McCormick [MKC] Conference call transcript for 2022 q3
2022-10-06 11:15:04
Fiscal: 2022 q3
Kasey Jenkins: Good morning. This is Kasey Jenkins, Chief Strategy Officer and Senior Vice President, Investor Relations. Thank you for joining today's Third Quarter Earnings Call. To accompany this call, we posted a set of slides at ir.mccormick.com. With me this morning are Lawrence Kurzius, Chairman and CEO; Brendan Foley, President and COO; and Mike Smith, Executive Vice President and CFO. During this call, we will refer to certain non-GAAP financial measures. The nature of those non-GAAP financial measures and the related reconciliations to the GAAP results are included in this morning's press release and slides. In our comments, certain percentages are rounded. Please refer to our presentation for complete information. Today's presentation contains projections and other forward-looking statements. Actual results could differ materially from those projected. The company undertakes no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events or other factors. Please refer to our forward-looking statements on Slide 2 for more information. I will now turn the discussion over to Lawrence.
Lawrence Kurzius: Good morning, everyone. Thanks for joining us. Third quarter sales increased 3% from the year ago period as anticipated. In constant currency, sales grew 6%, reflecting 10% growth from pricing actions, partially offset by a 1% decline from the Kitchen Basics divestiture and 1% decline attributable to the exit of low-margin business in India and the consumer business in Russia and a 2% decline in all other volume and product mix. Our underlying third quarter growth reflects the strength of our broad global portfolio as well as the effective execution of our strategies and pricing actions against the backdrop of a volatile operating environment. Using 2019 as a pre-pandemic baseline, third quarter sales grew at a constant currency three-year compounded annual growth rate, or CAGR, up 7%, reflecting the sustained momentum in our business across both our Consumer and Flavor Solutions segments. Moving to profit, adjusted operating income was down 12% or 11% in constant currency adjusted earnings per share was down 14%. During the third quarter, supply chain challenges continued and recovery of certain constrained materials is taking longer than expected. We continue to incur elevated costs to meet high demand in our Flavor Solutions segment. While in our Consumer segment, where demand moderated from elevated consumption trends more quickly than expected, we are experiencing lower-than-optimal operating leverage. Across the supply chain, we remain focused on managing inventory levels and eliminating inefficiencies, though the normalization of our supply chain cost is taking longer than expected, pressure in gross margin and profit realization in the current period. Over the coming months, we will be aggressively eliminating supply chain inefficiencies. Importantly, as we had expected in the third quarter, our price increases are catching up with the pace of cost inflation in both segments. We began to recover the cost inflation that had been outpacing our pricing actions and other levers both significantly in the Consumer segment. We expect this will continue into the next year as we plan to fully offset inflation over time. Before discussing our third quarter segment performance in more detail, I'd like to comment on our supply chain plan, starting on Slide 5. We have a focused plan in flight that leverages the discipline of our established Comprehensive Continuous Improvement or CCI program to ensure that we are able to flexibly support customer demand, both where it has been sustained at higher levels and where it has moderated, while eliminating inefficiencies and normalizing both our cost structure and inventory levels. Our actions are well underway. Our top supply chain priority remains keeping our customers in supply and supporting their growth. There are areas of our business that have sustained high levels of demand for an extended period and our supply chain has been pressured to meet this demand. We have several initiatives in progress that will increase our capacity, strengthen our supply chain resiliency and importantly, enable us to service our customers so they can grow their business. For example, we're investing in additional Flavor Solutions seasoning capacity, which will be online in early 2023. We're expanding FONA's footprint to support our flavor growth. We recently opened our new U.K. Peterborough Flavor Solutions manufacturing facility to support our strong growth momentum with quick service restaurants. And just earlier this week, the first pallet was shipped from our new Maryland Logistics Center. And from a cost perspective, as we responded to demand volatility over the past several years, we have incurred additional costs above inflation to service our customers and have seen inefficiencies develop in our supply chain. These are costs we have absorbed. We have not passed into customers on our pricing actions. We are targeting to eliminate at least $100 million of these costs with a significant benefit in 2023. We're moving aggressively to take these costs and inefficiencies out as well as normalized inventory levels that have built up. Some of our actions include investing to increase both manufacturing capacity and reliability in bottleneck areas to enable better customer service and repatriation of production from excessive use of co-packers. We're returning to more normal ship schedules and reducing our spend on expensive surge capacity. We are already seeing the benefit of lower overtime and temporary labor reductions. In this more normalized environment as well as through customer collaboration, we are already beginning to reduce expedited freight costs and less-than-truckload shipping costs as well as other transportation inefficiencies. We are resolving raw material and packaging supply issues. For example, we are beyond the shortages of blast bottles and certain organic spices, which impacted supply of our U.S. gourmet line. A supplier facility closure announced in September drove the discontinuation of a component of our dry recipe mix packaging and through our quick qualification of alternative supply, we mitigated a major disruption during the fourth quarter. Long-running shortage of French's mustard bottle will be resolved in the first half of 2023 as new molds come online at a second supplier. And from an inventory perspective, we are also executing on plans to return to historical safety stock levels, which were raised to protect against supply disruption. We expect the impact of our actions to normalize our supply chain costs, increase our efficiency and ability to meet demand, lower our inventory levels and importantly, increase our profit realization beginning in the first half of 2023. We have managed through various supply chain challenges over the last several years with the peak disruption experienced in the third quarter of last year. Since then, there has been steady improvement building progress and bolstering our confidence in our plan to enhance our operational performance and optimize our cost structure. While we will always prioritize meeting our customers' needs, I'm encouraged by our disciplined approach to resolving the increased cost within our supply chain. We've continued to define and quantify specific actions within our plans as we - since we shared we would be driving the elimination of the supply chain inefficiencies in our preannouncement last month. We look forward to sharing more details and progress with you in January, when we provide our 2023 outlook. Now moving to third quarter business update for each of our segments. Starting with our Consumer segment on Slide 6 and the status of our pricing actions, our third quarter sales reflect the impact of our pricing actions in all three regions, with an acceleration of effective pricing in the quarter versus the first half of the year, in line with what we expected. While broad pressure on Consumers' cost of lending from inflation, which heightened during our third quarter, as resulted in higher price elasticity than we originally anticipated, our elasticities remain lower than historical levels. And our most recent pricing actions, which in the U.S. took effect as we began our fourth quarter, we focused on areas that are less elastic and did not take pricing on some products where we had seen the highest elasticity. Now, for some further highlights by region, starting with the Americas. Our total U.S. branded portfolio consumption as indicated by our IRI consumption data and combined with unmeasured channels grew 4%, in line with our shipments. And over the last three years, since 2019, consumption has grown at a three-year CAGR of 