United Natural Foods, Inc. (UNFI) Q1 2016 Earnings Report, Transcript and Summary

Greetings, and welcome to the United Natural Foods First Quarter Fiscal 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I’d now like to turn the conference over to Ms. Katie Turner for opening remarks. Thank you. Ms. Turner, you may now begin.

Thank you. Good afternoon. By now you should have received a copy of the first quarter fiscal year 2016 earnings press release, issued today at approximately 4:05 pm Eastern Time. The earnings press release and webcast are available under the Investor Section at the Company’s Web site at www.unfi.com. On the call today are Steve Spinner, President and Chief Executive Officer; Sean Griffin, Chief Operating Officer; and Mike Zechmeister, Chief Financial Officer. Before we begin, we’d like to remind everyone that comments made by Management during today's call may contain forward-looking statements. These forward-looking statements discuss plans, expectations, estimates and projections that might involve significant risks and uncertainties. Actual results may differ materially from the results discussed in these forward-looking statements. In addition, in today's earnings press release and during today’s call, Management will provide both, GAAP and non-GAAP financial measures. These non-GAAP financial measures include, net sales, operating income, earnings per diluted share and free cash flow. A reconciliation of these GAAP to non-GAAP financial measures can be found on the Company's investor site. And with that, I’d like to turn the call over to Steve Spinner.

