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Q2 2017 Earnings Call Transcript

Published: 9 Aug 2017

[Operator:]

Good afternoon, ladies and gentlemen and welcome to the Blue Buffalo 2017 Second 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:]

Thanks Liz. Good afternoon, everyone and welcome to Blue Buffalo's Q2 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 earlier in the year with the SEC 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'm joined by our CEO, Billy Bishop. With that, let me turn it over to Billy.

[Billy Bishop:]

Thanks Mike. Welcome everyone. I'm pleased to share our second quarter results with you today as well as walk you through the evolution of our go-to-market model to reach more pet parents and feed more pets, which is where I'd like to spend the majority of the time on today's call. Let's get started with a look at Q2. Our consumer takeaway at retail remains robust. Our sell-through to pet parents grew 7% year-over-year, well ahead of the market and represented a sequential improvement for BLUE. Our growth was primarily driven by continued strong performance in e-commerce that was partially offset by continued headwinds in brick and mortar retailers. Our reported 2.8% growth rate was four points lower than our sell-through in the quarter. This gap was driven by an inventory catchup primarily at superstores. We expanded our margins through strong supply chain performance, positive mix, and pricing. And we continue to strengthen our master brand with unwavering support of media, pet parent education, and innovation designed to meet the needs of pets and pet parents. Now, let's take a look at the market dynamics and our performance at retail. In Q2, the U.S. pet food market remained healthy and continued to grow low single-digits. And while our brand equity is as strong as ever, we're not immune to the headwinds at our brick and mortar specialty retailers. Sequentially, our sell-through growth rate of 7% has improved below versus last quarter, but still came in a bit lower than our earlier expectations. Consistent with our discussions on recent earnings calls, the pet superstore channel has continued to see a slowdown due to reduced traffic. Given this trend, our Q2 superstore sell-through was down approximately 6% versus last year. Outside of pet superstores, we estimate our sell-through growth rate in the quarter was 30%. In these channels, e-commerce continue to grow rapidly while we saw pressure in brick and mortar stores. On the e-commerce side, we continue to increase our sales and gain share in this high growth channel. As we had previously discussed, we enjoy significant competitive advantages in e-commerce, given our higher value per pound as well as our industry-leading advertising investment that creates consumer pull for BLUE. In fact, BLUE is the largest pet food brand in the e-commerce channel, with one-fifth of all BLUE retail sales going through e-commerce, much of it on subscription. As discussed on previous calls, WTO, our shorthand for Wet Foods, Treats and Other Products, is a key part of our growth strategy and remains an area of focus for us. In Q2, our topline WTO growth was lower than usual, primarily as a result of a timing shift. More importantly, as I will discuss with you in a few minutes, we'll be unlocking our strong growth potential in WTO with the evolution of our go-to-market model. Now, turning to our announcement of expanded distribution of the BLUE Life Protection product line. As you may recall, as part of our IPO two years ago, we laid out a clear growth strategy that still guides us. One of the pillars of this growth strategy is to reach more pet parents and to feed more pets by making BLUE more available as we still feed less than 3% of pets in the U.S. We have been executing on this strategy over the last few years by increasing our points of distribution in a broader set of specialty retailers. This is followed by an increase in emphasis on e-commerce and entering into the veterinary channel. Up until now, we only sold our products into the channels representing less than half of the total U.S. pet food market by dollars share. To continue to reach more pet parents and feed more pets, we've also been assessing the FDM channel which makes up over 50% of the market by value and over two-thirds by volume. So, clearly this opportunity is too big for a major pet food player to ignore, especially one with tremendous brand equity that we've built for over a decade with massive brand building support of over $700 million and counting. At the BUFF, we believe in being bold, doing our homework, making the right business decisions and executing superbly. That's how we built our business from day one. As we studied the different ways to evolve our go to market strategy and enter FDM, we thought it was important to be very deliberate in order to maximize our potential in the long run while making sure that this new growth is as incremental to our existing specialty retailer base as possible. We recognize that every channel has its unique characteristics. And in order to become a top player at these FDM retailers, we needed to leverage the strong brand equity we built and bring a product portfolio that match their customer base and shopping patterns. We wanted to make sure that we partnered with the right retailers for the launch to ensure the best fit and the strongest in-store execution for BLUE, and ultimately lay a strong foundation for the BUFF in this large channel. As you saw on our announcement, we're partnering with four of the leading mass and grocery retailers in the U.S. These four retailers account for approximately 8% to 9% of the U.S. pet food market in dollar terms compared to our current distribution reach of approximately 40%. So, this is a significant expansion for us. We just began shipping and you'll see us in stores shortly. We have a strong launch plan which will include highly visible in-store presence for our BLUE Life Protection Formula dog and cat product lines that include Dry Foods, Wet Foods and Treats. LPF is our largest product line with attractive price point so we believe it's the perfect choice for the FDM channel as the new mainstream brand for pet parents. While the LPF product portfolio will vary by account and store format, we developed new smaller bag sizes, tip the right price points to match the shopping patterns in FDM. As part of our deep dive into our WTO growth strategy, we identified an important insight. Looking at the data, FDM over indexes on cats and WTO compared to the specialty channel which we believe will be very incremental to the BUFF. In fact, it became clear to us that WTO under-indexing and the specialty channels has been a significant barrier for us to achieve our WTO penetration goals. The underlying insight is that Wet Foods and Treats are more likely to be impulse items and benefit from the more frequent shopping trips in grocery and mass retailers. This compares to the less frequent and more planned shopping trips to the pet specialty stores for items like larger bags of dry dog foods or for scheduled services. Overall, we're pumped about our entry into the FDM and the impact it will have on our goal of reaching more pet parents and feeding more pets. Going forward, we expect to enter additional retail accounts, but this will be a selective and deliberate process focused on the quality of the distribution and the commitment to meet the high bar we're setting on FDM rather than a blanket effort to build ACV points. Now, I'd like to tell you how we're going to continue support our specialty retail partners. As a reminder, we are the leader in this channel with over two times the share of the next brand. And our support starts with a differentiated product portfolio that reflects the needs of pet parents who shop in pet specialty. With regard to LPF, specialty retailers will have access to different larger bag sizes that match the shopping patterns of their customers. They will also carry all of our customized LPF formulas given the dedicated shelf space and the higher level of service they can provide to pet parents. As part of this differentiated offering, our Wilderness, Basics, Freedom, and Earth's Essentials product lines will continue to be sold exclusively in the specialty channel. And going forward, we will continue to rollout new innovation and unique marketing and merchandising solutions to help fuel the growth of our pet specialty partners. This includes our mission-driven marketing program such as Pet Cancer Awareness and Service Dogs for Heroes. As we grow our business in these different channels, we will leverage all the tools in BLUE's unique go to market model to meet each channel's needs. Last, but certainly not least, we will ramp up our advertising and in-store merchandising support for both LPFs and for our specialty exclusive lines to drive consumer pull everywhere BLUE products are sold. Over the last week, we have had constructive conversations with all of our major retail partners. They appreciate our efforts to make our expansions incremental to our specialty retail business as possible. Although it's early days, the most important aspect is that we are all focused to continue to grow our business together. Overall, I'm very pleased with our game plan to continue to lead in the specialty channel where we begin building the foundation to become a top brand in FDM. Now, I'll pass it on to Mike to take you through our financials.

