United Natural Foods, Inc. (UNFI) Q2 2009 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to United Natural Foods' Second Quarter 2009 Conference Call. During today's presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator Instructions). This conference is being recorded today Tuesday, February 24, 2009. I'd now like to turn the conference over to Scott Eckstein from Financial Relations Board; please go ahead.

Thank you, operator. And good morning everyone. By now you should have all received a copy of this morning's press release. If anyone still needs a copy, please contact Joe Calabrese in our New York office at 212-827-3772 and we'll send you a copy immediately following this morning's conference call. With us this morning from management is Steve Spinner, President and Chief Executive Officer; and Mark Shamber, Chief Financial Officer. We'll begin this morning with opening comments from management and then we will open the line for questions. As a reminder, this call is also being webcast today and can be accessed over the internet at www.unfi.com. Before we begin, as usual, we would like to remind everyone about the cautionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on this morning's conference call. With that, I'd like to turn the call over to Steve Spinner. Steve, please go ahead.

Thank you, Scott. And good morning everybody and thanks for joining us this morning. What an interesting, exciting and challenging environment? While I feel good about UNFI's performance in the quarter and year-to-date, uncertainty remains regarding many of the key drivers that affect our operations. Fuel, sales growth, product cost and inventory are all areas, that just eighteen months ago were quite predictable. But despite this uncertainty, I am very pleased with our quarter earnings of $0.32 per share, reflecting a 52% increase in earnings for the quarter. And sales adjusted for Specialty grew 4.5%. While strong relative to the current conditions, sales have fallen off very dramatically since late October. When we are looking through the details of our sales, there are expected changes in product movement. Our pasta, yoghurt, bulk, breads, baked (ph), snacks, less expensive cakes has had strong growth, while household, pet food and bottled water fell off most significantly, reflecting changes in consumer mindset towards less expensive alternatives. And during the last three months, we've worked hard to look at economic conditions facing our industry and have taken steps to convert these challenges into opportunities. And this morning we'll talk about some of these steps in details. Rest assured, we believe that given UNFI's leadership position in the Natural, Organic and Specialty channels, there is considerable growth potential over the next several years, despite the current industry malaise. Now let's talk a little bit about free cash and working capital. When I came on board I made a commitment to improve our working capital and during the quarter we created $42.2 million in positive free cash-flow and improved our liquidity by $9.5 million. And this was achieved by managing capital expenditures and inventory, while carefully taking action to control expenses. Historically, our company has managed inventory quite successfully, while delivering extremely high levels of service to our customers. Our intention is hold our suppliers more accountable to service level without relying on UNFI to carry long inventory positions. And during the next year, we'll be meeting with suppliers and begin the long but mutually beneficial process of renegotiating how we do business together. Throughout the last quarter, we managed our service levels and our inventory quite effectively. From a CapEx perspective, UNFI will continue to invest in projects that deliver reasonable rate of return for the company. And this includes construction of a Texas facility and IT projects that will unite the company overtime towards a common set of information systems and infrastructure. UNFI Specialty Distribution continues to progress. In the quarter we experienced about a penny per share of dilution compared with $0.08 per share in the prior year period. And this represents a significant improvement and sends a clear signal that our integration plans are on track. With the move into your new York, PA facility complete, we are now ready for the first blending of our Specialty business with UNFI Natural & Organic. This project when complete in the fourth quarter will put us in the enviable position of offering customers in the Mid-Atlantic region, the most comprehensive product offering available. And we're seeing some positive momentum with approximately 10 to 15 million in new Specialty business rolling out over the next three or six months We are also diligently working on expanding our customer relationships to include a broader array of products. Most importantly UNFI is now well positioned to aggressively negotiate with new customers, offering a complete Natural & Organic, Specialty, supplement and produce program throughout the U.S. Our Albert's Organics, Select Nutrition, Eastern and Western divisions are now working extremely closely to take advantage of cross selling opportunities that exist across all of our channels of distribution. In addition, our growth through the conventional channel including national and mass will begin ramping up dramatically as we further integrate and expand our Specialty programs across the country. Looking forward we will be working diligently on expanding our SKU offering to our independent Natural & Organic retailers. Given our scale and national distribution platform there are categories of products that can potentially increase our growth to this very important class of customer. Also during the next twelve to twenty four months UNFI will be standardizing business practices across all of our businesses making UNFI more efficient and cost effective or providing greater value to all of our customers through increasing service levels, products and systems. At the same time having UNFI go to market as one company, easy doing business with from a customer and supplier perspective. Our sales and service associates should and will be able to represent all categories of products, including produce, supplements, Specialty, Natural & Organic to all of our customers. I look forward to sharing our three-year strategic view of the business during an analyst meeting that will be scheduled for York, Pennsylvania on June 23, 2009. Mark will provide more clarity on gross margin and expenses shortly. We've revived our sales outlook for the year given trends since November 2008 to between 2.5% and 4% growth. Also CapEx will be 40 to 45 million, a reduction of 17 million. Expense reductions primarily driven by fuel cost savings and disciplined management of costs will enable the company to manage EPS to a $28 to a $36 per share. And our EPS range is primarily driven by potential exposure to the latest PCA peanut recall and continued sales uncertainty. Looking back over the last quarter, I am extremely pleased and proud of the associates of UNFI. They buckled down, adjusted, changed and delivered despite really tough challenges. We have not wavered from our view that companies can be at the forefront of sustainability and environmental stewardship as evidenced by our previously released Gold LEED certification for our new Ridgefield, Washington facility. We've identified opportunities for growth, improvement and positive change regardless of economy factors outside our immediate control. And now I would like to turn the call over to Mark Shamber, UNFI's Chief Financial Officer.

