Lifecore Biomedical, Inc. (LFCR) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. And welcome to the Landec Third Quarter Fiscal Year 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, today’s program is being recorded. I would now like to introduce your host for today’s program Molly Hemmeter, President and CEO of Landec Corporation. Please go ahead.

Good morning. And thank you for joining Landec's third quarter of fiscal year 2016 earnings call. With me on the call today is Greg Skinner, Landec's Chief Financial Officer. During today's call, we may make forward-looking statements that involve certain risks and uncertainties that could cause actual results to differ materially. These risks are outlined in our filings with the Securities and Exchange Commission, including the Company's Form 10-K for fiscal 2015. In the fiscal 2016 third quarter consolidated revenues decreased 6% to $130 million from $138.8 million in the third quarter of last year. Due to a 7% decrease in Apio's packaged fresh vegetable business and a 22% decrease in Apio's export business. These decreases were both primarily due to severe produce shortages, as a result of weather related effects from this year’s El Nino which equaled the strongest El Nino in recorded history. As far as the rise in the temperature of the Pacific Ocean causing higher than usual daytime and nighttime land temperatures that significantly affected Crops. These decreases were partially offset by a 6% increase in revenues at Lifecore. This growth was moderated by several shipments scheduled for the third quarter being rescheduled at the request of several customers to our fourth quarter. Primarily due to the GreenLine trademark write down we recorded a net loss of $0.78 per share during the third quarter. Excluding the impact from the GreenLine trademark name write down, the Company generated net income of $0.01 per share during the quarter. The one-time non-cash $34 million write down of our GreenLine tradename was due to our strategic decision to convert our GreenLine branded bean products at retail to our more nationally recognized Eat Smart brand. This decision was driven by both favorable results from our online marketing and social networking programs and requests from our retail customers to deliver all of our products under the single Eat Smart brand In December we completed our second online consumer marketing program. In the last 12 months, which was focused on Eat Smart branded products. This geo targeted program was conducted for a three month period in the Eastern United States and Canada and delivered a 21% sales lift, repeating the results that we experienced during the first program one-year earlier. In addition, major customers have requested that we consolidate the two product offerings under Eat Smart to deliver a more consistent on self experience and allow for more efficient promotional strategies. By consolidating Apio's retail products under a single consumer brand, Apio's sales and marketing resources will be able to focus on supporting the Eat Smart brand and driving greater consumer awareness and spending efficiencies. In addition to the GreenLine tradename write down, operating income was significantly impacted by the decrease in revenues, but more importantly by $6.6 million of excess costs related to severe produce shortages at Apio. However, these produce shortages did not impact our salad kit as Apio was able to supply all demand for these products. The produce shortages would have been much more significant on our gross margin had it not been for the continued growth of salad kits, which we’re able to partially offset the negative sourcing variances. Gross profit in Apio’s packaged fresh vegetable business would have increased $1.2 million from the year ago period if not for the $6.6 million in excess produce cost and the gross margin in our packaged fresh vegetable business would have increased 180 basis points to 10.2%. Although weather conditions have recently improved, we are still managing the lingering effects from this year's El Nino. Throughout most of our second and third fiscal quarters, we experienced significant deviations in both daytime and nighttime average temperatures in our growing regions. These deviations affected plant health and growth rates resulting in significant crop yield losses, poor quality, and changes in the timing of harvesting outside of planned harvesting schedules, all of which drove up the cost of sourcing quality produce items. Despite our best efforts to meet the increasing demand for our products, there was simply not enough supply from our contracted growers, or for purchase on the open market, to meet demand. Importantly, we were able to fill all orders for our higher margin Eat Smart salad kits, which continued to grow at double-digit rates. Eat Smart salad kit revenues grew 20% in the third quarter of fiscal year 2016, compared to the third quarter last year and grew 31% in the first nine months of fiscal 2016 compared to the same period last year. Our Lifecore Biomedical’s business had another good quarter. In addition to revenues growing 6%, operating income grew 26% reflecting the anticipated improvement for Lifecore's business in fiscal 2016. Before I discuss the outlook for the rest of the year and preliminary look at next year, let me turn the call over to Greg for some financial highlights.

Thank you, Molly, and good morning, everyone. Revenues in the third quarter of fiscal 2016 decreased 6% to $130 million from $135 million in the prior year quarter. The decrease was primarily due to an 8% decrease in Apio total revenues, partially offset by a 6% increase in revenues at Lifecore. We reported a net loss during the third quarter of $21.2 million or $0.78 per share compared to net income of $3.8 million or $0.14 per share in the prior year quarter. The net loss was primarily due to the $34 million, $21.5 million net of taxes write down of our GreenLine tradename. Excluding the impact from the GreenLine tradename write down, the Company generated net income of $0.01 per share during the quarter. Operating income was also impacted by the $6.6 million of excess costs related to the severe produce shortages at Apio. The year-over-year change in operating income was also due to a $2.1 million lower increase in the fair market value of the Company's Windset investment as a result in delays in Windset expansion plans due to permitting delay. The loss in the third quarter was partially offset by a $1 million increase in pre-tax income at Lifecore due to higher revenues and a higher gross margin due to a favorable sales mix change compared to third quarter of fiscal 2015, and from a $2.3 million decrease in income taxes, excluding the tax benefit from the GreenLine tradename impairment charge. Revenues in the first nine months of fiscal 2016 increased to $405.8 million from $404.8 million in the same period last year. The increase was primarily due to first a 16%, or $4.8 million, increase in revenues at Lifecore, Second, a $1.6 million increase in licensing revenues at Corporate. And third, a $641,000 increase in revenues in Apio's packaged fresh vegetable business. These increases were partially offset by 11% or $6 million decrease in revenues in Apio's export business. Excluding the extra week during the first nine months of fiscal 2015, which resulted in approximately $9 million in additional revenues last fiscal year, revenues for the first nine months of fiscal 2016 increased 3% compared to the same period last year. We recorded a net loss for the first nine months of 2016, $16.4 million or $0.61 per share, compared to net income of $9.3 million, or $0.34 per share, in the prior year. The net loss was due to the write down of the GreenLine tradename. Excluding the impact from the GreenLine tradename write down, the Company generated net income of $0.19 per share for the first nine months of fiscal 2016. Operating income for the first nine months of fiscal 2016 was also impacted by the $12.6 million of excess costs related to the severe produce shortages at Apio. The year-over-year change in operating income was also due to a $3.9 million increase in operating expenses at Apio to drive the growth of our existing and new salad kit product, and from additional headcount hired over the past year. And a $2.5 million reduction in the increase in the fair market value of the Company's Windset investment as a result of delays in its expansion plans. The loss during the first nine months of fiscal year 2016 was partially offset by $4.8 million increase in pre-tax income at Lifecore due to higher revenues, as well as a higher gross margin due to favorable sales mix change compared to the first nine months of last year, and from a $2.6 million decrease in income taxes, excluding the tax benefit from the GreenLine tradename impairment charge. Excluding the impact from the GreenLine tradename write down, the Company generated net income of $0.19 per share during the first nine months of fiscal 2016. Turning to our financial position, at the end of the third quarter of fiscal 2016 cash totaled $8.2 million after generating $6.3 million in cash flow from operations receiving $14.6 million in net borrowing and investing $26.2 million in property and equipment primarily for capacity expansions during the first nine months of fiscal 2016. The company had $36.2 million available under the lines of credit as of February 28, 2016. Let me turn the call back to Molly.

