Lancaster Colony Corp (LANC) 2018 Q4 法說會逐字稿

Good morning. My name is Denise, and I'll be your conference call facilitator today. At this time, I'd like to welcome everyone to the Lancaster Colony Corporation Fiscal Year 2018 Fourth Quarter Conference Call. Conducting today's call will be Dave Ciesinski, President and CEO; and Doug Fell, Vice President and CFO. (Operator Instructions)

And now to begin the conference call, here is Dale Ganobsik, Vice President of Investor Relations and Treasurer for Lancaster Colony Corporation.

Thank you, Denise. Good morning, everyone, and thank you for joining us today for Lancaster Colony's Fiscal Year 2018 Fourth Quarter Conference Call.

Let me remind everyone before we begin that our discussion this morning may include forward-looking statements, which are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially, and the company undertake no obligation to update these statements based upon subsequent events. A detailed discussion of these risks and uncertainties is contained in the company's filings with the SEC.

Also note that the audio replay of this call will be archived and available on our company's website, lancastercolony.com, later this afternoon. With that said, I'll now turn the call over to Dave -- Lancaster Colony's President and CEO, Dave Ciesinski. Dave?

Thanks, Dale, and good morning, everyone. It's a pleasure to be here with you today as we review our fourth quarter results for FY 2018. Doug and I will provide comments on the quarter, the year, and the fiscal year '19 outlook. Following that, we'll be happy to respond to any of your questions.

For the fourth quarter, consolidated net sales increased 6.3% to $308.2 million versus $289.9 million last year. Retail net sales increased 1.7% to $156.8 million, driven by refrigerated dressings and dips along with shelf-stable dressings and sauces sold under licenses. Frozen bread was down for the quarter, as influenced by the impact of the shift in the Easter holiday from our fiscal fourth quarter last year to our fiscal third quarter this year.

On the pricing front, we continued to make progress implementing price increases with our retail customers to help offset higher commodity cost and freight cost. We also reduced the level of trade spending (technical difficulty) optimize those costs through our investment in category management tools.

Foodservice net sales grew a strong 11.6% to $151.4 million driven by segment-wide sales volume increases (technical difficulty) with our national chain customers. Pricing actions also helped to offset higher freight and commodity cost.

Consolidated gross (technical difficulty) as the favorable influences from the (technical difficulty) spending, reduced coupon expenses and cost savings realized from our Lean/Six Sigma program overcame the impact of higher freight and commodity costs.

SG&A expenses increased $3.5 million as the prior-year quarter included a onetime pretax benefit of $1.4 million from the full settlement of a class-action lawsuit. The higher level of SG&A cost also reflected higher expenditures for retail consumer promotions.

Consolidated operating income was essentially flat at $42.9 million, while consolidated operating margin declined 80 basis points due to the factors referenced above, including a less favorable sales mix as sales growth in the Foodservice segment outpaced that of Retail.

Retail segment operating margin declined from 20.5% to 19.1% (technical difficulty) influenced by the $1.4 million onetime benefit in last year's fiscal fourth quarter from the lawsuit. Other factors resulting in the reduced Retail segment operating margin were the higher costs in the quarter for freight and commodities in addition to the increased spend in Retail consumer promotions.

The Foodservice segment operating margin improved from 9.9% to 10.6% largely due to price recovery from our national accounts and pricing implemented in branded Foodservice.

Net income was $32.4 million or $1.18 per diluted share compared to $28.5 million or $1.04 per diluted share last year. The regular quarterly cash dividend paid on June 29, 2018, was maintained at the higher amount of $0.60 per share set in November of 2017.

Turning our attention to Retail sell-through data from IRI for the 13 weeks ending July 1, 2018, we maintained our share leadership position in all of our 6 categories. During the quarter, we were able to increase our share in 2 out of the 6 categories, while we saw a modest pull-back in the remainder due to our targeted pricing and trade reduction activities.

