Central Garden & Pet Company - Earnings Call - Q3 2020

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by. Welcome to Central Garden & Pet's third quarter fiscal 2020 financial results conference call. My name is Devin, and I will be your conference operator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. If anyone should require operator assistance during the conference, please press star followed by the zero on your touch-tone phone. As a reminder, this conference is being recorded. I would now like to turn the call over to Howard Machek. Please go ahead.

Howard Machek (VP Finance and Corporate Controller)

Thank you. Good afternoon, everyone. Thank you for joining us. With me on the call today are Tim Cofer, Central's Chief Executive Officer; Niko Lahanas, Chief Financial Officer; J.D. Walker, President, Garden-branded business; and John Hanson, President, Pet Consumer Products. Our press release, providing results for our third quarter ending June 27, 2020, is available on our website at www.central.com and contains the GAAP-to-non-GAAP reconciliation for the non-GAAP measures discussed on this call. Before I turn the call over to Tim, I would like to remind you that statements made during this conference call, which are not historical facts, including the potential impact of COVID-19 on our business, expectations for new product introductions, long-term organic growth goals, future acquisitions and future revenue, margin expansion, cost savings, and profitability, are forward-looking statements subject to risks and uncertainties that could cause actual results to differ materially from those implied by forward-looking statements.

These risks and others are described in Central's Securities and Exchange Commission filings, including our annual report on Form 10-K filed on November 27, 2019. Central undertakes no obligation to publicly update these forward-looking statements to reflect new information, subsequent events, or otherwise. Now I will turn the call over to our CEO, Tim Cofer. Tim?

Tim Cofer (CEO)

Thanks, Howard. Good afternoon, everyone, and thank you for joining our Q3 earnings call. I hope you, your colleagues, and loved ones are all safe and healthy. Thankfully, the Central team has continued to see a relatively small number of cases of COVID-19, and our facilities remain diligent about maintaining the highest health and safety standards. Thanks to our team's hard work, all of our manufacturing facilities and distribution centers remain open and fully operational. I'm very proud to share that Central Garden & Pet's third quarter was the best-performing quarter in our company's history. As you saw in our press release, overall sales for the quarter increased 18% versus prior year. Our sales growth was driven by broad-based organic strength of 16.5%, with contributions from both segments as well as the inorganic contribution of our C&S acquisition.

As I reflect on all our company has been managing over the past few months, I attribute our strong performance to a few factors. First and most importantly, our people. I continue to be inspired by the resilience and dedication of our employees across the company as they collaborate with each other, with their communities, and with customers to ensure our business operates safely and as seamlessly as possible in these truly unprecedented times. This has required incredible commitment and coordination. In recognition of our frontline workers across manufacturing, logistics, and merchandising, I am pleased to share that we recently awarded a well-deserved special bonus to thank them for their unwavering dedication. Second, the attractiveness and resilience of our industries.

Despite the volatility and awkward downward pressure seen across various industries over the last few months, both the pet and garden industries have remained strong, proving that they can weather tough storms and maintain a resiliency in recessionary environments. Our retail partners have done a great job too, both online and offline, to ensure shoppers can satisfy their needs in our categories. Third, strong consumer fundamentals. There is no question we are seeing robust consumer demand. This growth goes beyond the initial COVID-19 pantry loading. Now more than ever, consumers see great value in beautifying their gardens and finding joy and comfort with their animal companions. We are seeing expanded consumption driven by both incremental household penetration as well as higher spending from current consumers.

In addition, we believe the distribution of stimulus checks drove higher consumption as consumers used a portion of discretionary dollars to engage with pet and garden products. Fourth, early wins from our evolving strategy. As I've mentioned in previous earnings calls, we embarked on a comprehensive strategic review early this year, and we've developed a new strategy named Vision 2025. This strategic roadmap outlines areas of focus and commitment to build core capabilities in areas like e-commerce, digital marketing, innovation, and cost control. We are seeing the early signs of the effectiveness of these efforts, and our teams have done a great job responding with agility to pandemic-related shifts. Most notable is the online demand surge, which we believe is a step change in consumer spending habits that will not likely reverse after the pandemic subsides.

