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Flowers Foods, Inc. (NYSE:FLO)

Q1 2014 Earnings Conference Call

May 15, 2014 8:30 AM ET

Executives

Marta Jones Turner – Executive Vice President-Corporate Relations

Allen L. Shiver – President and Chief Executive Officer

R. Steve Kinsey – Executive Vice President and Chief Financial Officer

Analysts

Farha Aslam – Stephens, Inc.

Eric R. Katzman – Deutsche Bank Securities, Inc.

Sarah-Jane Burns – Findlay Park Partners LLP

William B. Chappell – SunTrust Robinson Humphrey

Brett M. Hundley – BB&T Capital Markets

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

Amit Sharma – BMO Capital Markets

Operator

Welcome to the Flowers Foods' First Quarter 2014 Earnings Call and Webcast. My name is Ellen, and I will be your operator for today's call. At this time all participants are in a listen-only mode, later we will conduct a question-and-answer session.

Please note that this conference is being recorded. I will now turn the call over to Marta Jones Turner. You may begin.

Marta Jones Turner

Thank you, Ellen, and good morning, everyone. Our first quarter 2014 results were released and the 10-Q was filed this morning. You will find the release and the link to the filing on our Web site, and a PowerPoint presentation to support our discussion and that posted on the conference call page. Well, you know that before we begin this morning I must remind you our presentation today may include forward-looking statements about the Company’s performance.

Although we believe the statements to be reasonable, those statements 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 Flowers Foods business are detailed fully in our SEC filings.

Participating on our call today we have Allen Shiver, Flowers Foods' President and Chief Executive Officer and Steve Kinsey, Executive Vice President and Chief Financial Officer. Following prepared remarks, we’ll open the call for your questions.

Now I am happy to turn the call over to President and Chief Executive Officer, Allen Shiver.

Allen L. Shiver

Thank you, Marta. Thank you for joining our call today. We’ve reported strong results for the quarter. Especially when compared to the dramatic growth we achieved in the last year’s first quarter, resulting from Hostess' liquidation. In the first quarter of 2014, we achieved sales growth of 2.6%, let’s look at our results by segment.

Our DSD segment which represents 84% of our business was up 5% driven by volume increases in our branded bread business, acquisitions and positive products mix. It’s interesting to note that our DSD sales were up 31%, if you go back two years to the first quarter of 2012.

Our market share, of bread, buns, and rolls for the total U.S. has also increased 3.3 points over the two year timeframe. Our growth shows that our team remains well positioned to take advantage of the opportunities brought on by industry consolidation.

As expected sales in our warehouse segment were down 8.3% due primarily to pressures on the warehouse cake business and Hostess cake has returned to the market. Our warehouse cake business has been impacted more than our DSD cake because Hostess cake distribution improved warehouse delivery. Even so looking at the two year review, our warehouse segment has maintained much of the cake business gains in 2013. Compared to the first quarter of 2012, warehouse cake has increased 13.5%.

Looking at our total cake business, including sales for both DSD and warehouse segments our cake business is up 22% over the first quarter two years ago. Much of our growth in cake is driven by our rollout of the Tastykake brand through our DSD system. Our Tastykake brand at retailers now annualizing at almost $500 million.

Our total share of the cake has increased 1.9 points in the two year periods. Our earnings were solid in the first quarter especially when you considered since this time last year we’ve taken on carrying calls for the acquired Hostess assets which strengthened our infrastructure by opening three new high-speed bread lines to support our sales growth and adding a substantial number of new distributor territories. These adjustments are needed for Flowers Foods future growth.

I’m pleased that our earnings were strong in spite of these costs that we’ve taken on this quarter one of 2013. As we told you at our March Analyst Day, our manufacturing efficiencies are improving. In the quarter efficiencies were up a 4 point over the fourth quarter to 92.3% that’s well on the way back to our historic high of 94%.

We’ve also improved day-to-day operations at our Fort Worth tortilla facility. We continue to evaluate our tortilla business and we are entering low margin foodservice contracts. The action we took to realign the Forth Worth tortilla business as part of our DSD segment allows us to focus on growth opportunities in branded retail tortillas. This is why the margins are much better.

The integration of our systems of Lepage continues and we’re seeing steady improvement. I think it’s important to clarify the issues of Lepage. Our SAC integration is complete and there are no problems with information flows across the business. The ongoing problem is in the transition to Flowers was ordering and forecasting model. Previously Lepage had a centralized model. Flowers model is decentralized, it puts the order and decision closer to the marketplace. Training of Lepage continues and as I’ve said, we’re making progress on the transition into our Flowers forecasting system.

During the quarter, we also added a high-speed bread line in Modesto, California. You may recall that we acquired that bakery in July 2013, as we sought our production solution for the Sara Lee California business we acquired from BBU.

