United Natural Foods Inc (UNFI) 2006 Q1 法說會逐字稿

Welcome to United Natural Foods first quarter 2006 conference call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question and answer session. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded today, Tuesday, November 29th of 2005.

I would now like to turn the conference other to Julie Tu with the Financial Relations Board.

Thank you and good morning, everyone. By now you should have all received a copy of this morning's press release. If any one still needs a copy, please call Janet Jasmine in our NY office at 212-827-3777, and we'll send you a copy immediately following this morning's conference call.

With us today this morning from management are Michael Funk, President and Chief Executive Officer, and Rick Puckett, Chief Financial Officer. We'll begin with some opening comments from management, and then will open up the line for questions. As a reminder, this call is also being webcast today, and can be accessed on the Internet on www.UNFI.com. Before we begin, as usual, we would like to remind everyone about the questionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on this morning's conference call.

With that, I'd like to turn the call over to Michael Funk. Please go ahead, Michael.

Yes. Thank you, and welcome to our first quarter conference call. Joining me today on the call is Rick Puckett, our Chief Financial Officer. The first quarter sales were 575.6 million. 21% increase from the 477.5 million recorded in the first quarter of fiscal 2005. Excluding acquisitions, our sales growth on a comparable basis was 17.5%.

It should be noted that these sales figures do not take into account the fact that we had two less shipping dates from the previous year, based on our change in reporting periods. We were very pleased with our growth in the quarter for all channels of our business.

Sales growth in the supermarket and the independent channels on a comparable basis was over 25%, a strong increase from previous quarters. As a percent of our overall sales mix, supernaturals were 35.6% of our business, supermarkets were 14%, Independents at 46%, Foodservice was 1.5%, and other miscellaneous categories were 3%. Whole Foods market was 25.5% of our total sales, and Wild Oats was 10.1%. Sales growth was consistent across all regions in the country, with growth coming in very strong in both east and west regions.

We continue to see our sales positively impacted by our strong service levels, and our ability to take advantage of solid industry sales trends and new store openings. Earnings Per Share for the first quarter came in at $0.27 for the quarter, excluding the items noted in the press release. This compares to our earnings of $0.24 the previous year, a 12.5% increase.

Our operating margin of 3.5% for the quarter was impacted by several negative factors. Fuel prices peaked to record highs during the quarter, accounting for an additional 10 basis points of cost, net of fuel surcharges, that we collected from our customers.

Our facility expansions both in Indiana and Rocklin, California, resulted in higher costs as these facilities ramp up efficiencies. As previously noted we forecast a 6 to 9-month time period to achieve optimum efficiencies, once these new facilities come on line. Rocklin, California began shipments in mid-October to our northern California region.

The move into our largest building in the country was a significant achievement, and service levels there stabilized within a few weeks of the move. It should also be noted, our additional expenses in continuing to carry the warehouses in Auburn, California where we previously operated from. These facilities are now vacant, and are being actively marketed for sale.

Greenwood, Indiana which opened in August, continues to improve in performance as well, and we look forward to continue to migrate business from other facilities to optimize our transportation expenses. Additional areas of focus are the integration of the Roots and Fruits acquisition in Minnesota, as well as Select Nutrition.

Both of these acquisitions have been challenging, but we anticipate continued improvement in the operations and profitability over the next few quarters. We are in the process of reviewing several key opportunities for improving the Company's performance over the company coming year, investing in technology and systems that can help us reduce our fuel consumption, and improve productivity is obviously a priority. Increasing our focus on regional management to better control costs and improve margins, particularly in our western region, is also a top priority.

Our UNFI branded initiatives continue to be a focus. To that end we have invested in additional staff, to help implement the sales of our private label brands. We are also working on improving retention and training of our associates to improve overall productivity and performance.

This quarter was especially challenging, in light of the spike and increased costs resulting from fuel and freight surcharges from our suppliers. Long-term we are confident in our ability to pass these increased costs along to our customers; however, there is a short-term impact, as it takes us 30 to 60 days in many cases to process these increases.

All-in-all I feel very pleased by the performance of the Company this quarter. We took on a number of special projects at the same time, and our team has responded extremely well in rising to this challenge. I look forward to continuing to identify new opportunities for UNFI to leverage our position as the nation's premiere distributor of natural and organic products.

I would now like to turn the call over to our Chief Financial Officer, Rick Puckett, for further comments on the quarter.

Thank you, Michael. Good morning, everyone. Reported net revenue was 575.6 million for the first quarter fiscal 2006, an increase of 20.5% over last years' first quarter, as Michael mentioned. Again our wholesale growth was at 17.5%.