For the full year, consolidated net sales increased 1.8% to a record $1.2 billion. The Retail segment net sales increased 1.4% to $650.2 million, driven by increased sales volume for shelf-stable dressings and sauces, the incremental sales from Angelic Bakehouse, pricing actions, reduced trade spending and lower coupon expenses.

The Foodservice segment net sales grew 2.2% to $572 million. After a very challenging first half of the fiscal year, segment sales improved significantly in the second half, both with inflationary pricing and volume gains contributing to this growth.

Consolidated operating income decreased $2.6 million to $172 million from $174.7 million last year. Excluding the pretax charge of $17.6 million in the prior year resulting from the company's withdrawal from an underfunded multiemployer pension plan, operating income declined $20.2 million or 10.5%. Increased commodity costs, particularly eggs (technical difficulty) were the primary causes for the drop in operating income. These were partially offset by cost savings realized from the company's Lean/Six Sigma program and pricing action.

At the segment level, driven by the same factors that I just mentioned, Retail operating margin (technical difficulty) while the Foodservice operating margin declined (technical difficulty)

Net income totaled $135.3 million or $4.92 per diluted share versus the prior year amount of $115.3 million or $4.20 per diluted share. (technical difficulty) lower federal income tax rate, the Tax Act also (technical difficulty)

net income amount was unfavorably impacted by the cost resulting from the company's withdrawal from the underfunded multiemployer pension plan of approximately $11.5 million or $0.42 per share. The regular cash dividend was also increased during the year for the 55th consecutive time.

With that, I'd now like to turn it over to Doug to make some comments on the balance sheet and (technical difficulty)

Thank you, Dave. Overall, our balance sheet remain strong. I will make a few brief comments on the more meaningful changes in our balance sheet since last year. From a high-level perspective, nearly all of the increase in our cash balances of $63 million since last year can be summarized as follows: cash provided by operating activities of $161 million, offset by regular dividends of $65 million and property additions of $31 million. Accounts receivable balances remained in line with sales volumes and our expectations.

Consistent with past quarters, (technical difficulty) increase in inventory reflects the impact of several items, including increased sales volumes, higher input costs from commodities, balancing the production within our plants for seasonal inventory builds, and some adjustments to our days of forward coverage to maintain high levels of customer service.

As I mentioned, fiscal year-to-date cash expenditures for property additions totaled $31 million. This is in line with expectations. Consistent with our past communications, in addition to the expansion project for our Angelic Bakehouse facility this year, the largest amounts were spent on new processing and automation equipment to accommodate growth and enhance productivity.

Looking ahead, at the present time, we anticipate capital expenditures to be in the range of $60 million to $80 million for fiscal '19 and, in general, will focus on projects to increase capacity and productivity. (technical difficulty) fiscal '19 is to expand production capacity to meet increased demand for our Sister Schubert products. This project is expected to start this fall with a projected completion date in fiscal '20. Other notable projects to be completed in fiscal '19 involve a dedicated innovation center and packaging capacity for our Retail dressings.

Depreciation and amortization expense totaled $27 million for fiscal '18 (technical difficulty) about $30 million for fiscal '19. As we conveyed last quarter, the increase in our accounts payable since June (technical difficulty) an emphasis by our procurement team to extend payment terms with our vendors in conjunction with our ongoing Lean/Six Sigma efforts.

With respect to our balance sheet capitalization, not much has changed since our last commentary. We continue to have no debt, over $650 million in total shareholders' equity, and nearly $206 million in cash and equivalents. Borrowing capacity under our credit facility remains at nearly $150 million.

Finally, and broadly speaking, as reported in our past quarter earnings release, our income tax provision for fiscal '18 was favorably impacted by the Tax Cuts and Jobs Act. Our blended effective tax rate for our fourth quarter was estimated to be 28.5%, yet our actual tax rate was 26%.

The favorable difference of 250 basis points was largely due to 2 discrete items of roughly equal size. First, the continued refinement of the estimated impact of the Tax Act on our deferred taxes. And second, the impact of the new accounting guidance on the tax treatment of employee stock option exercises. Looking forward, at this time, we continue to estimate our effective tax rate for fiscal '19 to be approximately 24%.

