United Natural Foods Inc (UNFI) 2010 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and thank you for standing by. And welcome to the United Natural Foods first quarter 2010 conference call. During today's presentation, all participants are in a listen-only mode. Following the presentation, the conference will be open for questions. (Operators Instructions) This conference is being recorded today, Thursday, December 10th, 2009. I would now like to turn the conference over to our host, Mr. Scott Eckstein, with Financial Relations Board. Go ahead, sir.

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

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

Thanks, Scott. Good morning, everyone, and thank you for joining us this morning. I'm quite pleased with our results in the first quarter of our fiscal year 2010. Earnings per share were up 16% over the prior year at $0.36 per share, on sales of $885 million, up 2.4%. Operating income was 3.1%, up 17 basis points from the prior year. During previous quarters, we've talked about volatility in sales and the unpredictable nature of our economic environment.

Today, we are experiencing positive growth trends with consistency in each week's sales. Additionally, inflation, which was running as high as 6% to 8% a year ago, is now at more historic levels with 2.1% during the quarter. This data points to an improving top line and a more stable economic environment. During the last several weeks, UNFI sales have been averaging about mid-single-digits positive versus the prior year. While encouraging, it is important to remember that we have now lapsed the most significant sales decline which occurred November through December. The end result is that we're beginning to feel more comfortable and more optimistic than confident that we have seen the bottom of the decline and things are beginning to improve. As such, we are prepared to provide top line revenue guidance of 2.5% to 5% for the year, and remain confident of our previously-disclosed annual EPS guidance of $1.48 to $1.58 per share.

As you know, we no longer break out our specialty sales due to our continuing integration of this business into our core distribution business. We're making very strong progress as specialty skews have now been added to three distribution centers in the West. Most importantly we have signed contracts with several new specialty and organic conventional customers, further demonstrating that the Company's strategy to acquire specialty was sound. This new business will begin during January of 2010, and roll out throughout the end of Q2 and Q3. There will be start-up costs associated with the implementation of these programs which I expect to be approximately $1.5 million or up to $1.5 million in each of these periods. I have a great deal of confidence that UNFI sales initiatives in this space will continue to drive top line revenue beginning in Q3 and running throughout the next fiscal year.

As additional guidance it's important to note that the gross margin for these large customers are traditionally lower than our core business. Alternatively the cost to serve is also considerably lower. It will be a shift over time of lower gross margin percent, offset by expense controls, resulting in continued growth to our earnings per share. Gross margin during the quarter was down 79 basis points versus prior year to 18.6%. And this was driven by two main factors. First, moderating fuel prices resulted in significantly lower fuel surcharges, which drove our gross margin and operating expenses down. Additionally during the quarter, we experienced start-up costs and gross margin charges associated with the ramp-up for significant new business and process improvement at our Woodstock Farms manufacturing facility.

UNFI's Texas facility is now well under way with occupancy expected during fiscal Q1 2011. Completion of this facility will result in a fully built-out national network of distribution facilities enabling a low-cost, high-service model based on being close to the customer. In addition, we will convert our focus from bricks and mortar to systems deployment while managing overall CapEx to less than 1% of revenue and on an annual basis.

During the quarter the company officially kicked off its new supply chain project which will result in national supply chain platform to include warehouse management, transportation management, and category management. This is a long-term project that will take three years to fully implement. Following up on our Q4 call, market share, operational excellence, one company platform, and continued innovation and sustain ability will drive long-term margin at revenue growth while remaining true to our core beliefs.

On a divisional basis our core distribution businesses performed well during the period. Several highlights include the opening of our new Charlotte Alberts facility, continued growth at Select Nutrition and very strong results in all of our UNFI regions. Our performance during the quarter is consistent with, expectations and I'm pleased that the new business opportunities identified a year ago are beginning to mature into more UNFI products being distributed into a greater variety of new and existing customers. Now, I'd like to turn the call over to Mark Shamber, UNFI Chief Financial Officer.

Thanks Steve. Good morning and welcome to everyone listening in on the call and the webcast. As Steve mentioned for the first quarter of fiscal 2010 net sales were $884.8 million, which represented an increase of approximately $20.5 million over last year's first quarter net sales of $864.2 million, resulting in sales growth for the quarter of 2.4%. Inflation continued to ease in comparison to the prior year and was at approximately 2.1% for the first quarter. The company reported net income of $15.5 million or $0.36 per diluted share, an increase of approximately 16% or $2.3 million over the prior year. Net income for the first quarter of fiscal 2009 was $13.2 million, or $0.31 per diluted share.

In the first quarter, sales to the super natural channel increased by 7.4% and continued to represent approximately 33% of sales. Independence sales declined by 1.6% for the quarter and independence now represents approximately 41% of our sales. The supermarket channel experienced growth of 4.3% over the prior year and continued to represent approximately 20% of sales. And then finally food service declined by approximately 4.1% over the prior year and represents approximately 2.6% of sales.