You'll hear more about our Vision 2025 strategy at our virtual investor day later this year. Despite these favorable drivers, it is important to recognize that our supply chain remains stressed during these challenging times where we've seen an unprecedented rapid increase in demand and higher costs in some areas to ensure the safety of our employees. We're committed to serving the needs of our consumers, and to that end, our employees are working around the clock to meet demand while at the same time we're actively engaged in long-term capacity expansion plans. Now, I'd like to provide some color around what we saw in the quarter, including trends and implications for our business related to the pandemic. As I said earlier, we experienced strong growth in both segments with organic sales of 18% in garden and 15% in pet. Let's look at the garden segment.

Gains were seen in our distribution business, controls and fertilizers, wild bird feed, as well as a late-season strength in our grass seed business. In terms of COVID-related impacts, the garden industry is clearly benefiting from consumers spending more time at home and turning to garden products to beautify their lawn and gardens and make being outdoors even more enjoyable. This drove increased consumption among existing consumers and attracted new users into the category, a benefit that we believe will extend into the future. This is similar to what we've seen in prior recessionary environments where consumers find themselves spending more time at home and enjoying their lawn and gardens. Also, as I mentioned earlier, we saw a clear shift forward in e-commerce, an area where garden products have historically been underpenetrated.

We believe this may be a lasting change to consumer buying habits, which reemphasizes the importance of our strategic focus on e-commerce and digital marketing. Finally, while our live goods business delivered a slight decline for the quarter versus prior year, we experienced a late-season rush as retailers loosened metering stances mid-quarter. We're particularly pleased with this turnaround given that live plants were under great pressure early in the quarter when retailer restrictions were most austere and consumer foot traffic was limited. It's also important to note that weather patterns this year have been the best we've seen in many years and nearly ideal for gardening. All said, it was a great quarter for the garden segment. Now let's turn to the pet segment. Gains were seen in consumables, distribution, animal supplies, and health and pet bedding. However, we continued to face headwinds in live fish.

In terms of COVID-related impacts, the pet industry is also experiencing benefits from consumers being at home. In addition to some continuance of the consumer stockpiling of edibles that we saw in late Q2, we are seeing record levels of pet ownership. It's estimated that pet ownership has increased 4% this year. This is a fundamental driver of the demand strength in the quarter and a likely tailwind in the coming quarters. As a result, we're seeing healthy household penetration increases across the dog, cat, small animals, and reptile categories. These factors have inspired strong demand in habitats, bedding, animal supplies, and health products, as well as dog treats and other pet consumables.

Also, similar to garden, our pet segment saw a clear acceleration in e-commerce where pet retailers, distributors, and manufacturers have been quickly pivoting to meet the dramatic increase in online demand by enhancing e-commerce capabilities, launching store and curbside pickup options, and diversifying delivery modes. Our e-commerce business now represents about 20% of total pet consumer brand sales. That's a material increase over last year. All indications are that this shift in consumer behavior will not likely revert back to pre-pandemic levels, and we're accelerating our efforts in the strategic focus area. Conversely, one area where we continued to experience COVID-related pressure was our live fish business. This was one of the pet categories hardest hit by the pandemic as many retailers imposed restrictions on live animals early on, and more recently, stress has shifted to the supply chain.

The good news is we're seeing this category steadily open back up, and we're in constant communication with both suppliers and customers in order to meet demand. Overall, a great quarter for the pet segment as well. Now, shifting back to total company results, our strong top-line performance in both segments, coupled with 40 basis points of gross margin improvement and meaningful SG&A efficiencies, culminated in an EPS of $1.27 for the quarter. That's up $0.47 compared to an EPS of $0.80 in the third quarter of 2019. I wanted to take a moment to expand a bit on the SG&A trends as COVID-19 is having a rather pronounced impact in this area, both from a year-over-year perspective as well as timing across fiscal 2020. Since the onset of the pandemic and the rollout of shelter-in-place mandates, travel and entertainment spending has seen dramatic decreases.