Modestor had an efficient bun and roll operation. Now, we’ve added a bread production line. I want to thank our team members who worked, who plan and execute the successful start-up of the Modesto bread line. That bakery along with the Henderson bakery that we opened in November is helping to meet our needs for the California market. We also cycled the Sara Lee California acquisition in the quarter. It is gratifying to see the progress being made in California market.

We now have a strong portfolio brands with Sara Lee, Nature's Own, Home Pride and Wonder. We also have excellent access to market and our own production capacity. All these things further enhanced our ability to grow in California. Last quarter at California, we got 12.6 share of the total category.

Our acquired bread brands continue to perform well. As we told you at the Analyst Day in March we’re getting good incremental sales as the brands we gained straight across our markets.

One other important development regarding the acquired brands, I’m very pleased to tell you that as of the beginning of quarter two Wonder, Home Pride, Merita, Butternut brands are available through all of our major retail customers. Our new markets achieved growth higher than our stated goal in the quarter. As expected our acquired brands along with Nature's Own and Tastykake are steadily gaining share in new markets. Our new markets are showing the benefit of those strong brands and have the exceptional service we provide to customers through our distribution system. We have tremendous growth potential in those new territories as we continue to gain share over time.

We also will push our geographic boundaries further to enter additional markets in the future, especially there is with major population centers. As we told you at the March, by 2018 we expect 90% of the U.S. population have access to Flowers’ fresh bread, buns, rolls and snack cakes. We will continue to gain market share as we reached new markets.

Our market share of total bread, buns and rolls sold in U.S. as reported in the IRi increased in the first quarter, compared to the same-period last year gaining 1.3 share points of dollars to a 14.1 shares.

At our Analyst Day, we told you to expect our market share for bread, buns and rolls to reach a 20 share by 2018. We also said that we expect to grow our cake business to a 12 share from our current 7 of total snack cake sales in the U.S.

I know you are interested in our plans for the assets we acquired from Hostess. Our Knoxville bakery started bread production this week, with Knoxville now running we have opened two others bakeries that we acquired from Hostess.

You’ll recall that we opened the Henderson, Nevada bakery on late November 2013. As we told you in New York we expect to open several additional bakeries over the next two to three years. We have listed nine bakery properties in 21 warehouses for sale.

Before we hear from Steve, let me say again that the first quarter was a strong quarter. We continue to see opportunities ahead for increased sales and increased earnings. Our team is focused on improving the business, executing in the marketplace and continuing to build value.

Now Steve will give the financial report, Steve?

R. Steve Kinsey

Thank you, Allen and good morning everyone. To begin with a quick reminder, as Allen said, we did shift the Fort Worth tortilla operation from the warehouse segment, to the DSD segment in Q1 of this year. All historical data related to this business has been moved as well, and the overall impact on the first quarter was fairly immaterial slightly less than $1 million in earnings before tax, that’s a little bit improvement over the back-half 2013.

Also, for those who might be new to the saga, our first quarter is a big 10 week quarter and fiscal 2014 is a 53 week year.

Now turning to the quarter, sales in the quarter were 2.6%, net price/mix contributing 2.9%. The acquired Sara Lee California business contributed 1.2% to the growth. Volume in the quarter was down 1.5% and as Allen stated we did tackle this early acquisition in the quarter.

Overall the performance of our DSD branded retail business was very strong. Our branded breads and buns showed significant growth driven by Nature's Own, the acquired brand and growth in our expansion markets. Expansion markets contributed 2.3% to the quarter sales growth.

We continue to see pressure on our cake business both from the DSD and warehouse segment, resulting from the reintroduction of Hostess cake. However, as Allen said, we are pleased that we have held on to a significant portion of the cake gains, over the past two years and we continued to be excited with the opportunities to expand our cake share as we roll out the Tastykake brand in our new markets.

Our foodservice business was up in dollars during the quarter driven primarily by pricing. Volumes were flat with fast food increases offsetting institutional declines. The DSD fast food and quick serve channels performed very well during the quarter.

We are also very pleased with the re-launch of the acquired brand and their contribution to the overall sales growth. We believe we can leverage these brands and the acquired facilities as we continue to increase penetrating in existing markets and in our new markets with a stronger product mix and immediate production capacity as needed to meet our growth targets.

Operating earnings or EBIT was down 6% this quarter compared to last year’s first quarter. Our EBIT margin was 8.5% of sales, still strong despite being down slightly from last year. Several factors contributed to the overall decline. First, we added $6.8 million of carrying costs associated with the recently acquired Hostess bread facilities. This affected our EBIT margin by 60 basis points.

We also continue to work through integration issues with the Lepage acquisition. Compared to last year’s first quarter, this negatively impacted the quarter approximately $0.01 per share. This is an improvement over the 2013 fourth quarter impact, and as Allen stated, we continue to make progress towards correcting these issues. As I said earlier, we have seen improvement in the result of our tortilla facility with the impact being immaterial in the quarter, less than $1 million.

