FLOWERS FOODS INC - Annual Report: 2019 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 28, 2019

OR

For the transition period from                      to                     

Commission file number 1-16247

FLOWERS FOODS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:

(229) 226-9110

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☒    No  ☐

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ☐    No  ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

Based on the closing sales price on the New York Stock Exchange on July 13, 2019 the aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant was $4,764,777,380.

On February 13, 2020, the number of shares outstanding of the registrant’s Common Stock, $0.01 par value, was 211,575,015.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the 2020 Annual Meeting of Shareholders to be held May 21, 2020, which is expected to be filed with the Securities and Exchange Commission on or about April 8, 2020, have been incorporated by reference into Part III, Items 10, 11, 12, 13 and 14 of this Annual Report on Form 10-K.

FORM 10-K REPORT

TABLE OF CONTENTS

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Forward-Looking Statements

Statements contained in this filing and certain other written or oral statements made from time to time by Flowers Foods, Inc. (the “company”, “Flowers Foods”, “Flowers”, “us”, “we”, or “our”) and its representatives that are not historical facts are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to current expectations regarding our future financial condition and results of operations and are often identified by the use of words and phrases such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “should,” “will,” “would,” “is likely to,” “is expected to” or “will continue,” or the negative of these terms or other comparable terminology. These forward-looking statements are based upon assumptions we believe are reasonable.

Forward-looking statements are based on current information and are subject to risks and uncertainties that could cause our actual results to differ materially from those projected. Certain factors that may cause actual results, performance, liquidity, and achievements to differ materially from those projected are discussed in this Annual Report on Form 10-K (the “Form 10-K”) and may include, but are not limited to:

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The foregoing list of important factors does not include all such factors, nor necessarily present them in order of importance. In addition, you should consult other disclosures made by the company (such as in our other filings with the Securities and Exchange Commission (“SEC”) or in company press releases) for other factors that may cause actual results to differ materially from those projected by the company. Refer to Part I, Item 1A., Risk Factors, of this Form 10-K for additional information regarding factors that could affect the company’s results of operations, financial condition and liquidity.

We caution you not to place undue reliance on forward-looking statements, as they speak only as of the date made and are inherently uncertain. The company undertakes no obligation to publicly revise or update such statements, except as required by law. You are advised, however, to consult any further public disclosures by the company (such as in our filings with the SEC or in company press releases) on related subjects.

We own or have rights to trademarks or trade names that we use in connection with the operation of our business, including our corporate names, logos and website names. In addition, we own or have the rights to copyrights, trade secrets and other proprietary rights that protect the content of our products and the formulations for such products. Solely for convenience, some of the trademarks, trade names and copyrights referred to in this Form 10-K are listed without the ^©, ^® and ™ symbols, but we will assert, to the fullest extent under applicable law, our rights to our trademarks, trade names and copyrights.

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PART I

The Company

Flowers Foods, Inc. (which we reference to herein as “we,” “our,” “us,” the “company,” “Flowers” or “Flowers Foods”) was founded in 1919 as a Georgia corporation when two brothers — William Howard and Joseph Hampton Flowers — opened Flowers Baking Company in Thomasville, Georgia. Flowers’ operating strategy from the beginning was to invest in efficient and technologically advanced bakeries, offer excellent baked foods, build strong brands, provide extraordinary service to customers, offer a workplace that fosters a team spirit, develop innovations to improve the business, and grow through strategic acquisitions.

Flowers is focused on opportunities for growth within the baked foods category and seeks to have its products available wherever bakery foods are sold or consumed — whether in homes, supermarkets, convenience stores, restaurants, fast food outlets, institutions, or vending machines. The company produces a wide range of breads, buns, rolls, snack cakes, and tortillas and is currently the second-largest producer and marketer of packaged bakery foods in the United States (“U.S.”).

Segment

We currently manage our business as one operating segment. On May 3, 2017, the company announced an enhanced organizational structure designed to provide greater focus on the company’s long-term strategic objectives, emphasize brand growth and innovation in line with a national branded food company, drive enhanced accountability, and reduce costs.  The new organizational structure establishes two business units (“BUs”) - Fresh Packaged Bread and Snacking/Specialty - and realigns key leadership roles.  The new structure also provides for centralized marketing, sales, supply chain, shared services/administrative, and corporate strategy functions, each with clearly defined roles and responsibilities.  The company has concluded that under the new organizational structure it has one operating segment based on the nature of products the company sells, its intertwined production and distribution model, the internal management structure and information that is regularly reviewed by the chief executive officer (“CEO”), who is the chief operating decision maker, for the purpose of assessing performance and allocating resources. Capital allocations, such as building a new bakery or other investments, impact both BUs, as the two BUs are so intertwined in production, sales, marketing and other functions. Beginning with the first quarter of 2019, the comparative periods are presented on a consolidated basis due to the change to a single operating segment.

See Note 2, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements of this Form 10-K for more detailed financial information about our operating segment. Our brands are among the best known in the baking industry. Many of our brands have a major presence in the product categories in which they compete. They have a leading share of fresh packaged branded sales measured in both dollars and units in the major metropolitan areas we serve in Southern markets.

Value Creation Strategies

In June 2016, the company launched Project Centennial, an enterprise-wide business and operational review to evaluate opportunities to streamline our operations, drive efficiencies, and invest in strategic capabilities that we believe will strengthen our competitive position and help us achieve our long-term objectives to build value for our shareholders. Since 2017, the company has been executing on the following strategic priorities:

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By delivering on these strategic imperatives, the company expects to deliver on its stated long-term goals of sales growth in the range of 2% to 4% and EBITDA margins in the range of 12% to 14%. The company defines EBITDA as earnings before interest, taxes, depreciation and amortization.

Since transitioning to these strategies in fiscal 2017, the company has:

Employees

We strive to treat all our team members and associates with respect and dignity and work to maintain good relationships and open communication. We are committed to equal employment opportunities and operating our facilities under all federal and state employment laws and regulations. In addition, our subsidiaries provide:

We employ approximately 9,700 people. Approximately 1,160 of these employees are covered by collective bargaining agreements.

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Brands & Products

The company reports sales as branded retail, store branded retail, or non-retail and other.  The non-retail and other category includes foodservice, restaurant, institutional, vending, thrift stores, and contract manufacturing.  The table below presents our major brands and the geographic locations in the U.S. where our products are available:

Brand Highlights

The table below presents our sales by product mix for fiscal 2019 on a consolidated basis.  Internal sales data warehouse (“SDW”) amounts may not compute due to rounding.

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The table below presents our sales by channel for fiscal 2019 on a consolidated basis.  Internal SDW amounts may not compute due to rounding.

Marketing

We support our key brands with an advertising and marketing effort that reaches out to consumers through electronic and in-store coupons, social media (such as Facebook and Twitter), digital media (including e-newsletters to consumers), websites (our brand sites and third-party sites), event and sports marketing, on-package promotional offers and sweepstakes, and print advertising. When appropriate, we may join other sponsors with promotional tie-ins. We often focus our marketing efforts on specific products and holidays, such as hamburger and hot dog bun sales during Memorial Day, the Fourth of July, and Labor Day, and snack cakes for specific seasons.

Customers

Our top 10 customers in fiscal 2019 accounted for 51.0% of sales. During fiscal 2019, our largest customer, Walmart/Sam’s Club, represented 21.1% of the company’s sales. The loss of, or a material negative change in our relationship with, Walmart/Sam’s Club or any other major customer could have a material adverse effect on our business. Walmart/Sam’s Club was the only customer to account for 10.0% or more of our sales during fiscal years 2019, 2018, and 2017.

Fresh baked foods’ customers include mass merchandisers, supermarkets and other retailers, restaurants, quick-serve chains, food wholesalers, institutions, dollar stores, and vending companies. We also sell returned and surplus product through a system of thrift stores. The company currently operates 282 such stores and reported sales of $74.8 million during fiscal 2019 from these outlets.

We also (1) supply national and regional restaurants, institutions and foodservice distributors, and retail in-store bakeries with breads and rolls; (2) sell packaged bakery products to wholesale distributors for ultimate sale to a wide variety of food outlets; and (3) sell packaged snack cakes primarily to customers who distribute them nationwide through multiple channels of distribution, including mass merchandisers, supermarkets, vending outlets and convenience stores. In certain circumstances, we enter into co-packing arrangements with retail customers or other food companies, some of which are competitors.

Distribution

We distribute our products through a direct-store-delivery (“DSD”) distribution system and a warehouse delivery system.  The DSD distribution system involves aggregating order levels and delivering products from bakeries to independent distributors for sale and direct delivery to customer stores. The independent distributors are responsible for ordering products, stocking shelves, maintaining special displays, and developing and maintaining good customer relations to ensure adequate inventory and removing unsold goods.  The warehouse delivery system involves primarily delivering our products to customers’ warehouses.

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The company has sold the majority of the distribution rights for territories to independent distributors under long-term financing arrangements. Independent distributors, highly motivated by financial incentives from their distribution rights ownership, strive to increase sales by offering outstanding service and merchandising. Independent distributors have the opportunity to benefit directly from the enhanced value of their distribution rights resulting from higher branded sales volume.

Our DSD distribution system is comprised of three types of territories: (1) independent distributors who own the rights to distribute certain brands of our fresh packaged bakery foods in defined geographic markets; (2) company-owned and operated territories with distribution rights that are classified as available for sale; and (3) other company operated territories.  The table below presents the approximate number of territories used by the company on December 28, 2019:

The company has developed proprietary software on the hand-held computers independent distributors use for ordering, sales transactions, and to manage their businesses. The company provides these hand-held computers to the independent distributors and charges them an administrative fee for their use and other administrative services.  This fee is recognized as a reduction to the company’s selling, distribution and administrative expenses.  Our proprietary software permits distributors to track and communicate inventory data to bakeries and to calculate recommended order levels based on historical sales data and recent trends. These orders are electronically transmitted to the appropriate bakery on a nightly basis. We believe this system assists us in minimizing returns of unsold goods.  The fees collected for each of the last three fiscal years were as follows (amounts in thousands):

In addition to hand-held computers, we maintain an IT platform that allows us to track sales, product returns, and profitability by selling location, bakery, day, and other criteria. The system provides us with daily, on-line access to sales and gross margin reports, allowing us to make prompt operational adjustments when appropriate. It also permits us to better forecast sales and improve independent distributors’ in-store product ordering by customer. This IT platform is integral to our hand-held computers.

