The Honest Company, Inc.
Q3 2022 Earnings Call Transcript

Published: 10 Nov 2022

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the Honest Company’s Third Quarter 2022 Earnings Call. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to Mr. Steve Austenfeld, Vice President, Investor Relations at Honest Company. Please go ahead, sir.

[Steve Austenfeld:]

Good morning, everyone. Thank you for joining our third quarter 2022 conference call. Joining me today are Nick Vlahos, Chief Executive Officer; and Kelly Kennedy, our Chief Financial Officer. Before we start, I’d like to remind you that we will be making certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook of our business and other matters referenced in our earnings release issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our earnings release issued today as well as our SEC filings for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events, except as required by law. Also, during this call, we will discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in the financial results section of today’s earnings release. A live broadcast of this call is also available in the Investor Relations section of our website at investors.honest.com. With that, I’ll turn the call over to Nick.

[Nick Vlahos:]

Thanks, Steve. Good morning, everyone, and thanks for joining us today. As noted in today’s earnings release, we delivered revenue of $85 million, the largest single quarter in our 10-year history. This strong performance reflected our focus on 3 strategic growth priorities

[Kelly Kennedy:]

Thank you, Nick, and welcome, everyone. I’ll start by highlighting our top line performance in the quarter, where revenue was up 2% versus a year ago on top of our highest single revenue quarter last year, slightly ahead of our expectations. Revenue was up 10%, excluding the impact of a prior year rotational club channel program that didn’t repeat this year. While we remain cautious as inflation continues to weigh on costs and impact our margins, we are taking action to mitigate higher input costs, including pricing actions, cost savings initiatives and a focus on margin-enhancing innovation. Starting with the key driver by product category. First, Diapers & Wipes. Our diapers and life business represented 65% of revenue this quarter and was up 3%, following 9% growth in the second quarter. Growth was balanced with positive trends in both volume and pricing and positive year-over-year trends across all of our key retail customers. This quarter, we also shipped initial orders to support the rollout into Walmart retail stores. In the Diapers & Wipes, we are seeing acceleration, particularly in larger sized offerings, which provide the best value to a consumer on a per unit cost basis. I also wanted to highlight the momentum in our baby wipe, which grew at more than double the rate of the overall category, driven by alternate uses of wipes beyond diapers. In Q3, we relaunched our training camp, which completes our clean conscious cipher portfolio. During the quarter, we leveraged a multi-tier strategy of marketing, packaging improvement, expanded shelf placement and stronger price positioning as we increased our assortment from 450 to 1,5 00 Target stores. Skin and Personal Care represented [Technical Difficulty] Our Health & Wellness business saw a big step-up in revenue versus recent trends, increasing 115% and representing nearly 10% of revenue. Growth in the quarter was driven by our baby clothing business, which converted from a royalty arrangement into a conventional supply arrangement in the third quarter, which allows us to recognize the full revenue and associated costs. This new arrangement was almost a year in the making, as we recognize the growth potential of this business and ability to cross-merchandise and leverage our existing consumers and customers. We expect to scale on a state clothing within our retail footprint in 2023, and over time, benefit from scale and operational efficiency. A great example of the growing demand for our honest pajamas made for family and baby made from organic cotton is the recent feature for the second year in a row as 1 of Oprah’s favorite things for the 2022 holidays. Combined with new gifting collections launching in Q4 and the sanitizing business, which has stabilized, we expect to build household and wellness revenue back to expected levels over time. Now turning to results by channel. Revenue in Q3 was split roughly 60% retail and 40% digital. This quarter, our business skewed more heavily towards the retail channel as we ship new distribution and continue to face softness in the digital channel. Digital channel revenue declined 14%, driven by an inventory adjustment at a key digital customer and a reduced digital marketing spend in the face of elevated advertising costs. As we’ve noted in the past, order patterns from retailers can vary, often driven by algorithms either outpacing or trailing consumer demand. In this case, consumption of this online retailer remains strong, up 20% in the quarter, while revenue was down over 20%. As more and more retailers are focusing on working capital, we expect further impacts from inventory reduction in Q4 despite solid underlying consumption trend. Over the coming months, we will be working closely with retailers to ensure they maintain adequate supply to meet consumer demand. As highlighted on previous calls, we have strategically shifted our marketing spend to invest in higher-return programs such as shopper marketing, which is reflected in our double-digit retailer growth in the quarter. Despite near-term challenges for our digital business, we continue to believe it will drive meaningful growth in the future and are investing to support the honest.com experience. During the year, we invested in site speed improvements, a modernized site layout and dynamic content tailored to consumer brand interest. These investments are delivering as we meaningfully improve the quality of our subscriber base this quarter and achieved a click-through rate that exceeds industry benchmarks. We look forward to sharing further developments with you in 2023, including the rollout of the new rewards program. Turning now to retail, where revenue increased 17%, including double-digit growth at our 5 largest customers in the retail channel. Highlights included a 16% increase at Target supported by our 83rd consecutive weeks of year-over-year point-of-sale growth, our participation in the 30th exclusive seasonal diaper program and an 8-foot natural shelf rack as part of the new baby planogram. The rollout of our hero skin care products in acne line in over 600 Ulta stores, with 10 skin care items in-store and a broader assortment online, including cosmetics, with velocity to date exceeding expectations. 