In addition, given shopper traffic restrictions and a focus on essential products, promotional opportunities have been limited. While travel-related spending is likely to remain depressed for the remainder of the fiscal year, we are committed to stepping up investment spend on smart and profitable opportunities. As such, I've challenged our teams to lean into our strategic investments in Q4, investing behind our current momentum and laying the foundation for sustainable, profitable growth in the future, consistent with our Vision 2025 strategy. Accordingly, we expect increased levels of investment spending in the final quarter of the year, and this will impact Q4 earnings. As a reminder, the fourth quarter is generally a smaller earnings quarter for us, and this, coupled with the heightened investment spending, leads us to anticipate a slight loss in Q4.

All said, considering the progress we've made to date and our aggressive investment plans for the future, we currently anticipate full-year 2020 EPS to be at or above $1.90, representing strong growth over our prior-year EPS of $1.61. Shifting gears, I also want to make sure I address the important social justice movement that received worldwide attention during the quarter. At Central Garden & Pet, we stand in solidarity against racism and violence. As part of our Vision 2025 strategy, we are committed to continuing to build a great place to work and a winning growth culture that embraces diversity and inclusion as a fundamental area of focus. To support our agenda, we're creating a diversity and inclusion council made up of employees from across our company to guide our efforts. We will also embed diversity and inclusion training, education, recruiting, and development as part of our new strategy.

The central leadership team and I are pursuing this work with passion, and we will continue to be ambassadors and champions for open conversation. We are committed to this work. As I have previewed during the past few earnings calls, in addition to continuing to deliver on our day-to-day business priorities, we have been diligently working on building and executing against our evolving long-term strategy. We will share more details of our Vision 2025 strategy at an investor day that will coincide with our Q4 earnings report. This virtual event will take place over a few hours, and participants can expect to learn more details of our new strategy, hear from our key leaders, and participate in a live Q&A session where we will field questions about our fiscal 2020 results and our Vision 2025 goals. The exact date and registration details will be communicated later.

In closing, I want to reiterate my sincere thanks to every Central employee for their role in helping the company deliver a historic quarter. I'm proud of all the hard work and efforts that went into making this quarter such a success. I'm also proud that our company can continue to play an essential role in our consumers' lives during this unprecedented time. I look forward to sharing more about Vision 2025 and our framework to deliver sustainable, profitable growth when we meet later this year. With that, let me turn it over to our CFO, Niko, to share more of the Q3 details of our company and across both garden and pet segments. Niko.

Niko Lahanas (CFO)

Thank you, Tim. Good afternoon, everyone. Third quarter total company sales increased 18%, or $127 million, to $834 million from $707 million in the third quarter of last year. Acquisitions contributed $10 million of revenues in the quarter. Organic sales were up 16.5%, aided by gains in both segments, particularly in the e-commerce channel, as Tim described earlier. Consolidated gross profit for the quarter increased $43 million, and gross margin increased 40 basis points to 31.4%, driven by a favorable mix of product sales and pricing. SG&A expense for the quarter increased 5%, or $7 million versus a year ago. This increase was driven by a number of factors, including higher variable compensation pools and logistics costs in conjunction with strong results, inorganic spending from our C&S acquisition, as well as PPE costs. These increases were partially offset by lower travel and entertainment and promotional spending.

Our corporate expense increase was primarily due to higher variable compensation pools and PPE costs. As a percent of sales, SG&A decreased 240 basis points to 18.9%. Central's operating income for the quarter increased to $105 million, and operating margin increased 290 basis points to 12.6% due to higher sales and gross margin, as well as accretion from the C&S acquisition, partially offset by higher SG&A expenses. EBITDA for the quarter increased 44% to $118 million. Turning now to the garden segment. For the quarter, garden segment sales rose 18%, or $64 million, to $420 million. The increase in sales, which was all organic, was driven by growth in garden distribution, controls and fertilizers, wild bird feed, and late-season strength in grass seed, partially offset by the decline related to our exited pottery business.

Garden segment operating income for the quarter increased by approximately $25 million, or 46%, compared to prior year, to a total of $78 million. Operating margin also increased by 360 basis points to 18.5%, driven by the organic strength mentioned previously, as well as lower selling, general and administrative spending. Garden EBITDA for the quarter increased 44% to $81 million. Turning to pet. Pet segment sales for the quarter rose 18%, or $63 million, to $413 million, and grew 15% on an organic basis. As Tim mentioned, organic sales were aided by strength in pet consumables, distribution, animal health, and small animal supplies. These gains were partially offset by continued headwinds in live fish. Pet segment operating income for the quarter increased by approximately $16 million, or 45%, compared to the prior year, to a total of $51 million.

