The Chefs' Warehouse, Inc. (CHEF) Q1 2016 Earnings Report, Transcript and Summary

Greetings and welcome to The Chefs’ Warehouse First Quarter 2016 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to your host, Alex Aldous, General Counsel and Corporate Secretary. Please go ahead.

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 first quarter 2016 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 companies 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 report on Form 10-Q, which are available at www.sec.gov. Today, we are going to provide a business update, go over our full first quarter results in detail and review our 2016 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 who are listening today. Our specialty business continues to be very strong. During the quarter, we experienced over 7.5% organic growth in net sales in our specialty division driven by unique customer growth of approximately 5.1%, placement growth of approximately 6.1% and case growth of approximately 7.5% versus the prior year’s first quarter. We have also continued to cycle out some of our non-core business, particularly in our protein division as we focus our efforts more on our chef-driven restaurants. This is not unusual as we have integrated other acquisitions, but to be fair, some of this has happened at a faster pace than what we had planned. On a consolidated basis, gross margins were flat versus the prior year’s quarter. As we expected, in our core specialty business, we saw a 52 basis point decrease in gross margins as we lapped a very strong prior year’s quarter. And while our protein business realized a 417 basis point increase in gross margins which was due to the contribution from the Del Monte acquisition and year-over-year operational improvements at Allen Brothers, we did not achieve the results we expected. Speaking of our protein business, we continue to believe that adding a center-of-the-plate category to our offering is a very important component of our growth. With over 400 total sales people expanding these categories is a great source of growth over the coming years. On average, our customers who buy center-of-the-plate from us buy 3x as many specialty food products. These are categories that require expertise and have a higher barrier to entry, which we feel complements our more complex specialty business very well. 2015 was a big year for our protein business as we transformed it with the acquisition of Del Monte and saw significant improvement at our Allen Brothers business. We still have much work to do with this division, but we expect that we will continue to make improvements in 2016. Integration of the Del Monte business has continued to progress. Our integration team is almost finished converting our back-end systems. So far, we have converted 5 of the 6 Del Monte branches to our IT platform and we expect to complete integration by the beginning of the third quarter of 2016. While we are pleased with our integration plans so far, converting systems and facilities always creates some disruption. We are working through those distractions and consequently expect a much stronger second half from our protein division. We believe that the best is yet to come for the protein division as we continue to cross-sell our specialty core products into our protein customers. Moving on to facilities, our most recent used distribution facility is finally opened in San Francisco. We newly opened a new 117,000 square foot facility that allowed us to consolidate two smaller facilities in San Francisco and also allows us ample room to growth. With four new facilities now open and operational as well as the sales team that has grown from roughly 300 team members at this time last year to slightly more than 400 team members at the end of Q1, we believe that we are positioned for many years of growth. We are also well positioned to tuck-in acquisitions in these as well as other existing markets to leverage our new infrastructure. So, in conclusion, 2016 is off to a solid start for our core specialty business. We have a great protein business that we are very excited about and a very solid infrastructure for continued growth. 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 March 25, 2016 increased 32.6% to $262.4 million from the $197.9 million for the first quarter ended March 27, 2015. The increase in net sales was the result of the acquisition of Del Monte in April 2015 as well as organic growth. This acquisition accounted for approximately $52.1 million of our sales growth for the quarter, while organic growth contributed the remaining $12.4 million or 6.3% growth over the prior year quarter. Inflation decreased approximately 90 basis points sequentially and was approximately 0.7% for the quarter. We saw significant inflation in the diary, chocolate and baking categories offset by deflation in the seafood and meat categories. Gross profit increased approximately 32.6% to $66.0 million for the first quarter of 2016 versus $49.8 million for the first quarter of 2015. Gross margins were flat at 25.1% for both the first quarter of 2016 and 2015. As Chris mentioned, gross margins were down approximately 52 basis points in our specialty division versus the first quarter of last year, which was an exceptionally strong prior year margin. This decrease in specialty margins compared to the prior year quarter – as compared to the prior quarter was offset by 417 basis point improvement in gross margins in our protein division. Total operating expense increased approximately 30.0% to $60.6 million for the first quarter of 2016 and $46.6 million for the first quarter of 2015. As a percentage of net sales, operating expenses were 23.1% for the first quarter of 2016 compared to 23.6% for the prior year quarter. The decrease in the company’s operating expense ratio is largely attributable to favorable transportation-related expenses and lower transportation-related cost associated with the prior year acquisition – transaction cost, I am sorry, related to the prior year acquisition of Del Monte offset in part by higher occupancy cost and operating costs from our new warehouse facilities and amortization expense related to Del Monte. More specifically, G&A expense has increased approximately $19.4 million – to approximately $19.4 million from the first quarter of 2016 compared to $15.0 million for the prior year quarter due largely to increased headcount, bad debt and amortization expenses offset by lower transaction costs. Operating income for the first quarter of 2016 was $5.4 million compared to $3.1 million for the first quarter of the prior year. As a percentage of net sales, operating income was 2.0% for the first quarter of ‘16 compared to 1.6% in the prior year’s first quarter. Interest expense increased to $3.7 million versus $1.8 million in the prior year first quarter due largely to incremental borrowings to fund the Del Monte acquisition. Income tax expense was $708,000 for the first quarter of ‘16 compared to $686,000 in the first quarter of 2015. Our effective tax rate was 41.6% for the quarter. Net income was $993,000 or $0.04 per diluted share for the first quarter of 2016, compared to $967,000 or $0.04 per diluted share for the first quarter of 2015. Note that the first quarter of 2015 included a $204,000 after-tax gain on the sale of assets. I would also like to point out that our subordinated convertible notes were anti-dilutive this quarter and therefore, the underlying 1.2 million shares are not included in our share count for the quarter. I would expect them to be dilutive for the remaining quarters in 2016 and for the full year. On a non-GAAP basis, adjusted EBITDA was $10.4 million for the first quarter of 2016, compared to $7.6 million for the prior year first quarter. Modified pro forma net income was $1.3 million and modified pro forma EPS was $0.05 for the first quarter of 2016, compared to modified pro forma net income of $1.9 million or $0.08 per share for the first quarter of the prior year. Based on current trends in the business, we are updating our – the following financial guidance for fiscal year 2016. We estimate that net sales for the full year ‘16 and I will remind you that, that includes a 53rd week to be in the range of $1.15 billion to $1.18 billion. Adjusted EBITDA will be between $68.0 million and $73.0 million. Net income will be between $20.5 million and $22.0 million. And net income per diluted share will be between $0.75 and $0.80 per share and modified pro forma EPS to be between $0.70 and $0.83 per share. This guidance is based on an effective tax rate of approximately 41.7% for 2016 and an estimated diluted share count of approximately 27.25 million shares. While we do not provide quarterly guidance, we do believe that the cadence of earnings in 2016 are weighted more towards the latter part of the year, due both to the effective – of the effect of the 53rd week in the fourth quarter, but also the continued ramp in efficiencies from our new warehouse facilities and IT systems. As a reminder, on a long-term basis, our growth targets are as follows; we expect to achieve 26% gross margins, operating expenses, excluding D&A, as a percentage of net sales to be down around 19% of revenue, and EBITDA margin of approximately 7% on a long-term basis. Also CapEx, which has been a significant drain for us over the last year or 2 years, as we have opened new facilities, we expect that normalized maintenance CapEx to be between $8 million and $10 million. With that operator, we will turn it over for questions.