[Mike Nathenson:]

Thanks Billy. Let's start with Q2 performance. Our overall net sales growth in the quarter was 2.8%, which was driven by 0.1% volume, 1.8% mix, and 0.9% pricing. For the quarter, Dry Foods grew 3.3% and WTO grow 0.7%. As expected, the sell-in growth rate of WTO reflected the lapping headwind of our 2016 second quarter innovation launch and we expect to see more normalized WTO growth rates beginning in Q3. Before I talk through the rest of the P&L, I'd like to touch on our sales growth by channel. As you may have seen in the public announcements, PetSmart completed its acquisition of Chewy.com, during the quarter. For today's call, my comments are going to be based on a pro forma look at channels, reflecting our historical channel segregation and we will, of course, continue to share required information about sales to material customers in our regulatory filings. Going forward, beginning with our Q3 results, we will also share additional channel details reflecting our evolving distribution landscape. Now, back to the numbers. As Billy discussed earlier on the call and consistent with our comments from our Q1 earnings call, headwinds continue to cross brick and mortar accounts. In super stores, which represented 57% of our mix in Q2, pet parent take away was down 6% compared to our sell-in, which was down 11% versus last year. You'll recall that our sell-in growth had been ahead of sell-through in the last few quarters, so this represents a catch up. Driven by continued strong growth of our sales in the e-commerce channel, our sales outside of pet superstores represented 43% of our sales mix in the quarter and grew by 28%. We estimate that our sell-through in these channels was a bit higher at approximately 30%. Now, let's turn to our margins and the bottom-line. As you saw in the earnings release, our gross margin remained strong in the quarter. Our gross margin was 46.7%, 230 basis points higher than last year. The increase in gross margin was driven primarily by supply chain efficiencies, including productivity and lower input cost. In Q2, we maintained the positive momentum in our operations and we're able to deliver meaningful productivity from our Heartland plant. Margins also benefited from positive mix and pricing. Now, let's turn to SG&A. Excluding the cost associated with our equity offerings as well as our litigation-related expenses, SG&A grew 10.2% in the quarter versus last year. The increase was primarily driven by investments in revenue generating activities. Our tax rate in the quarter was 34.7% compared to 37% 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. On the bottom-line, Q2 adjusted net income was $43 million, up 11.6% and adjusted diluted EPS was $0.21 per share, up 10.9%. 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. We continue to produce strong cash flow. Year-to-date, our operating cash flow, defined as cash from operations less CapEx, was $30 million. Our CapEx was $33 million. And at the end of the quarter, we had $339 million of cash on our balance sheet. Also during the quarter, we successfully refinanced our debt. We refreshed our original $400 million term loan B and expanded our undrawn revolving credit facility to $120 million, which is appropriate for the current size of our business. The good news is that we were able to reduce our ongoing borrowing costs by 75 basis points. Now, turning to our 2017 guidance. For the full year, we are reaffirming our guidance for the topline and for the bottom-line. Our expected net sales range is between $1.24 billion and $1.27 billion. Our guidance implies an 8% to 10% topline growth for the year and a 10% to 15% topline growth for the back half of the year, which is consistent with our long-term algorithm. For EPS, we are maintaining our guidance of $0.91 to $0.94 per share. Within our reaffirmed EPS guidance, we're increasing our investment in brand building SG&A to support the new additional distribution as well as drive excitement and pet parent demand for our specialty exclusive lines of Wilderness, Basics, Freedom, and Earth's Essentials. This additional brand building investment is being funded by our strong gross margins and savings from lower borrowing costs. As always, we will continue to keep a tight lid on overhead spending. For taxes, we anticipate a full year tax rate range of 36.5% to 37%. On the capital side, our $200 million capital investment program to expand our manufacturing footprint and strengthen our R&D capabilities is on track. For 2017, we expect to spend between $150 million and $170 million of capital, which also includes our ongoing CapEx. And finally, as mentioned on our press release, the Board of Directors has authorized a $50 million share repurchase program, primarily to offset dilution from our equity compensation programs. We expect to complete the buyback before the end of the year. The announcement of our first share repurchase program coincides with the announcement of this new chapter in our go-to-market strategy, which reflects our confidence in the future as well as our commitment to maximize shareholder value. Now, I'll turn it back over to Billy.