Thank you Steve and welcome to everyone listing in the call as well as the webcast. Net sales for the second quarter of fiscal 2009 were $847.6 million, which represents growth of 2% or approximately $17 million over prior year's second quarter net sales of $831 million. Excluding our Specialty division, net sales for the second quarter yielded comparable sales growth of 4.5%. Year-to-date net sales of 1.71 billion, yielding sales growth of a 144.8 million or 9.2% over the prior year. At 19.1% gross margin for the quarter showed a 50 basis point improvement over the prior year's second quarter gross margin of 18.6. Gross margin in the second quarter benefited from a combination of the Specialty division's higher gross margin and fuel surcharges that were in effect in both November and December. As a reminder, Specialty's full service model generates a higher gross margin than our Natural and Organic business, but it also carries with it higher operating expenses in providing these services. Gross margin for the first six months of fiscal 2009 was 19.3%, compared to 18.5% the prior year, an improvement of 74 basis points, also due to the two factors mentioned previously. Our operating expenses for the quarter were 16.1%, compared to 16.3 for the same period last year. This represents a 19 basis point improvement over the prior year as operating expenses benefited from lower fuel costs and a small operating loss within UNFI Specialty of approximately $0.5 million. Our second quarter results also include approximately $2.6 million or 31 basis points, in costs associated with relocating to our new facility in York, Pennsylvania which began shipping in second week of January as well as ongoing costs associated with our Moreno Valley, California relocations. During the quarter we recorded share based comp expense of $1.6 million or 19 basis points, compared to the expense of $1.4 million or 17 basis points in the prior year. Fuel costs for the quarter were approximately 74 basis points, a decrease of 36 basis points over the first quarter of fiscal 2009 and an improvement of 29 basis points over the prior year's second quarter. Our inventory days-on-hand was an average of 58 days for the second quarter. However, our days-on-hand as of the end of the second quarter was approximately 50 days, which is at the high end of our target range of 47 to 50 days. During the quarter, we made a concerted effort to adjust our inventory levels to match the changes in sales trends, as well as to work down inventory levels at are two relocated facilities in York, Pennsylvania and Moreno Valley, California. DSO for the second quarter was at 20 days, favorable to our target range of 22 to 25 days, and a one day improvement over the prior year. Capital expenditures were $17 million or 1% of revenues for the first six months of fiscal 2009, which is below our target for the current year. We expect our CapEx to increase during the second half of fiscal 2009 as we begin the build out of the new leased facility in the Texas market during the fourth fiscal quarter. Free cash flow for the second quarter was positive 42 million compared to the prior year second quarter, which was a negative 29 million. For the first half of fiscal 2009 free cash flow was approximately a $0.50 million negative. For the second half of fiscal 2009, we would expect a positive free cash flow of approximately 20 to $30 million, based on current sales trends. Interest expense in the quarter of $3.2 million was approximately 6% lower sequentially and approximately 37% lower year-over-year. The sequential and year-over-year decreases were primarily driven by lower average interest rates, partially offset by higher average debt levels during the quarter. With inventory levels now back within our desired range, we would expect interest expense to be lower in the second half of fiscal 2009, barring any increases in interest rates. The company's outstanding commitments under its amended and restated credit facility as of the end of January were approximately $390 million with liquidity of approximately $94 million. As discussed in our press release, we've updated our sales and earnings guidance for fiscal 2009. We are revising our projected net-to-net sales from a range of 3.63 to $3.7 billion to a range of 3.45 to $3.5 billion, which represents full year comparable sales growth over fiscal 2008 of 4.5 to 6%. Our earnings per share guidance has been revised slightly to a range of a $1.28 to $1.36 per diluted share. Our updated guidance reflects recent trends of slower sales growth as well as the uncertainty surrounding the impact of the recent peanut recall on sales and inventory reimbursement for the remainder of fiscal 2009. Previously, our EPS guidance has been in the range of a $1.32 to $1.38 per diluted share. Finally, we are lowering our anticipated fiscal 2009, CapEx guidance to 40 to $45 million. Previously, we had expected fiscal 2009 CapEx to be in the range of 57 million to $62 million. Included in our CapEx guidance for the remainder of fiscal 2009 are some final expenditures associated with our recently opened York, Pennsylvania facility, as well as costs associated with our planned Texas facility, which we expect to begin construction in the fourth quarter fiscal of 2009, with operations commencing in fiscal 2010. At this point I conclude our prepared remarks and we'll turn the call back over to moderator to facilitate any question.

