Newell Brands - Q2 2023

Transcript

Operator (participant)

Morning. Welcome to Newell Brands' Q2 2023 earnings conference call. At this time, all participants are on a listen-only mode. After a brief discussion by management, we will open up the call for your questions. In order to stay within the time schedule for the call, please limit yourself to one question during the Q&A session. As a reminder, today's conference call is being recorded. A live webcast of this call is available at ir.newellbrands.com. I will now turn the call over to Sofya Tsinis, Vice President of Investor Relations. Ms. Tsinis, you may begin.

Sofya Tsinis (VP of Investor Relations)

Thank you. Good morning, everyone. Welcome to Newell Brands' Q2 earnings call. On the call with me today are Chris Peterson, our President and CEO, and Mark Erceg, our CFO. Before we begin, I'd like to inform you that during the course of today's call, we'll be making forward-looking statements which involve risks and uncertainties. Actual results and outcomes may differ materially, and we undertake no obligation to update forward-looking statements. I refer you to the cautionary language and risk factors available in our earnings release, our Form 10-K, Form 10-Q and other SEC filings available on our investor relations website for a further discussion of the factors affecting forward-looking statements. Please also recognize that today's remarks will refer to certain non-GAAP financial measures, including those referred to as normalized measures.

We believe these non-GAAP measures are useful to investors, although they should not be considered superior to the measures presented in accordance with GAAP. Explanations of these non-GAAP measures and available reconciliations between GAAP and non-GAAP measures can be found in today's earnings release and tables that were furnished to the SEC. Thank you. Now I'll turn the call over to Chris.

Chris Peterson (President and CEO)

Thank you, Sofya. Good morning, everyone, welcome to our Q2 call. Q2 results were in line with or ahead of our projections on all key metrics. As expected, top-line results were pressured by normalizing category trends, constrained consumer spending on discretionary products, and retailer inventory destocking. Operating margins, earnings per share, and cash flow were all well ahead of expectations as we made meaningful progress on productivity initiatives and working capital reduction. While our results met or exceeded our expectations for the quarter, on an absolute basis, we aspire for significant improvement going forward. That is why we recently created and deployed a new corporate strategy based on a comprehensive company-wide capability assessment with an integrated set of where-to-play and how-to-win choices. We're very excited about the clarity this work is bringing to the business and the value creation opportunity ahead of us.

We also recognize that the path forward will not be a straight line. During our Q1 earnings call, we laid out five key priorities for fiscal 2023, which are all progressing nicely. Let me say just a few words regarding each of them. First, starting with operating cash flow, year-to-date, we have driven a year-over-year improvement of over $700 million, largely by right-sizing our inventory levels through improved forecasting and supply planning processes. Second, gross margin performance improved sequentially behind our ongoing FUEL productivity program and Project Ovid, which you will recall, completely transformed Newell's domestic go-to-market operations. We are on track for a record high year on productivity savings across the supply chain. Third, Project Phoenix is simplifying and strengthening the organization by leveraging scale, reducing complexity, streamlining the operating model, and driving operational efficiencies.

The program is pacing well and is on track to deliver $220 million-$250 million in pre-tax savings upon its full implementation. Fourth, our SKU count, which was over 100,000 as recently as five years ago, is expected to be down to less than 25,000 by the end of the year, with numerous other complexity reduction actions also underway. Finally, we have successfully transitioned to and are operating in a new operating model with three segments, centralized manufacturing and supply chain, and a One Newell approach with our top four customers and across most geographies.

It is from this much improved operational and organizational foundation that we made an important where-to-play choice to focus on and drive a proportionate amount of our organizational and financial resources to our top 25 brands and our top 10 countries, which each represent about 90% of sales and profits. Once that decision was made, we turned our attention to our how-to-win choices, which were fully informed by the capability assessment we have just completed. That assessment clearly demonstrated the need for us to significantly improve our abilities in consumer and customer understanding, innovation, brand building, brand communication, and retail execution. That's why when we revealed our new strategy in Paris last month, we said we are making a major pivot in our front-end, consumer-facing capabilities to properly support leading brands in top countries.

Since these how-to-win choices are cornerstone elements of the new integrated strategy, we have started to fill talent gaps across key areas and have established clear action plans and KPIs for each capability improvement project. For example, we are upgrading the company's ability to understand consumer and customer wants and needs. This should enable actionable insights around superior product development, leading to stronger claims and a more impactful and focused innovation pipeline as we concentrate on fewer, bigger, and longer-lasting innovations. In addition, we recently revamped Newell's innovation process, which will be underpinned by proprietary consumer insights. As part of this work, we designed and instituted a project clearing system and implemented an enterprise-wide biannual innovation process to sharpen the company's innovation plans, drive alignment on the funnel, and determine prioritization and resource allocation as we identify bigger bets.

We also put in place a centralized tracking system for all new initiatives to enable multi-year technology platforms and ensure appropriate financial rigor to drive accretive margins. Relative to brand building and brand communication, we are building out a comprehensive brand management function, which was not in place previously. Going forward, Newell's brand managers and the multifunctional teams who support them, will be responsible for profitably growing our top 25 brands in our top 10 countries, alongside a newly redesigned brand communications governance process. Finally, as it relates to retail execution, our sales teams are leveraging the portfolio of Newell's leading brands and scale to actively pursue new distribution opportunities, which they've identified across every business, while also dramatically improving our sales fundamentals in existing accounts.