Thanks for your participation with us this morning. I will now turn the call back over to Dave for our concluding comments. Dave?

Thanks, Doug. Looking ahead to fiscal year 2019, Retail sales will benefit from new product introductions, including Marzetti Simple Harvest plant-based dips, a fresh lineup of 60-calorie Flatout wraps and new Angelic Bakehouse sprouted grain wraps that are made with superfoods such as kale and spinach, beets and sweet potatoes.

In addition, our Retail segment expects to build upon the recent rollout of the new Olive Garden Parmesan Ranch dressing flavor and implement a follow-on program to our recent successful retail test of Buffalo Wild Wings.

In the Foodservice segment, we expect to continue to strengthen our existing customer base and pursue new opportunities for profitable growth through our culinary expertise and noted reputation for custom-formulated products.

And based on our current assessment, commodity costs are projected to remain unfavorable in fiscal year '19, although to a lesser extent than we experienced in fiscal year 2018. Freight costs are expected to persist as a headwind through the first half of 2019. Higher pricing in both Retail and Foodservice segments will help to offset these increased costs. In addition, our supply chain team will remain focused on cost-savings initiatives and opportunities throughout the coming year.

Finally, I'd like to expand upon Doug's reference to our forecasted FY '19 capital expenditures of $60 million to $80 million. This past May, our Board of Directors approved 3 significant strategic projects that will drive long-term benefits to our business, but elevate our short-term capital spending. The first project is a material capacity expansion for our Sister Schubert business. This project will not only help the continued growth of our Retail business but also position us to meet the increasing demand from one of our key Foodservice customers.

The second strategic project is a new high-speed bottling line that will be installed at our dressing and sauce facility in Columbus, Ohio. This project will enable us to in-source some retail dressing volume that's currently co-packed and also provide us with added capacity for future growth.

The third strategic project is a new innovation center that's planned for construction in the Columbus area. This facility will enable us to bring Retail and Foodservice R&D teams and our quality team all together in one central location to more effectively collaborate within our organization, but also with our Retail and Foodservice partners. We believe that innovation is the key to our success.

We expect the innovation center and the bottling line projects to be completed in fiscal year '19, and as Doug mentioned, we anticipate the Sister Schubert expansion project to be completed in fiscal year '20, most likely the back half. Excluding these 3 strategic projects, we expect our fiscal year '19 capital spending to be essentially in line with that of fiscal year '18.

That concludes our prepared remarks for today, and we'd be happy to take any of your questions.

(Operator Instructions) Your first question comes from Michael Gallo with CL King.

Just a couple of questions. I guess, just to delve a little bit on your margin commentary, obviously, fiscal 2018 was a difficult year from a margin perspective. You had higher commodity and labor as well as logistics costs. You had obviously, the issues related for the fire, which impacted some of your retail volumes as you went through the year. It would seem that -- at least the commentary you have here suggests that there is going to be some continued headwinds in fiscal '20. You do have better -- I think you'll have better price realization, it would seem. So I guess, sort of boiling it down, do you expect that you will be able to materially improve your gross margins in 2020? Or will it be just a continued transition where you will continue to have to take costs out and get pricing just to kind of hold the line or slightly improve margin?

Sure. So Mike, great question and why don't I dive in for you. So if you think about it, we and the industry have been talking about 2 forms of inflation coming in. First, the raw material and packaging and freight. As we think about the sequencing of fiscal year '18, which we just ended, and fiscal year '19, the first thing we're seeing is a bit of a step down in commodity inflation as context. We expect to see 1 more quarter of just pure commodity inflation, principally driven by eggs, and then we think that it will continue to be inflationary, but at a more modest pace through the remainder of the year.

