The Chefs' Warehouse, Inc. (CHEF) Q3 2015 Earnings Report, Transcript and Summary

Greetings and welcome to The Chefs’ Warehouse Third Quarter 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It’s now my pleasure to introduce your host, Mr. Alex Aldous, General Counsel and Corporate Secretary. Thank you, sir. You may now begin.

Thank you, operator. Good afternoon, everyone. With me on today’s call are Chris Pappas, Founder, Chairman and CEO and John Austin, CFO. By now, you should have access to our third quarter 2015 earnings press release. It can also be found at www.chefswarehouse.com under the Investor Relations section. Throughout this conference call, we will be presenting non-GAAP financial measures including among others, historical and estimated EBITDA and adjusted EBITDA as well as both historical and estimated modified pro forma net income and modified pro forma earnings per share. These measurements are not calculated in accordance with GAAP and maybe calculated differently in other company’s similarly titled non-GAAP financial measures. Quantitative reconciliations of our non-GAAP financial measures to their most directly comparable GAAP financial measures appear in today’s press release. Before we begin our formal remarks, I need to remind everyone that part of our discussion today will include forward-looking statements, including statements regarding our estimated financial performance. Such forward-looking statements are not guarantees of future performance and therefore you should not put undue reliance on them. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Some of these risks are mentioned in today’s release. Others are discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q, which are available at www.sec.gov. Today, we are going to provide a business update, go over our third quarter results in detail and review our 2015 guidance. Then we will open the call for questions. With that, I would like to turn the call over to Chris Pappas. Chris?

Thanks, Alex and welcome to all listening today. We are very pleased with our results for the third quarter. During the quarter, our organic growth in net sales was approximately 5%. This was particularly strong in our core specialty business, which was driven by unique customer growth of approximately 7.7%, placement growth of approximately 6.6%, and case growth of approximately 6.8% versus the prior year’s third quarter. Our top line growth was muted somewhat as we shed some business in our Allen Brothers unit as we returned the business to profitability. The year-over-year inflation decelerated sequentially from the significant inflation we saw in late 2014 and early 2015. We continue to see relatively high inflation in certain protein and chocolate categories, which were offset somewhat by deflation in dairy, cheese and seafood. However, we continue to be very pleased with our ability to manage that inflation. During the quarter on a consolidated basis, we saw a 103 basis point increase in gross margins. In our core specialty business, we saw a 20 basis point increase and realized a 547 basis point increase in our protein business. Much of that improvement in protein comes from our turnaround efforts at Allen Brothers, which continues to make progress in becoming the world class company we believe it will be. Moving on to few other specific business updates. In regard to Del Monte, integration of that business has gone very smoothly. Our integration team is in the midst of converting our backend systems. So far, we have converted the Sacramento branch, which includes Del Monte’s headquarter function, with two more branches scheduled for the fourth quarter. We expect that process to be completed in the first quarter of 2016. Moving on to our facilities, we now have a 22-person team, 15 in the sales function based in Chicago who have been working tirelessly and making great progress on building up our customer base in that market. Year-to-date, we have invested over $1.1 million in startup costs, which is slightly ahead of plan. We continue to believe that Chicago market has the long-term potential to be one of our largest markets. We have continued to increase our capacity and accelerate our case growth at our new Bronx and Las Vegas facilities. Both facilities are fully operational with the exception of the Bronx office space and are beginning to improve operational efficiencies. We look forward to continuing to build sales volume in those markets to better leverage that occupancy cost. Our new San Francisco warehouse is still set to open by the first of the New Year. This location will facilitate the consolidation of an additional casino warehouse as well as one of the Del Monte facilities. Now that we are near completion of all these capital projects, we are once again generating free cash flow. While it’s just a start, we do expect to continue de-leveraging our balance sheet over the coming quarters. We continue to be presented with many acquisition opportunities and are actively looking at those that meet our criteria. We believe that there are meaningful additional attractive opportunities for us to capitalize. To wrap up before turning the call over to John, our core business is performing well. Our protein business has continued to improve. And with almost all of our new facilities up and running, we feel that we are positioned very well for the future. And with that, I will turn it over to Mr. John Austin to discuss more detailed financial information. John?