Although it's still early days, I'm encouraged by the progress we are making in bringing the integrated set of where to play and how to win strategies to life. Importantly, these are not just corporate plans. They've been formally cascaded throughout the organization, informing the segment, functional, and regional strategies where work is ongoing. Key members of the leadership team and I have visited 6 of our top 10 countries across Europe and Latin America in the last 2 months to ensure we are driving the strategy into execution. Before turning the call over to Mark, who will discuss our financial results and outlook in detail, I want to address the revisions we have made to our top line estimates for the H2 of the year.

We are incrementally more cautious on the consumption of discretionary products, largely due to the resumption of student loan payments in October. As payments restart after a multi-year moratorium, many consumers will undoubtedly have to manage their budgets even tighter, given persistently high core inflation, which has lowered real consumer income. Several of our major retail customers recently revised their shipping terms on our business, moving from what is known as direct import to domestic fulfillment. While we welcome this move because we expect this change to be a positive for Newell longer term, it does put additional one-time pressure on back half shipments as their weeks of inventory coverage comes down further as a result of the transition. We are now planning the baby business more conservatively in the back half of the year due to the bankruptcy of buybuy BABY.

Up until now, we assumed in our financial modeling that a buyer would emerge for most of their stores. Since that is no longer likely, we have adjusted our sales forecast accordingly. Revising our top line outlook and related demand plan now allows us to continue the strong progress we have made on inventory reduction, which is why we are maintaining our operating cash flow guidance for the year. Additionally, we are taking bold actions to drive stronger productivity in the supply chain, which were made possible by our recent decision to consolidate our supply chain into a centralized organization structure. Specifically, after benchmarking indirect overhead at each of Newell's key facilities, we are taking a series of discrete, site-specific actions to right-size the company's manufacturing labor force.

These decisions are never easy, but we are committed to building a One Newell optimized global manufacturing network that minimizes total landed cost, optimizes asset utilization, and leverages Newell's global scale. Moving forward, we are assessing how to optimize the company's entire plant network as we look to transition to more regionalized, multi-sourced plants with upgraded automation and digitization capabilities, where appropriate. We will, of course, share more of the relevant details as plans are finalized. These top-line revisions notwithstanding, we remain optimistic on the back-to-school season, which kicks into full gear in the coming weeks, and we continue to expect much stronger performance for the company in the back half relative to the H1 of the year. The pace of change has accelerated across the company, we are moving with speed and agility to unlock the full potential of the enterprise.

On a personal note, I would like to thank Newell Brands' employees for welcoming me as their new CEO and for their strong endorsement of the new company strategy. At its core, our new strategy focuses on improving the company's consumer-facing capabilities while distorting investment to the most attractive value pools and simultaneously building upon the strengthened operational and organizational foundation we have built over the past several years. Their unwavering commitment to our purpose of delighting consumers by lighting up everyday moments inspires me every day. We have plenty of work ahead, but I sincerely believe we are off to a great start. While we continue to navigate through a challenging macroeconomic backdrop in the near term, I remain confident in our ability to accelerate the company's financial performance over the long term. I will now hand the call over to Mark Erceg.

Mark Erceg (CFO)

Thanks, Chris. Good morning, everyone. As Chris indicated earlier, our Q2 results continued to reflect the significant macro-driven top-line pressures we have been contending with since the Q3 of last year. Namely, soft consumer demand, as inflation continues to put pressure on discretionary spending and some categories continue to normalize, along with trade inventory destocking and the bankruptcy of a major retailer. Thus, while the 13% contraction in net sales of $2.2 billion and the 11.9% decline in core sales might, on the surface, be discouraging, we believe a more thorough examination shows the interventions we have made to improve the underlying structural economics of the business and strengthen operating cash flow are working as intended.

For example, normalized gross margin and operating margin both improved sequentially due to enhanced productivity efforts and Project Phoenix savings, which were critical in helping mitigate the significant 400 basis point headwind during the quarter from inflation. Nonetheless, Newell's normalized operating margin contracted 490 basis points versus last year to 9.1%, as normalized gross margin declined 320 basis points versus last year to 29.9%, and top line softness resulted in a 160 basis point increase in the normalized SG&A sales ratio. In addition, during the Q2, net interest expense did increase $21 million to $76 million, reflecting overall higher debt and interest rates versus year ago.

The decision to rightsize the dividend in a nearly $700 million year-over-year reduction in inventory allowed us to lower debt levels versus last quarter by nearly $300 million. Our effective normalized tax rate of 13.7% was slightly below a year ago, which, when combined with the other elements we just reviewed, brought normalized diluted earnings per share in at $0.24, which was considerably better than the $0.10-$0.18 outlook we had previously provided. Turning to operating cash flow, the planning team did a great job managing inventory levels down while increasing fill rates, which in North America improved to 94% year-to-date from 82% last year. This allowed us to generate $277 million of positive operating cash flow year-to-date through the Q2.

Importantly, this stands in stark contrast to a $450 million use of cash during the same period last year. Through the first six months of 2023, operating cash flow improved by more than $700 million, and encouragingly, in-transit inventory as of June 30th was approximately $275 million below year-ago levels, so we are confident inventory levels will be even lower throughout the balance of the year. The company's leverage increased to 6.3 times at the end of Q2, which was nearly one full turn better than anticipated. We believe leverage has peaked and expect it to drop to approximately five times by the end of the year. Our long-term goal is to achieve leverage at 2.5 times.