8%, which highlights how the sustained shift in consumer consumption continues to drive increased demand for our products and outpace pre-pandemic levels. In early August, we divested our Kitchen Basics business. We consistently grew this brand over the years but as it was the only U.S. brand we had in the stock and our resources were better focused on core categories where we have leading brands. Demand has remained high with strong growth in the majority of our categories. Spices and seasonings has been one of our strongest categories in the past three years. And as a result, we are lapping all-time highs in consumption. This has created challenging comparisons in some product lines, such as baking related items, which have returned to a pre-pandemic level unlike most of our categories. Drilling-related items were impacted versus last year by high meat prices, although grilling is still strong versus pre-pandemic. Health conditions continue to improve as seen in our recipe mix share performance, with the fourth consecutive quarter of share gain. Our spices and seasoning share was pressured by service-related distribution losses, a shortage of certain packaging items as well as certain organic prices, which has largely been resolved and some trading down by consumers who remain under pressure from broad-based inflation. We are using our category and revenue management capabilities to strengthen our spices and seasoning presence on shelf. The strength of our brands and our category leadership has recently won us new distribution, which we're beginning to realize now. In EMEA, we continue to have solid share performance at herbs, spices and seasonings in the U.K., Eastern Europe and Italy, somewhat offset by softer performance in France. We are continuing to gain share on Frank's RedHot in the U.K., and we are beginning to build momentum with Cholula as we expand that brand into this market. For the quarter and year-to-date versus last year, as well as since 2019, we are driving the U.K. hot sauce category growth. Our Bottone brand of homemade dessert products in France, a product line of unique to our EMEA region, as flows, we have seen baking return to a more pre-pandemic baseline level in EMEA to, again, unlike our other categories. Turning to the Asia Pacific region. Last year, the region experienced supply chain challenges such as ocean freight capacity constraints and lapping that impact contributed to growth in the third quarter. Additionally, following an extended lockdown in the second quarter, COVID resurgence in Shanghai and some other cities throughout China eased as we began the third quarter, resulting in trade and pantry replenishment contributing to growth. Recently, several cities in Central China, which is the primary market of our Wuhan operations, have experienced new COVID-related lockdowns and we are continually monitoring the situation. Overall, our China performance is on track with our expectations. Across all regions in our consumer segment, we are achieving the price realization we expected and we're executing on our proven growth strategies, pivoting action plans as needed based on our consumer insights and the environment. We continue to invest behind our brands. We increased brand marketing investments in the third quarter and have additional investments planned for the fourth quarter. In addition to our highly effective and inspiring holiday messaging, we have pivoted our digital messaging to emphasize value and show consumers how our products help them stretch their grocery dollars without sacrificing flavor. We are focusing our innovation efforts to meet the needs of consumers concerned about their budgets. In the Americas, we have launched a new Lawry's branded opening price point range of every day 10 spices. And our large-size format Super Deal is one of the best-performing product lines as consumers are looking for greater value. This format size is approximately a 40% better value per ounce than the smaller sizes. We've also launched large-sized resealable pouches of top-selling items in markets across all regions. In terms of category management, we are collaborating with our customers to ensure the right assortment and price points on shelf to optimize category performance and increase profitability for our customers. And as always, we have a strong merchandising program planned for the holiday season. We are confident in our brand marketing investments, innovation and category management initiatives, which will continue to drive strong growth. Turning to Flavor Solutions on Slide 8. Our sales performance for the quarter was strong, with growth led by our pricing actions in all three regions with an increase in our effective pricing versus the first half of the year as we expected. Now for some regional highlights. In the Americas, strong growth was driven by snack seasonings, savory flavors and branded foodservice products. Demand continues to strengthen the branded foodservice restaurant and institutional foodservice customers as mobility and strong summer travel continued to fuel consumption. And importantly, we also are expanding distribution. In EMEA, growth remained strong across our entire customer base. Our third quarter growth was led by strong quick service restaurant, or QSR, momentum in all markets partially driven by expanded distribution and our customers' promotional activities. And we're seeing an acceleration of demand in branded foodservice as customers shift to more economical formats. Our full spectrum of solutions across price points is driving growth. We are winning in both regions with our new product momentum. In Americas, growth from new products contributed approximately 25% more growth in flavors in the third quarter than the year ago period, driven by beverage, savory snacks and Performance Nutrition flavors. We are continuing to win share in these categories. And in EMEA, our third quarter new product launches accelerated versus earlier in the year. And for the full year, we expect new product introductions to outpace 2021. We are fueling future growth. In APG, we're driving further menu penetration with our QSR customers, winning new limited time offers as well as realizing growth from strong performance of their core menu items we flavor. In many cases, we are the heat in their spicy offerings. Overall, Flavor Solutions has remained strong and for certain parts of our business in the Americas and EMEA regions, our supply chain continues to be pressured to meet this high demand. And as I said earlier, we are still taking on some extraordinary costs to service our customers. We appreciate our customers working with us, and we see light ahead. Now some summary comments before turning it over to Mike. Turning to Slide 9. Global demand for Flavor remains the foundation of our sales growth, and we have intentionally focused on great fast-growing categories that will continue to differentiate our performance. We continue to capitalize on the long-term consumer trends that accelerated during the pandemic, healthy and flavorful cooking, increased digital engagement trusted brands and purpose-minded practices. These long-term trends and the rising global demand for great taste are more relevant today than ever with the younger generations fueling them at a greater rate. McCormick is uniquely positioned to capitalize on this demand for great taste with the breadth and reach of our strong global flavor portfolio. We are delivering flavor experiences for every meal occasion through our products and our customers' products and are driving growth. We are end-to-end flavor. We remain focused on the long-term goals, strategies and values that have made us so successful. We have grown and compounded that growth over the years including through the pandemic and other periods of volatility. Our solid track record of achieving our long-term objectives highlights the resiliency of our business through a variety of market conditions as well as our focus on sales growth and profit realization. The long-term fundamentals that drove our industry-leading historical performance remains strong, the strength of our business model, the value of our products and capabilities and the execution of our proven strategies by our experienced leaders, while adapting to changes accordingly, give us confidence in our growth momentum and in our ability to navigate the global dynamic environment. The compounding benefits of our relentless focus on growth, performance and people continues to position McCormick to drive sales growth and balanced with our focus on lowering costs to expand margins realize long-term sustainable earnings growth. The team work of our McCormick employees, driver momentum and success and I want to thank them for their dedicated efforts and engagement. And now I will turn it over to Mike.
