Lifecore Biomedical, Inc. (LFCR) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Landec Corporation Second Quarter Fiscal Year 2017 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.

Thanks, Jonathan. Good morning and thank you for joining Landec's second quarter of fiscal year 2017 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 2016. Our results in the second quarter and the first six months of fiscal 2017 demonstrate our progress and the transformation of our two operating businesses. The transformations taking place at both Apio and Lifecore are twofold. First, a clear focus on building internal innovation capabilities to drive a shift in our product mix to higher value items; and second, the expansion into adjacent high growth markets to ensure we are positioned for long-term sustainable growth. For the second quarter, our consolidated gross margin increased 160 basis points to 13.9% compared to the second quarter of fiscal 2016 and for the first six months consolidated gross margin increased 220 basis points to 14.9%. We are on our way to achieving our full fiscal year 2017 net income growth guidance of 50% to 70%. These improvements in consolidated gross margin along with operating income increase is up 16% in the second quarter and 30% for the first six months, generated net income and earnings per share results that were consistent with our guidance even though consolidated revenues in the second quarter and first six months of fiscal 2017 were lower than expected. Consolidated revenues declined 3% in both the second quarter and the first six months, primarily due to our strategic decision to reduce low margin business and our packaged fresh vegetables business beginning in the second half of fiscal 2016. The packaged fresh vegetable business revenues were also impacted by an unexpected much lower market growth for salad kits in the Canadian retail market than what we were projecting, which partially resulted from a recall of a competitor’s salad product in January of last year and also from Costco deciding to move to a multi-sourcing strategy for salad kits. It is interesting to note that the Costco decision to move to multi-sourcing of salad kits may provide new opportunities for Eat Smart salads in Costco in the future. Importantly, for the first six months of fiscal 2017, Lifecore is on track to achieve a record year. Lifecore revenues for the first six months of fiscal 2017 increased 27% to 24.3 million and operating income increased 46% to 4.7 million compared to the first six months of last year, due primarily to a favorable product mix resulting in an increased percentage of revenue derived from high margin fermentation sale. Lifecore’s growth has been fueled by a dramatic evolution in its business model from that of an HA supplier to a fully integrated Contract Development and Manufacturing Organization or CDMO. As a fully integrated CDMO, Lifecore offers expertise and capabilities in fermentation, specialty formulation, aseptic filling, and final packaging of both devices and drugs for hard-to-handle materials. Over the many years working with highly viscous HA products, Lifecore has developed innovative processes and handling techniques for these materials that are also used for an adjacent injectables market. These unique capabilities and Lifecore’s dedication to creating a culture of pharma elegance has broadened its appeal to a much wider customer base. The evolution of Lifecore to a fully integrated CDMO has expanded its markets, materials, products and services to go beyond the HA market. As such, revenues and operating income are expected to continue to grow on average at lower-double digits for the foreseeable future. Apio is also having a good year despite lower revenues compared to a year ago. At Apio, we have focused on transforming the business from a commodity business to a branded packaged fresh vegetable company differentiated in the market through innovation. Over the last several years, we have also expanded our business from the traditional core vegetable bags and trays to the adjacent, high growth, more profitable salad kit segment, thereby increasing our size of the market in which we compete from 1.3 billion to 3.2 billion. At Apio, overall, even with revenues down 5%, gross margin was up 200 basis points, gross profit was up 13%, and operating profit was up 9%, a considerable improvement during the first six months of fiscal year 2017 compared to the same period last year, reflecting the continuing shift in product mix to innovative higher margin products, normal raw material sourcing conditions, and increasing operating efficiency. We’ve positioned both of our businesses to benefit from the favorable market trends driven by people making choices to live healthier lives. Apio delivered packaged fresh vegetable products that makes it convenient and delicious to eat healthy. Lifecore helps to bring FDA approved drugs and medical devices to market that enhance the ability to stay active. We will continue to differentiate ourselves through innovation and build an internal -- build our internal innovation capabilities within our branded food products and biomaterials businesses to deliver new products the consumers and customer value. Before I go into more details on our progress and plans for the rest of fiscal 2017 and our strategic objectives over the next three to five years, let me turn the call over to Greg for some financial highlights.