As we look towards the balance of the year, Chris laid out the incremental top-line pressures we are facing, so I will not reiterate them. However, it does bear mentioning that this additional sales compression, coupled with our decision to lower inventory balances even further, does create a short-term fixed cost absorption challenge. Although we are aggressively optimizing the company's manufacturing labor force within the confines of our existing plant network, fixed cost deleveraging will still weigh on our H2 gross and operating margins. H2 operating margin will also be impacted by our decision to invest in capability building and brand support to implement and accelerate critical aspects of our new corporate strategy. Given that context, we've assumed the following for the Q3: Net sales of $2.11 billion-$2.16 billion, with core sales down 7%-5%.

Traditionally, we do not prospectively comment on gross margin, but in this instance, we think it's important to point out Q3 normalized gross margin is expected to represent an inflection point as strong productivity gains, inclusive of our simplification efforts and 1st July pricing activity across roughly 30% of our U.S. business, primarily in the Home and Commercial Solutions segment, are only partially offset by inflation and fixed cost absorption. We expect SG&A to be higher on a year-over-year basis in both dollar terms and as a % of sales as we increase brand support and invest in front-end capabilities such as consumer and customer understanding, revenue growth management, data analytics, and retail execution, among others. Parenthetically, last year's 3rd quarter SG&A was favorably impacted by a meaningful drop in management compensation accruals.

Q3 normalized operating margin is expected to be in the range of 8.5%-9.4%. While this is admittedly down versus last year, the rate of decline is expected to ease relative to both Q2 and the H1, as the structural economics of the business should continue to improve. We forecast interest expense to be substantially higher year-over-year and expect a mid-teens tax rate. All in, we are guiding to normalize Q3 earnings per share in the range of $0.20-$0.24. For the full year, we expect net sales of $8.2 billion-$8.34 billion, driven by a core sales decline of 12%-10%.

Normalized operating margin is expected to be 7.8%-8.2% as we reflect the negative top-line flow-through and incremental capability investments discussed earlier. Interest expense is forecasted to be up slightly versus year ago. The tax team has done some terrific planning work, which should create a sizable tax benefit in the Q4. Assuming that benefit is realized, the full year normalized effective tax rate is expected to be close to 0. Normalized diluted earnings per share are now expected to be $0.80-$0.90.

Relative to cash, which was our number 1 priority this year, we continue to anticipate $700 million-$900 million of operating cash flow, inclusive of $95 million-$120 million of cash payments related to Project Phoenix, which remains on track to realize $140 million-$160 million of pre-tax savings this year. The midpoint of our operating cash flow range implies operating cash flow will improve by more than $1 billion year-over-year, with free cash flow productivity comfortably above 100%. With all that said, let's summarize the key takeaways from today's call. First, top-line pressures are expected to persist throughout the balance of the year, as core inflation moderates, trade destocking slows, and we cycle against easier comps, we anticipate that our top-line results will improve on a relative basis.

Second, we believe the underlying structural economics of the business will improve in the back half behind significant interventions across all facets of the business. In fact, at the midpoint of our guidance range, we expect H2 normalized operating margin to expand over 200 basis points versus year-ago and more than 350 basis points versus the H1 of this year. Frankly, this would be a good outcome, since again, using the midpoint of our range, all year net sales are expected to be down approximately $1.2 billion versus last year. Moreover, since we expect inventory to drop by approximately 25% year-over-year, and the July 1st 2023 price increase to negatively impact unit volume, one could reasonably assume production volumes will be down this year by 20%-25%.

Thus, the amount of cost takeout required to hold Newell's gross margin flat, let alone expand it, against this backdrop, is not inconsequential and should provide significant positive financial leverage once the macroeconomic environment stabilizes and we begin to see the benefits of the major pivot we are making in our front-end consumer-facing capabilities. Third, the year-over-year increase in operating cash flow is expected to be at least $1 billion, which speaks for itself. Finally, we now have a unified corporate strategy based on a comprehensive company-wide capability assessment, with very clear where to play and how to win choices. We believe strongly in the strategy and are investing behind it as we move with deliberate speed to unlock the full potential of Newell's portfolio of leading brands. Operator, if you could, please open the call for questions.

Operator (participant)

Certainly, Ladies and gentlemen, to ask a question, you will need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, press star one one again. Please stand by while we compile the Q&A roster. First question coming from the line of Bill Chappell with Truist Securities. Your line is open.

Bill Chappell (Managing Director and Senior Equity Research Analyst)

Thanks. Good morning.

Mark Erceg (CFO)

Morning, Bill.

Bill Chappell (Managing Director and Senior Equity Research Analyst)

Just to I guess trying to understand the, the front-facing moves right now in, in, in terms of it's looking more or sounding more with brand managers and focused on core brands, kind of a P&G model. I guess historically, a lot of the Newell Brands' categories don't have a whole lot of marketing or advertising or promotional support, you know, so it was kind of deemed as not always that necessary. I'm just trying to understand, you know, going forward, you're gonna be stepping up and doing more merchandising, marketing, stuff like that, when a lot of your competitors won't. I'm just trying to understand how useful this will be. I mean, it certainly will help, but, but, you know, and how you kind of looked at the categories when, when applying this model to it.