Thank you. We'll now begin the question-and-answer session. (Operator Instructions). Our first question is from the line of John Heinbockel with Goldman Sachs. Please go ahead.

Couple of things, Steve, can you talk about retailer destocking, how widespread a trend has that been and you would think that at some point here we would get a restocking and you'd start to see your shipments maybe pickup a little abnormally. Have seen that yet or do you think you will see that?

We have not seen significant destocking at the retail level at this point, John.

Yeah, I think, John it might have been more from a home destocking the pantry than what we saw in the retailers. Many of them, particularly our customers based with the independents don't have large back-office areas where they can afford to store, you know a lot of products. There might have been a small amount of that in October, November but it didn't last very long because, again with the frequency of deliveries and the amount of backroom space they have is just not that much that they can carry.

What about at Millbrook, or did you see there, same thing very little destocking?

Yeah, I mean, again we have the full service model at Millbrook, where... I mean the Specialty division. So we're basically managing a lot of the products that are on the shelves. And so, again we're coordinating on the sales side, so there is not excessive amounts that are in the backroom areas.

But to your point John, in the Specialty side and this would obviously make sense the decrease in sales was more dramatic on the Specialty side than it was on the Natural & Organic.

I guess what I'm trying to figure is that consumer take away or that's just your shipments because of retailers working inventory down, or both?

We don't really think it's the retailers taking inventory down as much as it is the consumer preferences changing. So the behavior of retail has changed, as it relates to...

Okay. So when you look at on the Organic side, you talked about the 4.5% growth, are we sort of stable at a mid-single digit growth rate in organic ex-Millbrook or we're not sure if we've reached stability yet.

The problem with answering that question is that we still... it's still fairly erratic so we still see our sales jumping around quite a bit. We're comfortable with the range that we provided for the back half of the year which is 2 to 4% roughly. But it changes fairly significantly week-to-week, month-to-month.

And then finally how do you dimensionalize the impact of the peanut recall. Tied in what would be that impact or broadly but how do you think about that impact, sales cost and how big could it be?

Yeah I mean the most significant part of the peanut issue for us comes out of our Hershey Imports where we were buying products from PCA manufacturing facility, obviously that product is recalled all the way back to 2007. We have no recourse with PCA obviously at this point. So we think that there is going to be some kind of claim that we're going to have to eat that's not reimbursed. We don't think it's overly significant; it has the potential of being 2, possibly $0.03.

All right, then if you seeing because of concerns about the safety of the product, other related products that should not have... should not see a drop in demand, have you seen that or not really?

No, I mean obviously this was a significant recall that affected lots and lots of products.

Right.

Obviously with peanut or peanut case as an ingredient, but I think it's limited to that.

Okay, thanks.

Thank you. Our next question is from the line of Greg Badishkanian with Citi. Please go ahead.

Hi, thanks. You mentioned sort of volatility over the last few months, but you haven't noticed the trend downward, it's just been volatile, right?

Yeah, I'd say that's accurate, Greg.

Okay. Alright. Good. And the... sort of the back half year, sales guidance is based on kind of the average over the last few months type of trend that you have been seeing, right?

Right, it is a balance of what we were seeing on the Natural & Organic side, as well as on the Specialty side with the lost business that we'll be annualizing and the trends we have seen in their customer base.

Okay. Good. So just a continuation of the current trend... those current trend. And just looking at fuel, diesel costs obviously, have come down. When do you get the full benefit of those lower costs?

Well, the full benefit probably doesn't come... I mean, I guess it is... we get the full benefit right now, but I guess that if you are talking year-over-year it will continue to help us until we get through the fourth quarter or really to the second quarter of next year. I mean right now, at 74 basis points you get an improvement of 36 basis points over what we had in the first quarter. But the third quarter was a similar number, last year, it was I think a 111 basis points and the fourth quarter was 137. So, as we've talked about the fuel surcharges going away with the lower fuel prices, we'll still stand to get a pick-up, a net pick-up because of the lower fuel cost if they hold where they are in both the third and fourth quarter.

Okay. That's in fact good, that's very helpful. And also, just kind of going back to the macro-environment, it's tough out there, but obliviously demands seems to holding up at least okay for you guys which is positive. And you mentioned some segments that were doing well or poorly, any other trends that we can discern from that or any... is there just more trading down to products that are sold there, even at home and made at home from scratch, or any other sort of trends that we can see?

No. I mean, it's all fairly commonsense. For those of you who follow the restaurant industry, you know what's happening there. People are eating out less and eating at home more, and people are either eating at home more or buying less expensive products. And we have seen that pretty consistently during the last quarter. So, I think you can, kind of back into which product categories are going to be impacted positively or negatively.

