United Natural Foods Inc (UNFI) 2009 Q4 法說會逐字稿

Good morning, ladies and gentlemen. Thank you so much for standing by. Welcome to the United Natural Foods fourth quarter 2009 conference call.

During today's presentation all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). Just a reminder the conference is being recorded today on September 9, 2009.

We'll now turn the conference over to [Scot Epstein] of Financial Relations Board.

Thank you, operator. And good morning, everyone. By now you should have all received a copy of this morning's press release. If anyone still needs a copy please call Joe Calabrese in our New York office at (212) 827-3772, and we'll send you a copy immediately following this morning's conference call.

With us this morning from management is Steve Spinner, President and Chief Executive Officer, and Mark Shamber, Chief Financial Officer. We will begin this morning with opening comments from management and then we'll open the line for questions. As a reminder this call is also being webcast today and can be accessed over the internet at www.unfi.com. Before we begin, as usual, we would like to remind everyone about the cautionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on this morning's conference call.

With that I would like to turn the call over to Steve Spinner. Steve, please go ahead.

Thanks, Scot. Good morning and thank you all for joining us.

What a year it's been. UNFI demonstrated its ability to be resilient in an exciting, challenging and rewarding 2009. And our numbers reflect a record earnings year. As you know, UNFI's 2009 fiscal year ended on August 1, 2009. And as I reflect upon the year, which was my first year at the Company, there are several important comments that I would like to make. First, sales came to a screeching halt in October of 2009 consistent with the US economy. This is an important comment because it's the first time in the history of the Company that we did not have top line revenue growth pushing us along. And second, the economic issues caused pressure on consumers willingness to remain committed to organic foods. Fortunately, we're optimistic that this is not a developing or continuing trend. Third, UNFI had completed the acquisition of a specialty foods distributor and was beginning a difficult integration. And fourth, we lost 8% product cost inflation and replaced it with more a normalized 4% inflation, which has further complicated top line revenue growth. And lastly, like most companies, we were very concerned for much of the year about access to capital and liquidity.

But let me briefly address these issues. While sales fell to flat they have stabilized, and while sales have stabilized at slightly positive, adjusting for year-over-year inflation comparisons sales may be picking up slightly. But despite these challenges, sales during 2009 grew to a record $3.45 billion, reflecting a 4.7% increase adjusting for the extra week during the year. We also fully recognized the need for increasing sales to existing customers and expanding our customer base. While these things take time, I'm confident that during the back half of your fiscal year we'll begin to see some growth. On the positive, we believe consumers will remain committed to organic foods. There has been a shift in where they buy these products. However, the demand for them will continue to be strong.

During the year, the Company also worked hard on insuring a high-level of customer service, while more effectively managing inventory levels. And our most important suppliers are working closely with us as we pursue a national strategy providing supply-chain efficiencies from point of manufacturer, to UNFI distribution center, to our customer and ultimately to the consumer. There has been lots of discussion regarding UNFI's decision to buy into the specialty foods space. This was the right decision. They are the right products for our customers and it will be the fastest-growing segment of our revenue growth. UNFI now distributes specialty products from five distribution centers and we have demonstrated real success in integrating this business. As we have previously disclosed the Company will no longer be reporting this business as a separate entity.

During the year, UNFI launched its strategic plan which will serve as an enabler to achieving our recently disclosed three-year financial objectives. This plan centers on increasing market share, operational excellence, managing our Company on a single platform with regional preferences and further enhancing our commitment to sustainability and service. One example of our execution towards these goals is our recent rollout of a national warehouse management and national procurement system upgrade to take place over the next several years. Financially, the fourth quarter and full fiscal 2009 were strong. This morning we announced $0.36 per share and $1.38 per share for the quarter and for the year. Our fourth quarter was negatively impacted by $0.02 per share due to higher state tax rates. EPS increases verses prior year in these periods were 20% and 22%. In addition, as UNFI focused on its balance sheet and capital structure, the Company generated over $75 million in free cash, and reduced its debt by over $92 million. Our associates demonstrated discipline, flexibility and focus as we maneuvered our way through a very challenging environment. And the result was an extremely strong performance as evidenced by UNFI's financial results in the quarter and for the year.

I anticipate continued focus on our balance sheet throughout fiscal 2010 with capital expenditures at approximately 1% of revenues. This includes construction of our new facility in Texas. EPS guidance for 2010 is $1.48 to $1.58 per share reflecting an 7.5% to 14.8% increase over 2009. CapEx will be approximately 1% of revenue or $35 million to $39 million. This morning the Company filed an S-3 shelf registration. While we do not have any current or pending plans for use of this registration, we believe that the timing of the filing is appropriate. Not being one to look backward, but forward, UNFI continues to face headwinds in growing our top line. In addition, it will be a challenge to continually reduce expenses and grow gross margin while aggressively pursuing market share expanse and the development of new revenue streams. However, I am confident that long-term we're making the right decisions that will further enhance shareholder value.