Thank you Molly and good morning everyone. Revenues in the second quarter of fiscal 2017 decreased 3% to 135.9 million from 140.4 million in the year ago quarter. The decrease was primarily due to a 9% decrease in revenues in Apio’s packaged fresh vegetables business, partially offset by a 16% increase in revenues at Lifecore, and a 16% increase in Apio’s export business. Net income in the second quarter of fiscal 2017 was 1.3 million or $0.05 per share compared to 1.9 million or $0.07 per share in the year ago quarter. Net income was negatively impacted by a one-time, non-recurring $1.2 million write-off of unamortized debt issuance cost, $1 million of which was non-cash from the refinancing of Landec’s debt during the quarter. Excluding this one-time expense, our earnings per share for the quarter would have been $0.08 per share or $0.01 higher than the second quarter of last year. In addition to the $1.2 million write-off, net income for the quarter was also reduced by a $1.2 million increase in operating expenses, primarily at Apio resulting from additional headcount hired during the past year in areas of sales and financial analysis and from no change in the fair market value of our Windset investment during the quarter compared to a $200,000 increase during the second quarter of last year. These decreases in net income were partially offset by first, a $2 million or 20% increase in gross profit in Apio’s packaged fresh vegetables business due to a favorable product mix shift to a higher percentage of revenues derived from salad kit sales and from favorable operating cost variances, specifically of lower produced sourcing costs and improved labor efficiencies in the company’s processing plants, and second from a $376,000 decrease in income taxes. Revenues in the first six months of fiscal 2017 decreased 3% to 268.3 million from 275.8 million in the same period last year. The decrease was primarily due to an 8% decrease in revenues and obvious packaged fresh vegetables business partially offset by a 27% increase in revenues in Lifecore and a 10% increase in Apio’s exports business. Net income in the first six months of fiscal 2017 was 4.6 million or $0.17 per share compared to 4.8 million or $0.18 per share in the first six months of fiscal 2016. The decrease in net income was due to, first, a $2.9 million increase in operating expenses primarily from headcount added during the last 12 months. Second, a $1.2 million write-off of unamortized debt issuance cost from the refinancing of debt during the second quarter. Third, a $290,000 decrease in operating income at Corporate due to the completion of the 15 month licensing agreement during the first quarter of fiscal 2017. And fourth, no increase in the fair market value or the company's Windset investment during the first six months of fiscal 2017 compared to $1 million increase in the first six months of last fiscal year. These decreases in net income during the first six months of fiscal 2017 were partially offset by 2 million or 24% increase in gross profit at Lifecore from increased revenues and from a 3.2 million or 14% increase in gross profits in Apio’s packaged fresh vegetable business due to a favorable product mix, favorable sourcing cost and operational productivity improvement initiatives during the first six months of fiscal 2017. Turning to our financial position, at the end of the second quarter of fiscal 2017 cash totaled 2.6 million after generating 5.5 million in cash flow from operations paying off $6.7 million of debt and investing 4.7 million in property and equipment primarily for capacity expansion during the quarter. At November 27, 2016 we had $98.5 million available to borrow under our line of credit. I'll turn the call back over to Molly.