Thanks, Greg. Due to the worse than expected negative impact from this year’s El Nino, we’re now projecting net revenues for all of fiscal year 2016 will be down slightly compared to last year, primarily due to not having adequate supply of produce for most of the second and third quarters and the loss of some customer business. We expect net income excluding the GreenLine trademark impairment charge will be $0.33 to $0.37 per share. The revised net income guidance for fiscal 2016 includes one, the impact of excess costs due to produce shortages and loss of some customer business. Two a significant reduction in projected increase in our Windset investment from our original guidance. Three, the continued focus on innovations to develop high margin product at Apio, Lifecore and the growth of the salad kit. And four, a record year at Lifecore. Regarding Windset, we’re estimating that its expansion delay and Windset’s lower production volumes during the last few months of calendar 2015 will reduce the increase in the fair market value of our investment in Windset to an increase of $1.0 million in fiscal 2016, down from our original projection of approximately $4 million. Windset expansion plans are slowly progressing. Windset recently completed the construction of a four-acre test facility and a four-acre propagation facility on land that Windset owns in the City of Santa Maria using a new type of greenhouse structure that Windset intends to use for trials for new crops. Windset is in the permitting process for building these new type of greenhouse structures on a commercial scale adjacent to its Santa Maria facility on lands located in County of Santa Barbara. The County of Santa Barbara recently approved 20-foot tall hoop houses, which allows the permitting process for Windset to move forward, although the process will still take time. Windset is also in the permitting process with the City of Santa Maria to construct additional glass greenhouse facilities on lands in the City of Santa Maria. Windset still expects that it will begin commercially harvesting crops by the end of calendar 2016 from the new site expansions. During the last few months of calendar year 2015, El Nino affected production from Windset's Mexican grower partners. Lower than anticipated production volumes and higher costs associated with purchased product required to meet Windset's committed sales programs resulted in operating results lower than planned. Despite these delays in production issues Windset has continued to realize double-digit annual growth in revenues and net income. Notably, we project that as of fiscal year end 2016, we will have realized a 24% annual return since our original investment in Windset in February of 2011. Our strategic focus on the assessing consumer needs and innovating new products of high value, is working as we shift in our product mix to higher margin products both at Apio and Lifecore. We’re working diligently at both companies to develop new products and customers and to expand capacity to meet anticipated new demand. At Lifecore, gross margins increased to 49% during the third quarter from 42% in the third quarter last year. For the first nine months, gross margins increased to 45% from 34% last year due to favorable sales mix change to higher margin products and services. Lifecore is having a record year after a down year last year. Compared to fiscal year 2015, we continue to expect Lifecore revenues to increase approximately 25% in fiscal 2016. And operating income to increase 130% to 140%. We expect double-digit revenue and operating income growth from this business next year and for the foreseeable future. We are extremely excited about Lifecore's future prospects given the potential growth of our existing business partnerships and the multitude of potential new business in its pipeline. Also at Lifecore, we have been expanding the aseptic filling and formulation capacity and preparing for incremental business from existing and new customers. When completed during the second quarter of fiscal 2017, Lifecore will have sufficient aseptic filling capacity to meet its growth plans for commercialized development opportunities that are consistent with its long-term projections. At Apio, if you exclude the excess costs from produce shortages and the related higher cost of servicing our customers, which amounted to $6.6 million for the third quarter and $12.6 million for the first nine months of fiscal 2016. Our gross margin in our packaged fresh vegetable business would have been 10.2% for the quarter and 12.6% year-to-date. This compares to 8.4% and 10.3% for the same periods last year. Our investments at Apio over the last three years in new product development to create highly nutritious salad kits made from superfood vegetables packed in our BreatheWay technology are demonstration thus far the underlying success of our innovation strategy. Salad kits revenues increased 31% year-over-year for the nine months ended February 2016. And have delivered an average annual compounded growth rate of approximately 80% from $26 million in fiscal 2013 to an estimated $145 million to $150 million in fiscal year 2016. We continue to study consumer trends and innovate products with a goal of launching one new product on average per quarter. We launched the Southwest salad kits during our second fiscal quarter and recently launched the Asian sesame salad kit during our third fiscal quarter. Both salad kits are currently being offered in retails stores in U.S. and Canada. Our strategy to differentiate ourselves through innovation is working. As we see the continued growth of our salad business and shift in our product mix, that increases profitability overtime. To enable this growth, we’re increasing capacity for producing Apio's vegetable products by more than tripling the size of our processing plant in Hanover, Pennsylvania. We expect this construction to be completed in mid-April. A portion of Apio's historical business consists of commodity like items that carry a very high cost to serve, especially in times of severe weather challenges. Even after incurring these costs to service our customers to the best of our ability, some of our customers have chosen to labor diverse or diversify their sourcing strategy by moving away from a sole supplier relationship for certain produce items. The result of these changes is a greater shift in our product mix as we see the size of our lower margin business declining this fiscal year and next fiscal year, while our innovative higher margin product offerings continue to grow. As we respond to the short-term sourcing challenges at Apio, it is important to reaffirm Apio's long-term strategy for growth which is to focus on delivering innovative on-trend products that make it easy and convenient for consumers to eat healthy while delivering high quality products and service to our customers. Looking to fiscal 2017, on a preliminary basis, we expect double-digit revenue growth in Apio's Eat Smart salad kit and we expect Lifecore to continue to deliver double-digit revenue growth and operating income growth in fiscal 2017. We see further revenue decline in Apio's lower margin commodity like vegetable business. We also expect net income to increase substantially year-over-year, assuming that produce sourcing returns to more normal levels and as we continue to focus our sales effort on higher margin products. We will provide more specific annual guidance for fiscal 2017 when we report our fiscal our fiscal 2016 year-end results. In summary, our strategic initiatives to develop innovative products, expand capacity and meet anticipated demand and change our product mix to higher margin products is working at Apio and at Lifecore. Over time, these strategies will continue to deliver value to our customers, our consumers and shareholders. Our continuing priorities are shifting our product mix to high- margin products at both Apio and Lifecore; secondly, developing innovative new salad kits to broaden and strengthen our product lines. Number three, focusing our new VP of Strategy and Business Development on evaluating the natural food product segment to identify areas where Landec can enter their new product development or strategic acquisitions or investment. Four, advancing our Lifecore programs with key customers and development partners. Five, investing in facility expansion and equipment to meet future anticipated demand at both Apio and Lifecore. And finally, number six, supporting Windset and its expansion plans to build new hydroponic controlled atmosphere structures using new growing methods for new crops. We are now open to questions.

