Annie's' (BNNY) CEO John Foraker on Q1 2015 Results - Earnings Call Transcript

Aug. 7.14 | About: Annie's, Inc. (BNNY)

Annie's (NYSE:BNNY)

Q1 2015 Earnings Call

August 07, 2014 5:00 pm ET

Executives

Ed Aaron - Senior Vice President of Strategic Planning and Investor Relations

John M. Foraker - Co-Founder, Chief Executive Officer and Director

Zahir M. Ibrahim - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer

Analysts

Kenneth Goldman - JP Morgan Chase & Co, Research Division

William B. Chappell - SunTrust Robinson Humphrey, Inc., Research Division

Christopher R. Growe - Stifel, Nicolaus & Company, Incorporated, Research Division

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

Scott Van Winkle - Canaccord Genuity, Research Division

David Palmer - RBC Capital Markets, LLC, Research Division

Jon Andersen - William Blair & Company L.L.C., Research Division

Operator

Well, good day, ladies and gentlemen, and welcome to the Annie's, Inc. Q1 Fiscal 2015 Earnings Conference Call. Today's conference is being recorded. I will now turn the conference over to Mr. Ed Aaron. Please go ahead, Mr. Aaron.

Ed Aaron

Thanks, operator. Good afternoon, everyone. Thank you for joining us for Annie's' fiscal 2015 first quarter conference call. With me today are CEO, John Foraker; and CFO, Zahir Ibrahim. As we begin, let me remind everyone that statements made during this conference call that are not historical facts, including any statements about the company's targets, beliefs, plans, opportunities or expectations, such as its expectations for the balance of fiscal 2015, growth prospects, costs and competition are forward-looking statements that are based on management's current plans, known information, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements, and you should not rely on these statements as an assurance of future events or results. Annie's does not undertake to update any of these statements in light of new information or future events.

Forward-looking statements involve inherent risks and uncertainties. There are a number of factors that could cause actual results to differ materially from those contained in today's forward-looking statements, including the risks and uncertainties described in today's press release and the Risk Factors sections of our filings with the SEC, including our annual report on Form 10-K for fiscal 2014. Such risks include risks relating to implementing our growth strategy, maintaining our brand and reputation, product liability claims, competition, new product introductions, reduced availability of and competition for organic ingredients and other inputs, supply chain and inventory management, our internal controls, our reliance on a limited number of distributors, retailers and contract manufacturers of our products, our acquisition of the Joplin manufacturing plant and expansion of our business models to include manufacturing, changes in consumer preferences, regulatory compliance and seasonality.

To provide better visibility into our normal operating performance, we are discussing adjusted financial results today which exclude the impact of the pizza recall, as well as costs associated with the Joplin acquisition and secondary offerings. Adjusted EBITDA also excludes the effects of stock-based compensation. Reconciliations between our U.S. GAAP and adjusted results can be found in our press release and are also available in the Investor Relations part of our website.

With that, I'd like to turn the call over to our CEO, John Foraker. John?

John M. Foraker

Thanks, Ed, and hello, everyone. Thanks for joining us today as we report our fiscal 2015 first quarter results. While Q1 was a weak quarter overall, results came in largely as expected, leaving us on track to achieving our full year growth objectives.

As we communicated last quarter, we face significant short-term pressure from a large customer inventory reduction and sizable increases in the cost of organic wheat. We also faced some unanticipated SG&A costs in the quarter. These factors mask a continuation of strong consumer trends, our focus on driving innovation and meaningful progress in our efforts to improve execution in a number of areas. These positive trends will become more evident in our results as we move past some of the anomalies that impacted our first quarter.

Consumer demand for Annie's products remains very healthy despite a more competitive environment. Consumption increased in the high teens during the quarter, driven by very strong baseline performance in all sales channels and in most categories.

We continue to make excellent progress in driving mainline distribution in conventional channels.

In U.S. grocery, our total number of distribution points increased 10% year-over-year. And distribution of our top-selling items, which we refer to as our Key 33, grew even faster, up 18% year-over-year to an average of 14.7 items per store. Our market share trends demonstrate that Annie's continues to perform very well head-to-head against the competition.