Now I would like to turn it over to Mark Shamber, our Chief Financial Officer.

Thank you, Steve. Good morning to everyone listening in on the call on the webcast.

Net sales for the fourth quarter of fiscal 2009 were $853.5 million. This represents an increase of $6.8 million, or 0.8% over fiscal 2008's fourth quarter revenues of $846.7 million adjusted for the extra week in fiscal 2008. As a reminder in fiscal 2008 our fourth quarter consisted of 14 weeks rather than the usual 13 weeks as fiscal 2008 was a 53-week fiscal year. On the straight year-over-year comparison net sales for the fourth quarter decreased by about $58.4 million over the prior year sales of $911.9 million. For the fiscal year ended August 1, 2009, net sales increased by $154.2 million, or approximately 4.7% to a record level of $3.455 billion compared to fiscal year 2008 net sales of $3.366 billion. In the fourth quarter sales to the supernatural channel increased 4.2%, and now represents approximately 33% of sales. Independence sales declined by 2.1% for the quarter and Independence continued to represent about 42% of sales.

Our supermarket channel experienced a decline of 2.8% over the prior year and represents approximately 20% of sales. The supermarket decline in sales does reflect some of the final lapping of lost business from the specialty division. Excluding that lost business supermarket growth would have been in excess of 7%. Food service declined by 6.5% over the prior year and represents approximately 2.3% of sales. Gross margin for the quarter finished at 19%, compared to 19.5% for the fourth quarter of fiscal 2008. This represented an approximately a 52 basis point decline over the prior year and is consistent with our gross margin in the third quarter. The decline in gross margin in comparison to fiscal 2008 was primarily the result of significantly lower fuel surcharge revenues in fiscal 2009 as diesel prices were roughly half of the levels they were at the prior year. This was partially offset by improved gross margins within the specialty division.

For the year, gross margin came in at 19.1% compared to 18.8% for the prior year, which represents an improve improvement of 29 basis points over fiscal 2008 primarily due to higher gross margin associated with the specialty distribution division and higher fuel surcharge revenues in the first half of fiscal 2009. Operating expenses for the fourth quarter were 15.6% of sales compared to 16.9% for the same period last year, 125 basis point improvement. During the quarter we incurred approximately $1.2 million, or 14 basis points in non-recurring expenses associated with the closing and integration our East Brunswick facility into our York, Pennsylvania facility, an expense associated with our vacated facilities in Fontana, California and New Oxford, Pennsylvania. During the quarter share-based compensation expense was approximately $0.9 million, or 11 basis points compared to expense of $1.2 million, or 13 basis points in the prior year. Fuel costs for the quarter were approximately 77 basis points, an increase of 11 basis points compared to the third quarter, but an improvement of 59 basis points over the prior year.

We estimate that our operating margin benefited 12 to 18 basis points from lower fuel prices over the prior year after netting out the higher fuel prices in the prior year and the related fuel surcharges. Operating expenses for the full-year were $15.9% of sales, compared to 16.1% for the same period last year, reflecting an improvement of 15 basis points over the prior year. For fiscal 2009, fuel costs decreased by 31 basis points to 82 basis points for the fiscal year compared to the prior year full-year numbers of 113 basis points, yielding a benefit-to-operating margin of approximately 6 to 9 basis points net of fuel surcharges. Operating income for the quarter came in at 3.4%, a 73 basis point improvement over the prior year's fourth quarter operating income of 2.6% and consistent with our operating margin in the fourth quarter of fiscal 2008 - - I'm sorry, fourth quarter of fiscal 2007. Operating income was 3.2% for the year, compared to 2.7% for fiscal 2008, an increase of 43 basis points. Interest expense in the quarter of $1.6 million was down approximately 8% sequentially and was approximately 61% lower year-over-year. The sequential and year-over-year decreases were due to a combination of lower debt levels and lower interest rates during the quarter.