[Operator Instructions]. Our first question comes from the line of Doug Cooper from Sidoti. Your question please.

Yes good morning Greg and Molly.

Good morning.

Good morning.

Thanks for taking my questions. I just want to delve a little bit deeper into your estimated $0.33 to $0.35 impact of El Nino on EPS. I just wanted to understand what exactly is included in that estimate. There's higher cost of servicing customers, retailers' mitigation strategies shifting to multi-suppliers, and cost of falling under over growth of broccoli in February. What's all included in there?

Boy, you did a good summary there. By and large, in those numbers, it's just the cost for the underlying products, so the raw products. So in the have a lot of joint ventures, so we own the crop or partially on the crop. As a result of weather, yields were down significantly, quality was down. And so as a result, what you expected to come off those fields you were not getting. You take the loss of that as being the owner of the crop during that time frame. In addition, and this also occurred in the non-joint venture side of our business where we just contract with growers, is, in order to service our customers, we were attempting to buy wherever we could on the open market to fill demand, and even in that case we weren't able to buy enough. But we were out buying at considerably above contracted price, and most of that could not be passed on to our consumers and our customers. So as a result, we took the hit for those purchases, and that's what the 6.6 and 12.6 represents.

Okay. Thanks for the clarification. And you got $12.6 million impact year-to-date for the nine months, and you are forecasting $15 million estimate for the year, plus some leftover costs in 4Q, so just kind of wanted to understand the lingering impacts in 4Q?

It was what occurred in March. The problems continued through March. We don't see this continuing into April and May.

Okay thank you.

Our next question comes from the line Tony Brenner from ROTH Capital Partners. Your question please.

Thank you. Greg, what is in the other expense line item other than the change in fair market value for Windset Farms?

From a year ago, it was the write off the Aesthetic Sciences investment. This year it's only Windset.

So the $1.3 million increase a year ago was actually for Windset, more like $1 million.

Yes, because there was a $793,000 write off a year ago from that investment.

Got it. And I believe, during the second quarter, Apio attempted to increase prices on bagged fresh vegetables. Did that stick or did competitors not meet the pricing and it had to be ended?

Good morning Tony. It was a temporary price increase to cover us for just a temporary period. So most of our customers went along with that and accepted that price increase, and that further offset some of our downside. But that was lifted after I think at the end of December that was lifted and we are back to normal pricing.

And then one other question regarding Apio, and the loss of exclusivity. I'm curious whether in some of your larger customers you are providing any sort of incentive to in order to retain that exclusivity, or if that's even legal?

No. Well, most of this business is in our commodity like products. So when they call and they say hey, we are thinking of not being a sole supplier and we are looking at the numbers, in actually most of these decisions are going to help our gross margin. So we can negotiate with customers to keep business that we want to keep, but in areas where it doesn't make sense, we are not going to do that.

No, I understand, but I'm specifically referring to larger customers where there's high volume. And it might be low-margin, but it's still profitable and picks up an awful lot of overhead since the volume is so great?

Right. So, we are making those decisions on a daily basis. At the same time, our commodity like products are going down. Our volumes of our salad kits are going up and they are starting to absorb that overhead. So, we see a nice dynamic going on, and we are just making these decisions one by one. And in some cases, we do keep the business after negotiation; in some we don't. And those are just a lot of one-off decisions that we need to make to decide when we should keep it and when we shouldn't. But overhead absorption is one of the factors we look at when making those decisions.

Thank you.

Thanks Tony.

Our next question comes from the line of Mitch Pinheiro from Wunderlich Securities. Your question please.