Pet operating margin also increased by 230 basis points to 12.3%, driven by strong sales contributions as well as improved overhead leverage. Pet EBITDA for the quarter increased 37% to $59 million. Now, getting back to our consolidated results. In the third quarter, we had other expense of $3.5 million compared to other income of $200,000 a year ago. This change was primarily due to the impairment of two JV investments that were impacted by the COVID-19 pandemic. Net interest expense increased $3 million to $11 million due primarily to lower interest income earned on cash balances as a softer market drove interest rate declines. Our tax rate for the quarter was 22.6% as compared to 23.5% in the quarter a year ago.

Turning to our balance sheet and cash flow statements, cash at the end of third quarter increased to $495 million, up from $446 million at the end of the third quarter last year. For the quarter, net cash provided by operations was $182 million versus $172 million in the third quarter a year ago due to increased EBITDA, partially offset by changes in working capital, largely related to strong demand, whereas you would expect receivables, payables, and liabilities were all up while inventory was down. CapEx was roughly in line with the third quarter of 2019 at $7 million. Total debt was $694 million, up $1 million from the same time last year. Our gross leverage ratio at the end of the quarter decreased to 2.4 times within our target range. At the end of the third quarter, we had no borrowings under our $400 million credit line.

Depreciation and amortization for the quarter was $13 million, in line with the prior-year period. During the quarter, we repurchased approximately 194,000 shares, or $5 million of our stock. There remains $100 million under the board's previously authorized share repurchase program and an additional 600,000 shares under the board's equity dilution authorization. Finally, turning to our fiscal 2020 outlook. Looking forward to the final quarter of the fiscal year, we anticipate a continuance of strong business momentum we saw in Q3, as well as heightened strategic investment spending to drive future profitability and growth, as Tim discussed previously. This step-up in investment, coupled with Q4 generally being a smaller earnings quarter for us, led us to anticipate a slight loss in Q4 and full-year 2020 EPS of $1.90 or higher. This represents strong growth over prior-year EPS of $1.61. Now, operator, please open the line for questions.

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press Star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press Star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up the handset before pressing the Star keys. One moment, please, while we pull for questions. Our first question comes from the line of Peter Graham with J.P. Morgan. Please proceed with your question.

Peter Graham (Senior Home Lending Advisor)

Hey, good afternoon, everyone, and congrats on a great quarter. Really impressive.

Niko Lahanas (CFO)

Thanks, Peter.

Peter Graham (Senior Home Lending Advisor)

I just wanted to touch on the cadence in the quarter and to the extent you were willing to share. Could you maybe speak to the trend you kind of saw in April and May and then kind of as June as restrictions were lifted? Is there anything that we need to be aware of from a sell-in versus sell-out standpoint? My second question, I know Q4 isn't a huge quarter for your business, but the company is cycling to kind of more one-time costs. I kind of was hoping you could help me bridge to your guidance. You mentioned top-line momentum is expected to continue. Does that mean similar strength versus Q3 in that any benefit from that strong growth will be fully reinvested? Anything you're willing to share on Q4 would be great. Thanks.

Tim Cofer (CEO)

Sure, Peter. This is Tim. I'll give it a start, and others can kick in. I think to your first question, we definitely saw shifting dynamics as you went through the quarter. You said, "Hey, what about April, May versus June?" If you go back to that kind of March, early days of pandemic and those first shelter-in-place orders that started taking place mid-March through really April, that was an unfavorable period for us. We saw that particularly on the garden side as a number of our retail partners took certain decisions to either close the open garden center or meter limit the traffic into the garden area. That made for a difficult and challenging start to the quarter.