Thanks Greg. We have made and will continue to make appropriate and timely investments in both Apio and Lifecore to expand our higher margin product portfolios during the innovations in the coming years. Over the last five years we have invested in new products and capacity regard the foundation for our current and future growth. We have doubled our profits and capacity at Apio and tripled our aseptic filling capacity at Lifecore to meet existing product demand and in anticipation of growing demand of our products, or simultaneously investing in product development at both Apio and Lifecore. Lifecore's demand and capacity have expanded dramatically over the past six years from manufacturing 1 million syringes per year to 3.5 million syringes per year today with a projection of increasing to 7 million syringes per year over the next three years and within the next 18 months Lifecore will be adding significant vial filling capacity to prepare for potential new products and its product development pipeline. Lifecore continues to be the preferred visco elastic supplier to global ophthalmic market leaders while now as a fully integrated CDMO broadening its services to grow beyond the HA market. As such revenues and operating income are expected to continue to grow on average at lower double digits for the foreseeable future. In October 2016 we announced that Lifecore will be initiating a targeted investment of up to $70 million to expand its vial configurations for aseptic fill and finished products providing Lifecore with the manufacturing capacity to deliver the anticipated growth in its long-term plan. This capital investment is specifically designed to align Lifecore's capability with the market expectations of our current and prospective customers. As mentioned in the October press release, 5 million in capital has been approved for this project with up to 12 million in additional capital expenditures to be approved contingent upon meeting specific milestones and ROIC or Return On Invested Capital targets. In addition to the tailwinds on positive healthy living trends Lifecore is also benefiting from a growing trend among both mature and startup pharmaceuticals and other medical material companies to outsource specialty services and manufacturing. With the growing number of products in the industry seeking FDA approval Lifecore is well positioned as a fully integrated CDMO to augment its pipeline with new projects to fuel its long-term growth. In our Apio business, we are benefiting from the continued shift among consumers to healthier eating as the categories in which we participate continue to grow. Our products are on trend and we are investing capital and adding resources to develop new products that continue to meet the needs of today's consumers. We are committed to deepening our innovation capabilities to ensure continued growth in this business. We project that the Eat Smart salad business will resume growing in a second half of 2017 and continue through 2018 servicing as a growth platform for several years thereafter as we continue to launch innovative new salads and penetrate the key retails in the U.S. Apio Eats Smart salad kits are highly penetrated in U.S. Club stores, Canadian Club stores, and in Canadian retail stores. We will continue to grow within these accounts as we deliver more innovative products to them. However, penetrating key U.S. accounts in the grocery and mass channels provides the most significant growth opportunity. Most recently we have seen significant year-over-year salad kit growth in both Sam’s Club and Walmart. Sam’s Club has expanded distribution of Sweet Kale salad to all club stores, increased promotional spend to drive sales of this item and recently tested the new Eat Smart Strawberry Harvest salad. Due to the positive consumer acceptance of the Strawberry Harvest salad, Sam's will be expanding this salad to all stores beginning this week. During our previous earnings release call we shared that the Walmart tests our Sweet Kale salad in 400 stores starting in May 2016. Due to its high performance, Walmart expanded distribution of this salad to 1,400 stores in October. Our next opportunity to expand in Walmart will be during their next store reset in April of 2017. To further differentiate Apio, we have invested in new more robust market data analytics platforms. Apio completed the transition from Nielsen Perishables Fresh facts data to the Nielsen Answers data platform last month which will significantly improve the insights we gathered to manage and drive innovation as well as pricing, promotional and merchandizing decisions with our customers. Nielsen Answers provide many advantageous over the previous system. Data is collected from approximately twice the number of stores. We also now have access to store specific product, pricing and promotional data and can breakdown the data among different banners, geographies and stores to enable Apio to build more effective pricing and promotional strategy. Importantly, we've also added Nielsen Homescan Panel which provides consumer scan data and shopper insights for all stores, including Costco. We've already started to share strategic trend and innovation data with certain key customers. Our goal is to share shopper insight data and product analytics with those strategic customers who choose Apio as their innovation partner to drive growth and profitability for both parties. Using our new database for the 52 weeks ending October 29, 2016, Apio's market share in North America in club and retail stores for packaged fresh vegetables was 17%. For the same time period Apio's North American market share for salad kits in club and retail stores was 13%. In the retail market only for salad kits Apio's salad kit has 44% market share in Canadian retail and a 3% market share in U.S. retail, highlighting our potential growth opportunity in the U.S. In U.S. retail, Eat Smart salad kit ACV is approximately 17% while in Canadian retail ACV for Eat Smart salad kits is 84%. Moving forward we're focused on three primary growth platforms. First, our Lifecore Biomedical business is growing at double-digit rate with new syringe filling capacity coming online over the next several months and vial filling capacity within the next 18 months. Both of which will be needed in the future to meet the demand we expect from our deep pipeline of development programs along with continuing growth from our existing business. Second, our Eat Smart salad products are on trend with the fast growing healthy living space and we expect this product segment in Apio to resume growth again beginning in fiscal 2018. Third, we're exploring new ways to leverage the national refrigerated infrastructure network at Apio to bring new healthy food products to market in the future. Landec's top priorities for the next 12 to 24 months are, number one, continuing to innovate new products at Apio to shift our product mix to higher margin products. Number two, expanding distribution of Apio's Eat Smart salads in retail by gaining new U.S. customers and broadening our offering within existing U.S. and Canadian customers in order to build the additional capacity recently added in Hanover, Pennsylvania. Three, evaluating new food products out of produce that Apio can offer through new product development and/or strategic acquisitions through its refrigerated supply chain. Four, executing on our Lifecore programs with existing customers and securing new partnerships utilizing our CDMO strategy supported by the new capacity at Lifecore. Five, increasing the return on invested capital by maximizing returns on each capital allocation decision. And six, supporting Windset and its expansion plans to build new hydroponic controlled atmosphere structures using new growing methods for new crops. In summary, our focus is on developing innovative products at Apio and Lifecore to deliver value to our customers, consumers, and our shareholders. We are now open for questions.

Certainly. [Operator Instructions] Our first question comes from the line of Mitch Pinheiro from Wunderlich Securities, your question please.

So couple of questions, just two questions first, let’s start with Lifecore. Of the growth at Lifecore in this quarter, what -- how would you break that down between the core HA business and new business -- non-HA business? And how is that [Multiple Speakers] I’m sorry.

Sorry. Go ahead Mitch.

I was just saying then -- and then how would you look at, as you look at your double-digit, low-double digit growth forecast going out, how does that breakdown as well?

Well as you recall, last year, the non-HA portion was about 25% of Lifecore’s revenues. This year that percentage, just as a result of the business development work that was done last year and the fact that some -- it is transitioning from business development to commercialization, it is expected to decrease some. It should be somewhere in the 15% in total for the year, which is pretty close to what it was for the first six months of the year. One of the major drivers in the first half of growth was really from existing customers and existing business, specifically our fermentation revenues, which are some of the highest margins, revenues that we have in the company. And so that was a main contribute to their growth in the first half of the year.

Okay. So our --.

