Flowers Foods Inc (FLO) 2004 Q2 法說會逐字稿

Welcome to the Flowers Foods second-quarter 2004 conference call. At this time all participants have been placed on a listen-only mode and the floor will be opened for questions following the presentation. It is now my pleasure to turn the floor over to your host, Marta Turner, Senior Vice President of Corporate Relations.

Good morning, everyone. Participating in our call today will be George Deese, Flowers Foods President and Chief Executive Officer, and Jimmy Woodward, our Senior Vice President and Chief Operating Officer. George and Jimmy plan to discuss our results and then take your questions. But before we start I want to remind you that Flowers Foods will host an analyst day in Atlanta on the 23rd of September and we hope you're planning to be there. If you have any questions about that event please call me.

I also must remind you that our presentation today may contain predictions, estimates or forward-looking statements. Our use of the words expect, believe or similar expressions will identify those forward-looking statements. While we believe them to be reasonable, these statements are subject to risks and uncertainties that could cause actual results to differ materially. In addition to some of the matters we'll discuss during the call, important factors related to our business are described in our filings with the SEC. Now I'm pleased to introduce Flowers Foods President and Chief Executive Officer George Deese.

Good morning and thank you for joining our conference call this morning and for your continued interest in Flowers Foods. Our company's performance continues to reflect the competitive advantages we worked to build through several decades. As you see in our news release, our second quarter was very good. In the face of a tough environment with the consuming public, and with higher cost ingredients, energy, healthcare and the startup of a new bakery in Denton, Texas, our sales did increase 6 percent without the variable interest entity and our income from continuing operations increased 8.7 percent. I'm happy to report that when reviewing IRI and panel (ph) data for the 12 weeks ending July 11th, we outperformed the packaged bread category. I will tell you more about our products and brand performance in a few moments, but first Jimmy will discuss our financial performance.

Good morning and thank you for joining the call and again want to reiterate that we think this was a good quarter in what has proven to be a difficult environment. Let's look at our consolidated financial statements, our statement of income first. Our Q2 sales of 360.7 million represent a 7 percent increase over the same quarter last year. The consolidation of the variable interest entity this year created approximately 1 percent of that increase. So the core business accounts for an increase of about 6 percent. The growth was due to 4.2 percent in volume increases and 2.3 percent in pricing which was offset then by about a half a percent decrease due to mix.

The unfavorable mix change was primarily in the specialty group snack products where we continue to have higher contract production. Flowers bakery continues to execute and penetrate in existing DSD markets and expand our DSD territory. Sales of our Nature's Own bread products continue to increase and foodservice sales increased in both the bakery's fresh distribution and in specialty frozen distribution on higher volume. The bakery's fresh bread sales under store brands and specialty snack cakes sales to the vending channel both had volume increases for the quarter.

The gross margin of 178.7 million is up some 4.1 percent over last year on the increased sales base. As a percentage of sales, however, the gross margin of 49.6 percent is 1.3 percent below the 50.9 percent reported last year. The margin decreased due to higher ingredient, labor and utility costs. The startup of the Denton, Texas plant cost us about a half a percent on the consolidated gross margin line. Our selling, marketing and administrative expenses of 143.4 million were 39.8 percent of sales, down 1.3 percent from 41.1 percent last year.

We were able to continue our focus on controlling costs while at the same time having a higher sales volume. You'll notice from the segment data the unallocated corporate expense decreased 2.5 million from last year. And we continue to incur costs related to our ongoing assessment of internal controls in our preparation for compliance this year with section 404.

The depreciation and amortization expense of 12.6 million is essentially flat with last year. The source of our interest income continues to primarily be the distributor notes with the balance coming from the cash we have invested. Interest income is reflected net of any interest expense we incur and that amount was essentially flat with the same quarter last year. The effective tax rate consolidated for the quarter is 38 percent. I'll remind you the effective rate on our wholly-owned base business remained at the historical level of 38.5 percent, but the consolidation of the variable interest entity as required by FIN 46, that is an S (ph) corporation and has no corporate tax before the consolidated numbers with our yield a lower effective consolidated tax rate.