Thank you. At this time we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Kelly Bania from BMO Capital Markets.

Hi, this is Lucy Hong for Kelly and thanks for taking my question. First, I am just wondering, can talk more about why gross margin is down in the specialty division this quarter, just wondering what’s driving the lower margins there since historically the specialty business has been fairly stable?

Yes, it has been very stable. First quarter of last year, which I don’t know, if you recall, but 2017 was – I am sorry, 2015 was coming off a very high inflation year in 2014. So we had about 27% gross margins in our specialty business in the first quarter of last year, that’s a little bit atypical and it was a very, very strong quarter. So while it was down sequentially about 20 basis points from the fourth quarter of last year, it’s much more normalized than down 50 basis points. It was right in line with where we expected it to be for this quarter, so.

Did that answer your question?

Yes. And thank you. And also, can you talk about the reasons for the lower guidance, is it because of the lower gross margins, can you just talk more about the rationale behind that?

Sure. A couple of things, one is first quarter came in below our expectations. It was primarily driven by the performance of our protein division, which was primarily – it’s a little bit of revenue miss as far as our expectations, but it was primarily gross margins related to the protein division. We did expect to get a bit more of a lift with the deflation we had in protein and expected to see a little bit more lift in gross margins. Gross margins were still fairly good in protein, which you saw in the 417 basis point increase. They were just a couple of points lower than where we expected them to be.

Okay. Thank you. And lastly, it seems like the broad liners have started to make progress with independent channel in recent quarters, so do you think they are gaining shares in that segment and do you expect to start competing with them more on a head-to-head basis going forward? Thanks.

Well, we compete with them everyday, and we have for 30 years. So we don’t expect never to have any competition. But you could see really from our strong growth in our core specialty broadline division, we grew case count by over 7.5%. Our real organic growth, when you take out attrition, which is normalized business we added over 15% of new business. So all our markers, indications, case growth, customer growth shows us really that we are taking market share. And really the only – the headwinds we had in our first quarter were predominantly due to our – we did a lot of – we converted five out of the six West Coast new Del Monte facilities. So, that kind of, it was really kind a headwind in our growth in that protein division. So we really back that out. We really see that we are taking market share and we are cross-selling and our business plan, really – we will fine tune it, but we are really staying on our business plan, because it continues to work very well.

Thank you.

Thank you. [Operator Instructions] Our next question comes from Mark Wiltamuth from Jefferies.

Hi, good afternoon.

Hi Mark.

Just wanted to know how much of the disruption affect there was in the quarter, you mentioned that switching over to IT systems may have impacted some of your meat performance as well?