Thank you, Katie, and welcome to our call this afternoon to review our first quarter 2016 results. First, I’d like to welcome Mike Zechmeister to UNFI as our new Chief Financial Officer. Mike brings over 20 years of experience at General Mills in a wide range of responsibilities, including M&A, treasury, operations, shared services, financial planning and IT. Some of you’ve spoken with Mike already and he is planning on getting out to many of you as we participate in the upcoming Investor Conferences. I can’t think of a better time to have Mike on board than now, given the Company’s opportunities that lie ahead. Before we start talking about the market dynamics facing our industry, I think it’s important to briefly talk about what brought us to where we’re today. And as many of you know, UNFI sales grew at a compounded annual rate of almost 13% from fiscal 2005 to fiscal 2010, and 17% from fiscal 2010 to fiscal 2015. UNFI's operating income grew at a compounded annual rate of almost 10% from fiscal 2005 to fiscal 2010 and 16% from fiscal 2010 to fiscal 2015. And in fiscal 2015 or last year, our sales grew 20% and our operating profit grew 15%. During these periods of time, UNFI invested in infrastructure, enhancements to our technology platform, including a new national warehouse management system, transportation management system, and inventory planning, demand planning system, while building out what we believe to be the most efficient network of national distribution centers in North America. These investments directly resulted in vastly improved service levels to our customers. Over the same time period, fiscal 2005 to 2015 our operating expenses as a percentage of sales decreased 322 basis points. What this highlight is that significant change in evolution is part of UNFI’s DNA. Whether it is related to rapid top line growth, acquisitions, deploying new technology, or managing significant shifts in consumer behavior, we understand change. And history has proven that UNFI has the capacity to adapt to evolving market dynamics while growing at the same time. Now I believe we can all agree that we were -- we are operating in a rapidly evolving environment. We all know that consumer preferences for healthier food option have been changing for the last several years. In fact, the acceleration that has taken place over the last 6 to 12 months has been spectacular and this is demonstrated by the significant and rather recent increase in the number of retail options for consumers to purchase natural organic products. As a result, we’ve seen an increase in competition across every retail channel and corresponding competition within wholesale distribution and supply chain. Private label natural and organic products which we estimate at approximately 30% of the retail market is growing extremely quickly and center store is under pressure as consumers choose fresh and healthier option. Throughout the 90s and up until 2014, our industry was a niche. There is no doubt that today we are mainstream. There is very compelling upside here. I believe that is there continues to be more demand for our products today than it was a year-ago and we believe the macro demand for healthier eating options should continue to grow 7% to 11% for the next decade. This rate of the industry growth is considerably higher than most adjacent food dominant channel and 2 to 3 times the growth of conventional products. Additionally, the overall industry growth rate do not currently reflect the rapid adoption of natural proteins, specialty cheeses, and clean ingredient based prepared foods. We believe this trend is very good for UNFI. While there is a significant evolution taking place at supply chain and retail level, we believe the overall demand for our products will trump the short-term dislocation of price, sales growth, and customer mix. Also there are several other important dynamics that we expect will continue over the next several years. M&A will play an accelerated role in the consolidation of manufacturers and producers within natural, organic, and specialty. M&A will play an accelerated role in the consolidation of food retailers driven by cost reduction and differentiation. Gross margins will continue to decline as competition increases both at retail and wholesale, forcing a greater reliance on differentiation, efficiency, and scale. Retailers will need to further define their model as demand moves to the perimeter. High quality food ingredient and health will also continue to play a major role in the lives of our consumers and in turn the products that consumers buy whether the brands are private-label or well-known national brands. And to that point, consumers will increasingly depend on UNFI with food quality assurance programs, the vigilant on their behalf in offering food products that clearly and simply are what they are advertise to be. UNFI will continue to be acquisitive with a strong pipeline. We’ve developed strong integration processes and a culture evaluation discipline resulting in successful integrations of our acquisition. So, having provided this important industry backdrop, I believe there are extremely compelling dynamics that will continue to propel UNFI forward, despite the short-term softness in some of our customer channels and the increased competitive pricing pressure we’re experiencing. One, three years ago, UNFI appropriately changed its strategy to migrate its distribution services to include fresh and perimeter. This building out the store strategy was followed by a $250 million investment in fresh ready distribution centers, capable of handling national multi temperature storage and the ability to deliver highly perishable products. Our strategy to further migrate to the parameter was again highlighted by the acquisitions of Tony's Fine Foods. UNFI is now distributing fresh perimeter based products at an annual run rate of approximately $1.3 billion per year, making UNFI one of the largest marketers of fresh to retail in the U.S. During the first quarter, our fresh business across Tony's and Albert’s compared to the prior year period was affected by protein price deflation of approximately $7 million. Strong categories with over 15% growth during the quarter compared to the prior year period were organic eggs, fresh pressed juices and natural proteins. I continue to be extremely bullish about our future in fresh as we integrate these products into our distribution centers and continue to look for attractive acquisition opportunities within this space. While the current revenue contraction we’re experiencing is difficult, we believe that the longer term 12 to 24 months growth horizon looks extremely compelling based on our proven strategy to build out the store through expansion of current customer relationships, new customer wins and M&A. Two, our scale and our close proximity to the consumer, as well as the cost advantages they bring to the retailer will continue to drive long-term growth. UNFI has built out what we believe to be the most dynamic and efficient model for slower moving retail products in North America. The very concept of slower moving inventory means that there has to be a sophisticated supply chain capable of moving these products around the country in an expeditious, but economic manner to keep service level high, while minimizing inventory on hand and freight costs for our retail customers. This provides us with the ability to win new customers and expand our relationships with existing customers into fresh, gourmet/ethnic, and additional product category. Our sales strategies include using our very unique operating platform to deliver meaningful product, service, and cost deliverables across mass conventional e-commerce, independents, food store, food service and drug and specialty retail channel. We believe that the short-term disruption base solely on price without any consideration for service, product on shelf, quality or infrastructure is not a sustainable practice for retailers. Based on our $785 million in annual contract renewals at Kroger, National Cooperative Grocers, Ahold, Del Hayes and others we announced today, we believe they agree with us. Additional -- additionally, as you know we recently announced the modification extension of our contract with Whole Foods through 2025. We are very fortunate to have bright, innovative and driven customers committed to taking back share across a rapidly changing retail landscape. Ethnic gourmet e-commerce and food service or channels remain extremely bullish on and are resource to grow. Our food service channel grew 29% in the quarter, representing 5.5% of our total net sales. In addition, our e-commerce business grew by 20 -- almost 26% over the prior year quarter and now represents approximately $170 million per year. Ethnic gourmet remains a channel where we continue to look for growth opportunities organically and through acquisition. There are markets around the country that demand a new distribution option for these products and we expect UNFI will be there to answer the call. We anticipate UNFI brands will continue to grow rapidly. Our Field Day, independent exclusive brand is on path to be a $50 million brand, growing 66% in the quarter. Our Woodstock product facility is now producing private-label snacks for Public, Costco, Trader Joe’s, Market Basket, Roundy’s and others. We are really excited by Field Day’s position as the 23rd largest brand in Natural and Woodstock as the 22nd largest brand in Natural. Innovations will drive differentiation at retail. With the mass acceptance of our products, UNFI stability to find, create, distribute and merchandise new and exciting products will be a significant part of our strategy. Historically, approximately 10% of our annual sales growth has been associated with the introduction of new products. We believe we’ve the data, the supply chain, and the infrastructure to bring these products in the fastest and most efficient method through DSD, e-commerce, redistribution or cross-doc. Innovation will also continue to define our continued focus on driving efficiency throughout organization as we continue to reduce our operating expenses as a percentage of our net sales. Our first quarter was a difficult start to our fiscal year. As we’ve discussed during our fourth quarter 2015 call, transitioning out of a $400 million distribution contract would be complicated and in fact it was. Inventory service levels, manufacturer promotional activity leading up to the change and other factors led to several unintended, but necessary costs. We believe, we service the customer in an exemplary manner through the termination date and are managing a difficult restructuring that resulted in a charge of $2.8 million in the quarter. The charge reflects costs incurred related to severance payment and other transitional costs consistent with our extremely important culture of doing what’s right. And this was completed while delivering our customers the highest service levels in over three years during the most critical time of the year. We had previously announced a restructuring charge in the amount of $4 million to $5 million, and expect to take the balance of the charge in the second quarter. Our first quarter also reflected challenges in Canada, associated with continued FX and an inability to pass through price increases to retailers at a rate that kept with the further degradation in the exchange rates. Additionally, our first quarter was impacted by a customer bad debt expense in the amount of $1.8 million. Now despite revising our annual guidance based on current trends, which Mike will share with you shortly, we’ve made terrific strides towards improving our free cash which we expect to be in the range of $80 million to $100 million this year and our balance sheet remains strong with over $250 million of liquidity, positioning us well to take advantage of acquisition opportunities that may present themselves. 2016 will be a transitional year for us, as we continue to execute against our proven strategy of building out the store, while transitioning out of a significant contract and expand more rapidly into fresh. I’m confident in UNFI’s ability to deliver long-term growth, driven by a significant advantage in scale, supply chain sophistication, customer diversity, proven fresh strategy, data driven service offering, innovation, balance sheet, and a strong history of performance and execution. I’m incredibly proud of our team of associates all driven to discover what’s next, while adapting, evolving, and continuing to deliver an exemplary service offering to our incredible customer base. Now, I’ll turn the call over to Mike to provide some additional financial detail. Mike?