Chris Peterson (President and CEO)

Yeah, that's helpful. Let me try to provide a little bit of perspective. One of the things that we identified when we did the capability assessment was that because we're coming from a place where every business unit and every category was operated sort of independently, we did not have centralized, standardized processes and approaches on the front-end capability, like we've been driving over the last four years on the supply chain and the, and the back end. So when you look at the company's performance, you can see pockets of good performance. So if you look at the, at the most recent periods, you know, we're growing market, market share on brands like Sharpie, on Rubbermaid, on EXPO, on Crock-Pot, but we're not growing market share on a wide swath of other brands

We believe the reason we're not growing market share broadly across the company is because we don't yet have the capability in place on consumer and customer understanding, innovation, brand building, brand communication, and retail execution consistently across all parts of the portfolio. We do believe, because we're starting from leading brands, in our top 25 brands, over two-thirds of them are leading brands in the categories in which we compete. We do believe that this model applies broadly. We've seen examples, based on all of the businesses that we're in, of the people that are growing market share, are in fact applying this model.

We think as we begin to drive and standardize and build this capability more broadly across the company and, and apply the same amount of operational rigor to it that we've done over the last several years on the supply chain in the back office, we think we can have a meaningful inflection point in terms of getting to a more sustainable top line growth algorithm.

Bill Chappell (Managing Director and Senior Equity Research Analyst)

Got it. I can't remember if I'm allowed to follow up, but I'll ask one anyways.

Chris Peterson (President and CEO)

Sure.

Bill Chappell (Managing Director and Senior Equity Research Analyst)

Mark, can you just maybe, give us a breakdown of the, in terms of the guidance, what, like, buybuy BABY, what the change in terms with retailers, in terms of inventory, you know, what, what, any just kind of roughly how that's negatively impacting, in buckets, the, the guidance for the, for the top line for this year?

Mark Erceg (CFO)

Yeah, let me, let me help you out with that. You might get a little bit more than you were anticipating here, but let's be clear on this point. Our prior range was $0.95-$1.00 rate, and we said we'd be towards the lower end of that range. From there, Chris enumerated a number of items that are gonna lower our sales in the back half, so I won't repeat those here, but that's obviously fairly consequential. Along with that, we have chosen to take our inventory levels even lower in order to ensure that we can maintain our cash flow range for the full year. In addition, we have some capability investments that we are making, which we cited, some A&P investments that we talked about as well.

There's a little bit of other items in there that are kind of mixed related. Those items are only partially offset by a meaningful progression in our programs related to cost takeout. This year will be an all-time high. We actually expect to take out about 6% of COGS through the FUEL initiative programs that we have in place. There'll be a little bit of resin and help, a little bit more transportation help, and a little bit of positive FX in the H2 of the year. Taking all those elements together, that would take you from roughly $0.95, let's call it, down to $0.70. We have a tax benefit that we have contemplated and put in that's worth roughly $0.15. That brings you to $0.85, which is the midpoint of the new range that we provided of $0.80-$0.90.

Chris Peterson (President and CEO)

Bill, on the top line, of the three factors I cited, I would say that the, the student loan repayment and, and the more conservative stance on discretionary products, as the first item, and the direct import to domestic shift are, are, are the two biggest of those items. The buybuy BABY is a little bit smaller, relative to the top line guidance change.

Bill Chappell (Managing Director and Senior Equity Research Analyst)

Got it. Thanks so much.

Operator (participant)

Thank you. Our next question coming from the line of Olivia Tong with Raymond James. Your line is open.

Olivia Tong (Managing Director)

Great. My first question's on gross margin. You gave a lot of detail on the changes to your sales outlook, but hoping to get some color on gross margin, which continued to show some sequential progress. Assuming you continue to see that sequential progress, should we expect it to turn positive in H2? You know, is that a fair assumption? If so, could you talk about some of the drivers that are underlying that? Thank you.

Mark Erceg (CFO)

Yeah, thank you. We feel really good about where we are with gross margin right now. If you looked at our Q1 results, gross margin was roughly 27%, and the print that we just issued, gross margin was 29.8%, so meaningful progression. As we think about the H1 versus the H2 dynamics, we're very confident that H2's gross margin will be several hundred basis points higher than where we were in the H1, you know, probably 300-400. What's driving that is a FUEL productivity program that has been in place for a number of years now. That program has only increased in its intensity now that we have consolidated the supply chain behind the Phoenix organizational changes.

We are literally on pace to take about 6% of COGS out of the gross margin line this year alone, which is quite important because we're still dealing with a lot of the after effects of inflation. Inflation in the H1 of the year is probably running around 400 basis points to the negative. In the H2, we think it'll be more like 100 basis points of compression because of inflation itself. The other things that we're doing that we talked about in the past are DC consolidation work, where we're gonna be going from effectively, you know, call it 1.9 million sq ft of space down to maybe 1.5 million sq ft. The network might go from, you know, 30 DCs down to something more like 20.

We talked about in the script the fact that we have just recently done a four-wall cost assessment that will save, on an annualized basis, over $50 million by getting after overhead and plant overhead and indirect operational elements along with some direct shifting crews. There's just a whole range of other things on the VA/VE side that we're also getting after. We feel like the productivity program is only gaining strength, and that's one of the reasons we feel good about gross margins. Also, there's a lot of other things at play, like the pricing effect that we just put in for seven-one, which will bring a bunch of additional pricing into the H2. Yes, we feel very good about where we are with gross margin.