Good. Alright. Thank you very much.

Sure.

Thank you. Our next question is from the line of Ed Aaron with RBC Capital Markets. Please go ahead.

Thanks. Good morning guys, and nice job on the quarter.

Thanks.

Good morning, Ed

So, I m just thinking about the kind of sales environment going forward. I m trying to better understand the price of last fiscal year (ph)... the products that you sell, because there is still a fair amount of inflation in the system, and that's probably is going roll off over the next few quarters. And so, if you look at trends right now, volumes are obviously down a bit from where they were a year ago, and just as that inflation rolls off, I m just kind wondering what type of volume reacceleration we might see, just that your total sales growth might need to decelerate further. Can you give us kind of any color in terms of what you've observed, maybe in the categories where you are seeing relatively high inflation as far as the actual price elasticity of those products?

Yeah, I mean, the inflation interestingly, if you look at inflation in this quarter versus the last two, hasn't come off all that significantly. Certainly, it would be as we said, we are going to see some deflation over the next four quarters. You would hope that you are going to see some. But I don't think we could really talk to demand by product category or its influence on our overall sales, just because there is so much volatility still in our sales in general.

But, all others being equal if you have that deflationary environment, would you expect your top-line growth to slow-down as that inflation rolls off or is it just kind of too early to say?

I think it's too early to say.

Yeah I would agree. I mean we... I think we saw probably from a year-over-year comparison standpoint, inflation hit the high mark in November and started to slowdown in December, January but it hasn't moved, as Steve mentioned, enough yet, for us to be able to comment on what that might do to sell trends.

I mean I can tell you the biggest single category deflating is organic produce.

Right. Okay, that's helpful thanks. And then I was hoping you could talk a little bit maybe elaborate a little bit on that 10 to 15 million of new Specialty business that is apparently coming on line, is that an annualized number or is that... how much you expect to get this fiscal year?

No, that's an annualized number, and for the most part it's expanding existing relationships into the Specialty space.

Okay. And then and just in terms of actually bringing on new accounts is there any new progress reported along those lines.

We've got a couple of customers that we're working very closely with. These things take a long time to build a relationship. We're optimistic but I can't give you a timeline.

Fair enough. And then last question, just on the gross margin, 50 basis point improvement, you talked about the positive impact of Specialty there but from a mix perspective, I would think that Specialty would have actually hurt you this quarter, because you owned that business a year ago and Specialty division was down in the quarter and so that the mix of Specialty actually went down. So why is that a positive contributor to the year-over-year gross margin change?

Well as mush as in fiscal '08 we did get some benefit from the gross margin on Specialty. In the second quarter, Ed, that was the first quarter that we had ownership of the division. And so if you recall if I go back to the conference call notes from that quarter there were a lot of comments about extra steps that we took in order to get products on hand, extra costs that we incurred given that they had such high out of stock levels right after the acquisition. So I'd say that we've made improvements to the point where we're now back to normal service levels, and we're back to the contribution on the margin side that we would have expected in the division all along, which is significantly stronger than it was in the first quarter that we owned them. So that despite the fact that they are providing a smaller percentage on the sales basis of our overall sales, they are providing a stronger gross margin in this quarter versus what they did in the second quarter of last year.

Okay, that makes sense. And one last house keeping item if I could. If you quickly give us the sales growth breakdown by channel, I didn't hear that if you have it, if you wouldn't mind giving us?

Sure, so for the quarter, second quarter's supernatural's were at 3.2%. Supermarkets were at negative 5.4, if you exclude Specialties they were 6.4% and independents were at 3.3%.

Great, thank you.

You're welcome.

Thank you. Our next question is from the line of Scott Mushkin with Jefferies. Please go ahead.

Hi guys this is actually Bakely (ph) filling in here for Scott here. This is really just following-off the last couple of questions. I mean what has been... I am going to ask basically the same question, so I'll just ask it differently. What's been the response from customers, Specialty new business as we go with this combined platform and that was kind of the idea back when you bought Millbrook, what's been the response?

It's been extremely positive. The beauty of UNFI Natural & Organic and Specialty is the product offering. So for retailers that want to have a significant offering in terms of breadth of line, new items et cetera we carry far more Natural & Organic SKUs than any of our composition. So that gives us a real added value option. Specialty, obviously makes it easier for them to make the decision because they buy Natural & Organic and Specialty together. But these retailers have existing contracts, it takes time to build a relationship. We didn't want to go to these customers until we were a 100% sure that we had an offering with a very high level of service and a high degree of confidence that our program could be better than the program they already had. And you know we're in that position now. And so, very confident and answer to your question; lots of good interest, just going to take some time, but I really don't have any doubt that we will ultimately proved that the acquisition of Millbrook was a very strategic one and one that was the right decision for the company.