On the pet side, we saw some similar dynamics in terms of some pet independents not opening as well as, in particular, on the live animal business, really a shutdown of that entire business for a period of time through retail partners. As quickly as that developed in the kind of mid-March to mid-April timeframe, Peter, things began to open up on the other side. By May and then June, we saw just a completely different dynamic. We saw all of our retail partners opening up, and we saw, quite honestly, unprecedented consumer demand in both of our categories, both garden and in pet. That was driven fundamentally by increases in household penetration.

We have data through the end of June that reinforced that this demand was a combination of both existing category users in garden and pet, increasing their buy rate, spending a little bit more in terms of purchase per occasion, dollar per occasion. Importantly, incremental households. As you would know, that is one of the more challenging and one of the more positive aspects, especially in mature categories like garden and pet. We are seeing two-three points of incremental household penetration across the various categories. As I referenced in my prepared remarks, we see pets themselves increased by about 4% in U.S. households through June versus prior year. That is a little bit of the kind of narrative on the quarter. Started rough, and by the end, it finished very strong. That obviously put some pressure on our supply chain to make that significant pivot.

At the beginning of the quarter, we were managing some downside risks. By the end, we literally are in a position now where we're rallying, working around the clock, and in some cases, really testing our near-term capacity limitations. Therefore, shifting to the second part of your question, as we go into the fourth quarter, our plan here is to really capitalize on this momentum, capitalize on the net favorable status we find ourselves in, both from a category basis, as well as, I will tell you, excellent execution on the part of the Central Garden & Pet teams. We plan to invest in the fourth quarter.

We plan to invest in a number of areas that are consistent with our long-term strategy, invest more into e-commerce, invest more into brand digital marketing, into innovation, into the opportunity for expanded distribution next year, as well as into capacity expansion because in some cases, we're now at a place where we need to accelerate prior capacity expansion plans. All of that, therefore, Peter, does put some, I would say, limits on earnings in the fourth quarter, and that explains the guidance that both Niko and I provided.

Niko Lahanas (CFO)

Peter, this is Niko. I would just add to what Tim said. Think of the investment in Q4 more or less as a timing shift. What we talked about a couple of quarters ago was our growth challenge and incremental investment that we wanted to make. The pandemic kind of threw that on its head a little bit, and we backed off in Q2 and Q3 on investment, waiting to see how it played out. We've seen our businesses perform rather well during the pandemic, and we want to execute on the overall strategy and continue to invest in the business. It's just now shifted to Q4 as we move forward. I think that's really the right way to think about it.

Peter Graham (Senior Home Lending Advisor)

That's helpful. Thanks. I'll pass it on.

Operator (participant)

Thank you. Our next question comes from the line of Brad Thomas with KeyBanc Capital Markets. Please proceed with your question.

Brad Thomas (Managing Director)

Hi, good afternoon. Thanks for taking my questions. Let me add my congratulations as well on nice quarter, nice execution here.

Niko Lahanas (CFO)

Thanks, Brad.

Brad Thomas (Managing Director)

I want to first ask about some of the performance in the pet category. We get a lot of questions from investors about the sustainability of some of the trends in the market, and I was hoping you could share some details, perhaps on trends within the type of animal, what you're seeing out of dog, cat, versus other, and then maybe the nature of some of the more repeatable purchases of items that you sell versus items that might be more one-time in nature and may not continue with the same strength that we saw in this quarter. Thanks.

John Hanson (President, Pet Consumer Products)

Sure. This is John. Really good question. As Tim mentioned in the remarks, we saw an increase in pet ownership of 4% in total. It was pretty much across the board: small animal, dog, and cat. With that, we saw an increase in household penetration on many of our categories combined up 3%. Because of this, we saw the type of POS consumption increases across brick and mortar and then explosive growth in e-com. As we look forward, we anticipate continued momentum in pet. We've got this tailwind in the front half of fiscal 2021 until we lap the first wave of COVID-19, which would be late Q2, early Q3. I would say after that, it will become much more difficult to predict what longer-term demand might look like.

Certainly, with new pet ownership, it's a good indicator of sustained increase in the category consumption versus pre-COVID. Hopefully, that answers your question.

Niko Lahanas (CFO)

Brad, I would add one other thing too. One of the more fractured parts of the pet industry has been the live animal supply chain. We have seen a lot of folks that actually wanted live animals that cannot get them. I think we are going to see probably a little bit of a reloading there where more live animals become available. We are not convinced that we are done with the cycle of the penetration rate. That could go on for a little bit longer just because that supply chain has been really, really fractured.

