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Q2 2016 Earnings Call Transcript

Published: 11 Aug 2016

[Operator:]

Good afternoon, ladies and gentlemen, and welcome to the Blue Buffalo 2016 Second Quarter Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to the CFO of Blue Buffalo, Mike Nathenson. Mr. Nathenson, you may begin.

[Mike Nathenson:]

Good afternoon, everyone, and welcome to Blue Buffalo's Q2 earnings call. Some reminders before we start. Today's conference call will include forward-looking statements. These statements are made on the basis of our views and assumptions as of this time and are not guarantees of future performance. Actual events or results may differ materially from these statements. For information about certain factors that could cause such differences, investors should refer to our Form S-1, which was filed with the SEC in June 2016 and is available on our website, including the information set forth under the captions Risk Factors and Statement Regarding Forward-Looking Disclosures. Except as required by law, the company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise. In today's discussion, revenue and sales refer to net sales. In our discussion, we will also refer to non-GAAP financial measures, which differ from our results prepared in accordance with GAAP. We will refer to adjusted EBITDA, adjusted net income and adjusted EPS, which exclude the costs associated with litigation and our public equity offerings. Adjusted EPS will refer to the adjusted diluted EPS. A full reconciliation with the corresponding GAAP measures is included in the press release and is posted on our IR website at ir.bluebuffalo.com. On today's call, I am joined by our CEO, 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 are pleased to share our results with you today. As you saw in our press release, Blue Buffalo's strong performance has continued in the second quarter. Having recently passed the one year mark since our IPO and now reporting our fourth quarter as a public company, we are proud of our performance and the way we’ve delivered on our commitment. Before we dive into details, I'd like to take a moment to remind everyone, particularly those of you who are new to the BUFF, who we are. Blue Buffalo is the undisputed leader in the wholesome natural pet food, the fastest growing segment of the $27 billion U.S. pet food market. And we are over four times the size of the next largest brand in this segment. As one of the largest brands in the overall pet food market in a sea of legacy brands losing their relevance with consumers, Blue has become the new mainstream brand that's delivering the products that consumers are looking for and connecting with pet parents in an authentic way. With that said, we still have only a 6% share in the U.S. and feed less than 3% of pets. So Blue Buffalo is a tremendous opportunity to grow. We have a clearly articulated growth strategy that starts with the U.S. market as we continue to gain share across both the more developed areas such as dry dog food and across our underdeveloped areas such as cat food and treats. We are winning in the fastest growing and differentiated specialty channels and e-commerce. We're also investing in new legs of growth as we're entering the veterinary channel and new international markets. Putting this all together, our goal is to continue to grow our revenues 10% plus in the coming years. We're also continuing to focus on productivity and our focus on expanding our margins in a high-quality sustainable way. With cost cutting being all the rage in the CPG world, I think we are quite unique in expanding our margins while maintaining strong top line growth. Our new three-year $200 million capital investment program is an important lever in this direction. In summary, we believe we are a new breed of CPG Company that's built for the 21st century. The second quarter was a great example of our competitively advantaged business model and how we execute against our strategy. Let's look at the highlights. Our revenue grew 12.9%. This growth was well above the market and as a result, we gained share. We continue to grow in the rapidly growing underdeveloped channels like e-commerce and farm and feed, while we continue to build our business in pet superstores and in neighborhood pet stores. We expanded our margins due to supply chain performance, positive mix and pricing. On the bottom line, combining our double-digit top line performance with expanded gross margins, we were able to continue to invest for future growth and still deliver healthy net income and EPS growth. Given our strong performance through the first half of the year, and our confidence for the full year, we are raising both our sales and EPS guidance. Now let's turn to market dynamics and our sell-through at retail. For Q2, we estimate the overall U.S. pet food market experience low single-digit growth, which is consistent with recent quarters. This compares to Blue's low double-digit growth in consumer takeaway, which resulted in continued share gains. Pet superstores have seen a slowdown. We estimate that overall channel growth in Q2 was flat to low single-digit. In this context, Blue’s U.S. superstore sell-through was less than 1% while essentially holding share consistent with our expectations. We experienced a promotional headwind as we lap some very aggressive promotional activity from last year driven by our retailer partners, which was a combination of bonus tags coupled with additional price discounts. Importantly, our retail partners recognized that this type of abnormally deep discounts doesn't drive incremental consumption and the demand in the elastic categories such as pet food, just pantry loading. As a result, our retail partners have chosen not to repeat them this year. Instead, they are focused on optimizing the in-store experience and merchandising as well as opening new stores. Outside of pet superstores, our largest driver of growth was consumer takeaway where we estimate our growth rate to be in the mid-30s. Given the growing importance of these retail partners, I'd like to provide a bit more color here. As a reminder, we have three main groups of accounts outside of pet superstores. One, regional neighborhood pet stores; two, farm and feed stores; and three, e-commerce retailers. We continue to see robust growth across all three groups of accounts. On the brick-and-mortar side, our performance in these channels reflects the runway we have ahead of us as we continue to increase our velocity, broaden our assortment in underpenetrated product types, and enter new locations particularly on the farm and feed side. The growing farm and feed channel services rural community and hobby farmers living in areas outlying major metropolitan markets. This channel includes approximately 10,000 doors ranging from tractor supply to the mid states co-op to the independent stores. We continue to see the farm and feed channel upgrade its retail format in existing markets and adding new doors. Pet food is seen as an important Staples category to help balance the seasonal parts of the business. As general store merchandisers, farm stores can devote less shelf space to pet foods than the larger format pet stores. As a result, they focus on the best-selling brands and Blue is a great fit as a leading wholesome natural pet food brand. We see very little overlap between our farm accounts and other retail partners as they give us access to new groups of consumers. On the e-commerce side, we continue to ramp up our sales and gain share in this rapidly growing channel across our major retail partners. As a reminder, we enjoy significant competitive advantages in e-commerce channel over the large, widely distributed brands given our high value per pound and addition to our unique go-to-market model that creates consumer pull for the Blue brand. We're gaining share by leveraging these competitive advantages, which is helping close our convenience gap against FDM and gain share in the $27 billion U.S. pet food market. As a reminder, over 50% of the dollars and over two-thirds of the volume is still sold through FDM. So we believe we continue to have tremendous headroom to move pet parents from shopping in FDM to the specialty channels where we sell Blue. In a few minutes, Mike will get into more details of our strong financial performance in the quarter. But first, let me turn it over to Billy, who will provide some additional color on our commercial performance.