I think, as you know, we've had a gross margin compression every year since the Jarden acquisition, and this is the year that we're hoping to turn that around.

Olivia Tong (Managing Director)

Got it. Thanks. Then, given your updated views on, on resource allocation across brands and categories and geographies, can you give us some idea on whether there are brands that are, are potentially seeing more spend rather than less, and then the level of divergence, you're expecting versus where it currently stands on the brands that are going to see, less support?

Chris Peterson (President and CEO)

Yeah, we are, as part of our plan, we are spending more money on A&P. The A&P spend that we've planned in the back half of the year is up versus last year and significantly up versus the front half of this year, and it is disproportionately focused on our leading brands. For example, we feel, and part of the reason we feel very good about the back-to-school period, which we're just entering, is that our customer service results have improved markedly, as Mark mentioned, from fill rates in the low 80s% to fill rates in the mid-to-high 90s% on the writing business. We've had a terrific sell-in in back to school.

The writing business, despite the core sales for the company being down in Q2, the writing business was, was up in Q2 on core sales. Our share of retailer assets, is, is improved this year versus prior year, and because of that, we are planning to spend more money in A&P this year than last year against that, because we believe we're well positioned for the season. We obviously haven't seen consumption yet, but we believe that's a good use of, of, of investment dollars. At the same time, we said when we rolled out the strategy that we have 80 master brands, and there's 25 that represent 90% of the sales and profits that we're gonna be focusing on.

At the same time, we are deprioritizing spending on those bottom 55 brands, because we believe the return on investment is much higher on the top 25.

Olivia Tong (Managing Director)

Thank you.

Operator (participant)

Thank you. Our next question coming from the line of Andrea Teixeira with JP Morgan. Your line is open.

Andrea Teixeira (Lead Analyst)

Thank you. I wanted to go back to what you just said to Olivia's question on, on the 55 brands, Chris.

Of course, this company has been through a huge transformation in kind of optimizing and selling brands and doing all of that amid all kind of deleveraging that you went through. I wonder if there is any thought to be made on some of these brands being divested? Conversely, I just want to think about, like, as you said, some of the, as you go through this, or this is something that you're going to reassess, post all this transformation process, that this product-that these projects are still giving you and starting to give you this year. On your comment, just a clarification on your comment about back to school. Of course, you haven't seen consumption yet.

Is this category also going through, in your view, some of the reductions, that, that retailers have been going through for, for inventory, or this is pretty much more immune, given that there's still, there's still positive impacts from reopening and, and, and, and office and all of that? Thank you.

Chris Peterson (President and CEO)

Yeah. So let me, let me start with the back to school question. The writing business, or the writing category is a little different. It is not going through the same dynamics on retailer de-stocking, consumer discretionary pullback, et cetera. The writing business is much more normalized. you know, we feel very confident that we are set up to gain market share during this back to school period, depending on which projection you look at. Some people project the writing category to be slightly down versus last year. Some people project it to be flat and some people to be up slightly. I think, you know, we, we're trying to take a middle-of-the-road view on that, but we're very confident that we're set up very well to gain market share during the period.

On the 55 brand question, that represent 10% of the company's sales and profits, I would put those 55 brands into 3 buckets. The largest bucket of the 55 are brands that we are going to continue to sell, but we just are going to support less, so to speak, in terms of innovation resources. We will continue to support them fully in terms of sales resources, but we think our innovation resources, our A&P dollars, are better spent on the top 25 than this other category. consider that sort of a milk type column, if you will, for those brands.

There's a second category of brands that we are going to proactively look to discontinue, and these are brands that represent a very small percent of the company's revenues and profits, and frankly, are a distraction, and we believe, we're better off just delisting them because we don't believe they're salable, we don't believe they're significant, and we don't, we don't think it's worth it to even go through the effort of trying to sell them. There'll be some brands in that category. There's a third category where we're going to look to do something different, and that could be a divestiture or a licensing type opportunity. That'll be a small subset. I don't think you're going to see massive change like we've had in the past from an M&A divestiture standpoint.

That is not our strategy. We believe that we have a strong portfolio. We just want to focus our efforts and our resources on the biggest brands that are market leading, which represent 90% of the sales and profit of the company.

Andrea Teixeira (Lead Analyst)

Chris, just to follow up on that. Thinking about the 10% headwind that eventually we're going to see happening, of course, we don't know the size, the size of each of the buckets you just described. Assuming that there's call it, mid-single digit potential headwind, if you were to simply delist some of these to your second bucket or potentially sell, is that something that we should be worry about into 2024 that could be a headwind, or you're going to manage this gradually?

Chris Peterson (President and CEO)

Yeah, I think we're going to manage it gradually. I don't expect it to be that high. I think, you know, could there be a period in the future where we have a low single-digit headwind from this? Possibly, but I think this is going to be an over time thing. I don't think it will rise to a mid-single-digit type level in any, in any given year.

Andrea Teixeira (Lead Analyst)

Thank you.

Operator (participant)

Thank you. Our next question coming from the line of Peter Grom with UBS. Your line is open.