This is even more impressive given the two less shipping days this year versus last year. This is the result of the Company's move to a fiscal period of a 5-4-4 format this year. This total Fiscal Year will be actually 2 less days in total versus last year. With the second quarter having 1 less day, the third quarter having 2 more days and the fourth quarter having 1 less day. The sales growth based on the same number of shipping days for the quarter was actually 24%, with the wholesale comp growth rate of 20.9%.

This quarter included for the first time the impact of expensing share based compensation, including stock options in accordance with FAS 123-R, which was actually effective for our company August 1, 2005. Previous guidance was issued on the impact of FAS 123-R on earnings for the quarter and full year earlier in November. For the first quarter of fiscal 2006 share based compensation negatively impacted earnings by $1.5 million before taxes, or $0.02 in earnings per diluted share, consistent with the guidance.

The Company reported net income of $10.3 million or $0.24 per diluted share excluding special items, but including the impact of share based compensation for the first quarter. Net income for the first quarter excluding share based compensation and special items was $11.3 million, or $0.27 per diluted share. And the net income for the first quarter of fiscal '06 including the effect of special items and the adoption of FAS 123-R was 7.7 million, or $0.18 per diluted share. This compares with net income of $9.9 million, or $0.24 per diluted share for the first quarter of last year. There were no special items for the first quarter of last year.

For the first quarter of this year ended October 29, 2005, special items consisted of incremental and redundant costs incurred during the transition from the Company's former warehouses and outside storage facilities in Auburn, California, and to the Company's new larger facility in Rocklin, California.

In addition, residual incremental costs associated with the opening of the Company's new Greenwood, Indiana facility were recorded in the period. Non recurring cash of 2.5 million noncash of $1 million was recorded, in accordance with the employment transition agreement between the Company and Steven Townsend, the Company's former President and CEO. These special items are detailed in the press release issued earlier today.

Gross margin for the quarter was slightly less than last quarter and last year at 19.2%. Fuel costs reached their peak for the year during our first fiscal quarter, the fuel surcharges that we are experiencing from our vendors also reached their peak in the quarter. We were not able to pass all the increased costs along to our customers, as surcharges increased rapidly during the quarter. There for our gross margins were negatively impacted for the quarter by approximately 5 to 8 basis points. So far during the second quarter we have seen a downward trend in the fuel surcharges from our vendors back towards a normal level but not yet at normal levels.

Fuel costs have not yet reached the levels that were experienced before we initiated our own fuel surcharge, as such, the higher fuel costs negatively impacted our operating income net of fuel surcharge by 10 basis points, and approximately $0.01 per share.

Our Operating expenses for the quarter were 15.9% of sales excluding special items compared to 15.7% for the same period last year. The increase was primarily due to the share based compensation expense recorded during the quarter of 26 basis points. In addition the inefficiencies that are currently being experienced at the new Rocklin, California and Greenwood, Indiana facilities, negatively impacted the quarter by 5 to 7 basis points.

As Michael said it typically takes a 6 to 9 month timeframe to get optimum efficiencies from a new facility. The Rocklin, California facility costs are reflective of some duplicate costs associated with two locations during the quarter. Previous buildings that are now vacant, will be marketed for sale. Any proceeds from the sale of the buildings will be used to pay down debt. We do not expect to record any significant gains or losses on the sale of the buildings.

Select Nutrition and Roots and Fruits are not fully integrated, which resulted in an additional hit of 10 to 15 basis points in operating costs and margins. Excluding special items, share based compensation and acquisitions, operating income was actually at 3.7% for the quarter, compared to 3.7% for the same period last year.

Our inventory was at 50 days for the first quarter within our target of 48 to 50 days. Inventories were higher due to the incremental transition into the Rocklin facility, resulting in duplicate inventory. DSO for the first quarter was at 23 days favorable to our target of 25 to 27 days. Capital expenditures were at $7.7 million for the three months ended, well within our target of 1.75% of revenue. Capital expenditures were related to the completion of the Rocklin, California facility.

Our full year guidance remains at the 30 to $35 million level. Interest costs were higher in the quarter sequentially and year-over-year. The sequential increase was driven by the increase in debt created with the increase in inventory from the Rocklin facility transition. The year-over-year comparison is driven by the new Greenwood facility inventory, the Rocklin transition, and the higher interest rates that have been experienced.

The Company's outstanding commitments under the amended and restated credit facility as of October 29, were approximately $151 million, with an available liquidity of $108 million. Our return on total capital was 19.3%, and our return on equity was 13.5% for the latest 12 months.

Both of these return ratios were impacted negatively by 50 basis points for the share based compensation expense. The press releases issued earlier today did highlight the fact that we are reconfirming our full year guidance. As a matter of clarification, the full year guidance for earnings per diluted share is $1.03 to $1.08. The release issued on November 11th erroneously had this at 1.02 to 1.07.