So going forward, we do see a lot of the growth in future years, you mentioned the double-digit growth going forward, it’s going to be in our non-HA area as we start to commercialize those opportunities that are in product development and as the one we just recently commercialized growth.

Okay. So of the Lifecore double-digit growth, say 10%, you expect 8%-ish to be coming from core HA and 2% coming from new business? Is that --?

I’d say, let me give you some ranges, we haven’t finished our -- we’re going -- we haven’t given guidance obviously for next year. But I can give you some broad ranges. Let’s say 5% to 8% of growth from HA business and then to get to the double-digits, it’s another 5% to 8% on top of that with non-HA business.

Okay. And in terms of that syringe capacity you had mentioned, the 1 million going to 3.5 million to 7 million, where are you now with capacity? Do you have 7 million syringe capacity now and it’s just a matter of filling it?

Yes. And if -- we would have that add maybe one more to get -- fully one more line to get fully to 7, but we have the facility room to do that.

Okay. And then back to Apio. When you look at sort of the -- on the salad kits in particular having sort of a flattish year. How does that breakdown, is that all Costco, the loss of that piece of the Costco business. I mean, if your U.S. business was growing 42% ex-Costco, I know it’s smaller than Canada. And I know Canada, I don’t know if you said specifically, but Canada was up at least in the mid-single digit somewhere, not as high as you expected but still up, that means Costco was the entire hit in the quarter and in the upcoming quarter. Is that correct?

You are correct. So, let me step back and give some perspective on this, I think a lot of people are going to have questions on this. So when we gave our guidance this year, we were well aware that Costco Canada was going to a dual sourcing strategy and so we did lose some business in Costco. They basically gave their smallest DC, one of their four DCs and their smallest one to another player for their Sweet Kale Salad to do dual sourcing. So that took us backwards in club. But in our guidance, we assumed very high growth rates in retail that would not only overcome that backwards momentum in club but actually still get us the double-digit growth in salad kits. What happened since then and after we’ve given guidance is that Costco U.S. also decided to give up more business. We did not, we won’t say this is a surprise, we did not see this coming, the U.S. already was dual sourced with a DC in the northeast carrying Taylor Farms Sweet Kale Salad, so we do not see another move coming, but they did give some of the business in Texas and Arizona to a third supplier. They have assured us over and over again that they will not take away any more of our business, but felt that just from a diversity of supply that it was a corporate mandate on their -- it's basically their highest selling item and the most profitable item to diversify in this area. So that took us back further and that’s why our guidance on the salad kits has changed this year. That being said, we’re still growing considerably in U.S. retail and to a smaller fashion in Canada, but it’s not enough to overcome -- it’s enough to just overcome that Costco loss. Does that help, it’s a long answer.

Yes, it does. It does. [Multiple Speakers]. But now, are they -- how has Costco -- is this a Kirkland-branded product?

No, this is all -- they don’t brand anything Kirkland in produce, [Multiple Speakers].

Okay, so the Sweet Kale Salad now in Texas and Arizona becomes -- it is not Eat Smart anymore, right? It would be whoever the supplier is?

That’s right.

So in a way, your recipe [Multiple Speakers] -- but it is the same basic -- has the same ingredients, same kind of salad dressing, et cetera?

Yeah, it does.

That doesn’t -- that’s some help --.

I will say there sales -- I will say I know that their sales have gone down since this transition and they’re not happy about that which is one reason they have assured us they won’t takeaway anymore.

And you also alluded to the fact that somehow second sourcing could help you. Can you talk about that a little more what you mean by that?

Yeah, so with this mandate with Costco, they are basically saying on any very successful product we’re going to make sure that we have multiple suppliers to protect ourselves just from the volatility in produce. We were hit the hardest this round for obvious reasons because we have the highest selling salad kit. But there's other products and other salad kits and they've been adding slots as they call them in Costco to increase the number of salad kits that they have. So what this means if there is another successful product that goes in we can actually get a share of someone else's product. And we'll see how that shakes out in the future. So it goes both ways right, we may lose some business, but other business may come to us, we're just the first ones to get it.

It just sounds like, in terms of second sourcing -- supply sourcing strategy by Costco, it is a little convoluted and circular, but -- because I don't -- there is not new suppliers. So everybody is just backing up the other one, so it is an interesting strategy. And I guess just the final part of that is, did Costco at all affect gross margin? I know your gross margin expanded at Apio. Would it have expanded more or less excluding the impact of Costco?

It would have expanded more, because our salad kit product -- if our salad kit business overall is the most profitable business so losing any salad business will affect our gross margins.

Okay, thanks for the questions. I will pass it on.

Thank you, our next question comes from the line of Tony Brenner from Roth Capital Partners, your question please.

I will stick on Apio for a moment. Of the 42% increase in the US, excluding Costco, how much of that did Walmart and Sam's Club account for?

