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Executives

Stephen B. Hughes - Chairman of the Board, Chief Executive Officer

Robert S. Gluck - Vice Chairman of the Board, Chief Operating Officer

Alan S. Gever - Chief Financial Officer, Executive Vice President

[John Mense] - Vice President of Finance and Investor Relations

Analysts

Robert Labick - CJS Securities

Gregory Badishkanian - Citigroup

Jon Andersen - William Blair & Company, LLC

[Tony Finner - Ross Capital Partners]

Suzanne Price - ThinkEquity Partners LLC

[Anthony Gurstein - Baron Capital]

[Steffan Mikatuk - Pike Place Capital]

Daniel Moore - Aquamarine Capital

Smart Balance Inc. (SMBL) Q2 2008 Earnings Call August 8, 2008 9:30 AM ET

Operator

Welcome to the Smart Balance 2008 second quarter earnings conference call and audio webcast. (Operator Instructions)

Statements made on this conference that are not historical facts including statements about the company’s plans, strategies, beliefs and expectations are forward looking and subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from such forward-looking statements for a number of reasons including those risks and uncertainties set forth in the company’s filings with the SEC and the company’s ability to raise prices as fast as commodity cost increases, introduce and expand distribution of new products, meet marketing and infrastructure needs, meet long-term debt covenants, and continue to grow net sales in a competitive environment with rising costs and an increased sensitive consumer. Please refer to our earnings release for the full statement.

And now I would like to turn the call over to John Mense, Smart Balance’s Vice President of Finance and Investor Relations.

John Mense

With me today are Steve Hughes, our Chairman and CEO, Bob Gluck, our Vice Chairman and COO, and Al Gever, our CFO. This morning we released our earnings results for the second quarter of 2008. If you have not seen the earnings release it is available in the Investor Center of our website at www.smartbalance.com under Company News. For the call today Steve will comment about Smart Balance’s progress in 2008. Bob will review our performance in the quarter and talk about a strategic productivity opportunity. Al will give details about our financial results and discuss our systems and implementation. Finally, Steve will discuss our outlook for 2008. After his remarks all of us will be available for your questions.

Because we acquired GFA brands during the second quarter of 2007 our reported financial results are not comparable to prior years. During the course of today’s call we may refer to results on an operating basis which include the results of Smart Balance since the acquisition and the results of GFA prior to the acquisition. We believe this will improve comparisons to prior periods because it reflects the performance and expenses of the operating entity. Please refer to our earnings release for reconciliation of operating basis results to GAAP results. The operating results should not be viewed in isolation or as a substitute for reported GAAP results.

I will now turn the call over to Steve.

Stephen B. Hughes

The second quarter was complex as we simultaneously increased distribution, changed sizes on our highest volume items, and started up our new ERP system. In addition our competition in the spreads category took an unprecedented two price increases while we had one. Despite this environment we continue to gain market share at our premium priced spreads business increasing this 13.7% share versus 13% in the second quarter of 2007.

We continued to expand distribution with +6% the initiative to increase average items on the shelf by 6% by the end of June from a year ago. Our top 20 accounts which represent 70% of our business reached the +6% target by the end of the quarter. It was a major accomplishment to achieve this in 12 months since we acquired the business. We believe that as a result of the economic pressure consumers are feeling there is a shift in spending from the grocery channel to super centers and club stores where we believe we are now well positioned following our +6% distribution days. We are seeing the channel shift in consumer purchases of our products at store level and will call these consumer purchases a concept that we’ll talk about today across all channels.

Including all channels we estimated the consumer purchases at store level on a dollar basis grew approximately 18% in the first half of the year. They were up 15% in the first quarter and they were up 21% in the second quarter. By all channels I mean grocery, super centers and club stores. The 18% growth in consumer consumption for the half closely correlates with the 19% in net revenue growth for the half. Importantly we are beginning to see an acceleration in consumer purchases versus last year. The first quarter was up 15%, April was up 21%, May was up 19%, and June was up 25%.

In addition to channel shift we believe at-home meal preparation will become more important in this challenging economic environment particularly as consumers reduce away-from-home spending and look to stretch every dollar. This trend will benefit the categories we are in. However, there is a recent IRI study that reflects that consumers financial concerns may have them focused a bit more on value in this period and stretching their dollars and a little less focused on health.

While we are gaining share and expect to do so, the extraordinary category pricing with related trade promotions and the broad economic environment are impacting the speed at which we can bring new consumers into the franchise. We feel good about our plan and execution of the Plus 6 but the pace of share growth will be dependent in part on consumer reaction to higher pricing and the level of competitive trade spending.

In June we began the conversion to the new size of our fastest-selling items. 16 ounce spreads are now going to 15 ounce and 48 ounce will be moving to 45 ounces. This will provide us both a margin benefit and a velocity benefit as our six highest velocity items will contain 6% less product which ultimately will increase velocity as consumers use-up rates will be 6% faster. This move brings us in line with the rest of the industry which reduced sizes over the past two years. This transition was more challenging than we anticipated as retailers had to draw down on inventories of existing products before they could make the change over at shelf. We believe this accounted for a large part of the difference between the +21% growth and consumer purchases in the quarter and the 13% growth in our net revenues in the quarter. I’m happy to report that this transition is in large part behind us at this point.

We continue to invest the majority of our spending in strategic brand development activities with new product innovations such as extra virgin olive oil, omega 3 enhanced spreads, and our 50/50 butter blends. And most importantly brand building programs in consumer marketing a strategic and sustainable program to bring new users to the brand.