Freight we expect to be a headwind for the entire first half. If you remember, the hurricanes hit at the very end of Q1, beginning of Q2, and then we saw a significant -- a subsequent and significant step up in those costs due to the new Department of Transportation rules. So we're going to see freight as a headwind through the first half and then plateau thereafter. So if you then take maybe 3 big steps back, I'll frame it in another context. Probably about 3 quarters ago, we began aggressively tracking, what we call PNOC, pricing net of commodities, and this is the first quarter where we're seeing positive PNOC in both segments. What we're doing is we're offsetting the cost in the absolute sense, but we haven't been able to get enough yet to necessarily hold margins.

So how do we think about this then on a go-forward basis? The first thing that I would share with you is that we're going to see probably a tougher first half, principally because of freight. Remember, the freight for us is up in the gross margin category. In one quarter, that's tougher, the first quarter, also driven by commodities. And then we're going to see -- what we expect to see is more improvement thereafter. If you look at the entire fiscal year, we would expect to see flat to modest improvement based on what we currently see today.

In terms of the year overall, though, would you expect to be able to improve gross profit?

Yes. And that's what I meant, Mike. I'm sorry if I wasn't clear. We would expect for the full year to see modest improvement, based on what we see today.

Okay, great. And then just a follow-up. In terms of just the step up in capital expenditures, I think, I heard you say the Sister Schubert's line wouldn't be complete till sometime in 2020. So should we expect this kind of stepped up level of capital expenditures to go for the next 2 fiscal years? Or would you expect that to kind of level off next year? Or perhaps not as high as '19, but stay somewhat elevated?

Mike, what I would tell you is, right now, what we have very clear line of sight here is what we've outlined. We're continuing to evaluate projects. You carve -- we went through the 3 that we're focused on, the most material of which is the capacity expansion for Sister Schubert. That project is going to be probably more heavily weighted towards fiscal year '19 with some costs incurred in '20. The other 2 are more modest and they're going to be completed in this upcoming fiscal year, fiscal year '19. So the best we can tell you now is, this is what we have clear line of sight to. As we continue to evaluate other opportunities with the board, especially when it takes our spending at an elevated level, you can count us to come back to you and sort of take you through what we're thinking.

Your next question comes from Jason Rodgers with Great Lakes Review.

Just wanted to follow up with the whole commodity cost question. Just looking at soybean oil, it's come down dramatically, and I was just wondering why you wouldn't see some type of tailwind in fiscal '19 from that?

That's a great question. So we are seeing soybean come down. That's been a class that's been favorably impacted. And what we're seeing on the flipside, though, is for us eggs are really large commodity category. We buy both whole eggs and yolks, and they remain elevated versus prior year. So that would be one. Packaging cost, linerboard, corrugate and resin, all remain elevated. And honestly, for us transportation cost is also included in that and that's a big number. If you think about our total business this past year, all in, we probably looked at somewhere in the range of 5% of gross inflation across the business. And what we're seeing is that inflation is going to remain elevated, albeit at a more modest rate into fiscal year '19. The trade stuff that's going on externally has helped us with soybean, but it hasn't seemed to give us any relief in the other classes.

Yes. And one thing I'll add to that, Jason, this is Dale, is that the basis cost, and to Dave's point, the transportation cost on soybean oil is really cut into what you would see just on the spot market for that. So just want to make you mindful of that.

All right. And very nice entries in the Foodservice segment for the quarter. How much of what that was due to onetime programs versus just a general better environment for the restaurant chains?

A fair amount of that was just from a couple of things. It was just a better overall restaurant environment, and we've been able to pick up some new accounts. We did benefit from an elevated level of LTOs, but that wasn't a big fight. If we sort of had to rank them for you, I would say, first and foremost, would have been the improved external environment and improvements within our business that were volume-driven. The second would have been pricing related associated with commodity inflation that we're finally getting through, and then the third component would have been driven by LTO activity.

All right. And if I could squeeze one more in. Would you happen to have what the volume increases were for the quarter in total and by segment?

Yes. I don't know. We don't necessarily break it out by segment, but I can tell you that the overall volume increase was about 2 points.

