morgan
Terry Bivens – JP Morgan
I wanted to draw you out just a little bit if I might on this whole business with the consumer. Particularly as we look at the better for use segment of frozen foods that’s where you operate with Smart Ones and Lean Cuisine and Healthy Choice. The numbers show the category basically just hit the wall in January and has been just tracking steadily down. The worry there would be that given a lot of this merchandise is premium priced if you could help us a little bit with how you would intend to attack that and get some better results out of the frozen segment.
I think as you look at our results for the quarter if you were to back frozen out of our results for the quarter our organic sales were up between 4% and 5%. Clearly we’re wrestling with the frozen issue and predominantly that is the United States. In terms of Smart Ones, we have been fairly disciplined, I think, and it really held our patterns, we watch this category decline and we watched our peers chase the decline in the category. Having said that, we are getting far more aggressive in the second half of the year and our marketing spending on Smart Ones will be up about 40% in the second half of the year.
Oriented towards basically our heavy user so we’re going to do a lot of couponing against heavy users. Medium, particularly print, we’ve got a few new items coming that I’m not going to talk about today, I’ll announce more details about it at Cagney. I think we have six or seven SKUs being launched in the spring to address particular segment opportunities.
The reality is that the category is fighting the prevailing trend of the consumer. The consumer is not buying “for me” products as we’ve talked in the past. As a consequence we’ve been extremely reluctant to jump in aggressively and simply chase the category down. Its like trying to throw a life boat on top of the Titanic. We do think the category as it hits this winter will level out a bit given the impending diet season, given the bad comps year ago and so as a consequence we’ve made a decision to invest aggressively in the second half as I said with marketing up about 40%.
Additionally, we’ve be increasing our D&A spending to bring better price points. The one thing that we have found interesting is the enormous footballing going on in this category with brands offering 6/$10 and in some cases 10/$10 and so forth. We’re going to try to avoid as much of that as we possibly can but we factor it into all of our numbers a far more aggressive approach to Smart Ones in the second half. Fundamentally we still need to be concerned about the category and address a lot of our efforts to bringing new consumers back into the franchise which is what our plans are aimed to do in the second half.
Your next question comes from Jonathan Feeney – Janney Montgomery Scott
Jonathan Feeney – Janney Montgomery Scott
I wanted to follow up a little bit on the increased promotional activity. I guess specifically I was wondering what role the food retailers are playing, some of the stress they’ve been under. On one hand they want to attract more consumers with value but on the other hand it seems to me that higher basket size, higher total dollars is something that’s a concern of theirs. At the margin do you think that food retailers are driving this more promotional activity or is it really that a little bit of buyer seeing deals other places and driving that and forcing the food manufacturers to play along?
I don’t think anything has fundamentally changed in the 35 years I’ve been in this business. I think fundamentally its always been a retailer, manufacturer contest to see where the money goes either directly to the consumer or back to the retailer. I think we’re not seeing anything different other then the pressure points created by private label and the reaction from the second tier brands where I think most of the pricing pressure is coming from, as the retailer tries to bring consumers into the store.
I think you’re also going to see more partnership, much as we did in New Zealand with our partnership with one of our customers we put more then 400 Wattie’s products on an initiative that our retailer basically split the cost with us on it to try to bring consumers in the store. If you remember in New Zealand we do almost 7% of the total grocery sales in that market so it had a huge effect not only on us and our shares but it actually lifted their business significantly.
I think what retailers are trying to find are things that generate foot traffic. I also think retailers are trying to take advantage of the continuing erosion in away from home consumption and so they’re looking for opportunities to bring categories or products back into the store that will attract those consumers.
I think the third thing is that the market itself in terms of the consumer manufacturers I think when the markets turned down last year I think all of us began to focus more aggressively on value and I don’t think we’ve all done the job on innovation that we need to, to continue to excite and entice consumers and frankly our customers in order to bring news to the category. You’ll see that change in our plans in the second half of the year.