Thanks, Chris and good afternoon everyone. Our net sales for the quarter ended September 25, 2015 increased approximately 33.4% to $277.5 million from the $208.1 million for the third quarter ended September 26, 2014. The increase in net sales was the result of organic growth, the acquisition of Del Monte and to a much lesser degree, the acquisition of Euro Gourmet last October. These acquisitions accounted for approximately $59.3 million of our sales growth for the quarter, while our organic growth contributed the remaining $10.1 million, or 4.9% growth over the prior year quarter. Inflation continued to moderate sequentially and was approximately 1.9% for the quarter. As Chris had mentioned, inflation in the meat and chocolate categories continue to be very high year-over-year, while the dairy, cheese and seafood categories were deflationary versus the prior year quarter. Our overall outlook for inflation for the full year 2015 continues to be in the 3% to 3.5% range. Gross profit increased approximately 39.0% to $70.5 million for the third quarter of 2015 versus $50.7 million for the third quarter of 2014. Gross profit margins increased 103 basis points to 25.4% from 24.4%, which as Chris pointed out was due to both strong margin improvement in our core specialty business as well as the continued operational improvement at Allen Brothers. Total operating expense increased approximately 38.3% to $57.6 million for the third quarter of 2015 from $41.7 million for the third quarter of 2014. As a percentage of net sales, operating expenses were 20.8% for the third quarter of 2015 compared to 20.0% for the third quarter of the prior year. The increase in our operating expense ratio was primarily the result of increased amortization expense related to the acquisition of Del Monte, the prior year recognition of a $1.5 million gain from the settlement with the sellers of Michael’s Finer Meats, which we had bought in 2012 and additionally increased occupancy cost, insurance and bad debt expense offset in part by lower fuel and freight costs negatively impacted our operating expense ratio. More specifically, G&A expenses increased approximately $17.1 million for the third quarter of 2015 compared to $10.5 million for the prior year quarter due primarily to the increased insurance and bad debt expenses I have previously mentioned and as well as amortization expense related to the Del Monte deal and the prior year gain associated with the settlement with the sellers of Michael’s Finer Meats. Operating income for the third quarter of 2015 was $12.9 million compared to $9.0 million for the third quarter of the prior year. Interest expense increased 106% to $3.9 million versus $1.9 million in the prior year quarter due to the increased debt associated with the Del Monte acquisition. Income tax expense was $3.7 million in the third quarter of 2015 compared to $2.9 million in the third quarter of 2014. Our effective tax rate was 41.6% in the third quarter of 2015 compared to 41.0% in the prior year quarter. Net income was $5.2 million or $0.20 per diluted share for the third quarter of 2015 compared to $4.2 million or $0.17 per diluted share for the third quarter of 2014. On a non-GAAP basis, adjusted EBITDA was $17.6 million for the third quarter of 2015 compared to $10.6 million for the prior year third quarter. Modified pro forma net income was $5.5 million and modified pro forma EPS was $0.21 for the third quarter of 2015 compared to modified pro forma net income of $3.7 million, or $0.15 per diluted share in the third quarter of the prior year. In regard to our outlook for the remainder of 2015, we are raising our expectations to incorporate our year-to-date results as well as the trends we are seeing in the business. We estimate that net sales for the full year 2015 will be in the range of $1.04 billion to $1.06 billion, adjusted EBITDA will be between $64.0 million and $66.0 million, net income will be between $15.5 million and $16.7 million, net income per diluted share will be between $0.60 and $0.64 per share, and modified pro forma EPS will be between $0.73 and $0.77. This guidance is based on an effective tax rate of approximately 41.5% for 2015 and an estimated diluted share count of approximately 26.5 million shares. With that, operator, we’ll turn it over for questions.

Thank you. [Operator Instructions] Thank you. Our first question is from Karen Short from Deutsche Bank. Please go ahead.

Hi. It’s actually Ryan Gilligan on for Karen. Can you guys remind us why there was a significant step down in D&A this quarter versus last quarter, because it seems like it drove a decent part of the [indiscernible] numbers?

Yes. Certainly, there is a little bit of noise or impact from the amortization expense. There is a couple of things. So, when we initially estimated what amortization expense was going to be and we gave guidance based upon that, we were estimating that based on our historic experience with acquisitions as far as how the purchase price was allocated and what the fair value of each of those intangibles was. As we got through that, we are substantially finished with our valuation we use at an outside valuation firm. And they were coming up with a much lower number as far as amortization expense. So, that did contribute to a little bit of the improvement versus prior year, but anyway, it’s based upon those GAAP valuations and the valuation firm’s results on the fair value of Del Monte acquisition.