Your next question comes from Brian Holland with Consumer Edge Research.

If I could ask first about maybe the reconciliation between the consumption trends that we're seeing in IRI versus the reported in the Retail segment. Not the first time this has happened, but there is a pretty meaningful gap between reported and tracked sales. Should we attribute that to Blue Buffalo sell-in? Or the extent to which Blue Buffalo sales are occurring in non-tracked channels? I'm just wondering if you're seeing a disconnect and if that's what you had attributed to? And then maybe just as a follow-on to that, if you could give us some sense about the scope of where that Blue Buffalo rollout is today, and how we think about where that -- what that looks like over the next 12 months.

Got it. Brian, I think you're saying Blue Buffalo, but knowing you like I do, I think what you mean is Buffalo Wild Wings, in our case?

Correct. Pardon me. Yes.

You and I were on the same frequency. I just want to make sure everybody else was as well. So going right to it, that was, in fact, one component of it. Why don't I talk about what we've done? To date, what we've run has been test within Costco that went extremely well. What we have planned to do is to expand that into all the club channel and into retail on a limited basis as well and it's going to extend across the year. You can expect to see the product really start to hit in the fall, sort of think the latter part of football season and go hard through football season into basketball season and March Madness. And then we'll sit down with our partners at Buffalo Wild Wings and really evaluate things from that point forward. So it was a contributor to the quarter, albeit a bit of a modest one.

The other contributor that we had that was material was the continued sell-in of our Olive Garden Parmesan Ranch. You had a specific question about how do we reconcile against what you see in the measured channels and what you're seeing otherwise. I think, probably what I would point to is, if you think about that 1.7%, that was partially also driven -- or more than partially. It was driven by pricing and some of the other net price realization tools. In our case, what we are doing, given the fight that we and the industry have had against inflation, is we are going back looking at category by category, and saying where do we have rented share and where do we have share that we own? Where does it make sense for us to pull back on trade spending where we think we can get justifiable price realization and work our way up a profit curve and where does it not? So in this case, in Retail, it was not a volume-led story as much as it was a pricing-led story.

That's helpful context. Maybe just a quick follow-on, on the pricing side. So I think the reported results and maybe a little bit with respect to your outlook to '19, it paints a more favorable or optimistic view of pricing than maybe your commentary in Q3. Which was -- quite candidly, sounded like there was still some concern about whether you would get that. So I'm just curious if you could maybe walk us through what sort of happened here over the last quarter that sort of -- I mean, again, this is my interpretation, that it looks this is coming in more the high-end of your expectations, so maybe what sort of transpired to get there?

Yes, absolutely. So we'll break it into the 2 segments. First of all, I think we probably started mentioning late Q2 and Q3 that we were seeing progress on the Foodservice side, and that continued and it was manifest; you guys can follow the way the numbers tumbled. On the Retail side, as far as the external environment, it honestly remains very, very contentious. They're contentious discussions. In some cases, we're seeing less price realization. In other cases, we're getting it to pulling back on trade and things like that. So I would say that the environment remains more or less consistent with what I outlined in Q3. The way we're getting there in some cases is lift and in other cases it ends up being by pulling back in trade. Like you, I keep track of sort of commentary from peers in the space, and I think what we're experiencing is quite consistent with what they're experiencing.

Okay. That's helpful. Last one for me. Just quick following on from the prior question, the last question you were asked, about Foodservice and the magnitude of growth there. So if we wouldn't ascribe too much of that growth or not a significant portion of your Foodservice growth to LTOs in Q4, and we think about kind of the setup that you have going into '19, I mean, should we -- can we take from this that sort of something at least in the mid- to high single-digit top line growth range for Foodservice is realistic for '19? Is that a fair characterization of sort of how you are set up?

