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Highlights From HNZ's Q2 Conference Call: Continued Growth Overseas; Guides Higher for FY10

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November 24, 2009 12:45 PM EST

HJ Heinz Co. (NYSE: HNZ) reports Q2 EPS of $0.76, 6 above the consensus of $0.70. Revenues came in at $2.67 billion, versus the consensus of $2.63 billion. Shares are flat today.

Highlights From HNZ's Q2 Conference Call:

Sees FY10 EPS of $2.72-$2.82, versus prior view of $2.60-$2.70 and the consensus of $2.75.
(CEO) Heinz delivered 2.5% growth in reported sales, 6% growth in operating income and earnings per share of $0.76.
On a constant currency basis we grew sales by 3.5%, operating income by more than 10% and EPS from continuing operations by almost 16%.
India one of our catalysts in immerging markets delivered 26% organic sales growth in the second quarter lead by strong sales of compounded Glucon-D nutritional beverages.
Latin America was another growth driver in the second quarter with 28% organic sales growth lead by higher sales of Heinz ketchup and baby food.
I'm particularly encouraged by our trajectory in Mexico a relatively new and promising geography for Heinz with more than 100 million consumers in the ninth largest ketchup market in the world.
Our team in Mexico has achieved a record ketchup share of 12% according to Neilson after a little more than year on the market.
Heinz baby food and Heinz ketchup have won the important exclusive endorsement of the Mexican Pediatric Association.
Turning to Europe, Russia continues to perform well with 16% organic sales growth in quarter two driven by higher volume of ketchup and baby food.
With expanding distribution in the world's second largest ketchup market our solid relationship with McDonald's (NYSE: MCD) and aggressive marketing the outlook for Heinz ketchup and sauces in this still largely untapped growth market is very encouraging.
We have recently added new ketchup capacity in our Otradnoe factory outside St. Petersburg and are planning further investments on our Georgievsk baby food factory to sustain our rapid momentum in infant nutrition.
Of note our European ketchup sales grew more than 10% organically in the quarter. Overall immerging markets generated 15% of the company's total sales in the second quarter as well as year-to-date and they remain well on track to deliver approximately 20% of our annual sales by 2013 more than double their contribution of five years ago.
Turning now to our three global core categories, Infant Nutrition delivered 8.7% organic sales growth in the quarter on the strength of new products and innovation, Ketchup and Sauces grew 3.7% as Heinz build share in a number of key markets.
In our Meals and Snacks category organic sales of Ambien meals like beans and soup increased 5.1% but Frozen declined 9.7% reflecting a difficult year-on-year comparison and a global trend of consumer's spending fewer dollars in the Frozen category.
Across our portfolio pricing of 4.6% offset lower volume of 4.1% in Q2 subject I'd like to address. The volume results while not at all satisfying did reflect a difficult comparison versus Q2 of fiscal 2009 when U.S. retailers drove significant volume growth in North American consumer products behind the heavy buy in ahead of quarter end price increases.
Importantly we expect meaningful volume growth in Q3 supported by actions that are already underway. We are significantly increasing marketing investments in the second half of the year particularly in North America and Europe while accelerating new product activity as well.
Globally we anticipate marketing will increase at least 15% this year compared to fiscal 2009. To provide further perspective this means that our marketing investments will have increased by more than $130 million over the last four years or almost 50%. Our increased investments underscore our commitment to driving profitable growth and volume.
In the U.K., meanwhile, Heinz has launched our largest marketing campaign in that key market in five years.
We are also significantly increasing our outlook for operating free cash flow to approximately $1 billion versus our original target of 850 to $900 million. And we still expect constant currency sales growth of four to 6%.
(CFO) Focusing in on continuing operations, we had a very strong quarter. On a reported basis sales were up 2.5%, gross margin increased 60 basis points, we increased consumer marketing at a double-digit rate and operating income advanced 6%.
Only EPS dropped and again that reflects the overlap of last year's currency hedge gains. On a constant currency basis the results are even better and particularly at EPS. I'm pleased that we delivered these results while recently ramping up our marketing investments to help drive more top line growth in the second half of the fiscal year.
As we've done for the last few quarters, here we've laid out the dynamics of the currency changes as they rippled through our P&L. Overall currency affected the year-on-year comparatives by $0.22. The impact of currency translation on current quarter results was small, only a penny.
While the pound, euro cross rate hurt EPS by $0.03. The larger impact obviously relates to the prior year currency hedge gains of $0.18, which had been adjusted out the prior year base year to get the two years on an apples-to-apples basis.