At this time, I will turn it back over to the moderator to facilitate questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question comes from Eric [Wiseman] with Goldman Sachs. Please go ahead.

Good Morning, guys. A few questions related to your guidance. When you look at your full year revenue guidance, I guess even the high-end of your range implies a fairly big decline in your growth for the remainder or the year, or from what you're currently experiencing. Is this just a case of being conservative, or are you seeing something in the remainder of the year that makes you a little more cautious?

I guess as a followup to that in a given where you've guided sales to get to your EPS guidance of$1.03 to $1.08, your EBITDA margins would have to be much better than where they've been recently, was just wondering if you could give us a little more color, or tie the pieces together, in term of what your assumptions are behind the guidance for the rest of the year?

I think relative to guidance for the rest of the year, we obviously hesitate to increase guidance after one quarter. So I think from a sales perspective, it is a conservative look at it. As it relates to the Earnings Per Share guidance, we do expense that we will get some improvement in the acquisitions that we've made, because they currently are both dilutive to our quarter, as we mentioned, and we expect that to be neutral to accretive for the rest of the year. In addition, we expect the Rocklin facility to come on-line with a little bit better efficiency as the year goes on.

Okay. And then could you just speak to this, I know, Michael, you spoke to the sales trends and you said that across customer channels that they were pretty strong. I was wondering if could dig into that a little bit, and talk about what specifically you're seeing in the different customer channels? They're all experiencing pretty good growth.

Is there any one in particular you think might be vulnerable to some softening?

I think these numbers do fluctuate on a quarterly basis. Typically we've seen the growth rates in the teens pretty consistently for the various channels. But I did want to note the strong growth in the Supermarket and Independents this past quarter. I think there's new store openings that are contributing to that, as well as just, it's an indicator of the overall health of the natural products industry.

Okay. Great. And then lastly, Rick, I know you spoke about this briefly in your prepared remarks but could you give us a little more color on the increase in your debt levels and interest expenses over the past quarter, and the past year, and whether the 2.4 million in interest expense you saw in this quarter is a new run rate, or do you plan to replace some of the short term debt with longer dated borrowings to offset some of the increase in the interest expense?

Sure. Actually the increase sequentially is almost entirely driven by the Rocklin facility increase in inventory. And you saw from our balance sheet, that our inventory increased a fair amount. There was certainly some duplicate inventory as we transitioned that business from one location to the other, because we want to maintain very high service levels so that customers are not impacted.

Therefore, I expect that to dissipate over the next quarter or so, as we get back to more of a run rate on the level of inventory in Rocklin. I would also say that if you recall, we spent $65 million or so last year in Capital Expenditures, and that certainly is still in our debt number, as we have not paid that off yet with internal cash flow. I do expect the debt levels to go down in the future as we contribute cash to the business, and as we get internally driven cash flow as well.

So those factors will help us in the future. I mean, the rate of interest obviously is not going down. It's sort of inching up and they're still predicting further rate hikes in the future. So I do think that we will continue to have an impact for the rate. I mean, if you look at the rate increase year-over-year on our debt levels, it impacted our interest by almost $0.5 million this quarter, over last year's quarter. So it's pretty significant just for the rate.

Okay. All right. Thank you.

Thank you. Our next question comes from Scott Mushkin with Banc of America Securities. Go ahead.

Hey, guys. Nice quarter considering all the pressures you were facing on the cost side. As far as technology and the new facility that you opened up in California, if you could just take a little bit of time to go over how it's different compared to some of your older facilities?

Well, it's nothing that we do not already have in place with some of our eastern facilities. The main difference with Rocklin, is it is larger at 485,000 square feet. It has really kind of the Best Practices of all the other facilities that we've built previously. But there isn't any one new technological thing that we're using there.

But it has great efficiencies with the space, having our building everything under one building, as opposed to operating under the three facilities that we had previously. So there's tremendous efficiencies that we're picking up.

And Scott, I would just add to that going forward, as we continue to roll, pick the light out across the company, Rocklin will certainly have that as well.

All right. And then, Michael, I think you mentioned about efficiency gains, as far as transportation goes. I know you guys have been working on the road net, and a quick update on that, and any other issues you have in there?

Well, right now we're in the process of reviewing a number of initiatives with operations and transportation people. And we think we have some innovative ideas, in terms of how to hedge our fuel consumption over the next coming year.

So we should have some things to talk about in the next quarter as we finalize some of these plans. But it's obviously an area of focus, and we're challenging the transportation and ops people to think outside the box a little bit, and come up with some new ideas. So I think we'll be able to again mention some things next quarter.

Any update on road net at all? Is it fully implemented at this stage? Where does it stand?