We also use scan-based trading technology (referred to as “pay by scan” or “PBS”) to track and monitor sales and inventories more effectively. PBS allows the independent distributors to bypass the often-lengthy product check-in with certain retail customers, which gives them more time to service customers and merchandise products. PBS also benefits retailers, who only pay suppliers for what they actually sell, or what is scanned at checkout. During the last three fiscal years, PBS sales were as follows (amounts in thousands):

Our warehouse distribution system delivers a portion of our packaged bakery snack products from a central distribution facility located near our Crossville, Tennessee snack cake bakery. We believe this centralized distribution system allows us to achieve both production and distribution efficiencies. Products coming from different bakeries are then cross-docked and shipped directly to customers’ warehouses nationwide. Our frozen bread and roll products are shipped to various outside freezer facilities for distribution to our customers.

Intellectual Property

We own a number of trademarks, trade names, patents, and licenses. The company also sells products under franchised and licensed trademarks and trade names which we do not own pursuant to contractual arrangements.  We consider all of our trademarks and trade names important to our business since we use them to build strong brand awareness and consumer loyalty.

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Raw Materials

Our primary baking ingredients are flour, sweeteners, shortening, yeast and water. We also purchase organic and gluten-free ingredients.  We also use paper products, such as corrugated cardboard, films and plastics to package our bakery foods. We strive to maintain diversified sources for all of our baking ingredients and packaging products.  In addition, we are dependent on natural gas or propane as fuel for firing our ovens.

Commodities, such as our baking ingredients, periodically experience price fluctuations. The cost of these inputs may fluctuate widely due to government policy and regulation, weather conditions, domestic and international demand, or other unforeseen circumstances. We enter into forward purchase agreements and other derivative financial instruments in an effort to manage the impact of such volatility in raw material prices, but some organic and specialty ingredients do not offer the same hedging opportunities to reduce the impact of price volatility.  Any decrease in the supply available under these agreements and instruments could increase the effective price of these raw materials to us and significantly impact our earnings.

Regulations

As a producer and marketer of food items, our operations are subject to regulation by various federal governmental agencies, including the U.S. Food and Drug Administration, the U.S. Department of Agriculture, the U.S. Federal Trade Commission, the U.S. Environmental Protection Agency, the U.S. Department of Commerce, and the U.S. Department of Labor (the “DOL”).  We also are subject to the regulations of various state agencies, with respect to production processes, product quality, packaging, labeling, storage, distribution, labor, and local regulations regarding the licensing of bakeries and the enforcement of state standards and facility inspections.  Under various statutes and regulations, these federal and state agencies prescribe requirements and establish standards for quality, purity, and labeling.  Failure to comply with one or more regulatory requirements could result in a variety of sanctions, including monetary fines or compulsory withdrawal of products from store shelves.  

Advertising of our businesses is subject to regulation by the Federal Trade Commission, and we are subject to certain health and safety regulations, including those issued under the Occupational Safety and Health Act.

The cost of compliance with such laws and regulations has not had a material adverse effect on the company’s business.  We believe we are currently in substantial compliance with all material federal, state and local laws and regulations affecting the company and its properties.  

Our operations, like those of similar businesses, are subject to various federal, state and local laws and regulations with respect to environmental matters, including air and water quality and underground fuel storage tanks, as well as other regulations intended to protect public health and the environment.  The company is not a party to any material proceedings arising under these laws and regulations.  We believe compliance with existing environmental laws and regulations will not materially affect the Consolidated Financial Statements or the competitive position of the company.  The company is currently in substantial compliance with all material environmental laws and regulations affecting the company and its properties.

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Competitive Overview

The U.S. market for fresh and frozen bakery products is estimated at $36 billion at retail. This category is intensely competitive and has experienced significant change in the last several years. From a national standpoint, Flowers Foods is currently the second-largest company in the U.S. fresh baking industry based on market share as presented in the following chart (amounts may not compute due to rounding). (Source: IRI Flowers custom database, 52 weeks ending 12-28-19; Flowers private label sales from SDW):

The current competitive landscape for breads and rolls in the U.S. baking industry now consists of Bimbo Bakeries USA, Flowers Foods, and Campbell Soup Company, under the Pepperidge Farm brand, along with smaller independent regional bakers, local bakeries, and retailer-owned bakeries.

There are a number of smaller regional bakers in the U.S. Some of these do not enjoy the competitive advantages of larger operations, including greater brand awareness and economies of scale in purchasing, distribution, production, IT, advertising and marketing. However, size alone is not sufficient to ensure success in our industry. The company faces significant competition from regional and independent bakeries in certain geographic areas.

Competition in the baking industry continues to be driven by a number of factors. These include the ability to serve consolidated retail and foodservice customers, generational changes in family-owned businesses, and competitors’ promotional efforts on branded bread and store brands. Competition typically is based on the ability to target changing consumer preferences, product availability, product quality, brand loyalty, price, and effective promotions. Customer service, including frequent deliveries to keep store shelves well-stocked, is also a competitive factor.

The company also faces competition from store brands that are produced either by us or our competitors. Store brands (also known as “private label”) have been offered by food retailers for decades. With the growth of mass merchandisers like Walmart and the ongoing consolidation of regional supermarkets into larger operations, store brands have become a significant competitor to the company in those areas where the company does not have the contract to produce the store brand. In general, the store brand share of retail fresh packaged bread in the U.S. accounts for approximately 23% of the dollar sales and approximately 35% of unit sales and has steadily declined over the past five years.

Other Available Information

Throughout this Form 10-K, we incorporate by reference information from parts of other documents filed with the SEC. The SEC allows us to disclose important information by referring to it in this manner, and you should review this information in addition to the information contained in this report.

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy statement for the annual shareholders’ meeting, as well as any amendments to those reports, are available free of charge through our website as soon as reasonably practicable after we file them with the SEC. You can learn more about us by reviewing our SEC filings on our website at www.flowersfoods.com in the “REPORTS & FILINGS” section of the “INVESTORS” tab. The SEC also maintains a website at www.sec.gov that contains reports, proxy statements and other information about SEC registrants, including the company. Except as otherwise expressly set forth herein, the information contained on our website is neither included nor incorporated by reference herein.

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The following corporate governance documents may be obtained free of charge through our website in the “CORPORATE GOVERNANCE” section of the “INVESTORS” tab (unless otherwise specified) or by sending a written request to Flowers Foods, Inc., 1919 Flowers Circle, Thomasville, GA 31757, Attention: Investor Relations.

You should carefully consider the risks described below, together with all of the other information included in this report, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing us. These risk factors are not listed in any order of significance.  Additional risks and uncertainties not presently known to us, or that we currently deem insignificant, may also impair our business operations. The occurrence of any of the following risks could harm our business, financial condition, liquidity or results of operations.

Economic conditions may negatively impact demand for our products, which could adversely impact our sales and operating profit.

The willingness of our customers and consumers to purchase our products may depend in part on economic conditions. Worsening economic conditions or future challenges to economic growth could have a negative impact on consumer demand, which could adversely affect our business. Deterioration of national and global economic conditions could cause consumers to shift purchases to more generic, lower-priced, or other value offerings, or consumers may forego certain purchases altogether during economic downturns and could result in decreased demand in the foodservice business. This economic uncertainty may increase pressure to reduce the prices of some of our products, limit our ability to increase or maintain prices, and reduce sales of higher margin products or shift our product mix to low-margin products.

In addition, changes in tax or interest rates, whether due to recession, financial and credit market disruptions or other reasons, could negatively impact us. In this regard, the administering regulatory authority announced it intends to phase out London Interbank Offered Rate (“LIBOR”) by the end of 2021. Certain of our variable rate debt and revolving credit facility use LIBOR as a benchmark for establishing interest rates. While we expect to have replaced or renegotiated our revolving credit facility by the end of 2021, we plan to incur additional indebtedness and/or negotiate new terms that will rely on an alternative method to LIBOR. Any legal or regulatory changes made in response to LIBOR’s future discontinuance may result in, among other things, a sudden or prolonged increase or decrease in LIBOR, a delay in the publication of LIBOR, or changes in the rules or methodologies in LIBOR. In addition, alternative methods to LIBOR may be impossible or impracticable to determine. While we do not expect that the transition from LIBOR and risks related thereto will have a material adverse effect on our financing costs, it is still uncertain at this time. If any of these events occurs, or if economic conditions become unfavorable, our sales and profitability could be adversely affected.

Increases in costs and/or shortages of raw materials, fuels and utilities could adversely impact our profitability.

Raw materials, such as flour, sweeteners, shortening, yeast, and water, which are used in our bakery products, are subject to price fluctuations. The cost of these inputs may fluctuate widely due to foreign and domestic government policies and regulations, weather conditions, domestic and international demand, or other unforeseen circumstances. Any substantial change in the prices or availability of raw materials may have an adverse impact on our profitability. We enter into forward purchase agreements and other derivative financial instruments from time to time to manage the impact of such volatility in raw materials prices; however, these strategies may not be adequate to overcome increases in market prices or availability. Our failure to enter into hedging or fixed price arrangements or any decrease in the availability or increase in the cost of these agreements and instruments could increase the price of these raw materials and significantly affect our earnings.

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In addition, we are dependent upon natural gas or propane for firing ovens. The independent distributors and third-party transportation companies are dependent upon gasoline and diesel for their vehicles. The cost of fuel may fluctuate widely due to economic and political conditions, government policy and regulation, war, or other unforeseen circumstances. Substantial future increases in prices for, or shortages of, these fuels could have a material adverse effect on our profitability, financial condition or results of operations. There can be no assurance that we can cover these potential cost increases through future pricing actions. Also, as a result of these pricing actions, consumers could purchase less or move from purchasing high-margin products to lower-margin products.  

Competition could adversely impact revenues and profitability.

