J M Smucker Co (SJM) 2018 Q3 法說會逐字稿

Good morning, and welcome to The J.M. Smucker Company's Fiscal 2018 Third Quarter Earnings Conference Call. This conference is being recorded. (Operator Instructions)

I will now turn the conference call over to Aaron Broholm, Vice President, Investor Relations. Please go ahead, sir.

Good morning, and thank you for joining us on our fiscal 2018 third quarter earnings conference call, particularly given the early time of our call, due to a number of CPG companies releasing earnings later this morning. As we will provide an update on our strategic initiatives at the CAGNY Conference on Wednesday, our scripted comments this morning will be focused on third quarter results and our full year outlook. Mark Smucker, President and CEO; and Mark Belgya, Vice Chair and CFO, will provide our prepared comments. Also participating in the Q&A are Steve Oakland, Vice Chair and President, U.S. Food and Beverage; Barry Dunaway, President, Pet Food and Pet Snacks; and Dave Lemmon, President, Canada and International and U.S. Away From Home.

During today's call, we will make forward-looking statements that reflect the company's current expectations about future plans and performance. These statements rely on assumptions and estimates, and actual results may differ materially due to risks and uncertainties. I encourage you to read the full disclosure concerning forward-looking statements in this morning's press release, which is located on our corporate website at jmsmucker.com. Additionally, please note the company uses non-GAAP results to evaluate performance internally as detailed in the press release. We have posted to our website a supplementary slide deck summarizing the quarterly results and our fiscal 2018 outlook, which can be accessed through the link to the webcast of this call. These slides and a replay of this call will be archived on our website. If you have additional questions after today's call, please contact me.

I will now turn the call over to Mark Smucker.

Thank you, Aaron. Good morning, everyone, and thank you for joining us.

Our efforts to position our business for growth continued to pay off this quarter. We achieved year-over-year sales growth, driven by key brands in every business and delivered strong adjusted earnings per share growth. Initial benefits of tax reform and ongoing cost discipline helped fuel EPS growth. We will continue to deliver long-term top and bottom line growth by executing our strategic road map, supporting a portfolio of leading and emerging brands and guided by a deep focus on consumer and customer insights.

During our CAGNY presentation next week, we will provide a more thorough update on our strategic road map and the 4 foundational pillars of innovation, investments, cost savings and acquisitions. This morning, let me highlight our progress as reflected in our third quarter results.

We achieved strong sales performance for leading -- for key leading brands in the quarter, demonstrating the ability of our brands to win in today's environment. This included mid-single-digit sales growth for Jif, Smucker's Fruit Spreads and Milk-Bone. In addition, we achieved low single-digit growth for Folgers, driven by our Away From Home coffee business. These gains were partially offset by reduced sales for the Crisco brand, reflecting lost distribution at a key customer and a timing-related decline for Natural Balance.

Net sales for our U.S. K-Cup portfolio grew 14% in the quarter, with gains for all of our brands. Dunkin' Donuts and Café Bustelo K-Cups continued to deliver double-digit increases, and Folgers K-Cups returned to growth in the quarter. In addition, margins on our K-Cup business improved significantly, all of which reflect the benefits of our enhanced partnership with Keurig Green Mountain.

We are now a year into the grocery and mass channel rollout of our Nature's Recipe premium dog food brand, and momentum continues. Net sales for the brand were up 24% in the third quarter and 39% year-to-date, benefiting from a national advertising campaign which is driving brand awareness and accelerating consumer takeaway despite increased competitive activity.

Momentum for the Smucker's Uncrustables brand also remained strong, with company-wide sales up 23% in the third quarter and on pace for another year of double-digit sales growth. In addition, construction of our new Uncrustable Sandwiches facility in Longmont, Colorado is on track. When complete in fiscal 2020, we will have capacity to further accelerate growth as we expect to double net sales from the $250 million level we project for the current fiscal year.

Innovation, including recent product launches such as Dunkin' Donuts Cold Brew coffee and Meow Mix Simple Servings cat food, contributed to sales growth in the quarter. In total, products introduced in the past 3 years delivered 7% of third quarter sales -- net sales. We look forward to sharing more on our innovation efforts next week, including the introduction of 2 new platforms that extend the reach of our iconic Folgers and Jif brands.

E-commerce also remains a significant area of strategic focus as we continue to place emphasis on this opportunity across our brands and businesses. While still a small base, year-to-date e-commerce sales for our U.S. retail businesses were up 78%, with pet food brands up 71% and coffee sales in the channel more than doubling. These represent 2 of the fastest-growing categories in e-commerce as they're well suited for a subscription model of repeat purchases. Although not all of these sales are incremental, we continue to earn our fair share as consumers shift to online purchases.

Another key component of our strategic road map is generating cost savings to provide the fuel for investment in top line growth and margin expansion. In addition to fully realizing our $200 million pet food synergies earlier in the year, we continue to make progress on our other cost-savings programs, including our initiative to strengthen cost discipline throughout the organization. These, along with benefits related to our new K-Cup agreement I spoke to earlier, are the key drivers in achieving our projected $100 million in cost savings this year as part of our $250 million cost management program that we expect to fully realize by 2020.

In addition to our cost-savings programs, we estimate an annual earnings benefit of $120 million from recent U.S. tax reform, nearly 1/2 of which is expected to be realized in fiscal 2018, with the full year benefit in 2019. These tax savings provide incremental fuel to invest in our growth initiatives, including increased marketing to support upcoming innovation, while also investing in our employees and the communities where they work, and of course, opportunities to increase cash returned to shareholders.

Let me close my comments by reiterating that we're executing against the strategic road map that we've set out to ensure a clear path to delivering on our 3 key financial priorities of top line growth, achieving significant cost savings and delivering earnings per share growth in line with our stated long-term objective. I would like to thank all of our employees for their efforts and continued dedication as they are collectively driving the success of our company.

I will now turn the call over to Mark.

