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Q3 2015 Earnings Call Transcript

Published: 13 Nov 2015

[Operator:]

Good afternoon, ladies and gentlemen, and welcome to the Blue Buffalo 2015 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] As a reminder, this conference call is being recorded. I would now like to turn the call over to the CFO of Blue Buffalo, Mike Nathenson. Mr. Nathenson, you may begin.

[Mike Nathenson:]

Good afternoon, everyone, and welcome to Blue Buffalo's Q3 2015 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 final prospectus for our initial public offering filed with the SEC and available on our website, including the information set forth under the captions Risk Factors and Special Note Regarding Forward-Looking Statements. 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 EBITDA, adjusted net income, and adjusted EPS, which exclude the costs associated with litigation and our initial public offering. 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, Kurt Schmidt; and our President and Chief Operating Officer, Billy Bishop. With that, let me turn it over to Kurt.

[Kurt Schmidt:]

Thanks, Mike. First, I too would like to welcome everyone to our call. We're pleased to share our quarterly results with you today. But before we get started I want to remind everyone who we are. Blue Buffalo is the undisputed leader in wholesome natural, the fastest growing segment of the $26 billion U.S. pet food category and we are four times the size of the next largest brand in our segment. Although Blue has become a mainstream brand that can speak to a broad range of pet parents we still only have 6% share in the U.S. and feed less than 3% of U.S. pets. We have a tremendous opportunity to grow both domestically and internationally with both our wholesome natural products and with our new line of veterinary exclusive therapeutic products which we've just introduced. Now let's dive into the third quarter results. I'm pleased to say that we have continued to roll volume well above the market, gain share, expand our presence in new markets, improve our margins and invest in our future. On the top line our sales grew 10.5% and reached $259 million. Looking at the bottom line, our adjusted net income was $34 million, an increase of 17% versus last year. In a few minutes Mike will get into more details of our strong financial performance in the quarter. Now let's look at the market dynamics and our performance at retail. We normally focus on year-over-year and longer-term chart trends because of the noise and volatility in any share data over shorter periods of time. But given the high income buttered [ph] environment we had discussed on our last call, I would also like to share some data points on our sequential quarterly performance in the market. In Q3 we estimate the overall U.S. pet food market continued to grow low single-digits, while the specialty channels we participated in were mid-single-digits. This compares to Blue's low double-digit growth in consumer takeaway at retail, resulting in share gains across the board on a year-over-year basis. We continue to gain share more rapidly in our underpenetrated channels, specifically farm and e-commerce, which along with the vet clinics are the fastest growing channels of the U.S. pet food markets. As a result, in Q3 our share has grown 24 basis points in tracked channels and the estimate that our shared has grown over 40 basis points versus Q3 last year across the total U.S. pet food category, including both tracked and un-track channels. And as a reminder, farm and e-commerce are un-tracked channels. When we look at our share performance on a sequential quarterly basis as we discussed on our last call, we were impacted by the highly competitive environment in pet super-stores. As expected, in pet super-stores we gave back some of the share gains we had made earlier in the year. Our performance outside of pet super-stores more than made up for the short-term share headwind. Putting these together, our total share in Q3 while up significantly versus last year, was essentially flat versus Q2. This is a strong performance given the unprecedented level of competitive activity in pet super-stores. I'm also pleased to announce that in the third quarter we officially launched our first wave of Blue Natural Veterinary Diet and we continue to execute on our market entry plans in Mexico and Japan. And finally, I'm excited to announce that as of quarter four we have successfully entered both Mexico and Japan and we are now shipping our wholesome natural Blue Buffalo portfolio to retailers in both markets. Let me give you some more details on our launch in these markets which we're very excited about. We're also pleased with the performance of our overall supply chain. The ramp up of Heartland in conjunction with continued optimization of the rest of our supply chain enabled us to deliver a gross margin of over 41% in Q3, one quarter earlier than our expectations. Finally, we have made significant progress in our discussions with counsel representing the plaintiffs in the ongoing consumer Class actions. We have reached a tentative understanding on a perpetual settlement value. Both sides are working in good faith to come to an agreement on the other terms of the settlement over the coming weeks. If the settlement agreement is finalized on terms satisfactory to both sides and approved by the court, we believe the potential settlement will enable us to significantly reduce our future legal expenses and litigating in the Class claim while preserving our claims for our recovery against our former ingredient supplier and broker. Mike will get into the financial implications in a few minutes. Now let me turn it over to Billy who will provide some additional color on our commercial performance.

