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Q1 2017 Earnings Call Transcript

Published: 10 May 2017

Operator:

Good afternoon, ladies and gentlemen and welcome to the Blue Buffalo 2017 First Quarter Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to the CFO of Blue Buffalo, Mike Nathenson. Mr. Nathenson, you may begin.
Mike Nathenson:

Good afternoon, everyone and welcome to Blue Buffalo’s Q1 earnings call. Some reminders before we start. Today’s conference call will include forward-looking statements. These statements are made on the basis of our views and assumptions as of this time and are not guarantees of future performance. Actual events or results may differ materially from these statements. For information about certain factors that could cause such differences, investors should refer to our 10-K, which was filed with the SEC recently and available on our website, including the information set forth under the captions Risk Factors and Statement Regarding Forward-Looking Disclosures. Except as required by law, the company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. In today’s discussion, revenue and sales refer to net sales. In our discussion, we will also refer to non-GAAP financial measures, which differ from our results prepared in accordance with GAAP. We will refer to adjusted SG&A, adjusted EBITDA, adjusted net income, and adjusted EPS, which exclude the costs associated with litigation and our public equity offerings. Adjusted EPS will refer to adjusted diluted EPS. A full reconciliation with the corresponding GAAP measures is included in the press release and is posted on our IR website at ir.bluebuffalo.com. On today’s call, I am joined by our CEO, Billy Bishop. With that, let me turn it over to Billy.
Billy Bishop:

Thanks Mike. Welcome everyone. I am pleased to share our results with you today. As you saw on our press release, Blue Buffalo’s off to a good start in 2017, as we continued to drive pet parent demand for our products across all channels in a dynamic retail environment. And we delivered high quality earnings growth which we feel great about. At Blue Buffalo, we have dedicated to creating pet foods with ingredients that pet parents prefer to feed their furry family members. And we’ve continually invested build one of the strongest, most recognized brands in the pet food industry. One of the benefits of sustained investment in our BLUE master brand is that we are a true pull brand, with pet parents seeking out our products in stores and online. As a result, Blue Buffalo has become the undisputed leader in wholesome natural pet food, the fastest growing segment of the $28 billion U.S. pet food market. And we are over four times the size of the next largest brand in this segment. Today, in the sea of legacy brands, losing their relevance with consumers, Blue has become the new mainstream brand that’s delivering products that pet parents are looking for and connecting with them in a true, authentic way. With that said we still only feed less than 3% of pets. So, Blue Buffalo has a tremendous opportunity to continue to grow both in the U.S. and internationally. As we look at Q1, we’re happy with our performance and here are the key highlights. Our revenue grew high single-digits versus last year. This growth was primarily driven by volume, which was well above market growth and as a result we gained share. We expanded our margins driven by supply chain performance, positive mix, and pricing. And we thrived in a market that experienced dynamic shifts in channel shopping behavior by continuing to strengthen our master brand with unwavering support in media, pet parent education and innovation, design to meet the needs of pets and pet parents. Now let’s start with a look at the market dynamics and our performance at retail. In Q1, the total U.S. pet food market remains strong and continued to grow low single-digits. From a channel perspective, e-commerce continued to grow rapidly, while brick and mortar channel slowed. Given our advantage, go-to-market model and Blue’s strong growth rate, we gained share. While pet parent demand for our products is robust, we are not immune to the changing dynamics in the retail landscape, especially in the short-term and we have experienced some variability among our distribution channels. Consistent with our discussions on recent calls, the pet superstore channel has seen a slowdown due to reduced traffic. Given this trend, our Q1 superstore sell-through was down approximately 6% to 7% versus last year. Outside of pet superstores, we estimate our sell-through growth rate in the quarter was in the mid-30s. In these channels, e-comm continued to grow very fast and we saw some pressure in other brick and mortar stores. On the e-commerce side, we continue to increase our sales and gain share in this rapidly growing channel. We enjoy significant competitive advantages in the e-commerce channel over the large, widely distributed brands given our higher value per pound as well as our industry leading advertising investment that creates consumer pull for the Blue. We are gaining share by leveraging these competitive advantages, which is helping close our convenience gap with food, drug, and mass. Now, I would like to provide some additional color on our commercial performance. At a high level, we continue to see the same strong category growth trends in the humanization of pets and premiumization of pet foods. These trends are reflected on both our commercial performance as well as our innovation. And as an example, our product lines contributed to the growth, but our more premium lines like Wilderness led the way. As mentioned on previous calls, WTO or our shorthand for wet foods, treats and other products is a key part of our growth strategy and continues to be an area of focus for us. Not only our wet foods and treats more premium than dry foods, they’re also margin accretive. In Q1, our WTO growth rate was 15.1%, which compares favorably to the 6.4% growth of our dry foods. I’m also pleased to report that we began the rollout of our 2017 innovation. At the end of Q1, we launched a new product line BLUE Earth’s Essentials, which delivers farm-to-table inspired cuisine for our furry family members. Consistent with the long-term trends of humanization and premiumization, Earth’s Essentials is a super premium product line made with carefully selected ingredients like fresh-cut salmon, and Asian Crane such as quinoa. The simple, honest recipes are nutrient rich and will help your furry friends thrive. Our Earth’s Essentials portfolio comes in three natural recipes, Harvest Table, Pacific Grill and Mountaintop Medley, the line up includes both dry and wet foods, as well as natural treats. For Wilderness, our meat rich natural evolutionary diet product line, we’re building on success of last year’s exotic regional recipes with the introduction of Wilderness, Flatland Feast that features turkey, quail and duck and Wilderness Snake River Grill featuring venison, trout and rabbit. Those recipes are available in dry and wet foods, as well as treats. In addition, we’ve also introduced more wet food innovation in our small breed divine delight squirmy line by including more delicious recipes and cuts in a convenient single serve cup. Finally, we’re looking to disrupt the Cat Treat category by launching natural crunchy cat treats under Blue Kitty Cravings and Wilderness. Cat treated as $750 million category at retail, primarily made up of crunchy treats. The great news is that our crunchy cat treat tastes great and are position well to grow up against the leading brand. Given the crunchy cat treats are virtual white space for Blue Buffalo, as well as the Wholesome Natural segment we feel that these products will be incremental to our portfolio. As you can see, we have a great innovation pipeline and we continue to push the balance of humanization trends with our new Earth’s Essentials line, we continue to fuel our high performing Wilderness line and we continue to push into underpenetrated areas with Divine Delights and Kitty Cravings. Its early days in the launch, so we look forward to talking more about this in future calls. Overall, I’m very pleased with our commercial performance. Now, I’ll pass it on to Mike for a closer look at the financials.
Mike Nathenson:

Thanks, Billy. Our overall net sales growth in the quarter was 7.9%. Looking at product types, we saw solid growth, both with our dry foods and WTO products. For the quarter, dry foods grew 6.4% and WTO grew 15.1%. Breaking down our overall sales, growth was driven by 5.2% volume, 2.1% mix and 0.6% pricing. Before I talk through the rest of the P&L, I’d like to touch on our sales growth by customer. In superstores, sell-in was 5% below last year, compared with pet parent sell-through, which was 6 percentage points to 7 percentage points below last year. This resulted in a modest inventory build. Given the continued strong growth of e-commerce, our sales outside of pet superstores represented 41% of our sales mix in the quarter, and grew 34%. We estimate the sell-through to pet parents in these channels was in the low-30s. Now, let’s turn to the bottom-line and our margins. As you saw on the earnings release, our profit metrics grew in the quarter driven by strong topline growth, expanding gross margins and a favorable tax rate. But we’re partially offset by investments in SG&A. Q1 adjusted net income was $45.2 million up 18% and adjusted diluted EPS was $0.23 per share up 17.3%. Our adjusted EBITDA was $77.8 million up 15% versus last year. Our gross margin in the quarter was 45.9%, 190 basis points higher than last year. The increase in gross margin was driven primarily by supply chain efficiencies, including lower input costs. In Q1, we maintain the positive momentum in our operations and we’re able to deliver meaningful productivity from our Heartland plant. Margins also benefited from positive mix, which was primarily driven by our more premium products growing faster than the overall portfolio, WTO growing faster than dry products. Now, let’s turn to SG&A. Excluding the costs associated with our equity offerings as well as our litigation-related expenses, SG&A grew 10.9% in the quarter versus last year. The increase was primarily driven by investments in revenue generating activities. Our tax rate in the quarter was 36.4% compared to 37.6% from the same quarter last year. The difference in the tax rates is driven by the new accounting standard that increases the tax benefit for the exercise of stock options, which we adopted in Q3 of 2016. As a reminder, a detailed reconciliation of our GAAP and adjusted financials can be found in the attachment to our 8-K and press release. Given strong topline and bottom line results as well as our capital efficient business model, we continue to produce strong cash flow. For the quarter, our operating cash flow, defined as cash from operations less CapEx, was $45 million. Our CapEx was $8 million in the quarter, and at the end of the quarter, we had $338 million of cash on our balance sheet. Before I talk to our guidance, I want to let our debt and equity investors know that we are planning to refinance our debt. Given that our revolver is due to expire later this year that make sense to refinance now. We are planning to refresh our original $400 million term loan B and expand our revolving credit facility to $120 million, which is appropriate for the current size of our business. And we expect to complete this transaction by the end of May. Now turning to our 2017 guidance. Our guidance remains the same. For the full year, we expect net sales between $1.24 billion to $1.27 billion and adjusted EPS of $0.91 to $0.94 per share. Our operating margin is expected to improve in 2017 driven by expanding gross margins and SG&A leverage. Looking at SG&A, we will continue to drive pet parent demand by investing in consumer pull activities consistent with our top line growth, and we will continue to keep a tight lid on overhead spending. Additionally, now that the steep SG&A ramp up for our strategic initiatives is behind us, we are moderating the spending growth in those areas. Taken together, this means SG&A leverage in 2017. Now, I want to provide some additional commentary on our guidance regarding the shape of the year. For sales, we expect our H2 sales to be meaningfully higher than H1. And within H1, we expect our Q2 top line to be similar in size as Q1. As a reminder, in Q2 2016, we benefited from a superstore inventory catch up that we don’t expect to repeat this year. On the SG&A side, SG&A growth in H1 will be higher than H2. Please note that we are planning to step up our marketing and advertising spending to support the market launch of our innovation in Q2. For taxes, we anticipate a full year tax rate range of 36% to 37%. When you put all that together, we expect our EPS growth rate to be higher in H2 compared to H1. And we’ll continue to update our guidance during our quarterly calls. On the capital side, we continue to make progress on our $200 million capital investment program to expand our manufacturing footprint and strengthen our R&D capabilities. Our program is on track and in 2017 we expect to spend between $150 million and $170 million of capital, which also includes our ongoing CapEx. Now, I’ll turn it back over to Billy.
Billy Bishop:

Thanks Mike. Before we open it up to questions, let me say the key points I’d like everyone to walk away with today. One, with a competitively advantage leader in the best part of the great category, the Wholesome Natural segment of the $70 billion global pet food market. Two, we’re off to a good start in 2017, as we continue to gain share in both the overall market and in the faster growing emerging channels. Three, our advantage to brand building approach is continue drive pet parent demand, well above the category even with the shifting dynamics in the retail landscape. Four, we’re seeing the benefits of improved supply chain performance, positive mix, and pricing in our expanded gross margin. And we’re confident about the expected benefits of our capital investment program, which will enable further productivity, flexibility, and innovation. And five, we’re confident in our full year outlook and we’re confident about our opportunity for future growth. With that, I’ll open it up to questions.
Operator:

Thank you very much, Mr. Bishop. [Operator Instructions] Our first question is from Andrew Lazar of Barclays.
Andrew Lazar:

Good afternoon, everybody.
Billy Bishop:

Hi, Andrew.
Andrew Lazar:

Two questions for me. First, would just be – I know last quarter you talked little bit about a couple of points of sell-in ahead of sell-through, I think primarily in the e-commerce channel. And that might weigh on under shipments in the first quarter. Can you just give us a sense of whether that happened and to what extent was it in line with what your thinking was or not. And then just if you could take us through some of the puts and takes as to what gives you the confidence that H2 will be stronger than H1, as you pointed out in your prepared remarks. Thank you.
Mike Nathenson:

All right. Hi, Andrew, it’s Mike. I’ll kick it off and then Billy and I’ll split the second question. As you know, e-comm is a fast growing channel for us. And we did mention last quarter that sell-in was a little bit higher than sell-through. And that was to support our growth and service levels obviously, in a fast growing environment. You need to have enough inventory to support that service. This quarter what we saw was balanced between essentially balance between sell-in and sell-through.
Billy Bishop:

And then Andrew to answer the second question to kick off, why we’re confident that H2 will be better than H1. We have several reasons both commercial and mechanical. I’ll tackle the commercial side. But first and foremost, we continue to focus on being a pull brand in driving pet parent demand for where all Blue products are sold. I talked about a new innovation that we’re excited about and that’s in the process of rolling out happen to be [indiscernible]
Mike Nathenson:

[indiscernible] in superstores. And when you look at it on the sell-in side, our net sales into superstores have also…
Andrew Lazar:

All right. Can I just add one thing?
Billy Bishop:

Sure.
Andrew Lazar:

If you could just start that one piece over again, my line got cutout, and I think some others had as well. I was hoping maybe – I heard some of Billy’s and then none of yours and I did get an e-mail or two that said other people had the same issues. So maybe you can just – if you wouldn’t mind just going through that again.
Mike Nathenson:

Sure, Andrew. I can take it from the top, guys. If you think we have any.
Mike Nathenson:

Can you hear us now?
Andrew Lazar:

I can hear you perfectly now. And I think some others have the same issue I did. So that’s why I wanted to mention that, when you just came back in.
Mike Nathenson:

Thanks. Appreciate it, Andrew. So again guys, what we have confidence that H2 is going to a be stronger than H1. Several reasons from a commercial standpoint that I’ll talk about. The first again, we focused on being a pull brand and driving pet parent demand for Blue, wherever Blue products are sold. Talked about our new innovation that we have coming out that we’re excited about, started to rollout at the end Q1, but that will also roll into Q2, which also result in space gains. We have new advertising campaigns to support our innovation that will raise awareness and drive trial. And we’ll continue to educate pet parents on our Wholesome Natural product portfolio, with our unique go-to-market model.
Andrew Lazar:

Okay.
Billy Bishop:

So, on the mechanical side, given the trends that we’ve seen some recent stabilization in pet parent sell-through dollars in superstores. So on the sell-in side, our net sales into superstores have also stabilize at approximately $175 million for the last three quarters. So that said, Q1 sell-in was slightly higher and there was some inventory build in Q1 that was related to the launch of our new innovation that happened at the end of the quarter, as well as some timing. And we expect that might unwind in the short-term. And then beginning in Q3, we will have lap a significantly higher selling and that was our – if you recall last year was around [indiscernible]
Andrew Lazar:

Okay. It’s Andrew I’m back again. I think it happened once again, Mike. We got you all the way up to $188 million. And then we lost you but you’re back now.
Mike Nathenson:

I’ll give it one more try.
Andrew Lazar:

Yes, I’m getting and others are having exact same issues. So I think it’s a broad-based issue.
Mike Nathenson:

Okay. We’ll certainly, work on that on our end. Yes, so what I was going to say – what I was saying was that beginning in Q3 we will have already lapped the significantly higher sell-in that we saw in H1 of 2016. So in H1 of 2016, we were selling at around $188 million per quarter. And that included some inventory catch up in Q2 of 2016 that we don’t expect to repeat. So when we start lapping that in Q3 you should see our growth rate improve sequentially.
Andrew Lazar:

Got it. Okay, thanks very much.
Operator:

Our next question is from David Driscoll of Citi.
David Driscoll:

And I would confirm what and – I wanted to make some really funny joke about Barclays not paying their bills, but they – we had the same problem that – we have some funny problem here that you guys do. So Andrew is telling the truth. On the Wholesome Natural category, did you – and apologies and said I just missed it. What did the category grow at during the quarter?
Mike Nathenson:

Hey, Andrew – hey David, it’s Mike. Gosh, I’ve got Andrew and David on the mind, sorry about that. David, the category grew low single-digits. So still remain strong.
David Driscoll:

And can you just explain, because I did get good that that you guys gain share and so forth. What do you make of a low single-digit rate of growth? Is this a temporary slowdown within the overall trend to moving to the premium Wholesome Natural? Or is there – there’s something bigger to take away from, because I’m sure investors are going to have all [indiscernible] Are you guys there?
Mike Nathenson:

Yes, we’re here, sorry about that. Sorry David. I wanted to ask why you asking the question about the overall pet food category growth or Wholesome Natural growth within that pet food category.
David Driscoll:

Wholesome Natural, please.
Mike Nathenson:

All right. We believe Wholesome Natural growth was in the high single-digit growth. So it’s mid – right in the mid to high single-digits. So it’s robust, very, very strong. It’s the overall category growth, which was low single-digits.
David Driscoll:

Good. You made my heart skipped a bit right there on that one. So yes, yes, definitely wanted to know about Wholesome Natural. On superstores, our work shows that superstore pricing is getting more competitive in the online channel with some of the big e-commerce players. Number one, do you guys see that same trend and then most importantly, how do you think that that will affect your business over time.
Mike Nathenson:

Well I think, we’ve noticed that the e-comm arms of brick and mortar are getting more competitive. So I think that’s true. For us in the long run, we want to be wherever – pet parents want to buy Wholesome Natural pet food. And if that’s on the e-comm arms of brick and mortar or through the dedicated e-comm retailers, all the better. As we’ve said in the past, we’re agnostic between which channels sells our product.
David Driscoll:

Well, maybe if I just try the same question, frankly differently, and let your market shares in the superstores are higher than in other channels. So if the superstores are getting more competitive in the online side, because that have any implication for you guys I mean is this something that you would say is potentially a positive, because your shares are higher in the superstores. And I’m assuming if that translates into the superstore online presence.
Billy Bishop:

Yes, David, this is Billy. I mean, again, I think given that we go to market given the fact that we’re a pull brand, given how fast we are growing on e-commerce right now, don’t have the same obviously level of share that we have in superstore. But I think it’s a positive I get something that we’re going to continue to grow as this channel continues to develop. So for us I think it’s good for Blue Buffalo.
David Driscoll:

Final question on Earth’s Essentials, what kind of potential do you see for the brand. Is this possibly another “Wilderness”? And then finally is the brand accretive to your margins.
Billy Bishop:

David, yes, I think Earth’s Essentials has potential, given how we go to market, which I think well. We’re excited about it, because it really again is continuing to drive the humanization and the premiumization of pet food. We love our farm-to-table cuisine concept. It’s popular today with pet parents. And again, I think this plays right up to the pet parents and looking to feed their pets foods with better ingredients. As you know, how we go to market we are going to be talking to consumers and pet parents about this. So you’ll see some TV advertising, you’ll see other forms of communication and education that will put behind it. And I think we have a great product portfolio in dry, wet and treat. So again, early days the product line is just literally rolling out right now, but we think it’s – it’s right on track with what pet parents are looking for.
Mike Nathenson:

And David, to answer your question, it is accretive to our margins.
David Driscoll:

Really helpful. Thank you guys so much, I’ll pass it along.
Billy Bishop:

Thanks, David.
Mike Nathenson:

Thanks.
Operator:

Our next question is from Faiza Alwy of Deutsche Bank.
Faiza Alwy:

Yes. Hi, Thank you. So Billy, I was wondering, if you could talk about the implications of PetSmart buying Chewy.com and how that might impact your business over the next couple of years.
Billy Bishop:

Hi, Faiza, sure. We’re optimistic. We have good business relationships with both of those customers and we’re a top brand for both Chewy and PetSmart. So for us we look forward to continuing to grow our businesses together.
Faiza Alwy:

Okay. And then Mike, could you just – I know you said it sounds like 59% of your sales came from the top to U.S. pet stores. Could you give us a breakdown for PetSmart and Petco separately?
Mike Nathenson:

Sure. The breakdown for PetSmart is 38.6% of our mix and for Petco is 20.6%.
Faiza Alwy:

Right, thank you.
Operator:

Our next question from Ken Goldman of JPMorgan.
Mike Nathenson:

Hi, Ken.
Ken Goldman:

Hi, thank you. I know we had some technical issues and I’m also on a train. So I do apologize, if it’s been asked already and just stop me if it has. But I was just curious, I think it’s second – at least the second straight quarter, where your receivables jumped up a little more than maybe what we had modeled. And I know you would talk about it last quarter is being somewhat of a combination maybe of timing and some channel shift. Can you just update us on maybe some of the reasons behind that and help us understand what the outlook is for next couple quarters.
Mike Nathenson:

Sure. It’s Mike here. So first of all, currently all of our customers are paying on time. And they are – the receivables level is higher based on customer mix and timing. There’s a portion of our customers that choose not to take advantage of our early pay discount. And as a result, our days receivable has grown, but that said our credit team is monitoring this very, very closely.
Ken Goldman:

That’s helpful. And when you say a portion of your customers is that related in anyway to the channel shift. And what I’m really getting at is are some of your e-comm customers just that they approach the terms for lack of a better word any differently than.
Billy Bishop:

Yes, Ken, I heard you cut out a little bit, I’m not sure if you can hear me. Okay, good we can hear you. I just want to make sure we didn’t lose you. We do really don’t go into that level of detail and discuss terms on a customer by customer level.
Ken Goldman:

Okay. I’ll hang up before I cut out again. Thanks very much.
Billy Bishop:

No worries.
Operator:

Our next question is from John Baumgartner of Wells Fargo.
John Baumgartner:

Hi, good afternoon, thanks for the question.
Billy Bishop:

Hi, John.
John Baumgartner:

Bill, I wanted to ask about the wet therapy business. And we’ve been hearing expectations around the industry that e-comm is increasing its merchandising of therapy. I guess really beginning this year and next year. And if so, I’m curious as to whether that route to market may help kind of get you back on track in terms of building distribution in that business.
Billy Bishop:

Sure, John. Obviously, the Internet is safe and e-commerce is making inroads across a lot of consumer product goods. So we’re watching that closely. The thing for us it’s about building relationships with the veterinarian community. So like I said before, it’s going to take time, but we really want to do it in a high quality meaningful way. So we can obviously have this be a future growth engine for us. So I think the Internet is here to stay obviously, e-commerce is here to stay, I think our important focus right now is to really get to know the clinics have then get to know Blue Buffalo and build this business one clinic at a time.
John Baumgartner:

Okay. So still bricks and mortar more or less.
Billy Bishop:

You got it.
John Baumgartner:

Okay. And then just a follow-up I apologize and I missed it when the phone cut out. But in terms of some of the slight acceleration of decline in the pet super sell-through. Do you sense at the how much of that is being driven by the shift e-comm versus maybe just some earlier consumer weakness? That’s at the industry more broadly. And do you have the sense for what kind of exit rate was pet sell-through and supers as the quarter ended?
Mike Nathenson:

Hey, John, it’s Mike. What we have continued to see is some stabilization in the sales dollars in pet superstores. So it’s a trend that we’re feeling pretty good about. I think when you look at the – kind of the month-to-month trends. I think January was the weaker month of the quarter, but it’s still early days in the sales trends in the quarter or actually in the year. So we’re hopefully optimistic, but we don’t want to get ahead of our SKUs on this. So from that standpoint, I hope that answers your question.
John Baumgartner:

Great. Thanks, Mike. Thanks for your time.
Mike Nathenson:

Thanks, John. You got it.
Operator:

Our next question is from Dara Mohsenian of Morgan Stanley.
Dara Mohsenian:

Hey guys.
Mike Nathenson:

Hey, Dara.
Dara Mohsenian:

So first Mike I just wanted to make sure I had to correct, you talked about nominal sales for the company being similar in Q2 to Q1. So that means we’re looking at roughly about 5% year-over-year sales growth in Q2. Is that right? Did you mean growth trends or are you talking about nominal sales dollars?
Mike Nathenson:

No, I’m talking about nominal sales dollars.
Dara Mohsenian:

Okay. And then that sort of gets into my question, because I guess I’m struggling to understand why the second half which snapped back so significantly to hit the midpoint of your full year guidance range. It implies you need to do 11%, 12% growth in the back half, so retail sales growth has been more in the high-single digit range in the last couple quarters. It’s been slowing sequentially over the last five quarters. So I know you gave some reasons why things get better. But I was hoping for some more kind of conceptual magnitude maybe around the innovation and some of the other factors, because it just seems like it’s a pretty big acceleration for the back half of the year in a typical environment.
Mike Nathenson:

Sure. So let’s just kind of focus a little bit on Q2 and Q1. Remember there’s some headwinds and some tailwinds and they’ve all been baked into their guidance. But when you look at it, we’re really lapping a Q2 2016 inventory catch up. That was very WTO focus last year if you recall. And in Q1, we had a modest inventory build and as I mentioned it and it may have been difficult to catch during that – cut out of the call, is that part of it was – our inventory pipeline was filling for our innovation toward the end of the quarter and part of it is timing. So we’ll see what the self-through rates look like when we get into the quarter. And when we look at it, the brick and mortar trends are continuing. But that said there’s also some tailwinds. In those tailwinds that we expect to – we are gaining space, our – rollout of our innovation is going to continue. And our brand building SG&A investments in both marketing and advertising are focused on the innovation launch. So when you marry that up with the e-comm momentum is very strong. Now looking at H2, right, if you look at the top end of the range of our guidance, right. That is assumes about $175 million of sales into superstores. It’s been that way for the last three quarters. So obviously, growth rates are driven by both the numerator and the denominator. And we saw the sales rate into superstores in Q1 to be a little bit higher than that. And then that’s relates to the inventory build that I just talked about. Once we get through H1. And in H1, we sold in $188 million a quarter last year. Once we’re through that into Q3 and H2 are our headwind, our growth rate in superstores goes from basically down mid-single digits to essentially flattish in the back half of the year. And so what you have to believe at the top end of our guidance is that we continue to sell in about $175 million a quarter in superstores, and sales outside of superstores continue to grow in the mid-30s. Obviously if there’s pressure on one of those or both of those, our results would be on the lower end of our guidance, but that’s why we give a guidance range. So hopefully that helps.
Dara Mohsenian:

That does help. So that helps a lot of the retail sales standpoint. Can you also talk a little bit about inventory, because obviously in the broader CPG industry, a lot of brick and mortar retailers have been cutting inventory, some pretty significant way which seems to be driven by the traffic and a shift in shared e-commerce. Those issues actually seem a lot more trouble in the pet superstores than broader brick and mortar and other CPG categories. So we’ve actually seen a build up in superstore inventory over the last few quarters. I know part of that is that comparisons to prior year. But are you worried at some point that superstores cut inventory significantly on your business and is that factored in at all and any visibility on that at the balance of the year would also be helpful?
Mike Nathenson:

Obviously, we monitor it closely and that’s why I gave some transparency into the sell-in and sell-through numbers here in the quarter. We had also given some information as well in Q4 of last year on our Q4 call. So the reason I bring it up is that, it’s actually factored into the low end of our guidance, right. So as I mentioned we’ve built some inventory in Q1. We expect it’s going to unwind, but there’s a reason I give the high end and low end of the guidance. So obviously, if the sales sell-through in superstores stays constant, but they reduce inventory. That’s another reason why the low end of our guidance may occur. So there’s lots of things that are built in and that’s why we give a range.
Dara Mohsenian:

Okay, that’s helpful. And can you just give us where the Q1 inventory for the innovation was the pipeline fill in Q1?
Mike Nathenson:

We don’t disclose that that level of detail. But I would tell you that the difference between sell-in and sell-through was probably around 50/50 innovation and then timing.
Dara Mohsenian:

All right, thank you very much.
Operator:

Our next question is from Pablo Zuanic with SIG.
Pablo Zuanic:

Yes. I’ve just two questions. Can you give us an update on international business, I think you said during 2016, it was 4% of sales and 2015 also 4% of sales, but just walk us through what to expect from international in 2017? What’s embedded in the guidance? That’s the first question. And then the second one, with all these blaring of the channels now PetSmart buying Chewy, I understand you don’t want to sell-in mass, but for example, brick and mortar mass, but would you can see they are selling in something like the jet platform or something like that I don’t know Wal-Mart owns. Thanks.
Billy Bishop:

Hey Pablo, it’s Billy. As far as the international update those – again, we’re seeing good progress with our strategic initiatives. I wish I had some crazy new news to share with you, but I don’t it’s all about gaining distribution, building distribution and obviously turning on some of our Blue marketing. So we are seeing good progress there and our businesses are growing. So we feel good about that. As far as selling anywhere else outside of specialty, I can tell you we’re focused right now on selling in specialty and again being a pull brand and driving pet parents at the time Blue products where we currently sell, so that’s our – that is our focus.
Pablo Zuanic:

Okay. And just if we follow-up, so when we talk about innovation and all these new product launches, what adjustments you have to make given the growth of e-commerce? I understand that it’s all about pool and advertizing and creating awareness through social media. How do you feature of these new products on a platform like Chewy or do you see really that the merchandising going to get for innovation is going to be mostly in brick and mortar and we shouldn’t expect a little feature in e-commerce as we go to the different platforms, if you can explain that. Thanks.
Billy Bishop:

Sure, Pablo. So again we like our – what we call our unique marketing model, because we think it serves all channels that we’re currently in today. So we think that all of our, if you call it advertising be a TV advertising, be a print advertising, be at our social media marketing. I think all of that feeds to each one of the channels in which we sell Blue product. Yes, there are different merchandising techniques that we’re learning whether that’s in brick and mortar stores or online that will continue to learn and continue to test and it’s successful, obviously scale. But we like how we go to market, we like how we support each one of our product lines. And I think you’ve seen that as a result that how we’ve been able to whether this really choppy channel dynamics that we’ve been experiencing for the last few quarters.
Pablo Zuanic:

Thanks. And just one very last one, you’re very kind to give us a breakdown between PetSmart and Petco. Can you break it down to 41% of the rest of sales between e-commerce, independent stores and farm and feed please, just roughly?
Mike Nathenson:

Thanks, Pablo. What we haven’t really disclosed that level of detail for those sales outside of superstores.
Pablo Zuanic:

Okay, but I guess, given this nicely, I’ll just follow-up on a quick one. I mean that push we’re keep hearing that our brands out there that only self to independent stores in brick and mortar right, and they don’t sell to a Petco or PetSmart because they have this type of agreement with independence to they will not go to the bigger superstores. So but by the same talking I wonder how those efforts from your side are going into those independent stores. It just seems to me that 41% is becoming more and more e-commerce and that the runway on independence is more limited on farm and feed, they only have so much phase. Can you comment on that? Thanks.
Billy Bishop:

Sure, Pablo, Billy again, and I think we’ve talked about this before and previous calls and we’re under penetrated in all channels outside of the superstores. So regardless that there are some softening and some headwinds we know, we still have opportunity to increase our penetration within the channels outside of the superstores. Farm is 6% of the market and right now it’s as large as e-commerce as you just look at the channels as they exist today. So again a very good spot to be in given their locations and have a 50 overall, I think retail geographic puzzle. So for us, we want all of our retail partners to win, and we’re committed to continuing to drive that parent demand for our products wherever it sold.
Pablo Zuanic:

Okay, thanks.
Mike Nathenson:

Thank you.
Operator:

Out next question is from Rupesh Parikh of Oppenheimer.
Unidentified Analyst:

Good afternoon. This is actually [indiscernible] on for Rupesh. Thanks for taking our questions. So I wanted to touch on neighborhood pet superstores – neighborhood side pet stores, and farm and feed stores. Just curious if you could talk a little bit about what you’re seeing there. And then also and more specifically curious your thoughts on if that shift online is also weighing on that channel’s traffic and growth
Billy Bishop:

Yes, sure. This is Billy. From a regional and neighborhood pet stores standpoints, the channel is growing low-single digits. And as I just mentioned we’re under penetrated within that channel. So we’re continually focusing on how we can build our business there. From a farm and feed standpoint channels also growing. We estimate low-single digits. Blue again I would say is underpenetrated given our broader portfolio of products that we have in superstore. So we see that as an opportunity for us. And net, net again we’re gaining share when you look at the entire market, so we feel good about that. E-commerce is obviously interesting. We find that our puppy and kitten share is the same size online as it is in our brick-and-mortar channels, which we take is a good sign. We choose to bringing in new pet parents. So I think you can’t say obviously it’s a clearly 100% incremental, but that e-commerce is going to touch and impact most all other channels. So we like again our marketing model and how we drive pet parent demand and that really is what well, Blue Buffalo is trying to do to help support all of our retail partners.
Unidentified Analyst:

Okay, great. Thank you.
Operator:

[Operator Instructions] Our next question is from Brian Holland of Consumer Edge Research.
Brian Holland:

Thanks so much. Quick on housekeeping I just on a little bit late, my questions so far been answered, but I just want to confirm, I believe you said earlier pet superstores down 6% to 7%. That sounds like in line and maybe just the touch worse than the prior quarter, if you guys can clarify that. And then I just I wanted to confirm your share position within the superstores and whether that had gone up or how steady or just how to think about that?
Mike Nathenson:

Sure, Brian. It’s Mike. From the superstore sales, the trends have been stable, so rather than look at the overlap, because that’s your – the implication around your growth rate is that we’ve consistently seen around $175 million sales into superstores over the last three quarters. So obviously in Q1 when you’re lapping $188 million sales from the year before, that’s what’s making the growth rate or creating the growth rate headwinds for us. So from that standpoint like I said, we’re seeing some stabilization in the underlying trends in superstores. As far as the share and superstores, it’s about flat.
Brian Holland:

Okay. Thank you, that’s helpful. And then just sort of moving that over to the e-commerce side, I’m curious and forgive me if you’ve addressed this earlier and I missed it, but what’s the share position online? And if you don’t want to specify number just maybe directionally how that’s moving, are you gaining share? I guess obviously, just both are sensitive to the perceived lower barriers-to-entries in the channel and how you guys hold up there. Is there way to think about sort of share shifts within e-commerce and how you’re holding up if that channel evolves and gets more crowded that’s just traffic but competitor?
Billy Bishop:

Sure, Brain. This is Billy. We believe we are the number one e-commerce brand based on some data that was published a few months ago. We know that our marketing model works, as I mentioned earlier and all the channels that we currently sell Blue. So yes, we are gaining share in e-commerce. And again we think it’s a channel and which we can bring new customers into and want to which I think has a long runway for growth ahead of it.
Brian Holland:

Okay, thanks. And then just thinking about the guidance last question for me. It’s always sounds like I guess guidance at the onset of the year implied I guess, at the high end that trend sort of remained stable on the low end that they could – you have some room for trends and deteriorate. I think that’s specific to superstore. You can correct me if I’m wrong, but so it sounds like so far trends are relatively stable. I’m just curious how the essentials line play then, and how that was factored into guidance and whether – and how that performing relative to the plan. Just do I understand right the way that you’re thinking about guidance for the year and that’s superstores performance thus far and I appreciated it’s early, but trending towards the higher end and then just any commentary about how essentials plays into that?
Bill Bishop:

Sure, Brain. I could get off with how Earth’s Essentials fit into that and then Michael will talk more about our guidance. You may have heard, let’s say this – you may not but the innovation is one of our three strategic planks. So our innovation is built into our long-term guidance and it’s always a part of how we look at the business. So I think Earth’s Essentials again is another great new product line that drives that humanization and premiumization that we’re seeing, happening in pet food. So again its early days for that particular product line is it just – right now fill in the shelves. But again, we think it’s right on the mark and we’re excited about serious innovation takes us.
Mike Nathenson:

And then, hi, this is Mike. I just want to jump in on the guidance. What we’ve said on our guidance and I’m not guiding to any either one end or the other of our guidance range is a reason I give a range. At the high end of the guidance as I said before is that it assumes about $175 million sales into super stores, and that the sales outside of superstores are in the mid-30s. Now obviously if there’s more pressure in brick and mortar and that could be a range of assumptions here, it could be – if inventory adjust, if sales softened a little bit or if there is softness outside of superstores, then obviously we would be at the lower end of our guidance range. I mean there is a number of different scenarios that could possibly happen and we give a range hopefully to cover the majority of them. We feel like the range is fairly centre cut and that’s why we give the range.
Brian Holland:

Okay, thanks, Mike. That is very helpful color. Thanks again. Best of luck.
Mike Nathenson:

Thanks, Brian.
Operator:

I am showing no more questions at this time. Mr. Bishop, I would now like to turn the conference back to you.
Billy Bishop:

All right. I want to thank all of our herd members around the world for a good start to 2017. It was a pleasure sharing our strong to quarter one results with everybody. And we look forward to talking to you guys again soon on our next call when we report our 2Q results. May the BUFF be with you guys.

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