[Billy Bishop:]

Thanks, Kurt. As Kurt mentioned, the Buff had a strong first half of 2016. All of our major product lines contributed to growth with Wilderness leading the pack. As I mentioned on our last earnings call, our renovation in Wilderness and in our new therapeutic line were beginning to ship to just a few of our customers. Now all of our new items are available to our entire customer base. We’re also encouraged by the strong performance of the underdeveloped parts of our portfolio. In the quarter, our cat products grew faster than our more penetrated dog portfolio even as the sales of our dog product portfolio continued to grow rapidly driving share gain. As we mentioned on previous calls, WTO which is our shorthand for wet foods, treats, and other products is a key leg of our growth strategy and continues to be an area of focus for us. You will notice that our WTO sales have been ramping up. The recent performance was driven by several factors. One, our renovation is focused on WTO, which includes treat offerings, as well as our Meat Roll products. Two, our promotional and merchandising program reflected a better balance between dry and WTO. And three, as expected there were some pipeline fill for our new product introductions, as we introduced new SKUs to a broader range of customers, gained additional shelf space and distribution and as a result, the sellthrough of our WTO outside of pet superstores accelerated. These are all areas we had discussed on our earlier calls as part of our WTO strategy and it's nice to see them playing out in the market and being reflected in our financial results. Looking ahead it's important to remember that in Q2 WTO growth rate benefited from initial stocking orders for our new product introductions. Therefore, while we still expect healthy growth rates for WTO for the full year, we expect the second half of WTO growth rate to moderate as we should shift the focus more to replenishment of the sellthrough of our full portfolio. So in summary, we’re encouraged by the progress we've made, but we know this is only the beginning. And this area continues to be a major focus for us as we are committed to becoming a larger player in these product sides. Turning to advertising, we continue to invest in brand communication as we launched our real pet parent TV advertising campaign for life protection formula. This new campaign sharpened our compare and decide message and really highlighted ah ha moment when pet parents realized there is a significant difference between what they thought they were feeding, and what they were actually feeding their pets. Beyond our new LPF campaign, we also made sure each one of our product lines received its owned dedicated advertising and marketing support. We have a lot of room to grow and this consistent investment has really made a positive impact on our brand awareness and brand equity ratings. With regard to supply chain, our gross margin performance reflected improved productivity as we lapped the heartland startup cost from 2015, got some tailwind from some lower input costs and benefited from positive mix and modest pricing we took earlier this year. Now I'd like to pass it onto Mike for a close look at the financials.

