The Honest Company, Inc.

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Ladies and gentlemen, thank you for standing by. Welcome to the Honest Company's third quarter 2022 earnings call. At this time, all participants are in a listen-only mode. After this speaker's presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would like to hand the conference over to Mr. Steve Ostenfeld, Vice President, Investor Relations at the Honest Company. Please go ahead, sir.

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

Thanks, Steve. Good morning, everyone, and thanks for joining us today. As noted in today's earnings release, we've delivered revenue of $85 million, the largest single quarter in our 10-year history. This strong performance reflected our focus on three strategic growth priorities, marketing, innovation, and distribution expansion. Highlights in the quarter included our performance in retail, where Honest's growth in track channels continues to outpace the category, significant distribution expansion that will continue into the fourth quarter, and the broadening of the Honest lifestyle brand through the integration of our rapidly growing baby clothing business. That said, we recognize the headwinds in the marketplace. Inflationary pressures across the supply chain remain an issue. Customer acquisition costs remain elevated. the digital channel remains challenged and retailers are increasingly focused on managing their working capital by reducing weeks of supply. Despite these challenges in an uncertain macroeconomic environment, we continue to see a resilient consumer in our categories. Consumers are as value conscious as ever, so we're meeting their needs through tailored product offerings, pack sizes, and promotions. Because Honest is a lifestyle brand that spans categories, consumers will be able to create value-oriented bundled solutions across diapers, wipes, personal care, beauty, household products, and now our curated collection of baby clothing. Based on consumption trends in the quarter, it's clear that the Honest brand continues to resonate with the clean, conscious consumer. Looking at 12-week track channel data ending October 2nd, Honest is gaining market share. as our growth to equal or outpace the category where we compete. Our unit velocities remain healthy following first half pricing actions as both volume and pricing are fueling our top line growth. This indicates the brand has pricing power even in this challenging economic environment. The overall category growth in track channels for diapers and wipes was 3%, coming almost exclusively from pricing. honest diapers and wipes grew 6%, balanced between volume and pricing. In baby personal care, the category declined 3%, while honest grew 7%. And in beauty, the category grew 9%, with honest growing 15% when including specialty retailers. As we execute against our key growth strategies, I wanted to provide an update on progress to date. Starting with marketing, which is the lever we pull to drive brand awareness, trial, and share of wallet. We continue to invest at a high level in our brand, with marketing spend at 14% of sales in the third quarter. Recognizing the elevated cost of digital marketing, as well as consumer shift to in-store shopping, we continue to optimize our marketing investment, finding higher return opportunities in areas like retail marketing, where we can cost-effectively reach our consumers and support new distributions. In Q3, there were several marketing examples across our skincare business. We had national marketing and merchandising campaigns with Ulta to support our launch into over 600 stores. Additionally, we amplified the moment with an Ulta-exclusive launch of our new Clearing Collection, focused on acne with a 360-degree marketing campaign, partnering with 25 TikTok Gen Z creators and influencers. while leveraging our influencer community as well. Overall, this full funnel campaign garnered over 30 million impressions and increased the share of our Gen Z consumer base by over 20% versus prior year. We also launched our Extreme Volume Mascara, supported by a robust omni-channel marketing campaign, featuring our founder and mega influencer, Jessica Alba, and several other influencers, generating over 40 million impressions. Turning to innovation, we're pleased with the momentum behind our 2022 product launches. We continue to innovate our beauty portfolio by expanding our extreme length mascara line, which ranks as the number one clean mascara on Amazon by launching extreme volume mascara on honest.com and with key retail partners. Initial demand has been strong, becoming one of our top five beauty items at Target. and a top new release tag at Amazon based on its revenue and ratings performance. We also launched our new acne skin clearing line exclusively at Ulta and Honest.com and a line of wellness supplements at GNC. Our Honest Beauty Fresh Flex Concealer earned a 2022 Allure Best of Beauty Award in the clean category, which is the ninth Allure Best of Beauty Award win for the Honest brand. These are examples of our continued focus on hero products within our three-year strategic product plan. In the fourth quarter, we look forward to our holiday gifting initiatives and the relaunch of our training pants to further drive revenue growth. On the distribution side, we're now executing our launch into over 2,500 Walmart stores. Following our launch into over 600 Ulta stores, over 1,400 GNC stores, and all Publix locations. We are also expanding our partnership with Nordstrom, with the launch of skin and cosmetics into Nordstrom Rack chain-wide. The expansion into Walmart is expected to be highly incremental, as over one-third of the locations where Honest will be introduced are in the South and Southeast, where Honest has traditionally been underrepresented in a part of the country which represents approximately 40% of US births. In store, you'll find end caps featuring 15 honest items, including diapers, wipes, and personal care, featuring an exclusive new sweet cream scent. Although still early, we're pleased with the incrementality of the business and look forward to acquiring new consumers and driving household penetration through this launch. In summary, We feel confident that continued focus against our key growth initiatives in marketing, innovation, and distribution will drive growth for the remainder of the year and into 2023. As we close out the year and look forward to 2023, we're closely watching a few areas. First, inflationary pressures remain high, particularly across the supply chain, digital advertising rates, and wages. In response, we focused on executing cost savings and taking pricing to offset some of the pressures. With price increases in January and June across roughly two-thirds of the portfolio, our elasticities have held as expected or better, and we continue to see volume growth across all categories. As we mentioned in our last call, we will be taking another round of pricing in mid-December that will impact roughly a quarter of the company's revenue. Second, Our digital business remains soft as consumers have shifted back to purchasing in-store and digital advertising costs remain elevated, impacting traffic and revenue online. Additionally, we see retailers managing their working capital and inventory in the face of economic uncertainty, impacting shipments and creating volatility despite strong consumption trends. As we focus on delivering our Q4 targets, the honest brand remains strong and the benefit of our omnichannel strategy allows us to meet consumer demand regardless of where consumers want to shop. We have conviction behind our strategy as we need to build the next modern CPG lifestyle brand and inspire consumers to love living consciously. Now, I will turn it over to our CFO, Kelly Kennedy.