It's not fully implemented. It is still being rolled out across the country. It takes quite a bit of time for each distribution center, because you're actually rerouting the entire facility each time you do this. That obviously impacts customer's delivery dates, and all kind of things. It's not something you can do in a week of or two. It takes a fair amount of time, Scott.

Are you guys seeing benefits that you thought you would see when you roll it into a facility?

We are. We actually used it to site the Greenwood facility, as an example. If we look to site new and future warehouses, when and if that is something we may want to do, we'll certainly use Road net to see where all the customers are.

And two more quick ones, hopefully. I know you guys have obviously been making acquisitions here and there. I know one place that you have made acquisitions here and there, and I know one place you have a little bit of a hole in your operations down in Florida. The question is with maybe nothing to buy down there, would you ever consider just going in there organically? Building a facility and trying to grow the business? Or is that something you wouldn't consider?

If you're talking about citing a new facility in Florida? That's certainly something that's on our radar. We again, have several areas of the country where we're looking at citing potential facilities, particularly again where there's some fuel savings involved. So Florida definitely is something that we're considering.

All right. I guess I'll skip my last one. Thanks so much for all your time.

Thank you. Our next question comes from Greg Badishkanian with Citigroup.

Great. Thanks. Good results. And did you say that organically the wholesale growth would have been 21% if you sort of look at it apples-to-apples on number of shipping days?

Well, 20.9, but, yes, 21%.

Okay. And you know, that's an obviously nice acceleration. What do you attribute that to primarily? Are there any products or regions that you maybe are growing faster and driving that overall growth, or is it just sort of across the board.

I think, Greg, that's what I was trying to kind of highlight, that the growth was strong through all channels, through all regions of the country. And there isn't really one specific thing to point to the acceleration just other than the fact that they're just nice solid trends across the board.

Okay. And Michael, I know you've been involved with the Company to a lesser degree over the past two years or so, before you were the CEO. Coming back as the CEO, what new opportunities do you think there are in the Company over the past weeks, months or so, that you have been CEO. What do you see as the biggest opportunities? Have you identified any yet?

I would say that I spent the first month here that I've been on the job, trying to get my arms around the business and getting intimate with the staff, as far as all these initiatives that we can be looking at. And I think there are several things that we are seeing. But it's a little bit preliminary to talk about them at this point.

I think again by next quarter we'll be kind of outlining some new strategies and some new initiatives that we see. I mean, by far the Company is on a solid direction, and there is no major reason to turn it upside down. But there's a lot of fine tuning I think that we can take advantage of to drive our costs down and it will improve margins. So we'll be outlining some of those on the next quarter's call.

Great. Thanks.

Thank you. Your next question comes from Ed Aaron with RBC Capital Markets. Please go ahead.

Hi. Good morning. A couple questions. First, Michael, I was hoping you could elaborate on the comment you made about making some operational changes, in terms of becoming more decentralized? I think you alluded to the western region specifically. Is there something structurally different about that region than your other regions?

Well, we've kind of gotten away from the regional management that we were under a few years back. And I think I'm a strong believer in trying to have people in each region that have P&L responsibilities and that are in charge of those regions. I think we've had for the last few years, people kind of stretched over the whole country. And I think the ability to manage this large territory, is not nearly as good as trying to manage a region.

So we are going to be building up our strength and depth of our management, and putting more focus on regional management. The west has suffered a lot of turnover on some of our senior staff over the last few years, and has the biggest opportunity for improving margin before us. So it's one of my focuses to try and get that turned around out west.

Okay. Great. And then I was also hoping you could maybe just elaborate a little bit more, I know you talked about it a little bit, but in terms of the growth trends that you're seeing on kind of a channel by channel basis. I know it's strong across the board.

But north of 20% growth in an independent channel, that's a pretty significant acceleration from what we've really seen in any given quarter over the last few years. I'm assuming that there are some market share gains happening in that channel. Do you have any way of kind of breaking out how much of that is organic, versus how much of it is new account gains, or just market share gains?

Yes. It's really a difficult number to get at. So I couldn't really answer that. But we've always thought that there was 1 or 2% involved in the independent number that would be attributed to market share gains. But this number does fluctuate like I said quarter-to-quarter. And we'll be reporting that each quarter and taking a look at it, and see if the trends continue to be that strong. But certainly something we're excited about, seeing the strength in that channel.

Okay. Great. And then just my last question with respect to fuel cost. You mentioned the 10 basis points of incremental cost. Is that on a sequential basis, or a year-over-year basis?

Actual actually on a basis of our expectation, if you will. And it's pretty close to what we've budgeted, Ed, is where the basis comes from. On a year-over-year basis, it's more like 12 or 13 basis points.

Great. Thank you.