Thanks, Steve, and good afternoon, everyone. Net sales for the first quarter of fiscal 2016 were $2.08 billion, which represents growth of 4.2% or approximately $84 million over the first quarter last year. Our overall sales growth for the same period was approximately 6.8%, excluding the impact of the termination of the Safeway Albertson’s contract. Inflation moderated for the quarter as it decreased 37 basis points sequentially, coming in at 2.44 versus last quarter. From a channel perspective, super naturals net sales outpaced overall sales growth up 7.2% over the prior year’s first quarter and represented 34% of total sales. Supermarkets sales declined 3.3% in Q1 versus the prior year and landed at 25% of total sales. Adjusting for the customer contract termination, supermarket sales increased 6.3% Q1 over the prior year. Independent channel grew at 3.4% in the first quarter over the prior year and Independent’s represented almost third of our sales at 32%. And finally food service sales were up 29% over the prior year and represented 5% of sales. Gross margin for the quarter came in at 15.1% and 88 basis point decline over the prior year's first quarter. Sequentially, this was a 28 basis point decline over the fourth quarter gross margin of 15.4%. The declining versus fourth quarter and prior year’s comparable quarter was due to the impact of continued weakness in the Canadian dollar, the reduction in fuel surcharge, moderate supply of promotional activity and a shift in sales for lower margin sales channels. Our operating expenses for the quarter improved to 12.5% of net sales or 12.4% in net sales excluding the $2.8 billion in severance and other transactional costs associated with our restructuring plan. This compares to 13.1% for the same period last year. Included in our operating expenses was also $1.8 million charge to reserve for the impact of a customer bankruptcy outburst. Excluding the restructuring, and the customer bankruptcy impact, the operating expenses as a percentage in net sales improved 78 basis points over Q1 last year. For the quarter, the total fuel costs decreased by 15 basis points and was -- and as a percent of net sales in comparison to the first quarter of fiscal ’15, and represented 54 basis points of distribution net sales. Our diesel fuel costs per gallon decreased by approximately 18% in the first quarter versus the same period in fiscal ’15 while the Department of Energy's national average fuel was down approximately 33% or a $1.22 per gallon compared to Q1 last year. Share-based compensation expense was flat on a dollar basis versus last year at $6 million in the quarter, representing 29 basis points of net sales compared to 30 basis points in the quarter of last year. Operating income for the first quarter was $53.9 million, down $4.5 million from the same period last year. Our operating margin in Q1 was 2.6%, a 33 basis point decline over the first quarter of fiscal ’15. Excluding $2.8 million in restructuring costs in the first quarter of fiscal ’16, adjusted operating income decreased $1.7 million versus the same period in fiscal ’15 and a percentage of net sales adjusted operating income for the first quarter of fiscal ’16 decreased 20 basis points to 2.7% compared to the same period last year. Contributing to the operating margin decline was also depreciation of 12 basis points driven by investments in new warehouses and technology and 9 basis points from the customer bankruptcy. Interest expense for the quarter of $3.7 million was 15% higher than Q1 of the prior year due to a interest rate swap agreement effective in August on our term loan. As communicated previously, we expect this swap will effectively fix the interest rate on the remaining term loan and will be -- which will be approximately 3% dilutive to EPS for the year. For the first quarter of fiscal ’16 the Company reported net income of $30.1 million or $0.60 per diluted share, a decrease of approximately 2.9 over prior year’s first quarter. Excluding $2.8 million of severance and other transactional costs in the quarter, adjusted net income was $0.63 per diluted share. The customer bankruptcy was also a $0.02 headwind to diluted EPS in the quarter. Inventory was $1.08 billion, an increase of 10% compared to first quarter due primarily to inventory build associated with the addition of one new distribution center and the phased inventory build at a second distribution center, as well as our commitment to improved service levels compared to first quarter last year. Day sales outstanding for the first quarter was consistent with the prior year first quarter at 21 days and a decrease of about half a day from fourth quarter of fiscal ’15. Capital expenditures were approximately $8 million or 0.004% of net sales for the quarter, with the largest portion related to investment in our new facility in Gilroy, California. For the first quarter of fiscal ’15, capital expenditures were $27 million or about 1.4% of sales. Outstanding lender commitments under our credit facility were $586 million at the end of the quarter, with available liquidity of approximately $252 million, including cash and cash equivalents. Our leverage at the end of the first quarter improved to 1.65 times on a trailing 12-month basis, which was the lowest level since the third quarter of fiscal ’14 just prior to the acquisition of Tony’s Fine. We generated negative free cash flow of $2 million in the first quarter as we built inventory in anticipation of the holiday season, free cash flow performance was a $124 million better than last year’s first quarter where capital spending was also higher. Our 12 month trailing free cash flow was $43.7 million and we anticipate generating $80 million to $100 million of free cash flow in fiscal ’16. As discussed in this afternoon’s press release, we’re revising our guidance for fiscal ’16; we expect net sales to be in the range of $8.4 billion to $8.6 billion, which represents 3% to 5% increased total sales over fiscal ’15. Our previous guidance was $8.5 billion to $8.7 billion. In addition, we’re updating our diluted earnings per share guidance for fiscal ’16 to a range of $2.73 to $2.84. Our previous GAAP guidance was $2.80 to $2.93 per diluted share. As a reminder, included in the fiscal ’16 earnings guidance is an estimated $4 million to $5 million of restructuring charges, of which $2.8 million were incurred in the first quarter. At this point, I will turn the call over to the operator to begin the question-and-answer session.