[Mike Nathenson:]

Thanks Billy. Our overall net sales growth in the quarter was 12.9%. Looking at product types, we saw strong growth both with our dry foods and WTO products. Our dry foods grew 10.6% and WTO grew 23%. Breaking down our overall sales growth, we grew principally by 8.5% volume, 3.5% of positive mix, and 0.9% of net pricing. As Kurt mentioned earlier, in Q2 of last year, we had significant bonus back promotion program that shipped extra pounds for the same price of LPF dry products before the additional price reductions at retail. As we lapped this bonus back program, these extra pounds have reduced our reported Q2 volume growth rate. Before I talk through the rest of the P&L, I'd like to touch on our sales growth by customer. Overall, sell-in was slightly ahead of sellthrough. In pet superstores, pet parent sellthrough was less than 1% and our sell-in was slightly higher at 3%. The difference in sell-in versus sellthrough is primarily driven by a modest increase in superstore inventory as a catch up from H2 2015. The sellthrough growth rate reflected some headwind from sharp promotional activity last year. Looking ahead, we have already lapped this and expect to see some improvement in superstore sellthrough growth rates in H2. However, we remain cautious about superstore traffic. Outside of pet superstores, our sales to other customers represented 35% of our total sales in the quarter and grew by 37%. We estimate that the sellthrough to pet parents in these channels grew at a similar rate. Looking ahead to H2, we expect the momentum in these channels to be strong. As we mentioned in previous calls, we are currently in the early stages of our entry into the veterinary channel and new international markets. As a result, these two areas did not materially contribute to the sales growth in the quarter. We expect to see more meaningful contributions in 2017 and beyond. Now let's turn to the bottom line and our margins. As you saw on our earnings release, our profit metrics grew strongly in the quarter driven by double-digit topline growth and expanding gross margins. Q2 adjusted net income was $38 million, up 45.7% and adjusted diluted EPS was $0.19 per share, up 45.2%. Our adjusted EBITDA was $68 million, up 40.7% versus last year and gross margin in the quarter was 44.4%, 510 basis points higher than last year. The increase in gross margin was driven primarily by supply chain efficiencies, including the benefits from our heartland facility, lower input costs, and lapping of last year's bonus bag promotion. Margins also benefited from positive mix and the modest pricing action we took in January. Now let's turn to SG&A. Excluding the costs associated with our equity offerings, as well as our litigation related expenses, SG&A grew 17% in the quarter versus last year. The increase was primarily driven by investments in our strategic initiatives as we continue to build our vet detailing force and our international infrastructure and additional costs associated with operating as a public company. 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. Our tax rate in the quarter was 37%, which reflects the benefits from certain state tax rate reductions as we resolved audits and the resulting one-time tax true ups from prior years. Overall, we now expect our full year tax rate to be approximately 37.3%. But given the variability driven by tax reporting rules, we expect our tax rate in Q3 to be lower than our Q4 rate. Given our strong top line and bottom line results, as well as our capital efficient business model, we continue to produce strong cash flow. For the first half of the year, our operating cash flow defined as cash from operations less Capex was $51 million. Our Capex was $4 million and at the end of the quarter we had $274 million of cash on our balance sheet. As a reminder, our year to date operating cash flow was reduced for the settlement of the U.S. class action lawsuits, which was $32 million pre-tax and $20 million net of taxes. Overall, on a year to date basis our cash flow and balance sheet continue to be strong. In Q2, we normalized our working capital, which year to date has been impacted by the timing differences of different items such as tax receivables, and customer shipments, as well as rebuilding of our inventory levels to better service our retail partners. Turning to our public float, we completed a secondary offering on behalf of our larger shareholders and as a result, our public float increased by over 40%. Now let's turn to our updated outlook for the full year. As you saw in our press release, we have raised the range of our guidance for both revenue and EPS, which is consistent with our long term targets of 10% plus top line growth and about 20% EPS growth. We now expect our full year net sales to be between $1.14 billion and $1.15 billion with adjusted EPS of $0.74 to $0.76 per share. With another quarter under our belt, we now expect our gross margins for the full year to be a proximally 44%, which is at the higher end of the range we discussed last quarter. Combining strong top line and expanding gross margins, with a favorable tax rate results in our full year EPS guidance of $0.74 to $0.76 per share. Finally, for capital expenditures, we expect to spend between $50 million and $60 million for the full year, which is below our prior guidance of $70 million to $80 million. Rest assured, our program is on track and we still plan to begin commissioning in 2018 and expect to see the P&L benefits in 2019. As you all know, we announced the acquisition of land in Richmond Indiana, and we have recently finished the engineering design. Given that the land acquisition took longer than expected, we began ordering equipment later than expected, but we expect to catch up in 2017. An important point to note is that this is a multiyear program and that this timing shift is not on the critical path, so it will not impact the overall project timeline. Now, I will turn it back over to Kurt.

[Kurt Schmidt:]

Thanks Mike. Before I open it up to questions, let me tell you the five points I'd like everyone to walk away with today. One, we are the competitively advantaged leader in the best part of a great category, wholesome natural segment in the $70 billion global pet food market. Two, we continue to gain share in the overall market and faster growing emerging channels, while we continue to build our business in pet superstores. Three, we have a broad-based momentum in our portfolio. From our more developed dry and dog food products to WTO and cat food products which are important legs of our continued growth. Four, we are seeing the benefits of improved supply chain performance in our expanded gross margin and we're confident about the expected benefits of our three-year capital investment program which will enable further productivity , flexibility, and innovation. And five, we delivered high quality results in H1. We're confident in our full year outlook and we're confident about our opportunity for future growth. Net, we have every reason to be excited about our future as the new breed of CPG Company. With that, I will open it up to questions.