Thank you, Nick, and welcome, everyone. I'll start by highlighting our top line performance in the quarter, where revenue was up 2% versus a year ago, on top of our highest single revenue quarter last year, slightly ahead of our expectations. Revenue was up 10%, excluding the impact of a prior year rotational club channel program that didn't repeat this year. While we've remained cautious as inflation continues to weigh on costs and impact our margins, we are taking action to mitigate higher input costs, including pricing actions, cost savings initiatives, and a focus on margin-enhancing innovation. Diving into key drivers by product category. First, diapers and wipes. Our diapers and wipes business represented 65% in revenue this quarter and was up 3% following 9% growth in the second quarter. Growth was balanced with positive trends in both volume and pricing and positive year-over-year trends across all of our key retail customers. This quarter, we also shipped initial orders to support the rollout into Walmart retail stores. In the diapers and wipes, we are seeing acceleration, particularly in larger size offerings, which provide the best value to the consumer on a per-unit cost basis. I also wanted to highlight the momentum in our baby wipes. which grew at more than double the rate of the overall category, driven by alternate uses of wipes beyond diapering. In Q3, we relaunched our training camp, which completes our clean conscious diaper portfolio. During the quarter, we leveraged a multi-tier strategy of marketing, packaging improvement, expanded shelf placement, and stronger price positioning as we increased our assortment from 450 to 1,500 target stores. Skin and personal care represented 25% of people's revenue per year.