The pressure points come from a combination of things. Obviously you’re seeing some deflation in some commodities, not all but some commodities are declining. You’re seeing a concerted push by the private label manufacturers to take advantage of what they see as a window of opportunity. We’re seeing a reaction from the owners of second and third tier brands who are doing everything they can to maintain their shelf space in basically a period when we’re looking at SKU rationalization across a number of retailers.
Finally what you’re seeing is the consumer that is trying optimize their shopping trips. Consumers are picking brands very carefully and in marrying those brand with either associated private label products or other products. The thing I caution everybody on in private label, there is no doubt that the private label trend is slowing, it is still a significant trend globally but it is slowing. You have to remember that the basket of goods that private label shares are built around include a lot of areas where the brands don’t compete and the brands don’t participate, particularly towards the front of the store in the US and UK in the chilled section.
I think its combination of pressure points. I think all the changes over a period of time those pressure points take on added urgency depending on the pressure point. Right now I think price is probably that pressure point.
Your next question comes from Alexia Howard – Sanford Bernstein
Alexia Howard – Sanford Bernstein
I want to switch over to gross margin and the outlook there. One specific point and then maybe more of a general question. On the Golden Circle acquisition I know that next quarter we get into the point where it might be less of an issue for margins. Could you quantify how much of a hit that was this quarter and how that’s likely to change going forward? More broadly, given the outlook for commodity cost inflation and productivity improvements, do you see any changes to your current outlook for the year for the gross margin for the rest of the year?
We’re doing well on gross margin so we’re pleased with the performance on that so far. As we look forward we do think that there will be some moderation in some of our commodity costs. We do still see the same headwind from tin plate and tomatoes and potatoes that we mentioned. As we look forward we do think gross margin will be a bit better and will be up to prior year so I think we’re in line with or better then the plans that we laid out from a gross margin standpoint.
The Golden Circle impact is give or take because its not precise, I would say around 20 or 30 basis points for the quarter. I don’t think you’re going to see a substantial turn in that business short term because we’re still in the process of moving after synergies, we’ve got the two manufacturing facilities in Australia that we’re working to upgrade. We’ve just signed a deal with Ocean Spray to represent them in Australia so we’re making some capital investments in both the Mill Park and the Northgate factory in Australia.
The other thing is we’ve launched two new items in Golden Circle; one called Raw which is a product of the original juice company and the other one is called LOL which is a short name for Laugh Out Loud which is a fizzy drink directed towards children. You’re going to see us continue to invest pretty aggressively as we try to grow the top line there.
I think given the seasonality of the business and given what’s happened to commodity costs I think it’ll be another six to nine months before we start seeing meaningful improvement in margins on Golden Circle. That was pretty much factored into our thinking.
Your next question comes from Ed Aaron – RBC Capital
Ed Aaron – RBC Capital
I wanted to get a quick clarification on the guidance. Was there any change to your constant currency operating profit or EPS assumptions for the year? How do the divestitures affect the full year numbers?
We’re on track for our constant currency numbers so we’re feeling good about that. As you saw, we’re off to a good start there for the first half of the year and expect solid results in the second half as well. That piece of it in line with expectations.
In terms of the divestitures, whatever divestitures come will end up being in discontinued operations so sort of a set aside from continuing ops which is what we’re focused on. The key there that you need to be aware of is that any of these divestitures that we might do will not have a material impact on ongoing profitability of the company and that’s why continuing operations is the appropriate measure.
Ed Aaron – RBC Capital
On the decision to ramp up the marketing spending, I know you talked a lot about how the external environment has thawed a bit which it makes you a little bit more inclined to spend. How much of its a function of the volumes maybe a little bit worse then what you might have expected over the last few months. The question more or less is when you look at the recent trends in the business how surprised were you by some of the volume pressure that you saw recently?
I don’t think we were surprised by the North American pressure because we knew we were comparing against a very difficult comp from last year. Food service actually surprised us on the upside a bit being down less than 1% organically given the foot traffic in that industry. There’s no doubt that one of the contributing factors to the decision to ramp up marketing has been the soft volume in Q1 and Q2 and you’ll see a dramatic change in Q3, Q4.