We are very pleased with the results of our milk test market in Florida. We believe we’ve optimized the consumer proposition and marketing plan. Wal-Mart will be expanding placements statewide in Florida in September. In addition we’ll be adding a new product, a reduces cholesterol item which is enhanced with plant sterols, into Florida this fall as well. Further expansion on milk will in large part depend on an improved commodity cost environment. For competitive reasons we’ll be discussing expansion plans beyond the test market in Florida only after customer presentations have been completed and prior to shipping into the market place.

Now let me turn it over to Bob who will review our strategic productivity opportunity program and provide his perspective on the current economic and commodity environment.

Robert S. Gluck

Second quarter net sales increased to 13.2% versus a year ago on an operating basis and was primarily due to higher pricing designed to recover commodity cost increases. Selling prices in the company’s core category of spreads were increased in February and June with yet another price increase, our third this year, implemented on August 4. As Steve mentioned earlier consumer purchases were up 21% for the second quarter representing a 6 percentage point improvement over the prior quarter. Consumer purchases is a very critical number that we focus on in running our business as it represents consumer activity at the store level, and as we all know, that’s the real world battlefield that we compete on every day of the week. So we need to be sure that we continue to make progress in that important area.

With two price increases in the spreads category implemented by competition during the second quarter, trade spending in the category was at extraordinarily high levels. Given our premium price position and loyal consumer following we consciously resisted the temptation to slug it out with competition and stayed the course by not significantly dialing up trade promotion spend levels. This decision no doubt cost us some transient promotional volume in the quarter but this volume shortfall was more than offset at the bottom line by higher average prices for our products.

Before I move on I’d like to look back at the first quarter for a moment. Net sales in the first quarter increased 25% on an operating basis versus prior year while consumer purchases across all channels grew an estimated 15% as retailer inventories began to build in lock step with our Plus 6 initiative. During the second quarter this pattern reversed as growth in consumer purchases was higher than net sales. We believe the difference between our net sales growth of 13% and the estimated growth in consumer purchases of 21% was largely related to retailers drawing down inventories in advance of our size chain conversion as Steve mentioned earlier. So the first six months net sales growth of 19% appears to be in balance with growth in consumer purchases of 18%.

Gross profit margin for the quarter of 41.4% versus 48.2% a year ago as the rate of the selling price increases lagged the rate of commodity cost increases. Similar to others in the food industry all of our input costs are up significantly from last year and in some cases more than double. Gross margin for the quarter was also pressured by relatively higher trade and promotion costs and one-time packaging and inventory write-offs. It’s also worthwhile to note that our gross profit margin was negatively impacted because we delayed our second price increase until June, one month later than our competition, in order to synchronize the new pricing with our size change conversion. This was done at the request of our customers and probably cost us 150 basis points of gross profit margin in the second quarter. Add to that the 100 basis point impact of the one-time packaging write-offs I referred to earlier and we’re looking at approximately 250 basis points of margin softness that should disappear as we move on. We expect our pricing actions in June and August, the cost benefit from the size changes, and our strategic productivity initiatives to improve gross margin going forward from the low point of the second quarter although still probably below last year’s levels.

We recently experienced a bit of a break in commodity prices over the past week or so as a result of softer barrel oil prices which we all know translates to lower bio-diesel demand, a strengthening in the US dollar, and recent sell-offs from some major hedge funds. We have a critical crop report due out the early part of next week which will help determine in part the near-term direction of commodity prices. Weather conditions in a number of important growing regions have been hot and dry leading some people to believe that the report will be neutral at best. Still tough to determine what actually is going to happen with commodities but hopefully the worst is behind us. Right now stability at current price levels would be a welcome relief.

Moving on as we discussed in last quarter’s call we kicked off our strategic productivity imitative with a team that’s reviewing all aspects of our operations of P&L for opportunities to improve efficiencies, reduce costs, and leverage the scale of our business across the entire supply chain. I’m pleased to report that we’ve identified a number of meaningful projects that will either help reduce supply chain costs or improve spending efficiencies or in some cases both. We believe the financial impact of these projects will be significant and we have recently added talent to our operation and distribution teams to ensure delivery of these savings and benefits. Most of the projects will have an impact beginning in 2009; however, we’re expecting some savings on packaging and ingredient costs to begin later this year in the seven figure range.

As we complete the start-up of the ERP system, we’ll also be able to add analytic tools to help identify additional saving opportunities.

Now Al Gever our CFO will take you through a more detailed review of our second quarter financial results and also provide an update on the progress of the ERP system installation.

Alan S. Gever

As John mentioned at the start of the call, in addition to GAAP reported results I’ll be referring at times to results on an operating basis which include the results of Smart Balance since the date of acquisition on May 21 of last year and the results of GFA brands prior to the acquisition. And this is all to provide you with more comparable statistics year-over-year.

Before getting into the numbers, I do want to start by reminding you that beginning with 2008 the company began accruing for certain trade incentives and marketing costs as prepaid expenses to better match recognition of expense to revenue. This is consistent with general practice in the consumer products industry. This methodology is a change from prior years and while this methodology may create some timing differences between prior year quarters, it has no impact on fiscal year results. So in accordance with FAS 154 we’ve applied a retrospective application of this change in this accounting principal and it’s being applied to our 2007 quarterly results both on a GAAP and an operating basis. And you’ll find information regarding that in the 10Q that will be issued later today.