And just, quick follow-up. Just on... a quick one, I know you talked about a little bit, how is the integration with the joint platform, do you feel that as good about the infrastructure in place?

Yeah, I mean, we are at the beginning stages of determining which platform we need to be on, which portions, whether it's vast management systems, transportation systems, supply chain management, we are looking at all of those things right know. Without a doubt, we need to have a one company facing, whether it's in any of the areas that I just mentioned or all of the above. That's exactly what we're trying to figure out as we speak. But there is lot of opportunity throughout the country. As we look at a one company platform, and again, it's just going to take us a little time to figure out what the best method to move forward is. And again, I think we'll be in a position to share a lot of that with you in June.

Great. Thanks.

Thank you. Our next question is from the line of Andrew Wolf with BB&T Capital Markets. Please go ahead. Andrew Wolf - BB&T Capital Markets: Good morning, thanks. Congratulations on the strong quarter.

Thank you, Andrew. Andrew Wolf - BB&T Capital Markets: Couple of questions, following on this supply chain. First, a near term question, as you were bring it down inventories, could you give us sense or could you give us what your service levels, did they remain intact or was there some spike(ph).

Yeah, I mean, on average when you look at our service level week-to-week over the period of a quarter. Our service levels were right where they needed to be. We've always run through one period where we have one DC or another that has a little blip but on average, service levels were right where they needed to be. I should make sure that everybody knows that our inventory today is higher than it was, for example a year ago. And so the company has managed at inventory levels lower than what they are today and we expect to get back to those levels, the challenge and opportunity is for us to work a lot closure with our suppliers and to help us get back manufacturing out of stock level down. On the UNFI side, some of the systems that we're talking about implementing will help us do a better job on our own internal service level. But, I think we can do both those things at the same time. Andrew Wolf - BB&T Capital Markets: Okay. That's sort of prelude into my next question, I know you want to get the details or more details in June at the conference. But just generally, in terms of systems and working with the vendors, sure rationalize supply chain. Are they co-dependent or is there work that can be done with the vendors before you have a unified purchasing system internally?

Yeah, I mean that's a great question, and the answer is yes and we started to do that. The idea is to give our suppliers more transparency into our product movement by skew, by DC. So that they have some consistency in how they produce the products. Right now, they don't have any transparency which is one of the reasons why the supply out of stock tends to be high as they are. And we can certainly begin the process of providing that transparency before we get to a national platform with a national supply chain model. So yeah, those things are happening, it's going to happen over time, but those discussions have already begun. Andrew Wolf - BB&T Capital Markets: Great. And lastly, just my version of the sales question is this. Some of the retailers reported already and some of the vendors as well. How they describe... and the government numbers look the same. For the business, food retailing and merchandising, really December looks like it was a trough at least as of now. Things got really kind of brutal into December and with it... if not a recovery at least a stabilization which means maybe some how other stocks have to be reordered from the retailers if they were managing inventories too tightly. So, if you look at the business like month-to-month November, December, January, February with December being the worst and sort of quasi... either stabilization to recovery in the last couple of periods and couple of months, does that kind of comport with how you view United Natural's business or you going to continue to think it too volatile to discern this... that kind of a trend.

Andy, I don't think we can really answer that question with a lot of certainty because of how our weeks matched up with the 53rd week from last year. So, for instance I would say that yes our December was a low point from a comp standpoint but our fiscal December this year had both the Christmas and the New Year holiday. And so there were two days where we weren't shipping that we normally would have been versus prior year where there is only one. So, it's made a week to week comparison for our weeks very difficult. But if you go strictly on calendar days I don't think that we saw a lot of change between the months I think that we saw the deceleration take place in late-October, early November, and then it was... again relatively consistent month-by-months from there, although we have again as we've mentioned we'd had weeks where we've had strong growth and then we've had weak growth. So there has been a lot of volatility. But I don't think that I can necessarily say with complete comfort that we could sort of backup that statement, or to answer your question and confirming the way everyone else has reported. Andrew Wolf - BB&T Capital Markets: Okay thanks

Look forward to see reporting how things go.

Our next question from the line of Gary Giblin with Goldsmith and Harris. Please go ahead.

Yeah, hi good morning. In your fourth quarter conference call you mentioned that as gas prices come down that you go kind of have to pass that on fairly quickly to the customer base but my question is, is there opportunity for gross margin expansion from lower gas prices, where the... or your pass through lags or something like that?

Gary there was an aspect of that, and we tried to eliminate that both on the upside and the downside going forward. So historically we have been working with a trailing indictor of a quarter of 13 weeks from a standpoint of fuel surcharge. With prices decelerating the way they did in the back half calendar of 2008 we went to a trailing four weeks on the surcharge, that brought down the fuel surcharge much more quickly in our east and west regions and to the point where they did not have it in place in January. Similarly we would be much faster to react once fuel prices go back up again at some point in the future. So I mean I think that at this point we recovered the way we had the lag set in place with to allow us in times of declining prices to recapture some of the expense that we had lost in time of rising prices, and I think that's come and gone in the second quarter and that, at this point going forward we'll be pretty timely in reacting to rising and look declining fuel prices.