We continue to not make any federal cash tax payments due to the tax loss carryforwards except for any alternative minimum tax, should we have any, we expect not to make any federal tax payments until 2005. And again, the loss carryforward from 2003 to fiscal 2004 was approximately $85 million. The amount reported as the minority interest in the variable interest entity represents all of the income of that entity as we have a zero equity interest in the variable interest entity. The effect of the consolidation on the financial statement is essentially they are grossed up for the variable interest entity and all of that in the net income has been eliminated.

All of the known and expected costs associated with matters related to our sale of the frozen dessert business have been reported in prior quarters so that you see we had zero in the discontinued operations for the current quarter. On a per-share fully diluted basis income from continuing operations was 33 cents per share. The diluted weighted average shares outstanding decreased since the same quarter a year ago as we did repurchase approximately 345,000 shares of our common stock during the quarter. If we turn over and look at the balance sheet, our cash position is 39.1 million at the end of the quarter. We continue to show zero bank debt and we have still left our unsecured $150 million credit line undrawn upon.

The cash-flow statement for the quarter shows 31.3 million of cash provided by operating activities for the quarter and, again, we are presenting a quarterly and a year-to-date cash-flow statement. In the quarter we used 11.7 million for capital expenditures. The Company paid approximately 5.5 million in dividends and used $8.5 million to purchase the approximately 345,000 shares in the quarter.

At this point in the fiscal year -- and again, this will be a 52-week year versus last year's 53 week fiscal year -- we have increased our previous guidance for sales by $10 million due to the additional sales expected in the state of Texas. For the year we expect sales to be 1,505,000,000 to 1,520,000,000 and this includes approximately 10 million in sales for the year from the consolidation of the variable interest entity -- and again, there is no net income reported as it's all eliminated. So income from continuing operations are expected to be in the 3.9 to 4 percent of sales range or earnings per share somewhere between $1.28 and $1.32 for the year.

The margin generated by the increased sales expected in Texas will probably be offset by costs incurred to establish the distribution. I might mention also impacting the second half will be the market impact of the hurricane that hit Florida. We do have a very good presence throughout the state of Florida. Our employees, our distributors and associates have, as always, been tremendously helpful throughout this event and we're fortunate that the Company did not experience any significant damage to our physical assets in Florida. However, the market has been and will be disrupted for both our customers and consumers. Based on the past week's performance we do not expect this market disruption will significantly impact our results for the year. With that, George, I'll turn it back to you.

Thank you, Jimmy. Once again our performance in a difficult environment shows the competitive advantages we have developed over several decades. Those being production efficiencies, better execution on the part of our team, the ability to compete effectively in retail as well as foodservice, and the strength of our brands -- Nature's Own, Cobblestone Mill, our regional white bread and our cake brands, Mrs. Freshley and Blue Bird.

Let's look at the profit categories. First of all, our local regional white bread brands, even though flat in volume, outperformed the category. Nature's Own, our soft rye brand, grew by double-digits in both units and dollars. Once again, both our core Nature's Own items and our Nature's Own health line items did very well. During the quarter you may remember that we introduced several new Nature's Own health line products aimed at the needs of health-conscious consumers. We're pleased with the performance of our new wheat and soy, our double fiber, and wheat and fiber bun and rolls. In the premium specialty category, our Cobblestone Mill bread performed well with increases driven by premium loaf breads being up double-digits.

Turning to the cake category, sales of our Blue Bird and Mrs. Freshley performed well during the quarter driven by growth in the mass and convenience store channels. On the Flowers bakery side, our cakes business grew in double digits. On the specialty group -- our special group continued to grow Mrs. Freshley sales with an increase of 4.5 percent during the quarter. Sales of our (indiscernible) product continue to build even though slowly and we expect sales of these products, as was previously said, to annualize in the $5 to $7 million range this year.

Our foodservice sales were up by mid single digits compared to last year's second quarter. We like the foodservice business. Our business model allows us to compete successfully in the foodservice arena. That's possible because of the several decades we have invested in our bakeries to make them more cost effective. We have been innovative in our approach to distribution, offering the very best service, fresh to our independent distributors or frozen through our (indiscernible) distribution systems. In short, we offer foodservice customers what they need.