Our lower debt levels were driven by a combination of improvements in our working capital levels and increased profitability. Our effective tax rate for the quarter was 42.8%, bringing our year-to-date effective tax rate to 40.9% and has been primarily driven by increases in state tax rates. For fiscal 2010 we expect our effective tax rate to be in the range of 40% to 41%. Net income for the fourth quarter of fiscal 2009 increased by 21% to $15.5 million, compared to the $12.8 million earned in the prior year. Diluted earnings per share increased to $0.36, a $0.06, or 20% increase over prior year diluted EPS of $0.30. Fiscal 2009 net income increased 22% to $59.2 million or $1.38 per diluted share compared to $48.5 million or $1.13 per diluted share for fiscal 2008. The Company's outstanding commitments under its amended and restated credit facility as of August 1, 2009 were approximately $219 million with available liquidity of $147 million, including cash and cash equivalents. Cash generated by operations for the fiscal year ended August 1 was approximately $108.3 million, compared to $9.1 million in the prior year, or an increase of $99.2 million. For the year we generated $76 million in free cash flow, of which over $60 million was generated in the fourth quarter.

At the end of the fourth quarter, our leverage had improved to approximately 1.9 times on a trailing 12 months basis, compared to 2.3 times at the end of the third quarter, or 3.1 times at the end of fiscal 2008. Inventory was at 48 days on hand for the fourth quarter in the middle of our target range of 47 to 50 days and a five-day improvement over the fourth quarter of fiscal 2008. Continuing effort by owl all our divisions to manage working catch levels while not impacting our service levels. This improvement was a result of continued efforts by all of our divisions to - - manage capital levels while not impacting our service level. DSO for the fourth quarter was at 19 days favorable to our target range, and a one-day improvement over the fourth quarter of the prior year. Capital expenditures were $6.9 million for the fourth quarter and $32.4 million for fiscal 2009, equating to approximately 0.93% of revenues for the fiscal year, and roughly the midpoint of of our revised guidance.

As discussed in the press release and mentioned by Steve, our fiscal 2010 capital expenditure guidance is $35 million to $39 million, or approximately 1% of revenues. Included in our fiscal 2010 CapEx guidance are costs associated opening a new distribution facility in Texas in late fiscal 2010, early fiscal 2011. The press release issued this morning also announced our full-year's earning per share and CapEx guidance for fiscal 2010. For the fiscal year ending July 31, 2010, earnings per diluted share are expected to be in the range of $1.48 to $1.58 per share, an increase of 7.5% to 14.8% over fiscal 2009. Our fiscal 2010 earnings guidance includes approximately $3.7 million, or approximately $0.05 per diluted share in labor costs and related start-up expenses associated with the opening of the new facility in Texas and ongoing expenses resulting from the exited facilities in New Oxford, Pennsylvania and Fontana, California. At this time we're not issuing top line sales guidance due to the continued uncertainty in the macro environment.

That concludes our prepared remarks. And at this time we'll turn the call over to the moderator to facilitate the question and answer session.

All right. Thank you, sir. Ladies and gentlemen, at this time we will begin our question-and-answer session. (Operator Instructions).

Our first question will be from the line of Ed Aaron with RBC Capital Markets. Please go ahead.

Thanks. Good morning, everybody.

Good morning, Ed.

I guess I wanted to start by asking about the lack of sales guidance. It's been out of character for you and I understand there is uncertainty out there. But - - the trends really actually really haven't been that volatile month-to-month, or certainly quarter-to-quarter, at least over the last two or three quarters. I'm wondering why there is so much uncertainty right now to the point where you wouldn't be able to give some preliminary guidance. And then secondly, can you maybe - - you gave earnings guidance, so you obviously have a range of sales expectations that you need to get to those numbers. Can you give us a sense of - - roughly a minimum sales level that you would need to have in order to hit your guidance.

Sure - - we thought long and hard about whether to provide revenue guidance for the year or not, so it's certainly not something that we took lightly. Basically the rationale is this. We have a ton of new business proposals out there. These things take a long time, and we're not sure when they are going to hit. We feel pretty confident that some of them are. We see a lot of fluctuation week-to-week in year-over-year sales growth. So we may go plus seven, negative two, plus four, negative three and as I said in my prepared remarks, we are starting to see some stability as you look out over the period of a month, or six weeks, or eight weeks, but still a lot of volatility week-to-week. What I would tell you is that I think it's relatively safe to say that we'll probably provide some update regarding revenue guidance quarter-to-quarter. And I think it's a safe assumption to use a 1% to 3% in Q1. But we didn't want to lock ourselves into giving specific guidance for the entire year at this time.

And as far as a minimum sales level for the full-year to get to the $1.48, is that something you feel comfortable providing?

Well I think, Ed, - - depending on the different variables as to where the tax rate comes in, what happens from an interest rate standpoint and what happens with fuel, the 1% to 3%, if you model it in as you model out and you play with some of the variables, I think if you take where we are in Q4, depending on where the items I just mentioned come out, I think that at 1% to 3% there is an opportunity to make the bottom end of the range. But it really is okay. Does fuel go in our favor? Where does the tax rate come out? Where do interest rates go? So that's - - it's certainly achievable at 1% to 3%, but I am going to leave it to you folks as to how you factor in those other variables and where you think they would come out. Because that is part of the challenge as well.