Turning to the P&L, I know this is a busy chart but there are a few items to note here. SG&A costs remain under tight control and in line with our plan, up only 1% during the quarter. The net interest in other line included the $92 million mark-to-market gain on currency hedges last year.
And our tax rate was 300 basis points better than prior year, reflecting tax planning and the settlement of tax audits during the quarter. Year-on-year this helped EPS for the quarter by $0.03. We now expect our full year tax rate to be at the low end of our previous estimate of 28 to 29%.
(Q&A) Bill, I wanted to draw you out just a little bit, if I might on this whole business with the consumer. Particularly as we look at kind of the better-for-you segment of Frozen Foods, that's where you operate with Smart Ones and Lean Cuisine and Healthy Choice. The numbers show the category basically just hit the wall in January, and has been just tracking steadily down. I guess the worry there would be that given that a lot of
this merchandise is kind of premium priced, if you could help us a little bit with how you intend to attack that and get some better results out of the Frozen segment?(A)I'd be glad to, Terry. I think as you look at our results for the quarter, if you were to back Frozen out of our results for the quarter, our organic sales were up between four and 5%. So clearly we're wrestling with the Frozen issue, and predominantly that is the United States. And in terms of Smart Ones, we have been fairly disciplined, I think, and have really held our powder as we've watched this category decline, and we've watched our peers chase the decline in the category. Having said that, we are getting far more aggressive in the second half of the year, and our marketing spending on Smart Ones will be up about 40% in the second half of the year, oriented towards basically our heavy users. So we're going to do a lot of couponing against heavy users, media, particularly print. We've got a few new items coming that I'm not going to talk about today. I'll announce more details about it at Cagney. I think we have six of seven SKUs being launched in the spring to address particular segment opportunities. But the reality is that the category is fighting the prevailing trend of the consumer, and the consumer is not buying "for me" products as we've talked in the past, and as a consequence we've been extremely reluctant to jump in aggressively and simply chase the category down. It's like trying to throw a lifeboat on top of the Titanic. We do think the category, as it hits this winter, will level out a bit, given the impending diet season, given the bad comps a year ago. And so as a consequence we've made a decision to invest aggressively in the second half, as I said, with marketing up about 40%. Additionally we'll be increasing our D&A spending to bring better price points. But the one thing that we have found interesting is the enormous footballing going on in this category with brands offering six for 10, in some cases 10 for 10 and so forth. We're going to try to avoid as much of that as we possibly can but we factor in to all of our numbers a far more aggressive approach to Smart Ones in the second
half. But fundamentally we still need to be concerned about the category and address a lot of our efforts to bringing new consumers back into the franchise, which is what our plans are aimed to do in the second half.
I just wanted to follow up a little bit on the increased promotional activity. I guess specifically I was wondering what roll the food retailers are playing? Some of the stress they've been under, on one hand they want to attract more consumers with value but on the other hand it seems to me that higher basket size, higher total dollars or something, that's a concern of theirs. So I mean after margin do you think that food retailers are driving this more promotional activity? Or is really a little bit of buyers seeing deals in other places and driving that and kind of forcing the food manufacturers to play along? (A) I don't think anything has fundamentally changed in the 35 years I've been in this business. I think fundamentally it's always been a retailer manufacturer contest to see where the money goes, either directly to the consumer or back to the retailer. So I think we're not seeing anything different other than the pressure points created by private label and the reaction from the second tier brands, where I think most of the pricing pressure's coming from as the retailer tries to bring consumers into the store. But I think you're also going to see more partnerships, much as we did in New Zealand with our partnership with one of our customers. We put 400, actually more than 400 Wattie's products on an initiative that our retailer basically split the cost with us on to try to bring consumers in the store. And if you remember, in New Zealand we do almost 7% of the total grocery sales in that market. So it had a huge affect, not only on us and our shares but it actually lifted their business significantly. So I think what retailers are trying to find are things that generate foot traffic. I also think that retailers are trying to take advantage of the continuing erosion and away-from-home consumption and so they're looking for opportunities to bring categories or products back into the store that will attract those consumers. I think the third thing is that the market itself, in terms of the consumer manufacturers, I think when the markets turned down last year I think all of us began to focus more aggressively on value. And I don't think we've all done the job on innovation that we need to do to continue to excite and entice consumers, and frankly our customers, in order to bring news to the category and you'll see that change in our plans in the second half of the year.