[Operator:]

Thank you very much Mr. Schmidt. [Operator Instructions] Our first question comes from the line of David Driscoll with Citi. Your line is open.

[David Driscoll:]

Great thank you and good evening.

[Mike Nathenson:]

Hi David, thanks.

[David Driscoll:]

Hi, I wanted to just start off with the revenue guidance and maybe just a bigger picture, given the slowdown in superstores, obviously it doesn't seem to have an impact in the quarter because you did so well in so many other channels, but when you think further out do you have any concerns about the pacing of revenue growth in the subsequent years because of what you are seeing in the superstores and given your high index to those channels?

[Kurt Schmidt:]

David this is Kurt, I will kick it off and then Mike can add some comments. First of all, I think for us it is important, really the blue brand is all about building consumer demand and consumer poll. And we are, as you look at our numbers, we drove double digit consumer takeaway in the first half. So, I think that is a powerful indication of our ability to drive this business in the future. In regards to superstores, I think you are seeing some of the experience of the general retail market. But we still think the superstores have a lot of opportunity ahead of them. Just to remember, 50% of - rather 70% of the volume is sold through FDM. And the superstores still provide a great experience. They offer a range of services, they have a compelling offer, the whole exponential side of it and they are also obviously investing in new parts of their business like e-commerce. You've seen some recent moves in that area. So we think overall long term guidance we are still extremely positive about it. Again, just a reminder, we feed 3% of U.S. pets, 4 in dog and 2 in cat, so there's a lot of scope in that. We feel quite good about the future. Despite any temporary slowdown we may see in one aspect of the channel.

[Mike Nathenson:]

The one thing I would add David, is that in Q2 there was a headwind from a promotional overlap that was a big factor in the quarter. Obviously, all the retailers are working on merchandising. They are working on improving the in store experience and they are actually opening stores. So, we still remain very confident.

[David Driscoll:]

This is a follow up on the growth question, I believe last year in the second quarter was when you launched your e-commerce efforts quite significantly. Can you talk about kind of what happens now that we’re going to be facing some of the comparisons in Q3 and Q4 to the e-com channel, will the rate of growth start to come down or are we still in such early innings in the e-commerce growth that the growth there should still be the largest of any of your channels? Thank you.

[Billy Bishop:]

Hi David, it’s Billy. No. We don't see this as a one-time lapping issue if you will or one time step up. I would say we're still in the very early innings of e-commerce. As you noted, last year second half we took our e-commerce customers direct and obviously started focusing on some marketing programs. So, we see e-commerce as a secular trend, and given Blue Buffalo's marketing model, we feel we're in very good position to grow as this channel continues to grow.

[David Driscoll:]

Terrific, I will pass it along. Thank you.

[Billy Bishop:]

Thanks.

[Operator:]

Thank you. Our next question comes from the line of Andrew Lazar with Barclays. Your line is open.

[Andrew Lazar:]

Good afternoon everybody.

[Mike Nathenson:]

Hi Andrew.

[Kurt Schmidt:]

Hi Andrew.

[Andrew Lazar:]

Hi, just a couple things if I could. First off, I guess the top line guidance for the full year implies a sequential slowdown in 2H despite easier comps in the back half of last year. I'm just trying to get a sense of that’s just conservatism or if there is something sort of discrete we need to take into account.

[Mike Nathenson:]

Hi Andrew, it’s Mike. Just to put it in perspective, the best way to think about this is that when you look at our growth rate in Q2, it was really impacted by a couple of things that we mentioned in our prepared remarks. The first thing is that there was some inventory catch up from H2 of last year, so we had mentioned that, as well as a little bit of WTO introductions. Together, those two things represented probably about one 1 point to 2 points to our overall growth in the quarter. So, when you look at the underlying growth in Q2 and you look at the H2 implied growth rate, it's not all that different.

[Andrew Lazar:]

Got it, that's helpful and then I guess embedded in that expectation, do you still look for I think you had initially looked for mid single digit takeaway in the pet superstore channel, is that now altered a little bit just given how the first half played out?

[Kurt Schmidt:]

Sure. I think that when we talked about this earlier in the year, we had formulated our guidance with the assumption that pet superstores would grow mid single digits and that outside of pet superstores our takeaway expectation was in the low to mid 20s. So obviously we've seen stronger performance in the first half of the year. So now as we look at what we're seeing going forward, we expect superstore growth to be in the low to mid single digits, and we expect that sales outside of superstores to be in the mid 20s up to 30%. So when you put that range together, it encompasses a variety of different possibilities, but we are very confident in our ability to deliver our guidance. When you look at the overall guidance for the year, it's 11% to 12% and we feel very strongly about that.