Gross margin for the quarter was 18.6%, which represents a 79 basis-point decline from the first quarter of fiscal 2009, where we had a gross margin of 19.4%. And also represents a 39 basis-point decline from the previous quarter. The year-over-year gross margin decline was due to a combination of lower fuel surcharge revenues and change in the mix of sales by channel. In addition, as Steve mentioned, we had some issues within our manufacturing division, Woodstock farms, which negatively impacted gross margin as well.

Operating expenses for the first quarter were 15.5% of net sales, compared to 16.5% for the same period last year, a 96 basis-point improvement. Fuel had a positive impact of 41 basis points in comparison to the first quarter of fiscal 2009, as fuel represented 69 basis points of distribution net sales in the quarter. Sequentially our feel costs improved by 8 basis points over the fourth quarter of fiscal 2009. And on a national basis diesel fuel costs in our first fiscal quarter increased by approximately 8% from the fourth quarter, to a national average price of $2.66 per gallon using the Department of Energy's weekly prices. For comparison purposes, this represents decrease of approximately 31% over the prior year average for the first quarter of $3.86 a gallon.

Share-based comp during the quarter was approximately $2.1 million or 24 basis points, compared to $1.7 million or 20 basis points in the prior year. Operating income for the quarter was 3.1%, a 17 basis-point improvement over the prior year first's operating income of 2.9%. While this does represents a 28 basis-point sequential decline compared to the fourth quarter of fiscal 2009, it is important to note that there are some seasonal aspects to our business, particularly with the addition of specialty. And therefore, we feel that the year-over-year comparisons of our operating margins are more applicable than sequential comparisons between certain quarters. Our effective tax rate for the quarter was 40%. And this represents an increase of about 0.4% over the fiscal 2009's first quarter. And that's primarily due to increasing tax rates and surcharges on a state level as well as some changes in our apportionment factors.

Our inventory was 49 days on hand for the first quarter in the middle of target range of 47 to 50 days and a decrease of three days in comparison to the prior year. Our higher inventory levels at the end of the quarter were higher than at year-end due to the normal inventory build that occurs for the holidays. Sequentially, inventory levels increased by one day compared to the fourth quarter of fiscal 2009.

DSO for the quarter was consistent with the fourth quarter at 19 days which is favorable to our target range and one-day improvement over the first quarter of the prior year. Capital expenditures were $9.7 million, or 1.1% of net sales for the three months just ended, which is slightly above our target spending.

At $1.4 million, interest expense reflects an approximately 60% decrease on a year-over-year basis due to lower debt levels associated with the continued use of free cash flow to pay down debt, combined with lower interest rates during the quarter. The company's outstanding commitments under our amended and restated credit facility as of the end of the quarter were approximately $207 million, with available liquidity of slightly more than $200 million when including cash and cash equivalence. Our leverage as of the end of the first quarter was approximately 1.7 times on a trailing 12-months basis. And we generated approximately $7.8 million of free cash flow during the quarter compared to negative free cash flow of $42.6 million in the first quarter of fiscal 2009, or a change of more than $50 million.

Finally on a trailing 12-months basis our return on equity was 10.9%. As discussed in this morning's press release we provided revenue guidance for fiscal year ending on July 31, 2010. For fiscal 2010 we expect full year revenues to increase by approximately 2.5% to 5% over fiscal 2009 levels, to a range of $3.54 billion to $3.63 billion. Factoring in our growth of 2.4% for the first quarter, this implies comparable growth of approximately 3.4% to 6.7% for the remainder of fiscal 2010. At this time, we have not changed our earnings per share guidance of $1.48 to $1.58 nor our CapEx guidance of $35 million to $39 million which were both issued in September. With that, I would now like turn the call over to the moderator to facilitate the question and answer session.

Ladies and gentlemen, (Operator's Instructions) One moment for our first question. And our first question comes from the line of Greg Badishkanian with Citigroup. Go ahead, please.

Great. Hi guys. Nice quarter and it is good to see things are continuing to improve. Just two questions. First is with respect to inflation this quarter versus last quarter, kind of what were you seeing there? Any main categories of deplationary pressure, and also the impact to dollar profit? And also from a fuel perspective, what type of fuel are you assuming in your current guidance?

Hey, Greg. So on inflation, it was I think really more a matter of a lot of categories moderating. The biggest categories that I had -- what we would call deflation, which was, 10% plus reduction in cost of produce and dairy, they don't -- they're not particularly material in the overall scheme of all of the categories that we sell. So I think it's more a factor of a wide range of products returning to more historical levels of inflation versus deflation in any one or two product categories.

Right.

And certainly if you look out over the course of the last 10 years, you would find that the historic rate of inflation is 2% to 4%. On the fuel, we don't -- I don't think we provide any disclosure on where we budget fuel. I will tell you, and I think we've talked about this in prior calls, that we do have about 30% of our fuel hedged and we feel very confident with that. And the reason we hedge 30% of our fuel is as you know, most of our contracts with customers have fuel surcharge language which covers the largest share of increase, if we get into a market will diesel is rapidly accelerating. The 30% hedge covers that differential between how much we pass along and how much we're exposed to.