Store brands and private-label was up slightly. Our strategy has been and continues to be for this private-label business in our mix where it can have a (indiscernible) branded business. In the new markets that we've talked about before that we entered this past year, sales are annualizing at about 1.5 percent for our bakeries group. That is on plan and again reflects good performance on the part of our team as well as mid market response to our products and our brands. We will continue expanding our reach in a steady and deliberate manner.

The acquisition of Sara Lee bakery groups Houston bakery and customer list for foodservice and private-label was announced during the quarter. As a result we expect to increase our sales by roughly $40 million on an annual basis, largely in foodservice. As I mentioned earlier, we do like the foodservice business. This new business is beginning to come on now even though it's slow, but by mid-September/1st of October we'll have all the customers on our existing route and we'll be adding an approximate 70 routes in our Houston, Dallas-Fort Worth and San Antonio market.

As Jimmy indicated, our new Texas -- Denton, Texas bakery started production this past quarter with buns and rolls serving the Dallas-Fort Worth market as well as our new market in Oklahoma. As a result of the Sara Lee acquisition, this will add additional volume to Denton. We expect to add other production lines to this bakery as our business continues to expand.

Taking a look at commodities. Happy to say that we have coverage for our flour and other commodities through the remainder of this year and well into 2005 at prices that will allow us to make our margins. Like most other food companies we are experiencing cost increases in a number of areas. We constantly monitor our costs and take corrective actions to improve our efficiencies and to take price increases as needed.

As Jimmy mentioned, we continued to generate good cash-flow during the quarter. As we have said before, we recognize the importance of investing where the cash will generate the best results for our shareholders. Over the long-term we expect about half to be used for dividends and capital investments and the remaining half for acquisitions of either Flowers stocks (ph) or new businesses that fit our plans for growth. Flowers Foods is in very good shape with efficient bakeries, outstanding distribution systems, great products, strong brands, extraordinary customer service and an exceptional team. Our expectation is that we will continue to outperform our industry. Now I'm happy to open the line up for calls.

(OPERATOR INSTRUCTIONS) Bill Leach, Neuberger Berman.

I have a couple of questions. I was just wondering if you could comment on the margins. If you take out your corporate expense your operating profit was actually down 4 percent and that was driven by 27 percent drop in the specialty segment which had been up 94 percent in the first quarter. So could you comment on the volatility there and the outlook for your operating margins excluding corporate expense going forward?

I'll comment briefly and then I'll let Jimmy explain on the (indiscernible). As Jimmy indicated, we did have quite a bit of product mix shift. In our cake group our costs were up somewhat and our other food companies have experienced also great costs when it comes to these types of products. But the marketplace does continue to shift and we did have extraordinary sales through our contract production business and the margins were not as good as we would have like. We have taken actions to correct that.

Bill, I would echo what George said. We did have some cost increases in things like cocoa and eggs, and energy, items that we had not fully hedged. And then I think the more significant change there in the margin was the shift -- we increased sales -- we had a good volume increase but the growth came in the contract production and then, as George mentioned, we did grow in the mass and convenience channels, but we did not have growth in the supermarket channels. And so we've got to continue to work on our mix of products in that particular snack cake area.

So do you think the specialty segment will be up year-over-year in the back half -- in EBIT?

We feel that proper corrective action has been taken and I think we should be pretty well online compared to last year in this segment.

You mean flat?

Frozen (indiscernible) is very good. Like I said, we have had some issues on our cake side, but with the action that has been taken I feel comfortable that we should be pretty close to last year in that segment.

Jimmy, can you give us any guidance on the corporate number? That was obviously a big positive variable this quarter and it was almost a little bit more than half of what it was in the first quarter.

Yes, I think again, Bill, corporate expenditures are not level throughout the year as we -- we early in the year were spending for consultants and other things trying to be prepared 4/04 compliance. We continue to incur some cost but it's obviously down slightly. I still think corporate's total spend for the year will be somewhere in that $25 to $30 million range. And if we just have to expense it as it's incurred and a lot of that has to do with third party professional services which are simply not even pro rata throughout the year.

Okay, great. Thank you very much.

Mitchell Pinheiro, Janney Montgomery Scott.