Peter Grom (Equity Research Analyst)

Thanks, operator. Good morning, everyone. You know, look, thank you so much for the color on the building blocks for, for guidance this year. I was just hoping to understand the implied ramp in the Q4, just in terms of operating margin. It just seems, you know, the outlook implies several hundred basis points of operating margin expansion. You know, you sound quite optimistic on gross margin. You know, can you just unpack that or what's implied in the Q4 a bit? Then, you know, back in June, you kind of mentioned, you know, core sales below an algorithm, operating margin expansion on algorithm for the next year. I, I think it was 12-18 months. Just seems that the exit rate would be implying something well ahead of that.

Is there anything specific about Q4 that we really shouldn't be extrapolating in terms of thinking about operating margin expansion into next year? Thanks.

Chris Peterson (President and CEO)

No, it's a great question. Look, I guess this is what I'd offer, and this is what I would say. Without getting bogged down in, in, you know, quarter dynamics, as we think about the H1 versus the H2, and as I just mentioned earlier, we think gross margin is going to continue to grow sequentially, you know, through the balance of the year, and we actually expect the H2 gross margin to be roughly 400 basis points above the H1 for all the reasons I cited. The FUEL productivity efforts and everything that's going along with it, the pricing effects that are in place. There's some normal business seasonality, where we tend to have a slightly higher percentage of our total year sales in the back half.

Mark Erceg (CFO)

we think the trade destocking will abate as we go further along. Our comps get easier. We have more E&O in the H1 than the H2. There's a whole litany of reasons why we're very, very confident that we have that progression right. With growth margin growing so strongly, you know, we also see operating income percent of sales following along as well, and we have that up roughly the same amount by about 400 basis points. One of the things I think is notable as we talk about the capability investments we're making, you know, I think we've demonstrated the ability to affect cost in a very positive way, and you're seeing that through the gross margin line.

If you think about what we're doing as it relates to overhead, however, overhead dollars, you know, in the H1 versus the H2, will be roughly comparable, because we're choosing to make investments in talent upgrades, change management capabilities, process improvements, data and technology enhancements. Then on the A&P side, you heard Chris mention it earlier, we're actually gonna probably be spending 50% more in the H2 than we spent on the first, where we have compelling consumer propositions.

If we think about the question that was asked earlier about the, you know, smaller brands maybe being a drag on the business, that might be true in part, but we believe the focus that's going to be put against the top 25 brands and the additional resources that go against those will more than offset that as we really start to accelerate, you know, on the top line, you know, in that regard. With your question about, you know, the commentary we provided at Deutsche Bank, when we talked about the next 12 to 18 months, I don't think what we provided there was explicit guidance per se. What we tried to say was that the next 12 to 18 months is gonna be characterized by a number of external challenges, where inflation is still gonna be moderate to high. There's some level of destocking.

I think the mild recession that we were concerned about is maybe less relevant now, because it seems like maybe we'll avoid that, which would be a good thing. During that time, we're gonna be fronting, you know, dollars towards the capability build out that we've spoken to and doing the brand rationalization effort. We had said that the core sales will be below our Evergreen targets. We think that's true. We said free cash flow predictability will be at or above. This year we're targeting over $100 now based on the good work that's being done. We said there'd be operating margin expansion, you know, at the evergreen target, which is roughly 50 basis points. Again, that wasn't explicit guidance for any given quarter.

This year, clearly, we have really strong progression on operating income, as a percent of sales in the H2 versus the first. And we are gonna be, over time, making some choices, to balance the bottom line progression on margin with additional A&P investments that we choose to make in order to put more marketing support behind our top brands. So it's gonna be a balanced approach going forward. We feel really good about where we are. If you look sequentially across every element of the P&L, it's playing out the way that we would have hoped.

Peter Grom (Equity Research Analyst)

No, that's super helpful. Then, Chris, I, I just had a question on, you know, visibility. You know, kind of the second straight quarter here, where, where things are moving a bit lower, and particularly around the quarter sales outlook. You've historically been very prudent. I, I guess I just, you know, has visibility improved, to the point where you, you feel like you can kind of get back to, to that conservatism, if you will, in the outlook so that we don't really see another call down, or, or does it still remain a bit murky?

Chris Peterson (President and CEO)

Yeah, I would... What I would say on visibility is, it is a challenging visibility period, primarily because we're dealing with the normalization from, from, you know, a once-in-a-lifetime pandemic of COVID-19. We're dealing with this massive inflation that's starting to come down and the impact that that's having on consumer purchases. We're dealing with retailer patterns on inventory that, that are unusual in nature as a result. The visibility is getting better. I will say that, you know, we were encouraged that we came in right in the middle of our top line guidance range for Q2 on core sales growth. We hit the mark on the, on the Q2 guidance. Obviously, the further out you go, the more challenging it is to provide top line guidance.

The thing that we're focused on is what's in our control, and we are moving at pace on the capability investments. We have brought in new talent, a president of brand management and innovation, a new head of consumer insights. We've changed out leadership in the Outdoor & Recreation segment. We have chartered projects specifically to go after improvement in the areas we talked about: consumer and customer understanding, innovation, brand building, brand communication, and retail execution. We are driving at pace on that, and we believe that those things will play out over the next 12 to 18 months. They're not gonna happen immediately because these things take some amount of time.

The thing that we're excited about is, as we begin to make those improvements, when you couple that with a, a very high-performing supply chain and back office organization that's delivering record, cost takeout levels, we're very optimistic about where we can take this business over the next couple of years.

Peter Grom (Equity Research Analyst)

Thanks so much. I'll pass it on.

Operator (participant)

Thank you. Our next question coming from the line of Lauren Lieberman with Barclays. Your line is open.