Factored into our range and into the organic comments that Art just made about constant currency marketing in the second half of this year is going to be up between 25% and 30% at a minimum. That just includes consumer marketing, we’ll also expend a little more D&A that’s factored all into our range as we continue to recognize three things.
One, the market is a little more receptive now, there’s no point in chasing consumers out the door. I think frankly that’s just a waste of money. Secondly, we are working on opportunities in terms of new products and some new initiatives we have in the second half of the year that will address the improving environment and frankly address some of the volume issues we’ve had in the first two quarters.
Third, some of our peers have gotten our attention with comments they’ve made to the market and to other people. While we won’t specify or name any of those peers, those peers have clearly gotten our attention and have maybe awaked some of our brand teams who have requested a little more support and a little more aggressive activity. The one thing I will say about marketing in the second half of the year, every single one of our operating businesses marketing will be up double digits in the second half of the year.
Your next question comes from David Driscoll – Citi Investment
David Driscoll – Citi Investment
I would like to probe a little bit further on the volume growth for the second half of the year. I’d like to ask the question a little differently then the others have asked. When you think about it and you think about new products, baseline volumes, or promoted volumes, the sense that I’m getting and I really want to make sure that I’m reading you right is that the large proportion of the increase in the back half of the year is to come from increased promotions. Is that the message today?
No, that is not the message. The message is we’re increasing marketing. You’ll see, for example, it will manifest itself on Ore-Ida and substantial increased in media. It will manifest itself in the emerging markets and substantial increases in media. On Smart Ones it will manifest itself in some pricing, some couponing, and some media. In ketchup it will predominantly manifest itself as additional consumer activity in terms of coupons and other activity directed directly at consumers and some pricing activity particularly on the 20oz size as we try to be more competitive with some of our peers and with our customers.
No, its a mixed bag and it basically fundamentally we started with ramping up our media efforts particularly in the UK behind “It Has To Be Heinz” a lot of that is media driven and a lot of it is store driven. Its a combination of both. With marketing up 25% to 30% at a minimum in the second half of the year that’s consumer marketing and D&A will be up as well. Fundamentally the focus is on driving sustainable growth not buying growth.
David Driscoll – Citi Investment
Can you make a comment on your interest expense guidance for 2010?
Interest expense has been relatively low in the first half. That will step up a bit in the back half largely because we had some income items and interest income. Interest expense is not as big a variability but less interest income in the back half. I think we’ve been averaging $60 million a quarter so in the first half that’ll be $10 million higher each quarter as we go forward.
Your next question comes from Chris Growe – Stifel Nicolaus
Chris Growe – Stifel Nicolaus
In relation to some of your comments about promotion when you started the year you were talking about a slight increase in promotion, something in the neighborhood of like 30 to 50 basis points. Can you give us a fell for where that may stand now for the year. Is it meaningfully higher then that or just a touch higher?
In the first half we’re right in that range. In the second half we’re going to be above that range. I think we’ll end the year probably, I’ll give you a range of say 70 maybe 80 basis points maybe even a little bit more depending on the opportunity. There’s no doubt that we’re ramping up D&A in the context of trying to get better price points. Just as importantly, trying to get better display activity tied in with some of our consumer activity. You saw that in the New Zealand slide, you saw that in the Heinz slide in the UK. We’ve gotten more display activity in the UK in the last 30 days then we’ve probably seen in the last 30 years, its been extremely remarkable.
We’re trying to marry it the best way we can with our consumer activity so that we optimize it. Some of its definitely going to price, particularly in brands like ketchup in the US we don’t need to do that in Europe where our ketchup business is really doing well. It’ll just be really up to how we determine the brands can benefit the most and how the operating company’s want to use the money.
Chris Growe – Stifel Nicolaus
Would you say the pressure on Heinz is in more from private label or more from these second and third tier brands that are keeping price points low for that so called thrifty consumer?
It depends on the category. Certainly in potatoes where we’ve had slower volume in the second quarter its private label. In ketchup its a combination of second tier brands and private label. In Smart Ones its all brands. Fundamentally the issue is interestingly enough everyone keeps being concerned about Western Europe, the issues have fundamentally been focused on North America. You’ll see North American’s spending up significantly in the second half as I just explained to David.