Mike Smith: Thanks, Lawrence, and good morning, everyone. Starting on Slide 12. Our top line constant currency sales grew 6% compared to the third quarter of last year, including a 1% unfavorable impact from the Kitchen Basics divestiture, as well as a 1% impact from the exits of low-margin business in India, and the consumer business in Russia. In our Consumer segment, we drove constant currency sales growth of 4%, with 10% related to pricing actions, partially offset by a 1% impact from the Kitchen Basics divestiture, as well as lower volume. With the exit of low-margin business in India and the consumer business in Russia contributing a combined 1% impact to the lower volume. On a three-year basis, our third quarter constant currency sales CAGR was 6%. On Slide 13, consumer sales in the Americas increased 3% in constant currency, driven by pricing actions, partially offset by a decline in volume as well as a 1% impact from the Kitchen Basics divestiture. As Lawrence mentioned, the volume decline was impacted not only by elasticities, but also by constrained supply of certain input materials, primarily packaging items. Over the past three years, constant currency sales in the Americas grew at a CAGR of 6%. In EMEA, constant currency consumer sales declined 1%, which included a 3% unfavorable impact from lower sales in Russia. Growth in other markets were driven by pricing actions, partially offset by lower volume, with the most significant volume impact attributable to lower sales of Vahine Hommade dessert products. Over the past three years, EMEA's constant currency sales grew at a 3% CAGR. Constant currency consumer sales in the Asia Pacific region grew 10%, including a 7% unfavorable impact from the exit of low-margin business in India. As Lawrence mentioned, growth was driven by higher volume, mainly attributable to trade and pantry replenishments in China, following the extended Shanghai lockdown last quarter, as well as the region lapping supply chain challenges in the year ago period. Pricing actions in all markets across the region also contributed to growth. On a three-year basis, APZ's third quarter constant currency sales grew at a 4% CAGR. Turning to our Flavor Solutions segment and Slide 16. We grew third quarter constant currency sales 10%, primarily due to pricing actions, with higher volume and product mix also contributing to growth. Third quarter constant currency sales for the last three years grew at an 8% CAGR. In the Americas, Flavor Solutions constant currency sales grew 10%, driven by pricing. Higher sales to packaged food and beverage companies with particular strength in snack seasonings, led the growth. Higher demand from branded foodservice customers also contributed to growth. Over the past three years, constant currency sales in the Americas grew at a CAGR of 8%. In EMEA, we drove 11% constant currency sales growth, with 7% related to price actions and 4% volume and mix. EMEA's Flavor Solutions growth, excluding a 1% decline related to lower sales in Russia, was broad-based across its portfolio, led by strong growth with QSR, branded foodservice and packaged food and beverage company customers. Over the past three years, EMEA's constant currency sales growth was 9% CAGR. In the Asia Pacific region, Flavor Solutions sales grew 11% in constant currency, with pricing actions and higher volume contributing to the increase. Growth was driven by higher sales to QSR customers, in part due to the timing of the promotional activities. APZ grew constant currency sales at a 6% CAGR over the past three years. As seen on Slide 20, adjusted gross profit margin declined 320 basis points in the third quarter versus the year ago period. Let me spend a moment on the significant drivers. First, almost 80% of this decline, approximately 250 basis points is due to the dilutive impact of pricing to offset our dollar cost increases. Next, I'll cover the impact of supply chain challenges on gross margin. In our Flavor Solutions segment, we have continued to incur elevated costs to meet high demand for certain parts of that business. And there has also been an unfavorable impact from the start-up and dual running costs as we transition production to our new U.K. Peterborough manufacturing facility. In our Consumer segment, where demand has moderated more quickly than we expected, we are experiencing lower operating leverage. Overall, while the normalization of our supply chain cost is taking longer than expected pressure in gross margin, we are taking actions to normalize our costs, as Lawrence mentioned, which we are confident will be reflected in our 2023 gross margin. Partially offsetting these impacts I just mentioned were our CCI-led cost savings, where we are on track to deliver our expected savings of $85 million for the full year. And finally, of note, in line with our expectations, the impact of our pricing actions in the third quarter began outpacing cost inflation in both segments, more significantly in the Consumer segment. We expect pricing to continue outpacing inflation into next year, as we plan to fully offset inflation over time. Overall, our cost recovery and gross margin improvement will vary by region and segment, with a slower Flavor Solutions recovery. Importantly, though, we have now passed the inflection point with significant gross margin improvement since last quarter, driven by our consumer segment performance, and, we expect further improvement in the fourth quarter. Now moving to Slide 21. Selling, general and administrative expenses, or SG&A, were comparable to the third quarter of last year with higher distribution costs and brand marketing investments, offset by lower employee benefit expenses. As a percent of net sales, SG&A declined 60 basis points. The net impact of the factors I just mentioned resulted in a constant currency decline in adjusted operating income, which excludes special charges and transaction and integration costs of 11% compared to the third quarter of 2021. In the Consumer segment, adjusted operating income declined 1% in constant currency. And in the Flavor Solutions segment, a decline of 34%. Turning to income taxes on Slide 22. Our third quarter adjusted effective tax rate was 21.2% compared to 14.1% in the year-ago period. Both periods were favorably impacted by discrete tax items with a more significant impact last year. At the bottom line, as shown on Slide 23, third