[Billy Bishop:]

Thanks Mike. Before opening up to questions, I'd like to conclude with these key points. One, Blue Buffalo is a competitively advantaged leader in the best part of a great category, the wholesome natural segment of the $70 billion global pet food market. Two, as a natural evolution of our go to market model, we are broadening the distribution of our LPF product line in a deliberate and thoughtful manner. Three, we're committed to continue to lead in the pet specialty channel and invest behind it. Our Wilderness, Basics, Freedom, and Earth's Essentials lines will continue to be sold exclusively in the pet specialty channel and we are increasing our brand building investment for a pet specialty. 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 is on track and will enable further productivity, flexibility and innovation. And five, we're excited about our future. We believe we are making the right choice to accelerate our path for the next $1 billion of sales. With that, I'll open it up to questions.

[Operator:]

Thank you very much Mr. Bishop. [Operator Instructions] Our first question is from David Driscoll of Citi.

[David Driscoll:]

Great. Thank you. And good evening guys.

[Billy Bishop:]

Good evening David.

[David Driscoll:]

So, a couple of questions. The first one for me is, what do you think is the size of the mass and grocery price for Blue Buffalo and why?

[Billy Bishop:]

Sure David. Billy here. Our goal is to be a top player in FDM, not a niche brand. So, the size of the prize is big. As you think you've heard me say, FDM, again, has over 50% of the dollars and 70% of the pounds in that channel. And that's obviously a lot of pet parents that are there that we want to feed BLUE. So, again, starting with our four retail partners, we feel we have a long way ahead of us, but our goal is to be successful with these accounts. And we think we can do that and leverage all the brand equity that we've been able to build to-date with our investments of over $700 million and counting. So, the size of the price is big. Blue Buffalo is a major player in the pet food space and we feel that we need our Life Protection Formula line there to bring in new pet parents.

[David Driscoll:]

Great. Mike, can you describe what gets the company to the top and bottom end of your second half revenue guidance that you described a moment ago between 10% and 15% for 2H 2017. So, what gets you to the top and the bottom end of it, please?

[Mike Nathenson:]

Sure. Happy to help. Let me just take a step back and just describe how we built the guidance and how it all fits together. And it really comes by looking at both the sell-through and the sell-in. So, let me start there. First off, our Q2 sell-through was 7%, as Billy mentioned on the call. And going forward, we expect the specialty, the base specialty sell-through expectations on sell-through to continue. Our FDM sell-through will be incremental as our distribution builds. So, overall, we see double-digit sell-through in H2. So, that's the sell-through side. Let me talk a little bit about sell-in so you can kind of put that together. On the sell-in side, it really starts with sell-through, right? Sell-through is the biggest component of sell-in. But there's also going to be the initial FDM pipeline fill, which any time you actually enter a channel, you're filling shelves, you're filling distribution points and that's going to be important for us and it will also may offset any possible inventory overhang that there might be in specialty. So, that's the two components of how it fits together. I think when you look at the guidance, both the high end and the low end; you still have to look at sell-through and sell-in. For the high end, for sell-through, we believe we can get to high single digits, low double-digit share in our four FDM accounts and maintain the momentum in pet specialty. So, that's what you have to believe on the sell-through side. On the sell-in side, the pipeline fill for FDM is going to more than offset any potential inventory headwinds in specialty brick and mortar. So, those are the combination at the high end. At the low end, there's -- anytime we give a range, there's a range of possibilities and scenarios to consider. But on the lower end, it may be a slower FDM build or more specialty brick and mortar headwinds.

[David Driscoll:]

Okay. But Mike, you clearly believe -- the team clearly believes that the top end is achievable given the second quarter results? Because the revenues obviously were --came a little bit lower than what The Street was modeling. Is that a fair comment?

[Mike Nathenson:]

Yes, that's a definite comment. So, really, the fundamental thing to focus on is the 7% sell-through that we had in Q2. Obviously, when we printed just under 3% topline sell-in growth, really what you had to look at is the sell-through growth. I think it's fair to say that our sell-through was improved versus Q1. But it was a little bit lower than our expectations in brick and mortar. And as a result, the anticipated inventory catch up was a little bit larger than expected. But the good news is through all that, our e-commerce channel continue to be very strong.

[David Driscoll:]

Last question for me. Billy, you mentioned this a bit in your prepared comments. But I just like to ask kind of point blank, what kind of risk is there that Blue Buffalo could lead shelf space in the superstores? Have the superstores given you any feedback on your launch in mass and grocery?

[Billy Bishop:]

Sure Dave. We've informed, obviously, our pet specialty partners. We're obviously going to be meeting with them in the coming weeks to continue to focus on how we can drive our businesses in the specialty channel. We are not pulling away from specialty channel whatsoever, we're increasing our investment. We want to continue to drive pet parents into that channel where they can find still the broadest of selection of BLUE products. So, for us, again, we're the number one brand in specialty, over two times the size of the next one. We want to continue to lead in the specialty channel and that's going to be a focus for us.