That makes sense. Thanks. And I guess just on inflation, how did it impact gross margins in the quarter and do you expect it to be a tailwind or headwind going forward?

Inflation was about 1.9%. And particularly in our core business, I think we feel very good about how we manage that. When you look at our top 10 categories, which we often talk about on our calls, I think there were four of those categories that were deflationary. So, we are seeing kind of at least a more normalized or return to a more normal environment where you have got some categories that are inflationary, some that are deflationary. We saw some nice margin improvement. Sorry about the background noise, we have got an open window here. So, some of the margin improvement we were seeing, I think managed through both the inflationary piece and the deflationary piece very effectively. And so overall about a 40 basis point improvement in our core business and managing inflation in the meat segment or protein segment is a little bit different. There is so much of that improvement in gross margin that’s driven just from operational improvements at Allen Brothers. So, it’s probably a little less inflationary driven than it is just operational improvements.

That’s really helpful. Thank you.

The next question is from Andrew Wolf from BB&T Capital Markets. Please go ahead.

Thanks. Good afternoon. On some of the better ability to manage pricing, when categories pricing is changing either up or down that you have been referencing the last couple of quarters, just the earnings power is stabilizing both with the meat business getting better at Allen Brothers, but also the core business. I guess, this is more for Chris, but could you kind of update me and others on the regional management structure that you switched to over the last few years, where that stands, are the – is pricing and operations really being run regionally now, and is that why a good better regional management structure, is that – the root of the change that’s helping your operating margins?

Yes. I think we have discussed this a few times over the past few years. Andy, they were not a new business. Since we went public and we start to do acquisitions, we had to create a bigger platform and kind of learn how to manage a much bigger company. I think we are starting to get the benefits of more experienced managers, putting so many people in place, breaking up the business. So, we are centralized, but we have given more power in a decentralized model to our regional vice presidents and to our sales managers, to our operational people. We now have pricing manages. I think that’s why you are seeing us being able to control the inflation and deflation much better than we did a few years ago. So, I believe we are running a much tighter, a better overall business. And I think you are starting to see us, finally, starting to get the benefits from a more mature team as we grow and are able to manage the different businesses that we have bought. We always reference core business. Our core business, we have very experienced managers and that business runs pretty tight and continues to grow. I mean, we had a good quarter in October. We are seeing really good numbers. So, I think we are just – I think, it’s just all starting to come together.

Okay, Chris. Thanks. Just to follow-up on the – I was really actually referring more to the core business. Just very simple terms, I mean, how many regions did you hire vice president where I couldn’t quite figure…

Yes, we have West, Midwest and the East Coast. So, it’s broken up pretty much into those three pieces. And then underneath that, there is layers of general managers, managers, and then Canada is its own island.

Yes. And actually, one of the original RVPs became kind of a RVP of operation. So it’s supporting more an operational role than a sales role.

Okay. And now could you give us a quick take on the same idea just briefly on the meat side, is it all rolling up to the former head of Del Monte?

Yes. It kind of is, there is a lot of – there is dotted lines, so in each region, so protein rolls up to protein. But in many regions, they crisscross. Our whole model is cross-selling. And I think that’s what you are starting to see. And that was our vision. As we start to share salespeople, information, share the same customers, we are starting to cross-sell at a much better rate. So, there is the direct lines, but there is also those dotted lines to the RVPs who are involved in making sure that both parts of the business are jelling together and it seems to be working really well.

Great. Well, this is encouraging. Just let me quick housekeeping back to Ryan’s question on the amortization. So was the $2.2 million this year – quarter, sorry and $3.2 million last quarter, which one is the run-rate or was there an adjustment in either one, can you just help us out with what to use for amortization given even you did it now until this quarter?

Yes. I mean, I think we obviously refined our estimates for this quarter. So, our guidance for the full year for D&A is between $15.5 million and $16 million, which I think at the beginning of the year, our estimate was between $18 million and $20 million.

Great, thank you.

Okay.

The next question is from Kelly Bania from BMO Capital. Please go ahead.

Hi, good evening. Congrats on a great quarter.

Thank you, Kelly.

Just first wanted to ask about competition from the broad liners, I think you had called that out last quarter and something no discussion of it today, so just curious if that just abated quicker than you thought or what really – what you are seeing from the broad liners today?