The U.S. bakery industry is highly competitive. Our principal competitors in these categories all have substantial financial, marketing, and other resources. In most product categories, we compete not only with other widely advertised branded products, but also with store branded products that are generally sold at lower prices. Competition is based on product availability, product quality, price, effective promotions, and the ability to target changing consumer preferences. Substantial growth in e-commerce has encouraged the entry of new competitors and business models, intensifying competition by simplifying distribution and lowering barriers to entry. The expanding presence of e-commerce retailers has impacted, and may continue to impact, consumer preferences and market dynamics, which in turn may negatively affect our sales or profits.  We experience price pressure from time to time due to competitors’ promotional activity and other pricing efforts. This pricing pressure is particularly strong during adverse economic periods. Increased competition could result in reduced sales, margins, profits and market share.

A disruption in the operation of our DSD distribution system could negatively affect our results of operations, financial condition and cash flows.

A material negative change in our relationship with the independent distributors, litigation or one or more adverse rulings by courts or regulatory or governmental bodies regarding our independent distributorship model, including actions or decisions that could affect the independent contractor classifications of the independent distributors, or an adverse judgment against the company for actions taken by the independent distributors, could materially and negatively affect our financial condition, results of operations and cash flows.

The costs of maintaining and enhancing the value and awareness of our brands are increasing, which could have an adverse impact on our revenues and profitability.

We rely on the success of our well-recognized brand names and we intend to maintain our strong brand recognition by continuing to devote resources to advertising, marketing and other brand building efforts. Brand value could diminish significantly due to several factors, including consumer perception that we have acted in an irresponsible manner, adverse publicity about our products (whether or not valid), our failure to maintain the quality of our products, the failure of our products to deliver consistently positive consumer experiences, or the products becoming unavailable to consumers. In addition, failure to comply with local or other laws and regulations could also hurt our reputation. Our marketing investments may not prove successful in maintaining or increasing our market share. If we are not able to successfully maintain our brand recognition or were to suffer damage to our reputation or loss of consumer confidence in our products for any of these reasons, our revenues and profitability could be adversely affected.

We rely on several large customers for a significant portion of sales and the loss of one of our large customers could adversely affect our business, financial condition or results of operations.

We have several large customers that account for a significant portion of sales, and the loss of one of our large customers could adversely affect our financial condition and results of operations. Our top ten customers accounted for 51.0% of sales during fiscal 2019. Our largest customer, Walmart/Sam’s Club, accounted for 21.1% of sales during this period. These customers do not typically enter long-term sales contracts, and instead make purchase decisions based on a combination of price, product quality, consumer demand, and customer service performance. At any time, they may use more of their shelf space, including space currently used for our products, for store branded products or for products from other suppliers. Additionally, our customers may face financial or other difficulties that may impact their operations and their purchases from us. Disputes with significant suppliers could also adversely affect our ability to supply products to our customers. If our sales to one or more of these customers are reduced, this reduction may adversely affect our business, financial condition or results of operations.

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Our inability to execute our business strategy could adversely affect our business.

We employ various operating strategies to maintain our position as one of the nation’s leading producers and marketers of bakery products available to customers through multiple channels of distribution.  In particular, we have initiated under Project Centennial, among other things, (i) the integration of acquisitions or the acquisition or disposition of assets at presently targeted values, (ii) the deployment of new systems and technology, and (iii) an enhanced organizational structure.  These and related demands on our resources may divert the organization’s attention from other business issues. Our success is partly dependent upon properly executing, and realizing cost savings or other benefits from, these often-complex initiatives. Any failure to implement our initiatives could adversely affect our ability to grow margins. If we are unsuccessful in implementing or executing Project Centennial or one or more of our business strategies, our business could be adversely affected.

Inability to anticipate or respond to changes in consumer preferences may result in decreased demand for our products, which could have an adverse impact on our future growth and operating results.

Our success depends in part on our ability to respond to current market trends and to anticipate the tastes and dietary habits of consumers, including concerns of consumers regarding health and wellness, obesity, product attributes, ingredients, and packaging. Similarly, demand for our products could be negatively affected by consumer concerns or perceptions regarding the health effects of specific ingredients such as, but not limited to, sodium, trans fats, sugar, processed wheat, or other product ingredients or attributes. Introduction of new products and product extensions requires significant development and marketing investment. If we fail to anticipate, identify, or react to changes in consumer preferences, or if we fail to introduce new and improved products on a timely basis, we could experience reduced demand for our products, which could cause our sales, profitability, and our operating results to suffer.

We may be adversely impacted by the failure to successfully execute acquisitions and divestitures and integrate acquired operations.

From time to time, the company undertakes acquisitions or divestitures. The success of any acquisition or divestiture depends on the company’s ability to identify opportunities that help us meet our strategic objectives, consummate a transaction on favorable contractual terms, and achieve expected returns and other financial benefits.

Acquisitions, including future acquisitions and the Canyon acquisition completed in fiscal 2018, require us to efficiently integrate the acquired business or businesses, which involves a significant degree of difficulty, including the following:

Divestitures have operational risks that may include impairment charges. Divestitures also present unique financial and operational risks, including diverting management attention from the existing core business, separating personnel and financial data and other systems, and adversely affecting existing business relationships with suppliers and customers.

In situations where acquisitions or divestitures are not successfully implemented or completed, or the expected benefits of such acquisitions or divestitures are not otherwise realized, the company’s business or financial results could be negatively impacted.

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We are subject to increasing legal complexity and could be party to litigation that may adversely affect our business.

Increasing legal complexity may continue to affect our operations and results in material ways. We are or could be subject to legal proceedings that may adversely affect our business, including class actions, administrative proceedings, government investigations, securities laws, employment and personal injury claims, disputes with current or former suppliers, claims by current or former distributors, and intellectual property claims (including claims that we infringed another party’s trademarks, copyrights, or patents). Inconsistent standards imposed by governmental authorities can adversely affect our business and increase our exposure to litigation. Litigation involving our independent distributor model and the independent contractor classification of the independent distributors, as well as litigation related to disclosure made by us in connection therewith, if determined adversely, could increase costs, negatively impact our business prospects and the business prospects of our distributors and subject us to incremental liability for their actions. We are also subject to the legal and compliance risks associated with privacy, data collection, protection and management, in particular as it relates to information we collect when we provide products to customers.

Disruption in our supply chain or distribution capabilities from political instability, armed hostilities, incidents of terrorism, natural disasters, weather, inferior product or ingredient supply, or labor strikes could have an adverse effect on our business, financial condition and results of operations.

Our ability to make, move and sell products is critical to our success. Damage or disruption to our manufacturing or distribution capabilities, or the manufacturing or distribution capabilities of our suppliers, due to weather, natural disaster, fire or explosion, terrorism, pandemics, inferior product or ingredient supply, labor strikes or work stoppages, or adverse outcomes in litigation involving our independent distributor model, could impair our ability to make, move or sell our products. Moreover, terrorist activity, armed conflict, political instability or natural disasters that may occur within or outside the U.S. may disrupt manufacturing, labor, and other business operations. Failure to take adequate steps to mitigate the likelihood or potential impact of such events and disruption to our manufacturing or distribution capabilities, or to effectively manage such events if they occur, could adversely affect our business, financial conditions and results of operations.

Product removals, damaged product or safety concerns could adversely impact our results of operations.

We may be required to recall certain of our products should they be mislabeled, contaminated, spoiled, tampered with or damaged. We may become involved in lawsuits and legal proceedings alleging that the consumption of any of our products causes or caused injury, illness or death. Any such product removal, damaged product or an adverse result in any litigation related to such a product removal or damaged product could have a material adverse effect on our operating and financial results in future periods, depending on the costs of the product removal from the market, the destruction of product inventory, diversion of management time and attention, contractual and other claims made by customers that we supply, loss of key customers, competitive reaction and consumer attitudes. Even if a product liability, consumer fraud or other claim is unsuccessful or without merit, the negative publicity surrounding such assertions regarding our products could adversely affect our reputation and brand image. We also could be adversely affected if our customers or consumers in our principal markets lose confidence in the safety and quality of our products.

During fiscal years 2018 and 2019, we have been required, and may be required in future periods, to remove certain of our products from the market should they be mislabeled, contaminated, spoiled, tampered with or damaged, including as a result of inferior ingredients provided by any of our suppliers.

Consolidation in the retail and foodservice industries could adversely affect our sales and profitability.

We expect consolidations among our retail and foodservice customers to continue. If this trend continues and our retail and foodservice customers continue to grow larger due to consolidation in their respective industries, they may demand lower pricing and increased promotional programs. In addition, these pressures may restrict our ability to increase prices, including in response to commodity and other cost increases. Our margins and profits could decrease if a reduction in prices or increased costs are not counterbalanced with increased sales volume.

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Our large customers may impose requirements on us that may adversely affect our results of operations.

From time to time, our large customers may re-evaluate or refine their business practices and impose new or revised requirements on us, the distributors, and the customers’ other suppliers. The growth of large mass merchandisers, supercenters and dollar stores, together with changes in consumer shopping patterns, have produced large, sophisticated customers with increased buying power and negotiating strength. Current trends among retailers and foodservice customers include fostering high levels of competition among suppliers, demanding new products or increased promotional programs, requiring suppliers to maintain or reduce product prices, reducing shelf space for our products, and requiring product delivery with shorter lead times. These business changes may involve inventory practices, logistics, or other aspects of the customer-supplier relationship. Compliance with requirements imposed by large customers may be costly and may have an adverse effect on our margins and profitability. However, if we fail to meet a large customer’s demands, we could lose that customer’s business, which also could adversely affect our sales and results of operations.

Increases in employee and employee-related costs could have adverse effects on our profitability.

Pension, health care, and workers’ compensation costs are increasing and will likely continue to do so. Any substantial increase in pension, health care or workers’ compensation costs may have an adverse impact on our profitability. The company records pension costs and the liabilities related to its benefit plans based on actuarial valuations, which include key assumptions determined by management. Material changes in pension costs may occur in the future due to changes in these assumptions. Future annual amounts could be impacted by various factors, such as changes in the number of plan participants, changes in the discount rate, changes in the expected long-term rate of return, changes in the level of contributions to the plan, and other factors. In addition, legislation or regulations involving labor and employment and employee benefit plans (including employee health care benefits and costs) may impact our operational results.