So let’s begin with our second quarter GAAP results. In the second quarter, net sales were $48 million with an operating loss of $500,000 and a net loss of $1.5 million which translates to a loss of $0.02 per share for the quarter. On an operating basis net sales increased 13.1% to $48 million versus $42.4 million in 2007 and that increase is primarily due to higher prices across almost all of our categories. We increased pricing on our products in June to cover rising costs following a similar action in February and as mentioned we’ve announced and we’ve affected an additional price increase on August 4 for the same reasons. These price increases again as mentioned are consistent with similar actions by others in the industry and in addition to that we have in fact begun shipments of our low weight sizes of our top selling spread products which began in June and puts Smart Balance spreads product line in line with the rest of the players in the category. So net sales increase of 13.1% was in fact lower in comparison to our estimated consumer purchases across all channels which increased 21% versus a year ago and we believe again that relative change in the growth in net sales was related to slower shelf conversion to the new sizes of spreads due to higher-than-anticipated inventories at the retail level. Bob explained that earlier.

The increase in net sales due to price is partially offset by a 3% decrease in case shipments and higher trade and promotion costs. At the product category level increases in case shipments on new products such as extra virgin olive oil spreads, omega 3 enhanced spreads, and our 50/50 butter blend products along with milk along with entire sales of cooking oil were more than offset by declines in base spreads and other categories.

Gross profit decreased $600,000 in the quarter to $19.9 million and that compares to $20.5 million in 2007 as the impact of higher pricing was more than offset by increases in input costs primarily in commodity raw materials along with higher trade and promotion costs and the lower volume. Gross profit as a percent of net sales decreased to 41.4% from 48.2% in 2007 due again to the timing lag in selling prices versus input cost increases along with the higher trade and promotion costs and some write-offs associated with packaging and product.

Operating income declined $6.5 million to a $0.5 million loss in 2008 from $6 million income in 2007. This is due primarily to higher general and administrative expenses, increased marketing costs of about $700,000, and a decline in gross profit. General and administrative expenses increased $5 million primarily due to higher costs as the company has expanded its organization for growth but also importantly includes higher non-cash expenses of $3.2 million in stock option expense, depreciation and amortization. Excluding these non-cash charges operating income would have declined $3.3 million to $4.3 million in 2008 from $7.6 million in 2007. I’d also like to add that for the quarter we comfortably met all bank debt covenants as required.

So as you know, starting last year we embarked on the process of transforming Smart Balance into a much larger business. A key element of this transformation was to replace the 20-year-old legacy system with a modern ERP system. Although we are a virtual company without production and distribution assets, we need to manage the increasingly complex supply chain as we expand. And now that Smart Balance is a public company we certainly also need to ensure that we are compliance with Sarbanes-Oxley requirements. So during the second quarter as Steve and Bob mentioned, we went live with our new system. While there were the usual headaches and adjustments that an installation of this magnitude usually causes, I’m pleased to report that the system is up and running and we’re now turning toward developing the now-available analytical tools and system enhancements that will truly transform the availability of information and our ability to use that for growth. I’m certain that along with the other members of the executive management team I would like to thank our employees who took on this project and put so much time and effort over the last nine months to make it happen. It was truly a tremendous performance by all.

And with that I’ll turn it back over to Steve who’ll give us some perspective on the outlook for the rest of the year.

Stephen S. Hughes

In summary, we remain focused on our long-term strategy despite the pressures that the increases in commodity costs and the current economic environment are creating for the entire industry. In fact we see this as a window of opportunity. Everyone who is competing in the category faces the same challenges we face but we are focused on executing a consumer and product innovation based plan that is both strategic and sustainable. Our plans for 2008 remain unchanged.

As we said before our number one priority is to optimize and expand our spreads business and I think we are well on the way to doing that. In fact we will focus on our core consumer base as we move through this period of price changes. We expect accelerated sales growth in the second half of 2008 as a result of increased distribution achieved through the company’s Plus 6 drive and in [inaudible] in our core category of extra virgin olive oil and omega 3 enhanced spreads and 50/50 butter blend as well as the impact of our size reduction. We also have the August price increase that we did not anticipate having for the back half of the year and that has been implemented.

We are encouraged by the acceleration of all channel consumer purchases at store level we were seeing in June of +25%. We are targeting 25% to 30% net revenue growth for the second half. It is a relatively wide range due to the uncertainty around consumer reaction to the increasingly higher prices that will be reflected after the August price increase particularly in the spreads category. The ability to get [inaudible] of our premium priced products becomes a bit more challenging in this environment. With this significant transition quarter now behind us though we believe the stage is set for solid acceleration in the second half.

Also I want to take a minute to reflect on the past 12 months. The second quarter marks the first year anniversary of our acquisition of Smart Balance and it has been a very, very busy year. And here are just a couple of our key accomplishments: Innovation resizing and share growth in our core spreads category, the national launch of butter blends, the successful test marketing of milk, strategic repositioning of the company and brand with our customers as evidenced by the success of Plus 6, the strategic progress we’ve made in channels outside of grocery, implementation of systems and processes essential to supporting a public company with a $500 million revenue and generating $100 million an EBITDA objective, most importantly the recruitment of a world class team with proven experience when it comes to building $500 million to a billion dollar brand. It’s important to keep in mind that all this was accomplished during a period when our commodity input costs had doubled and consumers were dealing with the worst pricing economic environment in 20 years. It has been a remarkable piece of work and I want to thank our team. There are only 56 of us but they’ve done what I consider the best piece of work I’ve seen in over a 12-month window in my 30-year career.