If I could throw one more question in, and thanks for that, and say the improvement that we have been seeing lately in term of sales, is that due, do you think primarily because you have easier comparisons. And even if it is the case, which categories, or is there any type of theme that you're seeing, that you're seeing the improvement with?

Yes, I mean, as much as we would like to take credit for all of the growth, you're absolutely right. We're comping a year ago that, if you recall, that's where the sales really took a deep dive. So that's absolutely true. Most of the growth as Mark talked about earlier, is coming in the conventional and supernatural channel.

And any particular category just across the board?

Just across the board.

Okay. Great. Thank you.

Great.

And our next question comes from the line of Mr. John Heinbockel with Goldman-Sachs. Go ahead, sir.

Hey Steve. I know specialty is more economically sensitive, have you seen that bounced back and chose stability alongside the organic product?

Hey, John. No, I think that the specialty growth is still lagging. The organic growth. Interestingly, what we found over the last year, is that the core organic products really did not have a significant fall-off. Where we did see significant fall-off, was in the periphery, organic pet food, paper products. But the core organic products did not fall off considerably. Specialty did across the board, and that's -- I think that's going to take a while for it to creep back to where it was. So the answer is specialty has not come back to the degree that it was a year ago.

But you've seen clear signs of the bottom, I guess is that fair?

I would say that that's true, yes.

Okay. The new contract wins you talked about, what would the annualized run rate on all of those be? Do you have a general range on that?

We've talked a lot about that and we figured that was going to be a big question point this morning. And we're not in a position to disclose that yet. We've signed the contracts with these customers. We're starting to gear up. We haven't shift the case yet. So I think what we're going to do is wait until we start shipping and that will put us in a position where we can kind of set the high-water mark of giving guidance around the total amount of business that's actually come on board.

Is that primarily specialty or it is a little bit of organic as well. And I guess all of these are totally new customers?

It is a little bit of both. It is new customers, it is extension of existing customers with new concepts within under their umbrella. And it is natural organic and specialty. And in some of the cases it is more specialty than natural. And in some it's the other way around. But in all of the cases, it's specialty, natural and organic.

Okay. And then finally the Woodstock cost, how material is that?

I'd say it's somewhere between 6 and 10 basis points impact on the margin for the quarter.

Okay. And that will not repeat, I take it?

Correct.

All right. Thank you.

All right .

Our next question comes from the line of Meredith Adler with Barclays Capital. Go ahead, please.

Hey, guys. If we could talk a little bit more about the new business. I think the last quarter you talked about kind of having a pipeline or people you were talking to, I wouldn't say a pipeline of new business, but what you hoped to accomplish. Could you talk about whether you still have a lot of conversations going on, and transactions that might be pending?

Sure. Meredith, the contracts that we've signed I think is a relatively conservative number of the total customer discussions that we're having. So my expectation is that the contract wins are going to continue throughout the next 12 months. So does that answer your question?

Yes, it does. And I was just also wondering if you could talk a little bit about some of the things you're doing around private label and branding. And I think you had particularly had an initiative to service independence better and give them something unique. Maybe you could talk about that a little bit.

Sure, we have pretty effectively rolled out a brand new blue marble brand called Field Day, which is a independent brand. And we've seen a lot of excitement around that category of products. I don't remember how many skews that we have under Field Day, but they're rolling out 20 to 30 at a time and we'll continue to roll out over the next couple years. So there has been a fair amount of excitement under that brand in the Independent channel. Blue Marble side, we are trying to determine what our -- well, we know what our go forward strategy is going to be to concentrate on a fewer number of core brands that we think are going to lead the charge for us, as opposed to the 27 different brands that we have today. So, there's some movement going around within Blue Marble as it relates to what our real go-forward brands will be as we look out over the next five years. But, again, we have some exciting brands, Tomorrow's Tortillas, Rising Moon, pizzas. So we have some great brands. It is a matter of really buckling down and determining how we go to market with each one of them.

My final question is about operational efficiency slash expense control. Obviously, you've done a good job of managing expenses this quarter and recently. Can you talk a little bit about what the potential is to continue that and obviously you have a big technology project coming. It won't be done, you said, for three years. But will there be some benefits as we go along, and are there other things you can do before the technology is in place?

Yes, I mean, that's a great question. And if you go back to some of the commentary I made as we take on more conventional business, which we will do, it is going to drive our gross margin percentage down over time. Which means that we have to be taking advantage of the cost savings that come directly out of the implementation of the supply chain project, as well as being more efficient in the way we service that channel. So the good news is that the additional conventional business forces us to make sure that we continue to reduce expenses slow and steady. You are not going to see any big movement in any one quarter. My hope is that as we get the technology implemented, which will take place in pieces, and as we become more efficient in determining how to get the cost out of servicing lower-margin business, that will continue to increase our EBIT margin and earnings while reducing expenses and seeing the gross margin percentage come down.

Great. Thank you very much.

And our next question comes from the line of Scott Mushkin with Jeffries. Go ahead, please.