I want to look at the top line for a second. Can you break out on the 6 percent base business sales growth what was -- what your same-store same route sales growth would be? I know you said I think new territories were contributing 1.5 percent, is that correct? Out of the 6 or it's on track to -- I was a little confused there.

Of the 6 percent, Mitch, what we look at is the continued business and then what we call new territories net of any that we may have exited which I don't think that's happened in the quarter. But the continued business, of the 6 percent I'd say about 2.6 percent of that was continued business and then 3.4 percent is what we call the net new business.

And you could (indiscernible) probably broken out a little further by saying new business -- that's the expanded territory that we mentioned and also new products that went into that mix.

And that's on a consolidated basis new business for both bakery and specialty.

Okay. So what -- and of that 2.6 of continued business, there was pricing there, right? There was 2.3, so would you say the volume in your route business was less than 1 percent on a same-store --?

No, I mean we had volume increases in both specialty and bakery in the core -- what we call the continued business.

Okay. When you look at the category trends, George, you had talked about favorable IRI data, the 12 weeks ending in July. Could you share a little bit of that with us how the category did in your territory and how your brands performed?

I'll try. As we know now with IRI and panel data and other sources, I look at that versus internal numbers and I talked about now we performed. I tried to (indiscernible) look at white bread both through panel data and IRI was down. But we performed -- we were basically flat on volume but just a tick in sales.

And the category, how would you categorize the category.

In white bread?

Yes.

It was down.

Low single digits?

I think it was between 3 and 4 percent. I think the supermarkets were -- IRI was down as much as 12 percent, but then if you look at the panel data they were way over that. So I think we're probably looking at 4 percent. I think you'll see that trend regardless of what category we're talking about, with IRI being down considerably. But the panel data will be enough (indiscernible) and so forth more than offsets that in a lot of cases.

So if that's the right (indiscernible) what would the category be for the let's say superpremium or the Nature's Own and Cobblestone Mill segment?

With our soft wheat bread is probably the best way to look at it. (indiscernible) we were up double-digits in both units and dollars. If you look at IRI on soft varieties, that volume had declined and overall we did see about a 5 percent increase in this particular segment.

Including panel data?

Yes, and we were up double-digits. On the premium products, I think everyone's reporting up numbers on that, it's up considerably. I did say we were up on the loaf products high double digits (indiscernible) and I think that's probably true with the overall data from both IRI and panel data with panel data being up a lot more.

From your experience and from what you're seeing in the marketplace how would you characterize the low carbon awareness and trends if you could? Relative to where we were a quarter or 2 ago and maybe relative to a year ago.

I think there was all out of excitement 6 months ago, a year ago. I think the retailers also helped drive that excitement with the baking industry because they saw the trend as early as we did or maybe before because of other categories. I think we were I guess one of the first commercial bakers out with reduced carb which was very successful and continues to be successful. I think the bloom is off, I think it has peaked from what I can see. It will not go way I don't think the way we might envision it would go way. I think carbs, whether we like it or not, is in people's minds and are consuming less carbs in total. I think that will be with us for a while.

Let me ask you this one last question. I was expecting better margin performance in the quarter and some of that was based on this mix shift towards the premium product and it didn't quite materialize as I expected. So my questions are -- is it -- was there pricing pressure due to the new entrants? Are you seeing less of a favorable mix shift from a margin standpoint because of increased competition or with the bloom off of the rose do you need to just throw more marketing spend at that category and/or, three, is it just the ingredient, raw material, utility, labor areas that just were overpowering in the quarter?

Mitch, I think Jimmy mentioned that when you look at the margin our Denton bakery did hurt us some this quarter. It was in our plan and we knew it would take a little away until we get up and going. By the way which the bakery, I will comment, it started up wonderfully and very pleased to have a wonderful line and hopefully analysts will get out and see it someday. Very pleased with it. And we did save health care costs some this quarter. But we also have, in looking at our overall cost structure that is always ongoing. If you look at our SG&A we were actually percentagewise down someone. Margins are correctable through continued manufacturing efficiencies and continuing to look at the pricing arena. We have taken some price increases but that always we work on the efficiency side, the cost side and see if we can't take enough cost out not to have to raise prices. Ultimately the consumer is upsetting the price of the product. But from a competitive standpoint, market to market, region to region there's different things going on in different places at different times. I'd always say it's always been competitive since I've been in this industry and it continues to be highly competitive. But I think your question was should we throw more promotions in to low carb?