As Winston Churchill once said, “I think we’ve reached the end of the beginning.” The foundation is in place, the team is set, and the stage is set to deliver the strategic sustainable growth consistent with building$500 million revenue, $100 million EBITDA business in the next three to five years.

And with that I’d like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Robert Labick - CJS Securities.

Robert Labick - CJS Securities

First I wanted to just take a step back and go over, I know you tried to explain this already, the inventory draw down and where we stand now? And given the drawdown of the 16 ounce size to allow for the 15 to come in consistently, are we at low levels right now?

Stephen B. Hughes

We’re in balance coming out of the quarter and we’re seeing as we move into the third quarter what we would expect to see a little recovery. I think the key on this is we have basically on these six items we have about 50,000 to 60,000 cases of inventory between us and the end of the store self so it’s about 360,000 cases of inventory that need to be adjusted and in some cases retailers drew down the warehouse inventory before they brought in the new products and in some cases they had to really run the product down on the shelf because they don’t want to have the wrong tag on the shelf relative to the old size and the new size on the shelf.

Robert Labick - CJS Securities

I understand that from an if everything was equal perspective, but what happened to the sell-in of the new SKUs. I mean, SKUs went from 12 to 14 up to 18 to 19 in certain locations. Shouldn’t that add to sell-in?

Stephen B. Hughes

Well that was kind of what we saw in the first quarter. We basically had shipments ahead of consumption in the first quarter and then we reversed that this quarter. If we hadn’t changed the size in the second quarter, we would have expected to see consumption in balance with consumption. So the Plus 6 really was mostly impacted on the shipment side in the first quarter. The second quarter has been an impact to the size change. We’re looking forward to the third quarter certainly because we’ll have those two major transitions behind us.

Robert Labick - CJS Securities

Can you update us on the progress in non-IRI locations?

Stephen B. Hughes

We don’t want to talk about specific customers but we had major progress in super centers in the quarter and we look to see now as we look at the numbers and you can tell by the consumption numbers in total we’re outpacing our out-of-store purchases faster. They’re performing at a higher level than the actual IRI numbers which are grocery only.

Robert Labick - CJS Securities

In terms of the price increase for August, can you tell us what the total price benefit is expected for Q4 now assuming it’s fully implemented by then?

Stephen B. Hughes

It’ll be 8.3% across the entire line on average.

Robert Labick - CJS Securities

So you’re looking for mid-20s percent price benefit in Q4. Is that right?

Stephen B. Hughes

Cumulatively correct.

Robert Labick - CJS Securities

Looking into 2009 can you just walk us through broadly the drivers for growth to meet your long-term 30% objective? Assuming you don’t’ get a benefit of price next year, what are going to be the actual drivers of growth for 09?

Stephen B. Hughes

We’re going to have the lapping effect of Plus 6. One of the things about Plus 6, right now we’re obviously put Plus 6 on the shelf just in time for two competitive price increases and extraordinary amount of trade promotion in that window, so I think muted the impact and benefit of Plus 6. In accounts that reset Plus 6 back in October, we’re actually growing share three times faster than our national average. So we still believe there’s going to be solid benefit on Plus 6 as this pricing environment moderates a bit. The second piece is we have some other obviously innovations coming in the market place as we got out to the next year but we basically feel that with our core businesses we’ve got a very robust program in place that we think will play out very nicely as we thought. I think right now the question really with the pricing we see in the market place is near term is a little disruption. There’s a lot of discounting that should balance out here as we go into the third and fourth quarters and get those price increases behind us.

Robert Labick - CJS Securities

Can you remind us the covenants for the back half of the year and if that will be restrictive to your marketing spending or how close you are to them?

Alan S. Gever

As I said in second quarter we comfortably made our covenants. Our plan is consistent with what we had planned on doing early on in the year and we anticipate that we should have no problems with covenant coverage through the remainder of the year.

Robert Labick - CJS Securities

What is the ultimate EBITDA necessary or adjusted operating income, to use the right term, at the end of 2008 to be in compliance with the covenants?

Alan S. Gever

It would be in the mid-20s.

Operator

Our next question comes from Gregory Badishkanian - Citigroup.

Gregory Badishkanian - Citigroup

Just looking back at the A.C. Nielson or IRI data at consumer takeaway, a dollar takeaway was nicely and I think you mentioned this and what our data shows is that unit growth was kind of flattish. I’m just wondering if the retailers are raising prices, why isn’t that flowing through to you guys?

Stephen B. Hughes

I think the dollar growth is certainly coming. You’re going through a fairly epic step-up in pricing. This is our fifth price increase, so I think category units have held up pretty well particularly when you consider the channel shift that’s going to super centers and clubs. We’re seeing that in our business as well. But I think there’s a settling out period here. I don’t ultimately think people are going to fundamentally stop, change their ultimate consumption of spreads. It’s a product that they need to cook at home. I think there’s always going to be some stutter accepting as they digest higher prices, but I’m pretty optimistic that once we get through this August price increase that behavior will settle down. We’re optimistic as well that our Plus 6 initiatives where with that extraordinary pricing promotion we saw in the second quarter settles down a little bit then we’ll begin to get some nice traction on those as we have in the lead accounts that reset last November.

Gregory Badishkanian - Citigroup

Looking at some of your other major new product initiatives like milk which could be big opportunities, which of these do you think has the biggest opportunity and which of those portfolio of these new products has the highest likelihood of producing decent results? The biggest opportunities and then the ones that are most likely to provide at least some good sales?