quarter 2022 adjusted earnings per share was $0.69 as compared to $0.80 for the year ago period. The decrease was driven by our lower adjusted operating income. A favorable impact from optimizing our debt portfolio in the third quarter was fully offset by the impact of higher adjusted effective tax rate in the third quarter of this year. On Slide 24, we've summarized highlights for cash flow and a quarter end balance sheet. Our cash flow from operations was $250 million through the third quarter of 2022, which is lower than the same period last year. This decrease was primarily driven by lower net income and higher inventory levels. We returned $298 million of cash to our shareholders through dividends and used $167 million for capital expenditures through the third quarter. Our priority is to continue to have a balanced use of cash, funding investments to drive growth, returning a significant portion to our shareholders through dividends and paying down debt. While our fourth quarter has historically generated our highest cash flow from operations, based on our current profit outlook and working capital position, we do not expect to delever to our targeted net debt to adjusted EBITDA ratio of approximately 3x by the end of fiscal 2022. We remain committed to a strong investment-grade rating and we have a history of strong cash generation and profit realization. With our improving gross margin as well as our plan to normalize our supply chain cost and inventory levels, we will be better positioned to continue paying down debt. Now turning to our 2022 financial outlook on Slide 25. We are projecting strong top line growth with profit impacted by cost inflation and supply chain challenges. We also expect there will be a 3 percentage point unfavorable impact of currency rates on sales and a 2 percentage point unfavorable impact on adjusted operating income and adjusted earnings per share. On the top line, we expect to grow constant currency sales 3% to 5%. We expect sales to be driven primarily by pricing. While we anticipate volume and product mix to be impacted by price elasticities, we expect elasticity to remain at a lower rate than historical levels given our focused approach led by consumer insights. Our volume and product mix will also be impacted by the divestiture of our Kitchen Basics business. The demand disruptions experienced in China and the exit of our consumer business in Russia as well as continual pruning of lower-margin business from our portfolio. We plan to drive continued growth through the strength of our brands as well as our category management, brand marketing, new products and customer engagement growth plans. We are projecting our 2022 adjusted gross profit margin to be 350 to 300 basis points lower than 2021, primarily driven by our Flavor Solutions segment. Given the rapidly escalating cost environment this year, cost inflation outpaced pricing in the first half of the year. We expect pricing to outpace inflation in the second half of the year and continue into next year. This adjusted gross margin compression reflects the impact of a high teens increase in cost inflation, higher supply chain costs, lower operating leverage and unfavorable impact of sales mix between segments and favorable impact from pricing and CCI-led cost savings. As a reminder, we have priced to offset dollar cost increases. This has a dilutive impact on our adjusted gross margin and is the primary driver of our projected compression. We expect our adjusted operating income to decline 11% to 9% in constant currency. In addition to our gross margin impacts I just mentioned, this projection also includes our CCI-led cost - total cost savings target of approximately $85 million and a low single-digit increase in brand marketing investments compared to 2021. We are projecting our 2022 adjusted effective income tax rate to be approximately 22%. This outlook is expected to be a year-over-year headwind to our 2022 adjusted earnings per share of approximately 2%. We are projecting our 2022 adjusted earnings per share to be in the range of $2.63 to $2.68 as compared to $3.05 in 2021. This projection includes a $0.02 unfavorable impact from the divestiture of the Kitchen Basics business. As we currently progress in our fourth quarter, we are confident in delivering our 2022 outlook, continuing our strong top line growth trajectory and as our guidance implies, delivering fourth quarter operating margin expansion while executing on a focused plan to drive improvement in our cost structure. We are targeting to eliminate at least $100 million of these costs or approximately a 150 basis point impact to our operating margin. With our proven track record of delivering CCI-led savings to fuel growth investments and expand our operating margin, we are leveraging the discipline of the CCI program to aggressively eliminate costs and inefficiencies. Overall, we are confident our focus on profit realization will drive margin improvement. And while parts of our plan to optimize our cost structure, will take longer than others, we expect to begin seeing the benefits of our actions in the first half of 2023. We look forward to sharing more details on progress with you in January when we provide our 2023 outlook.
Lawrence Kurzius: Thank you, Mike. Now that Mike has shared our financial results and outlook in more detail, I'd like to recap the key takeaways as seen on Slide 26. Our third quarter sales performance reflects the strength of our broad global portfolio and the effective execution of our strategies against the backdrop of a volatile operating environment. Our sales growth momentum is strong. The challenges in our supply chain have taken longer to normalize, we have now passed an inflection point. We have begun to recover the cost inflation that has been outpacing our pricing actions while executing on a plan to aggressively eliminate supply chain costs, and we expect 2022 fourth operating margin expansion and continued improvement into 2023. Our long-term performance, including through periods of volatility and has been industry-leading and long-term fundamentals that drove this historical performance remains strong. We have a proven track record of execution and are confident we will successfully navigate this dynamic environment for our future sustainable growth and build long-term value for our shareholders. Now let's turn to your questions.