No, my question was that I was expecting a greater margin benefit due to the product mix shift. And since it at least -- it doesn't look like that materialized I was wondering whether it was all in the ingredients on the cost side or whether there was pricing pressure creating less of a margin for the premium products.

I would say that we did not promote as much this quarter because we did see some -- quite a few increases come in on the cost side so we didn't promote as heavily hoping that would keep our margins pretty strong. But (indiscernible) look at our margins on the key categories that you mentioned particularly Nature's Own and Cobblestone our margins were very good there.

So most of the degradation was a (indiscernible) factor and a specialty shift towards the lower margin contract baking?

Very well said. That's how we'll sum it up.

Thank you very much.

Tim Ramey, D.A. Davidson. Terry Bivens, Bear Stearns.

Two questions. First of all, just in terms of the high-end. I mean it seems like IBC is pushing pretty heavily with this Baker's Inn and Sara Lee is reporting pretty good results with the new fresh line. First of all, what have you seen from those 2 competitors and now has it impacted on your business on the high-end?

I'd say that I thought both of them -- I think they are doing a good job. I can't speak for them, I just see it out in the marketplace that Sara Lee has made an impact on their branded product -- regional brands that they own. You take all that into consideration I'm not sure of the final results, but they are doing a very good job with their presence in the marketplace. I just think it puts pressure on us to keep our Nature's Own focused and continue to press on with innovation and have a wonderful quality product with no artificial flavors, colors, preservatives and continue to build on the health line aspect of innovation. So that's what I see taking place on Nature's Own and, as I said, we're up double-digits on sales and dollars for the quarter.

It doesn't seem to have hit you too much. Let me just ask you this. I know you don't want to comment too much on a competitor’s product, but anecdotally it seems to me that Bakers Inn is getting primarily out of aisle distribution at this point in the introductory phase. Is that your experience, number one? And number two, do you think since if indeed it is out of aisle that maybe that's why it hasn't had too much of an impact on you guys because you're still in the bread aisle? Is that a reasonable way to look at it?

I do think it's a fair assessment. It comes down also to location of displays. If they're in a wonderful position, yes, you can see more products.

And last thing. I've heard some talk that Wal-Mart is pretty actively delinking the private-label business from the branded business. In other words just because you may supply them with private-label, the linkage is pretty skinny there between what they'll give you on the branded side. Has that been your experience?

Yes, I think that's a work in progress and Wal-Mart is a great customer along with -- all of our customers are outstanding customers. But it is a work in progress and that's why we worked so hard to build our brands so that they are very meaningful to the retailer and to the consumer. But that is a work in progress.

Thank you very much.

Eric Katzman, Deutsche Bank.

I don't have too many questions. But Jimmy, you said that the cost to Denton was about 2 to 3 cents a share if you work it down from what did you say? 50 basis points on the gross margin?

Yes, I think about half a percent of the consolidated of that margin shortfall, yes.

So I think that worked out at a regular tax rate to be about 2 to 3 cents.

I would say probably between 1 and 2 cents.

Okay. When does -- I think, George, you said that that facility is progressing nicely. When do you think that that cost either goes breakeven or starts to be a contributor?

Very fortunately we have not had any startup problems at all. Any time you start new bakeries, as you well know, it takes a lot of people (indiscernible) you could capitalize a lot of that (indiscernible) happens so you do have to expense an awful lot of things. We have quite honestly in training 3 shifts of people and starting up you have 1 shift of volume. But by October 1st -- September 15th/October 1st we will 3 good shifts of volume in this plant. So we'll see a big difference come October 1st.

Okay. And the second question was in terms of the fuel, can you remind me again about -- is this the fuel that you use to run your facilities or the split between what you pay or what you help out on the independent routes?