That is fair. And Steve, also, you said in your prepared remarks I think that it is going to be difficult to continue to reduce expenses while at the same time pursuing new business. I guess on some level I interpreted that as if you perhaps you might look to sharpen your pencil a bit to get some new business through the door. Am I reading that correctly. And then could you maybe just address that new business issue a bit more broadly, because I think that we would have all expected by now that there would be - - you would have had more wins materialize.

Yes, I think you are right on it with your commentary and I think that historically we have worked hard to keep our pricing intact solely because we provide an extremely high-level of service with the widest available of skew assortment. But - - we have had to sharpen our pencils a little bit and we have gotten a lot more aggressive on some of these proposals. And as you might guess, there is some turmoil in the marketplace, that, hopefully, we're going to take advantage of. I'm not disappointed by our ability to get new business on board. These things take a long time. We started as soon as I came on board. We have got quite a bit in the active category. I'm confident that they are going to hit when the time is right, and we'll deal with it when we get there. We've had quite a few smaller wins in the specialty side, and as I said we now have specialty in five distribution centers across the country. We have added it to two distribution centers on the West Coast and are now selling some customers that have been natural customers that are now also specialty customers as well. So, again, I'm not overly worried about the top line. I think it's going to come. It's just going to take some time.

Thanks. I have a couple more, but I will jump back in the queue.

Thank you. We'll take our next question from the line of Andrew Wolf with BB&T Capital Markets. Please go ahead.

Thanks, good morning. And congratulations on the quarter and the year.

Steve, is the volatility - - I know you guys since last fall have been talking about a lot of volatility in weekly sales. Are you seeing that come in a little bit, or is it still pretty wide week-to-week?

Andy, I would say that it's still relatively wide. I mean, without giving specifics on the first five weeks of the fiscal year, I can tell you that the range from one week to the next - - that if I take the high week of the first five weeks and the low week, there is a 12% spread between where different weeks come in. So I mean, that is still pretty choppy from our standpoint.

Okay. Fair enough. Now if I took out - - you said conventional would have been up 7% excluding sort of one-time lost business, or large.

Yes. It's at least 7%, Andy. With the integration of the East Brunswick facility, we really don't have the ability to give it specifically. But I can say that it's at lease that and then there are some elements that make it a little difficult to break out beyond there.

So on a go-forward basis, or if we were to straight-line this quarter, conventional is now - - has the best growth rate is one way to think of things?

Correct.

And I just did a back of the envelope, but it looks like if you adjust for that, internal sales growth might have been around 2% for the quarter? I s that kind of in the ballpark?

Andy, I will say that we didn't even try to do it with the specialty because of its difficulties. So I didn't try to do the calc, but if that is where it worked out, it's probably in the range.

And Steve, are you guys saying that just sales - - if you look at the last four months and three months of quarter and what you are talking about now, have you seen and you factor out the high volatility. When did you start seeing a little pick-up in sales? Has it been slow and gradual or is it more recent?

I think that you have to consider two things and I talked about it in the prepared remarks, but this change in inflation, right? So we had food cost inflation of about 8% a year-ago, where the manufacturers were pushing through just price increase after price increase. We have gotten to a more normalized 4% range inflation. If you normalize that differential into our overall growth rate, we're starting to see that sales may be picking up very slightly, but still - - in that 1% to 3% range.

So your case movements improving?

Widely.

Good.

I hear you, but at least it's improving.

Okay.

I also wanted to ask about fuel deflation, a few questions. Can you quantify how much that affected sales? That is versus last year.

No, Andy, the number on sales is minimal. I mean, it's not even a tenth of a percent what we would get for fuel revenue in the quarter. It does have a significant margin impact because it's a complete pass-through to margin. But the impact on the sales it's not even really (inaudible).

Got it. And what is the assumption in 2010 guidance? I know you spoke of it as an uncertainty which is clear but - - what's in your 148 to 158.

You are talking about fuel?

Yes. Just fuel. And then I have one last question for Steve and then I'll - -

Number one, we've locked about a-third of our fuel in. So we know the price we're going pay for about a-third of our fuel. And obviously, we tend to be pretty conservative as we look at fuel costs going out into 2010. - - I would say that as long as fuel stays where it is, plus or minus, call it $0.20 a gallon, we'll be fine. If fuel all of a sudden spikes back up to high 3's, mid-4's then we're in a whole new game. But we certainly don't expect that to happen.