You know, I wouldn't be that bold at this point. I think I would back off that some, honestly. Things fell into place nicely this time around. If I step back and sort of look at what we are, I'll give you maybe the way we view the business internally. First of all, the overall economy seems to be coming along at a much stronger pace. I think consumers are seeing the benefit of more money in their pocket and higher consumer confidence, and it seems to be benefiting the traffic at our restaurants. So we looked at Technomic data recently, and we could see, if you look at the 200 largest national accounts, all of them seem to be seeing a measure of benefit in traffic and in terms of a little bit higher ring from what's happening. We're also seeing this as it pertains to our mix of customers.

All that being said, it's hard to say that we continue to grow in this segment at the rate at which we do, because in some respects we're lapping some easier comps. I would expect to see something, I'd probably say, in the low single digit range on a normalized basis across the entire segment today. It's just where I am. Now, that's coming off of -- really, if you look at the segment, where it's probably running, let's call it, down 50 basis points to, in some cases, down 100 basis points. So I think you've seen an inflection point, but I would be reticent to say that I expect to see it in the entire industry and in our business run in the mid- to high-single digits. I just -- I don't see the fundamentals there to support that, Brian.

Your next question comes from Brett Hundley with The Vertical Group.

Congratulations on a good quarter here in a tough environment. I wanted to ask you -- I wanted to go back to the margin outlook and try and get a better handle on gross margin. So if I heard everything correctly, you guys finally got PNOC into positive territory during Q4, correct?

Yes.

Okay. And the reason I want to confirm that is because your gross margin performance was pretty solid. It was close to last year, when you consider that for much of the year you've been trending 150 to 200 basis points below the prior year. And then you guys finally got close to even during the quarter. And I guess what I'm trying to understand is, when I think about the impacts that have weighed on you during fiscal '18, and I try and think about how to put my model together for fiscal '20 and -- or excuse me, fiscal '19 and fiscal '20 -- the way I've always kind of lined things up is, look, as you guys went through fiscal '18, you had this commodity drag that was upwards of 100 basis points by my math. You had a freight drag that I think was close to 100 basis points, if I'm not mistaken. And then you had a garlic bread issue that weighed on you that you've not gotten around.

All along you've been lagging with pricing and trying to recover a good portion of that or pricing related efforts. And you've also had your Lean/Six Sigma efforts, and if I'm not mistaken, I think a lot of the cost saving efficiency work that you've been trying to drive is potentially upwards of a 200-basis-point impact to margins, if not more over time. And so you can correct me if I'm wrong on any of these. But the point I'm trying to make is, if you guys are able to get PNOC positive and let's say there comes a point during fiscal '19 where you recover freight, you recover commodities and you're even again. Those Lean/Six Sigma efforts, all else equal, should really flow in and give you guys some really nice margin improvement, potentially as you exit fiscal '19 and fiscal '20. But I just want to make sure that I'm on the right track there because if your PNOC was positive in Q4 '18, I would have maybe expected better gross margin performance, so maybe you can just help me tie all this together? I hope that makes sense.

So I'll take you through a couple of things, maybe starting first with kind of an update on our Lean/Six Sigma program. It continues to be up and running. With every passing quarter, we graduate another class of green belts and the program gets more completely seeded into the organization. I think I mentioned in a prior call, we were achieving somewhere in the mid-7 figures of savings every single quarter, and that seems to be where we've sort of got the organization up to a gallop and we continue to run at that pace. So you're exactly right on that piece, Brett.

Maybe it might be helpful to sort of help you true-up sort of PNOC versus margin. When we think about pricing, really there's 2 things. The first thing you want to do is you want to cover the cost in the absolute sense, and that's sort of what PNOC gives you. And then you want to make sure that you're getting enough pricing, not only to cover your input costs but to continue to protect your margins, right? So pricing to go in excess of PNOC and get margin protection. What we've done this time through is we're getting the PNOC. And PNOC, by the way, includes both pricing and the cost savings, both components of that, has exceeded the amount that we're seeing in the input cost. The reason why you're not seeing necessarily flow all the way into holding margins or expanding margins is there is still an increment that we haven't completely covered, that we're working against, which is that difference between covering the inflation to cover the input costs, and also expanding it beyond that to hold on to our margin. That's the piece that's happening, just as a little context for why there is a little further unwinding in this period.