Hey, guys, this is Blakely Smith filling in for Scott. Two quick housekeeping items. On interest expenses have you guys provided -- (inaudible) expense line. I just want to do see if you provided any guidance for that for the rest of the year.

No, we historically haven't, Blakely, but obviously if we continue to pay down debt and interest rates, you know, I think Bernanke was quoted the other day as sort of saying that, the Fed has the ability to keep interest rates at low levels for an extended period of time. So as long as rates stay where they are, and we continue to generate free cash, I would expect that on a sequential basis interest expense would be relatively within range, 100,000 to 200,000, of where it is each quarter, and/or declining. So I mean, it is consistent -- I think that is one area if you were to look quarter to quarter since the end of Q2, that we've continued to pay it down. And then rates being where they are have been to our benefit, where our debt on the revolving credit facility is at LIBOR plus 75, so we have an all-in rate now in a little under 1%.

Thanks. And then for the revenue guidance, what level of new customer signings are you assuming in the 2.5% to 5%?

I guess what I would say is only the customers we've already signed are in the guidance that we've given. You would not have anything prospective in our guidance.

Okay. And, lets see, on the uptick in volume in the quarter, to what extent do you think that was replenishment of destocked inventories either within the channel or do you have any read through into consumers pantries, if you will? Do you feel like this is a pickup in demand or sort of -- at the customer site or the retailers side restocking?

I mean, we don't have any view into the actual consumer, per se. And I don't think we believe that it's a restocking going on. I think it's just a general perspective that things are improving, and consumers are coming back to some of the products that they may have lived without for some time.

Okay. Thanks. And let's see. Two quick ones on fuel surcharge, kind of struggle with this fuel surcharge timing. I mean, do we expect sort of -- and you may have addressed this, but I want a little clarity. As you come through the surcharge benefit, do you expect continued headwind on that lap as we head forward? Obviously prices have already come down year-over-year. But I know there is some timing issues in the surcharges, just hoping to get a little color there.

Well, I think the important thing to remember Blakely is that when you look at the fuel surcharge, when we have that in place we're still netting out to the negative, where the surcharge only recovers 70% to 80% of what we're incurring from an expense standpoint. Net net to operating margin it is still a detriment. If we lap the headwinds where we had high fuel surcharges and they now go away in the current year, we will see gross margin take a significant decline, because it's basically a 100% pass-through, where you record the revenue, the expenses below the gross margin line operating expenses. But when you look at operating margin, there is a net benefit to the margin of that remaining 20% to 30% that you're getting a pickup in the quarter. So there is headwind on the gross margin side but there a tailwind from an operating margin standpoint , as you look at fuel

Okay. Great. Thanks very much .

Next question is from the line of Ed Aaron with RBC Capital Market. Go ahead, sir.

Thanks, good morning.

Good morning, Ed.

Okay. So on the specialty business, you had alluded in the recent past about a few I guess smaller customers that you picked up along the way. I wasn't under the impression that any of those added up to anything hugely material. I know you're not ready to quantify these new wins, but do you think they're big enough so that they can really get the ball rolling to help secure other businesses, other pieces of business as other customers sort of see you supplying these retailers and recognize that you're capable of performing in that specialty category?

Yes, I mean you're right on. The reason why we had to have the small wins we were in geographies where we didn't carry the specialty products in the DCs. So the wins put us in a position where we now had the specialty mix in the West Coast primarily. So now that we have the product in the facilities, and we've got a sales force to go out and promote it, it puts us in a much better position to be able to go to a large group of customers to sell the natural organic and specialty mix of skews.

Okay. Thanks. And then on the margin, Mark, when you can comment on comments you made about seasonality. I think they were down 30 basis points sequentially at the EBIT line. And I know you had a manufacturing issue that cost you 6 to 10 basis points. If I'm not mistaken in the fourth quarter, you also had some costs, start-up costs that have since gone away. So that would seem to explain that the entire sequential declines would be attributed to seasonality, but that 30 basis points seems to be a big number to be explained by seasonality alone. Can you help me understand what I might be missing there?

Well, just let me make one comment on the manufacturing facility. We have two things going on. Number one, we basically doubled the size of that business in some customer wins. So there was a fair amount of business retooling, inventory transition, and start-up costs associated specifically with Woodstock in the quarter that we think are one-time, that we won't see again. I'll let Mark talk a little bit about the seasonality of the gross margin.

Yes, are you talking about the operating margin or gross, I guess, maybe? I thought you were asking me -- you sort of asked the question starting with the operating margin where it was 30 BIPS down, but then you referenced the gross. And I guess maybe, you are backing that out and saying net-net, we still had 30 basis points down, is that the question?

Yes. I'm just looking for a bit more of a bridge to get to 30 basis points sequential decline and operating margin?