Okay. And Steve, the last question is in answering Ed's question on going after market share and sharpening the pencil, does that mean that as United Natural goes to market now, that you need to use prices a lever to get new customers, more than you had expected? Because I think the thought previously was, - - if you were at least adequate or as good as the next guy in specialty, and layer on to that the "Best in Class" natural, that that in and of itself would get the customer wins? But should we interpret what you're saying is what you really need is also some price inducement on the specialty side?

I will tell you this, we'll never use price as a lever to win business, because you get it on price, you lose it on price. So I'm not a big believer in that. However, in all of the prospective customer sales activity, we need to be competitive and if that means sharpening our pencil to do so, that is what we're going to do. But there is a big distinction between picking up business in order to be competitive in the market place versus using prices as a means to win business.

Got it, all right. Thank you.

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

Thanks for taking the question. I would like to just go back to a little discussion about expenses. You did an outstanding job managing expenses this year, some of that is perhaps the complete/integration of Millbrook. But maybe you could talk a little bit about the outlook for expenses for the coming year.

I think, Meredith, that we have certainly pulled some levers to maintain expense control as given the challenging environment. Certainly, continued progress on the integration of specialty has been helpful. I am sort of a little cautious from a standpoint of giving expenses and trying to give out too much information to basically build the P&L's for the year. But I would say that the run rates that we're at now are probably maintainable, and then, there is the opportunity, depending on the quarter, third quarter is usually our best quarter from an operating expense standpoint. Second quarter is usually our most challenging. I think that expenses could fluctuate 10, 15 basis points either way from where they are right now.

But Meredith, long-term, continually reducing expenses by itself is not a sustainable model. So we have got to get some top line revenue growth, we've got to continue to manage our expenses and things will happen for us. So to Mark's point, I think we're pretty comfortable with where we are on the expense side.

Right. There is an element, certainly, as we gain leverage that some of our fixed costs as a percentage decrease, and so that as we give up gross margin - - over longer periods of time, that the expenses should go down by more than that and we should see improvements in the operating income. But from a standpoint of where we are right now, I think it's sustainable and - - there will be some moment up, moment down, depending on quarter and the volumes that we're seeing.

The biggest opportunity that we have for expense reduction is opening Texas. Right now we're covering Texas from Denver and that is the beauty of opening up that facility is that we eliminate the miles that we're currently covering just to get there.

Okay. Great. And then another question I have is just talk a little bit more about the fuel lock-in that you did already. I am assuming that you got that at a good price. Why didn't you do more and would you continue to think about doing more given that it looks like there is a chance that fuel prices will go up.

Yes, I mean we thought a lot about that. I have got some experience in this, and given where the fuel prices were and where we think fuel prices are going, we were comfortable with booking a-third of our fuel. Just as a logistical note, we don't operate a lot of our own built-in fuel tanks, so it makes it a little more complicated to book more than a-third. It can be done, but it's just a little more complicated. So looking at the economics of fuel prices that we could book at versus where we think fuel is going generally, we felt pretty good about it. The second factor is that our contracts have fuel surcharge language in it. So there is a fair amount of risk of increasing fuel prices that are offset by fuel surcharges that kick in at certain rates.

Okay. Great. And then just two quick questions. For you Steve, I thought in your opening remarks you said something about that the customer showed that organic was sensitive to the economy, but I was under the impression that specialty was the area that had been weakest this past year. Did I mishear you?

What I said was that we were a little concerned in the beginning that there may have been a trend developing that said the consumer might be shying away from organics. That has been proven incorrect. So we have seen that the demand for the organic products has remained. What we have seen is a shift in where a lot of the consumers are buying it, as evidenced by the changes in our increases by channel. The independents are relatively flat. Supernatural and conventional supermarkets are up quite a bit more. So it's been more of a shift than anything else. Specialty foods, generally, you are right. We're much more negatively impacted than sales of organics. But the upside and the comments I made in the opening was that we feel pretty good that consumers are still pretty committed to buying organics.

And my final question is for Mark. You talked about having filed an S-1, but you don't have any plans right now. If you were to do something, what would your intention be? I think all you have is bank debt now, would you plan to term out the bank debt for a longer time or something like that?

Meredith, just one correction, it was an S-3, or a shelf registration versus S-1. And if you were to take a look at it, we left it very open as to in the future what we could do. So it allows us to do equity, it allows us to debt, it would allow us do a variety of other instruments that are a combination of both. Really, we just felt the timing was right, having released year-end earnings, we are not in danger from an accelerated filer standpoint of not being able to do what is known as a quicksy shelf. But if we turn back the clock six months ago, when the markets were a little bit crazy - - our market cap had dropped below $700 million, which is the threshold for being able to file one. So we thought it would be best to have it up and in place at this point in time, even though we don't have any current plans to draw down against it.