Brad Thomas (Managing Director)

That's really helpful. Thank you, guys. If I could add a follow-up just about how to think about modeling for Q, I guess, Niko, can you give us any more quantification of the magnitude of what the investments would be that you're making in Q4 specifically for one? For two, should we think of that as a new step-up in a run rate? I mean, are there things like advertising that will continue through next year? Are they more one-time in nature? Just any more description of what exactly you'll be spending on in the quarter. Thanks.

Niko Lahanas (CFO)

We're not going to guide on the amount of the investments. What I would tell you is the way to think about it is more of a run rate. We aim to invest in the business and continue to invest in the business. It is by no means a one-shot kind of deal. That is the way we feel. We want to look really long-term, and we have a nice momentum right now to build off of. A lot of the investments will be CapEx. I cannot think of a better way to invest in a business from a long-term perspective. It really demonstrates conviction behind our business as we invest in CapEx and capacity. It is going to be substantial. We're not going to guide on it. I think look for more investment as we go down the line.

Brad Thomas (Managing Director)

Understood. Congratulations and looking forward to even more detail when you all hold your event in November.

J.D. Walker (President, Garden-Branded Business)

Thanks, Brad.

Niko Lahanas (CFO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of William Roeder with Bank of America. Please proceed with your question.

William Roeder (Analyst)

Hi. Thanks for taking the question. Given the strong results, you certainly have lots of cash. I guess, given the higher share price, how are you viewing allocation at this point in terms of share repurchases versus M&A? I guess, how are you trying to balance those?

Niko Lahanas (CFO)

Good question. We still value M&A and internal investment as the priority. As the share price dips and goes up and down, we'll be opportunistic. As you can see, as the share price went up in Q3, we were less aggressive in the market around buybacks. Tim and I view this as a huge opportunity to invest in the business. Of course, M&A being core here at Central and a huge priority for us. I would look at it in those terms.

William Roeder (Analyst)

I know historically you've been pretty disciplined, but I imagine valuations for both pet and garden are relatively elevated right now given the strength. Would you consider acquisitions outside of those areas if there were synergies in terms of distribution or manufacturing customers, etc.?

Niko Lahanas (CFO)

Absolutely. We're evaluating a number of them now. You hit the nail on the head. We look for synergies around delivering to the same customers, same channels, things of that nature. We just continue to evaluate everything and anything right now.

William Roeder (Analyst)

Great. Thanks for taking the question. I'll pass it to others.

Operator (participant)

Thank you. Our next question comes from the line of Bill Chappell with First Securities. Please proceed with your question.

Hi. This is actually Grant on for Bill. Thanks for taking the question. Good afternoon, everyone.

Tim Cofer (CEO)

Have a good day.

Good afternoon. Had wanted to start just on the e-commerce growth, trying to get a sense of the margin mix implications as both garden and pet e-commerce seem to be growing faster than the brick and mortar business. I would imagine a lot of the garden is click and collect. Correct me if I'm wrong. The pet side, maybe more DTC, but any margin impacts going forward as that business continues to grow.

Sure. I'll start. I mean, first of all, on e-commerce, there's no doubt, as I said earlier, we're seeing that dramatic increase and really that consumer shift in terms of channel choice. This last quarter, I think we had maybe 10 consecutive weeks of growth kind of in that 80-100% range. Truly explosive growth on e-commerce on the pet side, also the garden side. Clearly, in garden, we're on a smaller base. It's a significantly underdeveloped set of categories. You're looking at kind of low single digit as a percent of total sales on the garden side. Whereas on the pet side, as I mentioned earlier, for pet, if you look at our pet-branded consumer business, you're looking at more like 20% of the entire business. To your point, it's becoming increasingly meaningful, and we are investing in it accordingly.

In terms of margins, at present, we've got a margin structure that is more or less parity to our brick and mortar. It differs by delivery mode, and obviously, it differs by product line. To your question, it's something we're very much paying very close attention to because as you play this out over the next many years, we do want to be sure that that is not presenting an unnecessary headwind to our overall objective to grow margins.