Operator: Thank you. Our first question is from the line of Ken Goldman with JPMorgan. Please proceed with your question.
Ken Goldman: Hi. Thanks so much.
Lawrence Kurzius: Hi. Good morning Ken.
Ken Goldman: Hi. Good morning. You highlighted that you've past the inflection point, right, where your pricing is now ahead of your costs. And this, of course, is natural, right, given the timing and not unexpected. But one of the push-backs we hear in the industry is that larger retail customers, as they start to, I guess, maybe notice these margin trends, they'll start to ask for a bigger piece of the profit pie. So I guess my question is to what extent do you expect sort of these gross margin net tailwinds to be sustainable? Or is it reasonable to expect maybe some pressure from customers as they see their vendors' margins starting to get better?
Lawrence Kurzius: Well, I think that there's always some tension when you're talking about pricing and margins with customers. And so I don't want to get into anything with any one specific customer. But right now, all of our customers recognize that inflation is ongoing, and we continue to have, I'd say, productive pricing discussions with our customers. We just did take another round that is effective here at fourth quarter. And we're really not seeing that kind of push back right now.
Mike Smith: I think the reality, Ken, is we're still recovering. Our pace of pricing has caught up now with cost and we say, we'll recover dollar to dollar in 2023. But there is a trend that is going in the right direction. And obviously, as we look at 2023, we look at what's the cost environment, things like that, we need to go again next year, but that's still -
Lawrence Kurzius: And I think particularly on the Flavor Solutions side of the business, we have - we still have more work to do.
Ken Goldman: Got it. Thank you. And then for my follow-up, you're guiding to at least $100 million of incremental cost savings. It's not a small number. So I just wanted to get a little bit of clarification. How much of that is incremental to ongoing CCI? And how much of that is derived from maybe a normalization of certain factors such as inventories versus what you would consider more, I guess, discrete savings beyond that?
Lawrence Kurzius: Well, first of all, all of this is incremental to our normal CCI program are using the processes and the organization Alpha Drives or CCI program to actually execute on these. This is incremental savings that we are and although some of the - you know I would characterize as a one-time take out the - it goes straight to run rate. These are incremental costs that we have incurred due to extensive search capacity, some of the things we talked about in our prepared remarks. So overtime, temporary labor and efficient shift, excessive use of CO-packers, a lot of premium transportation charges, we do expect to get that out of our system, get back to our pre-pandemic operating standards. And we would expect - while this is a one-time takeout, it goes straight to run rate.
Ken Goldman: Understood. Thanks so much. Yes, very clear.
Operator: Our next question is from the line of Robert Moskow with Credit Suisse. Please proceed with your question.
Robert Moskow: Hi. Thanks. So Flavor Solutions is really the division that has stumbled the most. I mean, when I look at profit this year compared to like pre-pandemic, it's well below your pre-pandemic levels. So can I assume that most of the $100 million in savings is - or recovery is going to happen there? And then my second question is, I remember years and years ago that the Flavor Solutions had problems because it was trying to do too many things for too many customers. It had spread itself too thin. It needed eventually to have a rationalization of its customer base. And I wanted to make sure that that's not possibly one of the root causes today. You've grown your sales a lot. Do you feel like the organization is capable of still getting back to like 12% operating margin across all of those customers?
Lawrence Kurzius: Yes. I think that stumble is the wrong way to characterize it. I think that we're a bit of a victim of our own success. We've won a lot of new business, and we prioritized keeping our customers in stock and supplying them. And that has put a lot of pressure on our supply chain in a few areas and we've got projects underway to address kind of a normalization of production and through capacity additions. Some of these wins are substantial, and we've had real brick-and-mortar projects that take a couple of years to put into place that are coming online right now and that are going to get at a lot of the extraordinary costs. There's some parts of our business, the 24/7 shifts that we've gotten out of most of our business, we're still doing that in a lot of our that's why I wouldn't say a lot in parts of our Flavor Solutions business, and that is a less efficient ship pattern even though it does get you some capacity to be an example of expensive surge capacity. But we've got new seasonings capacity coming online in the Americas, some of it now, so some of it in the first - early part of 2023. We're starting up a new flavor solutions plant in the U.K. We've got expanded distribution that that's shipping really starting to ship right now. And so I think that we've got a lot going for us in Flavor Solutions to support that strong growth in a more efficient way. As a margin issue on Flavor Solutions, partly is just the way our contractual arrangements work with our customers, there is a pass-through mechanism for the major raw materials that go into their products. There's a lag to it. In times when inflation was 1%, 2%, 3%, that flag really wasn't important. But this year, where it's been double-digit, it has been important. And we are going to catch that up.
Mike Smith: I think remember, we've talked about this before, over half of the dilution this year is due to the cost versus pricing. So that's just the math that we'll get back over time. Also, these projects, Lawrence mentioned, there's a lot of double running costs as we bring those big projects up like U.K., Peterborough that eventually will go away. So that will help the margins, too. To your point, though, about - are we spread too thin? I actually have to flavor division back in 2005 when that was identified, there's no comparison to today. It's really focus and Lawrence, why donât youâ¦
Lawrence Kurzius: I was just going to say, Mike, one thing I would add there, Rob, is the composition and the profile of our business is so different to 2005. And this - our strategy to keep driving and evolving the business towards that higher value-added portfolio is what you're seeing in our business portfolio today. And so there's a very different, I think, set of conditions compared to the point you referenced. And we have done a lot of portfolio pruning behind the scenes as we - especially as we went through these last three years, where the extraordinary growth that we have in the parts of the business that we're focused on more than made up for parts of the business where we were getting out of low-margin high-touch businesses. And I think it's been a self-reinforcing strategy. The migration of our business more and more towards the value-added, technically insulated and flavor end of the spectrum has made our product wins stickier and our R&D teams more able to work on new business not focused on constantly re-winning bid business.