I think, Eric, what we were referencing was the oven fuel; natural gas used to fire the ovens would be the increase that we saw in the cost of goods sold line. There again, the way our system works the distributor would bear the cost of fuel to operate your vehicle. Obviously we have to, through pricing and otherwise, help with that. That would be down in selling and distribution costs.

Okay. And then in terms of the outlook on just pure raw materials -- I guess we probably hit a peak, at least it appears like a peak, in the second quarter. Soybean oil and other costs are down 20, 30 percent and I'm assuming the crop is as good as it at least appears at this point. When should that, given where you're hedged, when should that start reversing itself and give you some benefit even on like dairy and eggs and other stuff like that, that's come down quite a bit too?

I guess we have to have good news/bad news. Good news we covered well in advance because we did see it running away some so we did hedge out. If we were buying spot market today we'd be lower obviously. But any time that we feel like we can go ahead and cover our commodities and still make our margins we try to go ahead and cover so we don't have a risk for our shareholders. Obviously some of the items you did mention are coming down now and we'll begin to enjoy some of those starting the first of the year. Obviously some of the smaller items, because we don't go out a long way on some of those, we'll obviously get some help certainly in the fourth-quarter. But the big items we'll see some help coming the new calendar year and fiscal year.

Eric, our hedging programs here again are focused on the major ingredients, flour obviously being the largest. So some of the things we experienced caused pressure on them in the second quarter like it and cocoa. We should, as prices come down, immediately see benefits from those price changes. We are able to hedge about half of our natural gas usage, so half of it's (indiscernible) and the other half floats. But the cost increases that we saw in the quarter really were more on the items that we've all hedge, corrugated being another one I can think of in the packaging area. And particularly on the specialty side where we ship frozen product, we use a lot of corrugated boxes there and we had increases. So in those items I think you'll see it moderate more with the market.

And then last question. Just in terms of the outlook for CapEx for the full year, interest expense and the tax rate?

I think none of that has really changed, Eric. I think on the tax rate, again, consolidated I'd expect it to be 38 percent and that's a function of consolidating the entity that is not subject to tax. Our core business is still about 38.5 percent, but then when we consolidate in that variable interest entity we get to about a 38 percent. CapEx, we have reviewed again, closely still expect that to be in the $45 million range for the year. Interest income I, think you'll continue to see it track much like this quarter; there are no plans for that to change significantly.

Okay, thank you.

Heather Jones, BB&T Capital.

I was just wondering, were there any costs associated with the Denton facility in the first quarter?

There was some, Heather. It was a little heavier in the second quarter because we began to add shifts. In the first quarter it was more equipment installation -- building preparedness and equipment installation and then in the second quarter is when we actually began to add people. As George said, to actually get 1 shift of production up and running, but then add people for the other 2 shifts because you've got all kinds of training to consider.

Okay. So you said the impact this quarter is 50 basis points of sales?

On the cost of goods sold line I think.

50 basis points of cost of goods?

Yes.

The reason I'm asking is just trying to -- I assume that impact should be gone by next year and just trying to figure out --.

Yes, as George said, actually we would expect September 15/October 1st of this year with the new business we're gaining in Texas, that all 3 of those shifts will actually be productive and we won't have this even in the third quarter.

So you don't expect much of an impact in third quarter?

Right.

And the fourth quarter, was it more like a million, half a million?

Let me just clarify that in the second quarter the half a percent cost of goods sold, again you're looking at about 1.1 million to 1.2 million pretax on the cost of what I would call the Denton startup.

Okay.

And I don't know that I have the first quarter number here in front of me. I think it was a little less than half of that in the first quarter, though. It was under 500,000 in the first quarter.

And in the third quarter we're still in that training mood. As I mentioned, the third quarter will almost be half gone when the volumes hit. So we'll have a little more cost or some more cost the third quarter, but the latter part of the third quarter the volume will be there and we'll significantly reduce that. Fourth quarter should be very good in regard to Denton.

Did I remember correctly that you expect Sara Lee to be up and running mid-September, to have all the customers in place?

Yes.

I think you said in the release 40 million in annualized sales. So what kind of sales increase are you expecting from the Sara Lee plant for the back half?

I think roughly 10 million (indiscernible). Heather, let me make sure that we clarify the actions that are taking place there. Sara Lee's Houston facility, they will close that facility and we will acquire a closed bakery. We don't have plans to utilize that facility. We may utilize some of the equipment in other of our locations, so we're not acquiring an operating facility. We did acquire as we call it a customer list, primarily foodservice and private-label customers, and in that base of business represents about 40 million in sales is what we believe we're going to pick up there in the state of Texas. And the Denton facility will be critical and is instrumental in fulfilling the production for that $40 million base of business.

Okay. The variable interest entity, should we expect that to add a percent of sales record for the Q3 and Q4 or --?

Yes, it's roughly that, Heather. That's about what I would expect.

Okay. And looking at the back half with the specialty group, the operating margins, I think you all had said that you expect it to be sort of flattish earnings but you just mentioned cocoa and eggs coming down. Do you expect this contract manufacturing increase to be sustained through the back half?

We do. Let me clarify also a little bit more. I think if you focus on bread and rolls for a moment, the margins we have there are (indiscernible). We do have some more work to do on the cake side. Even though it's improving we're still continuing to work on increasing our margins through efficiencies and through pricing as we can get it.

Okay. And I don't know if you'll tell us this, but what drove the increase in that contract manufacturing? Who are you doing it for and what was the reason behind such an increase?

I'd rather not answer that question at this time.

Okay. Thank you very much.

David Liebowitz, Burnham.

Trying to tie up a few loose ends. When we spoke earlier about the specialty products that were a drag during the quarter, were we talking about the Hispanic lines that you introduced last year or were there other products in there as well?

No, our specialty group, David -- thanks for that question -- our specialty group consists of 2 groups; one, frozen bread and rolls, and the other division is our cake business. The cake business was a drag this quarter but it didn't have anything to do with our Hispanic project.

So that is still making progress?

Yes, it is.

Also when we look at the Sara Lee acquisition, besides the costs that you already discussed, are there going to be operating charges that we have not factored into our estimates for the back half of the year?

Not at all. Just like Denton -- Jimmy explained very well what's going on in Denton to wrap up. But to take care of the manufacturing side we've also been ramping up to take care of the sales volume through route distribution. So we've had underway and it's been charged off (indiscernible) training people in training to add these 70 new routes which will be going on gradually over the next 3-4 weeks. (multiple speakers).

There are no onetime charges or anything like that expected. Again as George mentioned, the roughly 70 routes that we're adding, this 40 million of base business is being obviously blended into the existing routes as well as we're having to add roughly 70 new routes and there are obviously costs to get those routes started, but all that has been expensed through the second quarter. There will be some more expense in the third quarter but we're still comfortable we can absorb that and meet the guidance we've put out.

The good news on that, as Jimmy indicated, about half of that volume will go on existing distributors and that's leveraged real well, and adding on 70 routes to take care of the additional -- (indiscernible) 40,000,000 in total there's no way 70 routes can do it. But because we have so many carryforwards and routes in the whole Texas market, some great synergies.

By the way, are you still selling routes to the route salesman or has that program ended?

No, we're still going through the same process.

And how many routes do we still have available for sale?

At any given time with new territories or turnover you could be in the 7 to 10 percent range of total. And I think we've announced we have roughly 3,100 territories throughout the Company.

Okay. Next, in terms of going into new territories, of late you seem to be doing this more by acquisition than internal expansion or stepout. Is there any formal policy in that regard?

David, did you say as of late?

Yes, it would appear the major expansions have come via acquisition rather than a stepout from an existing venue that you're already servicing.

I do understand the question. Historically -- you're right, historically there were so many bakeries that you could acquire with the right cost structure (indiscernible) them that it made sense and consolidation going on we (indiscernible) part of that and I think publicly we've said we've had 115 acquisitions since roughly 1968. And we still think that's growth after the Company. But we also feel like we can expand from existing bakeries from where we are today like north of Lynchburg which is on our northernmost part and we're going into the Northern Virginia market. So all the way across our boundary line we have bakeries located in a way that we feel like we can expand out that 100 to 150 miles from our present borders because we do have plants located strategically that can help us with that. That will not always be the case, we still are continuing to look at acquisition and when it makes sense operationally and financially we still grow that way as well.