Thanks. That's helpful. Actually, just one on the garden side, a question kind of going into the fall here with the consumer engagement of the category. Would think there would still be some strong demand for the grass seed business. Want to get your thoughts on that. Then how are inventory levels coming out of the main season looking for that business? Thank you.

J.D. Walker (President, Garden-Branded Business)

Sure. This is J.D. Thanks for the question. I'll take that. I would say going into Q4 and into the fall season, we feel very optimistic. The trends that we've seen, the strong trends that we've seen in grass seed, it's been referenced a couple of times, continue to be strong going into the fall. The retailer inventory levels are at an acceptable level. They're not out of balance. Tim's talked about new users in the category, so we feel good about that. Our customers are bullish on the category, and we are investing in demand creation for the fall. All of those are reasons for us to feel confident and bullish on the fall season. I will say, as always, weather is a critical factor. Lawn damage during the summer will certainly lead to stronger fall demand.

If we see the excessive heat during the fall that we saw last year, that could have a dampening effect on our retail takeaway. Overall, I'd say we're cautiously optimistic as we move forward.

Thank you. I'll pass it on.

Operator (participant)

Thank you. As a reminder, ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. The next question comes from the line of Karru Martinson with Jefferies. Please proceed with your question.

Karru Martinson (Managing Director)

Good afternoon. It's been a while since we've heard the weather was very good, and that was a driver of the business. I'm happy to hear that. Just when you guys talked about the supply chain being stressed, I mean, but inventories at retail, you said, are within the normal bounds. What is the stress that's being created? Are we missing orders? Are there sales that are falling through or being delayed? What are we seeing there, and what investment needs to be made to ease that stress on the supply chain?

Tim Cofer (CEO)

Sure. First, to your point on weather, indeed, weather was favorable this year, and it has not been for the last two years. Both in 2018 and especially 2019, it was a headwind. Sadly, that is the nature of weather. It can be cyclical and unpredictable. Obviously, it is a corollary to the strength of the garden season. This year, it happens to be a beneficial one. To your question on supply chain, it is stressed. That is a word I chose carefully. It is stressed in a number of ways. First, there are increased costs to running our supply chain. Those costs are driven by the incremental safety precautions we have taken to address our number one priority, which is obviously the health and safety of our employees. It is increased PPE. It is increased sanitation. That does manifest in higher costs in the supply chain.

Second, there are select raw material supply challenges. There are some import restrictions we've worked through. Obviously, you're well aware of some continuing macro challenges with China. As Niko referenced earlier, particularly in live animals, there's been some supply challenge, particularly, I would say, in areas like fish, tropical fish, especially. There are even some product lines we make that have sources of raw materials or packaging equipment that compete with other categories that are in great demand given the current pandemic. Think spray bottles. Think waste management pads, etc., vis-à-vis face masks. In select cases, I would tell you there are some labor availability challenges. While I'm pleased to report that as of today, all of our facilities, manufacturing plants, and distribution centers are up and operational, throughout the last quarter, there were days where a given facility needed temporary shutdown.

Finally, given the strength of the demand in both of our core categories, we are finding that demand is occasionally outstripping our nearing capacity. To your question, yes, that has resulted in compromised service levels on certain lines at certain times with certain customers below our ideal promise to our retail partner. The stress is real. I think on the positive side, despite everything I have just shared per your question, we were still able to execute very well and deliver a historic quarter.

Karru Martinson (Managing Director)

Absolutely.

J.D. Walker (President, Garden-Branded Business)

Tim, if I could, I'd just like to add a comment for clarification. When I talked about the retail inventories being not out of balance, I was specifically speaking to grasses there going into the fall season. Some of our other categories are much more stressed, much more challenged. There is no question we left some money on the table during the quarter.

Karru Martinson (Managing Director)

Thank you for that clarification. Just lastly, in terms of the tariff aspect, when you talked about certainly not getting some of the raw materials out of China, is there a tariff headwind still that we need to be factoring into our models, or is that just now anniversary and we go forward from here?