Chris Growe – Stifel Nicolaus
You started the year with a view that you’re going to pull out about $250 million of costs. Related to that I’m curious if you’re on track for that? Related to that are there any incremental costs you have to bring through the P&L to achieve those cost savings? Could we see some incremental costs in the second half of the year?
Yes, we’re well on track to deliver the productivity savings we’ve committed to and I think you can see the benefits not only in earnings but in cash flow. Its interesting to me, we haven’t had one comment about cash which more then doubled and has more then quadrupled through the first half. I guess maybe we think cash is more important then you do.
The other thing is right now in terms of how we look at the second half, we’re to date not planning anything dramatic that would require a break out from the P&L. We just continue to run our costs through the P&L as we normally have. The exception to that would be the divestitures related to discontinued ops and we have the two businesses that Art referred to the UK frozen business which we frankly have been trying to divest for a number of years and the Kabobs business. We’ll have a few more of those very small non-strategic and as Art said material impact to the P&L.
Other then that I think we remain well on track and I don’t think you’ll see any surprises in the second half of the year regarding any expenses on that area.
Your next question comes from Rob Moskow – Credit Suisse
Rob Moskow – Credit Suisse
I want to know if you could help us a little bit more on currency. What is the forecast now for the impact on the top line? My model shows 9% sales growth from currency in the back half of the year using spot rates. I think you guys might be a little bit more conservative then that.
The key thing to keep in mind is our largest and most important foreign currency is the UK pound. That, as you saw in Q2, is still 8% below where it was Q2 last year. Obviously we have the translation and the transaction impact as you go down through the P&L. Again, as you come back to our sales outlook we are on track with the constant currency sales out look that we gave at the start of the year, the 4% to 6% number is still right on track. We’ll see where currencies go from here.
We’ve got some of our currencies largely covered for the third quarter but fourth quarter is largely floating and so we’ve got some variability there and we’ll see where that goes from here. We’re basically letting the currency flow through into the range.
In the second half of the year I think we’ll be in line, ex the pound with whatever the currency impact it. I think you’ve got to remember the down currencies are hitting us hard too, not only the UK but the Indonesian rupiah that’s a sizeable business, the ruble and the vloty are also taking us down. We should be up commensurate with whatever the currency impact is say 6% to 8% right now which would factor in the decline in the UK. We’re going to be right on the constant currency number. If currency is worth nine it will be nine, if its worth five it will be five. We’re tracking right against that constant currency number.
Rob Moskow – Credit Suisse
Meg brought up an interesting point I think that the consumer has been shifting to lower sizes of packaging of some categories that you’re in, ketchup in particular. Even if its not a good value, because they’re only going to the grocery store with like $50 in their pocket they might have to buy smaller packages. Can you give me more categories that you’re seeing that in and how are you responding to that trend? You mentioned ketchup already but anywhere else that you need to respond to that, maybe potatoes.
We’re predominantly seeing that in ketchup and only in the United States because in Europe we addressed it by introducing a small milliliter product last year. I think in Europe you’ve seen in our 10% organic sales growth for ketchup. In the US if you look at our ketchup business about 35% to 45% of our share loss is related to what’s happened on small sizes.
Our large sizes continue to perform extremely well because the value perception on a relative basis versus private label and competitors is pretty good. As a result, where we are taking action on ketchup is on the smaller sizes to address the very issue you mentioned, price points.
On potatoes we’re seeing something entirely different. In our business, fundamentally is a two pound business in potatoes and we have a larger share in two pounds then private label does yet we’ve never been focused on large size potatoes which would be four pounds or larger. As a result, private label has about two thirds of that category, we have one third and we’re launching three SKUs in large sizes in the second half of the year to address that.
Part of that is because consumers see the economy associated with that large size. It really depends on the category and it depends on what consumers are looking for in terms of whether its side of the plate, whether its a condiment or a sauce, whether its a finish meal or a finished product. Fundamentally the only major business we’ve seen that trade down is in ketchup.