We have risks related to our pension plans, which could impact the company’s liquidity.

The company has noncontributory defined benefit pension plans covering certain employees maintained under the Employee Retirement Income Security Act of 1974 (“ERISA”). The funding obligations for our pension plans are impacted by the performance of the financial markets. During fiscal 2018, the company adopted a de-risking investment strategy for its pension assets in Plan No. 1 and the termination of Plan No. 1 is expected to occur by May 2020.  The termination of Plan No. 1 has resulted in a short-term conservative investment outlook, while Plan No. 2 is still managed as a long-term asset.  

As a result of the termination, we will be required to make significant cash contributions to fund Plan No. 1’s unfunded vested benefit, which could adversely affect our financial condition, liquidity or results of operations, the amount of which will depend on the lump sum offer participation rate of eligible participants.  Based on the estimated value of assets held in the plan, the company currently estimates that a cash contribution of approximately $17.0 million to $35.0 million will be required to fully fund the plan’s liabilities at termination.  In addition, based on current assumptions of the level of lump sum distributions elected by eligible plan participants, among other assumptions, the company estimates a final non-cash settlement charge of approximately $125.0 million to $143.0 million will be triggered in the first quarter of fiscal 2020.

If the financial markets do not provide the long-term returns that are expected, the likelihood of the company being required to make larger contributions will increase, which could impact our liquidity. The equity markets can be, and recently have been, very volatile, and therefore our estimate of future contribution requirements can change dramatically in relatively short periods of time. Similarly, changes in interest rates can impact our contribution requirements. In a low interest rate environment, the likelihood of larger required contributions increases. Adverse developments in any of these areas could adversely affect our financial condition, liquidity or results of operations.  

We may be adversely impacted if our IT systems fail to perform adequately, including with respect to cybersecurity issues.

The efficient operation of our business depends on our IT systems. We rely on our IT systems to effectively manage our business data, communications, supply chain, order entry and fulfillment, and other business processes. The failure of our IT systems (including those provided to us by third parties) to perform as we anticipate could disrupt our business and could result in billing, collecting and ordering errors, processing inefficiencies, and the loss of sales and customers, causing our business and results of operations to suffer.

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In addition, our IT systems may be vulnerable to damage or interruption from circumstances beyond our control, including fire, natural disasters, systems failures, security breaches or intrusions (including theft of customer, consumer or other confidential data), and viruses. If we are unable to prevent physical and electronic break-ins, cyber-attacks and other information security breaches, we may suffer financial and reputational damage, be subject to litigation or incur remediation costs or penalties because of the unauthorized disclosure of confidential information belonging to us or to our partners, customers, suppliers or employees.

Climate change, or legal, regulatory, or market measures to address climate change, may negatively affect our business and operations.

There is growing concern that carbon dioxide and other greenhouse gases in the atmosphere may have an adverse impact on global temperatures, weather patterns, and the frequency and severity of extreme weather and natural disasters. In the event that such climate change has a negative effect on agricultural productivity, we may be subject to decreased availability or less favorable pricing for certain commodities that are necessary for our products, such as corn and wheat. Adverse weather conditions and natural disasters can reduce crop size and crop quality, which in turn could reduce our supplies of raw materials, lower recoveries of usable raw materials, increase the prices of our raw materials, increase our cost of transporting and storing raw materials, or disrupt our production schedules.

We may also be subjected to decreased availability or less favorable pricing for water as a result of such change, which could impact our production and distribution operations. In addition, natural disasters and extreme weather conditions may disrupt the productivity of our facilities or the operation of our supply chain. The increasing concern over climate change also may result in more regional, federal, and/or global legal and regulatory requirements to reduce or mitigate the effects of greenhouse gases. In the event that such regulation is enacted and is more aggressive than the sustainability measures that we are currently undertaking to monitor our emissions and improve our energy efficiency, we may experience significant increases in our costs of operation and delivery. In particular, increasing regulation of fuel emissions could substantially increase the distribution and supply chain costs associated with our products. As a result, climate change could negatively affect our business and operations.

Government regulation could adversely impact our results of operations and financial condition.

As a producer and marketer of food items, our production processes, product quality, packaging, labeling, storage, and distribution are subject to regulation by various federal, state and local government entities and agencies. In addition, the marketing and labeling of food products has come under increased scrutiny in recent years, and the food industry has been subject to an increasing number of legal proceedings and claims relating to alleged false or deceptive marketing and labeling under federal, state or local laws or regulations. Uncertainty regarding labeling standards has led to customer confusions and legal challenges.

In addition, our operations are subject to extensive and increasingly stringent regulations administered by the Environmental Protection Agency related to the discharge of materials into the environment and the handling and disposition of wastes. Failure to comply with these regulations can have serious consequences, including civil and administrative penalties and negative publicity. Changes in applicable laws or regulations or evolving interpretations thereof, including increased government regulations to limit carbon dioxide and other greenhouse gas emissions as a result of concern over climate change, may result in increased compliance costs, capital expenditures, and other financial obligations for us, which could affect our profitability or impede the production or distribution of our products, and affect our sales.

Compliance with federal, state and local laws and regulations is costly and time consuming. Failure to comply with, or violations of, applicable laws and the regulatory requirements of one or more of these entities and agencies could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, any of which could result in increased operating costs and adversely affect our results of operations and financial condition. Legal proceedings or claims related to our marketing could damage our reputation and/or adversely affect our business or financial results.  

Executive Offices

The address and telephone number of our principal executive offices are 1919 Flowers Circle, Thomasville, Georgia 31757, (229) 226-9110.

Information about our Executive Officers

The following table sets forth certain information regarding the persons who currently serve as the executive officers of Flowers Foods.

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EXECUTIVE OFFICERS

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None

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The company currently operates 46 bakeries, of which 44 are owned and two are leased. We believe our properties are in good condition, well maintained, and sufficient for our present operations. Our production plant locations are:

In Thomasville, Georgia, the company leases properties that house shared services functions and our IT group and owns several properties for our corporate offices.

For a description of all material pending legal proceedings, See Note 24, Commitments and Contingencies, of Notes to Consolidated Financial Statements of this Form 10-K.

Not Applicable

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PART II

Market Information

Shares of the company’s common stock are quoted on the New York Stock Exchange (the “NYSE”) under the symbol “FLO.” 

Holders

As of February 13, 2020, there were approximately 3,435 holders of record of the company’s common stock.

Dividends

The payment of dividends is subject to the discretion of the Board. The Board bases its decisions regarding dividends on, among other things, general business conditions, our financial results, contractual, legal and regulatory restrictions regarding dividend payments and any other factors the Board may consider relevant.

Securities Authorized for Issuance Under Equity Compensation Plans

The following chart sets forth the amounts of securities authorized for issuance under the company’s compensation plans as of December 28, 2019.

Under the company’s 2014 Omnibus Equity and Incentive Compensation Plan (the “Omnibus Plan”), the Board is authorized to grant a variety of stock-based awards, including stock options, restricted stock and deferred stock, to its directors and certain of its employees. The number of securities set forth in column (c) above reflects securities available for issuance as stock options, restricted stock and deferred stock under the company’s compensation plans. The number of shares originally available under the Omnibus Plan is 8,000,000 shares. The Omnibus Plan replaced the Flowers Foods’ 2001 Equity and Performance Incentive Plan, as amended and restated as of April 1, 2009 (“EPIP”), the Stock Appreciation Rights Plan, and the Annual Executive Bonus Plan. As a result, no additional shares will be issued under the EPIP. See Note 19, Stock-Based Compensation, of Notes to Consolidated Financial Statements of this Form 10-K for additional information on equity compensation plans.

Purchases of Equity Securities by the Issuer

The company did not purchase any shares of its common stock during the fourth quarter of fiscal 2019.

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Stock Performance Graph

The chart below is a comparison of the cumulative total return (assuming the reinvestment of all dividends paid) of our common stock, Standard & Poor’s 500 Index, Standard & Poor’s 500 Packaged Foods and Meats Index, and Standard & Poor’s MidCap 400 Index for the period January 3, 2015 through December 28, 2019, the last day of our 2019 fiscal year.

Companies in the S&P 500 Index, the S&P 500 Packaged Foods and Meats Index, and the S&P MidCap 400 Index are weighted by market capitalization and indexed to $100 at January 3, 2015. Flowers Foods’ share price is also indexed to $100 at December 28, 2019.

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The selected consolidated historical financial data presented below as of and for the fiscal years 2019, 2018, 2017, 2016, and 2015 have been derived from the audited Consolidated Financial Statements of the company. The results of operations presented below are not necessarily indicative of results that may be expected for any future period and should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, and our Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included in this Form 10-K (amounts in thousands, except per share data).

Notes to the Selected Financial Data table for additional context

The company adopted Accounting Standard Update (“ASU”) No. 2016-02 Leases (ASC Topic 842, the “new standard”) that requires companies to recognize lease liabilities and a right-of-use asset for virtually all leases on the balance sheet.  The company adopted this standard at the beginning of our fiscal 2019 using the modified retrospective transition method.  The impact at adoption was an increase to assets of $387.3 million and an increase to liabilities of $391.9 million.  See Note 3, Recent Accounting Pronouncements, of Notes to Consolidated Financial Statements of this Form 10-K, for details of the impact at adoption.

The company purchased Canyon on December 14, 2018.  See Note 10, Acquisition, of Notes to Consolidated Financial Statements of this Form 10-K, for more detailed disclosures for the acquisition.  Its results of operations for the period from December 14, 2018 through December 29, 2018 were excluded due to immateriality and were reported in the first quarter of fiscal 2019.

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The following discussion should be read in conjunction with Item 1., Business, and the Consolidated Financial Statements and accompanying Notes to Consolidated Financial Statements included in this Form 10-K. The following information contains forward-looking statements which involve certain risks and uncertainties. See Forward-Looking Statements at the beginning of this Form 10-K.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is segregated into four sections, including:

MATTERS AFFECTING COMPARABILITY

Detailed below are matters affecting comparability as well as other significant events that will provide additional context while reading this discussion:

In fiscal 2017, we recognized an income tax benefit of $48.2 million related to the estimated benefit of the Tax Cuts and Jobs Act of 2017 (the “Act”).  In fiscal 2018, we recognized an additional benefit of $5.6 million as an adjustment to the fiscal 2017 amount.  These tax benefits partially offset the net expense amount of the pre-tax items in each respective fiscal year detailed above.