Niko Lahanas (CFO)

I'll do it. I would say the tariff situation is going to continue for us, but I'll remind everyone that we really only have about 10% of our cost of goods exposure to China. We continue to look for remedies around the tariffs. Things like sourcing from different countries. We also work with the vendors to lower the cost. We look to insource things that were previously outsourced. When all else fails, we will take price where needed. We think it'll be a continuing issue going forward, but so far, we've dealt with it quite well, and we expect to do the same in the future.

Karru Martinson (Managing Director)

Thank you very much, guys. Appreciate it.

Operator (participant)

Thank you. Our next question comes from the line of Jim Cartier with Montes Crespi. Please proceed with your question.

Jim Chartier (Senior Equity Research Analyst)

First, did you guys quantify the amount of the special bonus?

Operator (participant)

Okay. It's dead on the end back with you. I apologize for that. Give me one moment.

J.D. Walker (President, Garden-Branded Business)

Kevin, I think we heard Jim's question about the bonus. Jim?

Jim Chartier (Senior Equity Research Analyst)

Yes. Did you quantify the amount of the special bonus during the quarter? Just looking at gross margin for fourth quarter, last year, it was down, I think, about 180 basis points. Could you just remind us what the drivers of that decline were last year and how are we thinking about gross margin this year? Thanks.

J.D. Walker (President, Garden-Branded Business)

We typically don't give margin guidance, so I'll speak more qualitatively. Last year, if you recall, we had quite a bit of bad weather, and our animal health business was really affected by that. We had some write-downs in that area in Q4. As far as the one-time bonus, we have not quantified that. As far as the margins go into Q4 of this year, we again don't guide on that. Really, it comes down to mix being such a big deal for us, and it's very difficult for us to guide on that. Obviously, the mix is really heavily dictated by weather. We are always very cautious around that.

Jim Chartier (Senior Equity Research Analyst)

Great. Just looking at the press release, I think it says grass seed for you is down year to date. Can you just kind of talk about that given what seems to be a pretty strong season for the grass seed business? Thanks.

J.D. Walker (President, Garden-Branded Business)

Yes. To be clear, the grass seed businesses, from a POS standpoint, from a consumption standpoint, is up versus prior year. It was late in coming, though. During the spring season, we had a number of canceled promotions that we had planned on that retailers, at the time of the onset of the pandemic, canceled a lot of their promotional support. That impacted our business. We've seen strength in the grass seed business over the last couple of months. Given what I said earlier, retail inventory is in good shape, strong promotional support going into the fall, we believe that we've worked through any inventory issues in retail, and we believe that the future looks bright for that business.

Jim Chartier (Senior Equity Research Analyst)

Great. Thanks. Best of luck in fourth quarter.

J.D. Walker (President, Garden-Branded Business)

Thank you.

Niko Lahanas (CFO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Carla Casella with J.P. Morgan. Please proceed with your question.

Carla Casella (Managing Director of Credit Research)

I'm wondering if you could give us a little bit more color on the pet segment. How much of your sales today are coming from that specialty channel versus mass versus online only? How that's changed and how you expect it to change post-COVID?

Tim Cofer (CEO)

For our organic growth, as we look at it in Q3, about two-thirds of it came from brick and mortar, and about a third of it came from e-com. As we look at our brick and mortar business, we get Nielsen and syndicated data for eight of the top 25 customers, and then we get POS for many of the others. It's really clear in brick and mortar that we gain share. That's a good place to be. When we look at e-com, clearly, with our largest customer, we gain share as well. We're feeling pretty good from a pet consumer product standpoint that we gain share in the market in Q3. If you look at our pet distribution business, we had very strong volume in that, and it was really driven by service reliability versus competition.

We feel good relative to our competitors in that channel as well and believe we gained share there as well.

Carla Casella (Managing Director of Credit Research)

That's great. Thank you very much.

J.D. Walker (President, Garden-Branded Business)

With that, we have time for one more question, operator.

Operator (participant)

We actually have no further questions in the queue at this time.

J.D. Walker (President, Garden-Branded Business)

Perfect. I thank everyone for joining today's call, and we look forward to speaking with you again for our fourth quarter earnings release as well as our first investor day. Have a good day.

Operator (participant)

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