Thank you, Mark. Good morning, everyone. I will start by providing additional color on 2 significant items included in our reported results for the third quarter.

First, let me summarize the benefits of the recently enacted U.S. income tax legislation on our tax provision. During the third quarter, we recognized a nonrecurring net tax benefit of $766 million. This primarily reflects a benefit from the remeasurement of our deferred tax assets and liabilities, which was slightly offset by expense related to the transition tax on undistributed foreign earnings. This net tax benefit has been excluded from our adjusted earnings per share results that I will discuss in a moment.

Third quarter adjusted earnings per share did, however, include a tax benefit of approximately $0.35 a share related to truing up our year-to-date tax rate as a result of income tax reform. For fiscal 2018, we expect a full year effective tax rate of 28%. This resulted in an effective tax rate of 19.7% for the third quarter in order to adjust the rate on a year-to-date basis down to 28%. For fiscal 2019, we project our effective tax rate will further decline to 23%, reflecting the full year benefit from income tax reform. We will provide any update to this estimate when we issue fiscal 2019 guidance during our year-end earnings call in June.

The second item impacting third quarter earnings was a noncash impairment charge of $177 million attributable to goodwill and certain trademarks within the pet food segment. The charge primarily reflects the reduction in our pet food outlook from what was previously modeled notably over the next 5 years as we now project long-term organic net sales growth for the pet food business of 2% to 3%.

With that background, let me provide an overview of third quarter results. GAAP earnings per share was $7.32 in the quarter. Excluding the onetime income tax benefits, the noncash impairment charge and other non-GAAP adjustments summarized in this morning's press release, third quarter adjusted earnings per share was $2.50, (inaudible) an increase of 25%. As noted previously, adjusted earnings per share includes an approximate $0.35 benefit in the current quarter related to income tax [reform]. Adjusted earnings per share was $2.15, an increase of 8% compared to the prior year. Net sales increased $25 million or 1% compared to the prior year, reflecting higher volume/mix, most notably for pet food and coffee, partially offset by a decline in oils. Net price realization and foreign currency exchange were both neutral in the quarter.

Adjusted gross profit increased $9 million or 1%, reflecting favorable volume/mix as the net impact of pricing and cost was also neutral in the quarter. Adjusted gross margin of 38.4% in the third quarter was in line with the prior year but below our projection due to an inventory obsolescence charge related to pet food and higher freight expense. Although we forecasted an increase in freight cost for the third quarter, the actual increase was greater than anticipated due to ongoing challenges within the U.S. transportation industry.

SD&A decreased $5 million in the third quarter or 2% compared to 2017, driven by lower administrative expenses, reflecting our cost-saving activities as well as lower selling expense. This was partially offset by a 5% increase in marketing expense. Factoring in all of this and the $3 million favorable change in other operating expense, adjusted operating income increased $17 million or 4% compared to the prior year, and adjusted operating margin increased 60 basis points to 21%.

Below operating income, a $3 million increase in interest expense, primarily due to the charges associated with our debt refinancing activities in the quarter and a $4 million impact of foreign currency exchange were more than offset by the lower tax rate and a 2% reduction in weighted average shares outstanding resulting from the company's share repurchase program executed in the fourth quarter of fiscal 2017.

Let me now turn to the segment-specific results, beginning with Coffee. Net sales were up 2% compared (inaudible) net price realization was (inaudible) lower as the impact of the 6% list price increase in January of the prior year continued to be offset in the quarter by trade investments to improve competitive pricing, most notably on roast and ground coffee. Net sales for Folgers declined 1% in the third quarter, representing a sequential improvement from the 6% sales decline last quarter and the 12% decline in the first quarter. Sales in the Dunkin' Donuts brand increased 7% on strong K-Cup performance. For Café Bustelo, net sales increased 24%, behind significant growth for both roast and ground and K-Cup offerings.

Coffee segment profit increased 6% in the third quarter, primarily due to favorable volume/mix and lower input cost. As anticipated, these factors were partially offset by higher marketing expense as well as start-up costs associated with upcoming coffee innovation. Segment profit margin of 33.1% was consistent with our expectations for the third quarter and represented a 550 basis point sequential improvement from the second quarter margin of 27.6%. We expect segment margin to improve further in the fourth quarter as we realize the benefit of lower green coffee cost.

In Consumer Foods, third quarter net sales were down 1% compared to the prior year as lower volume/mix of 3% was mostly offset by higher pricing. Sales for the Jif brand increased 2%, while the Smucker's brand was up 9%, benefiting from growth in both Uncrustable frozen sandwiches and Fruit Spreads. Sales for the Crisco brand declined 15%, partially reflecting lost distribution at a key retailer in the club channel, which we lapped late in the third quarter.

Consumer Foods segment profit increased 2% compared to the prior year despite the profit impact associated with the volume/mix decline in the oils business and higher freight cost. Profit growth continues to reflect successful execution of our pricing strategies and effective management of manufacturing and supply chain cost.

Turning to the Pet Food segment. Net sales increased 2% compared to the prior year as volume/mix contributed 3 percentage points. This was partially offset by lower net price realization. Sales for our mainstream dog food brands increased 5%, driven by the 24% increase in Nature's Recipe that Mark discussed. In cat food, sales for both Meow Mix and 9Lives were up slightly in the quarter. Pet snacks sales increased 6%, including growth for the Milk-Bone brand. And lastly, within premium pet food, sales for the Natural Balance brand decreased 9%, primarily due to the timing of shipments to certain retailers, which has already begun to reverse in the fourth quarter.

Pet Food segment profit decreased 7% compared to the prior year. This was driven by a charge related to obsolete inventory, which was approximately $7 million higher than in the prior year. Higher freight cost and an 11% increase in marketing expense also contributed to the segment profit decline.