[Andrew Lazar:]

Got it thanks for that. Two last quick things. One on gross margin, obviously you're already trending above 44% through the first half. So, again like with sales just trying to get a sense of what I should think about that impacts the second half of the year that gets us to 44% for the year or again if that's just more conservatism on your part?

[Kurt Schmidt:]

Well I think there's a lot of things that impact the gross margin. The results that we had seen is consistent with the range that we had given before, it is at the higher end of the range. And there's always some puts and takes in any particular quarter from promotional timing to mixed differences. So from our perspective, we are very again comfortable with the 44%, but there's nothing material other than the things I’ve just talked about.

[Andrew Lazar:]

Last thing would be, I think past several quarters you've given some shelf productivity metrics versus some new competitive options out there. And I guess I'm curious if you have any of that data updated handy, I guess more importantly, has this data started to better inform retailer decisions with respect to shelf resets yet and if not, maybe why hasn't it or do you expect that still to come at some point maybe in the back half of this year or into the beginning of next year?

[Mike Nathenson:]

Andrew it is Mike, I'll kick it off and then I will hand it back over.

[Andrew Lazar:]

Thank you.

[Mike Nathenson:]

We don't have the updated shelf metrics on a month to month or quarter to quarter basis. But the reason it becomes more obviously more important is that really we don't expect to see much change since last we talked about it. Obviously, in the superstores typically resets happen on a fairly infrequent basis, typically in midyear and at the beginning of the year. And we expect that that's when that data usually comes home to roost.

[Andrew Lazar:]

Great thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Dara Mohsenian with Morgan Stanley. Your line is open.

[Dara Mohsenian:]

Hi, good evening guys.

[Mike Nathenson:]

Hi Dara.

[Kurt Schmidt:]

Hi Dara.

[Dara Mohsenian:]

So, gross margins have been coming better than expected for a few quarters now, mainly driven by Heartland savings. I was hoping you could just review what level of savings you're now expecting from Heartland given the upside in gross margins we’ve seen, and if you can compare that to the savings you'd ultimately expect to realize from the next tranche of manufacturing with the Heartland addition in the Greenfield side over the next few years.

[Mike Nathenson:]

This is Mike. I think the best way to think about this is that we have when you look at our high ROIC impact and the way we allocate capital. The way we look at this is that we want to prove out our demand, build capacity to service a portion of that demand, and then fill it up as fast as possible. And what you're seeing here in our results is Heartland is up and running, it's doing quite well, and we are quite happy with the supply chain team, with people on the ground and [indiscernible] doing great. And so when you look at our gross margins, we are seeing the bulk of the benefit. But that said, let me talk about how we expect to improve our margins going forward. Now there's a couple of different ways to think about it. There is things that are just systemic that we work on every day every week every month. The kind of things that we look at is obviously ongoing productivity that will continue to drive. And there's always an opportunity to do better in any supply chain system. The second thing is that we expect to continue to get positive mix and we get positive mix from selling our more premium products of basics, wilderness and freedom faster than our life protection formula and we get positive mix for selling wet tree and other feeds faster than our dry formulation. And you saw some of that in our Q2 results. So from that standpoint, we're working on those as I said everything will day, every single month. But then there's also structural changes that we’ll have going forward. So, once we're through the commissioning and the scale up and ramp up of our new facilities, then you will see an additional step up, step function improvement in our gross margin. But that won’t be until 2019.

[Dara Mohsenian:]

Okay. And then, accounts receivable were up significantly year-over-year in the quarter. Can you just run through what drove that perhaps at the innovation, but any clarity there would be helpful on what you're expecting the back half of the year on that one [indiscernible].

[Kurt Schmidt:]

Sure. From a working capital standpoint, when you look at our year to date look at our balance sheet and you look at our year to date cash flow, there were some differences in AR, part of that was - the biggest part of that was a tax receivable. So from that standpoint what we saw was a change in that particular piece. The other area that I draw your attention to in working capital is inventory. So inventory, we grew our inventory since year end, modestly around 4% to 5%. And that really reflects the actual increase in our topline sales. But quarter-to-quarter, what we had experienced at the end of Q4 last year and in Q1 this year is that we had some inventory sell down as our sales grew faster than our projections and as a result our inventory levels dropped a little bit. We took the opportunity in Q2 to rebuild our inventory levels to more normalized rates.

[Dara Mohsenian:]

Okay, thanks.

[Operator:]

Thank you. Our next question comes from the line of John Baumgartner with Wells Fargo. Your line is now open.

[John Baumgartner:]

Hi good afternoon. Thanks for the question. I like to ask maybe a bit more big picture, in terms of your comments around moving pet parents from FDM into specialty. It seems though the traditional players in FDM are investing more in all natural and in Greenfield themselves. They are supporting it with more brand building as well. Can you speak a bit to the competitive dynamic there, maybe how it impacts the migration of consumers into specialty going forward, does it make for more heavy lifting on your part, does the fall on the supers themselves the retailers to kind of shoulder that and kind of level the playing field or just curious about that dynamic going forward.

[Billy Bishop:]

Sure John this is Billy. Again, this is something that I would say is it new. We've seen a lot of these major brands put significant marketing dollars behind their natural brands if you will be it Nestle Purina with Pet Promise, Canyon Ranch, Morris with sensible choice and with neutral, Colgate obviously has done some of that in the past. So, for us it's really nothing new. So, obviously we're continuing to watch what the bigger companies are doing and what's happening in FDM. But we really love again the specialty channels given how we can market our line of blue products. As you know, we have four unique product lines that are designed to meet the special needs of all dogs and cats be it lifestage of breed size, and each one of our product lines has different pricing strategies. So we feel we are in a good position to continue to execute our marketing model bring folks from those FDM channels into specialty and find the right product that meets their pet specific needs and we think that's a way to win for the long term.

[Kurt Schmidt:]

And John, this is Kurt just to add to that, again I'd remind you of our performance, the double digit consumer takeaway, so we continue to build the brand. In fact as I said in my opening comments, we have created the mainstream brand and wholesome natural the power brand been wholesome natural.

[John Baumgartner:]

Great. I guess maybe just to build on that. Is it your sense right now that with all the activity going on in FDM and the heightened activity around some of the innovation new products that there is really not a link between that and the slowdown in the Pet super challenge in terms of just traffic?

[Kurt Schmidt:]

This is Kurt. No, I think that's more of a macro issue. I think if you look across retail, you have seen some of those effects across different types of retailers.

[John Baumgartner:]

Okay, thank you very much.

[Operator:]

Thank you our next question comes from the line of Joe Edelstein, with Stephens Inc. Your line is open.

[Joe Edelstein:]

Thank you and good afternoon everyone.

[Mike Nathenson:]

Hi Joe.

[Kurt Schmidt:]

Good afternoon Joe.

[Joe Edelstein:]

So, Billy you mentioned just a few of the brands there, I was hoping you could just expand on that and let us know if you are seeing new product launches, new reformulations that are coming down the pike year that you want to make sure that we’re all aware of and really just the question is, on the assumption that the legacy brands aren’t just going to stand idle here that they are looking the gains that you are posting and that there would be some additional level of competition coming at some point I would think, but I'd love to get your thoughts there.

[Billy Bishop:]

Yeah, Joe, it's kind of the same story. We’ve been competing against these bigger brands for some time now and they've gone through their course of natural type products. So, again, this is something that's not new and we know that these legacy brands are always looking for something new to bring to market. So I guess net-net there's really nothing new to report at this time.

[Kurt Schmidt:]

This is Kurt. The only thing I would add to it, again, you have to go through the history of this category over the past 10 years, it's been incredibly competitive. And I can go down the list of the elephant’s graveyard of brands that have come in and out from the multinational legacy companies like that PetPromise [indiscernible] Mars’ SENSIBLE CHOICE, NUTRO’s Performance, the list goes on and on. So I have to put in that context. With that said, we've been in a hotly contested – I mean, obviously, the dynamics of this category is so great, and with the stickiness of the category, it's obviously very attractive. And you see – if you look over the history, you get some winners and you get some losers, people are going up and people are going down. I think the one constant in that is Blue has continued to perform.

[Joe Edelstein:]

Yeah, it's been a very impressive track record as you've built and – as you go forward, I'm curious how much benefit you might expect around pricing. I think you mentioned some favorable pricing really relative to the discounting from a year ago and probably something on the order 400 basis points or so – just how sustainable is that and is there some additional benefit related to those promotions as they were winding down, say, a year ago in the back half that you can still cycle positively here as you think about this second half in 2016?

[Mike Nathenson:]

Sure. What I would say is that, I don't see 400 basis points of pricing. I think that the way we look at this is we actually break it down into gross pricing and then we look at figuring out the best way to optimize our trade promotion dollars as we think about it going forward. So let me just talk about gross pricing first and then we will talk about how we manage our trade dollars. First on the gross pricing level, this category has been able to cover inflation with pricing over time. So if you look back 5, 6, 10 years, you see a constant ability to actually reflect in pricing any kind of commodity increases or commodity shocks to the system. And Blue has been no different. We've been able to do that. The gross pricing actions we took at the beginning of the year were on SKUs that just covered a few areas. They actually kind of covered some of the inflation that we had seen in some of our exotic proteins and we had talked about that back in the earlier quarters. Now as it relates to how we manage our trade spending, we want to make sure obviously that we are competitive and always looking to get better, stronger and faster in a way we manage our production dollars. Typically, what we've seen is we've seen the sharp discounts like we talked about in our prepared remarks really don't generate incremental consumption. Remember, pet food is – a dog or cat doesn't eat more just because you bought it on sale. It really just give you a pantry loading. We're always trying to get, as I said, better, stronger and faster and optimize our trade spending and merchandising. And you can see that in some of the ways that we pull together our programs early in the year. And Billy, do you want to talk about some of the earlier programs that we did?

[Billy Bishop:]

No, I mean, I think for us, it's about again working with our retail partners in creating the most effective and efficient promotions given the depth and breadth of our product line and how we go to market. We like to leverage obviously both in store activities with our out of store activities to make them go and I don't think we're going to change from that strategy for the second half of the year.

[Joe Edelstein:]

I appreciate all the commentary. And just last question is, at what point might you look to update some of those longer-term targets, the 2018 targets particularly around the gross margin level, obviously, there is already been a couple questions asked on that for how it’s going to look in the back of this year, but the progression over the next few years should still be quite meaningful just in terms of does it actually go higher than some of those 2018 targets is certainly I think on everybody's mind here.

[Mike Nathenson:]

I think you're absolutely right and you're actually spot on in your analysis. I way I think about it is and the way we’ve constructed it is, we changed our gross margin – I'm sorry our long-term guidance to reflect 10% and 20% EPS – our 10% top line growth and about 20% EPS growth. When you tumble the numbers, really what you have to do is you have to increase your gross margin in order to hit those numbers. Back when we originally gave gross margin guidance and long-term guidance, it was with the backdrop that we were delivering 39% gross margin. And part of our construct was that we needed to improve gross margin through the ramp up and commissioning of our Heartland facility. And as a result, we actually laid out back then the 10% plus 20% EPS growth with gross margins in the mid 40s. While you can see we're actually getting very close to that now. And going forward, we expect to continue to do better. I had already mentioned earlier on the call around the things that are driving our gross margin around mix, productivity, and then also from 2018 and 2019 standpoint, we're going to ramp up and to commissioning on our new plants, so there's going to be a little bit of a headwind to gross margins back then in 2018 just like there was some headwind when we commissioned and ramped up Heartland in 2015. And then in 2019, you will see a gross margin step up. But again, we're very optimistic. We feel like we've got a track record of actually delivering gross margin improvements consistent with our commitments, and we expect to do the same in 2018 and 2019.

[Joe Edelstein:]

That's great and good luck for the rest of the year.

[Mike Nathenson:]

Thanks.

[Kurt Schmidt:]

Thank you.

[Billy Bishop:]

Thank you.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from the line of Phil Terpolilli with Wedbush. Your line is open.

[Phil Terpolilli:]

Hi, everyone. Thanks for taking the question. Just a couple of quick ones. We talked a lot about gross margin, but why don’t you just kind of revisit SG&A a little bit, it looks like still ramping this quarter. I guess, one, can you just break that down a little bit more sort of the incremental that we've been seeing and maybe how much is that in international versus anything else you are doing and then still any sense of kind of bigger picture when we can actually start to get a little more leverage on that line?

[Mike Nathenson:]

Sure. I think the one thing that we really hang our hats on is our ability and our consistent focus on the way we manage SG&A. In previous quarters, we talked about our approach, our overall approach is to hold the line on overhead costs. We want to keep that – our target is to keep that close to inflation levels. We want to make sure that in our existing businesses that we continue to invest in our brand building, marketing, advertising, everything – which is consistent with our top line growth. And then we want to make sure that we also invest ahead of scale and ahead of curve on our new strategic initiatives, which are in this case the therapeutic side as well as our international business. And so we're still hold to that. We look at it very closely. We are patient investors, but we're also very, very prudent. So as we go ahead and we ramp up our SG&A and as you correctly pointed out, our SG&A is increasing this year. We're also making sure that the way we spend it is very prudent and that we also make sure that we're looking at key milestones, so each one of our business we monitor key milestones. And we want to make sure that it's kind of meeting our expectations and making sure that the size of the prize is still as attractive and as exciting as it was before. And in this case that is absolutely the case here.

[Kurt Schmidt:]

Yeah, and just a reminder – this is Kurt. When you think about one of those strategic pillars in that, it's really important to remember it has to big functions for us. First one, as we said, is to engage the vets because they are the number one recommenders of pet food, very important to us and we are now doing that. We now have a phase to the vet. The second one, as we said, is enter the $1.7 billion therapeutic market that's growing at about a 5% CAGR, that is basically three players and there's no way to get a full line of wholesome natural. 18% of the market is wholesome natural, and we're bringing natural products to therapeutic. So the strategic side of that is very, very important.

[Phil Terpolilli:]

That's really helpful. Thanks. And then just one quick last one. One of the sort of big mass players bought a company this week that participates in e-commerce channel. Any thoughts there? I know in the past you’ve talked about really trying to stay away from distributing in the FDM channel, but are certain things like this creating different opportunities for you? Thanks.

[Billy Bishop:]

Sure, this is Billy. We’ve been on that site for a little while as well as other specialty brands too. Our understanding at this time is that they are going to run that business separately, but we have no plans to go to food drug and mass at this time.

[Phil Terpolilli:]

Okay, thanks a lot.

[Operator:]

Thank you. Our next question comes from the line of [indiscernible] with JPMorgan. Your line is open.

[Unidentified Analyst:]

Good evening, guys. I wanted to ask about the progress you are making in Japan and Mexico. You launched in those markets at the end of last year. I wanted to see whether you are on track with your initial plans and how long it will take for you to start considering entering other markets as well? Thanks.

[Billy Bishop:]

Hi, Sofia [ph], it's Billy. We are in the distribution building phase in both countries and we've been able to say obviously expanded distribution growth in both countries quarter over quarter, so that's a key metric for us right now is making sure that we're getting into the doors that we are trying to get into. On top of that, pet parent takeaway is positive. As Mike alluded to, we still see the size of the prize as big as ever. So we want to be a mile deep and an inch-wide as it relates to our international plan. And so far we are getting some good learnings and I think we will see some more meaningful contribution as we look into 2017 and beyond. But early signs again are focused on distribution and we are liking what we're seeing so far.

[Unidentified Analyst:]

Okay. And a separate question just on the long-term commentary about 2018 potentially being the year where you incur some of the startup cost for the new plant. I guess is there a way that this benefits from favorable mix and productivity could offset the startup cost or is that a year where you, at this point, always see gross margin being under pressure?

[Billy Bishop:]

No, no, no, it’s all of the above, right. My commentary around the things that are happening every day, every week, every month, is the positive mix. It’s the productivity. Obviously that will continue as we go. And all I’m saying is that just like at the Heartland, whenever you startup any new plant, there's always some startup and ramp up and commissioning costs associated with that. And then as it gets closer, when get – when we finish up 2017, we talk about 2018 guidance, I will be able to provide a little bit more detail to that.

[Unidentified Analyst:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line David Driscoll with Citi. Your line is open.

[David Driscoll:]

Sorry, thank you. I was on mute there. Just a couple of quick follow us. First, Mike, can you quantify the pipeline fill on the WTO 23% growth in the second quarter?

[Mike Nathenson:]

In total, as I said, when you look at the inventory build, primarily the largest piece of that was overall inventory catch up and then there was primarily some pipeline bill. But we are still expecting as we look at the full year for our WTO growth that it’s still going to be very robust, it’s still going to be ahead of dry and it's still very good. I think when you look at the Q2 underlying growth rate for WTO, it was in the teen.

[David Driscoll:]

Okay. Billy, I wanted to ask – just a little bit more color on WTO and specifically what I saw in stores with some more promotional activity with the dry products and then encouraging the wet purchases. So when I look at this, I don't know the – from your comments, if I can tell the difference between the momentum that you saw in wet product versus the momentum that you saw treats, where are you doing a little better and where do you want to continue to see some improvements?

[Billy Bishop:]

Sure, David. Again, as I mentioned in earlier calls, we're focusing more obviously on how we can accelerate our growth with our wet treat and other type products. You've seen us, I think, bundle some wet treat products with our dry foods both from a merchandising standpoint and from a promotional standpoint. And that seems to be working well for us. And there's obviously we have some innovation. So the key is that we continue to focus on driving relevant innovation, making sure we're communicating to pet parent effectively letting know that they can find wholesome natural products within wet treats and other. We've been expanding our penetration of wet treats and other in our underpenetrated or underdeveloped channels. So we're not going to take your focus away from that, and that's something we will continue to work on for a long time.

[David Driscoll:]

Great. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Andrew Lazar with Barclays. Your line is open.

[Andrew Lazar:]

Hi, thanks for the quick follow-up.

[Mike Nathenson:]

Hi, Andrew.

[Andrew Lazar:]

You are saying how you expect superstore takeaway to start to accelerate a bit in the second half. I was wondering if you had seen I guess any early evidence of that in July or early August yet that's notable or if not yet? Thank you.

[Mike Nathenson:]

Andrew, this is Mike. We don't give commentary kind of mid-quarter. We are very comfortable in the full year and thus we are very comfortable raising our full year guidance. And from that standpoint that all took into account all the growth that we've seen in July and through August 10 of what we are selling. So, as I said, it's all baked in there and we're confident in our number.

[Andrew Lazar:]

Got it. Thank you.

[Operator:]

Thank you. This concludes today's Q&A session. Mr. Schmidt, I would now like to turn the call back to you.

[Kurt Schmidt:]

Thank you. Thanks again to everyone for joining us. It was a pleasure sharing our strong Q2 results with you and we look forward to talking again when we report our Q3 results in November. I also want to thank – take the time to thank our herd members around the world for really making things happen. Thank you guys.

[Operator:]

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