Yes. Again, I think our broad line competition, it’s a healthy competition. They are mostly either large public companies or companies that are going public. So they have trucks, they have people, they have of overhead, so I think we complete very well. We are not after most of their core customers and really they are not really geared to compete in many of our core customers, which are smaller independents that buy a little bit of everything, which is really our model. So, I think there is always going to be competition going. And I think that we really focus on what we do real well. And I think from – you see our case growth, it’s really healthy. It shows that our model is working and we continue to work really hard to ensure that we continue to grow. And we continue to add sales people and new categories and I think we each have our space.

Great, that’s very helpful. And then I am just curious as the performance of Allen Brothers kind of rebounds and it’s been improving, where do you see that stabilizing. And can you speak at all to just what the impact of this high protein inflation is having on the Del Monte business in isolation?

Yes. Well, Del Monte performed to our expectation. So it was our anticipation when we went to buy Del Monte that we were buying a leader and a team that knew how to navigate in the protein business and it’s proven, thank god to come true. So they are very good at navigating and managing their business and they brought that expertise to helping us manage Allen Brothers. So I think we said on the last call, we continue to improve at Allen Brothers. We continue to believe that it’s going to have a profitable year. And we continue the best is still yet to come. We have to stabilize it. We had to get our production to the expectation of our customers. We have to re-staff it and add more sales staff. And as we rollout more Allen Brothers throughout Chicago and nationally inflation, deflation, the market gets used to it. There is little ups and downs, but nothing to what we saw last year, really when we had our issues, more typical is you are up or down a point or so not like what we did experience last year. So I think what we are experiencing now is well managed business, performing better and better. And now, it’s we just we keep adding customers. We should get to what we are expecting to get when we bought Allen Brothers. So we are really excited about it.

Great. And then if I could just ask one more, just where do see you that kind of protein inflation as you look out over the next couple of quarters, do you see that moderating and what could be the impact of that or how do you manage that in a moderating protein environment?

Yes. Well, it’s really GP dollars that we are really sensitive to. So the outlook really for beef in general, I mean I think you saw chicken come down with the threat of the virus kind of people aren’t that concerned that’s not going to be any chicken. And the pork pricing has come down. Cattle futures have come down. So the outlook for, especially beef over the next 3 years is pretty much the herd is replenishing itself. So prices should normalize from their highs, which we are anticipating that it will be healthy for margins. And now, it’s really managing GP dollars. And the good part of the sector that we are in, we sell more of the expensive products, upper choice and prime. And those cuts are usually, pretty much in demand to the better restaurants and steakhouses. And those prices usually, don’t go I mean, we haven’t seen the highs that we have and but I don’t think we are going to see that market drop off to ridiculous low. So I think we are going to start to go back to traditional pricing. And I think the margins are going to normalize to where our margins are. We expected them to be in the mid-20s and I think that’s where the margins will settle.

That’s very helpful. And then I guess just for John, John you had talked about in the past kind of targeting a expense ratio, if you look at OpEx plus D&A of close to 19%, can you just talk about progress towards that timing, how you feel about that goal?

Yes, I think there is a couple of things. So as I mentioned in my prepared remarks, our total OpEx ratio is about 20.8%. There is a little bit of noise and obviously in our adjusted EBITDA and adjusted EPS tables that we included in the press release. If you adjust for all of that and adjust for amortization, there is a fair amount of noise around amortization that leaves kind of and it’s not really an EBITDA ratio, but it’s about 19.8% when you kind of normalize for those unusual items compared to last year, which I think was 19.7%. So we are – I think we are – we still have some more ways to go, I think on our 19% target. I think we said about $1.2 billion is kind of where we thought we would get into that.

Yes. Kelly, as we grow into our New York warehouse and our Vegas warehouse, San Francisco warehouse and Chicago, we built – that was we built and they will come. So as we start as to fill up and get more capacity in those warehouses, the kind of a fixed overhead basically rents, power, refrigerators are running, so we anticipate that’s going to drive our overhead down.

Yes. So I think our – we are still comfortable with that 19% long-term target, I would say we are probably in the middle innings as far as growing into that.

Great. Thank you very much.

The next question is from Scott Van Winkle with Canaccord Genuity. Please go ahead.

I got a follow-up on that last question. So your existing footprint is what you are targeting $2 billion with, correct?

Scott, that’s a wide question.

Yes, that’s a big number. We said $1.2 billion is where we thought we would get into the right scale to be leveraging today. So I think we took $2 billion is a big number.