[David Driscoll:]

That very helpful. Thanks guys, I'll pass it along.

[Billy Bishop:]

Thanks David.

[Operator:]

Our next question is from John Baumgartner from Wells Fargo.

[John Baumgartner:]

Hi, good afternoon. Thanks for the question.

[Billy Bishop:]

Hey John.

[John Baumgartner:]

Mike, I'd like to ask about the mix component to your revenue growth. Up until now, the model has really been driven largely by volume. But looking at some of the innovation rolled out in the first half particularly on Treats, the price per pound premium is pretty significant. So, I guess how are you thinking about the limitation on price points, elasticity there? And at what point the consumer maybe pushes back in terms of the mix?

[Mike Nathenson:]

I think the most important thing is really to focus on price gaps, in terms of how we think about it. So, there's lots of different components. But the first and foremost one is that we want to make sure that we maintain reasonable price gaps between each of our lines, particularly Life Protection Formula and some of the engineered brands that we compete with. So, that's our first consideration when we go after that. The question you asked about mix is really all about how we are approaching this. One is that we continue to innovate in our more premium lines like Wilderness, Basics, Freedom, and Earth's Essentials. And we're doing that by following the humanization and premiumization trends. Within WTO, there are Treats -- Wet Foods tend to be more of an impulse purchase and they tend to be exciting treats, obviously, to give to your pets. But we think there's a lot of run way there.

[John Baumgartner:]

Great. Thank you.

[Operator:]

Our next question is from Faiza Alwy of Deutsche Bank.

[Faiza Alwy:]

Yes, hi. So, I just wanted to talk about your share trends in the superstore channel and online. So one, can you tell us what percentage of your sales this quarter were online? I think Billy, you mentioned one-fifth, so was that just for this quarter? Or was that over the last 12 months? And then just if you could expand on the share count.

[Billy Bishop:]

Sure Faiza. Yes, one-fifth of our sales in the quarter was from online. And again, we continue to gain share and grow with that fast-growing channel. Overall, we have a 6% share in the pet food market, we have a mid-teens share, we estimate, within specialty, and we have 20% share within our superstores and low double-digit outside of super stores.

[Faiza Alwy:]

But how do you think these shares are trending? Do you think you're still gaining share online and at the pet superstores? Or do you think some of the smaller, sort of, mid-tier brands are taking share?

[Billy Bishop:]

No Faiza, overall, we feel we're gaining share in the pet food marketplace. Again, we invest more than any other brand to drive pet parent demand for BLUE, wherever BLUE sold. And that's something that we're going to continue to do. So, for us, our focus is on how we can win on every channel that BLUE participates and it's all about, again, communicating to pet parents and delivering the products that they we're looking for.

[Faiza Alwy:]

Okay. And Billy could just talk a little bit more about how you're reaching new pet parents? Because it feels like a lot of the engineered brands have reformulated their products. So, do you feel like there's less switching now into the natural wholesome category? So, is a lot of your growth coming now from your new pet parents? So, if you could just -- do you agree with that statement? And if so, how are you communicating to new pet parents?

[Billy Bishop:]

Sure Faiza. No, we still see a big opportunity in bringing people in from the engineered brands into Blue Buffalo products. We still see that opportunity in specialty. We, obviously, now with our expansion of our Life Protection Formula into food drug and mass, see a great opportunity there. Given the fact that we have been driving those pet parents out of specialty -- out of excuse me, food, drug, and mass into specialty. So, I think it's going to be nice now to be next to source of volume within our FDM partners. So, no, I mean first we got to continue to educate pet parents. We know that they want the wholesome natural formulas. We feel this again as a cultural shift. It's not just a trend. But people want to see their pets healthier, better-for-them, products. And again, Blue Buffalo wants to be the leader in all of those channels.

[Faiza Alwy:]

All right. Thank you.

[Billy Bishop:]

Thanks.

[Operator:]

Our next question is from Ken Goldman of JPMorgan.

[Ken Goldman:]

Hi, thank you. Two questions from me, if I can. First, still little bit more color, if you don't mind, on the process of why you decided to take one of your products mainstream now? Previously, at least maybe my interpretation was that you were somewhat hesitant to do that. So, curious what the process was in getting to that? And then my second question is I'm just not sure within your guidance and I'm not sure if anyone is, really people including inside the company, how much you're modeling in for losses and this goes to Dave Driscoll's question, from your legacy customers? Because if you haven't had a real conversation, you haven't met with, head-to-head, with Petco and PetSmart yet, not to mention the name, although we know what we're talking about, how do you really know in your back half how much are going to loose from them? And I'm just trying to get a sense because all you said so far is you had constructive conversations. Not quite sure what that means. I'm just trying to dig a little bit more into that if you don't mind. Thank you.