Okay, thanks. And then just my second question is you mentioned in your prepared remarks Steve that you are going to have a lot of presumably head-to-head vendor discussion. So my question is does the guidance presented in the press release assume any improved margins or lower cost of goods from that or could that be incremental upside?

Yeah, there is no incremental gross margin assumed in our numbers as a result of those discussions. It's really too early for us at this point to have a good enough understanding of how that all plays out. I certainly view it as upside for both the supplier and for UNFI.

I mean is that the primary focuses of those discussions, I mean of course you discussing a lot of things. But that is a lot of it how to do math on lower food prices for instance on the produce side or even on the package side?

I mean Gary I think it's all of the above. I mean we as a company in a lot... for a lot of our suppliers are their single largest customer, and we need to do a better job being more transparent with them. So that we can provide them with more consistency as I've said earlier around the way they produce product. Our view has to be in the entire... of the entire supply chain. How it's produced, where it's stored, how we move the product around the country to our DCs and how we ultimately get it to our customer. And those are thing that will, I think, highlight some very big opportunities for us to lower cost of goods, reduce the inventory, perhaps increase our gross margin and do the same thing for our supplier.

Okay. I understand. Good luck with those discussions and with the year ahead.

Thanks.

Thanks, Gary.

Thank you. Our next question is from the line of Meredith Adler with Barclays Capital. Please go ahead.

Thanks. Maybe, I'll just follow-on first on the question that Gary just asked. It's fair to say that what you think about saving money and improving the gross margin, you are really talking about a win-win of lowering the supply chain cost and sharing, and it's not about doing an arm twist on anybody to get better pricing per case?

That is 100% accurate.

Okay. And I was wondering if you could just also go back to the discussion about inflation. I have heard retailers say that prices tend to be sticky on the upside and sticky on the downside when cost are going up and when they are going down. And so that you probably on the downside pickup a little bit more gross profit penny. Do you think that's right, especially that organic product being deflationary right now?

I am not sure, I understand the question.

Your costs are going down, is your cost going down faster than what it's costing your customers to buy from you?

I don't think so, I don't think so. Organic produce... keep in mind, our inventory position on organic produce is very small, returning very quickly. So there is no real lag between the time that we buy it and the time that we sell it. The lag obviously is much longer on more shelf stable grocery, typical Natural & Organic products. So, I am not sure I see that yet.

Okay. And you are not seeing particular declines in those packaged foods yet, right?

Not yet.

And then I'd like another question, is kind of two parts about combining Specialty and Natural & Organic. You talk about getting one sales force that's going sell everything. How challenging is it to educate the sale force about the other products, and is it easier for one sales force to pick up on the other piece and another. I mean is there... is that going to be a lot of work?

Yeah, I mean it's really a combination of both. I mean from our perspective, what we want to have is, one point of contact for the customer. So the customer wants to buy Natural & Organic, Specialty, Albert's, Select Nutrition, they have one point of contact and not multiple. Now, that doesn't mean that that one sales person will have to have all the knowledge around all those product categories because they can't, it's impossible. But it does mean that they would be the point of contact making sure that we've brought in the right resources to make sure that the customer is educated and understood what they were going be potentially getting from us. So it's a combination of one point of contact supported by lots of field support specialists.

Great. That makes sense. And have you ever quantified the benefit from having distribution center like York, which has... will send shipments out of both kinds of products to those customers that buy both. They must be a pretty big, say, revenue per employee kind of savings there?

Commonsense would say, yeah, it should be. We have not quantified that. Also keep in mind that in some cases what we want to have happened is, the sales associate, who is responsible for the customer manages all the products going into that customer, regardless of where they come from. In some cases, it maybe more efficient to ship the supplements from Select Nutrition via UPS, and maybe more efficient to sell them, an organic produce from an Albert's facility that may be closer. So, there is not one black and white answer. It's a matter of looking at the entire supply chain. But from the sales perspective and the customer perspective, it's one company.

Okay. That makes sense. And then my final question is; because you provide a full service model on the Specialty side, which I know part of that means that the ordering is done by your own delivery folks. Is there any risk that they are not moving quickly enough to flow the orders for those kinds of product. I mean it's kind of an incentive for them to continue to ship so they went out of room?

Yeah, I know I don't think that, that's the case because the retailer certainly going to hold us accountable for their inventory.

Okay great. Thank you very much.

Thank you. Our next question is from the line of Chris Krueger with Northland Securities. Please go ahead.

Good morning, guys.

Good morning Chris.

Hi, one quick question. There has been a lot of talk about the impact of private label products and I think last Whole Foods I indicated some progress there as well. What's your overview of the impact of private label on your business?