Good morning Molly, Greg.

Good morning.

Hey man.

So, in the year, I guess the comments in the press release, you talked about you expect to lose some business in Apio as you were just talking about this. I mean could you quantify? Are we talking Apio in the non-Eat Smart, the non-value-added, are we talking, what should we expect a 5% decline in the other stuff, 10%? Do we have any help you can give us would be nice?

If you looked at just year-to-date, and what we are projecting for this fiscal year, and what we originally anticipated for this year, our revenues are going to be down, but the majority of that is a result of produce shortages. So that is the lion's share of why we are going to be down this year. There is a portion that is associated with the loss of business in our core crop. Now, I'd love to be able to give you a specific answer, Mitch, but as Molly just said, we are in the process of making the determinations of which businesses we're going to retain and go after, knowing that it's even slower margin but it does absorb overhead, there are other reasons to retain it our salad kit business so on and so forth. So I can't really put a percentage on it at this point, but we are expecting that business will be down overall this year. It was $300 million last year, by the way. It will be down this year and we expect it to be down next year. Now it's probably more in that 5%, maybe 10% range. It's not dramatic, but it is going to be down.

Okay, that was helpful. So when I look at the gross margin so you had about a 10 point, your adjusted sort of gross margin in that 10.7% area. With the moves that you are making, we're going to see that gross margin expand, all things being equal. Is that right?

Yes.

Yes.

Okay. How about when I look at fiscal 2017 and the initial guidance or the preliminary stuff was very helpful, but when I look back at fiscal 2014, is there any – where you did $0.71, what would prevent you from reaching that type of earnings level in fiscal 2017?

Let me take you Mitch through a couple of tailwinds and headwinds. So, the tailwinds that we are seeing next year are continued double-digit growth in our Lifecore business, as well as continued double-digit growth in our salad kit business. So those are two core growth drivers for next year and we see those continuing to move forward at high growth rates. The headwinds we are facing are primarily three. And these are the headwinds that are going to come down to how large these headwinds are during our budgeting process to see where we end up for next year. First of all, there's the loss business that we already discussed. So we need to quantify that. Greg just gave you a range of the loss business, but that's one of the headwinds. The other one is cost increases. So we are continuing to get minimum wage increases. We also our growers. We didn't even bear the brunt of the losses. We still made money this year. Our growers are having a really tough time and want to increase costs for their harvesting and their crops. So we are going to be looking at cost increases. Every year, we have to make judgment calls on how we much we want to invest in strategic initiatives that are going to help our growth in the future. So between lost business, cost increases and further investments in growth for the future, those are the different levers we are trying to balance.

We should also add when you look back to 2014, Mitch that was a year where Windset added 64 acres to their production, huge, huge increase that year. And as a result, our increase and our fair market value for that year alone was $10 million. That was like $0.24 of that $0.71 was Windset. And when we look to next year, this year we've already said it's going to be around $1 million. A lot of that is due to the delay. When we look to next year, as a result of that being the first year that we go from a forward-looking discounted cash flow type of analysis to 100% contractual, which is a look-back, and based on the change in the way we're going to be calculating it next year. We expect the Windset investment to be flat to only slightly up next year as a result of that change. And then going forward, when you look to 2018, and their expansion is done and we have a full 12 months of EBITDA of the new expansion, you should see a substantial increase in Windset starting in 2018.

That is very helpful.

It's a big $10 million swing.

Yes. So then two other questions. With Windset, while we are on Windset, so the commercial availability of this new crops available in 2016, will that have any, that won't have a real meaningful impact on their fair market value?

In 2017.

Yes, in your fiscal 2017.

The contractual formula is a 12-month look-back in EBITDA times a multiple that was negotiated back in 2010, so remember what multiples were back then, plus cash, less debt and equity. That is the formula to put a value on Windset. Then you times that by our 26.9% ownership. And that gives you the investment value each quarter, and then you compare it to the previous quarter and you book the difference. Well, as a result of that formula, you're going to have all the debt, all the cash usage as the expansion occurs. Then you start actually generating EBITDA, but it's very late in our fiscal year, so you only have a few months worth of the EBITDA in your formula but you have 100% of the debt and use of cash. So, as a result, what we are projecting right now is that their growth in their existing business, the growth from the few months of EBITDA from the expansion will offset that debt and cash increase. And that's why we are not expecting a large increase next year, or possibly none.

Okay. And just a final question?

To go forward, to finish it, go forward into 2018, you've now incurred all the debt. You are now generating cash, you're paying down the debt and you have full 12 months of EBITDA, so you should see a big pickup in 2018.

Okay. Thank you. Then finally, just inventories they are up 10% year-over-year. I was curious what's driving that?

It is the delay in the delay in the shipments at Lifecore that's going to happen in the fourth quarter.

Alright thank you for taking the questions.

Thank you. Our next question comes from the line of Morris Ajzenman from Griffin. Your question please.

Hey, Molly. Hey, Greg.

Hi, Morris.

Hey, Morris.

Back on Windset, I understand the change in fair market valuation from a discount to value to future revenue streams to a 12-month look-back. But nonetheless, with the approval now, you have Santa Maria going forward, you have the County of Santa Barbara giving approval for the 20 foot hoop house. What incremental increase in capacity will we have in these areas that are touched on by year-end? How much will capacity be up as we exit calendar 2016?

Well, the glass greenhouses that they are looking to build are going to probably be in the 30 to 35 acre range. So you’ve got 100 – they own 208 right now. So do the math, what is that? 15% for glass. And then these new structures are for a new crop, so it’s not increasing the capacity for tomatoes or peppers or cucumbers. This is a new crop that is yet to be disclosed what they are putting in there. But it’s all new capacity because it’s a new crop. And as far as the size of that, I think that’s what they’re going through right now in the permitting process with the County. So I can’t tell you what the ultimate size of that structure is going to be, probably somewhere in the 30 to 50 acre range.