Most of that. Most of that number Tony. [Multiple Speakers] They don't talk about distribution increase. Yes, sure, so Sam's I think we mentioned had year-over-year, last year they started to expand distribution on the Sweet Kale Salad, so that year-over-year -- by the end of last year we had full distribution so we're seeing some growth, some pretty big growth from Sam’s on a year over year basis. In addition they’ve been heavily promoting the item. They've really found that promoting -- believe this or not, promoting just our Sweet Kale Salad not only increases the sales of that product, but actually elevates the entire produce department. So they've been promoting and demoing, demoing meaning they taste it in store, the Sweet Kale Salad on a pretty regular basis which is really driving awareness of our product and our sales. Because of the success of that they've been partnering with us more closely on innovation and tried another salad, and remember they are a club formats, so they don't have as many facings as retail would, but they decided to open up another slot. They tested our Strawberry Harvest which I believe we said we launched last quarter, it did extremely well and so starting this week they're expanding that to all doors. So this growth in Sam's is helping to overcome some of the backward movement we saw in Costco. And then on the Walmart front we started with the 400 doors, we went to 1,400 just in October and one thing I can say about that is the data so far is looking promising. We're in discussions with them and their next reset is not till April, so I won't have any news until then.

Okay. Can you talk about other new prospective accounts that [Multiple Speakers] --.

We've had some other distribution of new products into some regional players in the U.S., but they're just not as the magnitude of those -- as high as the magnitude of those two accounts.

Okay. Sticking on salad kits, can you break down Canada versus the U.S. in terms of those revenues?

Well, we typically don't disclose our revenues by geography, but what I can do is give you a little sense of market size. So, if you step back the salad kit market in North America including club and retails is $1.6 billion that comes from the Nielsen. If you look at the club business meaning primarily Costco, the total potential there is about 250 million, let's call it 200 million, Canadian retail is also about 200 million. So, U.S. retail is $1.2 billion of the overall $1.6 billion market.

I am sorry, US retail [Multiple Speakers]. U.S. retail is what?

U.S. by market share.

U.S. retail?

U.S. retail 1.2 billion of the 1.6 billion. And when we say we're focused so we have very high penetration in both Canadian retail and Costco, but if you look at the market size by those channels, right. The big opportunity is really in U.S. retail and we have an extremely small share right now about 3% prior to this Walmart expansion and so that's where -- obviously our focus is on maintaining and growing our Canadian retail business and our Costco business, but we're also focused on penetrating U.S. retail.

Got it. And my last question, Lifecore's margins for the six months were up sharply, but they were down fairly sharply in the second quarter. I know that some products ship sporadically. Is that what happened in the second quarter and what kind of forward impact is that going to have?

Yes, Tony, it's purely a timing issue in a shift. As you know, third quarter is Lifecore’s biggest quarter of the year. It’s when they have the majority of their fermentations sale shipments for the year. And as far as the first and second, they actually had a rather large shipment shipped from the second to the first which had a pretty dramatic impact on margins, so it's purely timing.

Thank you. Your next question comes from the line of Zack Ajzenman from Griffin Securities. Your question please.

First question on salad kits and new salad kits, introductions for new salad kits. Can you give us a little more handle on timing and what to expect because it really sounds like it could certainly help either, A, take market share in some of these increased slot opportunities in club and retail and, B, just help with overall penetration in the salad kit market?

Definitely, so last year -- at the end of last year we discussed that we'd launch two new salad kits, it was the Asian Sesame Salad and the Southwest salad. This year in the first quarter we launched the Strawberry Harvest and we're just launching another new kit called Sunflower Kale, it has like a Dijon dressing. So, I want to step back and kind of talk about -- use this opportunity to talk about our sales force. So, we've talked about we need to go into the major U.S. accounts. I want to emphasize the major transformation that we've been go through at Apio and I said in the opening remarks that we're really shifting the company and transforming it from a commodity company to a true innovation company. And to do that we started in marketing and product development and really started to create these internal innovation capabilities. What we also have found is we had to do the same kind of transformation in our sales force and we did not have the capabilities in our sales force at the time to really get into the highly competitive and sophisticated key U.S. accounts. Who are holding multi-year contracts with some of our competitors and to do that it is a much more sophisticated sell with analytics and you have to show constant innovation. And so it was in about May of last year that we hired our new Chief Customer and Sales Officer, we did not do it prior to that because if he would have come in and make some big sales, we didn't have the capacity. We had to expand Hanover first. So, in order we made sure that we were expanding the capacity our salad business in Hanover, then we hired a new Head of Sales who since May has been transforming the sales organization and both people capabilities and systems. And this is just going to take some time, but immediately they were able to get into Walmart, make the sale, make this market test happen, we are in active discussions with Kroger, and that’s what we're going through right now. So, if you pair the innovation capabilities we've been bringing -- we've been bringing to the table and we have a very nice pipeline of new products that are really set up for the next several years and now you pair that with the sales force who is able to enter those key accounts with the analytics, the vision of been a differentiated innovation player in a three year product development pipeline that we can put in front of these large customers, that sets us up for future growth. At the same time that's going to take time, because it takes time to displace competitors and it takes time to build these relationships and get new systems in place, but the momentum that's happening right now with our sales force is very promising.