EBIT margin in the quarter was also impacted by the overall effect of our declining cake volume in both our DSD and warehouse segments quarter-over-quarter. Earnings per share for the quarter of $0.29 were down 6.5% compared to last year’s first quarter on an adjusted basis. Overall, we are pleased with this performance, given the additional costs I just discussed. The acquired facilities, carrying costs and interest expense to fund the recent acquisition negatively impacted the quarter approximately $0.03 per share.

Turning to gross margin, we are very pleased with the improvement of our gross margin in the quarter. Gross margin was 48.6% compared to 48.2% the last year’s first quarter. This 40 basis point improvement as a percent of sales was driven by 120 basis point improvement in input cost as a percent of sales. This improvement was negatively affected by 40 basis point decline as a result of $4 million of carrying costs during the quarter related to the acquired Hostess facility and another approximately 50 basis point decline due to higher workforce-related costs.

Decreased efficiencies quarter-over-quarter negatively affected gross margin by approximately 30 basis points. Though we have short-term cost pressures that are negatively impacting gross margin, we expect longer term to continue to see gross margin improve as we sell certain idle bakeries and warehouses, continue to work on improving our efficiency and work through the short-term issue of Lepage.

Selling, distribution and admin costs from the quarter were 36.8% of sales, compared to an adjusted 36% of sales in last year’s first quarter. So the primary driver of this 80 basis point increase was higher distributor discount as a percent of sales. These increases in distributor discount as a percent were not completely offset by decline in workforce related cost due to the ongoing cost related to our market expansion, our route conversion both in California and the Northeast, and increased headcount resulting from our growth.

Now turning to our balance sheet, cash flow in the quarter was strong. As you can see cash flow provided by operations was a positive roughly $122 million in the first quarter.

During the quarter, we are very pleased that we were able to pay down roughly $82 million in debt. And in the quarter, was approximately $840 million in total debt. So at the end of the quarter, our debt-to-EBITDA leverage ratio based on the trailing 12 months EBITDA was 2.1 times. During the quarter, we also paid dividend of approximately $24 million and funded roughly $24 million in capital expenditures. We also repurchased $9.5 million of common stock or approximately 4,65,000 shares under our share repurchase program. We have approximately 8.5 million shares remaining on the current authorization.

Turning to that 2014 outlook, Flowers' cake, recently we have seen a run-up in wheat due to the impact of drier weather and global political instability. We will see the most impact from this run-up in the back half, primarily in our fourth quarter calls. However, we are pleased overall with our ingredient coverage for 2014, but we still have a few items open that can negatively impact our results. However, this is all reflected in our 2014 guidance.

Thank you for your interest in Flowers Foods, and now I will turn the call back to Allen.

Allen L. Shiver

Thank you Steve. In the second quarter, we are seeing continued strong performance at our expansion markets. We are encouraged by the results of our test market of Cobblestone Bread Company’s specialty bread and rolls. Our efficiencies are improving. We are making progress addressing challenges in Fort Worth and Lepage. 2014 will be another good year of performance for Flowers Foods. We also see growth opportunities in years to come as we gain share in expansion markets spread into mid territories, introduce new products and make future acquisitions. Our strategies represent, our team is experienced and motivated, the Flowers’ way continues to deliver for our shareholders. Ellen will now open the call to questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) The first question is from Farha Aslam with Stephens. Please go ahead.

Farha Aslam – Stephens, Inc.

Hi good morning.

Allen L. Shiver

Good morning Farha.

Farha Aslam – Stephens, Inc.

Three questions the first, let’s start with your manufacturing efficiencies, they were 92.3% this quarter. What is your target and when do you think you can achieve that?

Allen L. Shiver

That’s historically our highest in 94% on efficiencies. We are well on the way back to that number, to setup specific date maybe a little tough, but I would certainly expect us to be closing in on that number by the end of this year.

Farha Aslam – Stephens, Inc.

Okay, so the second half is kind of – end of the second half is achievable?

Allen L. Shiver

Yes.

Farha Aslam – Stephens, Inc.

Okay then and then, an update on Aunt Millie's kind of when do you think they will start distributing Flowers’ products into the Chicago market and how will that flow through into your P&L?

Allen L. Shiver

Farha, that is the licensing agreement with Aunt Millie's, and they are actually introducing the brands as we speak. If I’m not mistaken they are already in the marketplace and, again, it is simply a licensing agreement. Those markets were markets that we do not have on our immediate expansion plans. And Aunt Millie’s is a very good baker that will do a good job getting the brands back into marketplace.

R. Steve Kinsey

This is Steve. That will actually come in as royalty income. We don’t expect that to be material at this point. They were reported in SG&A as an offset. But if they were to become material, we’d have to move it out to the sales line.

Farha Aslam – Stephens, Inc.

Okay. Great. And then my last question relates to the promotional cadence in the category. Could you share with us kind of how you’re seeing the market develop as you’re reintroducing that Wonder brand?

Allen L. Shiver

The category continues to be aggressive from a pricing standpoint. The conditions that we’ve described in the last two calls really continue. From a positive standpoint, if you look at our numbers, you’ll see that the growth in private label in the segment, private label has been flat for the last quarter, but our promotional activity as it relates to brands continues.