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Our health and wellness business saw a big step up in revenue versus recent trends, increasing 115% and representing nearly 10% of revenue. Growth in the quarter was driven by our baby clothing business, which converted from a royalty arrangement to a conventional supply arrangement in the third quarter, which allows us to recognize the full revenue and associated costs. This new arrangement was almost a year in the making as we recognize the growth potential of this business and ability to cross merchandise and leverage our existing consumers and customers. We expect to scale Honest Baby clothing within our retail footprint in 2023 and over time benefit from scale and operational efficiency. A great example of the growing demand for Honest Pajamas for Family and Baby made from organic cotton is a recent feature for the second year in a row as one of Oprah's favorite things for the 2022 holidays. Combined with new gifting collections launching in Q4 and the sanitizing business, which has stabilized, we expect to build household and wellness revenue back to expected levels over time. Now turning to results by channel. Revenue in Q3 was split roughly 60% retail and 40% digital. This quarter, our business skewed more heavily towards the retail channel as we shipped new distribution and continued to face softness in the digital channel. Digital channel revenue declined 14%, driven by an inventory adjustment at a key digital customer and a reduced digital marketing spend in the face of elevated advertising costs. As we've noted in the past, order patterns from retailers can vary, often driven by algorithms either outpacing or trailing consumer demands. In this case, consumption at this online retailer remained strong, up 20% in the quarter, while revenue was down over 20%. As more and more retailers are focusing on working capital, we expect further impacts from inventory reductions in Q4, despite solid underlying consumption trends. Over the coming months, we will be working closely with retailers to ensure they maintain adequate supply to meet consumer demands. As highlighted on previous calls, we have strategically shifted our marketing spend to invest in higher return programs, such as shopper marketing, which is reflected in our double-digit retailer growth in the quarter. Despite near-term challenges for our digital business, we continue to believe it will drive meaningful growth in the future and are investing to support the Honest.com experience. During the year, we invested in site speed improvements, a modernized site layout, and dynamic content tailored to consumer brand interests. These investments are delivering as we meaningfully improve the quality of our subscriber base this quarter and achieve the click-through rate that exceeds industry benchmarks. We look forward to sharing further developments with you in 2023, including the rollout of a new rewards program. Turning now to retail, where revenue increased 17%, including double-digit growth at our five largest customers in the retail channel. Highlights included a 16% increase at Target, supported by our 83rd consecutive week of year-over-year point-of-sale growth, our participation in the 30th exclusive seasonal diaper program, and an 8-foot natural shelf set as part of the new baby planogram. The rollout of our Hero Skin Care products and acne line at over 600 Ulta stores with 10 skincare items in store and a broader assortment online, including cosmetics, with velocities to date exceeding expectations. 50% year-over-year growth at Kroger since launching Clubbox Cycles earlier in the year, which has led to Onyx being the number one clean and natural brand in their stores, and our launch in Publix, a leading grocery chain in the Southeast, where our personal care items are already achieving top velocities in the category. Retail growth was also driven by the launch of diapers, wipes, and personal care items into over 2,500 Walmart stores, which offset the revenue generated last year in the club rotational program. Now turning to gross margin. Gross margin was 30.3% in the third quarter of 2022, a 30 basis point sequential improvement versus the second quarter, as compared to 36% in the third quarter of 2021. This reflects approximately 825 basis points of higher supply chain costs versus the prior year, negative 170 basis points for mixed and trade spending, offset by roughly 425 basis points from pricing and cost savings. The biggest impact came from higher product costs, including inbound freight, which increased approximately 510 basis points versus a year ago. This increase was generally in line with our forecast. In addition, fulfillment costs increased approximately 315 basis points versus a year ago, which was higher than expected due to labor warehousing costs. These higher costs were due to a combination of the timing of inventory receipts and shipments to support new retail distribution, as well as the impact of the consolidation of our Fontana warehouse into Las Vegas, causing short-term operational inefficiencies. We expect these costs to remain elevated through the end of the year. While some spot rates for inbound ocean freight and U.S. trucking have come down, any benefit would take some time to be seen in our margins as we capitalize inbound costs into inventory. Also, we're mindful that a decrease in rates earlier in the year quickly reversed, eliminating any upside, so the sustainability of any cost decreases remains uncertain. During the quarter, we reflected the full benefit of pricing taken earlier in the year which enhanced margin by 375 basis points. As Nick noted, we are pleased with the execution at retail stores as our price gaps versus conventional products remain in line and consumer reaction to pricing has been in line or better than anticipated. In track channel data for the quarter, we have seen increases in both volume and sales in our category. In the third quarter, we announced additional pricing to retailers on a select number of diapers, wipes, and personal care items taking effect mid-December with price increases in the mid to high single-digit range. Given the continued cost pressures facing all companies and price points currently in the market, we believe taking pricing now on select items will be successful in the market and further help to offset cost pressures in 2023. Regarding input cost pressures, we are facing continued inflation impacts on key commodities, such as flux poles. We are currently evaluating options for offsetting these cost pressures, which may require a combination of additional pricing, tax size optimization, and other cost initiatives to deliver margin targets as we move into 2023. Turning to operating costs and profitability. Operating expenses increased $3 million this quarter, but were flat, excluding costs attributed to a $1.5 million donation of sanitizing products and $1.6 million in litigation expense. As we work to align inventory to demand, we have looked to various strategies to address excess inventory in sanitizing products, which includes leveraging our partnerships to support charitable programs with honest products. The donation reflects our commitment to social responsibility and builds on our long history of product donations to benefit those in need. Marketing spend was 14% of sales in line with our planned support for the Honest brand and reflected a higher level of retail marketing support versus a year ago. Adjusted EBITDA for the third quarter of 2022 was negative 5.6 million. Excluding the product donation, adjusted EBITDA was negative 4 million. We ended the third quarter with $41 million in cash, cash equivalents, and short-term investments with no debt. This quarter, we invested $15 million of our cash in higher inventory and accounts receivable as we executed our Walmart launch into over 2,500 stores nationally and brought our baby clothing business in-house. Both of these initiatives will materially boost our revenue growth in 2023. Going forward, while we expect our absolute levels of inventory to increase as our business grows, we expect our inventory turnover ratio to improve as we gain greater understanding of consumption patterns with our customers and recognize the benefit of our warehouse consolidation executed earlier in the year. We believe the company's increased investment in working capital supports the growth of the business and don't anticipate it having a material impact on the company's cash position going forward. Turning to our fiscal year 2022 outlook, we are updating our full-year revenue outlook to be in the range of 310 to 315 million, reflecting inventory adjustments at a key digital customer who reduced its weeks of supply. Our consumption remains strong, so we are working closely with all retailers to ensure they are able to meet consumer demand. We expect full-year gross margin to be between 30 and 31%, reflecting approximately 600 basis points of higher supply chain costs versus 2021, and 100 basis points in incremental trade investment, supporting new distribution, offset by roughly 350 basis points from pricing and cost savings. We continue to expect full-year adjusted EBITDA to be in the range of negative 10 million to negative 20 million. but narrowing closer to negative 20 million. This reflects positive adjusted EBITDA in the fourth quarter, which assumes sequential growth margin improvement, lower seasonal marketing spend, and aggressive management of controllable costs. It also assumes no further material increases in product and fulfillment costs. Before we open it up for questions, I'd like to share our preliminary view on revenue for the first half of 2023. Our first half revenue outlook for 2023 is for revenue growth in the range of 7% to 10%. This contemplates the retail distribution expansion in the second half of 2022, a new round of price increases on select ciphers, wipes, and personal care items effective the middle of next month, balanced by uncertainty in U.S. consumer spending, and continued tight inventory management by retailers. As the year progresses, we will be lapping two significant events. the benefits of material 2022 retail expansion, and back half revenues from baby clothing. We will provide a more detailed 2023 outlook on our fourth quarter earnings poll in March 2023, including gross margin and adjusted EBITDA outlook. In conclusion, I'm pleased with the momentum of the business as we expand our omni-channel footprint and make honest products more accessible to consumers in the U.S. and abroad. As we bring 2022 to a close, we are pleased that a number of factors that created volatility in our results over the last year will largely be behind us, including COVID impacts on our household and wellness business, digital demand volatility, one-time rotational programs, inventory retailer rebalancing, and unprecedented inflationary pressures. We have set a solid foundation for growth in 2023 and are confident in our ability to deliver more consistent top and bottom line performance in the coming year. With that, I'll turn the call over to the operator, and we look forward to answering any questions.