[Billy Bishop:]

Thanks Kurt. Our solid performance in the quarter was a direct result of our continued execution against our unique go to market model which is built on our three planks; education, product innovation, and investment in our highly effective brand communication. During Q3 we continued to invest and all of our key brand building vehicles. Each one of our major product lines received its own advertizing support and we continue to educate pet parents on the difference between Blue and other brands by driving pet parents on line to take our True BLUE Test. Given the heightened competitive environment in pet super-stores we saw in Q3 and continue to see in Q4, we've put in place strong marketing and promotional program supporting our brand. As we've tried different promotional programs throughout the year, we learn more about what works better and what doesn't work as well. As we put our plans together for 2016 we're looking to redeploy our marketing and promotional dollars more efficiently and effectively. For example, we're planning to reduce dollar off promos that frankly don’t work well on that food category even the elastic demand especially in dry foods. Instead, we'll focus on more targeted promotions and storytelling themes across our product lines. Consistent with our long-term strategy we continue to invest in the entrées into new markets. As I mentioned on our Q2 call, we've been ramping up True Blue veterinary program. We've now begun to talk directly to the veterinarians who are the number one influences in pet food selection. The rollout of our national veterinary detailing force will take place over the next few years, as we expand our geographic reach and increase our coverage of vet clinics. Our vet initiative will advance two goals. The first is to educate the veterinarian community about Blue Buffalo and generate recommendations for our current portfolio of wholesome natural products that are in the market today. Our second goal is to enter the therapeutic or Rx food market segment. The Rx pet foods are over $1.5 billion in retail sales in the U.S. and have been fueled by the same kind of humanization trends that have been driving wholesome natural pet foods. Rx pet foods are therapeutic foods prescribed by the veterinarians to address specific medical conditions. It is a three-player market and the ingredient profiles of the existing Rx products are very similar to the engineered brands we've been competing successfully against. Although the existing Rx products offer satisfactory therapeutic benefits they don't offer the wholesome natural ingredients pet parents prefer. Up until our launch neither the vets nor pet parents had a natural choice. We're still in the very early days of this strategic initiative, but we're learning every day and continuing to improve our execution as we ramp up our programs. We track all our sales calls and KPIs for field marketing activities such as lunch and learns with the clinic staff and the placement of our promotional materials in the clinics. The good news is we are having great success in being able to enter the vet clinics to tell our story and we're meeting our internal goals. It is clear the veterinarian community is eager to learn more about Blue Buffalo. Since we started piloting the True Blue veterinary program last year, we have touched approximately 5% of the clinics across the country. Our coverage will continue to increase as we ramp up our vet detailing force. Our first wave of Blue Rx products started shipping in the latter part of Q3. The first wave includes three dry formulas, Blue HF for dogs and Blue HF for cats which are formulated with novel, hydrolyzed proteins for pets with food intolerances and Blue GI for cats which is formulated with easily digestible ingredients along with probiotic fibers to help maintain a healthy GI. As we discussed on our last call, we believe we can disrupt the Rx pet food market by offering Rx products with equivalent therapeutic benefits, but with formulas based on wholesome natural ingredients. Of course this won't happen overnight given the high barriers to entry in the Rx market segment. We are committed to continuing to build our coverage of and relationships with the vet clinics through our vet detailing force and dedicated resources. We will continue to introduce new products against the different therapeutic indications. We will continue to build the case for the efficacy of our products as we expand our portfolio of clinical trials and in-clinic case studies. The adoption will accelerate as more veterinarians have direct experience with our products. This is the classic S-curve for adoption and with the very early stages focusing on the early adopter veterinarians. We continue to be very excited about our long-term opportunity in the Rx market segment. As Kurt mentioned, we recently launched our products in Mexico and Japan. Consistent with our strategy our entries into Mexico and Japan are full market entries. We establish a full Blue Buffalo presence rather than a simple export model in order to realize the full long-term potential of these large and important markets. This takes tremendous effort across the organization as we built up the local teams, put in place the infrastructure and our sales and distribution networks. We are thankful to all the buffs for their hard work. Our core local teams are now in place and already feel a part of the herd. We've established distributor partnerships and anchor retail partners in each of these markets. The trade acceptance is very positive and our distribution is building and we are just starting to see the early consumer reaction in the initial launch stores and we're encouraged by what we're seeing. Our brand building efforts are now just beginning and in summary we feel great about our progress today, but it is still early on in our launch in these new markets. So we look forward to sharing updates with investors as we move forward. In Q3 we largely completed our ramp up of Heartland, our first production facility. During the quarter we were able to achieve milestones for production throughput and operational efficiency. Going forward we will continue to optimize our systems as well as improve our productivity targets. Now I'd like to pass it on to Mike for a closer look at the financials.