Stephen B. Hughes

I think we’ve got doubles and home runs in the portfolio. I think cooking oil which we’ve seen some very nice performance on this year and peanut butter are two real doubles for us in the mix and we’ll be obviously focused on those going into 2009. To the other question Bob had I think they’ll be nice contributors next year with some of the things we’re going to focus on there. Clearly, milk’s a very big idea. We had consumer quantitative testing before we launched. Everything we learned in test market data was consistent with that initial work. Right now it’s really going to be a function of really getting the right commodity cost window in milk before we really can push that broadly. But that’s an idea that we think has got real consumer traction. We’re very pleased with what’s happened in Florida and we’ll begin to move forward on that when the commodity window is appropriate. So we also have a pipeline of ideas behind. This goal is going to be to get to $500 million and ultimately if we can be successful and go beyond that as we did on Healthy Choice, this’ll be a 10 to 12 category proposition and that’s what we have the team working on. And we’ll have innovation as we move forward. Each six months we’ll have hopefully items that will be rolling out and hopefully items that’ll be going to test.

Operator

Our next question comes from Jon Anderson - William Blair & Company, LLC.

Jon Anderson - William Blair & Company, LLC

Talking about the divergence between sell-in for your reported sales and the sell-through that we saw at retail, as you move through the quarter and into July are you seeing that relationship come into balance and how should we think about that relationship for the second half of the year?

Stephen B. Hughes

First of all, a lot of this disruption really happened late in June as we got into the heart of the transition window of the size change. We’re pleased with what we’re seeing in July and we think the balance between consumption and shipments is there. We have a little clean-up to do on the size change but we think the majority of that is behind us and we’re definitely looking forward to the second half. I’ve been through a lot of quarters and I think we had a plan going into the quarter that if we had not had the size change and not had the second price increase from competition and all of that activity there, I think we would be talking about a balance there that would be very consistent with expectations. We really feel that that’s behind us and we’re starting off the third quarter looking to really now get into pushing off that platform we’ve set and accelerate the growth.

Jon Anderson - William Blair & Company, LLC

The third price increase, the August 4 price increase, did you follow the industry on that and what was the magnitude of that pricing increase?

Stephen B. Hughes

What happened in the category, we learned really late May or early June that the category was moving up essentially June 30. We then had a 60-day window to implement so that was really why we had August 4. We have to give our customers 60 days. And that’s going to be an 8.3% increase. So the two things to have yet to impact our business from a velocity standpoint on a net revenue basis will be really the benefit of the size change. While we’re shipping that now, consumers have to buy that and use it up and come back 6% faster than they would previously and then the next price increase.

Jon Anderson - William Blair & Company, LLC

The comment on “in this consumer/competitive environment the ability to generate trial is more difficult right now.” What are the things you’re thinking about doing or what can you do from a marketing or mix perspective to try and improve upon that going forward?

Stephen B. Hughes

I wouldn’t’ want to get too specific on our tactics because clearly for competitive reasons we’re probably not alone on this call. But I would say that we are doing some fine-tuning of our tactics. I feel very good about our back half plan. I feel very good about what we’re going to be doing from both the consumer and trade standpoint in the back half. Again, we’re in uncharted water here and this is not a win sprint; it’s a marathon. I think what we’re doing is highly strategic and highly sustainable. I think what happened the second quarter was very transitional and not terribly sustainable by our competition. So we’ll just have to see when that sorts out. We’re not controlling when that sorts out but ultimately we think it will sort out and I think we’re going to make nice progress in the back half.

Jon Anderson - William Blair & Company, LLC

Last question on gross margins. With the price increase August 4 and the resize largely complete at this point, a little bit of easing obviously in the last week or so in commodities, should we think about gross margin trending back up into your long-term target range of 45% to 50% during the second half of the year or are we still too early to think about getting there?

Robert S. Gluck

We’re certainly going to see we think an improvement over Q2s levels. As I indicated we had a couple of one-timers there, the impact of the price delay and the packaging and inventory write-offs is about a 250 basis points of spreads. We probably weren’t that far behind Q1 which was toward the low end of our range, so we’re hoping that being able to take advantage of a little softening in the commodity prices which over the near term could maybe get us back to the low end of that range, but it’s going to be a little while I think until we’re going to be able to get broadly into the mid to upper range of that 45% to 50% and that’s probably more something we’d be looking at second half of next year.

Stephen B. Hughes

I think also the work Bob and the team is doing on the strategic productivity opportunity is going to have some benefit to the second half; not great though as you look at the full-year benefits and initiatives they’ll be material next year.

Operator

Our next question comes from Tony Finner - Ross Capital Partners.

Tony Finner - Ross Capital Partners

What was the new milk product that Steve was being introduced?

Stephen B. Hughes

This is a product we’re quite pleased with. This is a product that reduces cholesterol, actively reduces cholesterol product which will have the enhancement of plant sterols in it. It’s a great tasting product we think when you put that up with the full flavor fat-free product. It’ll be a 1% product. We think it really does provide us with a full range of heart healthy milk products. I think it’s interesting talking with one of our consumer relations people yesterday and the calls that she’s getting about the great taste of this great milk product are really pretty heartening. I think we’ve really have figured the product side of this out nicely. We might have a range. The chocolate product hasn’t performed as well because we’re really probably targeting older households with these products so we think the four-item range of the fat-free with the taste of 2% , the 1% product, the lactose-free product, and the reduces cholesterol product we think is the right lineup for us the creative a breach with this type product.

Tony Finner - Ross Capital Partners

You mentioned that you’re waiting for a better commodity window before rolling this out further. Milk prices I believe are down around 15% over the past two months. What sort of a window are you waiting for?