In the U.S. grocery channel, where the impact of new mac & cheese competition has been the most pronounced, our category share grew by nearly a full point year-over-year. The grocery channel also saw continued strength in snacks during the quarter, with cookies, crackers and fruit snacks all growing in excess of 20%. The $0.06 adjusted loss we incurred in the quarter included a $0.03 impact from stock-based compensation expense relating to prior periods and $0.03 in unanticipated professional services costs, primarily audit, legal and consulting fees related to addressing the material weakness and associated litigation matters.

Without these unexpected costs, our earnings would have been breakeven, better than we expected at the time we set annual guidance.

Net sales increased 10%, split evenly between base business growth and contract manufacturing revenues under our new 3-year supply agreement with Safeway. Without the inventory reductions by our largest customer, UNFI, net sales growth would have been north of 20%. We expect inventory reductions at this customer to continue for the next couple of quarters, but to a lesser degree than we experienced in Q1.

Consumption trends in the natural channel remain very strong, growing approximately 9% in the quarter. The effects of the inventory reduction were highly visible in our margin performance as well, adversely impacting our mix, trade spend efficiency and SG&A rates.

First quarter gross margin performance was also challenged by significant input cost inflation, including a year-over-year increase in the price of organic wheat of close to 40%, spending to support our accelerated pace of innovation and lower margin contract manufacturing revenue that came with the acquisition of the Joplin plant.

As we look ahead to the remainder of the year, we are realistic about the challenges we face, but equally confident in our ability to deliver much improved financial results. We expect our categories to remain competitive and the cost environment to remain difficult. At the same time, we expect continued strong consumption and strong volume growth throughout the year, and we expect margins to benefit from price realization and important operational improvements, including a focus on enhancing our sourcing strategies, executing our Fat Rabbit productivity initiatives and strengthening our demand planning processes.

We have robust plans in place to drive strong top line performance going forward. We expect to benefit from continuing mainline distribution gains and product innovation. The mainline distribution we have been adding over the past few years has been performing well. And in each category review, we are seeing bigger and better opportunities to drive our distribution, assortment, placement and merchandising to higher levels.

natural/organic is clearly a focus now for most retailers, and Annie's is a leader in that discussion.

On the innovation front, we continue to be excited about that the rollout of bag snacks. Retailer interest in both grocery and mass channels has been very positive, with a number of key accounts not only accepting these items, but also expanding their assortment of our cookies and crackers. Last month, we began shipping these items to 2 additional large retailers, and we expect distribution to expand significantly through the rest of fiscal '15.

Other new product introductions are also progressing well. Our Bernie's Farm line and Snack and Meal kits are launching now to good initial demand. Additionally, this month, we began shipping our new frozen snack items, pizza poppers and mini pizza bagels into over 1,700 Target stores. We are excited by the potential for frozen snacks because they taste great, they have an attractive entry price point and the margins are better than our earlier frozen products.

In the supply chain area, we're making very good progress in enhancing our capabilities and improving visibility.

First, on the sourcing side, we continue to navigate through a very difficult supply environment, especially for organic wheat. We've made great strides in our efforts to broaden our base of wheat supply and deepen our relationships at the farmer level. These efforts are bearing fruit. We're now largely contracted into our fiscal fourth quarter, providing good visibility into our full-year costs. And while organic wheat costs remains historically high, we do see early signs toward price stability in this important commodity. The steps we are taking in this area position us well for the future as supply and demand come into a more normalized balance, which we expect.

Second, we are nearing the completion of a major supply chain project involving a transition to a new manufacturing partner for our fruit snacks business, which continues to grow rapidly. This is by far the single largest productivity project in our company's history. Production is now up and running at our new manufacturer, and we expect the transition to be completed by the end of Q2, consistent with what we communicated to you on our last call.

We now own the formulas and control the most important commodities in our fruit snack supply chain, enabling lower costs and enhanced transparency. The cost savings from this transition are a key driver of our outlook for margin improvement in the second half of the year.

Third, the Joplin acquisition, which closed in early April, is off to a good start. The initial integration work has been seamless, our IT transition is proceeding as expected and productivity metrics in the plant are running according to plan. We are now implementing key initiatives in Joplin that will accelerate our pace of innovation and drive productivity improvement throughout our baked snacks business. For example, this quarter, we plan to consolidate production of our certified organic Brick [ph] Graham crackers into the Joplin facility, which we expect will drive significant improvement in our overall production costs, as well as enhance capacity and ability to really drive long-term success for these items.