Okay, so it’s fair to say, as we exit calendar 2016, you will have a meaningful increase in capacity. Again, we don’t know what meaningful is, but it should be well, well into the double digits.

Yes.

Yes.

Okay. And then how does it play out to next year? Will there be further capacity additions?

I think they are going to see how this new structure, new crop, how it works, are they getting the yields, are they getting the pricing they need. And obviously with success, they could double that size pretty quickly based on the land that they have over there.

And traditionally, when you are building these facilities, I think it’s correct to state that you’ve usually presold a lot of the produce you grow?

Yes.

Is that going to be the case with these new expansions?

Yes.

Okay.

Yes, because remember they own 200 – slightly over 200 acres. But they market for other growers about 500-plus acres, so which is at a much lower margin, because they are just acting as a sales agent basically and using their label to do the sale. So as they add capacity to what they grow and sell, they will reduce, or not increase as the case may be, the amount that they market for others, and that has a fairly substantial increase in their margins as a result.

Okay. Shifting gears over to the Hanover facility, I think you said at the end of April, which is in a few days or so, you will finish increasing the size of the Hanover facility, the plant. What will be the production capability once that is done versus what it was pre the increase in the size of the plant?

We approximately tripled the size of our plant in Hanover. And that will allow us to – I think the best way to think of it is we can double the size of our salad kit business with this new capacity. So, we are currently at about $150 million in sales this year and we could bring that to $300 million with this increased expansion.

Okay, perfect. Thank you.

You’re welcome.

Yes. Thanks, Morris.

Thank you. Our next question comes from the line of Brent Rystrom from Feltl. Your question please.

Yes, thanks. Good morning guys.

Hi Brent, good morning.

Hi Brent.

Molly, could you repeat – you said year-to-date salad kit growth for the 39 weeks was what?

Was 32%.

32%, thank you. Out of curiosity, can you share with us how many SKUs your average retailer has of the salad kits?

Yes. On average, I would say they carry about three. That being said, there is a huge breadth. So some of our retailers or the small ones with very small footprint carry one, and that would be our Sweet Kale Salad. Our retailers in Canada carry up to eight SKUs, different salads. So it’s really – the average is around three, but it varies very dramatically. And one of our strategies moving forward is to increase the average number of SKUs per account by launching all the new salads that we’ve mentioned.

When you look at that and you think about it in that context, a year ago, would it have been a similar number, about three?

I think we’ve gone up. It was more like at the 2.5 mark a year ago, and now we are at about 3.4, something like that. So we are increasing over time.

When we think about the context of your comments about growth for 2017, I know a lot of questions on the core legacy business at Apio. How should we think about salad kits? Is the 32% year-to-date a better proxy than the 20% in the third quarter? Or is the 20% a good number to think about go forward?

Yes. As our numbers get larger, it’s really hard to keep those 20% numbers. So as we continue to increase in size, I think our overall growth rate is going to stay in the double digits. It’s been gradually declined. So you might want to think more in the 10% to 20% range for growth. That being said, what we are looking to do and where our biggest growth potential is really getting into these U.S. key retail accounts. So there’s a number of the major accounts we are not in. We are talking to all of them right now. We are starting some tests in a couple of them. If we land a lot of doors, and one or two of those big accounts, you’re going to see a spike. We don’t know when that’s going to happen. It will happen one day. The question is when will that happen? So you’re going to see a major spike as soon as we land a major account, and I just don’t know if it will be next year or the year after.

Thank you. That’s extremely helpful. I just want to make sure I understand something about the hoop houses. So the County has approved hoop houses to 20 feet? Is that correct?

Yes.

Correct.

And then are they still considering for future adjustment that you could build a taller hoop house possibly or is that now off the table?

I haven’t heard that it’s on the table at all.

All right. From a capital perspective, there was a February building permit you guys filed for one building in Santa Maria for a $1.25 million cost. What does that buy you? What is that building and what is it buying?

That’s the 30 to 35 acre new glass green house. That’s on the existing original property of Windset [Multiple Speakers]

I’m sorry?

It’s behind the current greenhouses. If you look toward Santa Maria…

Yes.

…it’s east of the current.

Okay. The $1.25 million, you’ll be able to build 30, 35 acres of greenhouses for that or is that just a portion?

No. It’s a portion. It’s like a down payment, if you will.

Okay.

These greenhouses, they go from, depending on the level of complexity, from $700,000 to $1.3 million an acre.

Okay. One final question then. I’m just jumping back here. So I’m looking at some of the stuff at Santa Maria. Is this all part of the Area 9 specific plan?

I’m sorry, what?

Is the greenhouse itself, is that all part of the Area 9 specific plan when I’m looking at Santa Maria’s – kind of their growth and zoning plans?

Wow, you have a greater level of knowledge than I have. I could only say it’s on the original 220 acres that they purchased in 2009.

All right. So when I’m looking at Area 9, it’s kind of bounded by Black Road on the west, Badaravia on the south. It’s just, it’s on the east side of A Street and there is not a road on the north side but it’s just south of Stowell. Is that generally the area?

That would be it, yes.

All right, all right. Thank you very much guys.

You’re welcome.

Thank you.

Thank you. Our next question comes from the line of Nelson Obus from Wynnefield Capital. Your question please.

Yes. Hi, there. Hello.

Hey, Nelson.

Hi, Nelson.

A bunch of questions. First of all, what you referred to as the commodity side of Apio as we know really has two parts to it, which is the legacy package component and the export component. I’ve kind of understood the export component to carry with it lower margins and infinitely small risk. So I know you’re looking at this thing. You’ve kind of presented this as a unit in terms of where you want to go with it. But as you look at those two commodity businesses, can you differentiate at this point which one from a risk-reward perspective do you feel has the most future in the Company?