Yes, I think what we have is there are some seasonal aspects to the business. As we start to go into for our standpoint a new fiscal year, there are efforts that we undertake, whether it is from an operational standpoint or SG&A standpoint that may be a bit more front loaded where we're getting the efficiencies for the whole year and the back portion of the year and that's really what the driver was. If I look at any particular line item, within our operating expenses, nothing is going to jump out where I can say, hey, it is 10 basis points or it is 12 basis points that led to that impact. But we do typically, I mean, like many companies when you go into a new fiscal year, you do have budgeted new heads, new projects things of that nature. A lot of those -- a lot of those things had been pushed back a little bit given the economic environment we were in during the back half of fiscal 2009. So I think from an expense standpoint you're seeing a little bit of investment on that side. But it's not -- it is not anything, again, where I could sort of cull it out and really give you a lot of clarity. From a volume standpoint, we don't see the same sort of pickup that we'll get in the back half of the year from a sales stand pointer. If you look, obviously Q1 and Q2 are usually sequentially flat or consistent with Q3 and Q4 of the prior fiscal year and then you see a significant jump-up. So that obviously plays a roll roles as well where you making the investment in certain area but you don't see the sales pickup until the third fiscal quarter. So I wish I could just point to a couple of items for you, but that is about as specific I can get.

Fair enough, thanks. One more quick one if I could. Steve, I'm guessing you have been work on these specialty customers that you managed to secure but you have been working on them for some period of time. What was it that enabled he to finally get you across the goal line there? Because based from the publicly traded super markets doesn't seem like they're having an easier time with our business, so I would not imagine it is so easy for you or anybody else to win new business from a supermarket at this particular point in time with the deflation headwinds their facing. Can you help us understand how you got that across the goal line?

Yes, there is a couple of factors. One was convincing the consumer -- the retailers that the issues that we had at (inaudible) were behind us, and so we've done that clearly. The big plus that we have is that for retailers that want to have a presence in the natural and organic space, we're really the only option when it come to skew variety, merchandising capacity, the ability to provide a full-service program. There's really nobody that can compete with us in that segment. If a lead of theirs is natural and organic, so I think that there is a tremendous amount of interest on the retail side of getting UNFI to be a player in the space. The obstacle in the past was that we didn't have specialty. And given their own structure, they had to award natural organic and specialty to one supplier. And so I think we're over that hump. There has been some uncertainty in the market on the competitive front. Which I think it is going to benefit us over time, but I think it's just a matter of being very proactive and aggressive and getting out there and demonstrating what we have, and how we do it. And that will win these companies over. I mean, all we need to do is get them in to see a couple of our new integrated facilities. They're big, they're bright, they're efficient, they have a lot of technology, and that's very attractive.

Thank you for taking my questions.

And our next question comes from the line of Andrew Wolf with BB&T Capital Markets. Please go ahead, sir.

Sure, thank you. Follow-up questions in the sales area. Steve, given the mid-single-digit trend you're run at this quarter, looking at the model and how that shakes out, is it fair to say that versus your sales guidance you're really looking for very little of the sales growth contribution, 2.5% to 5% to come from these new customer wins given that they come so late in the year?

I would say that is accurate.

And as you start to get other contracts as you spoke to, would they potentially start to go in this year's number or more likely in fiscal 2011?

Probably not. I would say fiscal 2011 at this point.

Right, if you think at a stand point , we talk sometimes, Andy, that we'll win a contract and it can be 60 to 120-day lead time before you start shipping them, so if we were to be awarded something today, we might not start shipping until fourth quarter at the earliest. So there may be a nominal benefit during fiscal 2010 but more of it would be in

And on the customer segments, sequentially the numbers speak for themselves.

The independents had a little positive delta, still negative but a little positive delta. And then you're saying obviously business is better now. Can you give us a sense of the of the independents also showing -- continuing to show something of a positive delta, versus where they were in the quarter you just reported?

Very marginally. Not to the degree that we're seeing it in conventional and super natural for sure. Which is why we're working so hard on the independent space to add a lot of categories, products, that UNFI has not historically carried for them. Specialty cheeses and protein, as an example.

Yes. And just turning to your guidance, you called out $1.5 million of transition costs for your new customers. Was that partially or was -- how was that -- was that anticipated in the current EPS guidance, which you issued previously?

No, it was not.

Okay. So should we interpret that you haven't revised guidance for that as you feel the sales momentum is better than what you might have thought when you set the sales guidance -- when you set the earnings guidance?

I think that's probably fair. I think there is probably a shift as to where some of the profitability may come from maybe in the second quarter and early part of the early quarter shifting more towards the back half of the year.

Some of these transition costs are going to be in this Q2 as well as Q3?

Yes because not all of the business is starting in Q2. Some of the business does not start until Q3. I mean, that's why -- I think that's why Steve it gave it as up to million and a half in 2Q and 3Q, because we're not sure -- we're not sure exactly how well ramped in this specific time lines haven't been established. So it could be up to a $1.5 million in both quarters, it could be more in Q2 and less in Q3.