Brick Grahams have performed exceptionally well in the natural channels, where we have amassed a dominant 60% market share just 2 years after launch. These items have low distribution levels in grocery and mass retailers, but are performing well. Improving our cost structure and expanding our capacity in this business will allow us to pursue sizable distribution opportunities in conventional channels, where we see lots of potential for growth.

While we are making good progress, we know we still have a lot left to accomplish as we work to develop our processes and systems. our operations team has responded really well to the significant challenges of the last couple of quarters. We've added key talent capabilities, and all of our people have stepped up to get us to the next level. I'm proud of the work they've collectively done.

With that, I'll now turn the call over to Zahir.

Zahir M. Ibrahim

Thanks, John. Before discussing our financial results in more detail, I would like to first address the recent change in our auditor. Following a careful search, we are delighted to announce the selection of KPMG as our new auditor. This transition has been fully completed, and KPMG have reviewed our 10-Q, which was filed today.

Turning to the first quarter financial performance. We reported an adjusted loss of $0.06 in the quarter. Without the SG&A headwinds that John alluded to earlier, results would have been breakeven and ahead of expectations.

Net sales were $43.3 million, up 10.1% year-over-year. We estimate that the UNFI inventory reductions impacted growth by at least $4 million or 10 percentage points.

Net sales for the base business increased 4.9%, led by 12.1% growth in snacks. The effects of the UNFI inventory reductions on net sales were most apparent in meals, which grew 5.2% in the quarter, and in dressings and condiments, which declined 12.8%.

Performance was strongest in the mass and other channel, which posted net sales growth in excess of 30% behind continued strong distribution and velocity growth. Contract manufacturing revenues out of our Joplin plant were $2 million, which is consistent with our expectations.

Turning to profitability. Adjusted gross margin was 28.2%, down from 38.8% in last year's first quarter. Commodity inflation, net of pricing, was a key factor in our year-over-year margin decline. We also faced headwinds on our trade rates and mix as a result of investments we are making to support an accelerated pace of innovation and due to customer inventory reductions.

Finally, as anticipated, the onboarding of low margin contract manufacturing revenue associated with our acquisition of the Joplin plant impacted gross margin comparisons in the quarter.

Adjusted SG&A expenses increased to 32.3% of sales from 28.7% a year ago driven by 2 factors. First, we realized approximately $1.1 million in higher professional service fees, the majority of which was unanticipated, and related to audit, legal and consulting costs. Second, in finalizing results for the quarter, we identified $900,000 of additional stock-based compensation costs related to prior years. This was recorded as a noncash expense in the first quarter. Had it not been for these 2 items, we would have realized a modest year-over-year improvement in our adjusted SG&A ratio, and that was despite the considerable infrastructure investments we have made in the past 12 months.

Consistent with guidance provided on our last call, we expect to deliver improved financial results as the year progresses. We expect second quarter earnings to decline year-over-year, but to a lesser degree than the first quarter. We continue to expect strong earnings growth in the second half as we benefit from mid-year pricing actions and strong productivity gains. As a result, we are reaffirming our guidance for the adjusted net sales growth of 18% to 20% and adjusted diluted EPS of $0.88 to $0.95.

Our balance sheet position continues to be strong despite the impact of seasonal working capital uses and a $7.5 million outflow associated with our acquisition of the Joplin plant. We finished the quarter in a net cash position. Inventories finished the quarter at $27.7 million, including an approximate $3 million relating to the Joplin acquisition, and approximately $2 million related to our strategic sourcing efforts in organic wheat. We expect to generate strong cash flow over the balance of the year, reflecting our outlook for enhanced profit delivery and our ongoing efforts to improve working capital.

With that, I will turn it back over to John for his concluding remarks.

John M. Foraker

Thanks, Zahir. In closing, I'd like to reiterate that we are making great progress addressing the challenges we've faced in recent quarters. Looking ahead, the significant pressure we face from customer inventory reductions and dramatic wheat inflation should begin to ease, and we have a clear path toward improved margin performance in the back half of the year. We are confident in our brand's continued traction with consumers, the pace of our successful innovation and our plans for growth in the year ahead. We are making significant investments in our people, systems and processes in order to deliver stronger and more predictable bottom line performance.