Robert Moskow: Great. I'm sorry to bring up 2005, but we're all old and we all remember it. So maybe just one follow-up. Of the $70 million or so of profit decline this year in Flavor Solutions, can you quantify how much of that is just pricing catch-up?
Mike Smith: I would say - I wouldn't - I think the bigger bucket is actually some of the excess costs that we've talked about, and which actually would have driven more sales if we could supply it. But the excess cost that we - for the reason we called down our preannouncement was we haven't been able to get those out of the system yet. Yeah, pricing is a bit behind, I mean, the thing that gives us the comfort that we're going to recover more margin Flavor Solutions as we've seen it in Consumer. The Consumer is turning positive from a gross margin and an operating profit perspective as pricing wave comes through, and you'll see the same in Flavor Solutions. But I don't have the exact number for you.
Robert Moskow: Okay. Thank you.
Operator: Our next question is from the line of Steve Powers with Deutsche Bank. Please proceed with your question.
Steve Powers: Yes. Thank you and good morning.
Lawrence Kurzius: Good morning.
Mike Smith: Good morning.
Steve Powers: Picking up on that last thread on the pricing catch up in Flavor Solutions, can you talk a little bit about the expected timing of that and cadence of that? Because it seems like most of it or a good portion of it should be, I think, foreseeable just based on the timing of the contracted adjustments in pricing and contract renewals and that kind of thing. So is it a - should we be expecting a relatively smooth catch-up from here? Or is it - is there a reason to believe that you can - that the catch-up happens on a more accelerated timing.
Lawrence Kurzius: I'd rather describe it more in terms of our gross margin trajectory than to talk about pricing too specifically because I'm worried that it's going to get into things that might have set our customers. But you can see the margin trajectory on this business beginning to turn. We talked about an inflection point. Flavor Solutions margins have been ticking down through the second quarter of the year. They're turning - the year-on-year comparison has narrowed in the third quarter and we expect it to continue to narrow and begin a recovery as we go through next year.
Mike Smith: Yes. I think from a dollar perspective, like I said before, for both Consumer and Flavor Solutions business, we will catch up on the cost next year. We just took branded foodservice, that's supported labor solutions along with our consumer business at the beginning of the quarter, that will be a positive going into next year rapidly. So yes, there's no like one thing bag you catch up. It's over time, but in 2023, we will catch up.
Steve Powers: Okay. Okay. And on the manufacturing start-up costs are those - I guess, what inning are we in there? And how much of that remains versus is in the rearview?
Lawrence Kurzius: I would say - I mean, from a - you're always going to have some of these programs to say that. So, you're always going to have some of this, I think this year is kind of a high watermark that we should get some get in next year. But some of these programs take a bit of time to get fully, fully done. These are big programs. I mean the project we just shipped our first panel thatâs marked down out of our big Northeast distribution center, but we want to move over time into 2023. We'll be moving parts of our business into that. So, there'll be a bit of inefficiency there. But...
Mike Smith: And I want to just emphasize that the things that we talked about on the call in terms of getting out the - on our prepared remarks in terms of getting at the cost for example. So, I don't want to overly focus on any one particular thing and give it too much weight. We were sharing examples and when we next report in January, we'll be able to give some progress updates on those exact examples as well as for other actions.
Steve Powers: Okay. Thank you. If I could, just one little housekeeping, sorry if I missed it but - just was there anything notable that caused - that resulted in reported EBIT this quarter coming in above what you had preannounced at quarter close, just anything as you close the books that was...
Lawrence Kurzius: Like I said, we've preannounced, we haven't closed our books yet. So these are all estimates and we felt pretty good where we landed. There was a couple of things. Tax came in a little bit more favorable at about penny, some other SG&A things given a little bit more favorable, but nothing materialâ¦
Steve Powers: No wonder.
Lawrence Kurzius: And right where we thought.
Mike Smith: Yes. I mean when we preannounced it was say -
Lawrence Kurzius: We had a little bit more visibility on the sales versus profit and between Q3 and Q4, there's a little shift.
Steve Powers: Yes, okay. Thanks so much.
Operator: Thank you. Our next question is from the line of Chris Growe with Stifel. Please proceed with your question.
Chris Growe: Thank you. good morning.
Lawrence Kurzius: Hi, good morning, Chris. How are you?
Chris Growe: No worries. No, thank you for accommodating my question. I appreciate it. I just wanted to get a couple of, I guess, follow-up questions. I just want to be sure on that lag in pricing in Flavor Solutions. When we talked some of the pass along features of that business, that had typically been like a one quarter lag, is that still the case? Or have you caught up now when you talk about pricing being over inflation at is, have you caught up with that? And I guess, I just want to also understand, was that a factor weighing on profit in the quarter? Or was it more just the supply chain challenges?
Lawrence Kurzius: Well, of course, it was a factor weighing on profit in the quarter end and has been all year. Again, every customer has got to sell different contractual arrangements. I think about a quarter lag is a good way to think about it. But remember, costs keep coming in. I mean we didn't just get cost inflation on January 1 and price for it. These costs have been steadily increasing all year, and in fact, continue to increase. The inflationary outlook has not settled. So there's been a bit of a - we've gotten - we've passed costs there, but there's been a bit of chasing it as new as costs have continued to go up. I'm going to let Brendan comment on this a little further.
Brendan Foley: Well, it's true. I think just the thing I would key in on is there is unlike, let's say, our consumer and our Flavors - our branded foodservice business, there's not sort of one moment in time where that pricing is, therefore, effective in the business. And so that's another way to maybe think about it, Chris. And I think just to build on part of your question, certainly, supply chain, as we've been talking about quite a bit in the prepared remarks, we're certainly an influence on how we're looking at that.