Lastly, in the International and Away from Home segment, net sales increased 2% compared to the prior year, with foreign currency exchange and volume/mix both contributing somewhat equally to sales growth. Lower net price realization partially offset these factors. The volume/mix growth was driven by increases across several of our U.S. Away From home categories as this business continues to outperform the broader industry, including the benefit of significant distribution gains. Segment profit increased 16%, with volume/mix, lower marketing expense and a favorable foreign currency exchange all contributing. In addition, prior year segment profit included a nonrecurring $2 million charge related to an asset disposal.

Turning to cash flow. Cash provided by operations was $469 million compared to $420 million in the prior year. Factoring in capital expenditures of $80 million, free cash flow was $389 million in the third quarter of 2018, bringing the year-to-date total to $693 million. We now project full year free cash flow of $825 million, assuming CapEx of $310 million. The increase from our previous guidance of $775 million reflects the benefit of reduced taxes, a portion of which was used to fund an incremental pension contribution of $20 million in the third quarter as well as a slight reduction in our working capital projection.

Let me now conclude with an update to our full year sales and earnings outlook. Our guidance excludes any potential postclosing impacts from the previously announced agreement to acquire the Wesson brand. Regarding the Wesson transaction, we're still waiting for approval from the U.S. Federal Trade Commission after having provided additional information through the second request process. We continue to forecast full year net sales to be in the range of flat to down slightly compared to the prior year. With regard to earnings, we're now guiding adjusted earnings per share to be in the range of $8.20 to $8.30. The increase from our previous range of $7.75 to $7.90 reflects the full year benefit of income tax reform, partially offset by the incremental freight headwind, which is expected to continue in the fourth quarter and the inventory obsolescence charge I spoke to earlier. Factoring in these last 2 items, we now project full year gross margin will be in line with the prior year. This compares to our previous guidance of an increase of up to 50 basis points.

In closing, let me reiterate that we're pleased with this quarter's results and feel confident in delivering on our guidance for the year. We thank you for your time this morning, and we will now open the call up to your questions.

Operator, if you would please queue up our first question.

(Operator Instructions) Our first question will come from David Driscoll from Citigroup.

Couple of questions here. So the first one just on coffee, I would like you guys to spend a little bit of time to talk about the single-serve coffee. Your numbers in Nielsen, the Nielsen data that we can see, they look good. It looks like things are really starting to turn the corner. But we'd just like to hear a little bit more about kind of the plans that you executed on Folgers and how -- maybe you could describe a little bit more about the opportunity in single-serve as you progress with this new advantaged contract. That would be my first question.

Sure, David. It's Steve Oakland. To really think about our single-serve business this quarter and the journey we're on, we'll go back to maybe the data we showed at back-to-school. That's the first time we showed graphically -- we broke down our coffee business and how it breaks down across the different segments with how the category breaks down. And if you remember, our one cup business was in the high 20s, maybe 25%, 27% at the time. And the category was, say, high 30s, 37% at the time. So we knew that, that was the biggest opportunity in front of us. Yes, there's also growth in premium coffee, et cetera, but the most important thing for us was to position ourselves in that category. So 1 quarter in, we saw our growth rates for the quarter were about double what the category grew for the quarter, driven by Dunkin' because that's our biggest business, clearly; but great growth in Bustelo. So our Bustelo brand continues to grow. And we're really more pleased by mid-single-digit growth on Folgers, right, our legacy business. So I think the contract -- we talked a lot about -- and you mentioned advantaged, I don't know that it's advantaged. I think it's much more competitive today and much more advantaged compared to how we were. I talked a lot about pricing. Yes, our economics are better, but our access is better. And what I mean by that is we have more pack sizes. We have -- we're unrestricted and unbound as far as channel, as far as customers, as far as how many items we've put in either a given channel or a given customer. So I think when you combine all of those things, the strength of the brand and, quite frankly, we've had some retailers get behind the platform over the holiday season. We saw that grow. So all of those things together, we think, led to growth at about double the category. And I would expect that to continue into the next quarter.

Just a follow-up, in coffee, you guys had pretty big expectations for the back half of the year, particularly the fourth quarter, although third quarter was notably up as well. Can you just confirm that those expectations are all being met and that you're pleased with the direction of coffee profitability?

Dave, this is Mark Belgya. Yes, we're still aligned with that. I think in one of our scripted comments, we called that out. In the fourth quarter, the benefit will come more from the green coffee. If you compare to a year ago's fourth quarter, that was still kind of a high period of cost, so we get the benefit this coming quarter. Everything else is in line.

Great. I appreciate that. Last question for me, just gross profit margin. I think you said it's now flat. It used to be up 50. Can you describe the factors that have affected the gross margin?

Yes. I'd call out 3, the -- one is just the ongoing impact of the freight that we've called out. It continues to increase. The second was the obsolescence charge. We plan obsolescence across the organization every year, by year and by quarter. We just exceeded that, so that flows through in our costing setup through our COGS, and thus affects gross margin. And I'd say the third thing probably is just mix. Obviously, we've given a little bit of range in terms of where we expect the end of the year, and although it hasn't really changed, some of the mix has changed. And I would just say some of the higher mix estimates have come down a little bit. So those are probably the 3 biggest drivers.

Our next question comes from Chris Growe from Stifel.

So just a quick question. As we think about the tax reform and the benefits coming in fiscal '19, without trying to get ahead of ourselves here in terms of guidance, but how should we think about that in terms of your desire to want to reinvest some of those benefits back behind the business? Or are you going to let that all flow through the bottom line? Or is it -- are you able to talk about that yet?

Yes. Chris, it's Mark Belgya. So obviously, we're like other companies that are not calendar year-end in that we will end up with blended rate. So what I would say, we will comment on this more next week at CAGNY, but we are using -- as we said in both our release and our quoted comments, that we're going to spend back against the business. We're going to spend back against our employees and also spend back by some increase in our charitable giving. We'll be more specific. But we are going to get a nice step-up obviously in '18 and '19, and at the same time, still be able to invest pretty significant growth in our marketing spend to support particularly the 2 innovation platforms that, again, we'll talk about next week in much more color.