Okay. And, Steve, this is a pretty general question, but overall and I know the new customer wins of folks in specialty kind of vary, kind of like they do in organic, by size, but in terms of gross profit and other metrics, but generally out of the gate, and once you're integrated and get through the transition costs, are these businesses going to be -- are these, despite the lower gross margin, you said there is lower costs to service these accounts. Overall, do they come out of the gate as around the current profitability margin for the company, or are you relying on the systems and other cost enhancements coming down the road to retain the current profitability rate?

Yes, I mean, philosophically we're not going to take business on that we know is going to be dilutive to earnings. So if we're forced into a position where we have to price it such that we think it's going to be dilutive, I think we're probably going to walk from that one. So, we have enough kind of internal view into where we think the expenses can get, both in terms of the technology that we have today, and in terms of the technology that we're going to be putting in, to feel pretty comfortable with how much less gross margin we can take in a customer and still have it be accretive to earnings. Okay. I guess I was getting that operating margin. When you bring in some of these customers, obviously you're not going to take -- lose money on a new business. I'm looking more at if sales are up -- if it boosts your sales X %, 2%, does it boost your earnings 2% or more? I think we're saying the same thing.

From where I sit today, given the amount of new business that I know we have coming on board, it's not going to be dilutive to operating margin. There will be other initiatives and programs that we have in place that should allow us to keep margins where they are and expand. And some of that may whether that expansion comes from a new business or comes from our initiatives, I mean, we wouldn't really divulge from that standpoint. ,

If you go back to our stated three-year targets, we're still comfortable with those targets.

Okay. Thanks. That's what I was getting at. Appreciate it.

Okay.

And our next question comes from the line of Scott Van Winkle with Canaccord Adams. Please go ahead, please.

Thanks. Mark, I just want to make sure I understand this -- the question and the answer that you had on the seasonality of margins. It sounds like the seasonality negatively impacted the gross margin, and the offset that you normally have with a channel mix and lower operating costs was offset by new initiatives that kind of through some additional expenses on there. Is that the way to think about it?

Yes, I mean I guess I would say that I don't think the season, I wouldn't say the seasonality had the impact so much on the gross margin as it did on the operating expenses. So I mean the gross margin really was more impacted by lower fuel surcharge, the shift toward the growth that you saw from the super markets and super naturals, in the decline in the independents, and then the sort of the impact we had from Woodstock Farms. I was speaking more on the seasonal aspect with respect to our operating expenses. Because as I said a lot of like many companies, once there is a new budget year folks who have put programs together, they want to get those programs started as soon as possible. They start hiring, they start incurring expenses, and that's really what we see in Q1 and Q2, where we don't necessarily always have that significant sales lift during those two quarters. It tends to be a modest lift in sales in Q1 versus Q4. Once in a while it's flat. So that's how I meant it, Scott. I'm not sure that clarifies it any better.

No, it does. Yes, so the channel mix on the gross margin and timing of expenses and seasonality on the operating margin is the way I would take it. Exactly. And then, Steve, on the start-up cost with new business, is there a time that you say, you know, if I got a $3 million investment over a couple of quarters in this new business, how long does it take you to pay that back?

It's really. Well, let me answer it two ways: The investment is primarily in human capital. Right? So, where we provide a full-service program. We have to go out and hire the folks to actually work in the stores. There is some additional equipment and related kind of stuff that we have to do. But the largest amount is up-front training, hiring, and getting people ramped up to serve the new customers. If you're talking about what's the pay-back? When do you start seeing a new customer be accretive to earnings as oppose to dilutive to earnings. I'm not sure what the answer to that is, quite frankly. It's probably at least 12 months.

Probably pretty close. When you factor in what the investment is. I think we're seeing from our standpoint, as we're gaining more of the conventional supermarket business, there is a much greater investment because you are going to that full-service or partial full-service model, where you do need to have, those folks on board for the day you start shipping, versus these scenarios where we might be cross-docking or where you're dropping it at the door and somebody else is putting it out on the shelves. So, I mean that is where we start to see a shift as we gain more conventional supermarket business.

Okay. So I guess I assumed in the past that when you had people in stores actually placing product on shelves, rather than the back room, that you used third parties for that. And so is this a change where it is going to be UNFI' employees handling that, or am I wrong about the historical use.

Historically, we did have some third-parties. Most of that has gone away and we are doing it ourselves.

Okay. And any impact from the rollout of the supply chain initiatives either in cost or fulfillment level or anything of that nature?

We're starting to get more and more suppliers signed up to our new Clearview program which is the precursor to our national category management initiative. So we see a lot of positive work being done there. The actual implementation of the software will not take place until I think the first part rolls in April-May time frame of next year. So we're right now in the middle of implementation. So, I think it's going to be, there is some small steps that we're taking that are going to move us in a positive direction. That will reduce costs, hopefully improve margin. But the real benefit is a little ways out.

Okay. Thank you very much.

Okay .

And our next question comes from the line of Gary Givlen with Windmiller. Go ahead, please.

Yes, hi. Given that the new business is approximately the same margin or a little -- potentially little better than on the operating margin line, the -- I guess the question is, you're increasing the revenue guidance is somewhat higher than where the street is at for the year, and the quarter came in better than the street on revenues, but your guidance isn't going up. Is that more of general conservatism or is it more focussed on the very short-term impact on the new business?