Chris Growe: Okay. Thank you for that. And then just to understand if I'm hearing it properly, but like the pricing should accelerate in the fourth quarter, it sounds like there will be, again, some continued catch-up in pricing, I guess that's true for Flavor Solutions. I think about Consumer, is that one where we should expect incremental pricing based on what you've announced so far, not asking for anything new there. But I also want to understand maybe how you're utilizing promotional spending there as a means of trying to trying to attack those price gap issues in some areas of the business there?
Lawrence Kurzius: I think you've got - I'm going to try and unpack that in pieces. We have been guiding all year. And it - and you can see it coming through now and not just in our reported numbers, but also through the scanner. But we would have more pricing in effect in the second half of the year, especially going into the fourth quarter than we have - than we did in the early part of the year. We've - in the Americas this year, taken a number of rounds of pricing that included the most recent one being here right at the beginning of the fourth quarter. And so there is more pricing in effect now about our consumer business primarily there. And so you can see that coming through now. And really, other than the contractual windows that we were just talking about in Flavor Solutions, we largely have our actions for this year in place and we're looking ahead to 2023 now. I think that in Asia, we've got one more round that goes into effect actually this month. But really, our 2022 actions are away. And I gave such a long answer to that, but I forgot the second part of your question, but I'm going to let Brendan answer it.
Brendan Foley: So I think where you were going was just looking for some context around promotional spending. And I think the context we provide is as we go into the holiday, we feel really good about our supply. We have a strong program planned for the holiday season as we would every year. But it certainly feels, I think, a little bit more robust now compared to, let's say, 2021 and 2020 just because we're in a better situation from the standpoint of the overall context in the market. So, we are turning back on promotions where we feel really confident about supply, and we're looking at the holiday season that way. Those choices are not necessarily connected to any pricing decisions we're making in the market, but really to support of the business. And helping to drive the category for our retailers.
Lawrence Kurzius: Yes. And I would say that our supply situation on the consumer business going to holiday is the best it's been in the last several years.
Chris Growe: Thatâs great. Thanks for all that context. I appreciate it.
Operator: Thank you. Our next question comes from the line of Andrew Lazar with Barclays. Please proceed with your question.
Andrew Lazar: Great. Good morning everybody.
Mike Smith: Hi.
Lawrence Kurzius: Good morning, Andrew.
Andrew Lazar: Maybe to start off, I think when you had preannounced results for the quarter, one of the factors that you had highlighted in the Consumer business was that sort of private label price points at some retailers on shelf had not yet really sort of moved upward leading to some price gaps that get wider maybe than you'd like or had been anticipated. And if I missed this, I apologize. I didn't know if that you've seen any movement there yet or have heard of any movement that's likely to happen on that front.
Lawrence Kurzius: Right. Andrew, no one has asked that yet. So I'm glad that you did not only a very short time since we preannounced. And so we don't have a lot of new information on consumer behavior or on retailer behavior. I'll let Brendan give some color on that, and then I'll take it back.
Brendan Foley: Yes, I think, Andrew, things are largely consistent with what we had discussed or shared broadly within the last four weeks. So, we haven't really seen a lot of new information or data. They seem this price gap seem to be kind of holding in the very same range that we talked about before. And - but we still are a leading supplier of private label into the category and we're passing those price increases along to customers just as we have on branded products and that's a retailer-by-retailer decision, I think, on what gets realized itself. But in the meanwhile, we're still driving a lot of that value programming that we had talked about whether it's not only our messaging, but also we're seeing a lot of lift in some of those parts of our portfolio that tend to drive more value. We offer - our offerings are really across the spectrum that would meet consumers' needs. And we're seeing growth on the premium end, we're seeing growth on the value end. In parts of our business like Gourmet Garden, which tend to be on the premium end, are actually doing really well in this context. And then we see our value sizes like super deal performing very strongly, also off shelf and in the market. And then we're introducing more value into the market through this opening price point worries program. And we're also doing that in other parts of our - in other markets around the world where we're - and many of them were launching re-sealable pouches that are larger than usual and allow consumers to kind of realize more value that way. But that's probably the added context I would share since the last month.
Lawrence Kurzius: Yes. And Andrew, it isn't exactly what you've asked, but it gives - give me a chance to talk about this a little bit. I want to emphasize that we have in our offering items for every price point and every retailer strategy and category from the premium end all the way down to opening price points and private label. And we spent a fair bit of time talking about the consumer that's under pressure and rightly so, we are concerned about pressure on the consumer, especially, the consumers on the lower half of the income spectrum. And we want to make sure that our products are accessible and approachable, but gourmet and premium end of our business is still very strong. And sometimes those price gaps can be exaggerated. And Brendan mentioned large size and super deal. The Nielsen data is a pretty blunt instrument when it reports unit price. It doesn't catch the fact that some of these value packs are really big and carry a high price point. If you adjust that out, the lower size packs that are growing strongly for us and that price gap actually narrows quite a bit.
Andrew Lazar: That's very helpful perspective. And then I know we're running short on time. Just a quick one. Obviously, we're not at a point where you're going to get too specific at all about next year, of course. But with, sort of, the inflection that's starting to happen in pricing, the new cost saves and over - margin recovery actions that you've kind of highlighted today, I guess, consensus already has McCormick, sort of, getting back to what we'll call more of an on-algorithm type of earnings growth next year, particularly as you would deem, I think, a bunch of the things you talked about impacting this year is somewhat more transitory as you improve them going forward. So I didn't know if there were even just any broad comments around that, whether there's a need, you think, to lean in right on the marketing side going into next year, just given whatever the value orientation of the consumer or some of the new product innovations you've got planned? Or just things larger puts and takes that we should sort of think about as given how, I guess, the Street has already started to sort of lock in expectations for next year? Thanks so much.
Lawrence Kurzius: So I will start with the caveat that we're not going to give any guidance for 2023. Right now, I've got - everyone is standing around here with - holding their breath - if I'm going to say something rash about that. But - so it is a bit early for that. And I appreciate saying confidence in the investment community that's reflected in those consensus outlook. But there are some big puts and takes. I'm going to let Mike talk about those.