Stephen B. Hughes

Well we want to be in the mid to low teens. That’s really the right zone for us. It has bounced a bit lately. It’s bounced up to $18.00; it’s back down to about $15.00 now, so we’re hopeful that’ll moderate as we go into the first half of next year. But we also want to see how this second half plays out with the performance of our core business, but I think we’ve got the answers we need out of the test market to move forward.

Tony Finner - Ross Capital Partners

So this is an ‘09 extension?

Stephen B. Hughes

‘09 depending upon what happens to commodities. If commodity milk 100 weight goes back to $20 we’ll not likely be doing much with milk next year, but if it settles out and moderates a bit then I think you’ll see us be moving forward.

Tony Finner - Ross Capital Partners

I’m sure that I don’t fully understand the rationale for accelerating back to close to a 30% revenue increase in the second half of the year. You did get some benefit from the additional SKUs. These were not all in place as you pointed out beginning June 30 but they were being implemented for eight months beginning last October. Secondly, there’s clearly consumer resistance to higher prices to the extent that volume in some of your categories have retailers actually declining and with another price increase now in effect, it’s hard to see how over the short term that outlook is going to improve. So I’m not sure.

Stephen B. Hughes

I would say we see the range as being 25% to 35%. June was a 25% growth number with a partial impact of the June price increase and no impact to the August price increase and no impact in terms of consumption on the size reduction. We’re had a pretty nice headwind relative to short term promotional dealings. Just to give you an example, we had an account where we would in the quarter run or our price point would be a 2 for 4 promotion or 2 for 5 promotion one time in the quarter. Two of our competitors in that quarter with the combined price increases ran three events and they were running, one ran two BOGOs, and another one ran a 10 for 10. And this is not a category where you can expand consumption. You can move inventory from the customer to the consumer but it’s not like you can do a 10 for 10 promotion and invite the neighborhood over to eat more margarines. So it was one of those things where I think there’s been a little imbalance in what’s happened in the second quarter from a competitive standpoint. I think we feel good about that 25% to 35% range. We’re in uncharted waters and we also have some nice channel shift going on that is not insignificant and we I think are well positioned in channels outside of grocery now.

Tony Finner - Ross Capital Partners

You’re implying that that is the current run rate, right?

Stephen B. Hughes

The 25% was what actually we saw in consumption in June and we had a partial impact of the June price increase, none of the August price increase, and no real benefit from the size change. And I think a bit of a muted impact of the Plus 6 because of all the static we saw from competitive dealing in the quarter.

Tony Finner - Ross Capital Partners

One would take from that that you’re by at least that much in the third quarter.

Stephen B. Hughes

I would just say we want to be prudent here because this is uncharted water.

Tony Finner - Ross Capital Partners

Why be prudent?

Stephen B. Hughes

I think we feel very good about the plan we’re implementing but we’re dealing with an environment that we haven’t really dealt with in 20 years. So we want to execute and see how the customer responds. And we don’t’ really want to disappoint. This is one of those things we’re in a window where we know people are watching this from a top line standpoint, we’ve got to manage this carefully from a bottom line standpoint as well, and we want to focus on execution and let the results speak for themselves as we go through the next several quarters.

Operator

Our next question comes from Suzanne Price - ThinkEquity Partners LLC.

Suzanne Price - ThinkEquity Partners LLC

A lot of my questions have been answered, but one is on the Plus 6 you said 70% of your revenue accounts have reached that level. Do you have a goal for when everybody on average will be at [inaudible] Plus 6?

Stephen B. Hughes

We have a little clean-up over the back half. Our focus really was the top 20 accounts. We wanted to get those nailed and cleaned up and done right. I’m thrilled with the work that our customer team has done, our sales team has done, as well as our partner with Acosta. They’ve done a great piece of work. Not only have we gotten Plus 6 I think the reflection here is we are viewed strategically as a different factor both as a company and as a brand by our customers today than when we did this initiative. So we’re just going to keep chipping away at these other accounts that are more in the middle of the country. We’re pleased with the progress we’ve made on some of the large customers in the middle of the country; now we’ve got to fill in around those. But we’ll be chipping away at that as we go through the back half of the year. But in terms of the real impact in value to the business I think again the top 20 set was right strategically a priority.

Suzanne Price - ThinkEquity Partners LLC

Do you think that by the end of the year that you’ll be able to announce that on average there are 18 SKUs in every store that you sell to?

Stephen B. Hughes

Absolutely. I think that’s our objective and we’ve got those offers and programs out there right now and they’ll be cleaned up here in the third quarter. By October it’ll be mostly done because at that point there are no real resets happening in the back half.

Suzanne Price - ThinkEquity Partners LLC

In line with the line increase you’re taking right now, should we see some type of promotional activity like your customers have been doing as well?

Stephen B. Hughes

Well no. We really believe that that’s not strategic. We don’t’ really want to rent users with short-term promotions. We want to strategically appeal to them with our marketing message and our products. So while competition really did have their flurry of activity in the second quarter, we’re going to go up without any from a trade standpoint any unique activity in the August window. We’re going to focus on building the consumer base by focusing our dollars against getting our message out and getting people to try the brand.

Suzanne Price - ThinkEquity Partners LLC

So we may they see increased advertising instead?

Stephen B. Hughes

Yes. I feel very good about our consumer marketing plan for the back half of the year. We have a very solid TV and related support activity going on. You’ll see that, but that’s part of our strategy. That’s not being driven by the price increase. That’s what we were planning to do anyway.

Operator

Our next question comes from [Anthony Gurstein - Baron Capital].

[Anthony Gurstein - Baron Capital]

Not to belabor this but if you can help me just a little bit. With the August price hike we’ve now got three price hikes in the year?

Stephen B. Hughes

That’s correct.

[Anthony Gurstein - Baron Capital]

Can you just remind me the amounts of that?

Stephen B. Hughes

They’re 8%, 11% and 8%.

[Anthony Gurstein - Baron Capital]

Looking at that and the second half guidance of 25% to 35% revenue growth, how much of that is coming from the pricing after all three of these taking effect, and what’s the breakdown between price and volume?

Stephen B. Hughes

It depends on where we are in that range. I think if we’re at the low end of that range it’ll be a lot of price and a little volume. If we get what we hope we’ll get in cases, we’ll be towards the higher end of that range. I think the biggest caution we have here is we’re in uncharted waters and we’ve got to focus on executing. We’ve got a great plan. We believe we’re getting traction as we saw in June. And we’re encouraged by what we’re seeing in July. But we’ve got a long way to go until January 1.

[Anthony Gurstein - Baron Capital]

Help me understand then if at the low end of that range most of it’s coming from pricing, how should we be thinking about the initiatives of the new products? If volumes are at the low end of that when we’re introducing all these new products, how should I interpret that?

Stephen B. Hughes

Again we want to be prudent here but on that low end of the range it would say that there’s competitive promotional activity right now. There’s a high level of promotional activity that’s just creating a bit of a headwind getting traction from [inaudible] but I think even on that low end of the range we would be outpacing category. Again, we really just feel that until we get into this and see what happens and execute and see what happens in this particular pricing environment, we want to give a wide range and hopefully exceed expectations but don’t plan for something that we haven’t really been through before which is three price increases in one year is not something I’ve really ever experienced. Five price increases in 18 months nobody’s experienced. So it’s a unique window and we just want to be careful with expectations.

[Anthony Gurstein - Baron Capital]

Bob, if you don’t mind, should we be thinking about what looks to be about 400 basis points of gross margin in the quarter being one time an effect so that you were closer to the 45%?

Robert S. Gluck

I’d say it was more 250 basis points Anthony as opposed to 500. If you do the math, we were 41.4% and 250 so we’re close to 44 as opposed to 45.

[Anthony Gurstein - Baron Capital]

And the 250 was what?

Robert S. Gluck

100 of that was for some one-time packaging and inventory write-offs, and another 150 basis points was we wound up delaying our price increase a month versus competition. That was at the request of the trade and they wanted to sync up the new pricing with our new size change so they didn’t have to change the shelf stickers twice.

[Anthony Gurstein - Baron Capital]

With palm oil at current levels, is this a time that you would consider starting to go long or are you long?

Robert S. Gluck

We’re still at historic levels. So I think the prudent thing is to be kind of short, look to buy on dips which we do, look to be opportunistic, but certainly we’re still mid-50s right now on soy oil for instance. The highest I had been through to this point in time was 48 in 20 years. So we’re still at all-time high levels.

[Anthony Gurstein - Baron Capital]

Let’s say things were unchanged. You kick in three price increases. If you annualized that and say ran palm oil at current prices, would your gross margins be above 45%?

Robert S. Gluck

The key is do we get some stability in commodity pricing. If we get some stability in commodity pricing, we’re going to see the full impact of these price increases offset all of that, and then we should see some improvement in gross profit margin. That said, the other variable that we don’t know about is what’s going to happen on the promotional trade spend front. So that comes between the sweat between gross and net sales. So we had almost a couple hundred basis points versus last year of impact on our gross margin from trade and consumer promotions. So to the extent they dial it up again, we’re going to be prudent but at the same time we need to be competitive. So that would restrict our ability to kind of move up quickly.

Operator

Our next question comes from [Steffan Mikatuk - Pike Place Capital].

[Steffan Mikatuk - Pike Place Capital]

Anthony asked a couple of my questions already but Steve if you could reconcile in the beginning of the call and I kind of missed it because you were going pretty quickly but you talked about the trends through the second quarter where it sounded like consumption was actually improving each month and then in the press release you’ve got this caution about how people respond to the price increase. So do you think consumers were actually kind of, they wouldn’t have known there was this price increase coming so it’s not like there was a pre-buy in front of that.

Stephen B. Hughes

Not from the consumer’s standpoint. I think our base business is very strong. We’re keeping our oil users, they’re moving up with us on price. We always said we did the research a year ago when we were $2.19 a pound. Our oil users were very price sensitive at $2.99. Well we never thought we’d get the $2.99 but guess what, we’re there. And what we’re finding is on the base business they’re sticking with us. Now the challenge is how to get the attention of the people that aren’t in the franchise right now when you’ve got this kind of competitive trade activity. That’s not going to last forever and I think I have to say I’m encouraged by June, +25% in June, knowing that we don’t have the full benefit of the June price increase and we’ve got the August price increase and we’ve got the size change coming, and I believe a good chunk of the benefit we’re going to see from Plus 6 was muted because of all the competitive trade activity. So I think we go into the third quarter feeling like we’re moving in the right direction. Though the extent to which we grow in the second half is going to be less dependent upon what we do than what the competitive economic environment does to the consumer and what competition does in trade promotion. Because again when you load up potential new buyer Smart Balance with BOGO or whatever else of their current product before they switch to us, then they’re stretched out in terms of when we can get a shot at them. But that’s all temporary and transitional. What’s happened is nothing strategic. We’ve had some transitional challenges relative to the price increase which when we first saw the second increase we were delighted to see it as you can imagine, but then as we looked at the June IRIs and saw the competitive activity we said, “Short term it’s going to create some static,” and it has. But we’re moving forward off of that and I feel we are very well positioned going into the back half of the year.