Gary, I mean I guess from that standpoint really where we're saying is you've got the investment costs that you need in order to take on that new business. And so while sales -- I mean, I'm not sure where the street numbers were, so I'll take your statement. If you say we're higher from a revenue standpoint for the quarter and for the year, than where the street had us, and you're asking why we didn't raise the earnings range that we had we talked about the fact that there will be an investment of up to a $1.5 million in the second quarter and the third quarter, so from our standpoint roughly $700,000 is a penny of earnings. So while there may be additional sales that were picking up, there is roughly could be anywhere upwards of $0.04 of additional expenses we didn't have in the plan, as well. So I think that's from our standpoint not necessarily being conservative on it, but being realistic, starting to get the sales volume and seeing how that plays out and comes on board, we're comfortable with what we issued previously but didn't see any reason to change it with the business that we've taken on.

Okay. A great clarification. And this follows up on Andy's questions. If you take a new customer, in the typical new customer, in the conventional supermarket side, and project out 12 months after start-up costs for that customer have been completed, is that customer going to have a higher than UNFI average company margin or equal? Because, I realize the gross margin is lower but you're also shipping full cases and full trucks and--

Gary, historically I would not now refer for instance any individual customer or individual agreement. I think that Steve referenced, we put our three-year targets out there and we feel that we haven't backed off those, and nor have we changed those from what we said in June. So, we would expect on average over the next three years, which would include fiscal 2010, that would you see an operating margin expansion of 10 to 15 basis points. Whether that come from the margin in our new customer, whether that comes from operational efficiencies, we're not going to necessarily get into that level of detail. Certainly if you were a new customer coming on board and you said that you had a higher margin than the average, we would most likely having them coming back to us right away. And if they were lower, existing customers would be approaching us and saying, why aren't we at that same margin? So for that reason we just don't go into individual customers' profitability.

Or class of trade.

We talked in generality of class of trades and that is as detailed as we'll get.

Yes, okay, I understand. Thank you very much.

And our next question comes from the line of Doug Thomas with JET Investment Research. Go ahead, sir.

Thank you. Good morning, I'm going to have to learn how to press star-one a lot faster, I guess. Most of my questions have been answered. I was just wondering there doesn't seem to be a day that goes by that we don't see, last week it was an article about salmonella in click Ken. This week there's been -- a lot of stories in school lunch beef. And the issues that the industry is really facing. And I'm just wondering from an awareness perspective, you've talked about exploring the possibility of getting into the protein business in one way or another. And I'm just trying to figure out how you view the value proposition that UNFI brings not just to your -- not just to your existing customers and new conventional customers, but what's the possibility to use this as a platform to expand within, for example, food service, or to use the Blue Marble brands, for example, to get you into some of these businesses that appear to be ripe for a company like yours?

Yes, Doug, you hit it right on the head and that is that we're using sophisticated refrigerated multi-temperature equipment. We're using sophisticated multi-temperature distribution facilities in both our core UNFI business as well as our Alberts business to deliver perishables. Everyone of our customers for the most part is buying some variety of natural antibiotic-free protein and/or specialty cheese. Sometimes, if you're in an urban market, these products tend to be easier to procure than if you're in a more rural market. So, all of our constituents have said on a supplier side, boy, it's a natural for us to sell our product through you. And our customers have said, boy, it would be great if we could buy these products through you, as opposed to having to seek them out from many different sources regionally. So, I don't think I'm telling you anything you don't already know. I think that is why it is attractive to us.

Okay, I think a couple of people alluded to the Kroger call this week which was flat-out terrible. I'm not asking you to talk about a particular customer, potential customers, but maybe in terms of explaining further explaining the value proposition of what you bring to a conventional retailer. They're buying from more than one supplier for organic and natural and specialty. But can you sort of talk a little bit about what exactly the cost savings are? Or can you put things in perspective in terms of explaining what the what the top couple of financial metrics that a new conventional customer, for example, on the west coast, would look for?

Sure. Retailers look at organic in a couple of different ways. There are retailers that are unbelievably focussed on organic, because of demand, because of the profit margin contribution and then everybody in between. Those who think, yes, we have to have it to those who barely carry it at all. For the retailers, that I would say fall within the middle of that range to the upper end of that range, organic is not an easy category. I mean, obviously you have to carry organic milk and you have to carry KASHI and Cliff bars. But there is a whole lot more to organic than those particular products. We use our own self-created data to determine what are the high volume organic skews in each one of the markets in which we trade. That's obviously very valuable data to that a conventional retailer who wants to focus on organic, has somebody to rely on that can say, look, these are the sets that you need in the stores by geography. Because if they don't have the right products, then the consumers are going to go somewhere else to get it. And as I said earlier, when it comes to the natural and organic space, we're the only company that has the full breadth of excuse. Some of our competition carries 3,000 or 4,000 items of the highest volume items -- products, but they couldn't begin to tell a retail customer about what is the appropriate mix that they should be carrying by geography. And we have a very built out marketing team and a very built out merchandising team that provides that service to retailers, should they request it. Or should we offer it. So that's really the big draw. And it's a big draw.