Got it. Thanks for the extra color. Moving over to Canada, it sounds like the whole salad kit market had a really difficult year in 2016. But why is it that it really seems to only affect your results in the most recent quarter?

We have been studying the Canadian retail market very closely and really just trying to figure it out. So I see two things that have happened, one, is the competitive recall that happened last January. There's a dramatic decline in growth rate right up to that recall and we haven’t completely recovered from that, even though it’s a while ago. And typically we see recoveries much faster. So there is a little speculation, but we’re talking to our buyers in Canada, they believe there is a lot of macroeconomic issues going on as well with unemployment, the oil industry and the exchange rate. That their sales, the overall store sales and higher premium items are down right now. So I think there is a couple of different things going on and with the total recall, it really made a bigger difference. So that being said. Why haven’t we seen it earlier? I think we were still expanding a lot of different distribution in the first half of the year, we were still gaining grounds with new products and seeing sales from just filling shelves versus higher velocity from consumers. That’s the insight I have as far as we continue to kind of study that market in the macroeconomics of what’s happening.

Thanks. That’s all for me.

Thank you. Our next question comes from the line of Anthony Vendetti from Maxim Group. Your question please.

Just to follow up more on the Costco situation, so in fiscal 2016 Costco was about 20% of revenues, and now that there is three sources in the U.S., are you getting more than one-third of that business? It sounds like you are. And right now, based on what you are seeing in terms of the run rate, is Costco going to be 15% or so of revenues unless that situation changes in terms of the number of sources they are using?

Right. So that’s a great question. The Costco sort of being about 20% because of the recent moves it’s down to about 17% of our business. This is a double edged sword right, because obviously we never want to lose business at Costco and they are a very strong part of ours, but we have been highly dependent on Costco and with our growth and retail, I think diversifying our customer base over the long-term will be positive for the overall company. So that’s how I see it playing out, again I’d rather not lose that business and we’re going to continue to work with Costco to strength our business with them. But that’s -- I think it’s going to drop to about 20% to 17%.

Okay. And Molly just on the --

We do have over -- and we do two other. We do over a third of the business. We still have way more than the majority in Canada, in the Costco Canada business and more than a third in the U.S.

Okay, so you're still the primary for both of those. And I guess the opportunity that you're talking about is to grow that, one is Costco could decide maybe they don't need three sources everywhere. But also with the rollout of your new salad kits, that's another way for you to grow the market share within Costco, even if they keep three sources in certain locations, correct?

That’s right. We put items in front of them over time. They have a salad rotation program and we’re always trying to make sure were one of the number one suppliers in that program. So this opportunity for more slot. That being said, they only have a few slots, it’s not like retail where you could get up to 10 facing one day. So as I’ve mentioned earlier, the market size, the total potential of Costco if you look at U.S. and Canada is a fixed amount and is much smaller than the overall market opportunity what you see in U.S. retail, by tenfold.

Just to understand how the market declined, the market opportunity for -- in Canada due to a competitor's product recall, is it because -- it wasn't an opportunity for you to gain more share, it was just there was less demand for those products because of the recall across all products, because people weren't able to -- consumers weren't able to differentiate what product. They just knew that salad kits were recalled and so they purchased less? Is that why it declined?

Two things, yes, so first of all we’re never happy when there is a recall anywhere in the industry. It’s not good for anyone, so we never want to see obviously ourselves or a competitor have a recall because it does in fact affect the entire category for a time. Usually that time is months, this one seems in Canada to be taken a little longer, but that being said this competitor had a pretty large market share. So I think it had a bigger effect on the market, there is a question earlier that said why was our shares still growing in the first part of the year and I think we did takeover some of that space from the competitor in the first half of the year and that’s why we did some distribution gains there. But now that’s kind of evened out, taking over the new distribution space and just the category overall is not turning as quickly. Again, still a mid-single digit growth, so this isn’t like a declining segment, but we are seeing not the high growth rates and it’s a 30s and 40s that we are seeing a little over a year ago.

Understood, understood. And just to quantify the Walmart opportunity, I assume, because Walmart has put such pressure on their suppliers, that it is not as high-margin business as other vendors maybe would be, but the salad kits are high margin for you guys in general. But what is the opportunity within Walmart? I know it comes up in April 2017. Is it possible at that point to decide to expand to all their stores or it is more likely an incremental step again before a potential national expansion?