Changes to segment reporting and reclassification of certain prior year amounts.  As of the beginning of fiscal 2019, we completed our transition to the new organizational structure and began managing our business as one operating segment.  Additionally, we have reclassified certain prior year amounts for comparability.    

Project Centennial consulting costs.  During the second quarter of fiscal 2016, we launched Project Centennial, an enterprise-wide business and operational review.  Key initiatives of the project are outlined in Item 1., Business, of this Form 10-K.  As of the end of fiscal 2016, we had completed the diagnostic phase and entered the implementation phase of the project. Consulting costs associated with the project in fiscal 2019, 2018, and 2017 were $0.8 million, $9.7 million, and $37.3 million, respectively.  Costs incurred in fiscal 2019 primarily related to the portfolio and supply chain network optimization initiative of Project Centennial and we anticipate incurring additional consulting costs between $7.0 million and $9.0 million in fiscal 2020 for this initiative.  In fiscal 2019, these costs were reflected in the selling, distribution and administrative expenses line item of the Consolidated Statements of Income.  

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Gain on divestiture of the non-core mix manufacturing business.  On January 14, 2017, we completed the sale of our non-core mix manufacturing business located in Cedar Rapids, Iowa and received proceeds, net of a working capital adjustment, of $41.2 million and recognized a gain of $28.9 million in our fiscal 2017 results of operations.  

Restructuring and related impairment charges associated with Project Centennial.  The following table details charges recorded in fiscal 2019, 2018, and 2017 (amounts in thousands):

In fiscal 2019, we closed our Opelika, Alabama bakery and recorded asset impairment charges with respect to the property, plant, equipment, and spare parts totaling $3.9 million and severance costs of $1.5 million.  Additionally, we recorded $1.8 million of asset impairment charges for a closed bakery included in assets held for sale and for other manufacturing line closures, and severance and relocation costs of $1.8 million related to transitioning to the new organizational structure.  Also, during fiscal 2019, we recorded a gain on sale of $0.8 million related to a facility that had been previously impaired in a prior year.  In the fourth quarter of fiscal 2019, we completed a brand rationalization study which resulted in $15.4 million of impairment charges for certain trademarks that we either no longer intend to use or plan to use on a more limited basis.  

In fiscal 2018, employee termination benefits and other cash charges were primarily for severance related to the plant closure discussed below and relocation costs associated with the company reorganization that was completed in fiscal 2018, net of an adjustment of $0.6 million to the VSIP charge recognized in fiscal 2017.  On November 7, 2018, the company announced the closure of a bakery in Brattleboro, Vermont as part of the supply chain optimization initiative under Project Centennial.  The facility ceased operating at the end of fiscal 2018 and resulted in severance charges discussed above, as well as property, plant and equipment impairments of $2.7 million.  Additionally, we completed a product rationalization project in fiscal 2018 that resulted in the write-off of certain ingredient, packaging and advertising displays for discontinued items, and decided to sell a closed manufacturing facility acquired as part of the Acquired Hostess Bread Assets in fiscal 2013 and to close two manufacturing lines in other bakeries resulting in asset impairments.

Employee termination benefits and other cash charges recorded in fiscal 2017 included the VSIP, severance related to other reorganizational initiatives, severance related to the plant closure discussed below, and relocation costs due to the company reorganization.  The VSIP was made available to certain employees who met the VSIP’s age, length-of-service, and business function criteria.  Approximately 325 employees elected to participate in the VSIP, and they accrued enhanced separation benefits totaling $29.7 million.  We paid $4.6 million of these benefits in fiscal 2017 and $24.2 million in fiscal 2018.  Other reorganizational initiatives we completed during the fourth quarter of fiscal 2017 resulted in severance charges of $2.0 million.  Additionally, on August 9, 2017, the company announced the closure of a snack cake bakery in Winston-Salem, North Carolina as part of its supply chain optimization initiative under Project Centennial.  The facility closed in November of fiscal 2017 and a portion of the production was transitioned to other facilities.  Closure costs included the recognition of impairments related to property, plant and equipment of $3.4 million and severance costs of $1.0 million.  We incurred reorganization costs, primarily relocation costs, of $1.9 million during fiscal 2017.  We substantially completed the brand rationalization study in the third quarter of fiscal 2017, which resulted in $66.2 million of impairment charges for certain trademarks that we either no longer intend to use or plan to use on a more limited basis.

Impairment of assets.  In fiscal 2018, we impaired a $2.5 million non-IDP notes receivable because the counterparty defaulted on the note, and we recognized a $3.5 million property, plant and equipment impairment for a construction in progress asset that was ultimately not placed into service.  

(Recovery) loss on inferior ingredients. In fiscal 2019, we incurred costs of $1.8 million related to receiving inferior ingredients and co-manufactured products, and received reimbursements totaling $1.8 million for a portion of previously incurred costs. In fiscal 2018, we recognized $7.4 million of currently identifiable and measurable costs associated with receiving inferior yeast and whey ingredients and received a reimbursement of $4.2 million.  The shipments of yeast were from one supplier and reduced product quality and disrupted production and distribution of foodservice and retail bread and buns at a number of the company’s bakeries during the second quarter of fiscal 2018.  On July 18, 2018, the company issued a voluntary recall due to the potential of inferior whey shipments.  The costs associated with inferior whey were incurred during the third quarter of fiscal 2018.  We continue to seek recovery of all losses.  

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Pension plan settlement loss.  At the beginning of fiscal 2016, the company began offering retired and terminated vested pension plan participants not yet receiving their benefit payments the option to elect to receive their benefit as a single lump sum payment.  Settlement charges of $7.8 million and $4.6 million for fiscal 2018 and 2017, respectively, were triggered as a result of lump sum distributions paid in each fiscal year.  There were no settlement charges triggered in fiscal 2019.  On September 28, 2018, the Board of Directors approved a resolution to terminate the Flowers Foods, Inc. Retirement Plan No. 1, effective December 31, 2018.  The plan was closed to new participants on January 1, 1999 and benefit accruals were previously frozen on or before August 1, 2008.  The company has commenced the plan termination process and distributed a portion of the pension plan assets as lump sum payments in January 2020 and the remaining balance will be transferred to an insurance company in the form of a nonparticipating group annuity contract during the first quarter of 2020.  The total payments distributed will depend on the lump sum offer participation rate of eligible participants.  Based on the estimated value of assets held in the plan, the company currently estimates that a cash contribution of approximately $17.0 million to $35.0 million will be required to fully fund the plan’s liabilities at termination.  In addition, based on current assumptions of the level of lump sum distributions elected by eligible plan participants, among other assumptions, the company estimates a final non-cash settlement charge of approximately $125.0 million to $143.0 million will be triggered in the first quarter of fiscal 2020.

Multi-employer pension plan withdrawal costs (“MEPP” costs).  On August 18, 2017, the union participants of the MEPP Fund at our Lakeland, Florida plant voted to withdraw from the MEPP Fund in the most recent collective bargaining agreement.  This resulted in the recognition of a $15.2 million pension plan withdrawal liability in the third quarter of fiscal 2017, and the recognition of $3.1 million of transition payments that were made on November 3, 2017 to, and for the benefit of, union participants as part of the collective bargaining agreement. During the first quarter of fiscal 2018, the pension plan withdrawal liability was revised for the final settlement and we recorded an additional $2.3 million of liability.  All payments related to the withdrawal from the MEPP Fund were completed by the end of the second quarter of fiscal 2018.

Legal settlements.  In fiscal 2019, 2018, and 2017, we reached agreements to settle distributor-related litigation in the aggregate amount of $29.3 million, $18.7 million and $6.0 million, respectively, including plaintiffs’ attorney fees.  We recorded a benefit of $1.3 million in fiscal 2019 related to an adjustment of a prior year settlement based on the final amount paid. Additionally, in fiscal 2018, we reached agreements to settle other non-IDP matters in the amount of $2.8 million. All amounts related to legal settlements are recorded in the selling, distribution and administrative expenses line item of the Consolidated Statements of Income.

Executive retirement agreement.  On February 15, 2019, Allen Shiver, president and chief executive officer of the company and member of the Board of Directors, notified the company he would be retiring from these positions effective May 23, 2019.  In connection with Mr. Shiver’s retirement, the company and Mr. Shiver entered into a retirement agreement and general release, as a part of the agreement, Mr. Shiver was paid $1.3 million upon his retirement, which was expensed in the first quarter of fiscal 2019.  Additionally, upon his retirement in the second quarter of fiscal 2019, we recognized a benefit of $0.6 million related to the forfeiture of his unvested long-term incentive stock awards.  These amounts are reflected in the selling, distribution, and administrative expenses line item of the Consolidated Statements of Income.

Income tax benefit related to the impact of the Tax Cuts and Jobs Act of 2017.  In the fourth quarter of fiscal 2017, we recognized an income tax benefit of $48.2 million related to the estimated benefit of the Act which was enacted on December 22, 2017.  The benefit primarily resulted from the revaluation of the company’s net deferred tax liability as of a result of the decrease in the corporate tax rate. In fiscal 2018, we recognized an additional benefit of $5.6 million as an adjustment to the fiscal 2017 amount.

Canyon Bakehouse LLC acquisition.  On December 14, 2018, we completed the acquisition of Canyon, a privately held, gluten-free baking company in Johnstown, Colorado, for $205.2 million total consideration.  Canyon operates one production facility in Johnstown, Colorado. The Canyon Bakehouse brand is the #1 gluten-free bread loaf brand in the U.S.  We funded the purchase price of the Canyon acquisition with cash on hand and borrowings under our accounts receivable securitization facility (the “AR facility”) and incurred acquisition-related expenses of $4.5 million.  Canyon’s results of operations for the period from December 14, 2018 through December 29, 2018 were excluded from our consolidated results for fiscal 2018 due to immateriality and were reported in our first quarter of fiscal 2019.  Prior to the acquisition, Canyon’s sales were distributed frozen through natural, specialty, grocery, and mass retailers around the country and this has and will continue.  In addition to frozen distribution, we began distributing Canyon branded products fresh via our DSD distribution system during the first quarter of fiscal 2019.  In January of fiscal 2020, we paid $5.0 million to the prior owner related to the contingent consideration recorded as part of the acquisition.

