SpartanNash Co (SPTN) 2017 Q3 法說會逐字稿

Good morning, and welcome to the SpartanNash Company Third Quarter Fiscal 2017 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Katie Turner. Please go ahead.

Thank you. Good morning, and welcome to SpartanNash Company's Third Quarter Fiscal 2017 Earnings Conference Call. On the call today from the company are Dave Staples, President and Chief Executive Officer; and Mark Shamber, Chief Financial Officer. By now, everyone should have access to the earnings release which went out yesterday at approximately 4:05 p.m. Eastern time. For a copy of the release, please visit SpartanNash's website at www.spartannash.com/investors. This call is being recorded, and a replay will be available on the company's website for approximately 10 days.

Before we begin, we'd like to remind everyone that comments made by management during today's call will 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. Internal and external factors that may cause such differences include, among others, competitive pressures amongst food, retail and distribution companies; the uncertainties inherent in implementing strategic plans and integrating operations [in inquiry access]; and general economic and market conditions.

Additional information about the risk factors and the uncertainties associated with SpartanNash's forward-looking statements can be found in the company's third quarter earnings release, fiscal 2016 annual report on Form 10-K and the company's other filings with the SEC. Because of these risks and uncertainties, investors should not place undue reliance on any forward-looking statement. SpartanNash disclaims any intention or obligation to update or revise any forward-looking statement.

This presentation includes certain non-GAAP metrics and comparable period measures to provide investors with useful information about the company's financial performance. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures

and other information required by Regulation G is included in the company's earnings release, which was issued after market close yesterday.

And it's now my pleasure to turn the call over to Dave.

Thank you, Katie. Good morning, everyone, and thank you for joining us today. The format of today's call will include my brief overview of the quarter and an update on our business. Mark will then provide additional detail on our operating and financial results before we open the call for your questions.

Overall, our third quarter sales trend continued to outperform the prior year's. We achieved strong top line growth of 5.9% due to contributions from Caito, organic growth of 5.2% in food distribution and sequential improvement in military revenue. Additionally, our focus on growing the top line while maintaining costs helped contribute to a 4.7% increase in adjusted EBITDA over the prior year, all of which demonstrate continued progress against key elements of our long-term strategic plan and reinforces our confidence that our strategy will drive long-term profitable growth.

Once again, the primary driver of our performance in the quarter was our food distribution segment, which delivered a 16.5% increase in sales and a 19.9% increase in adjusted earnings. We also experienced encouraging trends in our military segment as we reversed the previous sales trend and grew sales from the preceding quarter by 7.3%. These results were despite the inefficiencies normally incurred when onboarding significant amounts of new business.

Additionally, the hurricanes began to negatively impact supply chain efficiencies and fill rates in both military and food distribution during the end of the quarter. We expect these impacts will be predominantly worked through the system by Thanksgiving. While the retail environment remains a challenge, we have a quality store base located in the right geographies and I'm excited about what the team is putting forth to our consumers in getting our sales to where we expect them.

Now let's take a look at our operating segments' performance and the strategic initiatives we have implemented to drive growth. In our food distribution segment, we continue to be pleased with our ability to leverage our network and industry knowledge to drive both top and bottom line growth. Similar to the second quarter, we expanded our business with new and existing customers and continued to leverage our strengths in private brand, network reach and data analytics to assist with our customers' growth. We are especially pleased to have begun shipping to several customers previously served by a distributor in the Illinois region that ceased operations.

We remain focused on integrating Caito and increasing production at the Fresh Kitchen facility. We've made progress implementing the food processing team over the last quarter and are currently working hard to take advantage of the strong interest in our offering. Initial responses from our prospects have been very positive, and we continue to be proactive in working with some of our largest current and potential customers as they evaluate their strategies in this area. While the Fresh Kitchen start-up is still underway, the offering of such products as meal components, better-for-you meals and grab-and-go items remains a key aspect of our meal solution strategic initiatives.

We also continue to leverage Caito to expand our fresh-cut produce and other fresh offerings throughout parts of our network. Currently, we don't expect much of a change in our sales trend over the next quarter as many companies are reluctant to launch new products or change suppliers going into the holiday season, and this is typically a slower period for cut fruit and vegetables. We do, however, remain confident in the strategic and the significant long-term opportunities of offering fresh-cut produce and prepared meals or meal components to our new and existing customers.

Turning to our military segment. We are pleased to report improvements in sales versus the preceding quarter as we began to benefit from new business in the Southwest and the expansion of DeCA's private brand program. Last quarter, we stated that we would generate positive sales and earnings on a year-over-year basis for the second half of the year, and we continue to expect to achieve this goal. We believe that the private brand offering when fully executed will improve contributions to DeCA by driving more traffic and business into the commissary as customers who left the commissaries in search of private brand products return for a full shop.

During the quarter, DeCA continued its private brand rollout and now expects some approximately 450 SKUs in the system by year-end. Preliminary plan has DeCA introducing up to an additional 1,400 products in 2018 as they move towards their stated target of up to 4,000 SKUs. By providing a combination of national and private brand products, the commissaries are offering one-stop shopping for military customers, which they believe should benefit all of the constituents of the DeCA system.

In the retail segment, our third quarter performance reflects a challenging environment, characterized by competitive pricing as traditional competitors fight for share and hard discounters continue to expand. While comps for the quarter were negative 2.5%, the trend improved through the quarter, and our team is fully focused on improving the trends even further. We continue to take actions to enhance our customer experience through an improved assortment of healthier-for-you products, value offerings in private brand and produce, as well as expanded natural and organic offerings and convenient meal solutions, such as meal kits, expanded grab-and-go offerings as well as incremental deli offering.

Additionally, we are very focused on the personalization of the customer shopping trip and the introduction of technology to allow for a quicker, more pleasant experience as well as the option of shopping anyplace, anytime. These are the types of offerings that demonstrate our commitment to quality and a differentiated offer from the price competitors. For example, Fast Lane, our new online ordering and curbside pickup service that was launched near the end of the second quarter, is now offered at 27 stores. Early results have been encouraging with larger orders and about half of the sales being incremental to our stores. We expect to offer Fast Lane at approximately 40 stores by the end of the year. Shortly after the third quarter ended, we also began piloting home delivery to Michigan locations to determine if and how we might offer this service on a wider basis.

Additionally, we continue to make targeted capital investment in our store base by converting select stores to the Family Fare banner and remodeling others. Our Forest Hills Foods store in Grand Rapids, Michigan has undergone a major remodel, with most of the changes focused on offering a more experiential shopping experience with increased fresh, healthy and value-added options. This location is our latest effort in our high-end format and features new concepts for us, such as the smokehouse, meal kit options, local craft beer growler stations and in-store cold-pressed juices and infused water. While not all of these concepts will work in every store and region, we plan to expand these offerings to other stores where they fit with the underlying customer demographics and market demand. We also believe that our testing of these offerings will benefit our independent customers as they work to address changing customer preferences.

As you might imagine, the majority of our focus is also on continuing to involve -- evolve our Family Fare banner by incorporating the right experiential and value offerings for our customers. Our remodels in South Dakota are delivering above our expectations for sales, and our fourth quarter remodel in Grand Rapids will have many of our latest concepts in place. We'll also be launching many of these features in several remodels during fiscal 2018.

We continue to enhance our private brand offerings for both independent customers and corporate-owned stores. In the third quarter, we began our efforts to convert our Spartan private label to our -- to the Our Family private brand at corporate and customer locations served by our Michigan distribution warehouse, and it is being well received, with strong sell-through at both our stores and our independent customers. We have introduced over 300 Our Family private brand items into the Michigan region, and we anticipate a total of 1,800 items, thus completing our conversion to company-wide private brands by the end of next year's first quarter. This conversion will also allow us to offer an expanded private brand assortment in our Michigan market. For the third quarter, private brand unit penetration in our retail operations was consistent with the national average of 22.3%, and we ended the quarter with approximately 4,900 unique private brand items as we continue to enhance our assortment.

As a result of our innovative offerings to our existing customer base, new products provided by our fresh-cut and meal solutions facility and several additional initiatives, we believe that we are well positioned for continued steady sales improvement in the food distribution and military segments. In our retail segment, we are fully committed to a return to positive comparable resource -- retail store sales and believe that our quality store base and continued focus on enhancing the customer experience through product offerings, technological enhancements and personalization efforts will enable us to achieve this goal.

Before I turn the call over to Mark, I'd like to officially welcome him to SpartanNash. Mark joined the team as CFO in September and immediately hit the ground running. We've already seen how his food distribution experience in the natural and organic space will help drive value for our shareholders and really look forward to his continued contributions.

With that, I will now turn the call over to Mark. Mark?

Thank you, Dave, and good morning to everyone listening in on the call and on the webcast. While I'm just approaching my 2-month mark with the company, I've been impressed by the quality of the team that we have in place and the warm welcome that I received. I'm excited about our long-term strategy and the traction that we're gaining at a number of elements of our strategy.

I'd like to start my comments by focusing on our sales growth and adjusted EBITDA for the third quarter before delving deeper into our financial results. Net sales for the third quarter of fiscal 2017 increased to $1.91 billion, an increase of $106.6 million or 5.9% over 2016 third quarter sales of $1.8 billion. Adjusted EBITDA grew by $2.5 million or 4.7% to $55.9 million over the prior year third quarter, and we delivered adjusted EPS of $0.54, which exceeded the prior year's adjusted EPS of $0.53, as we battle our way through a challenging retail environment. On a GAAP basis, the company lost $3.32 per diluted share in the quarter compared to diluted EPS of $0.44 per share in the third quarter of fiscal 2016.

Shifting to our operating segments. Food distribution net sales were up $132.9 million or 16.5% to $937.4 million due to contributions from our recent acquisitions and organic sales growth of 5.2% as we continue to better leverage our network and provide value-added services to our customers. We experienced inflation of 136 basis points in food distribution in the quarter, an improvement of 106 basis points compared to the 30 basis points of inflation in the second quarter. This was the first quarter in well over a year where we experienced inflation in all categories and we lapped some high single-digit inflationary figures in a couple of categories from last year's third quarter that helped drive some of the increase that we saw. Consistent with our commentary from last quarter, we currently expect to see only a modest uptick in inflation in the fourth quarter.

From an earnings perspective, third quarter operating earnings for food distribution increased 7.4% to $20.4 million due to our higher sales growth and lower incentive compensation expense, partially offset by Caito-related start-up and integration expense as well as higher health care expenses. Adjusted operating income totaled $23.8 million in the quarter, an approximate 20% increase over the prior year's third quarter adjusted rate -- adjusted operating income of $19.8 million.

Net sales in our military segment came in essentially flat at $505.6 million for the quarter compared to $506.6 million in the prior year. However, from a sequential perspective, net sales increased by 7.3% or approximately $34.5 million over the second quarter of fiscal 2017. The increased sales in private brands and from the additional sales volume acquired in the Southwest during the quarter basically offset the sales declines of the DeCA-operated locations we serve.

Operating earnings for military in the third quarter totaled $1.1 million compared to $2.9 million in the same period in the prior year. The decline in earnings from a GAAP perspective was driven by the various factors covered in the press release. The military segment's adjusted operating earnings increased by $0.2 million on a year-over-year basis to $3.1 million for the third quarter of fiscal 2017. Our team remains focused on becoming an even more efficient organization from a supply chain perspective, and we continue to make progress in this area during the quarter.

In our retail segment, net sales were $463.6 million versus $489 million for the same period last year, with $16.7 million of the sales decline driven by the sale or closure of retail stores, along with a decrease in comparable store sales excluding fuel of 2.5%, which is a slight decline from last quarter. Although on a 2-year stack basis, comp sales improved sequentially. In connection with our continued store rationalization initiatives and to drive incremental food distribution business, we've sold 2 stores, 1 each in Q3 and Q4 to date. We've also closed 3 retail stores in Q3 and 1 store in Q4. As a result, we now operate 145 corporate-owned retail stores.

Third quarter adjusted operating earnings for retail were $8.5 million compared to $12.4 million in the prior year's third quarter, reflecting the challenging sales environment and incremental margin investments. On a GAAP basis, the retail segment reported an operating loss in the third quarter of fiscal 2017 of $215.3 million compared to operating earnings of $8 million in fiscal 2016's third quarter. The primary drivers of the loss were a goodwill impairment charge of $189 million and asset impairment and restructuring charges totaling $35.6 million. While our retail segment continues to generate operating income and we're seeing trends improve from a comparable sales growth perspective, the current retail environment led to a reevaluation of goodwill and the recognition of $189 million goodwill impairment in our retail segment.

For some perspective, we have been able to avoid incurring a goodwill impairment during the course of the Great Recession unlike a number of our larger retail peers, but the combination of recent factors led to a different outcome in our analysis this quarter despite the overall health of our retail segment. In extending our analysis to our store base based on an individual-store level, we recorded a noncash asset impairment of approximately $32.5 million. In total, we recorded restructuring charges and asset impairments of $224.7 million in the quarter, with the remaining $3.2 million comprised of other restructuring activities and related costs.

From an operating cash flow perspective, on a consolidated basis, we generated $33.3 million in the third quarter compared to $24 million in the third quarter of fiscal 2016, an increase of $9.3 million. Year-to-date, operating cash flow is $71.6 million for fiscal 2017 compared to $81.1 million last year. The quarter's increase was primarily due to lower customer advances to support sales growth, partially offset by changes in working capital, particularly higher AR balances associated with sales to new and existing distribution customers. During the third quarter, we paid a quarterly cash dividend of $0.165 per share totaling $6.1 million, and we repurchased approximately 562,000 shares of stock for $14.6 million.

Our total net long-term borrowings increased $251.1 million to $657.8 million at the end of the quarter compared to $406.7 million at the end of fiscal 2016 largely as a result of funding our recent acquisitions but also due to the timing of various working capital [needs]. Our net long-term debt to adjusted EBITDA ratio was 2.75:1, and we remain committed to our long-term target of 2x. And barring any additional M&A activity, we expect this ratio will continue to improve as we grow sales, improve operating efficiencies and reduce our debt load by utilizing our free cash to pay down debt.

As covered in the press release, we are updating fiscal 2017 earnings guidance. We now expect adjusted earnings per share from continuing operations to be approximately $2.06 per share to $2.12 per share and our operating loss from continuing operations to be approximately $2.04 per diluted share to $2.10 per diluted share. Finally, with the continued easing of deflationary pressures and the modest rates of food inflation that we've seen to date in the back half of fiscal 2017, we do not expect to offset any of the deflation-related LIFO benefit of approximately $0.07 per diluted share realized in the fourth quarter of fiscal 2016.

As Dave covered in his remarks, in retail, we continue to focus on further improving our customer experience by investing in our store base, offering a more personalized shopping trip and greater consumer convenience through our technological and product offerings, such as Fast Lane, meal solutions and our test of home delivery, along with the successful launch of the Our Family brand into our Michigan region.

In the military segment, the new business secured in the third quarter, along with the growth and expansion of our private brand program with DeCA, will drive our return to positive sales growth in the fourth quarter.

Due to changes in the timing of commencing certain capital projects originally planned to be operational late in the fourth quarter, we are updating our expectations for fiscal 2017 capital expenditures to now be in the range of $71 million to $73 million versus our previous guidance of $75 million to $78 million. Despite having the capital committed to deploy towards these projects, the time line for the availability of the equipment to be purchased has pushed some of this capital spend into fiscal 2018.

We now increase -- we now anticipate that depreciation and amortization will be approximately $82 million to $84 million due to the lower capital expenditures and the benefit of certain asset impairment charges. We project that interest expense for the fiscal year will be approximately $25 million to $26 million. Finally, we expect our full year income tax rate will be between 39.7% to 40.2% on a reported basis and 34.3% to 34.8% on an adjusted basis, which effectively implies a fourth quarter tax rate of 36.3% to 36.8%.

And with that, I'll turn the call over to the operator to facilitate the question-and-answer session.

Thanks, Mark. Let me take over here. So just in summary, before we turn the call over to the operator, our third quarter results really reinforce the progress we're making against our strategic plan and demonstrate that customers are responding positively to our efforts.

Looking to the remainder of 2017 and well into 2018, we believe operating conditions, particularly in the retail sector, are likely to remain challenging, and we are focused on maximizing the growth opportunities in our food distribution and military segments through our expanded product offerings, innovative solutions and unique supply chain capabilities. We will continue to invest in our retail store base and are eager to expand the test of several of our recently introduced value and customer experience-enhancing concepts to new geographies. We expect these initiatives as well as our Fast Lane and pilot home delivery services will lead to increased customer satisfaction and loyalty, particularly as they are deployed over the next year. We are encouraged by the work that our team is doing to evolve our business and believe that these efforts and our financial strength position us to grow sales and earnings across segments on a sustained basis.

Now I'll turn the call over to our operator, Carrie, to facilitate the question-and-answer session. Carrie?

(Operator Instructions) First question will come from Scott Mushkin of Wolfe Research.

So a couple of things. So I wanted to talk about the organic growth in distribution, which I think was pretty strong again this quarter, and I just wanted you to clarify what that number was. I think it was in the release but I just want to make sure I got it. And then the second thing is on that -- on the organic growth in distribution. I think I asked this last time. Obviously, you're doing a good job selling into your customers. I guess I was wondering if you can give us a picture on how they are doing. I mean, the environment is so tough. Your retail business is -- is struggling, but how are your customers doing? Not what you're selling to them, but what's going on out the door for them? And then I have one more question after that.

All right. Well, I think I'm keeping up with you here. But I -- we'll start with the first one. Yes, our organic growth in distribution was strong at 5.2%, and it's something we're really proud of. I think it demonstrates the creativity of our team, the thought leadership that they present to the customer. Our involvement in retail and the effort we put into building a good retail company really give us an edge up when it comes to working with our customers, whether that be the conventional operators or our national accounts, because we walk the talk. We live what's going on in the market, and that enables us, I think, to be nimble and thoughtful on how we bring solutions to our customers. And that then helps us sell more to them because we're helping them address needs or issues that they have. As to how our customers are doing, I think it's like everybody. We have some customers that are just knocking the ball out of the park, and then we have others that are doing as great as always. And like anybody, I'm sure there's some that aren't doing as well as you'd like. But overall, our customer base is well positioned for this environment. We don't -- we are not a major metropolitan company, right -- a major metropolitan area company. Our customers are suburban, rurals, county seats, tourism areas. And they're more of that -- that market where the competition is there, it's been there, they're somewhat isolated from some of the other things, at least to some extent. No one's totally isolated. So we have a good customer base with a lot of retailers that invest in their stores and run a great outfit, and they're the kind of place people would be proud to shop. So it's a challenging environment, but it's not the first time retail has been challenging. That's what makes it exciting.

Do you think, on balance, they're comping positive?

Scott, probably on balance, I would assume they kind of are with the market as a whole. I mean, some are flattish, and some are somewhat down. I mean, as you look at it, I think they're solid. But yes, I think it's a tough environment for them like everybody else, but I think they're doing pretty well.

So then my second question was around scale. You guys have an acquisitive company. How should we think of scale in this new environment? Is it more important than ever? Does that make you want to do something -- if you were to think strategically, do something larger? And [a] follow-up to scale... Is the retail business, is -- do you need more scale there?

So let me break it into components. Scale, overall -- I think scale's always important, but I don't believe it's the end-all. We've got a nice sized business. We're not about being the biggest. I don't think being the biggest is the answer. I think being the best is the answer. And I think that's a combination of scale but also a combination of what you do and how you do it. And so I think we're more about being the best offer, the best all-around offer and being the best offer in the areas that are growing as well as the best offer in that stable center store. So yes, I mean, scale is always important, but I don't think it's the end-all, be-all. I think there's always more room for that more nimble, that “more in tune with what's going on in the environment” competitor than necessarily being the biggest. I believe we [give] very good cost of sales. I think we partner well with the CPGs. I think they look at us as someone who's trying things, trying innovative things, someone they can bring ideas to and who -- over 2,000 stores that we serve plus our own 150 stores, that's a pretty good mass. And if somebody has a good idea and we can make it work in that 2,000-plus stores, it's going to be meaningful for them. And so I think we've got scale. Hey, as you look at our M&A, some of that M&A will be right in the core, I think, because, like I say, there's nothing wrong with having more scale. There's nothing wrong with completing our network, building it out further. But also, you're going to see some of our M&A be more tangential. Where -- I mean, we will be a bigger company, obviously, if we acquire something, but we will be bigger in those tangential areas that we think have a greater growth profile as well. So we don't -- I guess we're not going to restrict ourselves to only making acquisitions for scale. We're gonna build a better company.

And Scott, I mean, just one more thing to add to Dave's comments. I mean, when you talk about getting the additional sales volume with scale, for us, one more case on the [chart] makes that chart more profitable, right? So selling more to our existing customer base, going to the same drops with a larger drop size helps drive our profitability versus acquiring an additional 100 customers that are all single store and have a small drop size. So it's what type of scale you gain and how you gain it that also is an important factor. And then just to -- you mentioned it in the beginning of your question. But yes, I mean, in the press release, the food distribution reference for the 5% is a comp sales figure that wouldn't include the acquisition -- wouldn't include the impact of the acquisition.

And the next question will come from Ryan Gilligan of Barclays.

I guess, on guidance, can you try to quantify the different buckets that are contributing to the guidance reduction? So how much of it is due to retail getting more competitive versus hurricanes versus onboarding of new customers, et cetera?

Yes. I mean -- well, I think, Ryan, the largest component would be the fact that we're not going to be able to capture the LIFO benefit that we had last year, so that was roughly $0.07 last year. We might get a little bit of a benefit, but for all intents and purposes, we're not factoring that in. I think as it relates to the retail environment and the Caito acquisition, the headwinds for Caito and some of the challenges within the retail environment, which you saw this quarter was a step down in profitability, the 2 of them probably split the remaining part of the reduction in the guidance. I think some of the other items that you highlighted, whether it's new onboarding costs, whether it's hurricane-related impacts or driver shortages or fill rate impacts or manufacturers who were having disruption coming out of the hurricane, I think that's what plays into our guidance on the range side, where we could achieve the higher end of the guidance if those aren't as big of an impact and we may drift towards the lower end of the guidance to the extent that those items materialize and/or continue for a longer period of time than we projected for the fourth quarter. Does that help? Does that answer the question?

Yes, definitely. And I guess, can you just give a little bit more color on the Caito integration, cross-selling and where productivity levels are now that you guys have gotten a little bit more time following the facility consolidation? And then, I guess, how should we think about the earnings contribution next year from Caito?

Yes. So I think as you look at Caito, we are continuing to focus on how we bring that to its full potential. As I said and we've said consistently, this is right in line with the trends in the industry. It's right in line with where the consumer is looking. And we're very, very bullish about where we're taking this operation. We've been working on the manufacturing management team, and we're continuing to bolster that. We're down to just a position or 2 we need to really have that run in the way we want. We've got a pipeline of interested current customers who want to expand their work with us as well as large new customers potentially, and so we're excited about that. You're not going to see much change, as I mentioned, in this quarter, the fourth quarter. As you're into the holidays, and that's not a time to launch a lot of new products or change suppliers on existing products. But I think as we move through that, into the back half of the first quarter and forward, we're going to start to actualize some of that pipeline, and the team is excited about it. And so as I look into next year, I think we're going to see that business begin to put forth what we expect, and I think everybody's going to be happy with it. And we've been happy with being able to bring that cut fruit and other type of fresh offerings into our existing network. In the Michigan and Ohio facilities and our North Carolina facility, we've really begun to benefit from those sales, and we're actually experimenting on can we get it out into our Western facilities. And so, hey, it's going to be a great partnership. It's not where we want it, obviously, today. I think we've been pretty clear on that. But we're putting in a lot of hard work. And our team down there is a good group of folks, and they're very committed and dedicated to delivering the type of value to the shareholders we believe we'll be able to do here.

That makes senses. And have the productivity and service levels at the facilities returned to the levels where they were before you closed one of the facilities?

I would say they're close. I think it's probably still a little bit behind in the productivity level in distribution. And there's -- with the Fresh Kitchen, until you get sales, it's hard [to have] productivity levels. And so I'd say they're getting there. We need to finish this -- getting this manufacturing team fully in place for the manufacturing side of the business to get to the productivity we're expecting. I think there's reasonable upside as we move into next year and we can improve productivity.

The next question will come from Shane Higgins of Deutsche Bank.

Just wanted to ask about the inflation trends. I think, Mark, you said that food distribution was seeing cost inflation or saw cost inflation of about 136 basis points in the quarter. I didn't hear -- I don't know if you said what retail experienced. Is it a similar level?

No, retail was probably about 58 basis points. Retail still has some categories where we're still seeing some deflation. And that's why we sort of called out that we've finally seen all categories of distribution move to positive from an inflationary perspective. We still have categories like dairy and frozen and -- to call out a couple within retail, where we've still got some deflationary aspects. And so they're trending lower even though -- their inflation levels are trending lower even though they did improve sequentially.

And how would you guys characterize the level of inflation that we're seeing today? And it sounds like you guys aren't expecting things to change materially in the fourth quarter, but would you say that for the most part, these costs are getting passed through really without any difficulty?

So I mean, I think when you look on the distribution side, it predominantly flows through. I mean, every once in a while, when you get into some of the commodities, you could have a local dairy or a local meat or produce purveyor that -- who's on the market trying to undercut when you pass it through. But that's rare in the distribution side. It typically flows. On the retail side, it is just very dependent upon your competitive set and the competitive market. And so what I think we've always found with inflation/ deflation in retail is, on the way up, people are a little sticky and hesitant to raise prices; and on the way down, people tend to hold prices a little bit until the competition forces them to go down. So I think when you look at that spread that Mark threw out there of 136 inflation at distribution and 58 points of inflation at retail, I think you're seeing that. That's the first time it's [flipped] on us in a number of quarters. So that would imply that it's not all passing through easily at retail, but some is. And it's -- and every quarter, a little more passes through, right? That stickiness works its way out.

Yes. No, I appreciate that color. I know these transitions can be sometimes be tricky. Can I just get an update on the store rationalization plans? I see you guys sold a couple of stores. You've closed a few. Just kind of thinking, into 2018, how we should model store count and what you guys are thinking about maybe over the next couple of years.

Yes. So we'll -- I mean I'm never going to give you exact accounts on those types of things. I mean, that's not the kind of thing we really want to discuss fully. However, I think we've been very clear that we have certain areas where we believe our -- we are going to continue to invest in our store base, and we believe they're the right geographies. We have a strong store base. We're in the locations we want to be in, and we will continue to drive that performance across those regions. We additionally have stores that are valuable -- important stores for us. They are cash contributors, they are good stores, quality associates doing a wonderful job every day, making that business work and serving our customers. However, they may not be exactly the kind of stores that fit with our strategy and our vision of what we want to be in retail. However, they will fit incredibly well with other peoples' vision of what they want to be and how they want to service the consumer. So we will take opportunities with those stores to either attract incremental distribution business or help benefit a current customer of ours with the opportunity to have growth. And so that's really how we look at it. So yes, it's been consistent and it will be consistent for a few more years as these stores either become attractive to others or become not as cash efficient as we'd like and then we move out of the format. So I guess that's how I will leave it without any more specificity. But it's part of our strategy, and we continue to execute that.

And the next question will come from Kelly Bania of BMO Capital Markets. (Operator Instructions)

Can you just elaborate a little bit on the operating margin pressure in the retail division? Is it just all this short-term lag in passing on inflation? Or is there any impact from anything else, such as the implementation of Fast Lane or any other factors?

Well -- so Kelly, I think as you look at it, I would say the majority of it, in my opinion, is sort of the passing on of food price inflation and just the general price competitiveness as you find some of the players reacting to a Lidl incursion or other type of dynamics in the market along those lines. I'd say that's the majority of it. And with everything, that works its way through the system, we have these events consistently in retail. It's a very, very dynamic market in retail now, which, if you're in retail, it makes it exciting. And it's why you chose retail as your path, right, because you enjoy that dynamics and you enjoy the ability to continue to revise and refine your offering and adapt to the consumers' desires and changing demand. I think whenever you launch programs like Fast Lane and whenever you do substantial remodels, testing new concepts, you typically invest in that, right? I mean, you would rather execute it flawlessly than fail in your launch. And so there's always extra costs with that. So yes, there's a little bit of pressure on our labor lines and some of our expense lines when you launch a program as big and as advanced as Fast Lane and when you open some significant remodels. But that works its way back out of the system as you get the programs up and running. So we will always invest when we launch things like that, so there's a little bit to that too, I would say.

And I guess just another question on the divergence between your retail sales performance and your organic revenue growth in your distribution business. Because it does seem like your distribution organic growth has really strengthened doing -- and doing pretty well. Is this just a regional thing? Because I think that business is much more geographically diversified versus a more concentrated geography for your retail business. I guess I'm just curious if you're hearing from your customers in distribution talk about the same kind of intense price competition that you seem to be seeing in your retail business.

Yes. I would say it is a much more diverse business, right? Our distribution goes to so many different states, so many different markets, so many different types of customers. I think that is part of it, and I also think we're blessed with some wonderful customers that are really growing incredibly well in that business. And so it's a combination of both. I would say it's the geographical -- geographic diversity and the fact that we have some very nice high-growth customers. And so those 2 things I think defray some of the concentrated issues that you may experience in, to your point, a retail market where well over half your stores are in one state.

Got it. And then just going back to Fast Lane. Is -- what is the margin impact of that long term? I think you have a fee structure in place for that service. But as you roll that out, is there any short-term expense pressure we should be kind of thinking about as we move into next year? And just curious how you think about that fee longer term because I think -- I believe Walmart is offering grocery pickup services for free. So just curious how you think about that longer term.

Yes. So like -- I think like we just said, yes, there will be some short-term cost implications to that as you roll out the program, as you refine your staffing levels to how each store reacts differently, right. Because our stores are not cookie-cutter demographically, cookie-cutter size-wise. There's just -- we have a diverse store base. And so different stores will respond differently to the rollout of the program, and thus, there is no one-size-fits-all way to launch it. So we have to learn as we do it. And like I said, we are going to err on doing it flawlessly and exceeding the customers' expectations for the rollout. So as we roll it out and those variances occur, we will adjust our cost structure appropriately. So yes, you will see some incremental expense here this quarter, next quarter. It won't be overwhelming, but it's additional. I mean, it's 1/10 or so here or there, right? I think though from a margin perspective, this, long term, has a very strong potential to enhance our profitability. We do have a fee, to your point. If you take the annual subscription method of $100, which sometimes we put on sale for significantly less, you're talking a pretty inconsequential number for an average user. And so -- well, I don't think that will be prohibitive, and I think our product offering is superior to some of the other people who might be doing it for free at least today. I believe that it won't be a barrier, and it helps contribute to the incremental cost. But the incremental service -- and when you think about how our stores are laid out, how we're typically located on the corner of Main and Main, we're on our customers' way to work or their way home from work or on the way to their children's practices or other events they may have. We're so conveniently located that -- and our system is so strong -- we tested a number of them and ours came out way ahead of every one we tested -- that I think the ease of use, the convenience of location, the quality of the products that we offer can compensate and should allow for some small fee, and I would say ours is a pretty small fee. So I believe long term, it will be a profitable venture. It will add to our profitability. And I think it's differentiated from an alternative of trying to do the same kind of thing at a supercenter where the supercenter isn't on your way typically. It's a huge parking lot that you have to navigate through. It's going to take longer. It's harder to know your shopper, where our people get to know the shopper incredibly well. It becomes a personal shopper, right? You actually develop a relationship with the shopper, and it's been really interesting for me to see the [D rate] on our sales. It's basically approximating the store. And the orders are way bigger, but they're buying their produce from us. They're trusting this associate to pick their produce. They're trusting this associate to pick their meat. And actually, I tease my wife, because she uses it a lot, I actually think our produce is better than when she was buying it. But I kind of get a little feedback when I (inaudible). It's just that -- I think there's so many intangibles along that relationship building. You just think how much people typically spend in marketing dollars to build that kind of a personal relationship, and so there's a lot to this program. I really like the click-and-collect, and I think our team is doing a fantastic job getting it in place.

And then maybe just last one for me on the military. I think the thought was, optimistically, long term, that can be as much as $600 million incremental. Is there anything that's changed your view about that? And can you talk about the timing of the ramp and if we should expect a similar sequential increase in terms of dollar sales for that segment in Q4?

Yes. So I think you -- so our guidance on military is that we believe the second half of the year, right, is going to be [positive] sales and earnings to the prior year. And so we closed a substantial gap in the third quarter, basically brought the sales in flat. Our military team is just doing a yeoman's effort when you think about what they're taking on, this business in the Southwest, the rollout of a private brand program. We have facilities in Florida and Georgia and Texas going through a hurricane. At the same time, you're doing all those things and still delivering as they did. We expect that pace of sales growth to increase so that we still achieve what we said. So we would expect fourth quarter sales to be better than a year ago, and we would expect that to grow over the course of next year. And so if you look at DeCA's rollout of their private brand program, they have a stated goal of 4,000 units. I think it's their current intent to try to get there over the next couple of years. So as we said in the script earlier, their goal that they stated at this point is 1,400 incremental items next year. There's only 450-ish items expected by the end of this year. That's a pretty significant acceleration in pace and volume. And as these products are in the facilities, the demand is going to grow and the acceptance by the consumer is going to pick up. And we really do believe that they're -- 22.3% of the consumer purchase is in private brand, for which DeCA has no offering -- had no offering prior to this. It should help draw consumers back to that commissary, which I -- which, we hope, benefits everybody, the CPG companies as well as DeCA. And it really continues to make these benefits for our heroes even stronger, and that's what this is about, right? We really support those troops and patriotism is a huge value for us. And we just think that this can be really part of that solution. As well as they've named a new interim director, Retired Admiral Bianchi and -- who is the gentleman who runs NEXCOM today. And so he's going to bring, I think, an even more retail focus than has been there in the past and really help that organization achieve what it believes it can.

The next question will come from Ajay Jain of Pivotal Research Group.

I wanted to follow up to the earlier question about the store rationalization process. It seems like the number of store closures accelerated in the quarter. I think Mark mentioned that you're now at 145 stores. So that's down, I think, 15 from the beginning of last year. So I understand you don't want to comment on the prospect of additional store closures that might take place in the future, but in terms of the locations that you've exited recently, did they go dark? Or are you finding buyers for those stores through your distribution network? I'm just trying figure out if there is some revenue shift from retail to distribution as a result of those recent store closures.

Yes. I mean, I'll start, Ajay, and I'll let -- maybe let Dave kind of take it from there. I mean, I would say that there were 2 stores that we closed that we sold to customers, one in the third quarter, one in the fourth quarter, as I covered in my comments. And then there were 3 stores in the South Dakota market where we closed those stores, but we did a big renovation and we opened 2 stores that -- based on what we've seen, we feel that we've had a lot of success in retaining the volume that might have been coming from the 5-store base that was open. And Dave, I don't know if you want to talk about those remodels.

Well, yes. Let me just -- yes, I think a couple of things. So Ajay, where we can find a home for these stores and to the extent it drives more distribution business, that's just a win, win, win, right? And the stores we keep open are cash contributors. If we were to close a store in the future and it didn't have a home at either our -- in a customer's network of stores or in a new customer's network of stores, it would only be because it no longer was generating the cash flow we thought was reasonable to keep it open. And so you'll see stores, if they go dark, it won't be a negative impact to our channel because we evaluate cash flow on a system-wide basis. So to the extent a store would go dark, it would be for that reason. Our hope and desire is that most of these stores that don't currently meet our format will find their way to a customer or to a new customer. And so in either case -- we will either have better cash flow or at least, worst case, the same cash flow.

Okay, that's very helpful. I have 2 related questions on Caito. First, do you have any sense for when the Fresh Kitchen business gets off the ground and it's no longer in the start-up category? And just related on Caito, it seems like there continues to be incremental softness each quarter, so I'm just wondering if you think that the run-rate level of revenue is going to stabilize in the fourth quarter. Or should we expect some continued softness, some incremental sales weakness? I'm just asking if that revenue run rate could get worse in the near term before things stabilize.

Well, I mean, Ajay, I think I'll take the -- I'll handle the second question first. And I would say that, that business has some seasonality aspects to it. And so certainly, if you were to look at the quarters individually, you might say that the fourth quarter would be softer from a sales standpoint. But I would say that when we look at the annual run rate, that's not indicative of where we think the run rate would be. So I would say that we're still comfortable with what we've said before on the run rate, but the fourth quarter, in and of itself, is usually one of the softer quarters from a produce and a veggie standpoint. And so you'll see some of that in those numbers. Having -- and then jumping to the first question, I mean, I think that we've got revenue. I don't think it certainly is a revenue level that we would like from a [kitchen] perspective. But I think that, certainly, we would not go beyond the end of fiscal '17, unless something was to change dramatically, with it being viewed as a start-up, I mean. And subject to change, if something was to happen, but I would say that our expectation, we -- by the end of the fiscal year that we'd probably not consider that as a start-up anymore.

I think you should see -- Ajay, I think you should see -- like I said earlier, I think in that back half of the first quarter, I think, is where we should start to begin realizing some of our pipeline of sales. And so you're -- our belief is you're going to see that business start moving in the direction we expect as we move through that half of the quarter.

Okay, that's helpful. I have one final question. If you can comment on how much you have reserved for the Gordy's relationship. I believe you're owed around $40 million through the receivership process.

Ajay, that's something that's disclosed in the 10-Q that we filed last quarter, and when we file our 10-Q for this quarter, which will be some point this week, it will be disclosed there. But it's not something we've provided yet, so I would leave it with what we'll put in the Q. But I would say that there's not been a material change from Q2 to Q3.

The only other thing I'd say on that -- because we're just not going to get into details of a customer. If you look at our run rate, so this will be more of a general business comment, any impact to our run rate started well back in Q2 and was fully realized this past quarter. And if anything, our expectation is our business will improve as that situation gets rectified as opposed to there being any real negative go-forward concerns.

And this concludes our question-and-answer session. I would now like to turn the conference back over to Dave Staples for any closing remarks.

Thank you, Carrie. I just want to thank everybody again for participating in the call, and I want to just continue to thank our wonderful associates for all the great hard work they're putting forth, the innovative efforts and really supporting our business as we continue to execute our strategic plans. And thank you -- I want to thank all our shareholders again for staying with us and being part of this journey that we think is very exciting.

So thank you, everybody, for being on the call, and we'll talk to you again in a quarter.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines. Have a great day.