Farha Aslam – Stephens, Inc.

And how are you responding to that?

Allen L. Shiver

Well, we’re projecting our brand’s share. I think, Farha, we’ll show that in many, many cases Flowers is a market leader from a pricing standpoint, but at the same time we have to protect our share in our marketplace.

Farha Aslam – Stephens, Inc.

Okay. Thank you so much.

Allen L. Shiver

Thank you, Farha.

Operator

The next question is from Eric Katzman with Deutsche Bank. Please go ahead.

Eric R. Katzman – Deutsche Bank Securities, Inc.

Hi, good morning everybody.

Allen L. Shiver

Good morning Eric.

Eric R. Katzman – Deutsche Bank Securities, Inc.

Let me just follow-up on Farha’s question. Is the price competition coming from BBU or is it coming from retailers funding it or some of the smaller players that are still out there?

R. Steve Kinsey

Eric, the price competition is primarily coming from competitive bakers. So you have the list.

Eric R. Katzman – Deutsche Bank Securities, Inc.

Okay. And I guess, with wheat cost, as you mentioned, Steve, rising, I guess why do you think that the market is still as promotional as it’s been the last couple of quarters? I mean have you sensed anything since the quarter ended with input costs going up that it could get a little more rational?

R. Steve Kinsey

Eric, I continue to be optimistic with all the changes taking place in the category that over the long-term pricing should become more rational. I wish I could report today that that was the case, but we’re really – I would not say there’s a deterioration in pricing. It’s really more of the same that we’ve experienced the last couple of quarters, really nothing in the way of commodity spikes or concerns that we push pricing one way or the other.

Allen L. Shiver

Eric, I would say most bakers probably had some covers on and since the spike just happened recently, you probably already priced most of your programs and products through the summer. We’ll continue to watch the back half. And as always, we typically take our pricing actions late fall. So we’ll build those off of the wheat prices at that time.

Eric R. Katzman – Deutsche Bank Securities, Inc.

Okay. And then, I guess Steve, kind of a question, you kind of noted in the press release that you’re in the process divesting some of the Hostess pieces that you don’t want. That’s I think $10 million you said of cost could come out. That's around $0.03 a share. Does that give you confidence in the high-end of your guidance range, and how do we think about that relative to the $0.07 spread of your guidance range today?

Allen L. Shiver

Currently, we are in the process of marketing of those facilities, I would say if you looking in the 10-Q, we have sold some of the warehouses, but today we have not sold in the bakery as far as closing any deals. So we would have to close that sometime in the second quarter to get that benefit in the back half. But right now, I would say that's still kind of up in the air as of when that benefit will start to roll in. Some of that factored in but not all of that factored in though, to hit the upper end of the range probably you would need some of that happen pretty quick?

Eric R. Katzman – Deutsche Bank Securities, Inc.

Okay. And then last question and I’ll pass it on, Allen you got to mention that all major national retailers are now selling Wonder Bread and Merita, and some of the others, I assume that includes Bentonville based retailer that reported results this morning. When did you start shipping in there, and did that initial shipment start to influence the results you just reported? Or is that kind of to come starting with the second quarter?

Allen L. Shiver

Eric, we started at the beginning of quarter two and the retailer in question obviously does a very good job with white bread segment, the brands that we introduced Wonder, Merita and so forth are strong brands in that white bread segment, so yes they will have a very positive impact on the overall brand growth.

Eric R. Katzman – Deutsche Bank Securities, Inc.

Okay, great thank you. Good luck.

Marta Jones Turner

Thank you.

Allen L. Shiver

Thank you, Eric.

Operator

Thank you. Our next question comes from Sarah Byrnes from Findlay Park Partners. Please go ahead.

Sarah-Jane Burns – Findlay Park Partners LLP

Good morning.

Allen L. Shiver

Good morning.

Sarah-Jane Burns – Findlay Park Partners LLP

Can I just ask about the new bakeries you've opened and where you are in utilization rates for those and typically when you open a new bakery, how long does it take to get to sort of your ideal level of sort of efficiency?

Allen L. Shiver

Sarah, we'll talk first about the Henderson, Nevada bakery. Again, it was a bakery that is well positioned geographically to help us not only in California, but also Arizona and that part of the world. In terms of efficiencies, each bakery is a little different based on conditions of equipment and so forth, but very encouraged about the progress in Henderson in terms of overall efficiencies.

As we mentioned earlier, the Knoxville bakery literally was just reopened this past week and we're excited about that facility as well, really providing significant capacity relief for the marketplace in that part of our geography. As far as efficiencies, each bakery is different, but I would say within six months to one year, we should be making significant progress to get our efficiencies in line, hopefully with other plants.

Sarah-Jane Burns – Findlay Park Partners LLP

Okay, thanks very much.

R. Steve Kinsey

Sarah this is Steve, when you look at the Henderson facility currently we only have a bread line operating there. We haven’t opened up the bun line yet, so with that bread line is operating pretty much like a two shift and we are working on the third shift.

Sarah-Jane Burns – Findlay Park Partners LLP

Right okay.

R. Steve Kinsey

Our efficiency level on bread and at Henderson is 90% currently.

Sarah-Jane Burns – Findlay Park Partners LLP

Great that was the second last one thing, okay. Thank you very much and well done on a nice quarter.

R. Steve Kinsey

Thank you.

Operator

The next question is from Bill Chappell with SunTrust. Please go ahead.

Allen L. Shiver

Good morning, Bill.

William B. Chappell – SunTrust Robinson Humphrey

Good morning, thank you. Yes, just trying to dig into the DSD numbers and I'm sorry if you've given this. If you take out the tortilla business and maybe even the cake business. Can you kind of give us an idea what the growth would have been? Because I assume tortilla you gave what the bottom line impact. I don't know what the top line impact. But I am assuming that was in decline.

Allen L. Shiver

Yes, if you look at the DSD business and you pull out and kind of rotate the client, we typically don't give this specifically. What I would say is you would be up another 100 to 200 basis points, so it was pretty significant.

William B. Chappell – SunTrust Robinson Humphrey

Okay. On the cake side, are you starting to see moderation in terms of basically for Tastykake cake of reacceleration of growth. Or is it, you still trying to go through another maybe quarter tough comps there?

Allen L. Shiver

Bill, I think the right way to look at our cake business is, do compare against quarter one of last year, I mean obviously that was a very unusual exceptional quarter. I’d like to look at our brand growth over two year period, and I really starting with our Mrs. Freshley's brand again comparing to that quarter one it was just completed to quarter one two years ago the brand is up 44%.

Likewise, if you look at our Tastykake brand, again, for the same two year time period the Tastykake brand is up 30%. So those are dramatic sales increases which hopefully is a good illustration of the overall health in the cake business on both DSD and warehouse. Now we are obviously we’re competing against a pretty tough comps last year, but overall our cake business is healthy.

R. Steve Kinsey

Hostess re-launch was in mid-July, late July, so in the second quarter we’ll be probably another tough comp and then we’ll didn’t see that level out in the back half.

William B. Chappell – SunTrust Robinson Humphrey

Okay. And then, back to the business at Bentonville retailer. I mean, I guess can you answer this simply. Was it worth the wait? Are you comfortable with kind of the product placement you're going to have? I think the thought was you could have always gotten in there on quick standalone displays, but just trying to get more color on that.

Allen L. Shiver

Bill, our sales team was excited about being in that retailer would be acquired brands and team in Bentonville is also excited about the opportunity to get these brands back in their customers' hands. So it's a win-win all the way around.

William B. Chappell – SunTrust Robinson Humphrey

Great. The last one, Steve, can you just remind me, this is a loaded question, but kind of thought process on dividends, payout ratio and the time of the year you typically adjust that…

R. Steve Kinsey

Sure. Actually – we typically adjust that at our first quarter board meeting and annual shareholders meeting and that’s coming up next week. We would – our goal would be to keep the dividend yield in line with where we have been. As you know, we are very focused on returning to our shareholders in the dividend very important to the management team in the board. So I don't expect any change philosophically in that when we meet next week.

William B. Chappell – SunTrust Robinson Humphrey

Thanks so much.

R. Steve Kinsey

Thank you, Bill.

Operator

The next question is from Brett Hundley with BB&T Capital Markets. Please go ahead.

Brett M. Hundley – BB&T Capital Markets

Hi, good morning guys.

Allen L. Shiver

Good morning.

Brett M. Hundley – BB&T Capital Markets

I just want to stay on Wonder et cetera, being back in all retailers now. Should we expect any incrementally better coverage of carrying cost because of that? Will there be further needs over the short time for opening of new bakeries. How should we think about that?

R. Steve Kinsey

Well obviously, as Allen said and you can see that these brands are doing very well in our expansion markets. So every dollar is incremental so will help offset some of the carrying costs, and then at the right time, as volume want to – you will make decisions about opening facilities. I think right now – with the opening of the Knoxville plant, what we’ve done on the West Coast.

We are pretty much safe through the rest of 2014. And as we talked about in March at the Analyst Day in New York, we will probably make an announcement late in the year about the next bakery to be opened. But as Allen said, we’re very pleased with the brands are performing and really excited about getting them into all of our major retailers and now in the new markets.

Brett M. Hundley – BB&T Capital Markets

I’m sorry, I want to stay on that topic too because the Hostess related sales did come in better than I expected, during the quarter. And I wanted to talk further about the re-implementation, and just get further color on your belief about where the space is coming from broadly?

Allen L. Shiver

Bill, the Hostess reintroduction, are you speaking of our brands that we acquired or Hostess cake?

Brett M. Hundley – BB&T Capital Markets

Your bread brand that you acquired?

Allen L. Shiver

If you look at and Steve said well, if you look at our expansion markets, we’re introducing Wonder, Butternut, Merita, and the other brands helping us grow significantly in our new markets. Couple I'd like to call out is this exceptional performance. If you look at the IRI data for Kansas City, we are now up to 8.02 share. Cincinnati we are on an 8 share, in our market like St. Louis, we are now up to 8.50 share. So the new brands in conjunction with Nature's Own and our Tastykake, really helping us establish our business in these new markets.

Brett M. Hundley – BB&T Capital Markets

Then in your kind of core legacy markets where the re-implementation of Hostess has come out are you still comfortable with how Nature's Own, volumes are performing?

Allen L. Shiver

Yes, we are.

R. Steve Kinsey

But, if you look at the category and I think Allen mentioned that in his comments, we actually sell private label down quite a bit this quarter. So it would appear that these brands are taking some of the volume back from private label as well as taking probably some volume from competitors’ brands.

Brett M. Hundley – BB&T Capital Markets

Okay. And then Steve, do you care to call out any type of negative whatever impact during the quarter?

R. Steve Kinsey

Overall, I would say there was some impact in the Northeast, just because it looked more severe than historical. But I would say weather did not impact us materially. It could have helped in some markets.

Brett M. Hundley – BB&T Capital Markets

Okay. And then just my final question, Allen. I think it’s interesting within the U.S. Food space, we’ve seen diversification within M&A landscape be rewarded by investors. And I think that has changed a little bit from recent years. And you talked about and you stuck to your strategy as far as geographical growth.

You have two basic products across bread and cake. But can you just talk a little bit about your thoughts over the next three to five years, conversations you might have with your management team, the Board et cetera as far as – of course standing with that strategy of expanding geographically. But maybe also, looking at diversification. If you could just give an answer for that I appreciate it?

Allen L. Shiver

Obviously we have more to do, geographically, so if you mentioned that, I think we are very positive about the success of our DSD business. There are some adjacent product categories that lend themselves well to DSD that potentially could be opportunities in the future, Tortillas is a good example. We got a lot to do in terms of developing our brand and retail, Tortillas business and we’re going to be focusing our DSD team's attention on that segment. But there are other product categories that at the right point in time that we would consider looking at.

In the near term, we’re excited about the growth potential to get to that 90 share of our DSD distribution in the U.S. and we’re very excited about the success we are having in new markets with the combination of Natures’ Own and Tastykake with the brands that we just acquired so long. I would say we're always looking for opportunities but in the near-term, we are focused on growing our DSD business.

Brett M. Hundley – BB&T Capital Markets

Thanks guys.

Allen L. Shiver

Thank you Brett.

Operator

Your next question is from Akshay Jagdale with KeyBanc Capital Markets. Please go ahead.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

Good morning.

Allen L. Shiver

Good morning Akshay.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

Good morning. Couple of questions. First one just on sales for the remainder of the year, obviously you didn’t change your guidance for the year but this quarter sales growth came in a little bit lighter than we were expecting. How did the sales growth performance come in relative to your internal expectations? That's the first question. And then secondly, your guidance implies three significant acceleration into the back half or for the remainder of the year. So can you help me to understand how, what are the drivers of that acceleration, thank you?

Allen L. Shiver

Sure, when you look at internally I would say we were all flat year off, somewhat from what we had expected internally as well. But we're coming into the back, the summer season, we see a lot of an acceleration usually and then we do expect the back half to pick out with the new – get into new products in the new markets. But we just felt like right now we're still targeted to hit within our range that we have out there.

So when we get you through the summer season and see how performance has been, then we can make the decisions about, if we need to adjust anything. But in the near-term, we felt comfortable leading the guidance we have there.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

And what was – can you help me with the incrementality of these new brands, I think you had mentioned at the Analyst Day was 20% incremental in 4Q and then at the Analyst Day, the level was more on 55%. What is the incrementality that you saw from the newly introduced brands in the quarter?

Allen L. Shiver

I’ll show you the incrementality is a very positive, we are around 75% of the total, obviously in new markets where the brands have been reintroduced where we had a very low share of the white bread segment. Incrementality is probably higher than that in new markets. But overall, we are very pleased with the results in that area.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

And how should we can conceptually think about the re-introduction into, basically in the Wal-Mart, and how is that going to conceptually impact your sales because you are obviously, it’s a big customer for you already, you had a really good year with them last year, I did see that this year, your sales especially in the warehouse segment to that customer are down pretty significantly. But can you just help us understand how this will flow through and I mean the real question is – how incremental – can the reintroduction of the Hostess brands be to your overall sales as a result of the introduction into Wal-Mart?

Allen L. Shiver

Obviously, the largest retailer in the country not having the brands improved until the beginning of the first quarter. Obviously, that impacted our numbers in the quarter, but now that we are in place and we are still working through final rack sets and we’re getting really good support with display activity, but because of that approval and additional space, it’s one of the reasons that we have confidence in our guidance going forward.

So I think we can quantify an individual retailer, but just to say that approval of the acquired brands in that account is significant to our sales growth going forward.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

So roughly do you think that will positively impact the incrementality number which currently stands at 75%?

Allen L. Shiver

I would say yes, again especially as we look at new markets, another positive, we’ve been seeing the entire category trending down for several quarters. It was encouraging the category is actually up slightly in terms of less dollars and units this past quarter. So that also is good thing.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

Okay, and then one for Steve, I guess on gross margins, really very good quarters on that. So I wanted to just make sure, we’re modeling it directly sequentially last year, if I remember got off to – out of the gates really fast. And then there was some growing things as you call them for the remainder of the year. I’m guessing we’re not going to see that this year, so we should in my estimates build half of the performance that we saw this quarter. Is that the right way to think about it? I mean will percentage gross margins sort of build off of where we were sequentially from now. Is that the best way to think about it?

R. Steve Kinsey

We do expect gross margin to be up year-over-year, so you should be it continue to improve on a quarterly basis quarter-over-quarter as we move through the year.

The one caution I would say, I did mention wheat costs being up primarily in the fourth quarter. Right now, we think we are in good shape there but if it were to continue to run that could change that then I would say, based on what we know today, we expect we’ll have incremental improvement in gross margin year-over-year.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

And just last one on the California expansion and the Sara Lee acquisition, the contribution from that particular business was much lower than I would have expected this quarter. Is there some seasonality there because you lapped it now and it looks like the incrementality is at the low end of what your balance was implying for the full year from that particular acquisition, so any color there. And then if you can update us on the route buildup, because obviously that was a big drag on SG&A again this quarter.

R. Steve Kinsey

Sure. When you look at California, if you recall, that acquisition was late February. So there’s only two periods where we cycled that particular acquisition in the quarter. And then, when you look at the overall cost from the route buildup, that’s kind of an ongoing cost until we are established in all the new markets, but that is fairly significant to the overall margin.

Allen L. Shiver

Akshay, in terms of routes, we now have over 400 routes serving all of the major retailers in California and it’s exciting that now that we control our own destiny from a manufacturing standpoint, product quality is substantially better. Product is fresher and our cost structure, as we’re producing our own product, will be better over time. So we’re encouraged about the future for California.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

When do you expect that SG&A sales to normalize? In other words, the 400 routes that you have, I’m guessing compared to your other mature markets are maybe 50% utilized and you are still paying your distributors fees, which is what’s causing the drag, right? Am I, one, understanding that correctly? And just roughly when do you we expect that to normalize? Is that in a year, two years or three years?

Allen L. Shiver

Typically a new market, it takes 18 to 24 months to really build that base and get the margin contribution up to where we like for it be. So you’re probably looking at another two years or so for that to stabilize.

R. Steve Kinsey

Akshay, from an operations standpoint, we really look at California as a big opportunity as opposed to a drag. And one of the encouraging things is that we’re building that route structure primarily with branded business. Nature’s Own is doing well. Home Pride is a brand that’s doing extremely well in California as well as Sara Lee. So, we’re encouraged and bullish about our results in California.

Akshay S. Jagdale – KeyBanc Capital Markets, Inc.

Great. Thank you.

Allen L. Shiver

Thank you.

Operator

(Operator Instructions) Your next question is from Amit Sharma with BMO Capital Markets. Please go ahead.

Amit Sharma – BMO Capital Markets

Hi, good morning, everyone.

Allen L. Shiver

Good morning, Amit.

Amit Sharma – BMO Capital Markets

Good morning. Thank you very much. Steve, can you talk about Lepage? Is it still about a 1% impact on top line?

R. Steve Kinsey

Sure. When you look, overall their sales were fairly strong in the quarter. They were kind of flattish year-over-year. As Allen said, it really gets down to kind of the order rate forecasting. Today we’re doing things a little different than what we do across the whole. So we’re spending a lot of time training, trying to make sure that everyone has the right tools to get the ordering back in line.

And then we opened three facilities up there, over very short period of time, just because of the production needs. So we are working through manufacturing efficiencies there as well. So the good thing is we have all the issues identified. We think we have a plan to improve those and we’re still targeting having most of this corrected by the end of this quarter, second quarter. We feel good about that.

Amit Sharma – BMO Capital Markets

So first quarter impact is still about 1% on top line?

Allen L. Shiver

What happened in the first quarter as we just missed opportunity, the sales were not down quarter-over-quarter, is just that we know we missed some of the selling opportunities they are not having the order forecasting in that we did it.

Amit Sharma – BMO Capital Markets

I mean major channel D are showing a pretty steep decline, so I think something is wrong with that right, in terms of all they are showing the sales, if your sales are flat.

Allen L. Shiver

We could talk about that offline.

Amit Sharma – BMO Capital Markets

Sure. And then last quarter you gave ACV levels for Hostess brands at 37%. What is that level now?

Allen L. Shiver

I actually asked for that number before the call this morning and I did not have that, it’s substantially higher than it was last quarter. If you’ll permit I will give you the exact number and I’ll call back.

Amit Sharma – BMO Capital Markets

Sure. The question that I had on that is if it is substantially higher which is inline with expectations, what kind of conversations you are having after retailers have like a few months to look at the performance of those brands. Are you getting incremental shelf space and those where you will have like five, six months to show the performance of those brand yet?

Allen L. Shiver

The conversation with retailer were very positive. Retailers will understand in this business brands in the white bread segment are very important. Brands are important, period, but especially important in the white bread segments. So when you will have discussions about Wonder which again has a – if there is a national brand, white bread it will be Wonder. They are very positive about supporting the brand in their stores each individual retailer reached at their baker departments in different times and again it’s based on returns and contribution to their business, but we are seeing growth in terms of overall shelf allocation for the acquired brands and are getting a lot of support from the retailers.

Amit Sharma – BMO Capital Markets

And just to further discussion on Hostess brand, $42 million sales in

Q1, we are entering into seasonally stronger period. I understand that this is a 16-week quarter, but sequentially as you come into the larger retailer as well sequentially should we build for larger contribution from Hostess sales, Hostess brands.

Allen L. Shiver

The sales and contribution that we anticipate from the acquired brands are included in our guidance. So I will not recommend any change at this point.

Amit Sharma – BMO Capital Markets

No, no not to change but just to get a better understanding of what is the contribution from the Hostess brand and okay…

Allen L. Shiver

I think it is just for the extra four weeks in the quarter and the fact that we now have each and all of our main – have the brands on all of our major retailers.

Amit Sharma – BMO Capital Markets

Right.

Allen L. Shiver

They performed very well in expansion markets that's where we are really seeing those the great roads, I’m not sure, there will be huge acceleration but you could see potentially flat pick up in the Hostess brand, just because now we have much greater penetration in the market.

Amit Sharma – BMO Capital Markets

And then Allen, you talked about category getting better and clearly the major channels show both volume and dollar sales for the category improve in the first quarter, was it 2013. Can you talk about is that the sales driving that, is that sustainable.

Allen L. Shiver

The category was up 1 share point in dollars and it was up 0.8 in units, whether it’s sustainable. I would certainly hope so, there is a lot of activity in the category from overall health and nutrition standpoint. It’s a change from the past. So we see it as certainly a move in the right direction. Time will tell, but we’re optimistic it’s sustainable.

Amit Sharma – BMO Capital Markets

Just a follow-up on that. I mean are you seeing retailers being a little more supportive of the category? Or you’re seeing just because you’re down and we sort of like catching up or easier comp if you may?

Allen L. Shiver

Retailers understand very well how important this category is to their overall business. They also understand the consolidation that is taking place in the baking industry. And Flowers is getting a lot of support, especially in our new markets. So I would say that in terms of the category, attitude from retailers is very positive and the retailer’s attitude in terms of support for Flowers is also very positive.

Amit Sharma – BMO Capital Markets

All right. And just one more final question from me. If we look at Hostess sales, not only just brand sales, but Hostess total fresh bread sales, now you give that break up of how much of your fresh bread sales are in private label, brand and food service. Is it a similar division for Hostess as well?

Allen L. Shiver

All of the acquired brands is in the branded segment of our report.

Amit Sharma – BMO Capital Markets

I understand that. The question really is, do you have opportunity to recapture some of Hostess' private and food service sales as well or is that opportunity gone to third parties?

Allen L. Shiver

We acquired the brands and any contracts it would have had with private label suppliers, we did not acquire any of that.

R. Steve Kinsey

They were not a big private label supplier when they exited, but any opportunities they gave up in private label or food service, I mean, we have had the opportunity to kind of recapture some of that through the normal bid process.

Allen L. Shiver

What private able label that Hostess had at the point of liquidation, it would have been redistributed to the remaining bakers at that time based on the bid.

Amit Sharma – BMO Capital Markets

And you garnered a good share of that business as well then?

Allen L. Shiver

Our focus has been growing the branded business and not the private label business. I don’t have the numbers in terms of what Hostess had and what we’ve picked up. Our focus has been on drilling the branded business.

Amit Sharma – BMO Capital Markets

Got it. Thank you very much.

Allen L. Shiver

Thank you.

Operator

We have no further questions at this time. I’ll turn the call back over to Mr. Allen Shiver for closing remarks.

Allen L. Shiver

Thank you very much for your support. This is certainly a very exciting time for Flowers Foods. We are the wonderful team. I’d like to use this opportunity to really recognize our manufacturing team for the outstanding job that they’ve done, bringing multiple plants and multiple lines up into operation, fantastic job. We’re excited about the results. We’re very optimistic about the rest of the year. Thank you so much and we will talk with you next quarter.

Operator

Thank you, ladies and gentlemen. This concludes the Flowers Foods first quarter 2014 earnings call and webcast.

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