In our emerging markets we have a bifurcation occurring. We have people buying the premium sizes, the larger sizes, the middle class grows and in places like Indonesia and China we offer small very efficient, very inexpensive pouches so that somebody can buy a soy sauce pouch for example for less then a dime, I think its about $0.07 and then use that as a serving and the next time they go to the store they can buy another one.
We’ve pretty much hit that in the markets and the emerging markets in particular. Doy Pack Ketchup in Russia is another one that comes to mind where we take a different package and allow consumers to have their choice of buying down or buying up. In the US we’re looking at options that would allow us to address that trend but fundamentally the major business that felt impact on is US ketchup.
Your next question comes from Eric Katzman – Deutsche Bank
Eric Katzman – Deutsche Bank
Maybe you could help me bridge the gap on the new guidance versus the old guidance because its not exactly clear to me. I guess you got a penny or two from the lower tax rate but the higher interest expense is going to hit you by a penny or two. Related to the guidance, how much is a function of better currency, how much is a function of just improving core results, and is there any impact from the divestitures in terms of an absence of losses that those businesses were generating?
We’re pretty much flowing through the currency upside, the base business is on track as I mentioned.
Eric Katzman – Deutsche Bank
Is that $0.05 or $0.10, how much is that?
We took up the range both top and bottom by $0.12 so its around that range probably $0.12 to $0.15 or so. I’ve got to tell you we’re still early in the year, we’re half way through. What exactly foreign currency is going to be, who knows. We think we’re comfortable at that point. As Bill mentioned, we’re investing heavily in the businesses as we go forward. We feel good about the base business results, the constant currency results we’re on track to what we had said earlier in the year and oh by the way we’re investing even more then we had originally anticipated.
The way to look at it is we’re taking the currency and flowing it through and we’re taking the operating upside and reinvesting in the business.
Eric Katzman – Deutsche Bank
You didn’t talk about the volume fixed cost de-leveraging in the quarter as a negative to gross margins. I’m wondering was that a factor given the volume drop and how much should that help you in the second half assuming you achieve the mid-single digit volume performance in North America on the back of the higher promotion. How do I think about the volume and how that’s affecting the gross margins?
There’s a couple ways to look at this thing. One is to look at our inventory in the first half of the year. We took our inventory down dramatically and we’ve taken a fairly sizeable hit from lost absorption. In addition, we’ve taken a cash flow hit from payables because some of those payables change in context of what you’re doing to reduce inventories.
I think what we expect to see in the second half of the year is continued discipline on inventory because we’ve made a lot of progress and we’re not going to give that progress back. We should see some benefits on the absorption side and on the payable side in the second half of the year as volume comes back up.
Eric Katzman – Deutsche Bank
To your comment about cash flow, I don’t know if we had in the press release a full cash flow statement but with the extra cash flow and somewhat better liquidity globally in the market, are you buying stock back with the extra cash?
Eric Katzman – Deutsche Bank
What are you doing with it?
We’re hording it. What we’re doing with it is what we’ve always done with it, supporting our dividend, looking at bolt on acquisitions. We made a small deal in Canada yesterday I’m very, very small in this Arthur’s, a chilled smoothie business. It gets us into a rapidly growing category and another chilled category to tie in with Renee’s in Canada. We continue to look at bringing in our debt down.
Clearly, if we conclude over time and the tax laws change and so forth and there are opportunities to return to repurchasing stock as a way to create value obviously that’s certainly in our quiver. We’ll continue to look at it. Right now focus is on supporting the dividend, bolt on acquisitions like the small Arthur’s deal we announced yesterday, brining down debt, and in share repurchase will sort of be the swing vote in terms of other opportunities on the M&A front and on the dividend front.
Clearly giving us more flexibility though.
Your next question comes from Bryan Spillane – Bank of America
Bryan Spillane – Bank of America
A follow up on the cash flow, can you break out just how much of the working capital improvement came from the AR securitization?