Reporting periods.  The company operates on a 52-53 week fiscal year ending the Saturday nearest December 31. Fiscal 2019, 2018, and 2017 consisted of 52 weeks.  Fiscal 2020 will consist of 53 weeks.

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Product recall.  On July 9, 2019, we issued a voluntary product recall for certain hamburger and hot dog buns and other bakery products due to the potential presence of small pieces of hard plastic that may have been introduced during production.  The products recalled were distributed to retail customers under a variety of brand names in 18 states.  We are not currently aware of any confirmed injuries or illnesses.  We incurred costs related to lost production time, scrapped inventory, and product removal, among other costs, of approximately $0.5 million and $0.3 million during the second and third quarters of fiscal 2019, respectively, however, we cannot currently estimate the impact of the recall on future periods.  

Impact of adoption of lease accounting standard.  We adopted the new lease accounting standard as of the beginning of fiscal 2019 using the modified retrospective method, as such, prior year amounts have not been restated.

EXECUTIVE OVERVIEW

We are the second-largest producer and marketer of packaged bakery foods in the U.S. with fiscal 2019 sales of $4.1 billion.  We operate in the highly competitive fresh bakery market and our product offerings include fresh breads, buns, rolls, snack cakes and tortillas, as well as frozen breads and rolls.  In the second quarter of fiscal 2017, the company announced an enhanced organizational structure designed to emphasize brand growth and innovation in line with a national branded food company, drive enhanced accountability, reduce costs, strengthen long-term strategy and provide greater focus on the strategic initiatives under Project Centennial.  We completed our transition to the new structure and began managing our business as one operating segment as of the beginning of fiscal 2019.  Prior to that time, the company managed its business and reported segment information in two operating segments, the DSD Segment and the Warehouse Segment.

We operate 46 plants in 18 states that produce a wide range of breads, buns, rolls, snack cakes, and tortillas.  See Item 1., Business, of this Form 10-K for information regarding our customers and brands, business strategies, strengths and core competencies, and competition and risks.  

Summary of Operating Results, Cash Flows and Financial Condition:

Sales increased 4.4% in fiscal 2019 as compared to fiscal 2018 primarily due to the Canyon acquisition, continued sales growth of the DKB branded deli-style breads and traditional branded loaf breads, significant growth in branded breakfast items, growth in store branded breads and rolls, and positive price/mix.  Partially offsetting these increases were softer sales for foodservice products.  Since the first quarter of fiscal 2018, we have introduced Nature’s Own Perfectly Crafted breads, Sun-Maid branded breakfast bread, DKB English muffins, and new varieties of DKB bagels, among other product launches, which contributed to the overall sales growth.  Sales in fiscal 2018 increased 0.8% as compared to fiscal 2017 due to continued sales growth for our branded organic products and positive price/mix, partially offset by volume declines for other branded products and in the non-retail channel and the impact of inferior ingredients.

Net income for fiscal 2019 increased 4.7% as compared to fiscal 2018 primarily due to increased sales and decreased Project Centennial consulting costs, loss on inferior ingredients, pension plan settlement losses, acquisition costs, and asset impairments.   A lower effective tax rate in the prior year, as well as higher workforce-related costs, increased marketing investments, and higher legal settlements and restructuring charges in the current year partially offset the overall increase. Net income increased 4.7% in fiscal 2018 as compared to fiscal 2017 primarily due to significantly lower restructuring and related impairment charges, MEPP costs and Project Centennial consulting costs as compared to the prior year, partially offset by the income tax benefit recognized from passage of the Act and the gain on divestiture, both recognized in the prior year.  Increased legal settlements, higher commodity prices, and the impact of inferior ingredients also negatively impacted fiscal 2018 earnings, net of the benefit of the VSIP, lower employee compensation costs and decreased tax rates.  

In fiscal 2019, we generated net cash flows from operations of $367.0 million and invested $103.7 million in capital expenditures.  We decreased our total indebtedness by $114.3 million and extended the maturity date of the AR facility to September 27, 2021.  We paid $160.0 million in dividends to our shareholders in fiscal 2019.  In fiscal 2018, we generated net cash flows from operations of $295.9 million, made cash payments of $200.2 million for the Canyon acquisition, and invested $99.4 million in capital expenditures.  We increased our total indebtedness by $173.3 million primarily as a result of borrowings under the AR facility to fund the Canyon acquisition and paid $150.2 million in dividends to our shareholders in fiscal 2018.

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Industry Trends

Critical Accounting Estimates

The company’s discussion and analysis of its results of operations and financial condition are based upon the Consolidated Financial Statements of the company, which have been prepared in accordance with generally accepted accounting principles in the U.S. (“GAAP”). The preparation of these financial statements requires the company to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of the revenues, expenses, and cash flows during the reporting period. On an ongoing basis, the company evaluates its estimates, including those related to customer programs and incentives, bad debts, raw materials, inventories, long-lived assets, leased assets, intangible assets, income taxes, restructuring, pensions and other post-retirement benefits, and contingencies and litigation. The company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

The selection and disclosure of the company’s critical accounting estimates have been discussed with the company’s audit committee. Note 2, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements of this Form 10-K includes a summary of the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements.  The following table lists, in no particular order of importance, areas of critical assumptions and estimates used in the preparation of the Consolidated Financial Statements.  Additional detail can be found in the following notes:  

Revenue Recognition.    Revenue is recognized when obligations under the terms of a contract with our customers are satisfied. Revenue is measured as the amount of consideration we expect to receive in exchange for transferring goods or providing services.  The company records both direct and estimated reductions to gross revenue for customer programs and incentive offerings at the time the incentive is offered or at the time of revenue recognition for the underlying transaction that results in progress by the customer towards earning the incentive. These allowances include price promotion discounts, coupons, customer rebates, cooperative advertising, and product returns. Consideration payable to a customer is recognized at the time control transfers and is a reduction to revenue.   The recognition of costs for promotion programs involves the use of judgment related to performance and redemption estimates. Estimates are made based on historical experience and other factors. Price promotion discount expense is recorded as a reduction to gross sales when the discounted product is sold to the customer.

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Derivative Financial Instruments.    The company’s cost of primary raw materials is highly correlated to certain commodities markets. Raw materials, such as our baking ingredients, experience price fluctuations. If actual market conditions become significantly different than those anticipated, raw material prices could increase significantly, adversely affecting our results of operations. We enter into forward purchase agreements and other derivative financial instruments qualifying for hedge accounting to manage the impact of volatility in raw material prices. The company measures the fair value of its derivative portfolio using fair value as the price that would be received to sell an asset or paid to transfer a liability in the principal market for that asset or liability. When quoted market prices for identical assets or liabilities are not available, the company bases fair value on internally developed models that use current market observable inputs, such as exchange-quoted futures prices and yield curves.  

Valuation of Long-Lived Assets, Goodwill and Other Intangible Assets.    The company records an impairment charge to property, plant and equipment, goodwill and intangible assets in accordance with applicable accounting standards when, based on certain indicators of impairment, it believes such assets have experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of these underlying assets could result in losses or an inability to recover the carrying value of the asset that may not be reflected in the asset’s current carrying value, thereby possibly requiring impairment charges in the future. Impairment charges recorded in fiscal years 2019, 2018, and 2017 are discussed above in the “Matters Affecting Comparability” section.

Flowers has concluded that under its new organizational structure the company has one operating segment based on the nature of products that Flowers sells, an intertwined production and distribution model, the internal management structure and information that is regularly reviewed by the CEO, who is the chief operating decision maker, for the purpose of assessing performance and allocating resources. This change to one operating segment aligns with the company’s internal structure and investors’ desire to have consistent external reporting.  We completed our transition to the new structure and began managing our business as one operating segment as of the beginning of fiscal 2019 and we have also determined we have one reporting unit.  Prior to that time, the company managed the business and reported segment information in two operating segments, the DSD Segment and the Warehouse Segment, which were also its reporting units.  

The company evaluates the recoverability of the carrying value of its goodwill on an annual basis or at a time when events occur that indicate the carrying value of the goodwill may be impaired using a two-step process. As discussed above, beginning in fiscal 2019, we changed to a single reporting unit and reassessed the recoverability of goodwill at that time and determined there was no impairment.  We have elected not to perform the qualitative approach. The first step of this evaluation is performed by calculating the fair value of the business segment, or reporting unit, with which the goodwill is associated. This fair value is compared to the carrying value of the reporting unit, and if less than the carrying value, the goodwill is evaluated for potential impairment under step two. Under step two of this calculation, goodwill is measured for potential impairment by comparing the implied fair value of the reporting unit’s goodwill, determined in the same manner as a business combination, with the carrying amount of the goodwill.

Our annual evaluation of goodwill impairment requires management judgment and the use of estimates and assumptions to determine the fair value of our reporting unit. Fair value is estimated using standard valuation methodologies incorporating market participant considerations and management’s assumptions on revenue, revenue growth rates, operating margins, discount rates, and EBITDA (defined as earnings before interest, taxes, depreciation and amortization). Our estimates can significantly affect the outcome of the test. We perform the fair value assessment using the income and market approach. Changes in our forecasted operating results and other assumptions could materially affect these estimates. This test is performed in the fourth quarter of each fiscal year unless circumstances require this analysis to be completed sooner. The income approach is tested using a sensitivity analysis to changes in the discount rate and yield a sufficient buffer to significant variances in our estimates. The estimated fair value of our reporting unit exceeded its carrying value in excess of $3.3 billion in fiscal 2019. Based on management’s evaluation, no impairment charges relating to goodwill were recorded for the fiscal years 2019, 2018, or 2017.