[Steffan Mikatuk - Pike Place Capital]

And the up 25% in June was takeaway or sell-in?

Stephen B. Hughes

Takeaway. That was takeaway from the store. The actual shipments in June were disappointing because that’s the month that we really had the size change and inventories had to be drawn down by the customers in advance of that. It was actually much more pronounced than we thought it was going to be. We thought it was going to be a fairly smooth transition but it wasn’t. We are encouraged in July about the recovery in terms of the balance between both shipments and consumption and what we’ve seen in June is reflected in terms of the consumption growth in what we’re seeing in July. So we think we’re off to a good start in the quarter but we’ve got a long way to go till we get to the end of the year.

[Steffan Mikatuk - Pike Place Capital]

For the customers taking Plus 6 then were you shipping the new product size in the quarter?

Stephen B. Hughes

The Plus 6 items were already resized so they shipped. Really most of that pipeline went out in the first quarter. The changes we had on the Plus 6 were really our six core highest velocity items that we’ve had forever. So it was really a tale of two cities in the first half and that’s why we say we look at the first half and say we’re up 18% consumption, 19% shipments. That’s in balance and we start the third quarter on a pretty clean basis.

Operator

Our next question comes from Daniel Moore - Aquamarine Capital.

Daniel Moore - Aquamarine Capital

If you look out to Q3 with 25% to 30% total price increases taken over the last six plus months and to products with Plus 6, let’s say we hit the low end of the 25%. That would indicate volumes were flat to down. If that is the case, would that be, I know it’s sort of conjecture, but a loss of share or are you seeing the overall category volume decline?

Stephen B. Hughes

We’re very confident we’re going to grow share in the second half. The question is the rate at which we grow share. This is a high class position but we’re going to grow share and we really at this point just don’t want to be too ambitious in how we project that because we’re dealing with quite a bit of uncertainty. We’ve had 26 quarters of growth in share and I think we’re positioned to actually accelerate that growth but until we do it we don’t want to get in front of ourselves because there’s just a lot of things that we don’t - We’ve got a lot of experience around this table here and we’ve never seen a competitive and pricing or economic environment quite like this and I think we’ve got a very strong hit. Everything we said we were going to do, we’ve done. We’ve got good evidence that where the Plus 6 has been on the shelf in these lead accounts, our share growth is three times national average. When we look at some of the lead accounts, we like what we’re seeing but the net net here is that we’re going to outperform the category significantly we think in the second half. And again the category I think ultimately there could be some digestion issues relative to these price points but ultimately I don’t think they’re going to consume a lot less margarine and spreads than they’ve consumed in the past. We just have to get the consumer comfortable with these new price points we’ll have as we go into the fall.

Daniel Moore - Aquamarine Capital

If you outperform the category and the category is relatively flattish even and you have 25% price increases cumulative, that would imply that 30% growth should be relatively conservative. You’ve had lots of headwinds and I think you’ve done a great job of managing for the long term those things that are in your control. One of the things that’s in your control is the ability to relay what’s happening in your business to investors and we’ve had two consecutive quarters of meaningful disappointment. You’ve probably already given the answer, but just give us confidence that as we look into the back half of the year the expectations that you talked about will be achievable if not conservative.

Stephen B. Hughes

I think again the range of 25% to 35% and what that implies from an exit run rate for the year is a pretty nice accomplishment. Again, go back to the last two quarters. Three competitive price increases, extraordinarily high levels of promotion in those [inaudible] of times. That’s transitional; that’s short term; but we got what we needed to get done done which is Plus 6. We have a very strong program in the back half. We feel very good about it on both the consumer and solid on the trade side and again, performance is what counts and I think we feel good about the hand we’re playing. The reality is we don’t control what competitors will do in terms of short-term promotions; we don’t’ control what the consumers will be reacting to all the competitive and economic issues they’re dealing with but the headline is what we’re doing is strategic and sustainable. And it is working and will continue to work. The question is the degree to which it will work based upon the things that are outside of our control.

Daniel Moore - Aquamarine Capital

All else being equal, if you were to hit say 30% and I say again all other variables being equal which there’s no control over, would you likely see a ramp in growth from Q3 to Q4? Would you expect it to be accelerating into the end of the year with the price increases?

Stephen B. Hughes

I think we’d be accelerating just on the strength of the full impact of the size reduction. Consumers have to buy the product that we just shipped, use it up and come back and buy it sooner. So we’re going to see some benefit of that in August; we’re going to see some benefit of that in September; we’re going to see some benefit of that in October depending on their purchase cycles; and then we got the price increase in the second half and the only caution there is I think we expect to see a lot of trade promotion around Thanksgiving and Christmas. I think that will be when the competition will be pretty active. Again, I think what we can only do is execute our plan and I’m pleased with where we are. I’m proud of the accomplishments of the organization. I think we’re well positioned and I think time will tell how much we grow, but we’re talking about 25% to 35% growth. I don’t think there’s anything to be ashamed about in that range of growth and I think we’ll just let the back half unfold. We certainly are encouraged about what happened in June and we think we’ll see continuation as we go through the third quarter.

Thanks everybody and we appreciate your time.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Smart Balance Inc. Q2 2008 Earnings Call Transcript
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