So this doesn't indicate that you are going to make an acquisition, does it?

It does not indicate that.

Okay. Thanks very much.

You're welcome.

All right, thank you. Our next question is from the line of Greg Badishkanian with Citi Group. Please go ahead.

Hi. This is Alvin [Ailey] stepping in for Greg. Just wanted to see if you've seen any changes to the pricing environment in light of some issues at one of you're large competitors?

I don't think so. We haven't seen a lot of wholesale change in the competitive environment.

Okay. And can you talk about your margins at specialty. Maybe how they are trending versus last quarter or versus your expectations at this point?

Alvin, I think we mentioned last quarter that we have integrated that business and we don't have clarity from a consolidated standpoint on the specialty side. So we don't break out any of the divisions individually and so, now that we have them integrated we're not going to break anything out on the specialty side. So unfortunately, there is no information to share with you in that respect.

Okay. And regarding organic food prices, have there been any recent volatile changes in particular categories or has it been pretty stable?

I think it's been relatively stable. We have been lapping some of the inflation, the heavy inflation, that we saw last year. And so we're back to a range of more modest price increases that are consistent with what we have seen longer term, but I wouldn't say that there has been any one category that has seen high inflation. On the produce side, we have seen heavy deflation to the extent in some categories it's double-digits.

Okay, thank you.

You're welcome.

Thank you. And our next question comes from the line of Scott Mushkin with Jefferies & Company. Please go ahead.

Thanks very much. Thanks, guys. I just wanted to delve a little bit more into the specialty business, not really looking for detailed numbers around it. But when we went out to the facility in Pennsylvania, and we walked through it and talking to the people there, they had indicated and we could see for ourselves that the list in the technology hadn't being been fully integrated where it needs to be if you were going to try to bid a big contract. I wonder if you could just give us an update on how that's going. To give you a concrete example, I think their was diet chocolate soda that you were still selling in onesies that they mentioned that probably should be all at a four-pack, which is the way it was. I was wondering if you could you give us some color into how that is going. And if you were able to secure a combined contract, do you feel like you could service it well at this stage?

Yes, they are completely integrated at this point. Like I said, three of the five DC's that now have specialty are fully integrated, which means that from those three DC's we can take any contract that includes natural/specialty and organic. Aside we're working hard to include quite a few other skew categories as well, whether it be specialty cheese or produce, so that we can truly be a one point of supply for the retailer. There are some big differences in the businesses on the natural side/organic side, we tend to sell more full cases than in eaches. Specialty is a lot of onesie and twosies, slow-mover onesie and twosies. And we don't think that we're going to be able to change that philosophy out of the gate. So we do - - we now sell a lot of specialty product in your carousels in out slow-moving warehouses. But to answer your question, specifically, they have been fully integrated in three facilities.

So you think you could handle a large account at this stage? This is just my opinion, but with some of the piece-pick stuff in the back area of the warehouse in Pennsylvania, it seems like it might be a little bit challenging if you ended up getting a big contract?

Yes, those products have all been fully integrated into your carousel, so it it would be fully transparent to the customer. And the answer is, yes. We will have some big wins and like I said, it's just a matter of timing.

All right then I had one other question that has to do with the channel switching that you are seeing may be picking up and the margin impact that may result. I was wondering if you would walk us through if we went forward three to five years, if this pattern continues with independents becoming less and traditional supermarkets becoming much more of the business. And what your thoughts are as that has to do with margins.

Yes, I mean long-term, common sense would tell you that we could see some contraction in our gross margin. We don't see that finding its way to our operating income line. We don't see, necessarily see, that falling it's way into our operating margin line. The conventional tends to be a little bit lower gross margin, but it's also less expensive to do it. So it's just a matter of looking at the P&L in a little different way. But I think you are right, over time it will be hard to continue to maintain the gross margin levels where they are if we get considerably more entrenched into the conventional space. But I don't it see it negatively impacting our year, our operating margin or our operating income.

Scott, that is part of the reason why we tend to try to guide people to look at the operating income margin versus focusing on the other gross margin or operating expenses. Because there is the tradeoff that you give up in that you may have a higher gross with an independent customer, but there are higher operating expenses associated with it, so that when you get to the bottom line it nets to a similar operating income percentage that you might have with the supermarket that has a lower gross margin and lower expenses.

That is great. Thanks for taking my questions.

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

Hi. Good morning, guys.

Good morning.

Earlier in the call, Steve, you indicated from last year that obviously sales came to a a screeching halt in October, 2008. Could you us a - - I know you don't break out monthly sales, but could you give us some kind of idea of what the growth range prior to that, during that, and maybe a month later than that. Or somewhat where it went from here to there?

Well, I mean I think the way you could look at it, Chris, is that if you look at where we finished Q1, we were in x the specialty portion of the business, which we are breaking out separately at the time. Our numbers were low double-digits, I think off the top I want to say, was somewhere around 10.5% to 11%. And then by the time we got to the end of Q2, our number x specialty was about 4.5%. So that is a 6% spread, roughly, right there, and if you think that the last two weeks, last three weeks of that first quarter reflected a slowdown, it probably says in excess of a 6% to 8% drop in sales from where we were going at to where it sort of slowed down to. So I think that is probably the best we could give you for an estimate as the impact that occurred last October.

Okay. That is good. Next question, I know you guys have done a great job of driving efficiencies and all that, but I believe in the past or maybe at your investor day you indicated one aspect that is kind of interesting is your workforce and the turnover of your workforce and how more experienced it's become and there is less training involved. Could you just kind of comment on that aspect?

Yes, I mean call it we're doing a better job managing our DC's, or state of the economy or both, but our turnover has dropped off dramatically. I don't recall off the top of my head the extent to which the turnover has fallen, but it's been significant. Obviously, when you have that happen, it dramatically increases the productivity, the efficiency and the time that you spend on training new-hire's. So obviously, common sense would direct you to we're far better off with lower turnover than we are with higher turnover. We're working very hard to understand all of the reasons why the turnover dropped so dramatical so that we can continue it.

Okay. Thank you.

Thank you. And we have a question from the line of Scott Van Winkle with Canaccord Adams. Please go ahead.

Hi, Mark. Most of my questions have been asked. But Mark, you responded to a question earlier that somebody was trying to break out what sales growth was excluding the impact of the fuel surcharge. I'm just wondering if you could kind of give us some indication on the independents that were done 2%, probably up a little bit excluding the extra week last year. Is that where all the impact is? Was that number materially higher if you exclude the fuel surcharge?

Scott, just to make sure that I am understanding the question. You are just trying to understand that if the prior year fuel surcharge was backed out of the prior year number, would the decline in the business have been greater or less or no impact?

Well more specifically on independents. Obviously, the year-over-year comparison would look better if that wasn't in last year. But you said it was immaterial to total sales growth and I'm wondering if it's a little more impactful to what the real growth rate in the independents would be?

Yes. I apologize, I did understand that you were asking about the independents specifically. I know what the top line number was from a fuel surcharge standpoint. I have to admit that I don't know the breakdown off the top from an independent standpoint. But I would say that it's not going to necessarily move the number that much on the independent side. It's still probably, again, knowing what the total number is, it's probably no more than a tenth of a percent on the gross. So I don't think it moves it materially, So maybe it's 2 versus 2.1 or it's 1.95 versus 2.1 negative growth, but it doesn't really move that overall decline in sales substantially.

Okay. Thank you.

All right, thank you. (Operator Instructions). Ed Aaron, please go ahead with your follow-up?

Thanks, just wanted to follow-up on that one to three percent top line that you steered us toward for the first quarter. I guess that implies a little bit of an acceleration. It seems like we are still in an environment of inflation coming down. So just trying to get comfortable with the assumptions that you are using there and what is going to drive it.

I'm not sure I followed the question.

Well, I think you said one to three percent sales growth for the first fiscal quarter is roughly where you expect to be?

Correct.

And I think the fourth quarter it was at the low-end of that and you still have inflation that presumably is moderating. So I'm wondering why the sales growth would reaccelerate a little bit in the first quarter if inflation is still coming down?

I think that when Steve talked about the inflation being at 4 plus percent for the fourth quarter, I think that is how the quarter averaged out of the for the month of July, the year-over-year inflation was about 3.2%. So really, I think that the moderation on the inflation side we think will be minimal or there won't be that much more as we go into Q1. And then when we saw sales slow down in fiscal 2009 was really the midpoint, roughly the middle of October. So you will lack some of that at that point. So I think those two combined - - as well as some of the trends we're seeing give us some optimism that there could be some acceleration.

I think long-term your inflation has averaged right around 3% so we're - - it seems like we're sort of almost back to the average.

Correct.

Is there any concern on your part that maybe we have a reversion below the mean?