Now fast-forward, how do we think about fiscal year '19? Overall, sort of in reference to Mike's question earlier in our commentary here, we expect to see -- based on what we're seeing today in the commodity environment, a sequential improvement for the year overall. We do expect to see that the first half is going to be weighed down because of the continued elevation of freight cost. For us and the industry, it's a big number, and we have 2 more full quarters of that to hit and 1 more quarter of eggs. So I think that's why we're saying we're going to see a bit of a drag. I think you would expect to see that the story continues to improve, but as far as more significant building, it's probably going to be back half just honestly because of the factors that I described. Egg inflation in Q1, all of inflation, but egg inflation predominantly, and then trans inflation for the first half.

That's really helpful. So as we get through H1 of '19, would it be your hope that by the end of that time period, so heading into H2, that final increment of pricing is through for you guys? I mean, all else equal?

You know, I'd like to think so, based on what we're seeing right now. And I think it also -- as we think about '20 and the periods thereafter, we're sort of assuming that we're going to see sort of a low grade of inflation on a going basis. Hopefully, not to the degree to which we saw it in fiscal year '18. But as we think about sort of inflation versus deflation, we're expecting a continued inflationary environment at probably somewhere in the half of the range that we were seeing in the most recent year. And I think it's because of the strength of the economy. It's because of things like linerboard and corrugate, where the owners are almost an oligopoly; resin suppliers that tend to operate the same way where -- those are areas where it continues to be tough. So we're expecting that the combination of our Lean/Six Sigma program and good careful pricing is going to allow us to continue to improve our margins and offset inflation.

Is labor included in that? Has labor cost popped up for you in any meaningful way?

It has. If you think about our business, roughly 2/3 of our absolute costs come from raw material and packaging, and about 1/3 of the costs are in conversion, of which labor would be a component. We are seeing labor. The most significant place where labor is biting us is in freight because it's really -- we don't have a truck shortage, we have trucker shortage and that's where you're seeing that inflation. Parenthetically, some of the things that we're doing in the space of Lean/Six Sigma, things like automating the end of lines with palletizers and stuff like that are helping take the edge off of some of the labor pinch that we're seeing in our factories. And that's part of our long-term plan, honestly, is to figure out where can we invest in automation to take out unskilled labor, so we're relying more predominantly on true skilled labor. That helps us today and as we think into the future about things like health care costs, workers' comp costs and everything else, it will help us as well.

The last I just want to ask you is on your reduced trade spend and couponing. I think that was something that was certainly well-planned heading into the quarter. I think you guys talked about that on your previous call, actually. And you've mentioned trade spend optimization tools. You've talked about that at length. Can you just delve more into the nature of these decisions, how quickly they're being made at corporate? And related, have you been able to measure the effectiveness of these decisions? I think that these actions are somewhat newer for you guys, but I'm curious if you've been able to measure effectiveness and whether these tools are working net-net for you guys?

Yes. So I think probably about a year ago or so, we talked about our priority to invest in this space, and we've invested in sort of a range of elasticity tools and others. And essentially what we've done are 2 things. One, we have centralized some of the decision-making around, for example, should you run a promotion at 2-for-5 versus 2-for-6 into a group of folks that are running the modeling on the elasticity, so we know when we're getting a good economic payback for a price and when we're not. And then what we're doing is there are folks farther out in the field that are working to focus on execution versus what those pricing decisions should be. So both the tools and the process are in place. And ideally, what we're doing is, on an iterative basis, looking in each of our categories, whether it's in bakery items or dressings and dips and making those decisions in the context of competition and inflation and everything else.

What I would tell you is, as with any other pricing decision, it requires time with the customer where we sit down and we sort of explain to the customer why we would like to move away from a BOGO to let's say a 2-for-5 or a 2-for 6. Sometimes they balk, sometimes they don't. If we feel very strongly about it, we'll really toe the line. If they can create the case with some sort of value-added provision for why that might make sense, we might listen to them. And we'll always work with them, but we may decide to go their route. But I think culturally what's evolved here is we're really using the tools, we're centralizing the strategic decision-making within the Retail business around those tools, and the folks in the field are just focusing in a bit more on just good execution.