Yes. Well, you can imagine, when all of a sudden, you are working on a BlackBerry and somebody hands you an Apple phone, there is a period, even though it might be a better tool, it was more disruptive than we expected even though our integration team is doing a great job, it’s just that freshman year. You have to get used to your new dorm, new ownership and really how to navigate and find information, thousands of items. So it – there is a tremendous learning curve, when you are trying to convert six facilities. So we are confident. Their customer account is healthy. We have a great leadership team now that’s integrated into Del Monte that they are working together. And we are very confident, we will start catching up second half of the year, once all these tools are in place and everybody knows. You see a lot of these things are done in the first year, Mark. We took our time to do it right. So we are kind of experiencing that headwind over the past so many months. And we are very optimistic about that, this thing is working and it will work much better. And we would also face that inflation, deflation. In the midst of it, we weren’t able to really get that leverage on the margin that we were expecting, usually in a deflationary environment. So it was a squarely quarter and with the transition onto the new platform, it kind of magnified it. So we are very optimistic, very confident that this is a road bump and we are going to have a great second half of the year.

Okay. And when I was talking with you in January, you had talked about some new systems and controls to kind of help your salespeople with pricing, during periods when inflation and deflation is moving around, could you talk about how effective those were on securing better pricing or at least making sure you weren’t hurt on margins, as prices moved around?

Yes. Well, they worked and they continue to work very well for most of our business. I think again, our headwind was really isolated with the division they are really trying to manage margin, while they are doing a brand new computer ERP system and you got that – so those tools are going into place and are going to be very effective, once they are all integrated.

Okay. And how did you feel like you did on margin dollars in the deflationary environment, did it hold up stabilize as you had expected?

Yes. Well, there are again, overall in our core specialty division, we did fine and the protein division, it did not meet expectation. And I think that it really was the integration. There is so much distraction with obviously, people all over your office and prices changing and it’s not the same screen you are looking at. So I think again, long-term we are going to give them the same tools that we have. We are going to upgrade the transparency, so they can – because we really should have had a margin lift in the first quarter, on the normal circumstances. So we are looking forward to really getting this thing done, getting it behind us and moving on.

Okay. And then how about the recovery of Allen Brothers, what inning do you think you are in there and is there more to go on getting that margin higher?

Yes. Again, Allen Brothers has definitely done better. We are gaining market share. We are getting customers. We still have a long way to go. I mean there is so much upside to it. So I still think we are in the second, third inning, because so much upside to the business.

Right, couple of things maybe to be put that in perspective also Mark is, we had about a 500 basis point improvement in gross margins in Allen Brothers year-over-year. So I think from a margin perspective they improved meaningfully. They are only 17% of our overall protein business, so it obviously, that all didn’t translate into consolidated margins. But they had a decent quarter, as we expected – as I said, they still came in short of where we thought that they would be, but they still had a nice improvement versus last year. Where I think they still have opportunity. We cycled out some business there, last year and we will start to lap that middle of the year. So I think Allen Brothers, one of their big aha moments or aha opportunities is getting more volumes through that facility.

Really, yes. And that’s really what’s left, because operationally they are functioning – they have operational excellence. So right now, it’s just gaining customers, adding sales people and feeding more tonnage through the system.

Okay. And then lastly, just how are you faring on gaining more efficiency from the new facilities, so I know there is some drag, as the new facilities come on especially in the Bronx warehouse, how are you doing on getting that dialed into actually get to the point where you have occupancy leverage?

Yes. Well, that’s actually a very positive note. So if we didn’t really have the headwinds that we had in getting this protein business up and going, you would have seen, we are starting to leverage our infrastructure, our cost of deliveries went down, we are doing a much better job in the warehouse. So even with the increased occupancy costs, we actually improved our efficiency in running our business. So we are starting to get leverage.

Yes, I think maybe a couple of granular points. I know I talked about G&A on my prepared remarks, but looking at adjusted OpEx, we were down about 25 basis points year-over-year, even despite the gross margin challenges in protein, but OpEx and leverage we were about 25% – 25 basis point improvement. There is a lot of color in that, so when you think about occupancy costs in all the new warehouses, actually occupancy cost was up about 49 basis points. Distribution costs were down around 70 basis points and that was – part of that’s from getting in a new facility, right. So we had a lot of extra truck rentals and storage capacity, things like that, fuel is down. So there is – net freight is down. We have negotiated better contract in our Allen Brothers facilities. So there is a lot of favorable things going on in transportation costs. And then selling and G&A were kind of net-net about flat. So you see some occupancy costs going up leveraging the transportation costs, so net-net we had about a 25 basis point improvement in our OpEx ratio.

Okay. Thank you very much.

Thank you, Mark.

Thank you. At this time, we have no further questions. I will turn the call back over to Chris Pappas for closing comments.

Yes. Well, thank you all for joining us today. Again, the – we did some remarkable things in the first quarter. We had a tremendous amount of work on the West Coast getting our new acquisition onto our platform. Our core business had still remarkable growth with over 7% organic growth. We did start to leverage our facilities and our infrastructure, so we have a lot of things to be proud of. And we expect to continue to do great things. And we look forward to speaking to you on our next call. Thank you very much for joining us.

Thank you. This does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.