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Meredith Adler of Barclays. Please go ahead.

Hey, guys, and hi, Mike. Nice to meet you.

Hi. Thanks.

First, I’d like to just ask you about this pipeline of acquisitions and within that I understand the third largest specialty distributor DPI was bought by private equity. Does that change the outlook for you being able to do acquisitions and what else is out there?

Yes, hi, Meredith. It’s Steve. The DPI would not have been on our list for a variety of reasons. But there are a ton of specialty, ethnic, gourmet, fresh, fresh across probably five or six or eight different channels. And so our pipeline is really strong. We got done making the Tony’s acquisition 16 months or so ago, we feel like we’re ready to do another one. We feel that the valuations for us are still realistic and so we -- I’m extremely optimistic that we’re going to make some good progress there. But in answer to your question, I don’t think that the DPI affects us at all.

Thank you. The next question is from John Heinbockel of Guggenheim. Please go ahead.

Hi guys. It’s actually Steve Forbes on today.

Hi, Steve.

As it relates to gross margin in the 90 basis points of erosion during the quarter, were the four impacts you mentioned [within release] [ph] in order of magnitude? And then, I guess, if you can just touch -- which of these headwinds were the greatest relative to your original expectations in the original guidance you laid out back in August?

Thanks, Steve. The four items listed there were not in order of magnitude. The FX was probably about 7 basis points. The fuel surcharge was probably about 15 basis points and the rest was split between the last two.

Thank you. The next question is from Karen Short of Deutsche Bank. Please go ahead.

Hi. Steve. Thanks for all the color you gave today in general just on the landscape. I guess, I kind of had a bigger picture question. So you talked about changing your strategy to focus on fresh, but I guess what I’m not clear about is when I look back on your mix of perishables and produce like going back to 2010 versus 2015, the mix really hasn’t changed that 20% of sales. So I guess my question is maybe I’m not looking at the numbers properly or maybe there has been a change in how you define different categories. But when I look at the mix by category groceries actually increased a lot from 47% to 54% and perishable produce is kind of stayed at 20%-ish, 21%, 19, 20%-ish. So I guess is there anything with that, the way you kind of categorize, what do you think perishables and produce can grow to over the next several years, because that’s obviously a big focus. Thanks.

Yes, Karen, I’m not sure what level of detail that you’re looking at. I’m not sure whether those numbers are just broad line.

It’s your presentation that you give at various, whether it’s …

Yes, I’m not sure that those numbers, we will have to take a look at that. I’m not sure that those numbers actually include an integrated Tony’s, because our actual percentage of perishable if you include Tony’s which is 100% perishable, and so you just do the basic math of Tony’s at about $900 million embedded in our $8.5 billion. It’s going to significantly shift those numbers. So we will take a look at that. As far as where we think fresh can grow, I mean, in a dollar perspective right because the product is so much more expensive than center store, even though on a case-by-case basis, if we grow our cases in a similar way that we grow grocery, our dollars are actually going to grow three times faster. Because the average case in grocery is about $15 and the average case in fresh is probably $50, $50 to $60. And so when you look at our M&A, we will have a heavy dependency on fresh when you look at the way we roll fresh out across the country, that’s going to have a pretty big influence in each one of the DCs that we put it into. So the lion’s share of our growth over the next couple of years is going to be what we typically would call fresh or anything that’s heavily perishable.