Lauren Lieberman (Managing Director and Senior U.S. Equity Research Analyst)

Great, thanks. Good morning. I know it might seem crazy to want to look way further out at this point, but I, I guess I was just curious. You guys have talked about, you know, evergreen, 50 basis points on average margin expansion, but what about the conversation on kind of longer-term P&L benchmarking? Because I understand unequivocally the opportunity that could be ahead in terms of positive operating leverage with all the structural cost takeout that you're doing.

Getting to a more, you know, stable and stronger and predictable top line. I'm just kind of not sure how to think about the reinvestment in capabilities as well. So even, like, if I look at, just playing with my numbers right now, you know, if I look at general expense, like, should I be thinking about 2024 as kind of reaching a benchmark level of proper investment in the business, and that you're making that step change this year, or I guess over a 4-quarter period, probably, or does that keep building? You know, just anything you can offer on maybe longer-term benchmarking on structure of the P&L would be helpful if you're willing to go there. Thanks.

Chris Peterson (President and CEO)

Yeah, I, let me try to provide a little bit of help. Let me start with 2024. I think in 2024, we're likely to have-- we've got a number of things that are effectively one time in nature in 2023, that should allow 2024 to be a bit of a bounce back year in terms of operating margins. I'll just give you a few of them. Inflation, which was, is, is significant, particularly in the H1 of this year, largely because of capitalized variances that are rolling off, should be behind us. As a result, based on what we're seeing today, we expect inflation to be a much smaller number in 2024 than it was in 2023.

We also expect fixed cost absorption to be a materially smaller impact in 2024 than 2023, because recall that this year we're dealing with the revenue decline, plus we're taking inventory down on top of that. That fixed cost absorption number is, is, is somewhat one time in nature. We also mentioned that our productivity is ramping up, and we've got a very strong funnel that we believe is gonna continue to drive very strong productivity next year. In addition to that, this year, as we're reducing inventory, we are being aggressive on what we call excess and obsolete inventory, so that we end the year with a clean inventory level.

Some of that excess and obsolete inventory, we are liquidating at a discount that, that we don't think we'll have to do as we head into next year, as we've gotten our inventory levels better. Then, obviously, the retailer inventory destocking is somewhat one-time in nature. So all of those things would tell you that in 2024, we should have an above algorithm year, certainly on margins. And, and that's what we're shooting for. I don't believe that 2024 is the end of the margin story, though. I think we have a significant opportunity going forward to continue to build operating margins for the next really three to five years.

Because a lot of the front-facing capability that we're putting in place, is also, in addition to getting top-line growth going, going to get margin going. Because when you develop a category-driving innovation, that is focused on large leading brands, that is targeted for the MPP and HPP segments, which our strategy calls for, those tend to be gross margin accretive initiatives, and that is our strategy. As we put this, consumer-facing capability in place, we believe that our innovation pipeline will get stronger. We believe the innovation pipeline will lead to better category growth, better market share gains, and gross margin improvement from a mix standpoint. All of those things have us confident that the longer-term margin opportunity in this business is, is significantly higher than where we are today.

Mark Erceg (CFO)

Yeah, Lauren, if I could add just one, one point that I think is relevant. You know, we had gross margin right around 30% in Q2. We talked about the fact that the H2 is gonna be considerably stronger for the reasons that Chris just reiterated. Our exit rate will be several hundred basis points beyond that. That's when we're still operating 46 manufacturing sites with capacity utilization, frankly, now, given where we are, probably in the low 30s, 90% of which are single-sourced, and many of which aren't in the right geographic locations to really optimize the global supply chain. We think we have tremendous opportunity on the cost takeout side, as well as all the innovation that will be brought forward.

It'll be more MPP, HPP, to push that meaningfully forward, which will give us, I think, the ability to spend more in A&P, also expand our operating margins considerably over time, while we get more efficient on the overhead line as the sales revenue starts to come back to us. We feel very good about, you know, the, the proposition of us monetizing this business over any reasonable period of time.

Lauren Lieberman (Managing Director and Senior U.S. Equity Research Analyst)

Okay. Thanks so much. That was really comprehensive. I appreciate it.

Operator (participant)

Thank you. Our next question coming from the line of Stephen Powers with Deutsche Bank. Your line is open.

Stephen Powers (Managing Director and Senior Equity Research Analyst)

Thanks. Thanks very much. Okay, so, everything you just, you just articulated makes, makes good sense to me and is exciting. I, I do wanna kinda, circle it back to what Peter was asking about in terms of the commentary, you know, a few months ago about the next 12 to 18 months not being a straight line. Everything, you know, Chris and Mark, you just described about, you know, the, you know, exiting, exiting 2023, and then, you know, the bounce back year in, in 2024 seems to run counter to that. Next 12 to 18 months being, you know, a lot more, a lot more grounded.

I mean, maybe it's just a, a, a change in kind of macro assumptions, but just seems like a very, very different message as to how we think about, you know, back half 2023 and 2024, grounded in June commentary versus grounded in, in your recent commentary. If you can just square that circle for me?

Chris Peterson (President and CEO)

Yeah, I, I think, if you step back, I think that we're, we're, we're trying to drive significant capability and improvement in a turnaround situation that the company is in, in a tough macro context that is hard to predict. When you put those things together, and you say, the macro environment currently is a headwind, we think it's going to turn to a tailwind, or at least moderate, but it's hard to predict exactly when that's going to happen. We know that we're on the right track from the strategy that we've just deployed, six weeks ago, but we also know that it's gonna take time to drive these capability improvements because they are significant changes to the way the company operates.