Well obviously with our new sales force, we’re extremely bullish, so we’re letting them know that it should go to all stores. So that’s definitely the goal in what we hope is the next step. As far as the scale of opportunity, I think in the last earnings call instead of kind of being specific about that side of the business, if we were to get Sweet Kale Salad that one SKU in all doors of Walmart for a year, that would be a $5 million to $7 million business. So it wouldn’t be 5 million to 7 million year-over-year because we had some this year. But a total of 5 million to 7 million for that one SKU. Now, what I don’t want people to do is say, if you get more SKUs just double and triple that because Sweet Kale Salad velocity is so high, right that having that in all doors is much greater revenue potential than having any other SKU in all doors. As a matter of fact, the Sweet Kale Salad right now is the number one velocity SKU of all salad kits in North America retail. That’s an amazing feat, okay. So we can’t say over 5 to 7 for Sweet Kale Salad if we’d ever give one more SKU, you double that. But that being said, it kind of gives you a feel for the scale of the business.

Sure, makes sense, makes sense, okay great thank you.

Thank you, [Operator Instructions] Our next question comes from the line of Brent Rines from Teltal.

Just a couple quick questions to follow up on a few of the other things. Can you give us proportionately a sense of how big the Sweet Kale Salads are as a percent overall of your salad kit sales?

No, we don't give out by product, just like we don't give out customers, except for our largest customer, we typically don't give out financials by product or by customer.

All right, so maybe a different way of asking, how do you guys feel about Sweet Kale Salad? I know right now it sounds like you feel very bullish. I was looking at some stuff that came out of Rabobank, their end-of-year summary of some of their surprising thoughts and trends from people in the consumer packaged food business, the products business, and other areas, retailers. And one of the themes was people were surprised by how quickly the Sweet Kale Salad market was matured. Are you sensing that market has matured? Not your share, but the market itself?

Well I guess you can say it's maturing as we're seeing slowing growth rate in Canada. I'm hoping that the U.S. retail growth rate still stays very robust for quite some times in the double-digits. Sweet Kale Salad specifically is interesting because you know you look at different products lifecycles and every product has a lifecycle, right so some might really hit it big and be on trend and be more of a niche and be big for two years and then fade away. Sweet Kale Salad has had an unbelievably long, it’s been out four years and it’s still growing in distribution tremendously and we're still seeing velocity increase. So I think you know the way I view Sweet Kale Salad is it’s becoming more of a staple. Like a Caesar Salad is or a Garden Blend Salad is, it's becoming more of a staple for people and then using it not just as a salad, but as an ingredient in a lot of different ways to fix vegetables whether it's in smoothies or stir fries, et cetera. So what I'm hoping is that it continues to mature. We have a lot of distribution gains that we can get into U.S. with this product and as awareness and household penetration grows we'll continue to see this grow. Our mind will always be you know, I'm always optimistically cautious, we also have to keep our eye on you know the lifecycle of this and make sure we're coming out with new products to follow behind it, because it -- to make sure we have the next big thing. I got to tell you our Strawberry Harvest Salad is doing extremely well, returns are very promising and we're looking to see that follow behind the Sweet Kale Salad is another high seller.

And I would imagine even if it is maturing, you are, if not the largest, one of the largest players. There would be substantial opportunity to consolidate even in a slower growth environment, right?

I'm not sure I understand that question.

So if they [indiscernible] growth in the category for Kale product is starting to slow considerably, you would still have opportunity to take market share as just one of leading participants, to squeeze out -- and I am sure there's a lot of people who tried to jump into the category and don't have the scale of business that you have.

Okay, I see your point. Yes, so, the point is, if the overall category growth is slowing, we instead of getting an extra slot which we did with Sweet Kale Salad, it was a new innovative item, a lot of people put it in right away because they found another place and expanded the category space. If category starts to grow, we're going to have to go after share. But I can't think of a better story to go after shares and with the highest velocity items and we're going to make through the most revenue and profits of any other SKU on that shelf, and so that's what we'll have to do, we'll have to take share from another salad kits.

And then, I have two final questions. One is just a simple one. I missed what you said, the new product coming out this quarter is. I knew you said it was something and Kale and I didn't hear what the first part was.

It's called the Sunflower Kale. It's actually a very similar to the Sweet Kale salad in the vegetable blend. Vegetable blend is similar to Sweet Kale salad, I believe it doesn't have the brussel sprouts, and it has a very popular Dijon mustard dressing. One of the other high selling SKUs in the category is a mustard Dijon type of salad and so we came out with our own version of that capitalizing on the favorability of the Sweet Kale Salad vegetable blend, but kind of shifted -- combining it with a very popular dressing flavor that we've seen in the market right now.

Thank you. My final question, then, is just on Costco. If you look at Costco outside of the regions where the second source was added, will the rest of Costco U.S. grow? And you may have said this, I apologize if you did.