Great, okay. That’s helpful. Thanks.

Okay.

Thank you. The next question is from Scott Mushkin of Wolfe Research. Please go ahead.

Hey, guys. I had a question and then maybe I missed it, because I was doing a couple of things, so I wanted to ask about current trends. So first off, current trends, I don’t know if you’ve made any comments on that, but I’d love to hear where things have been going lately. Then the second thing, Steve, it goes to some of what you’ve said in your presentation or in your thoughts. It seems to me that the demand for slow moving items is growing at the grocery store, even in the mass channel. It seems like you guys have the best group of assets to deliver this. Yet there is like a disconnect, so like why isn’t there, I guess, more wins, more contracts? It seems broadly speaking you have something that the food at home channel really needs. So maybe you can kind of square that too.

Well, I mean, Scott, the first way to look at that is during the last quarter we secured in contract extensions about 43% to 45% of our business. That’s staggeringly large number that’s been keeping us pretty busy. But I think you’re 100% right. I think that we will find a way to use our infrastructure, selling it to channels that we don’t currently have a position in, regardless whether it’s specialty retailer or a mass retailer or the drug retailer, because based upon our network are closest to the consumer, that everybody could access to the SKUs, they are all very well set up to bring down direct retailer cost of goods by a significant amount, just by eliminating LTL shipment. And so that is a part of our -- what we’re looking to do long-term, and I think it will come. It’s just right now, the whole industry is evolving, and we’re not only evolving with is, but despite a rough first quarter, I think we’re better positioned than anybody to take advantage of the change. As far as the trends, yes, Scott we were at -- what we’re seeing right now is in line with the revised guidance that we presented today. And I think it’s important to note that keep in mind that our revised guidance of 3% to 5% assumes no big contract in this year, but we had it in last year. So if you were to adjust the contract, the $400 million out of both years that 3% to 5% become 7.5% to 9.5%. And so depending upon how you look at it, that’s kind of the way we’ve decided to give the guidance and the current trends are certainly well within that number.

Okay. But you are -- that’s, you haven’t seen any -- we’ve been hearing maybe that things have improved lately a little bit. I mean are you guys seeing that at all or not really, and then I will yield.

We’re only one period into the second quarter. I think it will be premature to comment on that.

Thank you. The next question is from Rupesh Parikh of Oppenheimer. Please go ahead.

Thanks for taking my question. So, Steve I wanted to go back to your comment in your -- in your prepared comments just about increasing wholesale competition and competitive pricing pressures. Is that strictly related to the Albertson’s contract loss or has something gotten worse recently?

No, I think it’s pretty consistent with the Albertson’s termination, but we live in a different world. So we’re going to have to do what we historically have done very well and that is to bring down the cost at a rate that’s greater than the decline in the gross margin. And certainly if you look back over the last couple of years, we’re done a great job at doing that. And as I look out over the next couple of years we’re going to have to do an even better job of doing it, but have every confidence that we can. Because as I said in the commentary Rupesh, nobody’s gross margin is going up. And so our challenge is to keep it moderate -- keep the decline moderated and make sure that we can bring the cost down and be really efficient.

Okay. Thank you.

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

Hi, Steve. I just wanted to get a little bit more on the margin commentary there. Is it -- the margins are coming down with the new contracts or is it more of a mix effect as we look as this year’s new guidance?

Yes, I think, Mark, it’s a combination of both. I mean there’s a little bit of noise in there around the Canadian FX that’s affecting our margins, that were probably going to get to a more normalized number as we get into Q3 and Q4 because the comps are more similar. But I think it’s a combination of both. As far as the channel shift, that’s going to be lumpy. So I think directionally you’re spot on it. It’s going to be a combination of both. I don’t -- Mike, do you have anything to add on that?

Yes. On the currency side we’ve got a headwind year-over-year of about 60 to 65 basis points on the top line and about 15 basis points to the gross margin.

And the other thing I would add is, there is a cyclical nature to manufacture promotional spend. It really is at the very highest level. When sales are good there’s less promotional activity. When sales aren’t so good there’s more. I think what complicates it for us in the first quarter is that we just had so much transition in our inventory as we transitioned out the $400 million. Once we get through the second quarter we’ll be in a much more normalized state.

Okay. And just on your renewals that you announced, was any of that incrementally new in terms of sales volume and on Kroger, in particular, since you did call them out. Was there an uptick in that one versus what you were doing previously?

Yes, I mean we’re not going to get into any of the specifics of any of the quantity, customer contracts. And when we’re in a position to talk about a material win you can rest assure that you guys will be the first ones to hear it.

Okay. And as we’re heading into holiday here, how is the out of stocks look?

Actually -- excuse me, this is Sean. Actually we look very solid. We’ve delivered through Thanksgiving a very high level of service, roughly in the range of 80 basis points better than last FY ’15, Q1.

Okay. Thank you very much.

Thank you. The next question is from Robby Ohmes of Bank of America. Please go ahead.

Hi. Thanks for taking my question. Steve, I was hoping you could remind us just the profitability of the growing fresh business versus the center store business. And if you think over the next half decade, was the expectation that fresh can easily grow for you guys much faster than it pressures center store like you were, I think indicating in your earlier comments. And then, related or separately, can you also just maybe update us on the self distribution trends for the supermarket customers, any changes there? Thanks.

Sure, Robby. The fresh profitability what drives the profitability for us in fresh [indiscernible] is delivering more to the customers that we’re already going to. And so the beauty of rolling out fresh is that we get a significant increase in our overall earnings growth and a more moderated growth in our operating margin. Because it’s a more expensive case that we might work on a lower gross margin, but the actual operating profit dollars associated with delivering that case is much higher and that’s just purely the math. And so, I think prior to us giving revised guidance for over the next three years which we’ve committed to doing before the end of this fiscal year, I would say if you look back on previous years, and some of the disclosures that we’ve given, you’ll see -- but I hope to see is an increased overall operating profit growth with a more marginal operating profit percentage growth, and that’s just the nature of selling more expensive inventory. On self distribution, I haven’t seen a lot of change in movement to self distribution. As a matter of fact we’ve had a great deal of success in moving some customers away from self distribution. I mean, if you take a look at the $785 million in contract expansion, a large percentage of those contracts have their self [ph] distribution option. And so, I think it’s something that we see as retailers having a tremendous confidence in the services that UNFI provides that they just can't do themselves.

Great. Thanks very much, Steve.

Okay.

Thank you. The next question is from Kelly Bania of BMO Capital Markets. Please go ahead.

Hi. Good evening. Thanks for taking my question. I was wondering if you could just elaborate on the comment on increased competitive pressure, and where you really see that and what the strategy is to kind of work through that, I guess?

Yes. I mean -- so Kelly, I mean there is the increased competitive pressures across a pretty wide berth, right. So because so many more retailers carry the product, so the retailers themselves are competing with one another. On the supply chain side, many more wholesale distributors they’re direct et cetera, et cetera are carrying the product which is making it more competitive. And so, I think as you look at UNFI as I said earlier, our margin certainly isn’t going to go up as we renegotiate these contracts. So the challenge for us is to make the distribution system and the supply chain related to it more efficient. I think that because we’ve gone from a niche to something that’s very mainstream, I think the natural occurrence across whether it’s the retail level, or at the wholesale level, at the supply chain level it’s going to become more competitive whether it be for services or whether it be ultimately for the price of the consumer. So for us the point of differentiation is one, having the scale to be the low cost producer. Two, having the products and the data to make sure that the retailers are carrying items that are differentiated and they’re not necessarily competing for exactly the same item. And then three is the strategy to be really good at ethnic/gourmet and fresh which I think at least today are a little bit protected from the doggy-dog world of what’s the price on a box of Kellogg's cereal. So it’s differentiation in scale and service.

Thanks. And just a follow-up on that, you talked about the size of the fresh business. Any color on the size of the ethnic/gourmet business? Right now you talked about the potential in the past, but where does that stand at the moment?

Yes, I mean -- it’s a pretty significant opportunity for us say, because we -- I think the last calculation is we had less than 3% market share in ethnic/gourmet. In ethnic/gourmet in size and don’t hold me to this exact number, but I think it’s -- at retail it’s about $70 billion so at wholesale it’s probably, I don’t know $40 billion to $50 billion or something like that. So it’s still much more fragmented than natural and organic, much less direct. A lot of small players across the country, and so it’s just a tremendous opportunity for us and we don’t have ethnic/gourmet in every market. So we’ll do that organically, and we’ll do it through some pretty good M&A as well.

Thank you. The next question is from Sean Naughton of Piper Jaffray. Please go ahead.

Hi. Good evening. So just on fuel, I think if I remember correctly it does hurt the gross margin once you called out but I think nets out at the operating income line. I guess, the first question is, first is that true. And then secondly, so how are you planning the rest of the year just in terms of some of the assumptions that you’re making in the model just around fuel FX and the outlook for inflation? Thank you.

Yes, Sean, your comments were right. The fuel surcharge impacts net sales and gross margin, but then the reduction in the cost of fuel comes in at the operating margin level for us. So the 15 basis points so affected the net sales and the headwind and also gross margin. But then purchase comes from the fact that diesel is coming down, is allowing us to buy cheaper and offset that to a large extent. Looking forward, it’s hard to tell what that market is going to do, but we’re in a position to continue to capitalize on the lower fuel costs moving forward.

Sean, I would add one other comment. This is one of those quarters where we just couldn’t get a break, because not only did we loose the fuel surcharge because the price of fuel had come down so far but for those of you who’ve followed us for a while we historically book somewhere around 30%, 40% of our fuel in a full contract or a hedge at or less than budget. And so, right now we’re facing a situation where the fuel price is now considerably lower than our both -- our both trends. So the actual rack price is lower than our hedged price and we don’t have the fuel surcharge. So we’re a little bit naked on probably 30% of our fuel which listen was the right decision and if we could plan where fuel was going we’d be in a different discussion. But that did have a fairly significant impact on us during the quarter, but it is what it is.

Understood. And anything on the -- just how you’re planning the business on FX and what you kind of see in the business for our inflation right now? I think, Steve, you had mentioned that Tony’s is obviously, it sounded like there was a little bit deflation area in the quarter?

Yes, I mean Tony’s we had some deflation in protein and specialty cheese. Overall I think our inflation rate is somewhat in the 2% range, 2.5%, and that’s probably going to be where it goes over the balance of the year.

Yes, I think that’s right. On the FX side, as we get into February the comps from a currency standpoint get to be a little more in line with what we’re seeing today. So we expect the FX impact to minimize beginning around February.

Okay. So you’re just kind of holding the current rate kind of where it is at this point on the Canadian dollar?

Yes.

Okay, great. Thank you.

Thank you. The next question is from Scott Van Winkle of Canaccord. Please go ahead.

Hi. Thanks. A couple of follow-ups, Steve first on all of the contract extensions you talked about, even if you exclude Whole Foods you’re talking about well over 10% of non Whole Foods business was renewed this quarter. Is there a reason why it’s happening so quickly in a short period of time? And then the second question or follow-up is; if you -- could you give us the numbers if you excluded all of your Albertson’s business this quarter would revenue growth have been 2%. Because if you look at the guidance of kind of 3% to 5%, it would look like you’re assuming a little better internal growth all normalized in your guidance than what you reported in Q1?

Okay. Yes, Scott we’ll talk about that. So with the renewal, it really wasn’t a factor of -- that we did something to push all this to happen. I think a lot of it was just the timing was right to do it both at the customer level and at the -- on the UNFI side. Certainly there was some M&A in our customers, so they felt it was important to get a contract renewed. We’re obviously in an evolving industry. And so, I think all the parties involved wanted to ensure that they had a longer term contract. So I wouldn’t say that it was really unusual, but I think we were just very the timing was right that we were fortunate to be able to extend as many contracts as we were able to which obviously gave us a tremendous amount of comfort and confidence in a fact that so much of our customer base sees the real value in what we do. And not only in terms of what we’ve done, but what they see us doing in the future. As it relates to the revenue growth, I think Mike is going to comment on that.

Yes, there was a lot going on in the quarter with the transfer of the inventory over to Safeway Albertson’s, so that was done at landed cost which was naturally a little dilutive to their earnings. But overall I would say it’s not a material impact on our margins.

I was -- what was the -- do you know the -- can you give us the revenue contribution from Albertson’s in the quarter, I mean obviously impacted by the wind down. But I’m wondering how significant that was as we try to remove that from our forward estimates?

I don’t think we know that. Certainly wasn’t material, but I think -- do we know the number without Albert in the quarter?

Scott, I don’t think we have that with us.

Okay. We’ll follow-up. Thank you.

Follow up. Yes.

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

Hello. Thanks. I missed some of the call, so you might have answered this. But I did hear you were asked about DPI, Steve. Did you get into, if not would you tell us why did you pass on it? I know they do Starbucks and some chains that maybe you’re not interested in, but was it a price discipline matter or is it more mix?

Andy, I think it would be unfair for me to get into a lot of detail around our M&A, but like I said earlier that was not a company that was a good fit for us.

Okay. And then, Mike on the 15 basis points from the Canadian foreign exchange if they impact your gross margin? What a big number, $0.15 a share. Can you tell us what was that headwind last year so we can get a sense of the swing, and was that $0.15 what was in the budget or did things get worse this quarter and you had to increase that amount, the 15 basis point?

Yes. So first of all the 15 basis points is a combination of constant currency, the translation part and the transactional impact. I can't speak to what we were facing at the same time last year. Although if you go back to Q1 of fiscal ’15 the Canadian dollar is about $0.90, and that was probably down a little from where it was prior year. But I can't speak to exactly what that amount was.

Yes, I mean, I think, Andy there is really two components, that FX issues that we’re facing in Canada right now. One is the just purely translational or in other words the high percentage of products that we buy from the United States in Canada in Canadian dollars. So we’ve got a translation problem there. The second part of it is and actually being able to pass through the significantly increased prices to the largest retailers in Canada which we have not had a great deal of success doing. So that’s caused a short-term gross margin issue, because we just can't pass the pricing through fast enough.

Yes, okay. I understand that. But was that $0.15 or the [technical difficulty] let’s stick with your basis point. Was that what you were looking for when you set guidance? I’m just trying to understand, another way to look at your guidance, you took down sales a little than a percent, 0.9% across the range and then you took down net income -- EPS 2.5% to 3%. So like a lot other question, this question is similar, what got worked other than in terms of the deleveraging effect?

Yes, I think there’s two -- I would answer that two ways. I think number one is, a lot of the one time issues that we had in the first quarter -- we had in the first quarter were not necessarily going to be able to make it up. So its not a matter of that things are getting worse, because we don’t think they’re getting worse, they’ll probably get better. But not better to the extent that we’re going to be able to cover some of the issues the one time events that we had in the first quarter. I think that’s the biggest reason. The second part of it is; we did have some headwind associated with FX. However that headwind to a large degree will dissipate as we get into the second quarter, just because the comps will go away.

Okay. That’s very spot on to the kind of question I was asking. Thank you.

Okay.

Thank you. The next question is from Stephen Grambling of Goldman. Please go ahead.

Hi. Good afternoon. I just have one quick follow-up to Scott’s question on contract extensions. And that’s just, can your terms be overwritten by a material change of control such as acquisitions. You did mention there’s a lot of potential consolidation in the industry, I’m just trying to understand did that potentially bring up more contracts for you to bid on or even some of your contracts become at risk? Thanks.

Honestly I don’t know the answer to that question. I think that some contracts probably do, some don’t. Our contracts to a large degree are heavily reliant on the fact that, we’re either providing value to the customer or we’re not. Most of the customers that we have did not -- all of the customers we had today are extremely focused on service level, differentiation, data, service and all of the offerings that we have. And as long as those things are good the contracts tend to get extended. And so even in the cases where there is a change in control, there’s a high degree of transparency and discussion around what happens with our distribution programs forward -- look like going forward. So I typically don’t worry about M&A and consolidation within our retailers because I think the retailers are all focused on the same things that we are. I think we had an experience last year that was extremely unusual and I’m not sure that we’ll see that again.

Fair enough. That’s helpful. Happy holidays.

Thank you.

Thank you. Our final question comes from Joe Edelstein of Stephens. Please go ahead.

Hi. Good afternoon. Thanks for taking the questions.

Thanks, Joe.

Just two questions here for me. The first Steve, earlier you mentioned just rolling out fresh across the network and part of that I’m assuming you’re referring to Tony’s. Is the Tony’s product something that you think you’ll be able to get across the full network this year within the fiscal year?

No, definitely not. We are going distribution-by-distribution center, and its going to take us a while. The way we’ll get fresh across the country is to acquire it. And that’s something that is important to me. I think that that’s the greatest opportunity for us to further differentiate UNFI across the country and I think M&A is going to be one of the best ways for us to do it. It may not all be in one fell swoop. We may have to buy it off a couple of pieces here, a couple of pieces there. But we have a lot of people who know how to do that and they have a lot of fresh in their background. So that’s what its going to take.

Okay. And I guess related to that, could you just remind us really what the company’s target debt levels are and I’d expect that, at least this year you could de-lever fairly quickly over the course of the full year and maybe that gives you some added flexibility, but just kind of the net debt ratio that you would target?

Yes, I mean right now we’re less than two times lever, 1.65. I think we typically have a fairly conservative view of the balance sheet in debt in general. We might have run up to the high 2’s to make an acquisition and then fairly quickly pay it off and bring it back down to sub 2, I think you can see that in our historical numbers. But I think it’s highly unlikely that we’d ever go to more than three times lever.

That’s helpful for the reminder. And just last question if I could, to squeeze in one more. It was nice to see the operating expenses narrow and despite some of the challenges to the top line. I was just curious, how quickly you were able to go back, rework some of the distribution routes following the Safeway contract. Just trying to gauge expectations and how much improvement you’d expect going forward and really, do you think you can hold or even see some operating margin expansion, maybe not this year but in the outer years?

Hi, Joe, this is Sean. Well actually the teams have done a terrific job coming off of the exit of Albertson’s and getting routing structures changed. But of course in the context of timing its sort of just coming on as we get into the holiday season and we’ve got many, many customers and we want to make sure that from a communication perspective that we’re giving all constituents plenty of time before we make and execute any significant changes to delivery times et cetera. But I would say that from a distribution perspective productivity and in this case, I’m thinking about throughput because certainly you’ll have benefits from the reduction in fuel expense on the transportation line that we’re looking at, we’re running in the range of 4.5% to 5% improvement throughput from a warehouse and distribution. So we’re looking very solid there.

Thanks for taking the questions, and good luck.

Thank you.

Okay.

Thank you. I would now like to turn the conference back over to management for any additional or closing comments.

Thank you for joining us this evening. Our industry is evolving. And UNFI’s strategy experience, proven history of performance will drive long-term shareholder value. Thanks and have a great holiday.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time and thank you.