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Q3 2017 Earnings Call Transcript

Published: 12 Nov 2017

Operator:

Good afternoon, ladies and gentlemen, and welcome to the Blue Buffalo 2017 Third 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] And as a reminder, this conference is being recorded. I would now like to turn the conference over to CFO of Blue Buffalo, Mike Nathenson. Mr. Nathenson, you may begin.
Michael Nathenson:

Thanks Amanda. Good afternoon everyone and welcome to Blue Buffalo's Q3 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 Web-site, 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 addition, our market share and sell-through estimates are based on third-party sources, such as customer and panel data, in combination with management estimates. 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 Web-site 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 third quarter results with you today as well as give you an update on our progress as we evolve our go-to-market strategy to reach more pet parents and feed more pets. Let's get started with a look at Q3. We continued to gain share and our consumer takeaway at retail remained robust. Our sell-through to pet parents grew 10% year-over-year, which is well ahead of the market and represents a sequential improvement from Q2 which had grown at 7%. Our reported 18.4% net revenue growth rate was about 8 points higher than our sell-through in the quarter, which was driven primarily by the pipeline fill to support our expanded distribution launch into select FDM retailers and partially offset by headwinds in the specialty channels. We expanded our margins while enhancing our distribution capabilities to support our go-to-market model, and we continued to strengthen our master brand with increased support across all channels. Now let's look at the market dynamics and our performance at retail. In Q3, the U.S. pet food market remained healthy and continued to grow low single digits. Consistent with the discussions on recent earnings calls, the pet superstore channel has continued to experience a slowdown due to reduced traffic. Given this trend, our Q3 superstore sell-through was down approximately 6% versus last year. In specialty channels outside of pet superstores, we estimate our sell-through growth rate in the quarter was approximately 28%. Within this channel, our e-commerce sales continued to grow and we continued to gain share. In fact, BLUE is the largest pet food brand in e-commerce channel with over a fifth of all BLUE retail sales now going through e-commerce, much of it on subscription. In total, sell-through in specialty channels grew 7% in the quarter. With our August launch into FDM, sales in this channel began to ramp up at the end of the quarter and contributed approximately 3 percentage points of the year-over-year sell-through growth in Q3. As you know from our 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. In Q3, our WTO revenue growth was 40.1%, driven by the FDM pipeline fill due to the higher mix of WTO in this channel. As we had discussed in our last call, unlocking the strong WTO growth potential is a key component of our evolving go-to-market model. We're also pleased to see our WTO sell-through growth in Q3 accelerate sequentially from approximately 7% to 15%, driven by both our specialty customers and the launch into FDM. Before I dive into the progress of our FDM launch, I'd like to remind everyone about the size of the prize. Up until August, we had only sold our products into specialty channels which represented less than half of the total U.S. pet food market by dollar share. Given that we feed less than 3% of pets, it makes sense for Blue to be a major player in the FDM channel and reach more pet parents and feed more pets. While we believe that pet specialty channels continue to have a differentiated offering that's difficult to match in other channels, our research suggests that there is a large portion of pet parents who prefer to buy their pet food at the same place they buy their human food. So these pet parents represent an incremental target for the BUFF. A big competitive advantage we have is the tremendous brand equity that we've built for over a decade with massive brand building support of over $750 million, and we're the clear leader in the Wholesome Natural market segment which resonate strongly with pet parents across the board as they continue to look for more natural products for their families, including their furry family members. We look forward to reaching more of these pet parents as we extend our distribution over the next few years. Now, let's look at our progress in FDM. As you know, in August we introduced our Life Protection Formula line into four select FDM retailers, and we were very pleased with the launch. Our pipeline fill into the channel and our initial in-store marketing were executed with excellence. We started building meaningful presence at our first four FDM retailers in the second week of August and we're still ramping up through Q4. At the end of Q3, our market share in these first four FDM retailers reached 5%. This already puts BLUE among the top brands in these four FDM retailers, surpassing both many well-known legacy FDM and Natural brands in only eight short weeks. As a point of reference, at these stores, BLUE is already over 4x the size of Nature's Recipe, which extended from specialty into FDM at the beginning of 2017, and BLUE is closing in on Rachael Ray Nutrish. We think this strong performance in such a short time is based on the brand's equity and the trust that we've built with pet parents over the last decade, which we will continue to leverage with broader distribution. Since we're new to the channel, incorporating early learnings is very important so we can take our execution to the next level. When you look beyond the averages, there's a range of performance and additional opportunities across our first four. At stores where we have the largest footprint, such as our largest national account, our market share is quickly approaching our goal of high single digit to low double digits. Conversely, in stores where our footprint is smaller, we have a gap to close relative to our market share expectations. At two of our retailers, the footprint started small and will continue to grow through year end, which is later than our original plan. Based on all of this, it will take us a little bit longer to reach our high single digit, low double digit share goal, and as a result we now expect our share in the first four FDM retailers to be about 6% by year-end. Overall, we're pumped about our entry into FDM and the impact it will have on our goal of reaching more pet parents and feeding more pets. As I mentioned before, we will enter additional retail accounts as we move forward, including a few more in Q4, which will increase sell-through beginning in 2018. Similar to our first four accounts, we're taking a selective and deliberate approach focused on the quality of distribution and the commitment to meet the high bar we're setting. Now, I'd like to turn to the specialty channel. As a reminder, we are the leader in this channel with over 2x the share of the next brand. In addition, we are committed to continue our support for our specialty partners and it starts with a differentiated product portfolio that reflects the needs of pet parents who shop in pet specialty. With regard to LPF, all of our specialty retailers have access to different, larger bag sizes that better match the shopping pattern of their customers. They also carry all of our solution-based LPF formulas given the dedicated shelf space and the higher level of service that specialty retailers provide to pet parents. And as part of this differentiated offering, our other product lines continue to be sold exclusively in the specialty channel. As you've seen, we've ramped up our advertising support for both LPF and for our specialty exclusive lines to drive consumer pull everywhere Blue products are sold. Since the announcement of our broadened distribution into FDM, we have had ongoing conversations with our retail partners, and as expected, there's been a range of reactions. At one end of the range, retailers focused on how we were going to minimize cannibalization and support our dedicated specialty lines to continue to grow. At the other end of the range, retailers pulled promotions, canceled off-shelf activity, and delayed purchase orders. This has caused additional headwind to our sell-through and an inventory headwind to our sell-in at the end of Q3 and into Q4. And as a result, our sell-in for the specialty channels grew only 1%, but our sell-through growth was stronger at 7% for the quarter. Our dialog with our specialty partners is ongoing and our focus continues to be to drive growth for both our retail partners and the BUFF. Overall, I'm really pleased with our ability to maintain our leadership in the specialty channel where we have begun building the foundation to become a major brand in FDM. Now, I'll pass it on to Mike to take you through our financials.
Michael Nathenson:

Thanks Billy. Let's start with Q3 performance. Overall net sales growth in the quarter was 18.4%, which was driven by 9.8% volume, 8.3% mix, and 0.3% pricing. The strong sales mix component is driven by our FDM launch, given the higher mix of WTO and smaller pack sizes. For the quarter, Dry Foods grew 13.3% and WTO grew 40.1%. Before I take you through the rest of the P&L, I'd like to touch on our sales growth by channel. For today's call, my comments are based on how we look at and manage the channels, which is also consistent with our historical channel segregation. In addition, I'll also provide commentary on our sales within FDM. And we will of course continue to share required information about sales to material customers in our regulatory filings. Now, back to the numbers. As Billy discussed earlier, and consistent with our comments from prior earnings calls, headwinds continued across brick and mortar accounts. In superstores, which represented 48.2% of our mix in Q3, both our pet parent takeaway and our sell-in were down 6% versus last year. Our sales to specialty channels outside of pet superstores represented 37.3% of our sales mix in the quarter and grew by 12%. We estimate that our sell-through in these channels was significantly higher at approximately 28%. As Billy mentioned earlier, there were some purchase order and inventory headwinds that impacted our sell-in growth. FDM represented 14.6% of our sales mix and contributed 17 percentage points of sell-in growth in the quarter. The majority of the FDM sales in Q3 represented the initial pipeline fill into our first four FDM retailer partners to support their permanent inventory holding power, while the balance was driven by replenishment for sell-through as our sales ramped up during the latter part of the quarter starting in the second week of August. And as Billy mentioned earlier, FDM accounted for 3 percentage points of the sell-through growth in Q3. 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 47.2%, 90 basis points higher than last year. The increase in gross margin was driven primarily by positive mix as well as supply-chain efficiencies, which were offset by higher warehouse and distribution costs associated with our FDM expansion. In order to properly support our FDM launch, we expanded one of our DCs, we rebalanced our inventory, and shifted distribution lanes to accommodate our growth. Over time, we'll be able to optimize our network and capture productivity. On the mix side, please keep in mind that part of our mix improvement is driven by the initial pipeline fill for our FDM launch and that going forward we will be supporting the usual levels of promotional activities. 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 20.5% in the quarter versus last year. The increase was primarily driven by investments in revenue-generating activities. As we mentioned on our Q2 call, we have increased our advertising to drive consumer pull in all of our channels. Our tax rate in the quarter was 36.4% compared to 33.1% 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 represented a year-to-date catch-up when we adopted the new standard in Q3 of 2016. On the bottom line, Q3 adjusted net income was $53 million, up 19.1%, and adjusted diluted EPS was $0.27 per share, up 19.6%. 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 $50 million. Our CapEx was $72 million and at the end of the quarter we had $308 million of cash on our balance sheet. In the quarter, we completed our $50 million share repurchase program, with a purchase of 2.1 million common shares. Now, turning to our guidance; for the full year 2017, our expected net sales range is now between $1.250 billion and $1.265 billion. For adjusted EPS, our guidance is now $0.91 to $0.93 per share. And for taxes, we anticipate a full year tax rate range of 36.4% to 36.9%. On the capital side, we are on track to spend between $150 million and $170 million this year, which includes our strategic CapEx and our ongoing CapEx. As we look at the program, we still expect start-up and scale-up to begin toward the middle of next year. We learned a lot from the startup of our first manufacturing plant at Heartland. Based on this, we expect the commissioning will take about four quarters, during which we'll have a gross margin headwind. Thereafter, we begin capturing the majority of the margin benefit from in-sourcing production. Like Heartland, we also expect ongoing future productivity programs to contribute to margin improvement. 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 in the $70 billion global pet food market. Two, our FDM initiative is off to a strong start and we look forward to painting that whitespace blue in the coming years. Three, we believe in the power of the BLUE brand and we'll continue to invest in brand-building activities. Four, we're confident about the expected benefits of our capital investment program, which will enable further productivity, flexibility and innovation. And five, we're excited about our future. We believe we're making the right choices to get us to the next $1 billion and beyond. With that, I'll open it up to questions.
Operator:

[Operator Instructions] And our first question comes from the line of David Driscoll of Citi. Your line is open.
David C. Driscoll:

I wanted to ask a few follow-up questions here on the grocery and mass launch. So, I think what you guys said is that you ended the quarter or through the quarter, I think you ended the quarter with a 5% market share and the expectation is that by the end of the fourth quarter you'll be at a 6% market share for the four initial launch customers. If I got those numbers correct, can you just talk about the cadence here? One additional share point seems a good bit less than maybe how you guys were thinking about this originally. I'd just like to understand what you've learned so far about the launch.
Billy Bishop:

Absolutely, David. This is Billy. First and foremost, we haven't changed our share target goal at all. So that is still our focus. We're encouraged. One data point here, we're encouraged by the fact that our largest national retailer, who already at a high single digit share at the end of Q3, and again, that's just in eight short weeks, and it's growing. So, we think that's good performance and we're going to continue to build off of that. What's happened is, within our four retailers, we're just in a different development timeline with our footprint. So, a couple of our retailers are expanding our footprint a little bit later than originally planned. One actually just finished expanding our footprint at the end of Q3, the beginning of Q4, and another one is continuing to expand our footprint, which won't take place until the end of Q4. So, when you factor all that in, we think that 6% share target is reasonable, but by no means are we settled on that. We're going to continue to develop our business to get to that mid single digit, high single digit early next year.
David C. Driscoll:

And then, Billy, you mentioned – I didn't actually catch what you said in your prepared comments, but here's just a question, do you expect to be fully distributed in the food and mass channels by the end of 2018? I think you said something about being selective. But can you just talk us through your thought process and logic about the expansion as it progresses far beyond the fourth quarter?
Billy Bishop:

Sure, David. Again, I think you've heard us say that we want to be a major player in this FDM channel. And obviously, we're going to have to bring on new accounts to do that. But we're still going to be taking a selective approach, focused on the quality of the distribution in this channel. So, again, given how we drive pet parent demand for BLUE, we're focused on making sure that we get the high-quality distribution that we need to continue to realize our goals. So, you'll see us do that throughout the course of next year. I'm not going to get into specifics as far as what that means from an acquisition timing standpoint, but we feel good about how we're doing it.
Michael Nathenson:

David, this is Mike. I was going to say, one thing I would add here is that we're planning to give more detailed guidance for 2018 on our next earnings call. So, stay tuned and we'll provide that information at that time.
David C. Driscoll:

That's fine, that's fine. And last one for me is on the FDM. Do you guys have a sense for the incrementality of the sales that you're generating? Is much of this simply people that were buying at PetSmart or Petco that are now buying in-store, or do you think that these initial FDM sales are largely incremental to your business?
Billy Bishop:

Sure, David. Again, Billy. It's still early days, but the data that we're seeing suggest that from a pet parent demand perspective, the bulk of these FDM sales are incremental. And I think you can see based on our acceleration that we've seen through takeaway going from 5% in Q1 to 7% in Q2 to now 10% here at the end of Q3, I think you're seeing that momentum build. So, again, early days, not saying that there won't be some dip on the specialty side down the road, but right now it looks very incremental to us.
David C. Driscoll:

Thanks for all the comments and I'll pass it along.
Operator:

Our next question is from the line of Faiza Alwy of Deutsche Bank. Your line is open.
Faiza Alwy:

So, I was wondering if, Mike, you could give us a breakdown for Petco and PetSmart, first of all within your top two customers?
Michael Nathenson:

Sure, happy to help. So, of the 48.2% share of our sales for superstores, 29.7% was PetSmart and 18.5% was Petco.
Faiza Alwy:

Okay, great, thanks. And then can you talk a little bit more about sell-through trends as it relates to Wet, Treats and Other? So, clearly you had great sell-in, and it sounds like it's mostly a pipeline fill into the mass channel. Could you comment specifically on how sell-through has been within that segment?
Billy Bishop:

Sure, Faiza. It's Billy again. We're happy with our initial WTO performance at our first four FDM retailers. On a sell-through basis, our WTO sell-through mix is already at 30% in FDM versus 20% in specialty. So, again, early days, but we're doing a significantly better job on WTO in food, drug and mass.
Faiza Alwy:

Okay, great. And then, Mike, just to follow up on the gross margins, can you quantify sort of the change from Q2 to Q3 in terms of the gross margin expansion? I know you talked about incremental cost as it relates to servicing the mass channel, but would it be possible for you to quantify that a little more, and then help us think through the headwind to gross margin next year as it relates to the new startup costs?
Michael Nathenson:

Sure. So, when we look at the gross margin, we are 50 basis points better in Q3 versus Q2. We had a significant headwind, as I said, from the warehouse and distribution cost. We don't disclose that level of detail per se. We still had a positive mix from Q2 to Q3, and that's as you would expect given the FDM launch and given the pipeline fill. One thing to also keep in mind is that we also still had positive mix between Q3 and Q2 associated with our base business as our more premium products grew faster than Life Protection Formula. So, from that perspective, that's what brings it together, but we are not disclosing that level of details.
Faiza Alwy:

Okay, thank you.
Operator:

Our next question is from the line of John Baumgartner of Wells Fargo. Your line is open.
John Baumgartner:

Billy, just kind of a follow-up on the delay in building some of that FDM market share, in those stores where the progress is behind expectations, can I understand just the issue there a bit better? Has there been more competitive merchandising from the competition that's delayed things, have the shelf turned over slower for different reasons? Just more detail on that will be helpful.
Billy Bishop:

Sure, John. Really it's just been a delay in going from off-shelf to in-line, and that's been the biggest delay.
John Baumgartner:

Okay. And then just to follow up, you mentioned some of the issues with the purchase orders and the inventories from some of the existing retailers following the FDM launch. Can you give a bit more detail in terms of how those conversations have evolved subsequently, what you're seeing in terms of support for your business and merchandising in Q4, I mean what your expectations are going forward from those retail customers?
Michael Nathenson:

Sure. It's Mike. Let me help with that. So, in specialty channels outside of superstores, our sell-through growth was higher than sell-in, so 28%. And as expected, that sell-through growth was robust, so we felt great about that. From a data perspective, when you look at it, there's a 16 point gap in sell-in and sell-through, and that was really driven by two pieces. The biggest piece is in small format brick-and-mortar. Remember, this segment uses a two-step distribution model, and in this area we saw both our distributors and our retailers take a wait-and-see point of view to their ordering, which had a compounding effect, compounding headwind to our sell-in. The good news is that we've seen more normalized ordering patterns early in Q4. The second piece is e-com. Our e-com business continues to be very fast growing and we do see inventory variability in the normal course of business. In this case there was a bit of a headwind, but it's really business as usual.
John Baumgartner:

Now that wait-and-see that you mentioned, is that some sort of function around uncertainty over cannibalization?
Billy Bishop:

Yes, John. It's Billy. I think it's just them just waiting to see how things shake out. So, again, we're seeing some normalization already reoccurring as we look into fourth quarter and beyond. But again, there's going to be a headwind, and we've built that headwind into our guidance as it relates to superstore and overall brick and mortar specialty, that we'll be able to again work through once we find that new normal. But all of that is built into our range of guidance.
John Baumgartner:

Great. Thanks for your time.
Operator:

Our next question is from the line of Ken Goldman of JPMorgan. Your line is open.
Ken Goldman:

I'm on the road and having some difficulty hearing, so I apologize if these have been asked before, but did you say that in your guidance it includes for the fourth quarter the benefit of Hy-Vee and HEBS customers? I'm just trying to get a sense of whether your guidance for the year would have been lowered at the top end perhaps by more than $0.01 had those additional customers not been added.
Michael Nathenson:

Ken, it's Mike. So, just want to let you know that we always had a couple of extra customers that were embedded in our guidance. Billy mentioned that on our Q2 call. But it's probably helpful just to walk through what's included in our guidance and kind of how we're thinking about it. So, I think given our performance in Q3 and through the first half of Q4, we've been able to tighten our range by raising the bottom end and trimming the top end, and in effect we've raised the midpoint of our guidance versus the guidance that we gave last quarter. But it breaks down into a couple of things. One is, our sell-through is progressing. So we expect our sell-through in Q4 to progress from Q3. So we feel very good about that. And then versus the top end of our guidance, our FDM share is lower than our earlier estimate, which is creating a gap. But offsetting that headwind, we're seeing higher incrementality of FDM sales, and our specialty business is stronger than the scenario we shared with everyone last quarter.
Ken Goldman:

Okay, thank you for that. And then just as a follow-up, just to understand exactly what's in your guidance again. And I think the numbers you're suggesting are that you did a sell-in of around $50 million into FDM and sell-through of about $9 million, so please tell me if my math is wrong there. But also, I just want to make sure, in your guidance is the potential reversal of this trend, right, potentially the idea that you may have sold it a little bit more than perhaps you needed to in the third quarter, is the potential for the reversal of that baked into some of your 4Q numbers?
Michael Nathenson:

It's Mike again. We feel great about where we are from an inventory perspective with our FDM retailers. Our sell-through is continuing to grow. And from our perspective, we always knew that when we sold into the pipeline fill that it would represent permanent holding power, plus it would also support sell-through throughout the half, throughout H2. And when you put it all together, it's exactly where we thought we would be. Our guidance is based on an H2 growth of 12% to 14.5%. And from that perspective, again, it's right where we expected to be altogether. Remember, the other thing is that our first four retailers keep ordering, right. So, as their sell-through increases, they are also continuing to order.
Ken Goldman:

Thank you very much.
Operator:

Our next question is from the line of Rupesh Parikh of Oppenheimer. Your line is open.
Rupesh Parikh:

So, I also want to just follow up on your commentary on the non-superstore, brick and mortar retailers. At those customers, have you at this point lost any shelf space?
Billy Bishop:

Rupesh, this is Billy. No, we haven't seen any major reduction in shelf space. What we've seen happen is some reduced off-shelf activity as well as some promotions that have been canceled.
Michael Nathenson:

Rupesh, the other thing I would add is that our sell-through in the sales outside of superstores is still robust, still 28%. So we still like what we see. I think our issue here has really been that headwind that we had talked about earlier.
Rupesh Parikh:

Okay. And then from a backlash perspective, I mean clearly you guys expected some cannibalization, the backlash that you're seeing, is it only confined to these non-superstore brick and mortar or have you seen any actions taken by your main pet superstore customers?
Billy Bishop:

No, Rupesh. Again, Billy here. We've seen some, again, a range of reactions that have taken place throughout our specialty partners, which include the superstores. So, again, we see reduced promotion activity, we see reduced off-shelf activity with some retailers, and again, that's all sort of within our expected range. So, that's been, again, what we've seen so far.
Rupesh Parikh:

Okay. And then my final question, I know last quarter when you set the guidance, there were concerns about the pet superstore, some inventory destocking. Just want to get a sense of whether you saw any impact from destocking this quarter and what your outlook is for Q4? Thank you.
Michael Nathenson:

It's Mike. We didn't see any impact from destocking in the superstores. So, what we saw was a balanced sell-in and sell-through. As I mentioned in the prepared remarks, they were both down 6%. But I think it's fair to say that at the end of quarter, the actual reaction really was a headwind to our share. So, when you look at it, when you take the actions that Billy described, we went from a share in July at superstores of around 21% and then we lost 100 basis points of share in September to 20%. So we have seen a reduction, and right now as we look at it into Q4, we're kind of holding at that same level. So we expect to see that same level of share headwind into the fourth quarter.
Rupesh Parikh:

Okay. Thank you.
Operator:

Our next question is from the line of Alexia Howard of Bernstein. Your line is open.
Alexia Howard:

Can I ask about – you mentioned earlier that the warehouse and distribution costs obviously affected the gross margin this quarter. Is that effect expected to continue for the remaining three quarters? We've been hearing that from other companies. And then also in terms of the marketing spending, how much was it up year-on-year this time and do you expect that level to continue and maybe even to go up from here? Thank you and I'll pass it on.
Michael Nathenson:

It's Mike. Let me just talk about the warehouse and distribution costs. I can't comment on what everyone else has said about their warehouse and distribution costs. What I will say is, the impact we have was really all about supporting our launch. So, we have two distribution centers, and in this case we expanded one of our distribution centers in anticipation of this launch. And so, whenever you do that, you have a bit of disruption to the supply chain. Now in this case we needed to rebalance inventory, we needed to shift some distribution lanes from one distribution center to the other one, and it created some additional costs in the quarter. Now, obviously as we are ramping up FDM, we're going to continue to face some distribution headwinds or warehouse and distribution headwinds, but going forward, we believe, we know we're going to be able to optimize this. So, once things get to be a bit more normal, then what you do is you run optimization of your routes, you optimize between your distribution centers once all of the distribution points are known, and we expect to get productivity. But this will be a headwind for a few quarters.
Billy Bishop:

In regards to our marketing efforts, you can expect us to continue to invest in building our brand and driving consumer demand for wherever Blue products are sold, and you should expect that to grow with the top line.
Alexia Howard:

Great. Thank you very much. I'll pass it on.
Operator:

Our next question is from the line of Brian Holland of Consumer Edge Research. Your line is open.
Brian Holland:

So, I just want to make sure I understand on the guidance, it sounds like you tied the tightening of this bringing in the high end of the guidance to sort of the delay in the rollout in those incremental channels, so I guess I want to confirm that that's the case. And then you talked about the range of responses that you received from your existing retailers as a result of that launch. I just want to sort of make sure that in aggregate what that nets out to as sort of within your comfort range or what your anticipated sort of response was from those retailers?
Michael Nathenson:

Sure. It's Mike. I'll start off and then hand it over to Billy. So lots of things go into our guidance. So, we consider a lot of factors. No one particular item is driving one particular movement. So, we try to give a center-cut version of what we expect to happen, but there is some variability. So, as I said, the good news is that our sell-through is progressing and improving from Q3 into Q4. That's the best metric that kind of indicates the health of our business. And as I did say that versus the top end of our guidance, our FDM share is lower than our earlier estimate, and I think that's a fair thing to call out and it is creating a gap. But the good news in offsetting that headwind is that our incrementality is much higher than we had originally expected. And then as part of the headwinds expected from this specialty business, it's stronger, we're actually seeing stronger performance than our scenario that we first shared last quarter when we gave our guidance.
Billy Bishop:

So, net-net, it's all within our range, Brian.
Brian Holland:

Okay. And then most of my questions have been answered, so I'll get out with this one. But as you talk about sort of building out and getting broader distribution, and I think I understand the reasons for phasing that in and then maybe not being more aggressive, but would love to hear your thoughts about that, and in particular, one, what were the limitations for you, sort of limiting your ability to pursue this more aggressively, whether it was capacity, whether it was thoughtfulness towards the pet superstores? And then also, sort of how do you balance that with – we certainly are hearing about more brands that are following your lead and maybe like-minded competitors to Blue Buffalo continuing to infiltrate the mass and grocery channel, so how do you balance, try and take a measured approach towards getting into mass and grocery with the fact that you've got this accelerating competition, just if you could walk us through your thought process there and what you see sort of the puts and takes as you continue to do that over the next 12 months and beyond?
Billy Bishop:

Sure, Brian. Billy here again. We're trying to obviously execute this rollout as thoughtfully as we possibly can to maximize the incrementality of this opportunity. Again, we feed 3% of pets and there's a lot more pet parents out there that we look to have relationships with and ultimately feed more pets. So, we're going about it in a thoughtful way, a strategic way. We are focused on the quality of the distribution. Again, Blue I think has a great story to tell and we want to do it in a high-quality way and it's important for us to align on that with our new partners. I think you've seen that take place with the execution of our first four, and I think you'll see that happen with our new additional partners as we're bringing them on. Again, we have five product lines that all serve a different purpose, that are all under our master brand strategy. We want to continue to educate pet parents on the wholesome natural goodness of our products and make sure that we again drive demand for wherever Blue products are sold. So, when you combine all that together, I think Blue can be a major player in all channels that we decide to play in.
Brian Holland:

[Indiscernible] continued best of luck.
Operator:

Our next question is from the line of Dara Mohsenian of JPM. Your line is open.
Dara Mohsenian:

First, just a clarity question, should we assume you hit your initial target of high single digits to low double digit share at some point in Q1 in those FDM retailers, is it still reasonable you get to your initial goals in Q1 if the issue is phasing? And then second, it sounded like you were really excited about the level of support from the initial retailers with the Q2 results. So why was there sort of this delay versus what you expected? I'm just not clear on the reason for the slower than expected phasing. Thanks.
Billy Bishop:

Sure, Dara. Billy. We expect to be in high single digits early next year. So that would take place I would say in Q1, before the end of Q1. In regard to the timing, again, I think we've got great placement in all of our four accounts. We knew that some accounts there would be some off-shelf activities and displace prior to them cutting us in line, and so for us it's just been slightly delayed than originally planned, nothing more than that. Again, we know that when our footprint is expanded, we've seen the performance again by our largest national retailer, we're already in that high single digit share at the end of Q3 and it's ramping from there. So, again, we feel good about it, it's a new channel for us, we're learning, we're applying those learnings, but we really feel good about where we're going.
Dara Mohsenian:

Okay. And then on the e-commerce side, I guess it sounds like continued momentum there. Can you give us a little more detail on your performance this quarter maybe versus the first half of the year in terms of sales growth, and any impact in terms of cannibalization from the FDM launch and how we should think about that, specifically on e-com from a cannibalization standpoint? Thanks.
Billy Bishop:

Sure. Again, we haven't seen any impact on the e-commerce side from our FDM launch. I think you all are familiar that most e-commerce players do carry a wide range of products that are sold both in FDM as well as in the specialty channels. So, I don't think it's new for them. So, again, we're excited about our growth on e-com. It continues to grow and be a bigger part of our business. And we think, as we said in the past, e-commerce is going to be around for a long time. So, we like how our marketing model applies itself to any channel in which Blue products are sold, and we're going to continue to execute against that model.
Michael Nathenson:

The other thing I would add is, now our sales mix of sales that go through the e-com channel is well over 20%. So, that's continued to grow throughout the year. We are continuing to gain share in e-com and we feel great about our performance.
Dara Mohsenian:

Okay. Thanks guys.
Operator:

Our next question is from the line of Peter Benedict of Baird. Your line is open.
Peter S. Benedict:

Just a couple of [indiscernible] here. Mike, just on the gross margin, I mean typically I think in the fourth quarter your gross margin tends to be below what you do in the third quarter, and it sounds like some of those warehouse and distribution headwinds may persist. So I just wanted to make sure, is there any reason why that relationship wouldn't continue this year, meaning fourth quarter gross margin be below where your third margin was?
Michael Nathenson:

No, that's not an unreasonable assumption. Obviously, seasonally you see a little bit more promotional activity that takes place. So we expect that to continue and we do expect some headwinds from our warehouse and distribution costs to continue. But from our perspective, we still expect to deliver fantastic gross margins for the year, growing quite well, and we feel great about where we are.
Peter S. Benedict:

Fair enough. And then just on the SG&A, similar type of question. You guys generally see a build in 4Q versus 3Q, but I recognize that the 3Q lift was kind of unusually large here given the launch. Should we be thinking SG&A more on par 3Q to 4Q or still see some lift in the fourth quarter? Thank you.
Michael Nathenson:

We're not going to go into that level of detail for SG&A. You've got almost all the pieces. You know what our top line is going to be, you've got a sense for what the gross margin is, and you know what the EPS range is. So, you can back into the SG&A from there. What I will say is that for the full year, given the strength of our gross margin, we are reinvesting part of that into SG&A this year, and as we look at the full year, you should not expect any leverage from SG&A overall for the full year.
Peter S. Benedict:

Okay, great. Thanks so much.
Operator:

Our next question is from the line of Pablo Zuanic of SIG. Your line is open.
Pablo Zuanic:

Just three brief questions. The first one, I'm trying to understand in terms of your market share guidance. So we are 5% now, 6% by end of December and then 9% by end of March. I mean, I don't want to get too mathematical, but normal linear, I mean why so bearish into the fourth quarter and so bullish into the first quarter, if you can just comment on cadence there? The second one, can you just talk in terms of your retail execution? Seems very impressive to walk into a Target and see your banners and your arrows and the signs to a Blue aisle there contrasting with all the other brands there, nobody is doing that. So you are pretty much bringing the know-how from the superstores into the aisle there. But just comment in terms of whether it's working out in terms of retail execution, are you going to become category captain in some of these places any time soon, but just comment, I think that would help. And then, third, in terms of advertising, I mean obviously your ads are more visible than normal primetime. I don't know if you can comment on ad spend, but how do you benchmark yourself when you are talking to [indiscernible] or Target, are you spending as much as Purina? Just give us a sense of that. Thanks.
Billy Bishop:

Sure, Pablo. This is Billy. I'll try to obviously answer your questions in order here. In regards to where we think we're going to be at the end of Q1 next year, we do feel we're going to be high single digits, and obviously there's a range there. So, I don't think we are anchoring to one particular number within that high single digit. But given how we see us developing and our footprint expanding, we think that high single digits, that range is reasonable to expect. In regards to our in-store signage, again, I think you've heard me say, we're trying to execute this expansion as thoughtfully as we possibly can and we are really focused on quality of distribution. And clearly, the signage and the support that we've seen so far I think speaks to that quality of distribution and it's something that we're hoping to continue to build on as we look to build and expand our footprint within food, drug and mass. So, I think we're getting some great support from our FDM partners. And then finally, I think you were asking about our advertising and how we communicate to pet parents. And again, this is something that is sort of built into our DNA and how we go to market. We do have an approach where we test, optimize and scale anything that we do from a media standpoint. So, we've got a great team that helps us identify where we feel the most efficient opportunities are to run our ads, and I think you've seen some of that take place obviously throughout Q3 and will continue through Q4. So, thanks for your questions and hope that covers them for you.
Pablo Zuanic:

A very quick one for Mike in terms of follow up, maybe you said this and I missed it, in terms of the sell-through in the third quarter to the superstores, whatever the number was, how does it compare with the first and second quarter, and did you say that sell-through for superstores you are expecting to get [indiscernible] getting better for the fourth quarter or was that just a general comment about sell-through for all the channels outside of FDM? Thanks.
Michael Nathenson:

Let me start backwards and work to it. So, what I said was that our sell-through overall for the business, including superstores, sales outside of superstores, and in FDM, is expected to progress from our Q3 number, which was 10%. So, we expect to get something closer to low double digits from a sell-through perspective. When we look at the sell-through at superstores, it's been fairly consistent throughout the year. You're looking at a channel that's been down mid-single digits, and that trend has continued. And then going forward into Q4, given the headwind that we had talked about before for superstores, given that we're down roughly around 5% of share from July to September, given the headwinds that we saw beginning in September and extending into Q4, when you combine that with a channel that is down mid-single digits, plus you have a share headwind that we're seeing at the end of September and into the quarter, that's continuing right about at that level, it's not unreasonable that our sell-through would be down double digits in Q4. But when you put it all together, the way we are achieving our strong sell-through in Q4 is that FDM is ramping and it continues to ramp, e-commerce is strong and continues to be strong, you've got some headwinds in brick and mortar, both small format and large format, but when you put it all together, that's how you get our sell-through expectation for Q4.
Pablo Zuanic:

Understood. Thank you.
Operator:

And our next question is from the line of Andrew Lazar of Barclays. Your line is open.
Andrew Lazar:

I'll keep this quick. Billy, I guess I'm just a little less familiar with I guess the competitive environment for sort of the Wholesome Natural space within FDM. So maybe just a quick little tour of just where are I guess Blue's price points for LPF sort of versus your Wholesome Natural competitors in FDM? Is it fairly consistent, are you at a premium, and if so, about how much, and then has there been anything unusual from your Wholesome Natural competitors as you've launched into that space, anything that you would deem outside of your expectations or irrational or anything like that? And that would be it. Thank you.
Billy Bishop:

Sure, Andrew. No, we see our pricing to be very similar to the other natural types that are in FDM. Again, still early days and we're I think learning a lot, like I said, as we go. But we know, competition regardless is very competitive in all channels. We have seen some additional new product rollouts. You've got Smucker's obviously continuing to roll out Nature's Recipe and now Mars launching CRAVE. So, we expect that some more folks will be coming into this channel, and for the most part we've been competing against these guys for a long time now. So, I would say, nothing super new, but clearly we'll keep everybody up to date.
Andrew Lazar:

Got it. And then how quickly are you seeing the overall just Wholesome Natural space being allocated in FDM rise or increase as a whole? So you're obviously taking your fair share or more, but is the overall space increasing just because that space is growing so much more rapidly for an FDM retailer versus mainstream? Thanks.
Billy Bishop:

Sure. Again, I'd believe that the food, drug and mass channel wants more natural products. They want to continue to premiumize their customer base. Again, it's still early. I don't see a ton of Wholesome Natural players in there. So, I think that, again, it's going to be an evolving process, and I know that retailers want strong brands that perform. So, I wouldn't be surprised, again, if the space continues to expand, there is a lot of space out there I think to go for, and I think there's a big opportunity obviously for Blue to continue to resonate with pet parents within that channel that are looking for these Wholesome Natural offerings that we provide.
Operator:

And we do have a follow-up question from the line of Alexia Howard of Bernstein. Your line is open.
Alexia Howard:

Thank you for the follow-up. It's been several months now since the closure of the deal between PetSmart and Chewy.com. Can you comment on any changes in either direction that you've seen, either in the online channel as a result of PetSmart's ownership or vice versa, any impact that it had in the other direction? Thank you and I'll pass it on.
Billy Bishop:

Sure. This is Billy. At this time, we haven't seen any changes worth noting guys.
Operator:

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

Thank you very much. We enjoyed sharing our evolving commercial game-plan with everyone as well as our Q3 results. I want to take a minute to thank all the Herd members around the world for making it happen, and we look forward to talking with you guys again as we report our Q4 results. May the BUFF be with you.

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