Yes. I think the $2 billion – I mean we have stated that we thought there was about another $700,000 to $900,000 of growth, pretty much within the footprint we cover with maybe the addition of one or two other markets. So we are anticipating a lot of growth in the footprint that we have, which is organic and hold-ins and possibly new categories. But obviously, we are driving right now to get more capacity because we make more money. We have a pretty much fixed overhead. Obviously, we can add a few more trucks and a few more people, but a lot of our overhead is fixed and that’s what we are trying to leverage right now.

I was kind of folding that into the question of talking about $1.2 billion is kind of your target for hitting your OpEx expectation, that doesn’t really assume Chicago is 90% capacity and I would assume that it doesn’t assume that there is significant amount of protein running through the Bronx, that I think the long-term goal is, is that right?

Yes. I have stated that we think that New York over the next 4 years or 5 years, we could double it, okay, maybe 6 years, 7 years. Chicago, we built that warehouse, we should be able to do, say $200 million out of that warehouse. San Francisco the same. So yes, we will have capacity to drastically drive new business into these facilities and grow our business.

Okay. And then when we think about Chicago, obviously you have some business there already, but when you Greenfield it, like the DC market, how long did it take to kind of catch a gear so to speak and each incremental dollar was a lot easier to get once you got to a certain point, is there a President or something that we can compare to?

Yes. Well, we are much more mature, much more bigger company with many more categories. When we Greenfield it, say Washington DC, we had much less inventory. We started off much smaller. So I would say this is more like Los Angeles, where it wasn’t exactly a Greenfield, but we started very small in San Francisco. So, usually what happens is we start to grow. I mean, we have 22 people now in Chicago and we anticipate to keep adding salespeople and expand our footprint. And usually, what happens is we will find a fold in and we will add a category. So, Chicago is really stated to be our top two, three, four market in the country. And New York is over $300 million and we think New York should be over $500 million, $600 million, so you could do the math. Where that inflection point comes, it depends on – organically, I think we stated that we expected to be $75 million over the next few years. So, with a tuck-in or two, could it be a $200 million business? Absolutely.

Okay. And then last question on the protein gross margins, I think, John, your comment was you expect the margins to kind of look similar to the core business at some point, where are we from the standpoint, maybe I should know what that protean margin was? I know it was up, obviously, 500 basis points year-over-year, but where are we relative to that target?

It’s still a little bit lower than our overall average. I think in the past, we have probably talked a little bit about protein and the customer mixes within protein. To the extent that protein businesses have a mix of maybe some core business and non-core business, it tends to have a little bit lower margin profile. One of the things we liked about Del Monte was it was a much more similar customer base, so it was much closer to our average margins, but overall, our protein business is couple of 100 basis points below our average.

That was the performance this quarter?

Yes.

Great, thank you very much.

The next question is from Mark Wiltamuth from Jefferies. Please go ahead.

Hi, good afternoon. I wanted to dig in a little bit on the de-leveraging opportunity here. How much free cash flow you think you could get to for next year and how much of that you think you could put towards debt reduction, because obviously this is going to influence your ability to do future acquisitions?

Yes, I think there is a couple of things. Obviously, we haven’t given guidance for next year. So, I am going to talk more generally about that, but if you look over the last year or two, we have been spending order of magnitude around $20 million worth of CapEx, maybe even a little bit north of that last year. And that number should return to a more kind of say $5 million to $10 million, $8 million would be a reasonable target for maintenance kind of CapEx. We are always going to have a few additions here and there, but we think that $5 million to $10 million range is a pretty reasonable number. If you kind of run out your models and organic growth is in that mid to high single-digits, you can come up with contribution from that, but we should be generating $20 million plus of free cash flow, I would think.

And do you have a debt-to-EBITDA target you got in mind or you expect you will just keep bouncing back again as you do more acquisitions?

Yes. I think we have always stated that we are comfortable anywhere in the 2 to 4 times debt-to-EBITDA. When you look at it on a pro forma basis for a full year of Del Monte, we are just above that. We are about 4.25 times in total leverage today. So, we are continuing to work our way down and we will get there. We will get back into that more historic ZIP code.

Okay, thank you very much.

That’s great.

This concludes the question-and-answer session. I will now turn the call back over to the presenters for any closing comments.

Yes. So, we thank everybody today for joining us on this call. We are very proud of our quarter and our continued ability to improve both the bottom line of our business and top line and we look forward to speaking with everybody on our next conference call. Thank you and have a great evening.

This concludes today’s conference call. You may now disconnect your lines. Thank you for participating and have a pleasant day.