[Mike Nathenson:]

Thanks Billy. Q3 adjusted net income was $33.8 million, an increase of 17% versus last year driven by 10.5% net sales growth our volume growth in the quarter versus last year was 9.9%. The remainder of our revenue growth was due to better overall mix which was partially offset by lower net price realization driven by increased promotional activity in the quarter. As Billy mentioned, we expect to have continued high levels of promotional spending in Q4. This is in addition to the seasonally higher promotion levels in the quarter for the industry. As we look into 2016 our goal is to reduce promotional spending back to more normalized levels. When you look at our growth by dry foods versus wet foods, treats and other what we call WTO in Q3 dry foods grew at 10.4% and WTO grew at 11%. While our WTO sales grew faster than dry foods in Q3 and year-to-date, our goal is to further accelerate our brand's development in these underpenetrated areas as we move forward. Before I talk through the rest of the P&L, I'd like to touch on our sales growth by customer. You will recall that Kurt talked to our consumer takeaway at retail where our share and sales grew more rapidly outside of pet super-stores. That is also the case at our revenue level, but the gap is larger. While Blue retail sales to pet parents through pet super-stores grew in high single digits in the quarter, Blue's net sales to pet super-stores grew only 1%. The difference is driven primarily by the new tighter inventory policies at our largest customers which was a headwind to our overall sales growth in Q3. We expect to continue to see this gap between selling and sellout trends at pet super-stores over the next several quarters which we have built into our full-year guidance. Our sales to other customers represented just under a third of our sales in the quarter and grew more than 30%. As Kurt and Billy mentioned, we're at the early stages of our entry into RX and new international markets. As a result, these two areas did not materially contribute to the sales growth in the quarter. We will see some very modest contribution in Q4, but we expect to see more meaningful contributions to the topline from these areas in 2016 and beyond. Now turning to our margins. During the quarter, adjusted EBITDA was $61.2 million up 16% versus last year. Gross margin in the quarter was 41.7% 160 bps higher versus last year and 240 bps higher versus Q2. The increase in gross margin was driven primarily by supply-chain efficiencies including the benefits from the ramp-up of our Heartland facility as well as positive mix. Now let's turn to SG&A. Excluding the $8 million costs associated with our IPO and our litigation related expenses, SG&A grew 17% in the quarter versus last year. The increase was primarily driven by investments in advertising and marketing, costs associated with building our vet detailing force and building our international infrastructure. For the remainder of the year and as I mentioned in our call last quarter, we will continue to increase our investments in the international markets and the veterinary channel as we rollout these strategic initiatives. As a result of these investments our SG&A expenses will grow faster than sales. Given our strong topline and bottom-line results and our capital efficient business model, we continue to produce strong cash flow. For the first three quarters of the year our operating cash flow defined as cash from operations less capital expenses was $88.7 million. With the completion of the build out of our Heartland facility in 2014 which was our major CapEx project our year-to-date capital expenses were a modest $5.4 million. You will recall that we are actively pursuing a number of what we believe will be high ROIC projects to build more internal capabilities in the next few years starting with our second dry food plant. So we expect our CapEx to increase as we ramp up those projects over the coming quarters. As Kurt mentioned earlier, we have reached a tentative understanding on a potential settlement for the class-actions. The current framework involves a $32 million settlement value which will be disclosed in the footnotes to our financials with the Q we'll file tomorrow. Other critical terms are still being negotiated. If the two sides reach agreement we would reflect the final terms of the settlement in our financial statements in accordance with gap. As Kurt said we continue to pursue our claims against the former supplier and broker vigorously. Any recovery from them in the future would be recorded as a gain and will be an offset against any contingent loss we'd accrue. Now turning to our outlook for the rest of 2015. For the full year we expect to deliver net sales of $1.02 billion and reflecting our stronger operating margin, we are revising our guidance for adjusted EPS to $0.60 for the year compared to our earlier guidance of $0.58 or better. We are planning on providing our annual guidance for 2016 during our Q4 and year-end earnings call next year. That said, we remain committed to our long-term guidance of 10% plus revenue growth and about 20% EPS growth Now, I'll turn it back over to Kurt.

[Kurt Schmidt:]

Thanks Mike. In summary, I am pleased with our performance and I am excited about the future at the new breed of CPG Company. We will continue to be the leader in driving the pet food category, executing against our unique go-to-market model and going after the opportunities ahead of us. With that, I’ll open it up to questions.

[Operator:]

Thank you very much Mr. Schmidt. [Operator Instructions] Our first question comes from the line of Andrew Lazar from Barclays. Your line is now open.

[Andrew Lazar:]

Good evening everybody.

[Kurt Schmidt:]

Hi, Andrew.

[Mike Nathenson:]

Hi, Andrew.

[Andrew Lazar:]

Two questions for me if I could. First, if you could just help us reconcile the differential between the scanner consumption data that’s out there and your report of sales and how we should expect that GAAP to look going forward?

[Kurt Schmidt:]

This is Kurt. I thank you for the question Andrew. Let me start off by saying first that GfK is only one of the data sets we use to track our business as well as competitive activity. That said, you need to understand the limitations of the data. First, outside the large accounts they make projections based on a sampling of stores which is obviously subject to noise and errors. For example, based on our internal data in Q3 our growth in pet stores was higher than that projected by GfK due to their sampling error. Second, they do not track our fastest growing channel of Ecom and Farm, or any of our international sales. Obviously that international is not a big issue right now, but it will become bigger as we move forward. And they obviously don’t have any visibility in the changes in inventory levels or trade spending. Going forward as our sales continued to grow more rapidly outside of pet super-stores, GfK data on its own will become less reliable for tracking our overall performance. So we caution everyone based on limitations we’ve discussed as well as the volatility in shares and sales numbers in the short periods of time, but let me finish on this we have very good visibility into our sell-thorough. We have point-of-sale data, sell-through data for the vast majority of our sales. In addition, we do have visibility into their inventories and that is how we plan our business.

[Andrew Lazar:]

Thanks for that and then, just a follow up – just digging into the inventory comments that you made at the pet super-stores a bit further. Is your expectation that consumption would still be expected to be up double-digit in the fourth quarter, but obviously sales could be a bit less robust because of this inventory tightening, is that the rationale for the slight guidance change from $1.02 billion in sales versus the $1.02 or better or is it something else that’s causing that slight change?

[Kurt Schmidt:]

No, Andrew you hit the nail right on the head. We feel great about delivering the $1.02 billion for the year. It's going to be a great year with double-digit growth against tough comps, tightened competitive activities and that’s just despite the tightening inventories at our largest retailers. Clearly when you look at the Q3 consumer takeaway, we’re very encouraged by the consumer throughput and the takeaway that we're seeing and we expect that momentum to continue into Q4. The only difference is the difference in the inventory policies at our largest customers.

[Mike Nathenson:]

And it's important to note that our out the door sales in pet super-stores, our consumer takeaway, is in the high single digits.

[Andrew Lazar:]

Alright, thank you very much.

[Kurt Schmidt:]

I was going to say one last thing Andrew. These inventory policies at our customers are out of our control. We feel great about the delivery of our commitments even in the face of these recent headwinds.

[Andrew Lazar:]

Thank you.

[Operator:]

And our next question comes from the line of John Faucher from JP Morgan. Your line is now open.

[John Faucher:]

Thanks. Sort of one follow-up question from Andrew's and then one separate question I guess. As we look at that usually and we see inventory tightening is that something that’s going to continue for the next couple of quarters? Is it just until we cycle through to next year? And then separately, I was encouraged by the performance on dry which was better than what we had anticipated, but as you mentioned, wet was a little bit weaker than anticipated. And how long do you think, how long until you see the wet business sort of bounce back and continue to grow at a more meaningful spread versus dry? Thanks.

[Mike Nathenson:]

Hi, John this is Mike. I’ll cover the inventory question and then I’ll turn it back over to Billy to talk about the other question you had. From an inventory standpoint we expect to cycle through these over the next few quarters until they lap them. We began to see this mid to late Q3 and so once we start lapping those, we would expect our sell-in and sell-through to be more normalized.

[Billy Bishop:]

And this is Billy guys. John in relation to your dry, wet and treat question, as we mentioned in our prepared remarks, wet, treat and other has been growing faster than dry foods, but that gap has narrowed and we're really not satisfied with the performance. We’re really focusing on working on four key areas to change that. The first is products. We are pleased with the products that we have. They do feel great and we also have a pipeline of innovation in these areas that will keep us moving forward. Second area is in marketing. We think we have some more work to do on the marketing side as it relates to getting through the pet patents, the wholesome natural market segment penetration of wet foods and treats is still lagging, Dry Foods and pet parents haven’t been focused on the ingredient message in these product types. When you look at the humanization side, the human side, healthy snacking is a major trend and we think this sets up very well for us. We just need to keep working on it. The third area is in distribution we have good distribution of our wet foods and treats and pet superstars – super-stores we have the higher shares, but we have very limited distribution elsewhere which we believe is a big opportunity for us. And distribution is even more important in these impulse oriented product types which is why FDM does well in wet and treats. And then finally for pricing and promotions, one of the reasons our wet treat and other sales have lagged is that with the heightened competitive environment among natural foods our focus this year has been more on dry foods where most compete directly against these guys. Going forward, we believe that we will have a lot of opportunity to be a lot smarter about promotions in wet treat and other as we expand the consumption.

[John Faucher:]

Great, thank you.

[Operator:]

And our next question comes from the line of Dara Mohsenian from Morgan Stanley. Your line is now open.

[Dara Mohsenian:]

Hey guys. Can you just tell us the pace of expansion plans as you enter into Japan and Mexico that you’re expecting over the next few years particularly in 2016 and how quick a ramp up we should see? And then separately, how much pipeline fill is kind of embedded in Q4 guidance for those two countries? And then also I was hoping you could give us a sense of how much the e-commerce has grown year-to-date or in Q3 for your business and any sense for how much cannibalization you think that has versus your base business or the incrementally from e-commerce? Thanks.

[Kurt Schmidt:]

Hi, this is Kurt. I will take the international one. We’re just getting started currently less than 4% of our sales were international outside the U.S. which I might add is essentially all Canada, but I remind everybody the pet food market is $50 billion outside of the U.S. So it is a very large opportunity. So when you look at other brands, other premium brands that we are following there is a much bigger part of them they have gone from almost 0 to 50% of the revenues coming out of the international markets. We are just at the beginning, so some of this is pipeline fill that is going into the market, but I will tell you I have been in Mexico in the last four to six weeks and I have been a week in Japan in the last four to six weeks. We have product on shelf. We started that in Q4. You see the displays and early indications are very promising and the early days the reception has been fantastic I might add. So it is going to be a slow build as we get into these markets, but right now all the signs are very positive for us. In regards to the e-commerce I will let Billy make some comments on that.

[Billy Bishop:]

Sure, hi Dara. I guess we have been talking about it, we think e-commerce is a great fit for Blue. We have a strong competitive advantage in this channel and we’re growing rapidly. We really view e-commerce a way to close the convenience gap with FDM with over 70% of pet food pounds and 55% of dollars were sold. As I talked about, we are gaining share rapidly in this channel. This is a secular trend we feel across all consumer categories and really is a perfect fit for pet food and Blue. We are continuing to partner with our brick-and-mortar retailers on the e-com side. We also recognize this as an important channel if they want to win in as well. And as we have shown in our S-1 in 2014 we estimated e-commerce is 2% of the total U.S. pet food market with Blue sales doubling that, as e-commerce continued to grow our re-sales has also continued to grow as a percept of overall sales. Let me disclose our growth rate by channel, but as I mentioned earlier our sales outside of pet super-stores were up over 30% in the quarter. And I will let Mike talk to any guidance as we move out.

[Mike Nathenson:]

Yes Dara, you would ask how much of international the load is included in our guidance, the reality is it’s small I mean compared to the size of our U.S. business it’s quite small, it is included, but it is not a material, it doesn’t have a material impact on the numbers here.

[Dara Mohsenian:]

Okay, thanks.

[Mike Nathenson:]

Okay, thanks.

[Operator:]

And our next question comes from the line of Chris Ferrara from Wells Fargo. Your line is now open.

[Chris Ferrara:]

Hey thanks. I guess guys first an easy one, I just want to make sure I’m getting this right though, your sell-through is high single digit in super-store but only plus 1 on the selling because of the inventories, so does that really suggest that at roughly half of your distribution you had something like a seven to eight point drag on sales meaning total company top line drag maybe 3% to 4% if you had not had that inventory correction, does that make sense?

[Kurt Schmidt:]

It certainly does make sense. Obviously the revenue growth would have been a few points higher without the tightening at the super-stores. Obviously when you work through the math, when you look at the gap between consumer takeaway and our net sales to super-store obviously the biggest factor there was the tightening of inventory. So that is about two-thirds of the gap. And then there was a bit of it which the other third was due to the higher promotional spending that we discussed earlier.

[Chris Ferrara:]

Okay, oaky. And then I guess, can you talk a little bit about the cadence of what you have seen around the Natural Balance launches as you are putting it just the competitive launches right, I mean, have you seen a crescendo in the level of promotion that you’re seeing? And I asked that in – I guess in the context of you’re saying in 2016 you would like to reduce the level of promotional spending, but I guess that would also entail you actually having an environment that is conducive to the sort of thing, so I guess any color there would be really helpful?

[Kurt Schmidt:]

Sure. Just to give you - everybody a little background I think as we mentioned during our Q2 call Natural Balance entered to our largest customer back in August with an unprecedented launch and full retailer support. I think most of you know we have been competing against Natural Balance for a long time and as we look at the data today we believe that Natural Balance generates about one tenth of Blue sales with about 40% of Blue space. In addition, Blue gained 24 bps of share year-over-year in Q3 and Natural Balance gained 6 bps while ACV increased by more than 60% versus Q3, 2014. So overall we feel great about our productivity. That said, there has been a lot of competition within the natural category within super-stores and we don’t see that pressure lightening up. I think the key is we want to make sure that we are putting the right promotional programs against the competitive pressure, so that we are as efficient and effective as we possibly can be going forward into next year. In addition, I guess I would just add guys that there is - we have seen over time these types of competitive moves have the greatest impact during their initial launch and then from that point on the impact tends to moderate before reaching a steady level. So we built in this continued headwind during Q4 due to the heightened competitive environment super-stores into our guidance.

[Chris Ferrara:]

Got it, thanks guys.

[Operator:]

And our next question comes from the line of Bill Schmidt from Deutsche Bank. Your line is now open.

[Bill Schmidt:]

Hey guys.

[Kurt Schmidt:]

Hey Bill.

[Bill Schmidt:]

Hey, I am going to be consistent here, just to ask you the percentage of sales by each of Petco and PetSmart respectively if you could?

[Kurt Schmidt:]

Sure in total it’s 68% it will be disclosed in the Q model [ph]. Hold on a few seconds and I will get the specific numbers for you. When we look at the pet super-stores for the total PetSmart total are represented 44.4% of our total and Petco represented 23.7%.

[Bill Schmidt:]

Okay great, that is very helpful, thank you. Why do you think PetSmart did this? You know what I mean because you had some great slides about how you drive the bulk of the categories growth, and then how long does it take for them to kind of adjust and say look there is shelf is three or four extra share in market. So I mean, how sticky are these like distribution gains and when do the kind of do the planogram resets based on that data?

[Kurt Schmidt:]

Well, I can’t speak to PetSmart strategy, I think that is best for them to talk about, but I think it is a reflection on the growth, where is all the growth coming from, it is from wholesome natural. And generally speaking, people are building the wholesome natural portfolios because that is the key driver in the pet specialty channel and the key driver in the overall category. But as you get through these launches, as you know it becomes a game of how productive you are and how much incremental sales you are generating for those customers and this is where our strength is. And I will just remind you as far as PetSmart we didn’t lose any space, it didn’t come from Blue. So it really is about a new launch with lot of support they did get quite a bit of support, but now we move past the support time and we’re very pleased with our productivity, our volume movements in those accounts. And remember, we well outperformed in a consumer takeaway. So competition is in the nature of the game and we’re probably the best company set up to defend and build our business because we’re the highest investor and as I have said often and what we think are the three most strategic planks in our business which is a investment and innovation, investment in pet parent education with our 12,00 pet detective force and in communication as we’re the leading advertising by far and away in the wholesome natural segment.

[Bill Schmidt:]

Okay, great and then just a two quick other ones, is there any change in Merrick behavior now that Nestle owns them and then the inventory reductions for those broad based across the category or they disproportionally aimed at you guys?

[Mike Nathenson:]

This is Mike. Why don’t I just take the last question first and then I’ll let and then Kurt will jump back into the, to your first question. We’ve every reason to believe this is everybody. So it's not just us nothing comes, they’re not picking on us or any individual manufactures for everybody.

[Bill Schmidt:]

Great, thanks.

[Kurt Schmidt:]

As far as Merrick, let me start off by two points, one may be competing against Merrick for a very long time. So this is not the first time one of the majors acquired a natural brand. Just to remind you we’ve had acquisitions by Mars have natural brands, P&G have natural brands and Big Heart have natural brands. In fact then P&G sold to Mars and acquired that and Big Heart obviously is now part of Smucker. So, it was the first one I’d make is, we say yes there is another admission at wholesome natural is the segment to be in and that the other majors haven’t had very good success building it on at their own. Having said that, we believe authenticity is key to success in today’s world and its going to be interesting to see how they manage this brand under the new corporate ownership, so that in time will tell on that.

[Bill Schmidt:]

Great, thanks so much.

[Operator:]

And our next question comes from the line of David Driscoll from Citi Research. Your line is now open.

[Alexis Borden:]

Hi, this is Alexis Borden for David this evening.

[Kurt Schmidt:]

Hi, Alexis.

[Mike Nathenson:]

Hi, Alexis.

[Alexis Borden:]

Hi, question so can you may be a talk a little bit about progress on the snack front and I know that's kind of one of the tenants of your story that there is opportunity to grow sales there and its accretive to the margin. And kind of what’s been going in snacks and kind of what’s kind of key metrics do you look at kind of understand where that business is going?

[Billy Bishop:]

Sure, Alexis this is Billy. As I went over before, we want to continue obviously to grow our wet, treat and other product types and I think those four key areas that I mentioned really are going to be our focus on how to do that. I think we do have a great pipeline- new products within treats and wet that we're looking for rolling out here in the near future and we also then we have do some more work on marketing as it relates again to communicating to the pet parents about the ingredient differences between hold some natural and there is engineered treats that are on the market today. On top of that we need to continue to expand our distribution in our underpenetrated channels which we think is a huge opportunity. And I think finally get our promotions right as it relates to driving higher consumption. So this year as we been talking about its been highly comparative from a dry food stand point and we’re going to start to really turn our attention now towards how to continue to drive sales on wet, treat and other.

[Alexis Borden:]

Okay and just follow up on the margins. You said that the plans was going to fully ramped down then you hardly on plant so is it still on track to produce the expected margin improvement in 2016? Basically margins came in better than we thought this quarter so we kindly seems like it’s on track on that it like to hear some thoughts.

[Billy Bishop:]

Yes, so as Kurt mentioned in his prepared remarks, we reached our target one quarter ahead four expectations and this was as I said driven by better performance around the supply chain as well as better mix. So as the ramp up phase of Heartland is now behind us we’re in the optimization phase. In fact over the last quarter we’ve been able to reach a 1 million pounds per day capacity production levels. And remember, capacity utilization is only one of the levers. That’s going to change as we go forward depending upon which diets we run, some days it will be higher, some days it will lower, depending upon pack sizes we run. So from that standpoint we’re always going to look for ways to continued to improve and optimize on this ongoing facility.