There’s a lot of puts and takes and ins and outs but the way we think about the AR securitization was that we put it in place in order to offset the incremental pension contribution. If you look at our Q2 cash flow the pension contribution actually far outweighed the size of the AR securitization. Net, net the two netted to a negative for cash flow for the quarter. If you think about it, the real drivers come back to working capital and to capital spending, some of which is timing.
Bryan Spillane – Bank of America
The working capital improvement did include the trade receivable securitization or not?
In the first quarter we had a fair amount of asset securitization that we talked to you about. The second quarter it was very, very small and the pension fund far outweighed.
The big improvement is the six day reduction in inventories. The way we think about it is that AR securitization and pension largely are targeted to balance. As you saw in Q2 there was much more pension outflow then securitization inflow.
Year to date about $130 million of asset securitization of, about $220 million pension of which about $200 is discretionary.
In the appendix we’ve got our typical cash score card. We’re trying to keep our comments down.
Bryan Spillane – Bank of America
Curious to know how the currency situation in Venezuela is affecting your organic growth, I know you had 38% organic growth in Latin America. How much of that was driven by the inflation in Venezuela? The second is, in terms of getting cash out are there any steps that you’re going to have to take or you’ve taken already to try to get cash out of Venezuela given where the questions about the value of the currency?
On Venezuela I want to be careful what we say about Venezuela for a lot of reasons, some which should be rather obvious. In terms of getting cash out we have historically been able to bring dividends out of the country. Let me leave it at that. I think as a company that’s 2.5% to 3% of our sales it is a situation we’re watching carefully but I’m going to be very careful what I say for a lot of reasons including a concern obviously about our team down there and so forth.
A lot of the rest of world benefits came in other places also. Our Mexican business is doing extremely well. Our volume growth in Venezuela is very strong. Our businesses in the Middle East and South America continue to perform the way we expect them to. I’m not trying to skip the question, I’m trying to avoid a problem. There is no doubt that we’re watching the Venezuela situation very carefully as are almost every other multi-national company that operates there.
Bryan Spillane – Bank of America
Infant nutrition is one of your best growing, fastest growing businesses globally. Any thoughts there in terms of the potential to expand that business. Mead Johnson is now going to be an independent company. Any additional thoughts on how you see that industry playing out and how Heinz plays a role with a pretty attractive growing profit pool.
I will give you some generic comments but if you’re expecting me to put my right foot in my mouth to join the left foot that I occasionally put in there I’m not going to do it. On Mean Johnson I’m not going to comment. We continue to look for opportunities in infant feeding as well as our other core categories as the Arthur’s deal I think in Canada showed yesterday.
Places where we think we can drive disproportionate growth where we can create value over a period of time. We think infant feeding is a terrific category and its obviously one of our better performing businesses. We continue to want to add scale and we continue to get bigger. There are lots of ways to do that outside of a major transaction. I think there are plenty of opportunities around the globe that we’re looking at.
That’s still a very fragmented category particularly as you look at many of the emerging markets. Lots of ways to grow over time both organically and through acquisition.
And we’re very focused on shareholder value.
Your next question comes from Andrew Lazar – Barclays Capital
Andrew Lazar – Barclays Capital
I wanted to put some of comments you made around value and hitting the right price point for consumers in more of an industry context from your perspective. I realize it differs a lot by category and which category we’re talking about but generally speaking one of the concerns for the overall industry right now is while volumes remain kind of weak broadly speaking, food companies are going to continue to talk more and more about hitting value for the consumer, raising promotional spending and lowering price points and such.
The concern is does all of the progress that the industry made over the last year and a half around getting pricing through in relation to input cost inflation and all that, does it all dissolve into some bit promotional mess and we end up in a worse place then we were two years ago and volumes are still weak to boot because the consumer is weak. I want to make sure and put it in perspective and get your perspective on that. Is that way an overstatement relative to what you’re seeing out there, even though you clearly have to hit certain price points in certain categories?
Its going to be a balancing act. I think we’ve done a better job of virtually anybody in this industry of balancing that recognition with the reality of the marketplace. As a consequence we’ve been able to drive organic growth while maintaining our price and through not getting into the kind of situation you’re describing. Obviously its affected our volume a bit in addition to some promotion related timing that you can’t ignore related to price increases last year in North America on November 1st.
Having said that, I think the industry and I’ve been in this industry a long time, I think the industry needs to recognize that we worked very hard to get to the value position we’re at today and I think people ought to be continuing to focus on creating value for consumers in ways other then just price either through innovation that brings consumers benefits they aren’t getting in the other products, packaging changes that allows consumers to buy similar volumes or trade down into lower volumes at better price points or better value perceptions, media that delivers true meaningful messages much like our Complan media does in India and some of our new advertising in the UK does.
I think its going to take enormous discipline. My big concern frankly related to the industry, I do not think the industry is going to give back everything its worth but I do think there are going to be examples in the industry where we’re going to have to impose a strong level of discipline and make sure we understand the trade-offs in the promotion activity and marketing activity we undertake that it truly will create sustainable growth.
I’ve used this term with all of you before, there’s no point in chasing profitless prosperity which is you’re buying your volume then it goes away the minute you stop buying it. That’s not the way you build the long term business. Having been in this job a long time that’s certainly not a method we’re going to employ.
There is no doubt that in certain categories price points are going to be the name of the game because of the size of private label in that category or the size of the second tier brand or the non-sensible ways people go to try to build businesses. Having been in this job and gone through that several times you cannot build the business on a short term basis. You still have to look long term.
I can tell you I can only speak for the Heinz Company we will continue to take a long term disciplined approach that allows us to crate sustainable growth in our developed markets. In addition, you can’t forget in our case the growth we’re getting out of the emerging markets. One of the focal points of this company, and has been for a long time, as you know we’ve been criticized heavily for it in the past, was the recognition that the developed world was going to get more intentionally competitive and that it would devolve into some of the issues you’re articulating and that the opportunity long term was to create value in these emerging markets as the middle class emerges.
I thought the Wall Street Journal did a nice job for us this morning on the article on Mexico and I think it says a lot about the strength of the management team here that Fernando Pocaterra was quoted about that we have on the ground leaders. I think what you will see in the case of the Heinz Company is disproportionate growth coming out of those markets more and more and shifted investments if we believe we can create more value.
I think ultimately this still comes down to leadership and discipline, your ability to innovate, the categories you operate in, the brand strength that you have, and in a willingness to take a little flack occasionally in the market from critics, who shall go nameless, who will point out short term issues that we recognize as are nothing more than that. We will not sacrifice that for a game of profitless prosperity which long term creates no value for anybody.
The other thing I would point out is if you think about our fiscal year and where the industry is, we’re overlapping the boom times and have been up until about now. As we look forward you’re going to be overlapping a different kind of environment and so it will be interesting to see that as we’re lapping the new economy, the new environment, things stabilize a bit and become easier going forward.
I want to add one comment. One of the benefits of experience and seniority is the ability not to move into denial. I think one of the criticisms that was leveled this industry early on and certainly I think is probably a relevant criticism even going forward is denial. We are not in denial here. We see what’s going on and we know how to react and we’re taking appropriate actions. I can’t promise that all those will work but I can sure promise you we will take appropriate actions in recognition of doing things that will drive value not destroy value.
I think denial is a dangerous thing and I think that comes from inexperience, sometimes it comes from other areas like lack of judgment. We are not in denial. We see what’s going on. We understand what’s going on and we’re going to deal with it the way we think is appropriate. I hope we’re right long term in creating value.
There are no further questions at this time. I will now turn the conference back over to management for any closing remarks.
We’re going to be presenting next week at the First Annual Citi 2009 Food Fest, give a shout out to David and his team, Food Manufacturing Conference next Thursday, December 3rd. I’ll be there with Chris Warmoth who heads up our Asia Pac Business so that’ll also be webcast. Coming up of course in February the Cagney presentation in Florida. I look forward to seeing you there.
As always, the IR team will be around all day today and tomorrow morning to answer any of your follow up questions. The main number 412-456-6020. Have a wonderful and warm Thanksgiving Holiday and we’ll see you soon.
Thank you again for participating in today’s conference call. You may now disconnect.
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