(Operator Instructions) Your next question comes from Frank Camma with Sidoti.

You kind of gave us some flavor on some increase here on the capital allocation with the CapEx. Just wondering if you could comment on the acquisition environment. Any changes there given what's going on just in -- can you just give us an update?

Sure. So great question, Frank. We remain really active in that space. I will tell you that we have a range of things that we sort of continue to work through, but that's sort of an evergreen process. As far as sort of specifically the pricing environment, valuations remain lofty even as interest rates go up. So we haven't really seen a material change in valuations and expectations, but rest assured, we're very aggressively out in the marketplace today.

Okay. And then, so given that and given the fact that you still have an excellent balance sheet, a lot of excess cash, does it ever make any sense to build out even partially your own freight network? Or is it just not practical given your different lines?

No. It's a great question. So today, if you look at our business sort of by history, we're heavily dependent within the broker space. If you think about it, essentially it falls into 1 of 3 categories where you can own your own assets, you can work with dedicated providers with the longer-term agreements or you can go out and buy on spot market. By tradition here, Frank, we have been heavily reliant on the spot market, where during times where there was a glut of trucks and drivers, we were a beneficiary. For you folks, you think about it this way, this is the way I thought about it. In an interest rate world, we were floating versus fixed. And fast-forward, when things changed, all of the sudden, the spot market prices went up more aggressively.

Now more narrowly into your question, we are looking at doing both, addressing it 2 ways. One, we are in the marketplace looking to secure drivers and assets. We have a small group of drivers today and our own assets, and we use those today in our most expensive lanes. What we also did, just this past quarter, is we put out an RFP where we talk to some of the biggest national freight providers, and we're looking to expand our utilization of dedicated freight. Which essentially allows us to have many of the same benefits of owning the assets but without having to own them. The big difference being when you own the trucks, you can ship the product outbound to the customer and then you can benefit from any sort of backhaul that you can generate. We can generate that same sort of benefit with backhaul by going to dedicated. So we are in the process actively of implementing the expansion of this dedicated work. And based on the results of the pilot, we would expect to expand that even further.

And ultimately (multiple speakers) -- yes, and just last point, if I may, Frank, just ultimately get into position where freight cost, as with other commodities, are more predictable for us. We don't like the volatility and we know that you folks don't either.

Your next question comes from Brian Holland with Consumer Edge Research.

Just a quick follow-up. Going back to the balance sheet, I think -- I believe I have this right, that in 2012 and in 2015, you paid a special dividend out. It sounds like there is a lot of stuff still in the pipeline from an M&A standpoint. I think within the past year or so, there has been a more stated preference for M&A as a use of capital, as opposed to maybe dividend or stuff like that. But just sort of curious if you could reset for us kind of what your priorities are for capital allocation? And maybe where something like a special dividend or what have you, where that might fall in line relative to M&A, et cetera?

Brian, this is Doug. I don't think much has changed since we've last communicated our thoughts on capital allocation. I think as Dave has mentioned, the number 1 opportunity is certainly to invest back into our business as we've discussed here today. And then certainly, as we've mentioned in our earnings release and the like, certainly to continue to look to extending our dividend increases. Beyond that, M&A is clearly in the forefront of our minds and would be our desire to look for an M&A opportunity before issuing any sort of special dividend, but we continue to evaluate that as we go through time. So again, I don't think much has changed since our last commentary on capital allocation.

If there are no further questions, I will now turn the call back over to Mr. Ciesinski for his concluding remarks.

Thanks, Denise, and thank you, everyone, for joining our call. We look forward to giving you guys an update on our progress in the fall. And in the meantime, we look forward to seeing you guys out in the marketplace.

This concludes today's conference call. You may now disconnect.