Okay. And then just related to the pet division, you had the obsolescence charge. I think you've had a recall recently as well. Is that an expense more likely for the fourth quarter? If you had any color around that, in relation to that recall?

Chris, it's Barry. Let me just provide a little color around that. Clearly, we just learned about this issue about a week ago when it was brought to our attention. So we quickly began an investigation. We partnered with the FDA on that. Both independently concluded there were no pet health safety concerns. But out of an abundance of concern, we did implement a voluntary withdrawal of that product. So we're working with our retailers to get that product out of the marketplace right now. From a cost standpoint, that's not reflected in any of our numbers yet. We're still trying to get our arms around what that cost will be. Clearly, as we investigate and work with the supplier who was involved in that situation, we would look to recover those costs. There may be a timing difference, so we may incur some of those costs this year. And then depending on the cost recovery, it just may be a timing issue. So that's how we're managing that.

Okay. And then just to be clear, maybe, Mark, for the obsolescence charge, is that sort of a onetime event you go through when you account for obsolescence, say, in pet this quarter?

Well, a couple of points, Chris. So obviously, what Barry just said, so that charge did not include any of the impact. I wouldn't say it's a onetime thing. As I mentioned, we plan obsolescence across the board for a variety of reasons. And it does have peaks and valleys. And depending on what the driver or the reason, kind of not only drive the timing but also the dollar amount. So I wouldn't call it a onetime review of anything. It's just a certain situation that we charge through the P&L whenever it occurs.

Our next question comes from Ken Goldman from JPMorgan.

All 3 food companies that reported this morning, they missed The Street's gross margin estimates by pretty wide margins. And everyone's pointing to freight, and obviously we can see the numbers and how bad that is. But I did have a couple of questions on that. First, is it harder to pass along freight than more foodstuff-related cost? I've heard that from some people, yes; from some people, no. I'm curious what your take is. And second, is there any read-through beyond freight here on that manufacturer-retailer power relationship? I know you've talked in the recent past how it's been a little harder to get pricing through with the same sort of alacrity that you've had in the past. So I'm just curious if that sort of relationship is getting harder, if the pendulum of power swings toward the retailer, just how you think about that would be helpful.

Ken, it's Steve. I'll start. With regard to freight, it is difficult to pass freight because it is -- and we can't predict it. If you have to get a spot load today, you're going to pay significantly more than what you pay for a contracted load. So when we get into a situation where we're moving freight between a manufacturing location and between one of our DCs or a customer brings an order up quicker than we had planned and we go to our spot freight system, that's a system that's been in place for all of us for years, right? Well, those charges are coming in at a multiple of what they used to be. So for us to even be able to tell you what that next load's going to cost is sometimes impossible, depending on how busy the lane is. So the key there is that we keep it on our contracted carriers. We keep it in our -- we keep our forecasting system with the customer as tight as we can so that we can plan on that distribution. That just doesn't happen. I mean, the customer comes to us with a special request, we have something break down or something goes wrong, and we have to move a load spot. I know it doesn't sound like a lot, but it's really difficult. The trucking industry right now is pretty tight, right, so a spot load is very difficult to do. So that's the freight issue. And with regard to the customer, I wouldn't say so. I think we saw an environment over the last year where the larger retailers took the hard discounters very seriously. They made some strong positioning statements around certain key categories. I think they've been very aggressive. But I wouldn't suggest that anything in the quarter or anything in our outlook reflects more difficulty with the customer. I think we have a pretty good sense, so there's probably going to be a tiny bit of inflation as we go forward in some of our raw materials. And I think freight is going to be something that the industry struggles with for the near term.

Yes. Ken, this is Mark. Just maybe to put some numbers behind the margin change. So the 2 items we called out, the freight and the inventory obsolescence charge, on our $1.9 billion of sales for the quarter, it accounted for almost a whole 100 basis points of margin. So it really was driven by those 2 factors.

Our next question comes from Pablo Zuanic from SIG.

First, I had a question on the pet food side, maybe for the [mass market] and Barry. So when you bought Big Heart, you talked about 5% growth, I believe, mid-single digits, dry; and cat, low single digits; treats, high. Now you've lowered that to 2% to 3%. Remind us what has changed. But more important than that, there are other pet food companies in the market, and those involve particularly in natural premium growing pretty much high single digits. So it would seem to me that when we think about this market valuation and the feedback we get from our investors is about your categories and your brands, I mean, there's an opportunity here for you to double down on Pet Food and improve the growth profile of that business with better brands and not necessarily have to cut the guidance from 5% to 2% to 3%. So if you can comment on that, why did you cut the guidance long term for Pet Food and whether you are in need of new brands there. I would add to the question in terms of a related comment. The Nature's Recipe launch has been very successful. I'm very impressed how quickly you got it through all the stores out there, but you're lapping it now and what's going to happen after that? What is the underlying sell-through rate? And can you extend that brand into wet or treats? It seems that it's more limited.

Pablo, this is Mark. I'll start with the first question, and then Barry will follow up with the rest. So if we go back, turn the clock back a few years to when we announced the transaction, looked at where both the industry and Big Heart was performing, I think you called out the numbers well. So the base dog and cat, which is about 1/2 the business, that was averaging modest low single-digit growth and that was really being managed by the previous owners to drive profit that they could invest in the other 1/2 of the business. The other 1/2 of the business, which was a little bit heavier skewed to the snack side, was in a period of growth, both industry-wide and Milk-Bone-specific. A lot of innovation that the Big Heart team had brought forward, and so we had carried that growth expectation not as much, but certainly above the low single digits of the base dog and cat food. And then lastly, specialty channel, as a channel, was growing dramatically, high single digits, low double digits. And I think as we've reported, and others have reported, there's been a significant decline in that as e-commerce has come into play and for a whole variety of factors within the industry. And we've kind of followed that. So it really is the latter 2 that have driven most of that change. There's been some competitive challenges in the snack arena. So Barry, I don't know if there's anything to add, but that was basically how we arrived at sort of that 4% to 5% that you quoted. And I think just reflecting where the industry is, particularly in that specialty channel and just some of the other competitors, we just feel more comfortable with the growth rates we quoted.