Thank you. Your next question comes from Gary Giblen with Brean Murray. Please go ahead.

Yes, hi. First to follow up on Eric W's question. Is there any specific reason why it looked like 11 to 12% on the revenue guidance year-over-year, or is that really just being conservative early in the year?

Well, I think just to repeat my response on Eric's question was in fact, we are pleased with where our sales growth is showing, but we are still just in the first quarter. So we hesitate raising full year guidance at this point.

Okay. Great. And then if diesel costs come down, is it possible that you would have a favorable margin impact from having surcharges in effect, which are for a period in excess of the actual cost impact of the diesel cost increase?

Not likely in that we would obviously adjust our fuel surcharges, as diesel prices do come down. But keeping in mind that the current price of diesel fuel is still 20% above the level, at which point we initiated the fuel surcharge to begin with. And when we initiated the fuel surcharge we were really only looking to compensate, or to basically offset the incremental costs that we were incurring. We're certainly not trying to make a profit on that.

Sure. No. I understand that. And if fuel leveled off at current levels, is the bottom-line what you're saying that the $0.01 earned EPS impairment that you had, would that not be there for a given fuel where it is now?

It would be above zero, Gary, but probably less than a penny because a penny was based on a quarter that was relatively high. But still fuel is not back down to the levels at which we started our fuel surcharge. So we would still have a negative impact.

Okay. Is it possible to increase the surcharge to offset this if the fuel remains, if you're continuing to have a negative spread to absorb some loss on fuel, can you pass on a further surcharge?

Well, I would say, Gary, on that question, as we get a better read on fuel prices, ultimately I think our customers would rather have us passing the costs through, our costs of good increases, and eliminating fuel surcharges. I would think that would be the long-term plan. And most people in the other food companies, food distribution, I think, are doing the same thing gradually eliminating surcharges and passing the costs through cost of goods.

Okay. And then finally, what's your outlook on the potential for increasing self distribution by Oats and Whole Foods, both of them have mentioned that in some small part at least. So what's your take on that?

Well, I think we were enjoying solid relationships with both Oats and Whole Foods. And we remain committed to servicing them long-term, and we think we can operate at higher service levels and lower costs than what they can do for themselves. And that guarantees our value to them long-term.

Sure. That makes sense. I mean, have those discussions been, have those points come up more frequently from those customers in your discussions with them?

Well, we still have several years in contracts with both those customers. But I think in general, we're looking to have more frequent conversations with them on long-term planning, making sure that we have, our facility planning takes into account the growth in various regions that those chains are planning. So trying to work a little closer with them on long-term planning.

Okay. Thanks very much. And good, great sales quarter.

Thanks.

Great.

Thank you. Your next question comes from Eric Larson with Piper Jaffray. Please go ahead.

Good Morning, everyone. Nice quarter. Glad to have you back, Michael.

Thanks, Eric.

Just a quick question. Obviously operating expenses increased at a rate faster than sales. I'm assuming that is all, this might be a question for Rick. But is probably all the stock option expensing. Is there anything from a depreciation expense point of view we need to know about in there, Rick?

Not in this quarter, but certainly going forward there will be a little bit of an increase in depreciation for the California facility, because it's a newer facility and bigger, and so on. But not significant, Eric, in terms of it's not going to move the needle all that much. But certainly the quarter did experience 26 basis points of decline, simply because of the share based option, or the share based compensation expense.

Exactly. Okay. And then just to follow on that point, Rick, CapEx for the year, are there any other areas to support the revenue growth that you're going to have to add meaningful capacity to? Where do you kind of sit right now on your warehousing utilization?

Yes. I think we may have mentioned a quarter or two ago that the facilities that we are concentrating on now, would certainly be the Seattle facility, and the Denver facility. And not necessarily in that order, but those are the two that have the highest capacity utilization today.

So we have in our plan and in our projections for CapEx certainly some funds in there to start to build an additional warehouse in one of those locations. Now, whether we'll get it finished by July 31st is yet to be seen, because we really haven't started anything yet, in terms of physical construction. But those are the areas that we're addressing.

Okay. Back to the stock based compensation expense, would you expect it to be 25 to 30 basis points per quarter for the rest of the year, or is there any other aberrations on a quarterly basis?

I think that's actually right. It should be about $0.02 a quarter.

Final question, Rick. Tax rate, it's about a point lower. Is that your best guess for the full year, or would you assume a 39% tax rate kind of like you've had historically?

We're essentially looking at a 38% rate for the full year.

Okay. Great. Thanks, everybody.

Thank you. Our next question comes from Scott Van Winkle with Adams Harkness. Please go ahead.

Okay. A couple of easy ones. Rick, I'm looking for you to kind of hand feed me here. What was the interest expense in the third quarter associated with the inventory for the northern California facility, can you break that out in dollars ?