I think on the supermarket side, it certainly hurt us a little bit over the years. Because in a lot of cases, we were shipping a national brand and some of the larger retail customers converted to private label and brought it into the room captive distribution centers. Whether that trend is going to reverse, we haven't seen that yet.

Okay. And Specialty or Millbrook, can you refresh my memory exactly what happened a year ago versus this year, you probably went over it on the call a year ago, but I know doing my math sales are down at double-digit rate year-over-year. Was it something unique in that period that makes that not really an apples-to-apples comparison or how should we look at that?

Well, I mean in the prior year Chris that was the first quarter after we taken over the business. And we spent a great portion of that quarter getting service levels back up to where they needed to be. And what ended up happening is because of the timeframe leading up to the acquisition, where service levels had been below what was acceptable; many of the customers had gone down the path of securing alternative sources for their distribution. And so, after that first quarter of ownership, we did lose some customers and so it's not an apple-to-apples comparison because we have... there is... we're working off of a smaller base and we haven't sort of annualized all of that lost sales as of yet. So that won't occur till probably the end of the third quarter, maybe a little bit into the fourth quarter, but where we lost some of that business in the second and third quarter of last year.

Okay. And obviously, the profitability of the division, it looks much better than it did a year ago. I know, you guys have previously guided for it to be dilutive by $0.06 this year. And it looks like it's dilutive by a penny and a quarter, which is a penny better than what I had looked for. Would you still stick with that $0.06 language or do you think it's potentially is breakeven even in the third quarter?

No. I'm going to... I think that we probably stick with it, meaning, as there always the potential that it could be sure. But I think that the run rate when you allocate the interest to it as well, which is how we get to those dilution numbers. They still get the allocated interest where they need to generate a certain amount of operating profitability to actually be accretive with the interest as well. So I think I'd stick with the fourth quarter.

And also keep in mind that the Specialty side of the business has been hit a little bit harder than the Natural & Organic.

Okay. That's all I got. Thanks.

Thank you. Our next question is from the line of Dedrik Bosch (ph) with Cannacord Adams. Please go ahead.

Hi, it's Scott Van Winkle. A couple of quickies for you, Mark. First, you mentioned the fuel surcharges ending in January in the east and west. Was there kind of an average number for that January quarter you could drill out?

An average... I'm sorry Scott an average number of...

The fuel surcharge through the quarter?

You know we...

It went to zero, essentially in January. I'm just wondering what the comparison will look like sequentially when we look at the April quarter relative to the January quarter?

Well we've always... I mean we've always given the number as excluding the surcharge. So I mean that -- there would be no change from a comparison standpoint. So you'd still be comparing it against the 74 basis points. We've always done because it's a mismatch on the income statement with the surcharge up and the revenues and the expenses for the fuel and operating expenses, we've always given an ex-the surcharge. So you will be comparing against the 74 basis points when we report Q3.

Okay. And your comments earlier about interest cost being lower in the back half. I don't know if I missed the more detail. What's driving... obviously, you're paying down some debt. But, is there -- have you locked in the lower rates and how significant is the benefit you got maybe from lower interest rates coming into January?

Well, we haven't locked in rates yet, with where the markets are and where interest rates swaps are, there has been very... probably only a 10 basis point movement in last three months or so. But rates, if you'd go back a year ago, I don't know the number off the top, but I'll say that second quarter last year interest rates was probably between 5 and 6%, whereas for this quarter it was probably little more than two plus percent on the revolver. So where we stand right now is that our borrowing cost against our revolver right now are probably 1.25 to 1.5%, and we have the term loan that's probably at 5/7. So we're certainly probably it decrease as the back half of the year goes along. But we are probably 200, 300 basis points more favorable on the borrowing rate in this year versus the prior year. And then you still on top of that, that we're paying down debt, our debt levels are down, virtue of timing as to when we sort of start to collect the cash and or reduce the payments going out of the door. But, since the end of the quarter, our debt levels are down 35 million, so our borrowings against the revolver are down to 262 right now versus 297 as of the end of Q2.

Okay. Thank you.

You're welcome.

(Operator Instructions). And our next question is from the line of Laura Olson (ph) with Credit Suisse. Please go ahead.

Hi. Just as a little takeaway from the last question, do you expect revolver drawings to continue to decline or a level there going to remain a little bit elevated for the foreseeable future, and then I just have a question on your competitive landscape?

I would say that the revolver... I would expect it in the third quarter, the revolver will pay down. I mean, I can't say exactly depending on the timing of some of the CapEx as to whether it'll go further from what it's already done in the first three, four weeks of the quarter. But then I would expect the borrowings to increase slightly in the fourth quarter when we start to build out the Texas facility, because there will be some payments that need to be made at that point in time. So, I'd expect it to be lower Q3 significantly and then perhaps a slight jump in Q4.