[Mike Nathenson:]

Sure Ken. So, again, why have we chosen this strategy? Again, we feel it's part of our natural evolution of our go-to-market strategy. We've always said that we want to reach more pet parents and feed more pets and this will help us do that. We have always planned to enter, at some point, given the strength of the BLUE brand and how we built our master brand. We have five unique product lines that are under the BLUE master brand. So, we have a wide range of products that meet the needs of pet parents and their pets. So, again, it is not a decision that was made overnight. It does take planning. It does take a while. So, I think if you look back, you can see how we've been putting the pieces of the puzzle together. Obviously, we have a mass policy. We've organized our resources, both human resources to have an experience base to enter this channel. And our supply chain, obviously, has greatly improved and we're expanding our reach there. So, this is something that is, again, part of our natural evolution of our go-to-market strategy. One that's going to help us reach more pet parents and feed more pets. To answer your second question, again, clearly, it's early. We have reached out and have had conversations with our pet specialty partners and are going to continue to meet with them and do so obviously in the near-term here. We are not pulling back any of our investments in those channel. We're actually increasing our investments to drive pet parent demand for BLUE products, for Wilderness, for Basics, for Freedom, for Earth's Essentials as well as LPF. So, we are not changing in any way, shape or form our commitment into our investment to the specialty channel. So, I know I can't speak directly nor do I choose to speak directly for our partners. We know they had to manage their business to the best of their abilities and we obviously respect that. But again, Blue Buffalo is the leader in the pet specialty marketplace with over two times the size of the next largest brand.

[Ken Goldman:]

Billy, that's helpful. But Iams is big too. How do we know that what you're doing is different than what happened with Iams 15, 20 years ago?

[Billy Bishop:]

Absolutely Ken. We're very familiar with that Iams experience; believe it was back in 2000 when they decided to increase their distribution, the result of that was a double of their business within four years. They become a top brand in the food, drug, and mass channel with double-digit share. They did a little bit differently than we are doing it. And we're taking more of a thoughtful approach. They took their entire product line, their entire Iams portfolio and expanded the distribution of that. We're taking a portion of our largest and most popular Life Protection Formula line and entering this channel that we think it's the right way, obviously, to reach their consumer there. We're doing it with different packaging sizes. Smaller bag sizes are more popular within the food, drug, and mass channel. I don't believe Iams had any packaging modifications when they did it. Where we see the Iams struggles really was when they didn't evolve enough to meet the demand of the pet parent and want the wholesome natural products. So, we see -- that's really where they missed the boat. It wasn't that they had expanded into food, drug, and mass. So, different times, different place. We really feel like we're taking again a thoughtful and delivered approach. And again, we're not pulling anything back from specialty.

[Ken Goldman:]

Thank you so much.

[Billy Bishop:]

You bet.

[Operator:]

Our next question is from Andrew Lazar, Barclays.

[Andrew Lazar:]

Hi everybody.

[Billy Bishop:]

Hey Andrew.

[Andrew Lazar:]

I guess first off, I -- up until pretty recently, you guys had always reaffirmed your pretty strong belief that your e-commerce effort and tactics were really the right strategy and what you needed to level the playing field, so to speak, with a lot of the mainstream players, particularly given the margin structure. Your product offers a lot of e-commerce retailers and such. And you've always talked about how that level of playing field and didn't mean that you needed to go into this more competitive, more price sensitive mainstream world. So, I'm trying to get a sense if something changed there in what you see is e-com being able to do in terms of leveling that playing field? And that will be the first question.

[Billy Bishop:]

Sure Andrew. We believe e-commerce is a great channel to be in. We realize we can reach a lot of pet parents that are looking for our entire Blue Buffalo portfolio. So, we still believe strongly that the e-commerce channel is a great channel to be in. And I would say moreover, we want to be in the channels where pet parents prefer to shop. And that really drives us given the size of the brand that we are and our overall vision and strategy to again reach more pet parents and feed more pets. So, we see the e-commerce channel, obviously, as the channel that's going to continue to grow as more pet parents prefer to shop online. That being said, we know that pet parents still, some of them just prefer to shop where they buy their groceries for the family members, their two-legged family members. We want to remove that friction and be able to touch those pet parents where they prefer to shop.

[Andrew Lazar:]

And then Mike I think you mentioned that the growth that you're expecting in the back half of the year on the topline, the 10% to 15% growth is obviously consistent with your long-term growth algorithm. And that's the -- obviously, the sell-in and hopefully, sell-through in FDM that's allowing you to get there. From that, can I take it to mean that this move -- this strategic distribution shift allows you basically to continue to hit, in your view, that long-term 10% plus topline algorithm going forward?

[Mike Nathenson:]

Absolutely. So, as Billy said, our number one objective is to reach more pet parents and feed more pets. But when you just take a half a step backwards and kind of start at the top, we only feed 3% of pets. And we've got a very strong master brand with very broad brand appeal. And we're confident that we can double or triple the business. I think at the end of the day, looking at our strategy and looking at our long-term guidance, if we have frozen our go-to-market strategy, I think it would've been difficult to hit the target. But a couple of things have happened over the last couple of years that are different than what anybody expected. So, e-com growth is certainly faster than anyone expected it to be. And specialty brick and mortar is softer than expectations. But through that, the FDM channel growth has been more stable. So, we needed to evolve our strategy to meet the evolving market conditions and that's really a natural evolution.

[Andrew Lazar:]

Then the very last thing and this is a little bit more nebulous. But when this first was announced last week, you certainly have -- certainly a lot of folks brought up a lot of examples and not just the Iams one, but just even across the broader consumer where premium-oriented brands moved in a more mainstream way and there's clearly opportunity to increase sales if they did that. But in some cases, it led to a, again, over time, a broader may be brand value sort of degradation a little bit. And really, that's partly why you're doing it in a very segmented way and only with Life Protection Formula and whatnot. But it does all sort of have the overall sort of BLUE brand halo. And I guess it's hard -- I know it's hard to assess, but I guess what's the -- how did that -- the potential effect to the brand value, if you will, that you've created entering to sort of a calculus of this whole decision?

[Billy Bishop:]

Sure Andrew. Again, we're -- obviously, we're very sensitive to our brand and how our brand is perceived. Our products are clearly premium products and we work up the premium scale from LPF up through the rest of our product lines. What we've been impressed with obviously is just how grocery continues to evolve to meet the needs of the natural and organic consumer that they are feeding. We know Kroger now sells more organic foods than Whole Foods. And every time we turn around, it seems like there's a Starbucks popping up inside these grocery chains. So, we think, again, that shoppers there are looking for these types of products. And given again the size of BLUE, we feel that we have to play there as well if we're going to continue to reach our mission of feeding more pets. So, we will continue to watch it. I'd love -- and I'm sure you will, to get a look at the four retailers that we're launching an FDM with; I think that the in-store execution has been great. And I think again, you'll see how BLUE continues to not only communicate, but really build; I think our brand awareness -- high-quality brand awareness at the point-of-sale.

[Andrew Lazar:]

Thanks so much.

[Billy Bishop:]

You bet.

[Operator:]

Our next question is from Rupesh Parikh of Oppenheimer.

[Rupesh Parikh:]

Thanks for taking my questions. So, I also had a few questions on the mass grocery rollout. Is there any color you can provide in terms of how many stores you expect to go into initially? And how you see that build in terms of store penetration overtime within the four customers?

[Billy Bishop:]

Sure Rupesh, this is Billy. Again, right now, we're focused on making our initial launch as successful as it can be with our four select retailers that we've chosen to enter the channel with. Roughly, it will be close to, I think, 6,000 new doors, is what we'll be in. So, again, the rollout is taking place now and we look to have it to be completed really September timeframe. But we will continue to obviously make sure we assess the developments and the quality of the distribution and in-store execution that we get and go from there.

[Rupesh Parikh:]

And then from an in-store perspective, what type of marketing efforts do you guys expect to do within those, I guess, within the grocery mass channel?

[Billy Bishop:]

Well, again -- excuse me; I think you're familiar with how we go to market. We have a lot of tools in the Blue Buffalo platform and we want to implement as many as we can, again, to educate pet parents and to feed more pets. So, you'll see, I think, good store, great in-store execution. You see us to continue to invest obviously in our broader communication and advertising. And again, we're going to continue to educate pet parents on BLUE products and to feed more pets. So, I think you'll see a little bit of everything.

[Rupesh Parikh:]

Okay, great. And then I have a question for Mike. Just on your commentary in terms of the higher range of guidance. I think you mentioned on the high end, you guys are assuming that you can get to a high single-digit, low double-digit share within mass and grocery. I was just curious, as you look at your SKU selection versus some of the other players within that channel, what would give you confidence to be able to get up to that level of share in the short period of time if you were to achieve the high end of your guidance?

[Billy Bishop:]

Sure Rupesh. I'll talk about, obviously, the products that we have within our LPF -- Life Protection Formula product line that we're entering into this channel with. But again, it's a portion of our most popular product line and our largest product line. We'll have Dry Foods, both dog and cat; Wet Foods, both dog and cat; and Treats, both dog and cat. We think we have the right packaging sizes because we have customized our packaging sizes, especially for Dry Foods that we fit meet -- that we feel meet that specific channel's shopping patterns. And again, I think we have a great line to capture puppies, to capture mature dogs, to capture large breed dogs. So, I think we'll have a nice product offering there to go after that high single-digit, double-digit share.

[Mike Nathenson:]

Yes, just one quick clarification, just to make sure we're all in the same page is that we're talking about high single-digit, low double-digit share just for these four retailers. So, it's not across all of FDM. But it is an important sub segment of that. In Billy's remarks, he talked about it being 8% to 9% of the pet food market which represents a 20% to 25% increase in our distribution reach. The other thing that gives me confidence, just from an in-store execution side is that we are getting space that's commensurate with those share levels of expectations for those share levels in those accounts.

[Rupesh Parikh:]

Okay, great. And then my final question, just from a modeling perspective as we look at this year, clearly you're ramping up the marketing spend and at the same time, you're getting the benefits of the distribution addition. Versus your guidance before the net, I guess, the rollout within -- into the mass grocery channel, is that a headwind for EPS or is that beneficial to your EPS guidance this year?

[Mike Nathenson:]

It's not margin dilutive is the best way to think about it.

[Rupesh Parikh:]

Okay, great. Thank you.

[Operator:]

Our next question is from Peter Benedict of Robert W. Baird.

[Peter Benedict:]

Hey guys, thanks for taking the question. My first is a follow up just on that last one. Just Mike, is it fair to say that the FDM channel margins, you expect them to be higher than the legacy business, I guess, with the higher mix of WTO being mainly the key driver? That's my first question.

[Mike Nathenson:]

Yes, there's always lots of puts and takes in terms of how we're approaching the channel. We have constructed our approach for all of our channels to make sure that we are not diluting the margins whenever we go into a new channel and this is especially true with FDM.

[Peter Benedict:]

Okay, perfect. And then how -- thinking a little longer term here, how should we think about the P&L dynamics when the new capacity comes online? I think it's later this year or early next year and if you can kind of update us on the timing of that. How should we think about kind of the margin implications? I know the last time you guys brought on capacity, there was a hit to the margins initially followed by obviously a very strong surge after that. So, just want to make sure we understand that at this point. Thank you.