In connection with acquisitions, the company has acquired trademarks, customer lists, and non-compete agreements, a portion of which are amortizable. The company evaluates these assets whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. The undiscounted future cash flows of each intangible asset are compared to the carrying amount, and if less than the carrying value, the intangible asset is written down to the extent the carrying amount exceeds the fair value. The fair value is computed using the same approach described above for goodwill and includes the same risks and estimates. The fair value of the trademarks could be less than our carrying value if any of our four material assumptions in our fair value analysis: (a) weighted average cost of capital; (b) long-term sales growth rates; (c) forecasted operating margins; and (d) market multiples do not meet our expectations, thereby requiring us to record an asset impairment. We use the multi-period excess earnings and relief from royalty methods to value these intangibles. The method used for impairment testing purposes is consistent with the valuation method employed at acquisition of the intangible asset.  Impairment charges recorded in fiscal 2019 and 2017 related to amortizable intangible assets totaled $15.4 million and $47.7 million, respectively, and are discussed above in the “Matters Affecting Comparability” section.  There were no impairment charges related to amortizable intangible assets for fiscal 2018.

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As of December 28, 2019, the company also owns a trademark acquired through an acquisition with a carrying value of $127.1 million that is an indefinite-lived intangible asset not subject to amortization. The company evaluates the recoverability of intangible assets not subject to amortization by comparing the fair value to the carrying value on an annual basis or at a time when events occur that indicate the carrying value may be impaired. In addition, the assets are evaluated to determine whether events and circumstances continue to support an indefinite life. The fair value is compared to the carrying value of the intangible asset, and if less than the carrying value, the intangible asset is written down to fair value. There are certain inherent risks included in our expectations about the performance of acquired trademarks and brands. If we are unable to implement our growth strategies for these acquired intangible assets as expected, it could adversely impact the carrying value of the brands. The fair value of the trademarks could be less than our carrying value if any of our four material assumptions in our fair value analysis: (a) weighted average cost of capital; (b) long-term sales growth rates; (c) forecasted operating margins; and (d) market multiples do not meet our expectations, thereby requiring us to record an asset impairment.  As of the end of fiscal 2019, the company has determined a trademark with a carrying value of $79.5 million no longer is deemed to have an indefinite life and we will begin amortizing this trademark in fiscal 2020 over its remaining useful life of 33 years.  As discussed above, during fiscal 2017, we recorded asset impairment charges of $18.5 million on certain indefinite-lived trademarks and determined these trademarks were no longer deemed to have an indefinite life.  

Leases.    The company’s leases consist of the following types of assets: two bakeries, corporate office space, warehouses, bakery equipment, transportation and IT equipment. The company uses the applicable incremental borrowing rate at lease commencement to perform the lease classification tests on lease components and to measure the lease liabilities and right-of-use assets in situations when discount rates implicit in leases cannot be readily determined.

Self-Insurance Reserves.    We are self-insured for various levels of general liability, auto liability, workers’ compensation, and employee medical and dental coverage. Insurance reserves are calculated on an undiscounted basis and are based on actual claim data and estimates of incurred but not reported claims developed utilizing historical claim trends. Projected settlements and incurred but not reported claims are estimated based on pending claims and historical trends and data. Though the company does not expect them to do so, actual settlements and claims could differ materially from those estimated. Material differences in actual settlements and claims could have an adverse effect on our financial condition and results of operations.

Income Tax Expense (Benefit) and Accruals.    The annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available to us in the various jurisdictions in which we operate. Changes in statutory rates and tax laws in jurisdictions in which we operate may have a material effect on the annual tax rate. The effect of these changes, if any, would be recognized as a discrete item upon enactment.

Deferred income taxes arise from temporary differences between the tax and financial statement recognition of revenues and expenses. Deferred tax assets and liabilities are measured based on the enacted tax rates that will apply in the years in which the temporary differences are expected to be recovered or paid. As such, in December 2017, the company revalued its deferred tax assets and liabilities as a result of passage of the Act.  Additional information on the tax impacts of the Act is presented in Note 23, Income Taxes, of Notes to Consolidated Financial Statements of this Form 10-K.

Our income tax expense, deferred tax assets and liabilities, and reserve for uncertain tax benefits reflect our best assessment of future taxes to be paid in the jurisdictions in which we operate. The company records a valuation allowance to reduce its deferred tax assets if we believe it is more likely than not that some or all of the deferred assets will not be realized. While the company considers future taxable income and ongoing prudent and feasible tax strategies in assessing the need for a valuation allowance, if these estimates and assumptions change in the future, the company may be required to adjust its valuation allowance, which could result in a charge to, or an increase in, income in the period such determination is made.  

Periodically, we face audits from federal and state tax authorities, which can result in challenges regarding the timing and amount of income or deductions. We provide reserves for potential exposures when we consider it more likely than not that a taxing authority may take a sustainable position on a matter contrary to our position. We evaluate these reserves on a quarterly basis to ensure that they have been appropriately adjusted for events, including audit settlements that may impact the ultimate payment of such potential exposures. While the ultimate outcome of audits cannot be predicted with certainty, we do not currently believe that current or future audits will have a material adverse effect on our consolidated financial condition or results of operations. The company is no longer subject to federal examination for years prior to fiscal 2016.

Postretirement Plans.    The company records pension costs and benefit obligations related to its defined benefit plans based on actuarial valuations. These valuations reflect key assumptions determined by management, including the discount rate, expected long-term rate of return on plan assets and mortality. Material changes in pension costs and in benefit obligations may occur in the future due to experience that is different than assumed and changes in these assumptions.

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Effective January 1, 2006, the company curtailed its largest defined benefit plan (“Plan No. 1”) that covered the majority of its workforce. Benefits under this plan are frozen, and no future benefits will accrue under this plan.  In addition to Plan No. 1, the company sponsors an ongoing defined benefit pension plan for union employees (“Plan No. 2”) and a frozen nonqualified plan covering former Tasty executives.

On January 1, 2016, the company began providing retired and terminated vested pension plan participants who have not yet started their payments the option to receive their benefit as a single lump sum payment.  Participants can elect this option when they retire or when they leave the company.  This change supports our long-term pension risk management strategy.  Lump sum payments made in 2017 triggered settlement charges as detailed in the table below (amounts in thousands).  Based on activity in 2018, primarily related to the VSIP, the company recorded settlement charges in each of the quarters of fiscal 2018.  The company recorded pension cost (income) on our qualified defined benefit plans and nonqualified plan in fiscal 2019, 2018, and 2017 as detailed in the table below (amounts in thousands).  We expect pension cost of approximately $2.0 million on our qualified defined benefit plans and nonqualified plan for fiscal 2020 excluding any potential settlement losses.  

For all but Plan No. 1, we use a spot rate approach (“granular method”) to estimate the service cost and interest cost components of benefit cost by applying the specific spot rates along the yield curve to the relevant projected cash flows, as we believe this provides the best estimate of service and interest costs.  

On September 28, 2018, the Board approved the termination of the Flowers Foods, Inc. Retirement Plan No. 1.  Therefore, the benefit obligations as of December 31, 2018 for Plan No. 1 were valued reflecting the plan termination cost to settle the obligations.  The single effective discount rate used to derive the estimated plan termination obligation was used to develop interest cost.  This approach does not use the mechanics of the granular calculation that was used for measurements prior to September 30, 2018.   The movement away from the granular approach for Plan No. 1 is considered a more precise estimation approach given the fact that assets are expected to be distributed within the next three months.  

On December 31, 2017, the company adopted a de-risking investment strategy for its pension assets.  As the funded status of the plans increases, over time the targeted allocation to return seeking assets will be reduced and the targeted allocation to fixed-income assets will be increased to better manage the company’s pension liability and reduce funded status volatility.  After the Board approved the termination of Plan No. 1, the plan administrator separated the assets of Plan No. 1 and Plan No. 2 on December 31, 2018.  Based on the funded status of the plans as of December 31, 2019, the asset allocation for each of the Flowers Foods’ pension plans has been adjusted as follows:

Plan No. 1: to 90 to 100% fixed-income securities, and 0-10% short-term investments and cash.  

Plan No. 2: to 0 to 80% equity securities, 20-100% fixed-income securities, and 0-10% short-term investments and cash.  

For the details of our pension plan assets, see Note 22, Postretirement Plans, of Notes to Consolidated Financial Statements of this Form 10-K.

In developing the expected long-term rate of return on plan assets at each measurement date, the company considers the plan assets’ historical actual returns, targeted asset allocations, and the anticipated future economic environment and long-term performance of the individual asset classes, based on the company’s investment strategy.  While appropriate consideration is given to recent and historical investment performance, the assumption represents management’s best estimate of the long-term prospective return.  Further, pension costs do not include an explicit expense assumption, and therefore the return on assets rate reflects the long-term expected return, net of expenses.  Based on these factors, the long-term rate of return assumption for the plans was set at 5.2% (Plan No. 1) and 7.4% (Plan No. 2) for fiscal 2019 and 4.8% (Plan No. 1) and 7.1% (Plan No. 2) for fiscal 2020.  

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The company utilizes the Society of Actuaries’ (“SOA”) published mortality tables and improvement scales in developing their best estimates of mortality. In October 2019, the SOA published its final report on their “standard” mortality table (“Pri-2012”) and released its annual update to the mortality improvement scale (“MP-2019”).  For purposes of measuring pension benefit obligations of Plan No. 1 at year-end 2019, the company used mortality rates based on the RP-2018 and MP-2018 mortality table and scale, with a 30% upward adjustment to mortality rates (i.e., the same basis that was used at year end 2018). At year-end 2019, for all plans except Plan No. 1, the company updated all mortality assumptions to reflect the most recent base mortality tables and mortality improvement projection scale released by the SOA in 2019, Pri-2012 and MP-2019, respectively. For Plan No. 2, the company will use a blue collar adjustment to the base table.  No other collar adjustments are applied for any other plans.  In addition, contingent annuitant mortality rates are applied for surviving spouses after the death of the original retiree.