Well, I don't think I have that number. I didn’t say what our Costco U.S. specific growth is outside of those and same stores sales for Sweet Kale Salad. I don't -- I actually don't have that number available.

Thank you. Our next question comes from the line of Chris Cooper from Lake Street Capital. Your question please.

One more question on Costco and their multi-sourcing strategy. Do you have an advantage with your BreatheWay membrane with those products or is Costco's product turnover so quick it doesn't matter?

I believe we have a definite advantage with our BreatheWay membrane. We do use our BreatheWay membrane on that club size bag of Sweet Kale Salad. I think it creates better quality and less shrink, and I think it's going to show in the velocity numbers as they have other competitors in there and I think they're going to see that ours continues to sell at a higher rate and they have less shrink. Time will tell with the new suppliers that they've added, but I believe it is a competitive advantage, yes.

Okay, good. Now I think you indicated that your vegetable sourcing is much better this year during the tough winter time than it was a year ago. I think last year you even had to reduce guidance in December because of that issue. Would you say it is back to normal or just -- it has just improved from last year?

I think its back to normal and it's been a good sourcing year for us. It's nice that during these calls we're not spending all the time on sourcing, right. It's been a nice positive topic for us this year.

Okay. The new efforts to expand into other food products using your refrigerated platform, do you have a time frame in mind for when that will happen?

It's definitely not this fiscal year, but we're starting -- we're more than starting, we’re looking at different product segments and really starting to focus resources on specific projects. So, I’d gear up for end of next fiscal year into the next -- end of fiscal year '18, fiscal year '19 timeframe, is when you'd start seeing some things come from that initiative, some benefits.

All right. Then my last question is on Lifecore. I know you indicated in your press release that there is lower business development revenue as the FDA approved a drug product, moving a customer from development to commercial production. Is that simply a time frame where there is a lag before you start getting more revenue from the development -- or commercialization phase?

Right, so they're in startup phase right now, it's a startup and they're selling and they're commercializing and they're ramping. So, yes, I think there's going to be a little bit of a lag as we see how the product does in the market. In the development piece on that project, we're pretty substantial. So, they outsourced a lot of their development -- so, but we do see the commercialization ramping up over the next several years.

Thank you. Our next question comes from the line of Colin Radke of Wedbush Securities. Your question please.

Just on the salad kits, so the revenue guidance doesn't imply much of a rebound in the second half, and I appreciate everything that is going on with Costco, but at the same time you mentioned you expect a rebound in the salad kit market in Canada. You also have another slot at Sam's. Just wondering why there wouldn't be more of an improved growth trajectory for the second half.

I think what we're seeing a lot is just a timing issue here. So, first of all Costco is a big part of our business. So, you have to appreciate that we -- going back with our Costco Sweet Kale Salad business and staying flat is a pretty dramatic increase in our retail business. The other is just timing and when we can get -- like for Walmart's growth, we're not going to see that, if we grow to another spot it won't till April. And with the single-digit growth in Canada right now, again, its growth but it's -- we have a lot to make up with the Costco loss. So, we just see it more flat through the rest of the year and then as we get these distribution gains we see it kind of kicking in again in fiscal year '18.

Okay, and so on Windset, what is the increase that’s included in guidance for this year? I know you said it wasn't substantial, but any way you are able to put some numbers around that or a little more granularity?

We can't get into specifics now but we see as we transition to the fact that we'll be looking back, we've now got their budget for next year, so we pretty much know what they anticipate. So think something in 0.5 million range for the third quarter maybe slightly higher in the fourth. [Multiple Speakers].

Got it, okay. And just on the OpEx, in terms of the investments in the sales force and everything, I think you had talked previously about a 20% increase in the consolidated operating expenses. It looks like you are trending well below that year-to-date. So just wondering, there would have to be a pretty substantial increase in the second half. Just wanted to confirm that is still the case and still what you are expecting.

Well, I think in the first half, knowing what was going on in some of other areas, we made some conscious decisions to not initiate sort of the projects to delay some things. But in the second half in order to be ready for the growth we anticipate in FY18, we’re going to have to start spend some of that money. So I am thinking that 20% increase that we talked for the whole year, we will realize in the last six months compared to the prior year six months. So expect the operating expense to pick up in the second half of the year.

Okay. That’s it for me. Thank you very much.

Thank you. [Operator Instructions]. And this does conclude the question-and-answer session of today’s program. I’d like to hand the program back to management for any further remarks.

Thanks Jonathan. Just want to thank everyone for joining us again. Again, at Landec, we are focused on running a very efficient business and focusing on our three core growth platforms. That our Lifecore business, which is continuing to grow at double-digits, our salad business and we are going to be expanding other food products over the next several years to leverage our Apio infrastructure. And that’s all we have Jonathan. Thanks so much.

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