No, great summary, Mark. And Pablo, let me focus on the second half of your question. First, we have a great portfolio of iconic brands that we still think have a lot of runway. When we think about Milk-Bone in particular, our objective is to take that brand into new segments, into some of these growth segments. So our innovation efforts are really to focus on how we take our brand into growth areas across snacks and across the entire portfolio. Let me talk about dog food, and you referenced Nature's Recipe. If you look at our consumption, we're up 27% across our entire dog portfolio for the latest 13 weeks, which is just outstanding. And that is across the entire portfolio. So Nature's is a big driver of that. But we're trying to manage the portfolio across value, mainstream and premium. And all of those brands are performing well as we manage that entire portfolio. Velocities continue to increase quarter-over-quarter. Our velocities with Nature's Recipe are up about 17% this quarter in units and 16% in dollars. So again, just nice to see that -- those velocities continue. We're going to sharpen our marketing support behind that brand as we go into this next year, some learnings based on the fact we've been in the market for the last 12 months. And so we're going to take those learnings, and we think we can drive even greater effectiveness with the marketing support behind that brand. As far as just adding to the portfolio other brands, we've always been an acquisitive company, and we'll continue to look for brands that would make sense in our portfolio across food and snacks. And then as far as taking Nature's Recipe into other segments and categories, absolutely, we do think that brand can play in categories like cat and like snacks. And it's just a matter of us prioritizing when we move into some of those segments and how we approach those opportunities. So that's on the radar screen. We wanted to get dog, we thought that was the right place to start. We're going to expand some of our wet offerings coming into this early year or early this summer. And a packaging refresh. We're going to actually swap out some other items that we think can be faster turning. So a lot of momentum behind that brand. We want to keep that going and then look to launch into other segments.

That's really helpful. Can I squeeze one on coffee? And maybe for Steve. Steve, we're talking about K-Cups, but just on roast and ground, it seems to me that there's still a big opportunity there for Dunkin' to get a lot more exposure and accelerate the premiumization of roast and ground. Is that realistic? And related to that, my only concern when I hear K-Cup growth much faster than roast and ground is that we are shifting into a lower-margin category. Am I missing something there? Or if you're swapping a serving of roast and ground for the swapping -- for the serving in K-Cups, in dollar terms, that's actually a good swap. If you can talk about that, please.

Certainly, Pablo. Well, you set us up great for CAGNY. We're going to show innovation in the premium sector, both in a new platform and in Dunkin'. So we felt K-Cups had -- we had to address K-Cups quickly. And I would suggest that K-Cups now are not dilutive. And if you look at the quarter, for us to have flat volume, 2% net sales, turn that into 6% profit at 33.1%, that would suggest that the mix was pretty good. So if -- anytime we have a flat roast and ground quarter, we're winning. I mean, our model obviously includes slight declines in that. So when we decline slower than the segment or don't decline, like we didn't this quarter, it really improves the model. So you're going to see investment in those other things. Clearly, we have to have a larger presence in premium coffee. And we had to fix K-Cup first. We think we're on our way to doing that. And the next effort that you'll see next week, frankly, is on premium.

Pablo, this is Mark Smucker. Just on margins, what I would tell you is that as it relates to these -- all these different segments, we've talked about mainstream, premium and single-serve. The dynamics in the category is such, and the way we manage the business is such that, at this point in time, margins are generally consistent across all of those categories and all -- or segments, I should say, and they're all profitable.

That's great. And Pablo, this is Barry, just one other point that I should have made when we were talking about Nature's. As we look at the performance of that brand, prelaunch into mass and when it was just in pet specialty, based on where we will end this fiscal year, we're projecting that brand in retail sales is going to be up about $80 million or 70%. So we've seen -- we still have the presence in pet specialty, and then by moving that brand over to the mass channel, just tremendous growth at retail. So just one other indication about the strength of that brand and the potential that it has.

And our next question comes from Scott Mushkin from Wolfe Research.

So I did have a kind of philosophical question as we move into CAGNY, and just kind of your thoughts on your business as we move into, I guess, accelerating investments and rolling out new platforms. What's your tolerance for actually seeing EBITDA come down to do this?

Scott, this is Mark Belgya. I'll start, and if anyone else wants to jump in. And welcome back. I think that the earlier question around marketing investments, we're going through the planning process for FY '19. And even next week at CAGNY, we'll give a little bit, but certainly not our outlook. And we feel that tax reform is obviously beneficial for a whole number of reasons. But as many of our peers have said also, it does provide an opportunity to support whether it's marketing investment or just investment in innovation. And we still want to grow our segment profitability even with the investments in the marketing. So we're going to continue to try to grow EBITDA and EBIT and operating margin as we move forward. And again, it's a little hard until we are specific in June with our guidance, but we're not necessarily backing off profitability growth. It's just nice that we do have some flexibility from an EPS perspective to utilize some of the tax reform to support that.

Yes. Scott, this is the other Mark, Smucker. Just agree with Mark. I mean, we still have an obligation to our shareholders to grow earnings, but we also have an obligation to grow our businesses. And so as Mark said, the tax reform does give us a unique window. Obviously, we're doing some significant cost savings as well. And we do expect marketing to be up significantly next year. But I would also point out that what we have really been doing as we execute the strategic road map is get our foundation in order and make sure that we're prioritizing the investments to those areas where we know we can grow. Consumer Foods is a very good example of that. So while you would have potentially seen that marketing has not increased in aggregate this year on Consumer, it has increased in those areas where we need to invest, like Uncrustables and Jif and things like that. So we may be deemphasizing some stuff in order to invest where we really think we can get the biggest bang for our buck.

Perfect. And then just a quick follow-up. I don't know if you guys have any comments on the Pillsbury brand, but I know you've been trying to get that one moving a little bit, and then I'll yield.

Scott, it's Steve. I think there's a great example of what Mark mentioned in the role of the brand. There are times when our cost structure is right, when things are right, and you may see volume decline on some businesses, but you'll see the overall segment that those businesses operate in perform pretty well. I mean, our Consumer Foods business did really well. We had great numbers on Jif, great numbers on Fruit Spreads. We continue to pour gas on Uncrustables. Okay? Well, that had to come from somewhere. And it came from our baking business, right? So there are times when some of these businesses are managed for profit. They may have the opportunity to grow at times, and we'll take those opportunities. And there'll be other times when we take the opportunity for them to generate fuel, and this is one of those times.

Scott, it's Mark Smucker again. The other thing I'd just point out on Pillsbury, just to build on what Steve said, is we have made some conscious decisions when we see that the competitive environment is such that in -- an investment in a brand might actually create a situation where profit is just too challenged. I think that's sort of been the case with Pillsbury this past year. We consciously chose not to go deep, if you will. That said, we do have some nice innovation coming out on Pillsbury in the next year. So it's not that we're ignoring it, and it's not that we're just letting it stagnate, but we do have some nice innovation that will continue to support that business going forward.

And our next question comes from Jason English from Goldman Sachs.

A question on coffee, then a bit on pet. My apologies, I got distracted and jumped on a little bit late so maybe you already disclosed this. But in terms of the margin expansion on coffee, can you unpack how much of it was driven by lower green coffee cost? And how much related to the new Keurig contract? And on that contract, whether you're sort of at full scale now or whether those benefits will continue to sequentially mount as we move into the fourth quarter?

Okay, let me -- Jason, I'll try to do that for you. This is Steve Oakland. I would say it's all of those things. We talked about green. As you know, we went through an expensive green cycle at the beginning of the year. We leaned in to get our pricing right on roast and ground. Green was basically flat for the quarter. The green, as Mark Belgya I think said in either one of the Q&A or scripted comments, is green will benefit us in the fourth quarter and going forward. So green was not a headwind or a tailwind this quarter. I think volume was positive. And if you look across all of our businesses, the volume mix component was good. The K-Cup agreement was good. And the K-Cup agreement, as I said earlier, is really going to -- yes, the economics are better, there's no question, but the access is better. So we're able to put K-Cups in some places we couldn't before. So I would say it's all of those things -- all of those things added up that led to where we are. Our forecasts for that kind of mix go into the next quarter, so it's hard to project coffee out too far. But it looks like the current momentum should continue into the next quarter.

That's helpful... Yes, it's good. I appreciate that. A question for Barry on pet. Barry, you mentioned the velocity momentum quarter-on-quarter. When we unpack the data, we see the same theme, but we also see it having stalled out since November, and I see you're kind of flatlining across. And you're running on Nature's Recipe at less than 1/2 the velocity rate of the category and well below some other premium brands, some of them even more new to the market, like Blue. Do you see that velocity sort of flatlining and relative underindexed as a gating factor for further distribution growth? Or do you think it's something that can continue to ramp over time?

Yes, there's no question, Jason, that there's more competition in the segment, without a doubt. But we are confident that we can continue to keep those velocities moving in the right direction. I've mentioned some more targeted advertising where I think, as we learned over the last year, as we see what the competitors' message is, how do we hone our message on Nature's, I think with some of the other new items we're bringing in to replace some of the items that were a little more slower moving, I think those can help as well. So I think we can get the -- continue to keep the velocities moving in the right direction. So we're optimistic about that.

And I think Mark Belgya, I think it was Mark Belgya, mentioned that Pet Snacks grew 6% this quarter, which is in sharp contrast to what we see in Nielsen. And if you look at Nielsen, it looks like snacks are going through the same thing that food did, a lot of premiumization, a lot of fragmentation, with you as the largest share donor. What's the disconnect between what you're reporting and what we're seeing in the data?

Jason, let me start there. First, you're right, there was a disconnect between consumption and our sales. A couple of things to keep in mind. We have significant businesses with customers and channels that are not measured, and so we're seeing some great performance with those customers and channels. So that's one area. Last year, we had made some investments behind some of our snack businesses in terms of coupons and intro, and so that was a timing issue as we think about the performance metrics. And then there has been some market price compression relative to where we're seeing units are up but dollars are down on a couple of select items. So those would be a couple of things that would be contributing to that. I would say as we look at where the retailers are today, looking at their assortments for the next year, we're really encouraged. We're seeing some nice increases in points of distribution across a number of our major customers. So we're enthusiastic about that. We've just recently launched some new innovation across Milk-Bone. It's pretty close in, but we've had tremendous acceptance of that item. And the natural meat segment, that's been driving a lot of growth. And in soft [and chewy], our Pup-Peroni brand kind of bumps up against that segment. We're bringing out a new item. Actually, we're going to accelerate the launch of that. Normally, we'd bring it out in June. We're going to start some early shipments of that. We think that's going to accelerate some growth across Pup-Peroni. And then as we think about the natural meat segment where that growth is coming, we're bringing some innovation out under the Milo's Kitchen brand. We had some good solid acceptance there and increases in distribution. So I think, yes, we've seen some of that disconnect just this quarter. But based on some of the things I mentioned, again, we're optimistic that the consumption numbers will match up a little closer with our sales numbers.

Before we go to the next question -- this is Mark Smucker -- just recognizing, I want to be respectful of everyone's time. We know that several of you may drop off at the bottom of the hour for a couple of the other earnings calls. But we will continue. We have a handful more questions, we would like to answer them. So for those of you that will stay on, we will take a handful more questions.

And our next question comes from Akshay Jagdale from Jefferies.

Steve, congratulations on your retirement. It's been a pleasure working with you. And with that, I do want to ask you a coffee question. So can you give us an update on what you're seeing in terms of the installed base in K-Cups? Obviously, Keurig's now back in the public realm, so we'll get more information from them, I'm sure, going forward. But can you give us an update on what you're seeing there? There's some excitement from them on building the installed base and sort of being a lot more focused. And I know your sales results for your brands and K-Cups were really good, and we haven't seen Folgers grow in a while in K-Cups. But overall, it looks like even their brands saw, for the first time in a long time, a stabilization of share. So just at a high level, installed base and has the shakeout sort of stabilized there, right, like are we sort of in a steady-state market share for all the brands, in your opinion? And then I'll just pass it on.

Sure. Akshay, I think we did see a small step-change over the holidays. And what I think there is, and I think our team would agree, is that we entered with this $49 machine, right, the machine they were able to sell for $150 for the holidays. And they sold a lot of those. If you saw the distribution around it, it was pretty solid. I've not seen personally what -- and I think we'll know over the next few months what we think the household penetration moved to, but I do think they reached a new consumer. And as we know, regardless of consumer demographics, convenience is still an important decision factor for every consumer. And so the fact that we put a lower-priced machine in a new set of households, I think will broaden the category. We think there's a great opportunity. And quite frankly, the customers that they align with really align with our brands. We're very strong with Bustelo there. We're very strong with Folgers there. And I think that's probably why we saw those growth numbers, right? Where they grew their installed base is directly aligned with where we're really successful with our brands. So we feel good about that. Having said that, I think we are going to see, at some point, some kind of a stabilization in that. I think they took one step-change. We also see roast and ground solid. We're excited to show you what we're going to show you next week at CAGNY because we think that premium roast and ground will also continue to grow. So I think the category dynamics look pretty good for the next year or 2. Coffee pricing, green coffee pricing looks stable, looks like we'll have a large crop this summer. The robusta crop is getting better from damage of a drought a year or so ago. So I think we're going to have stable supply and pretty good dynamics over the next year.

Our next question comes from Robert Moskow from Crédit Suisse.

I wanted to kind of jump ahead to like the first half of fiscal '19 with respect to your green coffee position. I imagine you're going to have a very easy comp in the first half there as well. But as I look at the commodity cost -- or commodity prices, they seem to just be very, very low compared to last year and maybe even ticking a little lower. Is there any risk that you might have to consider a list price reduction on coffee? And then also, do you look at your competitors in ground coffee as being relatively stable in their pricing decisions? Private-label pricing, is that considered -- do you think that's stable? Or do you think there's a risk that, that goes lower, too?

Sure, Rob. Honestly, anytime we have low green coffee pricing, there's the potential for competitive activity that focuses on that. Private-label companies tend to be shorter. The branded guys tend to be longer. The premium guys tend to be very long just because the supply chain in premium coffee is much more cumbersome than the supply chain in mainstream coffee. So I would expect that. I would not expect any competitive activity beyond that, that can be funded with green. And what I mean by that is I wouldn't expect it to hurt margins, right? So if there is competitive activity in the category, it'll be funded by green. I wouldn't expect it to be funded by margin. And I think there's another important dynamic happening. As we grow K-Cups double digits, the larger K-Cups in premium become as a percentage of our portfolio, the less dependent we are on green. The green coffee pricing is a very small component of the K-Cup business, right? It's really your conversion cost, and we've addressed that. So I would argue our business is more stable this year and going forward than it was last year.

And so do you think it's fair to say that the ongoing margin for coffee can kind of hang around here at 30%, low 30s kind of margin?

Rob, this is Mark Belgya. Yes, that's exactly right. I think last quarter, we had made a comment realizing that we have -- we're well below that. We were in the mid-20s last quarter. And we said that if we deliver Q3 and Q4 as we expected that we should get back over that 30% and then on a forward basis being driven by all the comments that Steve had. Our expectation is still sort of low 30% segment profit.

Our next question comes from Rob Dickerson from Deutsche Bank.

One quick one is just if there's an update on Wesson? Just seems like it's taking a bit longer than it normally does.

Sure. It's Steve Oakland. We've been involved in the second request process. We've provided the information they requested. I don't know that this isn't taking maybe a little longer, and I'm not sure that's -- I wouldn't read anything into that. I would read it more into the fact that, that organization isn't fully staffed. So we would expect to know when we know. It's one of these things we can't drive. So we're as anxiously awaiting their thoughts as you are.

Okay. Fair enough. And then just, I guess, back to coffee and kind of what's implied in Q4. I think at some point, you said you'd expect operating profit to decline like low single digit, I think, for the year. And kind of how it's tracking, if it implies, let's say, I don't know, 30% plus year-over-year in Q4. The last time we saw that, which I think was Q4 '16, was when coffee costs maybe were getting lower year-over-year. So I'm just curious, is the profit potential uptick in Q4, is that, yes, it's driven by coffee, but there's also this maybe a little tailwind coming from the mix benefit on K-Cup. Just trying to -- I'm basically trying to rightsize what's implied for Q4 in Coffee segment operating profit year-over-year relative to what we've seen historically based upon where the price of coffee is -- cost of coffee?

Rob, it's Mark again. So couple of comments. One is that -- I think it was in our scripted comments, that we would expect Q4 segment profit, your operating profit as you call it, would be up sequentially over Q3. And so we will continue to benefit obviously compared to a year ago's fourth quarter with the benefits of the new Keurig contract, so that'll be sort of a continuation of what you saw in Q3. The new news is the impact of green coffee. As Steve said, that was basically a neutral in Q3. That, we will benefit in Q4, and that's driving what we'll call that incremental improvement sequentially over Q3.

Okay. Cool. And then just -- I'm not sure how much you can say or will say on '19 in terms of free cash flow. We saw this morning, right, you're increasing your target for free cash flow for '18. But it seems like, obviously, with tax reform and maybe even net of investment and where inventories could be, given lower coffee cost, is it -- is the expectation that free cash flow, hopefully in '19, there could be a material increase? Or are there other investments? I fully understand you're not giving guidance for '19, but just kind of any commentary you can provide on free cash flow growth potential over the next year.

Sure. Well, obviously, I can't say what the number is, and I can't -- we all have our own definition of material. But what I can say is that the incremental benefit of just tax, if you just go from the [20 24], it's about the, call it, $50 million to $60 million incremental over where we would end this year. So all things being equal, you would expect to see some increase from that. I guess I'll just hold on that until we give you more of an update in the end of the year. Obviously, factors come into play as working capital expectations, but we would expect to be up because of tax.

Okay. Great. And the last quick one, more for Mr. Smucker. Kind of to Ken's point earlier on a number of U.S. companies are feeling gross margin pressure, but then also a number of companies saying, "Well, if we have a tax benefit, we might reinvest that back up." So I'm just curious, just kind of general feel if we look out over next year, if everyone were to plan to increase that investment, that marketing spend, brand building, what have you, how does that play out? Like how does that -- how does that change the total industry if everybody is spending more? That's it.

On marketing specifically, you're asking, Rob?

Sure. I just -- I just -- like, yes -- before you go through your budget process, you say this is how much we're going to spend. I think you probably think, well, hopefully, it's just as much or more than others would spend in each of our given categories where we want to focus. So as you do that, even if it's a casual conversation, I was just curious as to how you think, if everybody spends, then does it kind of remain at constant, right, like, if -- it's all relative?

Yes. Clearly, our industry is very competitive. And I think at the end of the day, it's hard for me to comment on what others might do. But I think going back to one of my earlier comments, our goal is really to invest in those areas where we really think the growth can come from. And so we've done -- and hopefully you'll see this next week, we've done a lot of work, very diligent work on understanding the consumer, what consumer needs are and how we are uniquely positioned to meet some of those consumer needs. So it's not to say that other companies aren't doing those same things. But I think where we are choosing to invest is probably the most important thing I could say. And broadly, if everybody invests more in the consumer, I think it's -- quite frankly, I think it's good for the industry because I think it helps consumers continue to regain trust in big food, if you will, and the brands that we represent. And so I think we have an obligation to our consumers to invest and to communicate directly with them as much as possible, particularly in the digital age.

Our next question comes from Farha Aslam from Stephens.

One quick question, just as a follow-on to your last answer. I just want to understand, are you going to try and get pricing to offset the freight inflation? And in terms of marketing spend, do you expect that to take the form of pricing, [slotting], increased like consumer-oriented advertising? Just some color on how much and where you're planning to spend that marketing dollar.

Well, Farha, it's Steve. I'll comment on the freight piece. When we look at pricing, we look at the whole gamut of cost. We look at freight, we look at raw materials, look at packaging, all of those things. So we will roll freight into that. And if we get to a point where we have justifiable price -- and today, price means justifiable price, right, what makes sense, we'll do that. So I don't think we -- I don't think freight has pushed us over that line on a business of our size that's $7 million or $8 million or $10 million a quarter. It's material to our results, but it's not material across a couple of billion dollars in sales in our business. So we probably haven't gotten there yet. And then...

Yes, Farha, it's Mark. And I guess in answer to your second question, when we talk about marketing generally, we're talking about marketing aimed at consumer. Obviously, there'll be innovation-related intro-type cost. That will be trade. But basically, when we speak of marketing, we're talking about consumer-directed spend.

So that could be mass media, digital advertising, experiential advertising that reaches the end consumer directly.

But it's not price promotion?

No, that's trade and customer-related, and that's a different line item on the income statement.

And our final question will come from John Baumgartner from Wells Fargo.

Just wanted to ask about consumer. I apologize if I missed this. But the concerns pertaining to private label have kind of been a drag there. And just looking at the Nielsen takeaway data, store brands have gained some share in baking mixes, in salad oils. And peanut butter, it looks as though maybe pricing's a bit sharper given some of the higher spot costs we're seeing for peanuts. So can you maybe speak a bit to what you're seeing in the environment? How much of this is just kind of commodity pass-through relative to anything more strategic? And how do you feel about your price points going into fiscal '19?

John, I guess, we talked a little bit, too. We did see some competitive activity in baking, where the economics of that didn't make sense to us. We invested in Fruit Spreads. We had nice growth. Our peanut butter business is solid. You'll see some innovation in that next week. And then as we look across the other things, Uncrustables and Sahale, the 2 pieces that we think can accelerate growth, both did. Yes, I think -- and I've spoken to this a number of times, I think there are some categories, and we participate in some of those, peanut butter might be one; baking is one, where hard discount wants to make a stand, where our discount retail wants to have a key price point on a key size. And we see that. But I don't think that's going to change the competitive dynamics that much for us. I think we're the #1 brand or #2 brand, with the exception of baking, in all those segments. We understand the competitive set. We understand the merchandising we need to do. In the peanut butter business, we tie it with Fruit Spreads. We've got a lot of multiplying leverage there that we do for merchandising. And so I think we're positioned well for that. I would expect the retailer to continue to use private label to position themselves within the marketplace within a certain customer demographic and against a certain competitor set. So -- and we're not suggesting that is going to change, but we're prepared and we have a strategy to compete in that different world.

John, this is Mark Smucker. Just to comment on the share. Particularly in the last share numbers, we buy IRI data, I think what we see is that leading brands, particularly #1 brands, tend to fare well even when private labels are making a push. And the numbers that we're seeing reflect that. And so you'll see the #2 and 3 brands, and at least particularly in this last period, generally look down versus some of our brands that are in the #1 spot.

Okay. So a little bit of pressure overall, but nothing really out of the ordinary?

I think that's fair.

That's a fair synopsis.

And I am showing no further questions from our phone lines. I would now like to turn the conference call back over to management for any concluding remarks.

I just want to thank everybody for their time. I appreciate it's a busy day for most of you. Just want to reiterate that we've spent a lot of time this past year making sure our foundation is strong and making sure that we're investing in the right things. And so we look forward to seeing you all and sharing more about that with you guys next week at CAGNY. Thank you.

Ladies and gentlemen, this concludes our conference call for today. Thank you all for participating, and have a nice day. All parties may now disconnect.