Okay, thanks. And then in terms of what's going on with some competitive issues, do you think there is going to be more consolidation or you seeing some weakness where some of the smaller players maybe forced to exit the market altogether, and what is your strategy in general in terms of growth or maintaining your scale as it is?

Yeah, I mean, I haven't seen a dramatic change in the competitive landscape, yet. I mean, I can only speak to what we're doing. We are out there aggressively expanding our business relationships with existing customers by adding more SKUs and services. The biggest potential upside for us is as we acquire some regional and national combined Natural Organic and Specialty contracts, and we think there is a lot of opportunity for us to do that.

Great, thanks.

Thank you. Our next question is from the line of Robert Koch with Mac Capital (ph). Please go ahead.

Hi, good morning.

Hi, good morning.

On the gross margin improvement, just for clarification, it looks has your mix of Organics and Specialty, has that skewed towards more Organic year-over-year?

Yeah, with the decline in sales in Specialty year-over-year, it has shifted more towards Natural & Organic, although as I mentioned I think it was answering the question for I want to say it was Chris or Ed, that it was more of the benefit from the gross margin side came from the fuel surcharge, as well as the improvement in the Specialty division even though it was off of the lower sales base.

How much was Specialty down in the quarter?

While, I mean, I don't have the number off the top, but I mean we're 2% with our overall growth and it was 4.5% excluding Specialty, so you can back into it from there.

I am sorry, what percentage is the Specialty in the quarter?

I said, I don't have that number off the top. I said that you can back into it from our overall growth of 2%, and it was 4.5% ex-Specialty, will let you get to what Specialty was for the quarter compared to last year.

Okay, do you expect the year-over-year gross margin to -- I mean how big was that account in the second quarter. On just from the services as you accounted the quarter following the acquisition and can we expect a similar magnitude going forward?

I mean I'm not going to sort of compare an improvement from the gross margin year-over-year from that side, I guess what I would say is that if you look at the gross margin in back half of the year with fuel prices where they are, that I would expect gross margin to be anywhere from 19 to 19.2 so roughly 10 basis points either way from where we are now. And that little leads to in some cases a benefit year-over-year and I think in the fourth quarter probably a little bit of a detriment because we've had such higher fuel surcharges last year with rising prices.

Right and then lastly I think you went over this already. What's your back half CapEx guidance and free cash flow?

Yeah, I mean I gave that... our expected a free cash flow for the year for the back half to be 20 to 30 million, which would say in the back in the back half of the year free cash flow of 20 to 30 million which will give full year of I guess 19.5 to 29.5 because we've got a half million negative. And then CapEx for the back half of the year I mean we're at 17 million through the first six months so if you deduct that from the 40 to 45 you get 23 to 28 million CapEx in the back half.

Thank you very much.

Thank you. Our next question is a follow-up from the line of Ed Aaron with RBC Capital Markets. Please go ahead.

I think you... just a couple of follow up questions first it sounds like the Texas, DC is getting pushed out more into 2010. Is there some savings from an EPS basis this year relative to your previous plan, because there is usually some start-up cost involved, so will some of that flow into 2010 as well. And then secondly, I think in your prepared remarks you talked about some potential for increased distribution within the independent channel which was kind of interesting only because I think you guys are pretty well distributed there already. So was just hoping you could maybe elaborate on that a little bit?

Well let me answer the second question first. There are categories of products that UNFI does not particular today doesn't carry. And those are all product categories that we are currently moving down the path to become significant suppliers in. And these are all products that our independent channel currently buys, they just don't buy it from us. The in relate... it relates to the Texas question, I will let Mark answer that one.

Yeah. I mean depending on how far we get into Texas in the fourth quarter, Ed would determine how we much we might have from a non-recurring standpoint, but certainly with it sliding back, some of that will come out of fiscal '09 and slide into fiscal 2010 because we won't necessarily for sake of discussion have started hiring people yet we may not be in a position where we're training drivers and/or selectors, receivers. So there certainly will be some non-recurring that will slide from the fourth quarter of '09, where it's likely going to land into first quarter, maybe even the second quarter fiscal '10. It was probably... our expectations were that we'd have roughly $0.02 I think non-recurring was the way I had laid it out at the beginning of the year in the fourth quarter. So, it could be as little... it could obviously be as little as zero depending on when we start, it would probably be no more than a penny at this point.

Thank you.

Thank you. And I show no further questions. I would like to turn the call back to management for any closing remarks.

Thanks. And thank you all for joining us this morning. Once again we are pleased with our results this quarter despite a tough environment. Yet there are lots of positive things happening here at UNFI, and we look forward to sharing them with you at our analyst and shareholder tour of York, PA on June 23rd. So please hold the date and thank you very much for joining us this morning. Have a great day.

Ladies and gentlemen, this concludes United Natural Foods second quarter 2009 conference call. If you'd like to listen to a replay of today's conference please dial 1800-405-2236 or 303-590-3000, followed by the access code of 11126389 and the pound sign. ACT would like to thank you for your participation. You may now disconnect.