Thank you. And as a reminder, to ask a question, you need to press star 1-1 on your telephone. Once again, that's star 1-1. Please send by. We'll compile the Q&A roster. Our first question comes from the line of Laura Champine from Loop Capital. Your line is open.

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

I'll start off, Laura, and give you some context around the strategic kind of rationale. When you think of this business, we've kind of been involved with it through a licensing arrangement for about a couple of years, so we've been monitoring it closely. What we like about the business is kind of two things. Number one, the digital component to this around acquisition and how we drive our AOV and kind of monetize that honest consumer kind of in that early life stage is really attractive because what we're talking about here is opportunities to really drive gifting, which obviously not only entails the baby clothing, but our personal care business, our diaper business, and start to offer more holistic solutions. And then the second thing that also is attractive is kind of the overlap in the consumer. About 80% of the consumers that are out there, there's an overlap between the target as it pertains to the honest consumer from a personal care perspective, as well as diaper perspective. And we think the bundling solutions around this initiative are really attractive. So this is something that, again, has been in the works for a little bit. It also gives us the opportunity as we think of household and wellness. as we think of the size of that category and what we're anticipating when we did the IPO to be able to kind of solidify that part of our business moving forward. So from a volume dollar perspective, it's also attractive. And then when we talk about kind of the incrementality of this, the way I would think about it is this initiative, as well as Walmart, as we look at next year, will drive about 5% to 7% incremental growth on an annualized basis. So when you take a look at both the new business from a Walmart standpoint, as well as now the baby clothing, we think the incrementality of this is attractive. And I'll let Kelly give some more details around the financial component.

Yeah, Laura. So for the quarter, the honest baby clothing was just under $4 million. It tends to be a little more seasonal. In nature, so Q3, we anticipate being the largest quarter as it relates to revenue as we ship on baby clothing out to retailers in advance of the holiday. While we only entered into the agreement about halfway through the year, it was anticipated and planned within our numbers. And they are run rating roughly to be about a $15 million business this year. with significant growth projected for this year. And going forward, big opportunities, as Nick mentioned, not only to leverage our distribution in the future, starting with the current arrangement, the overall margin structure and EBITDA structure is at par. with the potential to be favorable as we consolidate within in 2023 within our warehouse facility.

Great. Thank you. Thank you, Laura.

Thank you. One moment for our next question. Our next question comes from Brian Spillane from Bank of America. Your line is open.

Hi. This is John Keepp. We're on for Brian. So looking at the release, you guys mentioned the eight points of drag as you lapped last year's rotation program in skin and personal care. Adjusting for that, it implies, I mean, correct me if my math is wrong, but it implies 16% to 17% growth otherwise. Is that a better gauge of the underlying momentum in that business?

I think if you look at the underlying, we would suggest you look to kind of the recent consumption data. We did highlight in the release that we had a 12-week track Data was up 6%. If you look at the most recent IRI data that just came out through 1030, our four-week, we've had some acceleration of the business. We've grown closer to 17% versus the category at 3%. So we've seen good underlying consumption trends within the tracks and retail channels. There were lots of puts and takes for Q3. We were up against, as we mentioned, the rotational program. We also had a drag as well with the destocking with one of our key digital partners that was also a slight drag as well on Q3. But of course, we shipped a lot of pipeline with Walmart, which in essence offsets the loss of the rotational program. And then, again, we did have a little bit more strength overall in our honest baby clothing than we had planned on coming into the quarter. So all of those puts and takes, if you think about 2%, we did highlight, you know, that excluding kind of that one-time program, the growth in Q3 would have been closer to 10%. So I think that's relatively in line with the consumption trends that you're seeing and reporting within the IRI data.

And if I could have a follow-up on, so Walmart was basically offsetting the rotation program lapse, so that's about six-ish million. Is there any Publix pipeline fill in the quarter as well?

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

Okay, thank you. Thank you. One moment for our next question. And as a reminder, that's star 11 for any questions. Our next question comes from Andrea Teixeira from JP Morgan. Your line is open.

Hi, this is Shavonna Chaudhary on behalf of Andrea. I just wanted to quickly ask about, now that retail channel makes up a bigger portion of your sales at 60% versus digital before, Can you please go over like your margin dynamics and like for retail versus digital? I mean, you did elaborate on the marketing spend being lower for retail versus digital and you're shifting away into retail more. But can you please go over like the other margin profile? Is it better or how do you see it going forward? Thank you.

Thanks for the question. I would first kind of give context as it pertains to kind of that 60-40 split. So as an omni-channel business and what we're driving here that's unique is driving that accessibility in multiple places within the market. We've seen kind of digital soften over the last year because now consumers have gravitated, kind of post this COVID period, more into stores. So as we're starting to drive a broader distribution and driving accessibility with partners like a Walmart, partners like you know, publics, we're going to be able to now make that product accessible broader. And it's also going to help us from a volatility perspective because now we have broader distribution. So digital is softer. You've got places to be able to offshoot kind of the overall revenue piece around other different partners from that standpoint. On a margin basis, it's almost equivalized. So when you look at digital versus retail, we have equivalized margin structures between both retail as well as digital. And I know Kelly's got some additional context that pertains to fulfillment as well as the overall footprint.

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

Thank you. That's very helpful. I'll pass it on.

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

I appreciate the participation today. I would just say from our standpoint, kind of three things. You know, number one, as you look at the underlying consumption of the business, it continues to be strong from an honest perspective. As you kind of eliminate some of the noise that's transpired here, you know, this year, kind of the second big takeaway as we enter, you know, next year, there's been a lot of historical moving parts, but we see stabilization as it pertains to 2023 around the supply chain volatility, kind of these rotational club programs, you know, the retailer inventory to stocking, as well as kind of the COVID impact. So we feel like that's behind us. And really the key takeaway as we look at kind of the third point is As we enter 2023, this continues to be for us a growth story. We talk about 7% to 10% growth really in the front half, but as we talk about kind of the back half, this kind of incremental business that we're talking about from a Walmart perspective, a baby perspective with the baby clothing line, we see that contributing between five to seven points of incremental growth. moving forward and that coupled with the innovation pipeline that we have uh that hits the back half of the year the benefits of pricing on an annualized basis as well as kind of expected new distribution uh gives us reason to believe that 2023 is going to be a very good year for the honest company and we're going to come back in our next earnings call as we close out q4 to give a full forecast, both from a top-line gross margin and profitability standpoint. So with that, I hope everybody has a great holiday season, and we look forward to our next call.

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