The company determines the fair value of substantially all of its plans’ assets utilizing market quotes rather than developing “smoothed” values, “market related” values, or other modeling techniques.  Plan asset gains or losses in a given year are included with other actuarial gains and losses due to remeasurement of the plans’ projected benefit obligations (“PBO”). If the total unrecognized gain or loss exceeds 10% of the larger of (i) the PBO or (ii) the market value of plan assets, the excess of the total unrecognized gain or loss is amortized over the expected average future lifetime of participants in the frozen pension plans.  Prior service cost or credit, which represents the effect on plan liabilities due to plan amendments, is amortized over the average remaining service period of active covered employees. The total unrecognized loss and prior service cost in accumulated other comprehensive income (“AOCI”) as of December 28, 2019 for the pension plans the company sponsors was $146.7 million. Amortization of this unrecognized loss and prior service cost during fiscal 2020 is expected to be approximately $7.8 million. To the extent that this unrecognized loss and prior service cost is subsequently recognized, the loss will increase the company’s pension costs in the future.

A sensitivity analysis of fiscal 2019 pension costs on a pre-tax basis and year-end benefit obligations for our qualified plans is presented in the table below (amounts in thousands) to changes in the discount rate and expected long-term rate of return on plan assets (“EROA”):

In fiscal 2020, the company expects to make a cash contribution to Plan No. 1 ranging from $17.0 million to $35.0 million and a $2.5 million cash contribution to Plan No. 2, and expects to pay $0.3 million in nonqualified pension benefits from corporate assets during fiscal 2020.

Stock-based compensation.    Stock-based compensation expense for all share-based payment awards granted is determined based on the grant date fair value. The company recognizes these compensation costs net of an estimated forfeiture rate, and recognizes compensation cost only for those shares expected to vest on a straight-line basis over the requisite service period of the award, which is generally the vesting term of the share-based payment award.

We grant performance stock awards that separately have a market and performance condition. The expense computed for the total shareholder return shares (“TSR”) is fixed and recognized on a straight-line basis over the vesting period. The expense computed for the return on invested capital (“ROIC”) shares can change depending on the attainment of performance condition goals. The expense for the ROIC shares can be within a range of 0% to 125% of the target. There is a possibility that this expense component will change in subsequent quarters depending on how the company performs relative to the ROIC target. Additionally, there are timed-based stock awards that vest over a period of three years.  See Note 19, Stock-Based Compensation, of Notes to Consolidated Financial Statements of this Form 10-K for additional information.  No awards were granted to employees by our Board of Directors in fiscal 2018. In early fiscal 2020, the company granted stock awards to certain employees and stock-based compensation expense is expected to increase approximately $6.0 million to $8.0 million as compared to fiscal 2019.

Commitments and contingencies.  The company and its subsidiaries from time to time are parties to, or targets of, lawsuits, claims, investigations and proceedings, including personal injury, commercial, contract, environmental, antitrust, product liability, health and safety and employment matters, including lawsuits related to the independent distributors, which are being handled and defended in the ordinary course of business.  Loss contingencies are recorded at the time it is probable an asset is impaired or a liability has been incurred and the amount can be reasonably estimated.  For litigation claims, the company considers the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the loss.  Losses are recorded in selling, distribution and administrative expense in the Consolidated Statements of Income.

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Results of Operations

The company’s results of operations, expressed as a percentage of sales, are set forth below for fiscal 2019 and fiscal 2018:

The company’s results of operations, expressed as a percentage of sales, are set forth below for fiscal 2018 and fiscal 2017:

NM – the computation is not meaningful

Percentages may not add due to rounding.

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Consolidated Results - Fiscal 2019 compared to Fiscal 2018

Sales (dollars in thousands)

The change in sales was attributable to the following:

Sales increased primarily due to the Canyon acquisition contribution, continued sales growth of DKB branded organic deli-style breads, and significant growth in branded breakfast items.  Growth in both store branded breads and buns and traditional branded loaf breads and overall positive price/mix also contributed to the sales increase.  These increases were partially offset by declines in foodservice sales.  Additionally, in the prior year, we incurred higher promotional activity associated with the launch of Nature’s Own Perfectly Crafted breads.  

The Canyon acquisition has extended our product offerings to include gluten-free items, both in the branded retail and store branded retail categories.  Prior to the acquisition, Canyon’s products were solely distributed by warehouse distribution.  During the first quarter of fiscal 2019, we began the rollout of Canyon’s branded products across our DSD distribution system as well, which we are continuing to implement.  

Branded retail sales increased due to the acquisition, growth in DKB branded products, more favorable price/mix, and branded product introductions.  We introduced Nature’s Own Perfectly Crafted breads in the second quarter of fiscal 2018, Sun-Maid breakfast bread late in the third quarter of fiscal 2018, and DKB English muffins in the first quarter of fiscal 2019.  We have continued to expand upon these product introductions with new varieties such as Nature’s Own Perfectly Crafted brioche bread.  Store branded retail sales increased due primarily to volume growth from increased distribution of store branded breads and buns, positive price/mix, and the Canyon acquisition.  Significant volume declines and negative price/mix for foodservice, and softer volume for vending and institutional items resulted in the decrease in non-retail and other sales.  Foodservice sales were negatively impacted by lost business related to the receipt of inferior ingredients beginning in the second quarter of fiscal 2018.

Materials, Supplies, Labor, and Other Production Costs (exclusive of depreciation and amortization shown separately; as a percent of sales)

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Costs were consistent with prior year as a percent of sales.  Improved sales and decreased ingredient costs as a percent of sales were offset by higher workforce-related costs and lower manufacturing efficiencies.  Favorable shifts in product mix largely resulted in lower ingredients and packaging costs as a percent of sales.  Workforce-related costs increased due to a competitive labor market and higher employee incentive costs year over year.  Sales and production costs were negatively impacted by the effects from inferior ingredients, although we cannot currently quantify these amounts.  

Raw materials, such as our baking ingredients, periodically experience price fluctuations. The cost of these inputs may fluctuate significantly due to government policy and regulation, weather conditions, domestic and international demand, or other unforeseen circumstances. We enter into forward purchase agreements and other derivative financial instruments in an effort to manage the impact of such volatility in raw material prices, but some organic and specialty ingredients do not offer the same hedging opportunities to reduce the impact of price volatility. Any decrease in the availability of these agreements could increase the effective price of these raw materials to us and significantly affect our earnings. We currently anticipate ingredient costs to be stable to moderately lower in fiscal 2020 relative to fiscal 2019.

Selling, Distribution and Administrative Expenses (as a percent of sales)   

Workforce-related costs were higher as a percent of sales as a result of increased employee incentive costs year over year and a competitive labor market.  Distributor distribution fees decreased primarily due to the Canyon acquisition as Canyon’s sales are largely warehouse-delivered.  The slight decrease in the Other line item in the table above primarily resulted from decreased consulting costs related to Project Centennial and prior year acquisition costs, mostly offset by increased legal settlements and greater investments in marketing in the current year.  As discussed in the “Matters Affecting Comparability” section above, in fiscal 2019, we recorded legal settlements of $28.0 million (inclusive of a $1.3 million benefit related to an adjustment of a prior year settlement based on the final amount paid).  In fiscal 2018, we recorded legal settlements of $21.5 million.  We incurred consulting costs associated with Project Centennial of $0.8 million in the current year compared to $9.7 million in the prior year, and anticipate additional consulting costs related to the project in the range of $7.0 million to $9.0 million in fiscal 2020.  We incurred acquisition costs of $4.5 million related to the Canyon acquisition in fiscal 2018.

MEPP Costs, (Recovery) Loss on Inferior Ingredients, Restructuring and Related Impairment Charges and Impairment of Assets

Refer to the discussion in the “Matters Affecting Comparability” section above regarding these items.

Depreciation and Amortization Expense

Depreciation and amortization expense decreased slightly as a percent of sales due to accelerated depreciation of certain right-of-use assets in the prior year and certain other property, plant and equipment becoming fully depreciated, partially offset by increased amortization expense from amortizing the Canyon intangible assets acquired at the end of fiscal 2018.

Income from Operations

Income from operations increased modestly year over year as a percent of sales largely due to sales increases, the prior year loss on inferior ingredients and impairment of assets, somewhat offset by increased restructuring charges year over year.  

Other Components of Net Periodic Pension and Postretirement Benefits Expense (Credit) and Pension Plan Settlement Loss

Other components of net periodic pension and postretirement benefits expense (credit) changed primarily due to a decrease in pension income resulting from the company changing its pension plan asset allocation to include a larger percentage of fixed-income assets as part of the plan termination process as discussed in the “Matter Affecting Comparability” section above.  Additionally, in fiscal 2018, we recorded $7.8 million of pension plan settlement losses.  We anticipate settlement charges of approximately $125.0 million to $143.0 million in the first quarter of fiscal 2020.

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Net Interest Expense

Net interest expense increased year over year due to higher average amounts outstanding under the company’s debt arrangements primarily due to funding the Canyon acquisition at the end of fiscal 2018, net of repayments we have made through fiscal 2019.

Income Tax Expense

The effective tax rate for fiscal 2019 was 22.4% compared to 20.3% in the prior year.  The rate in the prior year was lower primarily due to recognizing an income tax benefit of $5.6 million to adjust the estimated provisional benefit recorded in fiscal 2017 related to tax reform enacted in December 2017.  The provisional amount was adjusted in the second quarter of fiscal 2018 to reflect timing differences reported on the 2017 federal tax return.  The adjustment resulted in a discrete tax benefit of $5.6 million, a reduction to federal income tax payable of $16.4 million and increase to federal deferred tax liabilities of $10.8 million.  The adjustment primarily relates to pension contributions and bonus depreciation on certain assets placed in service during fiscal 2017.  This benefit was partially offset by stock-based compensation shortfalls in 2018 compared to windfalls in the current year.     

In 2019, the most significant difference in the effective rate and the statutory rate was for state income taxes.  The primary differences in the effective rate and the statutory rate for the prior year were for adjustments to provisional taxes related to tax reform and state income taxes.

Comprehensive Income

The increase in comprehensive income year over year resulted primarily from the increase in net income and the prior year pension plan actuarial loss, net of the prior year pension plan settlement loss.

Consolidated Results - Fiscal 2018 compared to Fiscal 2017

Sales (dollars in thousands)

The change in sales was attributable to the following: