The Honest Company, Inc.

Good day and thank you for standing by. Welcome to the Honest Company Q2 2023 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 11 on your telephone. You will then hear an automated message advising that your hand is raised. To withdraw your question, please press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker,

Steve Austinsell. Please go ahead.

Good afternoon, everyone, and thank you for joining our second quarter 2023 conference call. Joining me today are Carla Vernon, our chief executive officer, and Kelly Kennedy, our chief financial officer. Before we start, I'd like to remind you that we will make 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 of 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'll find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures and the financial results section of today's earnings release. A live broadcast of this call is also available on the investor relations section of our website at investors.honest.com. With that, I'll turn the call over to Carla.

Thanks, Steve. Good afternoon, everyone, and thanks for joining us today. I'm pleased to be with you to share our strong second quarter results, related performance drivers, and our increased outlook for both revenue and adjusted EBITDA for the year. Our brand strength is evident in revenue growth of 8% in the quarter and 14% for the first half of the year. Growth was balanced across retail and digital channels and delivered through both volume and pricing. Looking at tracked channel data, which covers approximately half of our revenue, Total consumption increased 24% this quarter. Diapers, which continue to be the heartbeat of the Honest brand, are growing market share through expanded equipment of our exclusive designs and seasonal prints that delight our consumers. And our portfolio of plant-based wipes delivered the highest share growth in the natural wipes category in the second quarter. They are beloved by our community for uses ranging from wiping babies' booties to cleaning kits and cooties. In addition to being pleased with the top line growth this quarter, we're also excited about the progress of the transformation initiative we introduced last quarter. Our transformation initiative, which encompasses the three main pillars of brand maximization, margin enhancement, and operating discipline, was launched earlier this year to drive improvement in our cost structure and margins and to support further investment in portfolio growth and brand building. Each of these three pillars drove meaningful advancements in the second quarter. Our focus on brand maximization drove improved marketing efficiencies and performance of our top items. By eliminating our lowest return marketing investments, and focusing our support on best-selling hero products across our diapers, wipes, and beauty portfolio, we were able to deliver revenue growth while also reducing our marketing spend. Our margin enhancement efforts were focused on structural cost savings initiatives and pricing actions that realign our pricing structure with the premium ingredients in our products. In the first half of this year, We negotiated significant operating cost improvements with our supply chain partners and completed pricing actions across baby and beauty, which are now reflected on shelf and online. We have also exited Asia and Europe, which significantly reduces the complexity in our business model. These actions will improve our margin structure for the second half of 2023 and into 2024. Additionally, we made progress implementing operating discipline as reflected in working capital improvements and inventory levels that now align with demand. This has driven significant improvement to our cash position and resulted in positive operating cash flow for the quarter. We believe honest portfolio strength combined with the benefits and discipline of our transformation initiative will advance our ability to drive improved cash flow, achieve profitability over time, and drive higher shareholder value. Kelly, I'll turn it over to you to review the financials, including further details on our transformation initiative. Thank you, Carla, and welcome, everyone. Our performance in the quarter reflected strong top-line results and improved gross margin trends and positive operating cash flow. all demonstrating strong execution against our strategic goals this quarter. As Carla highlighted, we also made meaningful progress on our transformation initiative this quarter, which sets the foundation for higher gross margin in the back half in 2024 and provides fuel to invest in and accelerate growth. Starting first with revenue results for the quarter, revenue was $85 million which increased 8% versus a year ago, reflecting growth in both channels, digital and retail. This growth reflects healthy track channel consumption trends, the impact of channel and category expansion, including Walmart and Honest Baby clothing, strong consumption at our key digital retailers, and pricing actions taken over the course of the last year. For the quarter, Volume was the largest driver of growth, reflecting strong results across our biggest retail and online customers, supported by new distribution added last year, partially offset by reduced revenue from low-margin parts of our portfolio, including the club channel and international market. Approximately one-third of our growth in the second quarter was driven by higher pricing, with the balance from volume. Turning to key drivers by product category. First, diapers and wipes. Our diapers and wipes business was up 6%, with honest consumption significantly outpacing the category. Looking at track channel performance, honest consumption growth in diapers and wipes in the second quarter increased 32%, well ahead of the 4% category growth. This reflects honest diapers growing eight times the pace of the category, and Honest Wife's growing five times the pace of the category in the last 12 weeks. Skin and personal care declined 2% as we scaled back low-margin products in the club channel. We continue to see momentum in skincare and beauty with double-digit growth across our retailers. Our household and wellness business increased 98%, We continue to scale the baby clothing business as we approach the one year anniversary of its integration this month. We remain quite pleased with both the underlying growth of baby clothing as well as the co-marketing benefits with our other baby products and gifting options. Now turning to results by channel. Digital channel revenue increased 10% while retail increased 5%. Similar to Q1, revenue in Q2 was almost equally split between channels, with retail at 51% of revenue and digital at 49%. Our omnichannel performance reflected recent retail distribution wins, robust track channel consumption, as well as strong purchases by our key digital retailer. Some highlights this quarter include continued strong performance at Target, which saw high single-digit consumption growth versus year ago, double-digit point of sales growth across diapers, wipes, and beauty items at Amazon, and continued strength at Walmart following our launch in the second half of 2022, as well as new distribution secured this year. Following the success of our launch into Walmart in the third quarter last year, we have transitioned from being primarily featured on end caps to an assortment of diapers, wipes, and personal care items now being shelved in line, which is the primary shopping destination for our categories. Initial indications are positive, and we are seeing velocity growth as a result. Our analysis also indicates that revenue from the expansion into Walmart has been highly incremental. Through this partnership, we've been able to significantly expand our reach and introduce Honest products to a new consumer, particularly in geographic regions such as the south and southeast where Honest has been underpenetrated. Now turning to gross margin. Gross margin was 27% in the second quarter compared to 30% in the second quarter of 2022. This includes approximately 100 basis points of transformation initiative costs. Gross margin versus a year-ago quarter reflects approximately 550 basis points of higher input costs and supply chain costs, offset by roughly 350 basis points of benefit from pricing, cost savings, and trade promotion efficiency. We expect the favorable impact of the transformation initiative, including recent pricing actions, to accelerate as we move into the back half of the year, benefiting gross margins. Turning to operating costs and profitability, operating expenses increased $2 million in the second quarter of 2023 compared to the second quarter of 2022, reflecting a $3 million increase in stock-based compensation due to accelerated vesting related to a prior separation agreement. Operating expenses were also impacted by a $1 million higher legal fees related to securities litigation expense, and roughly a half million dollars of restructuring expense, offset by reduced marketing spend, as we shifted towards higher return brand building opportunities. Adjusted EBITDA for the second quarter of 2023 was negative $4 million, which included $1 million in costs related to the transformation initiative. Turning to the balance sheet, we ended the quarter with $18 million in cash, cash equivalents and short-term investments, an increase of 6 million versus last quarter. Operating cash flow was positive 4 million, and the company continues to have no debt. Our cash position improved in great part from our second consecutive quarter of meaningful reduction in our inventory balance, which decreased by 16 million in the quarter. Year to date, we've significantly exceeded our initial goal of reducing inventories by $20 million. We believe our current inventory level is aligned with demand with a modest opportunity for further reduction as we complete transformation initiative activities and move through unproductive inventory in the second half. Now turning to our outlook for 2023. Following strong consumption trends in the first half and the progress on our transformation initiative, we are increasing our full year 2023 outlook. we now expect revenue to be up low single to mid single digits versus full year 2022 versus a prior expectation of being up low single digits. The company's full year 2023 revenue outlook reflects continued positive track channel consumption and the benefit of mid-year pricing actions offset by revenue growth headwinds in the second half as we last significant new distribution shift in 2022 and the impact of exiting low margin and low priority product lines. Adjusted EBITDA is now expected to be in the range of negative $22 million to negative $26 million, including $8 to $10 million in costs and charges related to the transformation initiative that will impact adjusted EBITDA in 2023. In total, we now anticipate the transformation initiative to incur $10 to $13 million in total project costs, a slight reduction versus our prior estimate, with the majority being non-cash. Year to date, we recognize $8 million of transformation initiative costs. Please see our earnings release for details on the P&L line item impact to date and for the balance of the year. We continue to anticipate the transformation initiative will generate an estimated $15 to $20 million in annualized benefits starting in late 2023 as we monetize pricing, drive cost savings, and reduce operating expenses. As we look to the second half of the year, our company and leadership team remain focused on realizing the benefit of the pricing actions taken to date, which restore our historical premiums in line with our brand positioning, improving our cost structure, including renegotiation of contracts and input costs across our key suppliers and vendors, driving efficiencies and higher returns from brand building investments to support higher margin growth, and finalizing the exit of low margin product lines and businesses. These actions will set a strong foundation for margin improvement in 2024 and beyond. With that, Let me turn it back to Carla before we open it up for questions. Thanks, Kelly. As we pivot to the second half of 2023, we remain relentlessly focused on delivering improved business fundamentals through the three transformation initiative pillars of brand maximization, margin enhancement, and operating discipline. The great progress we've made so far on the transformation initiative, and our strong first half revenue reinforces my conviction that the honest brand has a long runway for growth. First, consumers continue to value our clean approach to product formulation and our commitment to the honest standard with over 3,500 ingredients and chemicals we choose not to use. Second, we have a differentiated and on-trend brand in a growing, clean, and natural segment that is outpacing conventional offerings. And third, we are confident that we have significant runway for additional points of distribution. While the overall ACV for the Honest portfolio has increased from 53% a year ago to 85% at the end of Q2, many of our best-selling items still have ACV levels of 30% or less. reinforcing the opportunity to grow our distribution and assortment if i could leave you with one thing it's that we remain committed to expanding margins and driving shareholder value as we continue to realize additional benefits from our transformation initiative these improvements will establish the foundation upon which we will expand the honest brand to become a larger more vibrant, and more widely available brand than it is today. With that, I turn the call over to the operator, and we look forward to answering your questions.

Certainly. As a reminder, to ask a question, please press star 11 on your telephone and wait for your name to be announced. To withdraw your question, please press star 11 again. Please wait while we compile the Q&A roster.

One moment for our first question. And our first question will come from Laura Champagne of Loop.

Your line is open.

Good afternoon, and thank you for taking my question. It's really about the restructuring's positive impact on revenues, which I just don't see that often. Is this the result of price increases, or is there something else in it?

Yeah, Laura, this is Kelly. Thank you for your questions. It is around pricing as we've realigned our pricing to be back to historical premiums. That's really what we're talking about when we talk about the positive revenue impacts of the transformation initiative. The other piece of the transformation initiative that I would just mention is certainly marketing efficiency and leaning in and supporting some of our best-selling items. So it's around focus. We did do a skew rationalization. So it's really leaning in and supporting some of our best sellers with both marketing, distribution, and just ensuring that we have the content to support those best sellers.

Got it. I know that Honest was a little slower to raise prices. Are you now in the position where you might be raising prices when competing brands lower prices? or is that not happening at this point?

Now, the pricing that is going out into the market in 2023 went in. There were a few different waves, but 90% of our pricing is in as of last month. There is a couple small in the sanitization that will be repriced later in the year, but the pricing that we have planned in 2023 is in market and done and is sufficient to offset the inflation that we experienced. Predominantly, that was inflation in 2022, but we also saw some increases in input costs from vendors in Q1. So now, you know, once that is fully realized, which we know that those went in mid-year, it'll be 2024, we feel we've taken sufficient pricing to cover that inflation.

Great.

Thank you. One moment for our next question. And our next question will be coming from Andrea Texiera of J.P.

Morgan. Your line is open.

Thank you. Good afternoon. So some of the – I have three product questions. I'm sorry. One is some of your obviously top-selling products have been, you know, as you said, Carla, still below or around 30% ACV. I was wondering if you can comment on the path to improve that. And then second, in terms of consumption against shipment trends, I can comment on that most recently and in particular as you implemented the price increases last month, how you're seeing elasticity there. And on the third part of my question is on the gross margin called out a couple of things like including exiting portions of your international business and the sanitation industry. as well as the skew rationalization. So I was wondering if that reduction of 290 business points year-over-year, how much of that was related to that? And if you can also comment on the guide, if the new guide includes the exit of those businesses or if that's adjusted out. Thank you.