Let’s talk about both parts separately. So, first of all, the kind of historical commodity like business at Apio, I mean Greg mentioned earlier that that was about $300 million in revenue. That is not all commodity business. There is some nice high-margin business within that and we typically don’t segment it out in detail. But we have our green bean business. We have tray business. We have some bag vegetable business and in that bag vegetable business, there’s a wide variety of commodities. So I just want to make sure we are clear that it’s not all that business that is low margin business. The green bean business is actually a very strong business. The trade business is a strong business, and it’s mostly a portion of the bag business that when we are talking about commodity like products is what we are talking about.

Yes, okay, that’s what I meant. Okay. [Multiple Speakers) traditional Apio versus…

Yes, I just wanted to clarify it to everyone on the phone. So this business is still strategic for us going forward. Obviously, there’s a lot of synergies with this business and our salad kit business. You’re dealing with buying greater pounds on the market that get your grow costs down. You leverage your customer relationships. And so those are still a very strategic part of the business. Export I would say is not a strategic part of the business, although it’s pretty reliable. It provides cash that we use to invest in the strategic part of the business. So I would say that export is the less strategic part of the business.

Does export though have…

It provides the cash.

Yes. I mean is there a question of sourcing there or is that pretty much pass-through that – I mean did that get impacted this year I guess is really the question?

The volume – yes, the volumes get impacted, but they are more on a – their prices go up. They only buy if they know they can sell it at the right price. It’s very much a true commodity business. So because their volumes were lower, we had less on the bottom line and less cash, but at the same time their gross margin percentages stay pretty much the same.

That’s fine.

That $300 million, Nelson, just to make it clear, that $300 million did not include export.

That’s fine.

I know, I know you break it out. Just a financial question because I know you’re building up staff and whatever and that shows up in SG&A. If you annualize the SG&A in the third quarter, it comes to $32 million, but if you look the nine months, it’s $35.5 million. So there is a $3.5 million delta which is a little bit actually negative. So I’m just wondering why the third quarter didn’t annualize for the entire nine months.

It’s because of our online marketing program that I mentioned. We did that in Q2.

Okay, that was historic.

And that was the three-months program where we spent significant dollars to market directly to consumers.

I got it. That’s fine. Now, sort of a broad question, I mean in terms of sourcing, and I’m only focused on sourcing and I don’t expect you to have all the answers. But meteorologically, and I’m a bit of a meteorological nut, this really was an outlier in a lot of places, not just California. I mean Albany got 10 inches of snow, which is I think the record low. But what are the lessons learned here? Are you still trying to put that together going forward in terms of your whole sourcing effort?

I’d say the major lessons are still that diversity is essential.

By the way, I don’t mean acquisitions. You’ve made that very clear where you want to go in acquisitions. But I mean in – yes.

In our sourcing strategy, right, which…

Yes, yes.

…this was just an unreal year. We are extremely diversified in our sourcing strategy, and yet it had every region where we were from the different areas in California, the next day you get a call about the desert being too cold, then you get a call about all the rains in Florida. So this has never happened in Apio’s 35-year history, and truly believe it’s an outlier that every one of our regions just got hit simultaneously. So, that being said, you still have to step back and you have to say what will we change next year? And you never know if this would happen again. So we’ve looked at our different strategies, including our growth deals versus our pound deals and the ratios between those two. We do different kinds of deals with different growers. We’ve looked at our over contract strategy and how much extra acreage we should plan each year in case there are weather issues, and we continue to look at more geographic areas to see if we should diversify more. We are also always looking into new varieties. When you look at different areas and different geographies, we start to learn about different varieties that might be more hearty in those areas as these temperatures continue to change over time. So, we are looking at all those variables as we begin to plan for our next fiscal year.

Okay, fine. And finally, Lifecore, which has some really interesting tidbits in here. Now, you talk about a favorable sales mix in the third quarter. But what we are really – when we look at the numbers here, we’re talking like a 7% increase in revenues leading to a 25% increase in net income. So, this is radical. Let’s start with that. Can you give us some sense of – I mean that’s a real favorable sale delta. What’s behind that enormous variation, positive variation?

Well. It really has to do with their pipeline, and it starts with development revenues. And as you know, because it’s been out in the public domain, they are working with Heron for a new product that hopefully will be approved by the FDA next month. That’s at least the plan. And in addition to that, they have several other development projects in the works that I can’t go into details or give names, but that is all extremely high margin business because it’s basically labor. And the fact that a lot higher percentage of their revenues this year are being driven from product development revenue than in the past, and their aseptic business is actually flat year-over-year, that’s their lowest margin business. And so as a result, you are seeing a substantial increase in margins, even though their revenues are up much less than what you would expect when you see that high of an increase in gross profit. And in addition, remember, a year ago, one of their major customers who cut their orders in half, well, that product that they cut in half, which has now come back fully, so in other words it’s double this year, is the highest margin product in the entire company.

Okay, the highest margin of the legacy products. I’ve got it.

Exactly.

Then – that was very helpful. Then you have a little notation here that Lifecore achieved its revenue growth despite several shipments scheduled for the third quarter being rescheduled at the request of several customers to our fourth quarter. Now, is this – what’s going on here? Is this HA? Is it a traditional product? Is there any reason for this delay? Or how would you deconstruct that, because it’s intriguing?

It was more expectations than timing. I mean if we were just looking at the fiscal year, we wouldn’t even be talking about this. But the issue is, unfortunately, you’ve got a report on a quarterly basis, and a couple of customers said, hey, look, instead of shipping that in February, could you ship it to us in March or April, whatever the case may be. So all it was just a request to delay the shipment for a month or two.

Yes [Multiple Speakers] with several. You mean that was just random? You mean it just happened affect a number of people, right?

Yes. And it could be just simple timing like you were going to go out at the last week in February and they say, oh, our plants for whatever, could you ship it next week? Well, then it shifts it into the fourth quarter. There’s nothing from a big picture standpoint here. This is just purely a few delays from the third to the fourth quarter.