Okay. Thank you very much. Terrific.

Thanks.

And our next question comes from the line of Ajay Jain with Pollings Securities please go ahead.

Hi, good morning and thanks for taking my question. Steve, in your prepared comments, I know you indicated that supplier pricing is getting back to more normalized level. I just want to know if that's also your assessment for the supermarket related business in general. I know you talked a little bit about this before, but with all the discounting going on in the conventional super markets, I'm wondering if the price competition in the center of the store, deflation, just at a retail level is starting to heat up from a buyer perspective as well.

Yes, I really can't intelligently talk to that one. You're talking in terms of a more EDLC, everyday low price, maybe collapsing in the margin, more discounting going on at the retail level. I don't have a lot of clarity into that. So, now I can only comment about what we see from the suppliers' perspective.

And what are you seeing from the suppliers' perspective?

Again, much more moderated inflation, back to that 2% to 4% range that we had referenced earlier. A lot of the pricing is a pass-through, so that the conventional retailer or the super natural or the, even the independent, the pricing and discounting is done directly between the manufacturer and the retailer. We'll serve as a conduit, but the actual change in the price occurs between those two.

I think, Ajay, another way from our standpoint is that last year when we saw things in the commodity prices rising we saw suppliers trying to put through a price increase every quarter, or twice a year, when historically it had been once a year or every six months. So I think really that we've seen that return to sort of a normal trend where, okay, there is a normal price increase or semi-annual but you're not trying to do it every quarter just to keep up with your commodity pricing is going.

Ok, but within that class of trade doesn't seem like you're speaking irrational pricing activity from a suppliers' perspective, is that a fair assessment?

That's fair.

Just lastly, on the (indiscernible) is it fair to assume that since that facility doesn't become operational until I guess August that there is no incremental impact on D & A. for this year?

If we get no certificate of occupancy until August, there will be no depreciation on that building in fiscal 2010.

Thanks for taking my question.

Ok. Operator I think we have time for one last question.

Our last question comes from the line of Michael Krestell with M. Partners. Go ahead, sir.

Great. Thanks for taking my call. Just two very quick ones. I'm wondering if you can talk about what the overall utilization or excess capacity. Maybe excess is the wrong word, but what exists out there in the network right now?

We're still probably in the mid-60s, maybe low-60s with some of the expansions we've done. I wouldn't call it excess capacity because really it's our investment for growth in some of this new business that we are winning. So, as we said in the past, there may be a particular facility that is operating at 100% where somebody else may be closer to 40 to 50. And that really is a function of the newer facilities that are much larger and should have growth handle in the next 10 years. They are probably closer to the 50 where some of the maturer facilities that have expansion 5 years from now or from that standpoint are closer to 100. So I would say we're probably a little bit lower than we have been for the last few years but that is really a function of beat getting the distribution network built out and position ourselves for not needing to do any new facilities or expansions for a number of years.

And at what what point are we talking? Is it three or five-year window before you need to look at it again?

If you can tell me what the demand is and where it will be I can give you that answer. It's a function, really, of we think we've strategized where we think we're good for the next three years, but if you tell me that I can pick up $200 million of business in the D.C., that D.C. goes overnight into an excess fully utilized scenario where we need to expand it.

I would tell you, and this might answer the question, the bulk of our CapEx spend over the next three years will not be on bricks and mortar.

Yes. Fully understood.

(Inaudible) and those kinds of things.

One other question. I know food service is a relatively small portion of the business, it seemed there was initiative to gear that up and capitalize on the opportunity and we haven't heard as much recently. So, I;m just wondering where that stands.

I'll comment on that. The overall food service category has been down considerably over the last year. In the restaurant trade n the business and institutional trade. So wherever you look in the food service category they have been hit considerably harder than we have from an economic perspective. So relatively speaking, our decline is, I think is much less than what it's been in some of the other companies. It's still a focus of ours. I think we're still trying to determine what our true go-forward strategy is on food service. It is a totally different model. We think it's probably more redistributor-based than it is direct-delivery. But we're still vetting through that. In the meantime, it's still a good category for us. We certainly have a lot of resources attached to it. But given the last 12 month, I think that we have been somewhat unscathed.

Okay. Great. Thanks for taking my call.

Thank you, sir. And at this time I will turn the conference back over to Mr. Spinner, for any closing remarks. Go ahead, sir.

Thanks for joining us this morning. UNFI is extremely proud of its position as a company, which will deliver long-term return to our shareholders, while continuing its dedication to sustain ability, the environment, support of the organic industry and philanthropy. Thank you, again, for joining us this morning and have a great holiday.

Ladies and gentlemen, that does conclude your conference for today. And if you would like to listen to a replay of today's conference, please dial 1-800-406-7325, or 303-590-3030, with the access code of 4183951 pound. That does conclude your call. Thank you for participating. You may now disconnect.