5 0% year-over-year growth at Kroger since launching Clubbox Diapers earlier in the year, which has led to Honest being the #1 clean and natural brand in their stores. And our launch in public, a leading grocery chain in the Southeast where our personal care items are already achieving top velocities in the category. Retail growth was also driven by the launch of diapers, wipes and personal care items into over 2,500 Walmart stores, which offset the revenue generated last year in the club rotational program. Now turning to gross margin. Gross margin was 30.3% in the third quarter of 2022, a 30 basis point sequential improvement versus the second quarter as compared to 36% in the third quarter of 2021. This reflects approximately 825 basis points of higher supply chain costs versus the prior year, negative 170 basis points from mix and trade spending, offset by roughly 425 basis points from pricing and cost savings. The biggest impact came from higher product costs, including inbound freight, which increased approximately 510 basis points versus a year ago. This increase was generally in line with our forecast. In addition, fulfillment costs increased approximately 315 basis points versus a year ago, which was higher than expected due to labor warehousing costs. These higher costs were due to a combination of the timing of inventory receipts in shipments to support new retail distribution as well as the impact of the consolidation of our Fontana warehouse into Las Vegas causing short-term operational inefficiencies. We expect these costs to remain elevated through the end of the year. While some spot rates for inbound ocean freight and U.S. trucking have come down, any benefit would take some time to be seen in our margins as we capitalize inbound costs into inventory. Also, we’re mindful that the decrease in rates earlier in the year quickly reversed, eliminating any upside so the sustainability of any cost decreases remains uncertain. During the quarter, we reflected the full benefit of pricing taken earlier in the year, which enhanced margin by 375 basis points. As Nick noted, we are pleased with the execution at retail stores as our price gaps versus conventional products remain in line and consumer reaction to pricing has been in line or better than anticipated. In track channel data for the quarter, we have seen increases in both volumes and sales in our category. In the third quarter, we announced additional pricing to retailers on a select number of diapers, wipes and personal care items, taking effect mid-December with price increases in the mid- to high single-digit range. Given the continued cost pressures facing all companies and price points currently in the market, we believe taking pricing now on select items will be successful in the market and further helped to offset cost pressures in 2023. Regarding input cost pressures, we are facing continued inflation impact on key commodities such as [indiscernible]. We are currently evaluating options for offsetting these cost pressures, which may require a combination of additional pricing, pack size optimization and other cost initiatives to deliver margin targets as we move into 2023. Turning to operating costs and profitability. Operating expenses increased $3 million this quarter, but were flat excluding costs attributed to a $1.5 million donation of sanitizing products and $1.6 million in litigation expense. As we work to align inventory to demand, we have looked to various strategies to address excess inventory in sanitizing products, which includes leveraging our partnerships to support charitable programs with Honest product. The donation reflects our commitment to social responsibility and build on our long history of product donations to benefit those in need. Marketing spend was 14% of sales, in line with our planned support for the Honest brand and reflected a higher level of retail marketing support versus a year ago. Adjusted EBITDA for the third quarter of 2022 was negative $5.6 million. Excluding the product donation, adjusted EBITDA was negative $4 million. We ended the third quarter with $41 million in cash, cash equivalents and short-term investments with no debt. This quarter, we invested $15 million of our cash in higher inventory and accounts receivable as we executed our Walmart launch into over 2,500 stores nationally and brought our baby clothing business in-house. Both of these initiatives will materially boost our revenue growth in 2023. Going forward, while we expect our absolute levels of inventory to increase as our business grows, we expect our inventory turnover ratio to improve as we gain greater understanding of consumption patterns with our customers and recognize the benefit of our warehouse consolidation executed earlier in the year. We believe the company’s increased investment in working capital supports the growth of the business and don’t anticipate it having a material impact on the company’s cash position going forward. Turning to our fiscal year 2022 outlook. We are updating our full year revenue outlook to be in the range of $310 million to $315 million, reflecting inventory adjustments at a key digital customer who reduced its weeks of supply. Our consumption remains strong so we are working closely with all retailers to ensure they are able to meet consumer demand. We expect full year gross margin to be between 30% and 31%, reflecting approximately 6 00 basis points of higher supply chain costs versus 2021 and 100 basis points in incremental trade investments, supporting new distribution, offset by roughly 35 0 basis points from pricing and cost savings. We continue to expect full year adjusted EBITDA to be in the range of negative $10 million to negative $20 million, but narrowing closer to negative $20 million. This reflects positive adjusted EBITDA in the fourth quarter, which assumes sequential gross margin improvement, lower seasonal marketing spend and aggressive management of controllable costs. It also assumes no further material increases in product and fulfillment costs. Before we open it up for questions, I’d like to share our preliminary view on revenue for the first half of 2023. Our first half revenue outlook for 2023 is for revenue growth in the range of 7% to 10%. This contemplates the retail distribution expansion in the second half of 2022, a new round of price increases on select diapers, wipes and personal care items effective the middle of next month, balanced by uncertainty in U.S. consumer spending and continued tight inventory management by retailers. As the year progresses, we will be lapping 2 significant events, the benefits of material 2022 retail expansion and back half revenue from baby clothing. We will provide a more detailed 2023 outlook on our fourth quarter earnings call in March 2023, including gross margin and adjusted EBITDA outlook. In conclusion, I’m pleased with the momentum of the business as we expand our omnichannel footprint and make Honest products more accessible to consumers in the U. S. and abroad. As we bring 2022 to a close, we are pleased that a number of factors that created volatility in our results over the last year will largely be behind us, including COVID impacts on our household and wellness business, digital demand volatility, onetime rotational program, inventory retailer rebalancing and unprecedented inflationary pressures. We have set a solid foundation for growth in 2023 and are confident in our ability to deliver more consistent top and bottom line performance in the coming year. With that, I’ll turn the call over to the operator, and we look forward to answering any questions.

[Operator:]

[Operator Instructions] Our first question will come from the line of Laura Champine from Loop Capital.

[Laura Champine:]

It’s Laura from Loop. My question is on the consolidation of the baby clothing line. What’s the strategic rationale? And could you be more specific on the contribution to revenues this quarter, next quarter and first half of next year since you’ve provided an initial revenue outlook? Also, I’d love to hear the impact to adjusted EBITDA?

[Nick Vlahos:]

Yes. I’ll start off, Laura and give you some context around the strategic kind of rationale. When you think of this business, we’ve kind of been involved with it through a licensing arrangement for about a couple of years. So we’ve been monitoring it closely. What we like about the business is kind of 2 things. Number one, the digital component to this around acquisition and how we drive our AOB and kind of monetize that honest consumer kind of in that early life stage is really attractive because what we’re talking about here is opportunities to really drive gifting, which obviously not only in baby clothing, but our personal care business, our diaper business will start to offer more holistic solutions. And then the second thing that also is attractive is kind of the overlap in the consumer, about 8 0% of the consumers that are out there, there’s an overlap between the Target as it pertains to the Honest consumer from a personal care perspective as well as diaper perspective. And we think the bundling solutions around this initiative are really attractive. So this is something that, again, has been in the works for a little bit. It also gives us the opportunity as we think of household and wellness as we think of the size of that category and what we were anticipating when we did the to be able to kind of solidify that part of our business moving forward. So from a volume dollar perspective, it’s also attractive. And then we talk about kind of the incrementality of this. The way I would think about it is this initiative as well as Walmart as we look at next year will drive about 5% to 7% incremental growth on an annualized basis. So when you take a look at both the new business from a Walmart standpoint as well as now the baby clothing, we think the incrementality of this is attractive, and I’ll let Kelly give some more details around the financials about it.

[Kelly Kennedy:]

Laura, so for the quarter, the Honest baby clothing was just under $4 million. It is -- tends to be a little more seasonal in nature. So Q3, we anticipate being the largest quarter as it relates to revenue as we ship on maybe closing out to retailers in advance of the holiday. While we only entered into the agreement about half way through the year it was anticipated and planned within our numbers and they are run rating roughly to be about a $15 million business this year with significant growth projected for this year, and going forward, big opportunities as Nick mentioned, not only to leverage our kind of distribution in the future. Starting with the current arrangements kind of the overall margin structure and EBITDA structure is kind of at par with the potential to be favorable as we consolidate within -- in 2023 within our warehouse facility. One moment for next question come from the line of Brian Spillane from Bank of America.

[Laura Champine:]

This is John Keeper on for Bryan. So looking at the release, you guys mentioned the 8 points of drag as you lapped last year’s rotation program in Skin and Personal Care. Adjusting for that, it implies -- I mean, correct me if my math is wrong, but it implies 16% to 17% growth otherwise. Is that a better gauge of the underlying momentum in that business?

[Kelly Kennedy:]

Yes. I think if you look at the underlying, we would suggest you look to kind of the recent consumption data. We did highlight in the release that we had a 12-week tracked data was up 6%. If you look at the most recent IRI data that just came out through 10

[Laura Champine:]

And if I could have a follow-up on. So Walmart is -- was basically offsetting the rotation program left, so that’s about 6-ish million. Is there any public pipeline fill in the quarter as well?

[Kelly Kennedy:]

No, we did expect that some of that Walmart Q3 shipment was pipeline. There was no other material pipeline still for the quarter.

[Operator:]

[Operator Instructions] Our next question will come from the line of Andrea Teixeira from JP Morgan.

[Unidentified Analyst:]

This is Shabana Choudhary [ph] on behalf of Andrea. I just wanted to quickly ask about now that retail channel makes up a bigger portion of your sales at 60% versus digital before. Can you please go over like your margin dynamics and like for retail versus digital? I mean you did elaborate on the marketing being lower for retail versus digital and you’re shifting away into retail more. But can you please go over like the other margin profile? Is it better? Or how do you see it going forward?

[Nick Vlahos:]

Thanks for the question. I would first kind of give context as it pertains to kind of that 60-40 split. So as an omnichannel business and what we’re driving here that’s unique is driving that accessibility in multiple places within the market. We’ve seen kind of digital soften over the last year because now consumers have gravitated kind of post this COVID period more into store. So as we’re starting to drive a broader distribution and driving accessibility with partners like a Walmart, partners like Publics. We’re going to be able to now make that product accessible broader, and it’s also going to help us from a volatility perspective because now we have broader distribution of digital softer, you got places to be able to offshoot kind of the overall revenue piece around other different markers from that standpoint. On a margin basis, it’s almost equivalized. So when you look at digital, versus retail, we have equivalized margin structures between both retail as well as digital. And I know Kelly got some additional context as certain kind of fulfillment as well as the overall footprint. So I don’t know, Kelly, if you want to add.

[Kelly Kennedy:]

Yes. If you think about it in terms of the retailer margin, pretty much equivalent to the fulfillment costs associated. That’s where we kind of come relatively in line between our 2 channels. I will mention that kind of certainly as we expand and retail growth we have, as we’ve highlighted we are getting better marketing efficiency and seeing better returns such that as you can see, marketing spend at about 14% for the quarter, historically, it’s at slightly higher levels than that. But we feel that we can pull back on marketing set because we’re getting the return. And a lot of that is around the shopper marketing that we’re doing in partnership and the ability to amplify that marketing to our retail partners. . In addition, there is some slight trade efficiency as we think about just kind of dilution spend as it relates to retailers. And so over time, we’ve always highlighted as the business grows, we do think there’s a potential for digital to have better margins. But again, at the scale we’re at right now, they’re relatively in line with our retail margins.

[Operator:]

And now I’ll turn it back to our CEO, Nick for any closing remarks.

[Nick Vlahos:]

I appreciate the participation today. I would just say from our standpoint, kind of 3 things

[Operator:]

And this concludes today’s conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.