Ed, I don't know that it's a concern, because what we have seen, I would have thought that we would have seen it before now if that had actually been the case. The last big round of increases sort of hit in the September timeframe, and earlier in the year, when we started to lapse some of the increases from last year, there was some concern about deflation and we started to refer to it it more as disinflation where you are still seeing the price increases but they are more in the normal range, normal quantities. If I dropped down to 2%, 2.25%, versus being at 3%, 3.25%, I don't know that I would expect it to be that much - - that quickly of that, but I think it would probably take over the next 12 months for it to slide all the way down to that level. Because there have been price increases put through in the first half of calendar 2009 that will still be lapping as we go into the first half of fiscal 2010. So I understand what you are saying, but I don't think it's - - we don't think internally that the impact is as great as you are concerned that it might be. I think we've got some comfort that there may still be a bit more to go but it shouldn't impact us that significantly.

Okay. And then last question question, the free-cash flow was great in the quarter. And I just wanted to get your prospective on why there was so much upside relative to where you guided as recently as last quarter. And then second, whether you think you've pulled forward some of that free-cash flow opportunity that you based those long-term objectives on when you met with us in York.

Yes, I think that the reason that we came in that much higher than the range is that I will credit our divisions is that we had talked about at the end of 2Q that we basically took inventory down a little faster than we should have and we needed to come back. You saw that bounce back in Q3 and we felt, when we got on the call three months ago, we felt that we were going to take a much more measured approach and ensure that we didn't make the service levels and out of stocks. And at that timeframe, I would have thought that we may be ended up closer to 50 days and I would have expected the sales trends to be a little stronger, which reflected where the guidance was. So I think the combination of the two allowed us to have better free-cash flow than we anticipated, although we were lighter in a couple of other areas. I think from where the consensus was, we were at the very low-end of our sales range. With respect to fiscal 2010 and 2012 and the three-year guidance we gave, I'm still relatively comfortable with the targets from the free-cash flow standpoint. Maybe during that timeframe we were closer to $30 million the first year or two than the out years but I still think we're within the ranges there. There is certainly some aspect that came out of 2010 that went into 2009 from a free-cash flow standpoint, but I think the range is still achievable.

Thanks.

Operator, I think we have time for one more question.

Okay. That is from the line of Michael Krestell with M Partners. Please go ahead.

Good morning. Just taking a look at the allowance for the doubtful accounts and the amount that was booked through on cash, it looks like it's been creeping up a little bit. And understandably that would be somewhat tied to the economic conditions that are out there. I was just wondering if you could comment broadly you can just comment sort of about the health of - - what the supplier base is and are you noticing any big changes in - - have you had a little more difficulties as we kind of moved through the summer months.

Yes, Michael, we did have a couple of hits during the year for certain customers, where they went bankrupt or they went away. I would say that it's been more from the conventional supermarket side where we have had from an exposure standpoint, some of that has been greater than the independents, which I think at beginning of the year were some of the concern that we had been asked about in the first couple of quarters. But - - it's really been a trend to where we have taken a couple of hits from individual accounts and then as a result of that, we have increased some of our reserves to mitigate any of that occurring in the future. I would say that with my DSO at 19 days, that really we haven't seen a significant deterioration, it's just been a couple of different customers. I can reference that there was one customer was 98% current on their payment terms and they filed bankruptcy the next day and we had an exposure from that standpoint. So it certainly has crept up over the prior years. We have had some customers file Chapter 11 and/or dissolve. But I would say from an overall standpoint that the credit teams have done an extremely strong job of managing our risk and we feel that we're well-reserved for our current exposures.

Okay and just one other question. At the investor day that you sort of discussed what the IT strategy was and some of the work that was going to be done there. Just wondering if there is any update from where you left it a couple of months ago.

Yes. We have done a couple of things since the last meeting. We have actually migrated one of our Legacy systems and decommissioned it and integrated them into one of our existing systems. We have gone ahead and made a purchase of a national warehouse management and procurement system that will now begin a process of integrating that will take a couple of years to get done. So while there is a lot of exciting things happening on the IT front and we're moving along at a pace that I'm very comfortable with.

Okay, that is great. Thank you very much.

Thank you. And please continue with any closing comments you may have.

Sure. Thank you all for joining us this morning. Again, I'm very encouraged by UNFI's strong operating results during 2009 and believe that we are making the right long-term decisions that will serve as a stepping stone for achieving our long-term financial objectives. Thanks again for joining us and have a great day.

All right. Thank you. Ladies and gentlemen, this concludes the United Natural Foods fourth quarter 2009 conference call. If you would like to listen to a replay of today's conference, you can do so by dialing 1 (800) 406-7325, or (303) 590-3030, input the access code 4141773. I would like to thank you very much for your participation today and you may now disconnect. Have a very pleasant rest of your day.