With the increase in inventory, it's about $300,000.

Okay.

For the quarter.

And Michael, you broke out Foodservice in your sales mix by channel. Was there anything to read into that? Was it a larger number than normal? I thought that was kind of usually included in the other.

Yes. I decided to start breaking that out, because it is an area of focus for us. We do feel like there's a lot of opportunity in bringing natural and organic products into the Foodservice arena. So it's something I thought would be helpful to track our progress by breaking it out. And I know you guys like more information.

The more the better.

Yes.

If I look at the sales mix by channel and focus on that, a couple of things. You mentioned the strong growth in supermarkets. Was there a new piece of business? It looks to me like there is a fairly significant acceleration in your supermarket channel.

Well, no, I wouldn't say there was one specific thing that we can point to. I mean, there are new stores opening every quarter. But in this past quarter maybe there was more than usual. But there wasn't any one new account that we brought in, that would account for the spike. It really is primarily increase in sales from existing customers that's driving the numbers.

Okay. And the growth in the supernaturals looked a little bit better, or basically in line with Q4? Is that right?

Yes. It's high teens, which it's been pretty consistently.

Right. Okay. Great. Thank you very much.

Thanks.

Our next question comes from Mark Chekanow with Sidoti. Please go ahead.

Hi. Could you talk a little bit you mentioned on the Select and the Roots and Fruits. Could you go through a little bit more detail some of the challenges and what you're trying to turn those two acquisitions from slightly dilutive, to neutral to accretive in the near-term?

Mark, let's take Select Nutrition first. One of the things that we have yet to do on the integration there, is to deal with the western region demand. We're still shipping that out of Philadelphia and Pennsylvania. If you'll remember, we closed the Visalia warehouse to take out some fixed costs there. We expect that we will integrate Select Nutrition into the Rocklin, California facility, when they are up and running and getting more efficient in their day-to-day business. So that will certainly change Select Nutrition's results on a month-by-month basis.

On the Roots and Fruits side, this was actually the quarter in which we closed the Roots and Fruits facility that we did not acquire, and we folded all of the product into our own facility in Minnesota. So there was quite a few inefficiencies as it related to that, that we didn't really break out specifically on the press release, but they certainly did impact our overall performance in the Minnesota area. So once, and that happened in October, by the way, so we didn't get the benefit of any of that really in the first quarter.

So going forward we expect that to be a much more efficient operation in Minnesota, and certainly will eliminate duplicate costs that we had up there.

Okay. And I think you mentioned about the options expense between 1.5 and 2 million per quarter. And that was very recently. Should we be assuming this kind of the 1.5 million run rate for each quarter, or should it pick up a little bit?

I don't think it will change dramatically what we do this year, in terms of options, or the expense associated with that. So I think it's still a good range.

Okay. Great. Thank you.

Your next question comes from Mark Husson with HSBC.

A couple of avenues of questioning. One on the supermarkets. Can you just talk a little bit about your relationship with the kind of business you do with supermarkets? I mean, supermarkets use wholesalers sometimes just to move cases around for them ,and sometimes for wholesalers to go out and provide a full range of product, and sourcing, specing product, and doing quality control. Is it more the latter, or more the former?

Well, I would say we have I think both parts of service levels to our customers. We like to give them a menu to choose from. And I think for the most part the full-service programs that we offer, where supermarkets get to get the benefit of our expertise, and our help in category merchandising, category management and that type of thing, is probably the preferred method of our service that they're using.

But there are other accounts that are looking for less service and a lower price. So we definitely offer both. So I think the supermarket's main value is utilizing our expertise to help them capitalize on the category.

I'm kind of new to the store. So you may have told us this before. But have you made public who your main accounts are on the supermarket side?

We actually haven't named specific customers other than to say, that we do actually do business with almost all of the regional supermarket chains in this country. And that's Stop & Shop, Fitzshaws, Publix, Raley's, and so on, and Wegmans. We also have done business with Kroger, with Super Value, et cetera.

Okay. The second item, first thing, of course, as that business mix in the supermarket seems to be flowing faster than the other channels a bit? Is that a lower margin business for you over time? Does that change your mix over time?

No. I would say in general supermarket is a higher margin business for us. Certainly over the last several years it's had growth rates that are comparable to our other channels, like supernaturals. It hasn't necessarily been exceeding the growth rates of Independents and supernaturals. It's kind of been keeping up with it. But this particular quarter was very strong, which is why I noted it.

And then the second avenue of questioning is just, in terms of your product mix again, how much of the stuff that you procure and distribute, is what you would call sort of fresh produce, meat, dairy, bakery, and that kind of thing?

It's around 32% in total, in terms of all perishables, the what we refer to as cooler/freezer items.

Has that changed over time?

I think it's still growing a little faster than the other categories, Mark. But over the last several quarters, it hasn't really changed. It's been growing fairly quickly, for the last year or so.

Okay. Then the other thing is, looking at the sort of spread between farm gate and wholesaler and wholesaler to retailer, in terms of gross margins on a number of these fresh items, the gross margin spread are way wider than they are on the conventional items, and haven't shown a lot of contraction yet? Is that something you expect to see, or do you see some different trend out there?

Well, I'll take a stab at that one. The organic produce and things of that nature actually has a shorter shelf life, so you're going to continue to have a little higher margin than probably the conventional side. But I think that's what's bringing people into stores these days is organic produce in many cases. And you'll see some of the larger supernatural stores with a very large produce section. And they keep that very fresh and very nice looking.

I'm just wondering over time what happens, both Food Lion recently and Wal-Mart have both talked about democratizing the entire category. I'm wondering what impact that has on gross margins over time. Clearly nothing yet, but what do you see?

I don't know. That's hard to predict. I think there's a number of factors at play here. I think the growth in demand for the products and the supply is still somewhat limited. I think that will continue to result in premiums being charged for the various organic sector. As time goes on and supply increases, we may see some decreases in that gap that you're referring to in pricing.

Great. Thanks very much.

Thank you. Your next question comes from Alec Patterson with RCM. Please go ahead.

A couple of quick items. I'm sorry get back on the options expense thing. But the P&L highlights a different level of pre-tax expense versus your foot notes. And I think that must be referring to the vesting of prior year periods. Just wanted to clarify that?

Yes. As a matter of fact, we vested 100% of the options that were issued in December of '04.

Okay. So would a fair estimate of prior period options expense if I were to use a pro forma number, be along the lines of that 1.5 million?

The guidance that we've put forth is in fact 6 to $8 million for the year. So I think 1.5 to 2 million would be the right number.

For last year?

For this year.

I know. I'm looking for a comparable pro forma number for last year?

I don't have that off the top to have my head, I'm sorry, Alec. I can't comment on that one.

Okay. That's all right. I can circle back. Just on the interest expense outlook, just want to be clear on that. You talked about rate increases but it was inventory related on a short-term basis and what not. Debt increases. Interest expense outlook for the year again?

Well, I think that we'll continue to see small increases in the rate. We've certainly accommodated that in our guidance for the full year. And we do not expect it to exceed what we have guided, as it relates to the interest component in that. So I don't think that we are going to be shocked or surprised. I think that we will continue to maintain debt levels that are at the present level and lower as we go forward. Because again, it also incorporates our CapEx guidance for the year.

Okay. I think I'm hearing that you expect it to be roughly around where it is in this quarter reported?

Well, I think that this quarter reported is higher, simply because of the inventory levels that we've had to create to transition the Rocklin, California facility.

You took that up, but rates are up. I'm just trying to net the two.

I'm not sure they exactly offset there. But I think that from my perspective, I don't see any real significant surprises on the interest cost in this year.

Okay. And then just lastly, in the area of inventory inflation, what do you guys think, in terms of the flow through of higher prices on inventory you're buying, that aren't related to fuel surcharges, but just underlying raw material and input costs, petro chemical related, what have you.

Is that flowing through your inventory? Are we seeing more of that coming? Have there be some price increases announced by companies to go into effect in the first of the new year? What are you seeing in the outlook there?

Well, from our perspective we've not seen a huge amount of inflation over the last couple years. It only averaged about 1.6 or 1.7%. We're obviously looking at prices on a daily basis. When they do change, we adjust as soon as we can, the pricing on that. So it may take 30 to 45 days to get it into the pricing, but we are able to pass that along.

Okay. So you're not worried about any step up coming the first of the year, because of the pass through facility?

There might be a delay in terms of getting it into the pricing, and to that extent we might be concerned, but ultimately we'll be able to pass that along in price.

Okay. You're not seeing any pricing that's out of the norm, is also what you're saying?

Other than fuel.

Right. Okay. Fair enough. Thank you.

Thank you. Your next question comes from Andrew Wolf with BB&T Capital Markets. Please go ahead.

Thank you. Good morning. Two questions related to your margins, the earlier margin discussion. On the fourth quarter call it was mentioned that I think the Company is piloting, or maybe beyond that but a pick to light technology, maybe in one of your DCs. Could you update us on that, and give us a sense in how that's going, and if that's something you're going to be planning to rollout to the entire franchise?

That's actually implemented in Chesterfield, New Hampshire as we speak. They've been running on it a good month or so I, I think. The next target I think is Philadelphia with Select Nutrition. Because that's a huge effort in picking. It's an UPS kind of shipping environment. So a pick to light system there will probably benefit us quite a bit.