Okay. And just in terms of getting a hold of Lifecore, especially for a lot of people who still look at this as a produce company, and I may be wrong about this myself, but we had a traditional business. It did about $40 million, of which a lot of it went into HA. In fact, most of it did, as I understand, with people like Bausch & Lomb as customers. Now, if I’m looking at this right, we’ve got contract manufacturing, operation certification. We are off on a different tangent with Heron, etc. I guess I have two questions. Is this the right way to look at this? And when you talk about some of the things that are on the come that you can’t talk about, is it fair to say that they are Heron-like in terms of us assembling the whole delivery package whether it be a syringe or not or something altogether different?

So I think, when we originally acquired Lifecore, it was truly an HA company. They had worked for 20 years in the HA business and learned how to handle a very, very viscous fluid called HA. What they were really doing over all those years is developing a true differentiated capability in two areas, one in fermentation, and the other in handling of viscous fluids, which includes aseptic filling. And so as we began to explore and the Lifecore team began to explore could those capabilities be used elsewhere, we found that there’s other biomaterials out there in other segments other than ophthalmic and orthopedic that actually have viscous fluids that could not find people who are able to handle these. So Lifecore has really broadened their capabilities from let’s call it an HA company to a true biomaterials company that’s focused on handling highly viscous fluids. And this has opened up a much greater market. I mean as you mentioned Heron, they are in the oncology space. And so typically most of our sales come from the ophthalmic space from applications and cataract surgeries, et cetera, in the orthopedic space. Now we’ve opened up different markets because we’re looking at this as capabilities versus a single material.

I got it. And just another differentiation, I thought that, with HA, you essentially delivered it to the end-assembler and you are just sort of a components supplier. But now with Heron and with the CMO certification, they actually give you the active material and you put the whole finished product together, including the viscous filler. Is that right, which reverses things?

That’s true. We’ve always been able to do either, so we can do the fermentation, then we can take that and go right into filling or we could take a product that’s already kind of a finished product and only do the filling, or we could only do the fermentation. So we can do both parts or either part, whatever the customer needs us to do. Of note, Nelson, interesting enough, I said just a couple of years ago we were completely an HA company. 20% of our revenues this year from Lifecore are actually non-HA products.

That was my next question, interesting. And I know a little bit about the contract research outsourcing business, a little less about contract manufacturing. But does that actually require a certification from each client or the fact that you now got from Heron, is that transferable? How does that change your status?

Yes. Every product that we do is FDA approved specifically for that product. So we’ve gone through the entire FDA process with Heron. Lifecore has specced into the FDA documents. So the capabilities that we created will transfer to other customers and the learnings that we created through those projects can transfer to other customers, but the actual certification from the FDA is specifically for Heron.

But that capability spectrum has increased so you can…

That’s right. That’s right.

I guess my final question is, I didn’t realize the development expenditure, the development revenue was so strong in the third quarter. But there was a little – I’m really looking at revenue now because with all of these HA delays from the third to fourth quarter, maybe there is a seasonal aspect here that I am missing. But I’ve always looked at Lifecore as sort of a $40 million business trying to get higher. But when I look at the third quarter and I see you did $15 million and I know that there were some good things that were propelling that $15 million but there were also some takes and take-backs that things fell – that things will fall in the fourth rather than the third. So I’m looking at this. And you’re annualizing at $60 million, and if I start playing around with fiscal 2017, I’m at a revenue number that’s going to be north of $60 million if the puts and the takes are equal in terms of the third quarter. So I’m not asking you for a specific number, but is my thinking right that for 2017, you could have revenues approaching or even above $60 million in Lifecore?

Well, I think where your math is off is this year. Historically, if you look back at Lifecore, their biggest quarter by far has always been our third quarter.

That’s what I thought.

And a lot of that has to do with these shipments that we had originally thought were going to happen in the third quarter, some had been shifted to the fourth. We expect the fourth-quarter revenues to be right in line with the third-quarter. So by year-end, they’re going to be between $50 million and $51 million for this year. So given our high-level look at next year, we are expecting low double-digit growth. If you do simple math, you’re talking $55 million, maybe $56 million.

Yes, that’s what I thought. Okay. So not over $60 million, but between $55 million and $60 million, which going back a couple of years is almost a 35% increase in where you were. And you’ve also used the term for the next several years, so we can expect that thing to – the revenues to continue to march forward towards higher numbers as we get out there. And you’ve build the capacity, correct, I mean?

Yes.

That’s correct.

Just last question. When this particular edition is done in Chaska, is there a way to look at what kind of revenue capacity you have or does it depend on the profitability of the individual contract?

The latter. Yes, it depends on which products we get in. We obviously have targets. We are looking at the success of Heron’s launch. If that becomes wildly successful, obviously we are going to have to build the capacity for that. And obviously the other stuff we have in the pipeline. But if all of that becomes commercial, this capacity expansion is in anticipation of success of our development programs.

Yes. I guess what I’m looking at is what revenue range would that take us to, just on the current increment to capacity?

We haven’t done the math. I don’t know.

Okay. Fair enough. We’ll stay tuned.

Thank you. Our next question comes from the line of Will Lauber from Sterling Capital Management. Your question please.

Hi.

Good morning. Hi, Will.

You guys had recently hired a new business development person. Is that correct?

Yes, yes.

Okay. What is – I know I think Greg had mentioned a while back that you guys have been, for a change, had been actually getting calls about license deals from interested companies. Is there any progress on that front? And then the new business development guy, kind of how is his time divided up between looking for acquisitions and potential licensing deals and other things?