Mike Smith: Yes. Obviously, a big wild part for next year is the inflation environment. So we're in the process now actually rolling up budgets and things like that, taking a look that drives pricing actions. Obviously, some of the other puts and takes you think about interest expense. Obviously, some of the actions we took this year might be a negative for next year. This cost pro we talked about, which we're going to give you a lot more detail in January. So I'd say, right now, there's so many big moving parts, it would be hard even to give you any guidance about.
Lawrence Kurzius: And frankly, incentive comp has to be rebuilt.
Mike Smith: Right.
Andrew Lazar: Thank you.
Operator: Our next question is from the line of Adam Samuelson with Goldman Sachs. Please proceed with your question.
Adam Samuelson: Yes. Thanks. Good morning. So a lot of ground has been covered. I wanted to just come back to Flavor Solutions quickly and just the way you'd characterize, kind of, the business performance on the strong demand. And I guess I'm trying to - volume mix in the quarter was up 80 basis points. And so I'm just trying to get a little bit more color on kind of the pieces within the Flavor Solutions business because it's not really one business. It's a collection of a bunch of them. It would seem from the way you characterize some areas of strength that maybe some of the higher-value flavor businesses were at or below kind of segment average growth? And just, A, is that the right calibration? And B, just any color on the growth of the - some of the different pieces?
Lawrence Kurzius: You know, certainly the pick of the part of it that was weak. We had strong performance on Flavor Solutions in that segment across the globe and really all segments. I'm sorry, I'll that's not to say all regions and all of the pieces of it. Well, maybe a little bit out maybe we did talk about a month ago. I mean some of the challenges on Flavor Solutions this year were cost related to plaque constraints. We could have sold more. We could have had higher volumes than you noted. So, I think from that perspective, some of the actions we've talked about it more capacity will help. But the demand is very strong and is very strong.
Adam Samuelson: Okay. All right. I just - I guess, relative to historical performance of that business, the 80 basis points of volume mix growth. And I know there's noisiness in the comps with COVID recovery and it's a lumpy business that doesn't always - usually that business could be stronger than 80 basis points of volume mix. So I'm trying to get the calibration of that.
Lawrence Kurzius: Yes. We had enormous price 10% pricing, we feel pretty good about.
Adam Samuelson: Okay. And then just quickly on SG&A, and you alluded to in - think about '23 a little bit. But it would seem like the way the gross margin and EBIT guidance lays out implied for the fourth quarter that total SG&A is going to be down high single digits. A, is that kind of the right calibration? And within that, just how much is incentive comp resetting lower talk about kind of the declines in SG&A dollars that you've seen this year?
Mike Smith: Yes. I mean, SG&A, you're right, it's going to be down in the quarter, and it's primarily driven by the incentive comp. We're also getting higher fixed cost leverage, too, as you think about it, but - yes.
Adam Samuelson: So is most of that decline in incentive comp as we think about the headwind that would be rolling into next year?
Mike Smith: I mean we adjust incentive comp every quarter, so I wouldn't take one quarter to then try to extrapolate the next year.
Adam Samuelson: Okay. All right. I appreciate the color. Thank you.
Operator: Thank you. Our final question is from the line of Peter Galbo with Bank of America. Please proceed with your question.
Peter Galbo: Hi guys. Good morning. Just two really quick ones for me. Maybe just to pick up on Adam's question there. Mike, I just wanted to clarify, the operating margin comment for the fourth quarter of operating margin expansion, that was a year-over-year comment in the fourth quarter, not a sequential?
Lawrence Kurzius: I think both.
Peter Galbo: Both. Okay. That's helpful. And then just a broader question on the - just thinking about the cost savings for next year. I know we spent a lot of time talking about that. But just as we think about like repatriating production, surge capacity coming down, normalizing inventory levels. Like is there a way to quantify, I would imagine the there's probably a volume impact that comes with that. You'll get the benefit on the cost side, but maybe there's an offset a little bit, at least on topline on volume. Is there any way to quantify that at this point?
Lawrence Kurzius: No, I don't think that's what we're saying at all. And I think we've quantified the cost benefit, but I don't think that there's an impact on volume at all. I mean this is a normalization and that we went through this year. And I don't think that has an impact. Now of course, we kind of don't want to get into 2023 guidance. But whatever - that would all be reflected in whatever guidance we give for next year. And I do want to emphasize that we've spent a lot of time talking about supply chain in our remarks and on the Q&A here. But you know, I do want to be clear that what's the most important thing I'm glad you really brought this point up about volume, is that the continued growing demand for flavor and the strong growth of our business that we're fueling with executing on our strategies, and with our passionate and engaged employees is the most important thing. Inflation is a reality and our pricing has caught up with it, we're seeing that coming through in the margin sale, you can see it, you know, see us keep caught up and take the actions that are necessary. And then comes supply chain, that's really kind of the third most important thing, which is to eliminate the excess of costs and inefficiencies that have crept into the supply chain. So I do want to keep that in perspective, that growth is still at the top of the heap.
Peter Galbo: Fair enough. Thanks very much guys.
Lawrence Kurzius: Thanks.
Operator: Thank you. At this time, I'll turn the floor over to management for closing remarks.
Lawrence Kurzius: Great, thank you. McCormick's alignment with consumer trends and the rising demand for flavor in combination with the presence and reach for global portfolio and our strategic investments, provide a strong foundation for sustainable growth. We're disciplined in our focus on the right opportunities and investing in our business. We're continuing to drive further growth as we successfully execute on our long term strategies actively respond to changing consumer behavior and capitalize on opportunities from a relative strength. We continue to be well positioned for continued success and remain committed to driving long term value for our shareholders.
Kasey Jenkins: Thank you, Lawrence. And thanks to everybody for joining today's call. If you have any further questions on today's information, please feel free to contact me. And this concludes this morning's call. Thank you, again.