The pressure points come from a combination of things. Obviously you're seeing some deflation in some commodities, not all but some commodities are declining. You're seeing a concerted push by the private label manufacturers to take advantage of what they see is a window of opportunity. And we're seeing a reaction from the owners of second and third tier brands who are doing everything they can to maintain their shelf space in basically a period when we're looking at SKU rationalization across a number of retailers. And then I think finally what you're seeing is a consumer that is trying to optimize their shopping trips. And so consumers are picking brands very carefully and then marrying those brands with either associated private label products or other products. But the thing I caution everybody on in private label, there is no doubt that the private label trend is slowing. It is still a significant trend globally but it is slowing and you have to remember that the basket of goods that private label shares are built around include a lot of areas where the brands don't compete and the brands don't participate particularly towards the front of the store in the U.S. and the U.K. in the chilled section. So I think it's a combination of pressure points. I think all that changes over a period of time is that those pressure points take on added urgency depending on the pressure point and right now I think price is probably that pressure point.
I just wanted to switch over to gross margins and the outlook there. One specific point and then maybe more of a general question. On the Golden Circle acquisition I know that with next quarter we get into the point where it might be less of an issue for margins. Could you just quantify how much of a hit that was this quarter and how that's likely to change going forward? And then more broadly given the outlook for commodity cost inflation and productivity improvements, do you see any changes to your current outlook for the year for the gross margin for the rest of the year?(A)To you point, Alexia, we're doing well on gross margins so we're pleased with the performance on that so far. As we look forward we do think that there will be some moderation in some of our commodity costs but we do still see the same headwind from tin plate and tomatoes and potatoes that we mentioned. So as we look forward we do think gross margin will be a bit better and will be up to prior years so I think we're in line with or better than the plans that we laid out from a gross margin standpoint. (A)I think, Alexia, the Golden Circle impact is give or take, because it's not precise, is I would say around 20, 30 basis points for the quarter. I don't think you're going to see a substantial turn in that business short term because we're still in the process of moving after synergies. We've got the two manufacturing facilities in Australia that we're working to upgrade. We've just signed a deal with Ocean Spray to represent them in Australia. So we're making some capital investments in both the Mill Park and the Northgate factory in Australia. And I think the other thing is we've launched two new items in Golden Circle. One is called Raw, which is a product of the original juice company, and the other one's called LOL, which is a short name for Laugh Out Loud, which is a fizzy drink directed towards children. So you're going to see us continue to invest pretty aggressively as we try to grow the top line there. But I think given the seasonality of the business and given what's happened to commodity costs, I think it'll be another six to nine months before we start seeing
meaningful improvement in margins on Golden Circle, but that was pretty much factored into our thinking.
Just wanted to get a quick clarification on the guidance. Was there any change to your constant currency operating profit or EPS assumptions for the year? And then secondly, how do the divestitures affect the full year numbers? (A)We're on track for our constant currency numbers. So we're feeling good about that. As you saw, we're off to a good start there for the first half of the year and anticipate solid results in the second half as well. So that piece of it in line with expectations. In terms of the divestitures, whatever divestitures come we'll end up being in discontinued operations. So sort of a set aside from continuing ops, which is what we're
focused on. And the key there that you need to be aware of is that any of these divestitures that we might do will not have a material impact on ongoing profitability of the company, and that's why continuing operations is
the appropriate measure.
And then just one other quick one if I might just on the kind of the decision to ramp up the marketing spending. I know you talked a lot about how the external environment has thawed a bit, which it makes you a little more inclined to spend, but how much of it's a function of the volumes may be being a little bit worse than what you might have expected over the last few months? I guess the question more or less is when you look at kind of the recent trends in the business, how surprised were you by some of the volume pressure that you saw recently? (A)Yeah. I don't think we were surprised by the North American pressure because we knew we were comparing against a very difficult comp from last year. Food Service actually surprised us on the upside a bit being down less than 1% organically given the foot traffic in that industry. But there's not doubt that one of the contributing factors to the decision to ramp up marketing has been the soft volume in Q1 and Q2, and you'll see a dramatic change in Q3, Q4. But factored into our range, and into the organic comments that Art just made about constant currency, marketing in the second half of this year is going to be up between 25 and 30% at a minimum, and that just includes consumer marketing. We'll also expend a little more D&A. That's factored all into our range as we continue to recognize three things. One, the market is a little more receptive now. There's no point in chasing consumers out the door. I think frankly that's just a waste of money. Secondly, we are working on opportunities in terms of new products and some new initiatives in the second half of the year that will address the improving environment, and frankly address some of the volume issues we've had in the first two quarters. And third, some of our peers have gotten our attention with comments they've made to the market and to other people, and while we won't specify or name any of those peers, those peers have clearly
gotten our attention and have maybe awakened some of our brand teams, who have requested a little more support and a little more aggressive activity. The one thing I will say about marketing in the second half of the year, every single one of our operating businesses, marketing will be up double digits in the second half of the year.