[Billy Bishop:]

Sure. Let me just quickly talk a little bit about the ramp here. I'll give more specific guidance for 2018 and the ramp-up and the scale-up of our new facilities after we finish the year. But suffice it to say, whenever you start up a new facility, you have ramp-up and scale-up cost, you've get commissioning, you've got betting of all the diets and all the equipment, extruders, the packaging systems, all of that. So, with each one of those test runs we do is we'll test the product, we'll make sure that we deliver the guaranteed analysis that we expect and then we'll actually feed it to pets to make sure that there aren't any unintended consequences, and then we'll throw all that product away. And so we'll do it at a small batch, we'll do it at a large batch. And once each one of our protein systems, each one of our extruder combinations, packaging combinations, is all done, then we'll start it up. But during that phase, there will be a headwind to our gross margin. You can see it in our results when we started up the Heartland facility at the back half of 2014. And -- nice to hear somebody has got a dog, it's awesome -- that you'll see that headwind as we do that commissioning. But once we get through that, then we expect the step function change in the margin to increase. So, that's the shape of what to expect with gross margin from the Heartland -- or from the new facilities. So, stay tuned, we'll give you more information as we get closer to year end.

[Peter Benedict:]

Okay, great. Well, that was our new puppy. So, -- and he also likes Protection.

[Billy Bishop:]

All right.

[Peter Benedict:]

So, great [Indiscernible] for the year, additional distribution. Thanks guys. Good luck.

[Billy Bishop:]

Thank you.

[Operator:]

Our next question is from Pablo Zuanic of SIG.

[Pablo Zuanic:]

Thank you. Afternoon everyone. Look, I have three questions. The first one, very basic. Do you have a sense of the penetration of the natural pet food as a segment of the FDM channel, of e-commerce right now, and of specialty? Just natural pet food in general, if you can comment on that.

[Billy Bishop:]

Well, I think the difficulty is that you actually -- there are unmeasured channels. But I can give you some directional guidance here. So, when we look at e-commerce, e-commerce tends to have a higher penetration of wholesome natural given the premium nature of those businesses. So, that's something to think about. Also, in specialty channels, you actually also see a higher penetration of wholesome natural as well. I mean, fundamentally, the wholesome natural segment really grew out of the Blue Buffalo growth. So, those things are tightly correlated and go hand-in-hand. When you look at the FDM channel, it is much lower. And obviously, as we go into that channel, we're expecting to help move the needle in wholesome natural in those channels as well.

[Pablo Zuanic:]

Okay. I was hoping you would give more precise numbers, but I understand. Look, my question here is as follows. And when I think of human natural organic F&B in the FDM channel, that's about 50% bigger than what's sold in specialty, in sprouts and the Whole Foods of the world. And for some reason, that had not been the case for pet food, right. Until before Rachael Ray, you would say a natural in mass was pretty much zero. And I wonder why? I mean, the supermarket people and the manufacturers are all very smart people so why haven't it happened before? And my answer would be, well, in field most into FDM, you're talking about a low price point, right? Here, we are talking about a $40, $50 bag that somebody will have to put in their trolley. I mean do you think that's been the issue why it's been difficult for this type of pet food to develop in mass?

[Billy Bishop:]

Hey Pablo. I really think it's been a brand issue. I think they've been clearly slower to I think capitalize on the wholesome natural pet food trend that's been taking place outside of FDM. And again, that's where we see a real opportunity to come in and be that leader in wholesome natural. So, you need the credibility, you need to invest, you need to, obviously, put in the investments and the time and effort to build brand equity. And that's why we feel good about the BUFF going in there.

[Mike Nathenson:]

And the other thing -- the last thing I'd add to that is that when we're orchestrating and choreographing our entry into FDM, we're still doing it and being very, very mindful of price points and price gaps. And I had mentioned it earlier is that we're -- we want to make sure that the price gap and the average cost per day to feed Blue Buffalo is very, very reasonable compared to any of the highly engineered products. So, from that standpoint, we think that's going to be great. And since those brands and those products are a direct source of volume for us, that also gives us some confidence that we're going to be successful in this.

[Pablo Zuanic:]

Thanks. And one last one. I guess I'll just make a comment. I mean, the pictures I've seen so far of public and major, I'm quite impressed with the space that you've been given. But that's more a comment than a question. Look, we can all speculate about what's going to happen with PetSmart, right? And -- but maybe you can talk about the state of your relationship there. And the reason -- the way I'm asking the question is that my understanding is that yes, superstores as a channel are struggling but Blue Buffalo is struggling more in that channel, that you're losing share. And I want to understand, is that the case, have you been losing share? How you've been losing space over time, if you can comment on that? Thank you.

[Billy Bishop:]

Sure Pablo. Yes. Focusing on superstores, our shares have been flat, relatively flat. We continue to innovate. We continue to invest into specialty. So, again, our Wilderness, Freedom, Basics, Earth's Essentials line in both Dry, Wet and Treat in both dog and cat offerings are there and we continue to drive pet parent awareness and demand for those products. So, again, I can't speak directly for our pet specialty superstore partners. But we want to continue to build our business within their stores.

[Mike Nathenson:]

Yes, just one thing I'd add to that, Pablo, is that when you look at share, you also have to understand what the trends are in their online arms of those brick and mortar retailers across all of our partners. And all of the reported -- none of the reported share numbers include any of that information as well and that's a big part of our success.

[Pablo Zuanic:]

Right. I'm going to squeeze one last one if I can. Look, I mean, obviously, we're not -- none of us can talk about why other brands do what they do. But the champion guys with Acana and Orijen, they decided that they would get out of Chewy, now it's owned by PetSmart so -- and then they are telling their small independent guys, look, we are out of Chewy, that's how good we are to you. And then you have people like Merrick now owned by Nestlé that are still at Petco, and apparently there's some noise apparently you have no plans to go to PetSmart because you have a relationship with Petco. So, those guys, that's the way they're playing it. But in your case, you're the largest in natural pet food, so I guess it's logical to think that given your size, you need to be in every channel. I don't know if you want to comment on that.