Mark Erceg (CFO)

We're moving the company into a new operating model with Project Phoenix, it's hard to predict exactly which quarter do those capability investments show up. We're very confident that they show up in the financial results 2 to 3 years from now, but whether they show up next quarter, or the quarter after, or the quarter after that, is hard to predict. I think the message that we were trying to deliver on the path forward not being a straight line, is we believe that the, that the line is going from the lower left to the upper right. We just don't know- can't tell you on a quarter-by-quarter basis, exactly what the slope of that line is gonna be.

If you look back a couple of years from now from where we are today, we believe you're gonna have seen significant and material improvement in the performance of the company.

Chris Peterson (President and CEO)

Right. If I could add one thing, during that period, when we said core sales growth would be below the Evergreen targets, because of obviously all the reasons that we've been discussing today, we were saying that, look, cash is gonna be our top priority, and it's gonna be, you know, moving forward, above our target. This year, we're gonna be, it'll probably be, you know, 100% free cash flow productivity, or, you know, or better. Then the operating margin expansion is gonna continue, in part because the gross margin takeout's so big and so extreme. We're very confident that's going to come to pass. I mean, we feel like over the next 12-18 months, sales might be a real challenge, but margin will progress and cash will be our focus.

Stephen Powers (Managing Director and Senior Equity Research Analyst)

Okay, okay. Okay, I, I guess, is there, is there, you know, as part of the strategy, are a lot of, you know, top-line accelerators over the course of time and, and, and kind of margin expansion drivers. I, I, I guess I'm, I'm, maybe, maybe at, at this point, is there kind of a, a, a, like a time order prioritization of where, where you think just kind of more of the low-hanging fruit is versus more of the, the kind of longer-term aspirational elements of that? Then as we go forward, do you, you anticipate we'll communicating some kind of scorecard against, against those, so we can track progress?

How are you thinking about, you know, both achieving, achieving them and also kind of communicating your progress as we go?

Chris Peterson (President and CEO)

Yeah, I think, I think it's a good thought, and we obviously have an internal scorecard that's very detailed, that we have just sort of put together. Once we finalized the strategy, we effectively chartered capability improvement projects with clear KPIs, owners, timelines, against each of them, and we are pursuing all of them simultaneously. They have different timelines relative to the execution. The consumer and customer understanding capability improvement plan and timeline, for example, looks different than creating a brand management organization timeline. We will endeavor to provide some more clarity on that as we go forward. I think we're at the place where we've commissioned all the projects.

We have owners, we have timelines, we have a clear plan, and we're, we're off and running. We're not delaying on any project, which is why I mentioned in the prepared remarks that the pace of change at the company has is accelerating dramatically, because we're taking on a lot in terms of capability improvements. The last thing I would say is that, if you, if you were to rate how difficult is it to do these capability improvements, typically, when you think about capability improvement, oftentimes people think about changing the people, the process, and/or the technology.

We've made dramatic improvement in the supply chain and in the back office, and simplification that we've been talking about over the last couple of years, whether it be the ERP systems, the IT applications, the FUEL productivity program, the SKU count, et cetera. All of that has gone well. That actually is harder to do than what we're talking about on the front end, because the supply on the back end oftentimes there's a meaningful technology component that is required that takes longer. In the front end, it tends to be more people and process-focused. So it doesn't mean it's easy, but it can happen faster. We have chartered the projects and the owners on aggressive timelines to begin to make progress.

Stephen Powers (Managing Director and Senior Equity Research Analyst)

Thank you very much.

Operator (participant)

Thank you. Our last question comes from the line of Filippo Falorni from Citi. Your line is open.

Filippo Falorni (Director of Equity Research)

Hey, good morning, everyone. I know we cover a lot of ground. I just wanna add maybe, Chris, on, you clearly announced a lot of strategic changes that's coming on, the more recent changes on the front end, the kind of the restructuring programs, changes in capital allocation. Any other areas where, where you think, like, there's more focus on your end, like, in terms of potential further changes in the organization that we should be thinking about?

Chris Peterson (President and CEO)

You know, I, I think we're at a point where, with the operating model change, with the capability assessment and the new strategy we've deployed, we're at a point where I think we've done all of the strategy work from a company standpoint at this point, or at least we've got the 90 for the 10, let's call it. Our focus now is shifting to drive that strategy into execution. Rather than sort of debate the strategy at this point, we think we've got the right strategy, and a strategy doesn't really come to life unless you execute it at the point of attack. We need to drive that strategy into execution. That takes time because you have to communicate it to the segments. You've got to communicate it to the geographies.

You have to communicate it to the functions. You've got to make sure that as you're cascading that strategy throughout the organization, it ultimately gets into every individual's work plan. As you do that, you begin to change the trajectory and the direction of the enterprise. I don't expect that we're gonna have significant changes in strategy at this point. I expect what you're gonna hear us talk more about is our progress at driving the strategy into action and execution.

Filippo Falorni (Director of Equity Research)

Great. Thank you. That's helpful.

Operator (participant)

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. A replay of today's call will be available later today on the company's website at ir.newellbrands.com. You may now disconnect. Everyone, have a great day.