Nice to hear from you, Andrea. Let me kick it off. This is Carla. with the conversation about the opportunity to increase distribution in our existing portfolio of items that, yes, we call them our hero items. So first and most importantly, what we're excited about is that our hero items are performing so strongly where they are. Our track channel data grew by 24% across all of Onyx items. That is strongly led by our hero items. That is so important because as we partner with our retailers to talk about the opportunity to increase either the visibility of expanding assortment, or even expanding facings in the aisles where we are and the doors where we are, our strong performance opens up the opportunity to have really good conversations about the growth we can drive on those existing shelf sets by expanding distribution of our top items. Of course, you know that's kind of a key way that household and CPG and beauty items work. With your top selling items, it's actually best in the categories if the distribution is enough to ensure that as the velocities turn, that supply is available of those most in-demand items. So we are in conversations with retailers about that strategy. Additionally, though, interestingly enough, For some of our key retailers, we're not yet in all the doors on our top items. This has been a bit of a learn as we go process. So for example, as you think about our entry into Walmart, as you know, and we've talked a lot of times, our entry into Walmart has really been led by a baby strategy. So as we now see the success and the relevance of the brand with the Walmart consumer, there's opportunity to make sure we say, there are aisles and categories we have not even yet introduced at doors where we're already in. So those are, I think two of the biggest ways. And sometimes the third way is certain retailers know that some products are relevant, both as you would walk through the baby aisle, but separately the adult personal care aisle, that same product or a variation of that product might be relevant in two different places in the store. So even just against our hero item, lots of, uh, sort of roads to Rome, as I call it, on the ways in which we drive more availability of the products that are most in demand and our consumers love. In addition to that, I would just say what we will layer on that is very exciting as the distribution grows, When you layer the marketing on top of more broad-shouldered distribution, not only does that improve the return on that marketing, but it ensures that as the brand has a bigger billboard in store, it's driven also with a much more focused marketing category on those hero items. I'll go ahead and take your second question. Your second question, Andrej. around consumption and the impact as we've taken pricing on the elasticity. And some of the pricing impacts just went in in the last 30 to 60 days. So we only have initial reads, but with the most recent consumption data, even the data that came out this morning, we're continuing to see the same trends and a slight acceleration in the tracks channel. which really reflects that new price on shelf. We've tended to take a pretty cautious approach about what the impact could be on the last two cities, thinking around the back half. It's still a little early, but we've been pleased to see continued growth in both volume and pricing. So, so far, so good. And we'll have a better read after we get a couple more months under our belt. And then finally, your question around the gross margin and exiting the low margin products. We did, as we highlighted in our call, we did finalize kind of the terms and agreements with some partners as we exited Asia and also closed down our operations in Europe. And both of those were reflected in the TI impact you saw in the gross margin for the second quarter, so that we highlighted there was approximately 100 basis point impact on gross margin. As we highlighted, there will be some additional impacts in Q3 still to come as we finalize some of the other portions of our initiative in other areas outside of kind of exiting some of the skew rationalization Predominantly, we are expecting that in Q3. So as you can think about margins for the back half, you know, we expect to absorb kind of the biggest bulk remainder of that in the third quarter. And then as we move into Q4 and into 2024, we'll be a little cleaner as it relates to the impact of TI on gross margin.

And then if I can... Just go back to Kelly, this point that you just made. I think we all struggle to see where the margin will land as we go. And I appreciate that's a lot of emphasis that you have been putting and Carla as well in terms of the discipline in the margin going forward. But can you give us an idea when you finish this transformation, what would be the target margin?

Yeah, so 2023, we would continue to have some impact on margin, even in going to the back half, but sequential improvement. What we highlighted were some short-term cost headwinds, both between the transformation initiative and some of the transportation costs, which as they have come down, just take some time to flow through. So we started to see some benefit. We'll see benefit of those lower transportation costs in the back half. As we highlighted both in Q1 and Q2, when you adjust for those impacts, basically the gross margin, adjusted gross margin, is kind of in that 28% to 29%. And we did get the benefit on two, two and a half points related to the pricing that we've taken. So there will be some slight additional pricing as we move into the back half. And we'll get the full benefit of all of those impacts, which would be pricing that has offset the inflation, a return to more normalized transportation costs going forward, and then some improvement due to cost savings that we've initiated in 2023 that really won't be that impactful until we move into 2024. So, sequentially, that's super important. But again, predominantly hitting 2024, so the 2023 step-up improvement will be marginal.

Great. Thank you very much. I'll pass it on.

Thank you. And I'm showing no further questions. I would now like to turn the conference back to management for closing remarks.

Okay. Well, it was a pleasure to be with you this quarter. Thank you again for joining us. And for your interest and support for The Honest Company, we look forward to be back here speaking with you next quarter.

Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.