Sure. So the name of our new hire is Peter Terone, and he’s been here since January. Peter has focused really on the natural food space. So when we bought – I just feel like we have a great opportunity for the future. We bought GreenLine four years ago now. And in those four years, we have focused on integrating our facilities with Apio’s Guadalupe facility. All the different plants are processing a multitude of different products. We have trucks going to every plant. We are doing one-stop with all our products to our customers. We have leveraged our customers, so our green bean customers are now buying vegetables, other vegetables, where our original Apio vegetables are also – customers are buying GreenLine. So we now have what I believe is a national infrastructure to service our customers, and it’s a refrigerated infrastructure. We have refrigerated warehousing at every location and we have our own fleet of refrigerated trucks. So, I look at that. And then you look at what our marketing team is doing. Our marketing and sales teams are out looking at consumer trends. And we are starting to identify wait a minute, look at all these healthy trends. We are having an amazing tailwind of consumers in the U.S. really starting to eat healthier, not just thinking about it, but actually acting upon it. And you can see the shift in the purchasing behaviors. And as we are studying trends, we are seeing other opportunities in other product areas. And I believe that with our – if we combine our infrastructure assets with our capabilities of innovation, that we can bring new products to market the produce area that leverage these capabilities. I would love to launch products outside of the produce area that do not have the volatility of the produce supply-chain and bring even higher gross margins to the table. So that’s the business that we’re focused on with Peter. He needs to define what those opportunities are. And we will be looking at both build and buy opportunities in bringing those to the table. And so that’s 100% of his focus. You mentioned our licensing technology. Just to finish on the natural foods, I mean we don’t see – this is going to take some effort. This isn’t something that’s going to come to fruition in fiscal year 2017, but we are hoping it comes to fruition very soon after that. But we need time to put a plan together and to execute that plan. On the licensing front, we do have more effort concentrated on licensing our BreatheWay technology specifically to other partners that use produce items that are not competitors of ours. So obviously most people know we already license our technology to Chiquita for the Chiquita To Go program with bananas. We license it to Windset on cucumbers and on peppers. And over the last couple of years, we’ve grown quite a pipeline of new partners that are interested in our technology, and we are in many R&D efforts with those. And we really started to focus on this more heavily over the last two years to build this pipeline. So these are typically longer-term projects, so as new deals come to fruition, we will definitely let you know.

And with your marketing plans, I know you probably were able to get some decent customer information from – I guess you had on the salad where you got one free, where you would send a coupon to the email addresses and stuff like that. Have you learned a lot more about your customer base for the salads from that?

We have. We’ve been doing some surveys in pack, very simple surveys, but we put them in our salads and just ask a few consumer questions and we gather data that way. We are getting a lot more interaction directly with consumers online and on our Facebook page. And we actually recently just completed a consumer segmentation study that we worked with an outside agency and with a lot of in-depth work to really start to target exactly who our consumer is and how our consumer is differentiated from that of our competitors. And so, again, just a couple of years ago, we had no focus on the consumer whatsoever. And as you can see by our SG&A numbers, we’ve added to our headcount in marketing over the last couple of years, and those teams now are really going to town learning more about the consumer, and as we learn about that, taking those insights to our product development strategies and our marketing strategies. And I think those are going to pay off.

I imagine it would be helpful when you get that information together to be taking it to your customers at grocery stores and saying this is who the customers are, and that might be useful to them as well.

You’ve got it. So that’s the story we are starting to build. And on that note, we actually just hired a new Chief Customer and Sales Officer for Apio. He is starting in May, and he will be helping us take the data that we’ve gathered from our marketing team and work with marketing to put it together in a story to take to our customers. So, you are right on target.

My last question is about Taylor Farms. I guess they’re the pretty much the low-cost person in the industry. And I’m just seeing a couple of different things where they might be starting to see some cost pressures, and I just want to get your take on that. I notice that I guess they were somewhat involved in the Costco E. coli issue, and then also seeing something recently, I guess their unions are trying to organize their labor and I guess they are a supplier to Chipotle, and they’ve had their own employees protesting against them in front of Chipotle. Do you see like any, maybe a more rational industry pricing environment going forward, or are you guys seeing any indication from Taylor Farms at all?

Not in the near future. Listen, none of us in the industry ever want to see anybody have a recall. First and foremost, we never want to see consumers get hurt or sick in any other way. So it’s very unfortunate what’s going on in that segment. Taylor Farms has a very different business model than us. They are much larger than we are, and they are a family business. They are not a public company. And they do very well at their business model, which is volume, high volume, low price. So, it’s very different. We’ve decided to go a completely different route, differentiate ourselves by innovating new products, higher margin products. With that increased profitability, we can invest it back into innovation and continue to build that model so that year-after-year, we can become more build those capabilities and each year build upon itself. As we deliver more gross margin, we can invest a little more, we can let a little bit of that drop to the bottom line and invest more in that innovation for the next year to grow further. And so we’re going in two – even though we are in the same market, we’re going in very different directions.

Have you seen any – have they gotten much into the salad kit business at all, or is there any pressure there?

Yes. They are in the salad kit business. They have a line of salad kits out there as well. And there is pressure there, although our price points are holding very well with our salad kits. We have not had any pressure with our price points. Consumers really value of our products, and they are willing to pay a price that both our customers and we can win.

All right. Thank you very much.

Thanks, Will.

Thank you. And I’m not showing any further questions in the queue at this time. I’d like to hand the program back for any further remarks.

I want to thank everyone for being with us today. Again, just to reiterate, moving forward, we know we have had some struggles with sourcing issues this year, but we have a very positive outlook on our future. We have three primary growth drivers that we are looking at for the future. The first is our salad kit business. We see that continuing to grow at double-digit rates. The second is Lifecore. Again, it has a multi-your strategy to also continue to grow at double-digit rates. And the third is what we talked about finally on the phone, is kind of an expansion into our more natural products and diversifying our product portfolio. More news on this to come. We are in very early stages, but we are excited about this initiative as well. So thank you for your interest in Landec.

Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day.