Management and our board continue to be intensely focused on taking all of the steps necessary to see that Annie's is positioned to fully deliver on our brand's substantial future potential. We look forward to updating you on our progress as the year continues to unfold.

With that, I'd like to turn it over to the operator for Q&A. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to Ken Goldman, JPMorgan.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

John, over the last few quarters, at the same time that some of the specialty, I guess, more natural-oriented retailers comps have slowed, the comps for conventional grocers have improved. And I'm just curious from your view, as a key organic vendor to these customers, how much of this trend do you think is taking place because the supermarkets are adding shelf space and doing a better job with organics? Or are you really not seeing that trend take place?

John M. Foraker

Well, I think we would characterize that we think that bigger grocers are certainly doing a better job focusing on natural/organic as a core initiative to try to draw that consumer into their store. I don't think there's really any question about that. Also, I think there's, obviously, some additional competition amongst the natural chains themselves that might be causing a little cannibalization between them. But in general, we still see very strong consumption growth across the natural channel and think the long-term outlook for that channel is really positive. But we also believe mainstream and mass retails are going to take a bigger part of that growing market in the future as well.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay. You gave guidance last quarter of a flat gross margin, SG&A up as a percent of sales and part on marketing, a 40% tax rate. Are all of those still intact as part of your guidance?

Zahir M. Ibrahim

Ken, yes, Q1 was obviously an unusually difficult quarter due to the confluence of factors that we mentioned earlier. And if you look at Q2, while we expect earnings to be down, the overall shape of the P&L will be considerably better than Q1. Gross margins will still be down year-over-year in Q2, but we expect strong progress over Q1. And then as you start looking ahead to the back half, you have some very visible margin drivers coming into play. And that's consistent with what we discussed on the previous call. So firstly, a price increase, which is greater than 4%, will take effect. Secondly, we'll be getting a big step-up in productivity, and that's coming from our fruit snacks conversion and a number of other projects in the pipeline. So we expect productivity savings in the aggregate to add 2 to 3 points to our margin as you think about the second half of the year. And then thirdly, trade spending as a percentage of sales is planned to be lower in the second half compared to the first half. And that's directly as a result of our innovations are biased to the first half of the year. So, yes, overall, we'd expect a lot of the big drivers to be in line. If you think of our inflation, that was broadly where we expected it in the first quarter. And we expect that to continue. We see some pressure from dairy, but overall, we feel inflation is broadly where we expected as well.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay, that is helpful. And if I could just ask a quick follow-up. As you made the decision to shift manufacturers on fruit snacks, I think that's what you said?

John M. Foraker

Yes.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Are there more -- I don't know how to ask this without you sort of giving a tell to your current manufacturers, but are there more opportunities potentially along the line to get meaningful supply chain improvements as we think about that beyond just fruit snacks?

John M. Foraker

Yes, for sure. We have a big pipeline of Fat Rabbits this year. The fruit snacks project is a very significant part of that, but we've got a lot of other things in that pipeline as well, and they range from the impact of bringing Brick Graham production into our own manufacturing facility, logistics improvements and the like. The nature of our business is to innovate into new categories, to go into new manufacturing arrangements. And as those businesses build and grow, we see a new host of Fat Rabbit opportunities for future efficiency being created. A comment on the fruit snack project, that's a project that we've been working on for over 3 years. And it's a very significant project, very complicated, required a ton of consumer research and a lot of planning. We feel really good about where it's at right now, and we think that provides a really great foundation for that business, which is performing exceptionally well for us to really drive the growth of that business with an improved profitability footprint over the next 3 to 5 years. But I do expect, as we continue to grow, that there will be projects like that, perhaps not as big as that every year, but in general, we expect to get ongoing productivity improvement as we grow this business from the level we are now to multiples of that.

Operator

Our next question will come from Bill Chappell with SunTrust.

William B. Chappell - SunTrust Robinson Humphrey, Inc., Research Division

Just, sorry, for housekeeping, but just want to make sure I understood. For your full year EPS guidance, that still includes these charges that you had in the fourth quarter or are you using the breakeven EPS number as a base?

John M. Foraker

Bill, you're correct. That would include the, I assume a $0.06 loss for the first quarter, including those items.

William B. Chappell - SunTrust Robinson Humphrey, Inc., Research Division

So if I'm looking at it right, I mean, these were just found in the past few months. So in effect, you're reaffirming guidance, but you found, I guess, a $0.06 headwind that you didn't have 3 months ago?

John M. Foraker

That's correct, but we did come in a little bit better than we had expected on an underlying basis.

William B. Chappell - SunTrust Robinson Humphrey, Inc., Research Division

Yes, that's the point, but I just want to make sure I was looking at it the right way. And then second, can you just maybe give us on -- if I'm looking at the hit, and I'm sorry if you've said this, from UNFI, was it equal across meals, snacks and dressings, condiments, other or was it weighted towards any one category? And will that kind of continue?

John M. Foraker

It was more focused in the meals and dressings business, and kind of for 2 different reasons. On the dressings side, UNFI is by far our biggest customer of those products. We tend to have our dressing business in natural/organic as a high share business, and really focus on the natural side of businesses. So it's going to impact that business more. And then on the meal side of our business, we tend to have very high velocity items that when you think of the context of an inventory optimization plan like UNFI's been effectively implementing, those are the easiest kinds of products to bring down volume quickly because you can order them on a very repetitive basis at lower numbers and be a lot more efficient. So it's a little hard to say if it's going to play exactly out like that through the rest of the year, but that's probably a good assumption. I would just point out that we took more than a $4 million hit in the first quarter. We had originally call that a full year impact of that in the range of $6 million to $8 million. So we think over the next 3 quarters, the impact is going to be much more tame.

William B. Chappell - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And the last one, on the commodity front. So you now have, I guess, a new head looking at the input costs. Is there a chance that there's cushion to the numbers if costs roll over this year or are you fairly locked where we wouldn't expect much volatility this year?

John M. Foraker

So Bill, the way I think about it is from a wheat perspective, we're pretty locked through at least well into our fourth quarter. So we wouldn't expect a whole lot of movement versus expectations there. I think the area where -- we're a little bit shorter on the dairy side. We're closer to spot there, maybe a little bit further out beyond that, but that's where, depending on what the markets do, you could see some wiggle either way.

Operator

Moving on to Chris Growe with Stifel.

Christopher R. Growe - Stifel, Nicolaus & Company, Incorporated, Research Division

I wanted to ask, and just to make sure I understand, the stock compensation cost, that was sort of a unique or onetime item. There's still those incremental stock compensation costs coming through this year. Is that correct?

Zahir M. Ibrahim

Yes. So there's a couple of things. You've got your normal stock-based compensation costs running through the P&L. And I suppose this item in -- just going through our normal quarter-end process as we determine that there was an expense relating to 4 futures [ph] investing that needed to be adjusted. And so specifically, it was around $900,000 [ph] in size. And related to prior periods, that go all the way back to 2008, and so clearly, immaterial to current and prior annual periods. In terms of -- so that gives you a context. It was the nature of the adjustment, but, yes, we have the normal ongoing stock-based comps running through as anticipated.

Christopher R. Growe - Stifel, Nicolaus & Company, Incorporated, Research Division

Okay. And then just if I could ask a question on the gross margin. Can you give any more color at all here around the input cost drag was -- even if not specifically, but was x basis points or in a range versus, say, mix versus maybe obsolescence cost? I'm just trying to frame that, and really I'm more interested in kind of how the model to gross margin in future quarters. This was unusually low in relation to what I expected.

Zahir M. Ibrahim

Sure. So I suppose when we went on the last call from a guidance perspective, we expected our margins to be lower. And a number of those drivers were what we saw. So the biggest element, the 2 main drivers, would be inflation and trade spend. And if we just take those in turn, from an inflation perspective, wheat was the biggest driver by far, and that was running at around 40% year-over-year. And you'd expect that because we saw a ramping-up of the wheat inflation in the back half of fiscal '14. And again, as I said previously, this is broadly in line with expectations for the quarter. And other commodities, we have swings either way. And overall, our inflation on commodities was around 10% for the quarter. In terms of trade spend, this included a greater level of support behind our innovation ramp-up. So firstly, we spent more on slotting than a year ago in terms of support behind the innovation included recent bag snacks launch, frozen entrées, the continued rollouts of the microwavable cups, as well as the launch of the snack and meal kits. So there was a lot of activity, and we invested accordingly behind those. Beyond those 2 items, some of the other drivers of our gross margin was mix. Now some of the higher innovation launched -- so innovation was around 13% of our sales for the quarter compared to around 9% last year. So you have a bigger impact from a mix perspective there. And then the other piece was the Joplin acquisition. So the supply arrangement that we have with Safeway, that was -- that impacted our margins by around 100 basis points as well.

Operator

We'll now hear from Mitch Pinheiro with Imperial Capital.

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

So just staying with Chris' last question, did you say -- the 40% was your wheat inflation and 10% was your total basket inflation? Did I understand that correctly?

Zahir M. Ibrahim

Yes, that's right.

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

Okay. So when I look at the second quarter as far as a gross margin, the slotting goes away, but it seems like everything else is pretty much intact, correct?

Zahir M. Ibrahim

Yes.

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

As far as headwinds are concerned?

Zahir M. Ibrahim

A couple of things. Firstly, you'd expect to see higher input inflation year-over-year. Just as we progressed through fiscal '14, you saw a ramp-up of input inflation, so to an extent the comps will be slightly easier from an inflation perspective. And that will continue during the course of the year. From a trade spend perspective, yes, we'll still have a decent level of slotting in Q2 as well. But the biggest driver's going to be the support behind innovation and how that starts to moderate during the course of the year.

John M. Foraker

And I'd just like to build on that. Also, as we mentioned in the prepared remarks, Fat Rabbits are starting to roll in, in the second quarter to a greater, much greater extent than they did in the first quarter. And for example, we're manufacturing a slot in our fruit snacks facility right now. And those lower costs will impact the second quarter. So we will see some sequential improvement from Fat Rabbits as well.

Ed Aaron

And lesser destocking than what we saw in the first quarter, will be a factor, too.

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

Okay. So lesser destocking, and again, across the meals and the dressings segment?

John M. Foraker

Probably focus more on those, but I wouldn't -- I'd say the impact through the rest of the year, as we mentioned earlier, is going to be less. It's a little harder to call out the exact impact by category over the next 3 quarters. It could -- just because of order timing and the like with UNFI, but that's probably a safe assumption.

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

Okay. And then -- and as you look at -- was there any pricing in the quarter? Did you take any pricing higher?

Zahir M. Ibrahim

Yes, so we saw between 1 and 2 points of pricing in the quarter, which is in line with what you saw in the final couple of quarters of fiscal '14 as well. And you'll see something similar on -- along those lines for the next quarter before it starts ramping up from the midyear price increase.

Mitchell B. Pinheiro - Imperial Capital, LLC, Research Division

And what will the total sort of annualized effect of the price increase amount to?

Zahir M. Ibrahim

Well, the price increase that we're going out with will be north of 4% midyear. So it will be somewhere between 3% and 4% on average, I'd have thought, for the year.

Operator

[Operator Instructions] We'll hear from Scott Van Winkle of Canaccord.

Scott Van Winkle - Canaccord Genuity, Research Division

First question is on the second quarter. I think the comment was you expect earnings to decline year-over-year. Does that include or exclude the $0.04 benefit last year? I think it was a $0.04 benefit from the pizza recall insurance proceeds?

Ed Aaron

Yes, that would exclude the impact of the pizza recall a year ago. So the base that you should be working off of is a $0.26 adjusted earnings number in Q2 last year.

Scott Van Winkle - Canaccord Genuity, Research Division

Great. And then the commentary about the key 33 and the distribution gain, what product categories are you seeing the greatest gains in? Is that the driver of the big snack growth we saw in the quarter?

John M. Foraker

It's part of it. It's pretty broad-based. The way to think about the key 33 gains we've gotten is very strong gains in mac & cheese, fruit snacks, cookies or I should say grahams and snack crackers. Those 4 categories are the biggest the focus areas for us for key 33, and that's where we've been having the most traction and success. And I would expect we would not only through the rest of this year, but into the next few years.

Scott Van Winkle - Canaccord Genuity, Research Division

And then on the competitive side, John, you started off talking about good performance in mac & cheese and taking a point of share in the category by entrants [ph]. What do you know that's going on out there competitively? To use a baseball reference, where are we as far as distribution of your competition, as far as are we in the third inning? Are we still pretty early on in that regard?

John M. Foraker

Well, a well-known competitor in the natural/organic space entered in late December, and they're probably up into the mid-40s, about 50 ACV nationally right now. Most of that effort's been focused in the top 10 grocery chains, and a lot of it in one big retailer, which is Kroger. We're performing extremely well head-to-head in that regard. We feel very comfortable with the fact that, that launch is not having any significant impact on us, which is what we've been saying. We do think it's impacting other competitors in the category, probably more mainstream competitors like the overall share leader in that category. And some smaller natural brands that have been around for a long time, that are taking pretty significant distribution losses as a result of it. We're not having that impact. There's another smaller competitor that has come into the category more recently, that is trying to extend their equity from snacks into that category. That's had virtually no impact on us, and we don't see a very significant impact on the category. That's in much earlier innings because it's really effectively just launched over the last couple of months. And I'd say the long-standing competitor that we've had in that space, that's naturally positioned, is losing a significant amount of distribution pretty much everywhere, and we have actually seen that brand being taken a lot more aggressively, perhaps as a result into some club channel configurations with really aggressive price points and things that we don't really think are sustainable over the longer term, and we've chosen not to match. So I would say that the competitive activity in the space has been very intense. I'd say that our brand has held up extremely well. We have a really loyal customer. We're still driving a significant portion of the growth in the category, and we're growing share in the category. Obviously, we have to be -- remain diligent, and we have to defend our space where we need to. And we're going to continue to be a very difficult competitor to compete against, and that's our plan.

Scott Van Winkle - Canaccord Genuity, Research Division

Great, John. And then one last one, on the SG&A, if you exclude the cost of the one-timers this quarter, I think you said the expense ratio was down year-over-year. That's pretty impressive given the revenue growth was obviously more modest. So with the lower sales to the large customer, were there efforts specifically this quarter to kind of reign in sales and marketing? I'm sure that the bringing in of a couple of million of contract manufacturing helped that mix shift as well?

Zahir M. Ibrahim

Yes, in terms of year-over-year, obviously, we've made considerable investments in our infrastructure, particularly headcount across the business. So you'd expect to see a headwind from that. As a leadership team, we've made a concerted effort to tightly manage our costs in the quarter. And you're seeing some of the impacts of that. There were some timing impacts as well. But yes, Scott, you've called it out.

Operator

David Palmer with RBC Capital Markets has the next question.

David Palmer - RBC Capital Markets, LLC, Research Division

The inventory reduction that you mentioned, that would be drag for over another 1 to 2 quarters, but less than the fiscal first quarter. I guess that was about a 10-point drag in the quarter. I guess I'm trying to get my head around how much less of a drag it will be? And what have you typically seen from these sort of destockings in the past?

Ed Aaron

So David, I'll kind of talk you through the numbers, and then, John, if you want to add anything. But it was at least a $4 million divot in the first quarter, and we're still very comfortable with that $6 million to $8 million range on a full-year basis. So that just gives you a sense of how much -- what the magnitude will be spread over the next couple of quarters.

David Palmer - RBC Capital Markets, LLC, Research Division

Okay. And just thinking ahead, asking the gross margin question in a different way, the way that this thing was modeling for a year, you would, through the combination of getting past some of these commodity pinches, the productivity, the pricing, certainly, the destocking trauma that your gross margin could approach where it's been on an annual basis from the past, that 39-plus perhaps by the end of the fiscal year. At least that was the thinking. Is that the sort of zip code that you think is possible? Are there other things that we should be thinking about that would be constraints or boosts to that, as we're thinking about this year evolving?

Zahir M. Ibrahim

Sure. We still see the shape of the gross margin curve similar to what we discussed before. And you'll see sequential improvement during the quarter of the year. Q3 and 4 will be similar to some of the levels that you're mentioning there, David. So in the upper 30s. What do we anticipate as being potential accelerators to that? Well, productivity, if we can enhance that, could be an accelerator. On the flip side of that, inflation to the extent it's slightly higher than that we expect at this point, that could have an impact. But probably, it's where we discussed previously.

Operator

[Operator Instructions] Jon Andersen, William Blair.

Jon Andersen - William Blair & Company L.L.C., Research Division

Most of my questions have been asked. I guess just a couple of follow-ups. You haven't talked too much about frozen in the Q&A. I guess, John, could you kind of articulate where you are today across, I guess, the major product offerings snacks, entrées and pizza, and kind where you would like to be at year-end if you have a successful year?

John M. Foraker

Right. So it's pretty consistent with what we've been messaging over the last few quarters. Frozen snacks is our third entry into the frozen area. We've learned a lot from our introductions over the past couple of years, and have really fine-tuned our approach to the category. So what we're doing in the snack area, which all along when we had identified taking Annie's brand into this area, we always thought that was one of the biggest opportunities for us. It just happened to be one of the more difficult from a supply chain standpoint to get into the kind of positioning that we wanted to from an ingredient and clean ingredient statement standpoint. We learned a bunch of things in these earlier launches. And what we've learned that's applied to this one is we're going to have a really good entry price point. So you can expect to buy a box of these for around $4. The other offerings that we've had, have been $8.99, $9.99 or higher price points. And when we look at the category and what we've learned, we see no evidence that there's any less of a consumer opportunity there from the research that we originally did a few years and have continued to build on. If anything, the opportunity is growing from a retailer perspective because those categories, as you know, are relatively unhealthy, and retailers are aggressively reaching out to brands like Annie's and others that appeal very strongly to millennial consumers, households run by millennial parents and young adults, who really have been moving away from frozen in general. And our brands are an opportunity for those retailers to innovate and bring them back into those categories. And so we're putting a major effort behind the frozen snacks. Those are launching nationally at Target. We expect those to expand very broadly after that. We are still working on enhancing our pizza offering. We don't have anything specifically to announce on this call, but we are working on it and have a plan. And then on the entrée part of the business, those items are doing okay. The lasagna items are doing particularly well. The other items are just doing okay. So we're looking at that, too, to figure out what's the right long-term approach to driving success in the frozen entrée category. So we're optimistic about the long term. It hasn't been easy. We don't think we've necessarily had exactly the right price value relationship and offerings to be successful. We think we're much closer to on that with frozen snacks, and we look forward to updating you on that in the next quarter, as well as our initiatives across the total frozen category.

Jon Andersen - William Blair & Company L.L.C., Research Division

Okay. And inventory, I guess, obsolescence wasn't mentioned as a headwind this quarter. I assume that's kind of behind us now. Is that a fair assumption?

Zahir M. Ibrahim

Jon, first thing, we modeled a continuation of some of the -- at a higher level that we saw at the back end of last year. So that's what we modeled into our numbers for this year. And in Q1, it was largely as expected. But it wasn't a material driver of the year-over-year margin change. We've made some really good progress in this area cross-functional teams to address the issue. But there's going to be a lag in terms of when you'll see that impact show up in the P&L. So typically, the obsolescence expense that you're seeing in the P&L right now is a result of decisions or inventory that was made 6 to 9 months ago. So the good progress that we're making right now, we'll start seeing the benefits of that in the back half of the year.

Jon Andersen - William Blair & Company L.L.C., Research Division

Okay. Just one quick one on pricing. The increase that's effective, I guess, midyear this year, is that pretty balanced across the portfolio? Or does it skew to one of the segments more than others?

John M. Foraker

It's pretty balanced. We've gone a little heavier in some spots and a little less in others. When we take pricing, we're very careful to look at price gaps, cliffs, elasticity, et cetera. And so we've been very thoughtful about how we've applied that. That price increase is out there. We don't expect any problem in getting it realized. We obviously have a good commodity story to support that we need one. And we feel like it's going to have very minimal impact on our positioning in the categories. And we think it's going to be really positive to the overall margin structure of the business in the second half.

Operator

And we have no further questions at this time. Mr. Aaron, I'll turn the conference back to you for closing or additional remarks.

John M. Foraker

That's it.

Ed Aaron

Thank you, everybody. We look forward to talking to you next quarter.

Operator

And again, ladies and gentlemen, that concludes our conference for today. We thank you all for your participation.

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