[Alexis Borden:]

Okay, so it sounds like it is pretty much done. Thank you.

[Operator:]

[Operator Instructions] And or next question comes from the line of Joe Edelstein from Stephens. Your line is now open.

[Joe Edelstein:]

Hi good evening everyone.

[Mike Nathenson:]

Hey Joe.

[Joe Edelstein:]

Yes, I was curious about your market share, just how that performed really more so on a same-store basis as you look out to all your retail partners, I'm just trying to get a sense if you could pass out the distribution gains separate from just kind of a same-store performance if you could?

[Mike Nathenson:]

Yes as we look at our share performance it is largely clearly in the retail is almost all organic growth at the retail levels. Obviously there will be some stores that pick up in our underpenetrated channels like the neighborhood pet stores and some of the regional would pick up a few new SKUs. But it is largely organic growth. Now the difference here is our e-com channel where we tend to grow faster and faster it is hard to know how to characterize that as distribution or organic. What I'll tell you is that we've been selling to the e-com, e-retailers for quite some time, but to be honest the demand just keeps building. So from that standpoint we've been very pleased with our performance.

[Joe Edelstein:]

Okay maybe if I'll just ask in a slightly different way we can count back into the same-store type performance. Just how many stores are you selling in today versus where you were a year ago and even just quantify how much progress you have made just in the last three months?

[Mike Nathenson:]

Well as we look at this, we're essentially selling into the same stores that we have been. I mean, in almost every store carries some product line or some aspect of our portfolio, whether that is dry foods, some might carry LPF, most like – if you look at the pet super-stores will carry all of our lines as well as the majority of all of our wet and treat foods. When you get into the regional some of them may not carry all of our lines or the complete lines of those. And from that standpoint, as I said we feel great about our performance. We don’t really disclose the details of what our store count is as we go forward, but hopefully that's helping you. If I am not getting it just kind of ask the question another way, I'm happy to have another go at it.

[Joe Edelstein:]

Yes we can always followup offline Mike, and maybe just to be clear again on the inventory controls, I mean is that really the primarily reason here why you’re not able to flow through kind of the full third quarter beats as you think about the updated guidance?

[Mike Nathenson:]

When you say the full third quarter beats, I suspect you are referring to what was…

[Joe Edelstein:]

At least, versus the consensus, yes the consensus numbers?

[Mike Nathenson:]

Just to remind everybody, we really give full year guidance, but you know that said, I am not blind to what the consensus is out there. And so when you look at the beat for the quarter about a third of it came from gross margin and about two thirds of it came from SG&A below the line. And when you look at the SG&A remember our SG&A is still up 17% versus the 10.5% revenue growth and there is some timing shift in SG&A between Q3 and Q4. But we have also been more efficient across several of the spending buckets and given these efficiencies in the better gross margin, our operating margin is coming in stronger than planned, which is why we are revising our EPS guidance up to $0.60 for the year.

[Joe Edelstein:]

That is helpful and if I could just squeeze in one more, I had a question as it relates to the cat food recall that was just issued last week. Was that product produced by third party and in any way would that open you up to any additional litigation since this did include a FDA banned ingredient?

[Billy Bishop:]

This is Billy. I will handle that one. Since you guys are aware, we would execute a voluntary recall of a limited amount of our Kitty Yums Chicken Recipe cat treat last week. This is an ingredient that is approved for dog food usage, but not cat and we have put an additional quality testing to ensure that this does not happen again.

[Kurt Schmidt:]

This is Kurt. I can't speak to whether litigation will come or not. Again, remind you, one lot of product and this is a very small recall, a couple of $100,000 in one unit.

[Joe Edelstein:]

Okay thanks for taking the question.

[Operator:]

I am showing no further questions at this time. Mr. Schmidt, I would now like to turn the conference back to you.

[Kurt Schmidt:]

Thank you. And I want to thank everyone and we really look forward to talking to you again next year when we report our Q4 and full year results. And I'd be remiss not end on one statement I'd like to make. I'd really like to thank our herd members around the world for making things happen. So guys, let's keep the stampede going. Thank you everyone.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may now all disconnect. Everyone have a great day.