[Billy Bishop:]

I think you got it, Pablo. So, now again, we want to feed -- reach more pet parents and feed more pets. Again, it's a portion of our Life Protection Formula line that is heading into food, drug, and mass; it's not our entire portfolio. Still have the large percentage of our overall BLUE master brand sales within the specialty channel and we're continuing to invest behind it.

[Pablo Zuanic:]

Thank you.

[Billy Bishop:]

Thank you.

[Operator:]

Our next question is from Dara Mohsenian of Morgan Stanley.

[Dara Mohsenian:]

Hey guys.

[Billy Bishop:]

Hi Dara.

[Dara Mohsenian:]

So, first, just a couple of detailed questions. You mentioned the initial launch is only in about 15% to 20% of the mass channel with these four customers. Do you expect to roll out to additional customers in the mass channel over time? And also, is it just the Life Protection brand or could you move other brands into that channel over time? And then second, to follow-up on Ken's question, this does feel like a change certainly versus in prior conversations we've had with you on the subject moving into mass. So, you mentioned this was always in your plans. Was this a specific timeframe in terms of a 2017 launch in your plans or is this earlier than you originally expected?

[Billy Bishop:]

Sure Dara. Again, right now, we're focusing on making our launch with a portion of our Life Protection Formula products in our four key retailers' success. We want to do it the right way, we want to have the right execution, and we want to continue obviously to feed new pets. We will look to expand off of that, but in a very selective approach. We're not, again, going out with a broad-based approach just to gain ACV points. So, for us, we want to do it in a very thoughtful and deliberate way and we're going to continue to execute along those lines. As far as your second question goes, it was always part of our long-term plan. We want to, again, reach more pet parents and feed more pets. Clearly, as Michael mentioned earlier, I mean the landscape in pet parent shopping patterns have changed a lot quicker than we all had thought, be it e-commerce growth, be it some of the headwinds we're seeing right now in our brick and mortar specialty partners. So, obviously, that became a factor in when we decided. But again, it's not an overnight decision. I mean, we -- there's a lot of planning that goes into place and it's something that took us a while to get to this point. But again, we feel a brand of our size, with our objective to feed more pets, has got to be in this channel to do so.

[Dara Mohsenian:]

Okay, appreciate the color. And I guess to change the subject a bit and move away from U.S., we haven't heard much about the international launches outside of Canada in the last few quarters. It seems like it's going to pretty slow build so far. So, can you give us an update on progress in international markets outside of Canada and how that's going?

[Billy Bishop:]

Absolutely. We've been happy with our progress in our international markets. They continue to grow quarter-over-quarter. So, -- maybe a little slower than originally thought but right on track, I think, for the long-term growth opportunity that we're looking for out of these channels -- out of these markets, excuse me. So, for us, we want to continue to learn. We want to continue to have some flexibility to make sure that we can execute as best we can in those markets to realize, again, that's future growth opportunity.

[Dara Mohsenian:]

Okay. Thanks guys.

[Billy Bishop:]

Thank you.

[Operator:]

[Operator Instructions] Our next question is from George Kelly of Imperial Capital.

[George Kelly:]

Hi guys. A couple of questions, first, on your e-commerce side of your business. What is your market share with the biggest e-commerce retailers? And how has that moved over the last couple of years?

[Billy Bishop:]

We don't disclose any specific information about any one particular customer. But what I can tell you obviously is e-commerce has continued to accelerate from a growth standpoint. Blue Buffalo is the number one brand on the e-commerce channel and, again, we're continuing to see a lot of growth runway there.

[Mike Nathenson:]

Just to add a little bit of color. Our share, we estimate, in e-commerce is in mid to high-teens and that's across all of the e-commerce channel. And I would tell you it's growing. From everything that we see, we're growing well in advance of what the total e-commerce channel is growing.

[George Kelly:]

Okay, that's helpful. And then another question about the online business. So, it was about 20% of your sales this year, can you help at all, what that portion was last year, what kind of growth are you seeing?

[Mike Nathenson:]

Well, we don't give the specific growth by channel outside of superstores. What I can tell you is if you go back to our S-1 and our IPO two years ago, when we published that information, our share of business that was sold online was in mid-single-digits.

[George Kelly:]

Okay, that helps. And then last question, just about the new facility. What's -- and not to ask for a specific guidance over 2018, maybe a better way to ask the question is, what is your maintenance CapEx this year outside of that project?

[Mike Nathenson:]

Well, I think that we've shared that. Our normal maintenance CapEx is expected to be right around $15 million going forward. So, this year, we have maintenance CapEx -- the normal sort of maintenance CapEx, plus we have some really nice productivity projects that we have invested in and that's helping drive some of the nice gross margin results that you're seeing. It's really driven by fantastic set of folks, who are running our supply chain organization, the people who are working in the plants day-after-day. Those are the guys, who are really carrying the ball here and they're doing a very nice job.

[George Kelly:]

Okay. Thank you.

[Operator:]

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

[Billy Bishop:]

Thanks. I first want to thank all the herd members around the world for all their continued hard work to build our BLUE brand. It was a pleasure sharing our evolving commercial game plan with everyone as well as our Q2 results. We look forward to chatting with you again when we report our Q3 results. May the BUFF be with you.