So we're rolling it out one distribution center at a time. And the CapEx guidance again incorporates the rollout of that particular technology. But it is having the kind of impacts that we expect. It is very easy to use. I've even been to Chesterfield and witnessed and actually done some of it myself. And that's without a whole lot of training. So it's very user friendly.

What % of the SKUs at a typical DC are candidates for this? I know it's a lower percent of sales as well.

It is a lower percentage of sales.

Maybe you could just give us a number. I believe, and Michael, you can correct me if this is not what you think, but it's somewhere between 4,000 and 5,000 SKUs in a 18,000 SKU kind of warehouse.

I think actually it's a little higher than that. Basically, it's all of our repack items which we would consider, all the supplements, personal care, and all the things we sell by the each. So in some of the DCs that number is 8,000, 9,000 SKUs, in a few of the DCs it's somewhat less. But it's a significant portion of our overall mix.

If this goes according to plan, would it bring down the inventory there, as well as obviously making the picking more efficient, or to just be more on the efficiency side?

No. This technology doesn't really allow us to eliminate SKUs. It just allows us to increase productivity and reduce the mistakes, and make it easier for our associates to learn how to use. But we do have some initiatives about removing some slow-moving SKUs out of our DCs, that we'll be talking about over the next quarter.

Okay. Got that. And then the other part of the margin, the other question, Rick, in answer to an earlier question about margins in general you pointed out the northern California facility, the new facility in Rocklin. It sounded like from what you said should ramp up pretty quickly, in terms of its margin which to me makes a lot of sense, given its capacity and staffing and all that. And I don't think I heard you address Greenwood. Was that just me not hearing you right, are you actually omitting the Greenwood facility as a likely contributor to margin expansion as well this year?

Well, I think Greenwood is still becoming more and more efficient as they go. But we don't exactly have last year to compare against there. We certainly are benefiting from the lower transportation cost, as a result of the citing of the Greenwood facility. But they're not at full efficiency at this point. It's just, I'm not sure I have a good base point to measure from in terms of what they will get to. So therefore I didn't necessarily talk about it.

How about just capacity utilization there? Have you transferred enough business into it that it's sufficient, that if the training goes well that, or does it need to take on growth or sales to get to the right operating margin as well?

Well, obviously the more business you put in a facility that's undercapacity, the better the margins are going to be. So it has a lot of capacity, and we still have a number of migrations of various routes in that region, that it can take on. So we just have to stagger those, so that customers aren't impacted in any negative way.

Okay. But is the Greenwood facility and the way things are working, pretty much to your plan, or is there anything awry?

No. I think it's been open for basically three months, and I think it's always a struggle to open up a new facility. The challenges around purchasing and in-stock rates are a little tougher, because the history isn't there, as it is when you're just replacing another facility. So that's been an area we've been really focused on.

But efficiencies are continuing to build. And as we said before, it takes six months or even nine months to get really where we want to be. So we're on our way there, but we're not there yet.

Right. Thank you.

[OPERATOR INSTRUCTIONS] Our next question is a followup with Mark Chekanow. Please go ahead.

I want to talk about some of the plans you had talked about for I guess logistics and transportation, given the high diesel environment. When you look at this, are you also looking at scenarios where diesel costs could come down, even perhaps to a sub $2 level? Would that make any plans that you're making now, maybe not worth it as far as the investment, or are these plans pretty much going to be in place regardless of diesel pricing, because the shipping and logistics makes so much sense?

Well, I don't know. Obviously we want to consider all options. But I haven't read too many forecasts that show diesel going under $2. We would probably be more prudent to plan for an ever-increasing diesel market over the next several years, and to have our plan based on that.

I guess I would just be asking in some sense as people make growth plans on certain assumptions, and if they don't come to fruition they've made a significant investment. So you would think that either way these plans for improving the transportation is not solely driven by diesel?

Right. If we end up producing a system that reduces our fuel consumption overall, and we're more efficient in our transportation, than regardless of the diesel price we would benefit.

Great. Thank you.

Thank you. Management, at this time I will turn the conference back to you for any closing comments you may have.

Well, thank you for your time and going over the first quarter with us. We want to remind you that United Natural Foods is your proxy for the natural foods industry. We look forward to speaking with you later.

Thank you. Ladies and gentlemen, that does conclude today's teleconference. Thank you for your participation. If you would like to listen to a replay of today's conference, you may dial in at 303-590-3000 or 1-800-405-2236, followed by the access code of 11042088 followed the # sign. Once again, those numbers are 303-590-3000 or 1-800-405-2236 followed by the access code of 11042088 followed by the pound sign. At this time, you may disconnect.