I think George mentioned it was like a percent and a half of our sales growth this quarter when we talk about the new territories, those are not acquisition territories. That's where we have, as George mentioned, we've reached out beyond what had been our historical boundaries from existing plants. So our goal annually is to try to grow the sales roughly 1 percent by expanding the territory of our existing plants without acquisitions.

And last question. Looking out to next year, how much margin improvement gains are you looking for?

We're early in the planning process for next year, so I don't have a specific number to give you, David. I think probably next quarter we'll be able to begin to give guidance on next year. Certainly we look at what our cost increases -- as we've mentioned, we have some of our major ingredients hedged even into next year partially and we're really beginning the planning phase right now.

Okay, thank you very much.

(OPERATOR INSTRUCTIONS) Mitchell Pinheiro, Janney Montgomery Scott.

Jimmy, I though that your Denton Sara Lee bakery was -- the way you described that was very helpful. The one thing I did want to just understand is of the 70 routes -- so you're in the process of selling those 70 routes, correct?

Not immediately. We will be but not immediately.

And that's what we routinely do is we get the territory established first with a good base of business and then with that base of business because we sell the territories as a multiple of the average weekly branded sales, we try to establish the base first and then we sell the territory.

Okay. So are these territories -- so if 70 routes do roughly 20 million in business, that's about 5,500 a week average weekly sales, and I'm just guessing that your core routes and your base business are doing above 6,000 a week. So I would assume that from the get go these routes would be above breakeven, is that correct?

I would agree with that statement, yes.

And at the moment, are you still -- or during the second quarter did you have and were you funding these routes? I mean, were there routes -- you're paying for drivers and capitalizing their -- expensing their capital costs and things like that. Was that happening in Q2?

Yes, as I mentioned, in Denton we have the training and developing our people there, but also on the route side. We go to great extremes so we can take care of our marketplace with people who are trained and when they hit the street they know exactly how to take care of the business. So we have expensed -- we've had roughly 70 people in training now for I'd say 3 or 4 weeks.

And just to clarify, when we talk about the Denton startup, there that discussion is on the production facility in Denton which was roughly 1.1-1.2 million pretax. The expenses that we incur to have people come on, begin training for these 70 routes, those are not in the Denton start up number. And those expenses are just absorbed in our normal operations, in our normal expense as incurred.

What would you estimate that to be?

I don't really have a number. There again, you didn't have all 70 obviously all start on the same day, so we began to take on additional people immediately upon announcing the transaction and I just don't have a specific number there.

Fair enough. And when you're looking at -- Sara Lee, they're closing that facility or has that been closed.

I think they announced they will close on September 15.

So they're still servicing these $40 million worth of clients.

Yes, they are. We had some crossover but not much. That's beginning to take place over the next 4 weeks, up until that September 15th it will all be complete.

Both companies’ goals have been to take care of the customers appropriately. And so that's really a transitory process of working with the customer and with Sara Lee and ourselves to make sure the customers are well taken care of.

And then the $20 million that you have on sales that are going onto your existing (indiscernible) in those markets, that seems like it would even double their sales per route. Is that correct or a very significant increase?

Well, we have a number of routes I can tell you right off the top in the state of Texas. But between Houston, east Texas tower (ph) and the Dallas-Fort Worth market it will just be absorbed by those distributors who are already in that market.

So you have some significant fixed cost leverage there.

It certainly helps, yes.

All right, thank you very much.

Thank you. I will turn the call back to George Deese for his closing comments.

Let me thank you again for your continued interest in Flowers Foods. We're pleased with the results we reported today and excited about the future. Now we're focused on the third quarter in the second half. As discussed, we feel confident that 2004 will be a year of solid performance. We look forward as (indiscernible) brining on our new customer base in Texas along with an outstanding new bakery in Denton. We remain focused on our strategy of investment, innovation, growth and increasing shareholder value. In closing, I want to thank all of our people in Florida who in the Flowers spirit went well beyond the call of duty in serving the marketplace during and now after hurricane Charlie. Job well done. As Marta said, we look forward to seeing you at our analyst day in Atlanta on September 23rd. Again, thank you for joining us this morning. Take care.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day.