United Natural Foods Inc (UNFI) 2011 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. And welcome to the United Natural second quarter 2011 conference call. During today's presentation, all participants will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) Today's conference is being recorded, March 3, 2011. I would now like to turn the conference to our host, Scott Eckstein, with the Financial Relations Board. Please go ahead.

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 contact 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; Mark Shamber, Chief Financial Officer; Shawn Griffith, Senior Vice President, National Distribution; and Lisa N'Chonon, Corporate Controller.

We will begin this morning with opening comments from Management, and then we will 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, Scott, and thank you all for joining us this morning for our discussion of UNFI's second quarter 2011 results. Once again, UNFI attained sales exceeding $1 billion in the quarter, achieving record growth to $1.11 billion versus the same period last year. Net income grew approximately 20%, and our earnings per diluted share increased 8%, to $0.39 per diluted share. As you know, during our first quarter, UNFI successfully completed a secondary issue of just over 4.4 million shares now included in our share count.

Our sales increased over 24%, and all channels of our business experienced robust growth. Adjusting for our Canadian acquisition and the acquisition of certain distribution assets of Whole Foods Market, sales were up a healthy 14.32%. Two years ago, we talked about market share as a primary driver of UNFI's future. Our sales in the period and outlook for the balance of the year reflect the success we have had throughout our businesses in attracting and growing our market share throughout our Company.

An important driver of this success has been the continued integration of specialty products throughout our distribution centers. Many of the new customer wins and expansion of current customers have included the SKUs that make up our specialty offering. In order to effectively manage 24% sales growth UNFI is fortunate to have a dedicated and highly capable workforce. Their commitment to excellence, passion for our Company, is without equal. They have created an environment where change and improvement is the driver of our success. Looking forward, we'll be concentrating our efforts on continued customer expansion across our current channels, as well as further penetration into new product categories focused primarily on specialty cheese and protein.

Sales grew across all of UNFI's core distribution channels, with the following breakdown -- independents, 13%; supermarkets, 34%; supernatural, 29%; food service, 29%. UNFI Canada also performed quite well during the quarter, and surpassed our internal targets for growth. We feel terrific about our new family of associates and distribution centers. Our initiatives towards market share expansion in Canada are progressing, and we believe that this acquisition has become an accretive, strategic part of UNFI's continued growth. The independent channel, which is extremely important to UNFI, has returned to hardy growth. Innovation, confidence in the economy, and a renewed focus on organics are helping revise growth in this group of UNFI's customers.

Internally, UNFI's proprietary [Wowsaville] independent portal, in addition to retail services and iUNFI technology, are all focused on adding meaningful value to the independent retailer. UNFI has been, and will continue to be, an ardent supporter of the organic industry, through innovative product offerings and the most passionate associates in the industry. We believe that based on our market share expansion, in conjunction with further confidence in the overall growth of the industry, UNFI sales guidance for the year will now be raised to a new range of $4.4 billion to $4.5 billion, or 17.1% to 19.8% over our 2010 results.

In addition, we are narrowing our earnings per share guidance for 2011 to range of $1.65 to $1.71 per diluted share. Inflation during the period was marginal, at slightly less than 1% during the quarter. We continue to believe that inflation will rise to approximately 1.5% to 3% over the next 18 to 24 months.

During last quarter, we talked quite a bit about our new building and technology platform in Lancaster, Texas. Business transfers from Denver, Colorado to Lancaster, Texas were substantially completed in February, an important step in mitigating transportation costs and improving service levels to the market. Because of the delayed business transfer, we continue to incur incremental higher than expected costs of approximately $2.5 million, to support this critically important initiative for UNFI. These costs associated with transportation, labor, and inventory shrink were dilutive to earnings during the quarter. Looking forward, with the business substantially completed during the first month of our third quarter, we expect nominal impact of approximately $1.5 million during the balance of the year from these types of costs.

Mark will share several important comments regarding gross margin shortly. However, it is important to note that as UNFI on-boards new customers and acquisitions at an aggressive rate, we will be hard-pressed in the short term to take enough costs out of our distribution system to compensate for the fall in associated operating margin. We do view this phenomenon as a short-term issue, occurring primarily during the next four to six quarters, which will be balanced by flushing through on-boarding costs, national implementation of UNFI supply chain solutions, national implementation of UNFI's warehouse management system, and managing service needs to cost.

While operating margin fell from 3.1% to 2.8% during the period, net income did increase 20%, to $18.7 million. The largest components of the decline was our cost associated with Lancaster, Texas, and the continued shift in customer mix. There has been considerable speculation regarding UNFI's relationship with Safeway. We are currently negotiating a distribution agreement, and until such time that a formal program is signed, we will not be disclosing any additional information. UNFI does not currently do business with Safeway or any of its [brands].

UNFI's balance sheet during the quarter remained strong, with leverage at 1.54 times. AR days were consistent with the prior quarter, at approximately 20 days. The inventory increased approximately five days to 54, reflecting the increased growth, associated service requirements, and the business transfer delay in Lancaster, Texas. Capital expenditures were well below our target at 0.6% of revenue for the quarter, and 0.66% of revenue for the first half of the year. With our increasing growth, we expect building capacity issues will drive the need to expand and relocate facilities over the next two years, while continuing to implement our national warehouse and supply chain technology platform.

Looking at industry and product growth reveals several promising trends. According to the Organic Trade Association's 2010 industry survey, average growth for organic food sales is projected to be at least 7%, up from 5% in 2009. Trends continue to indicate sequential growth towards the end of calendar 2010; and clearly, UNFI is growing net of acquisitions at a rate that exceeds the estimated growth of the industry. In addition, according to the same survey, 41% of customers were buying more organic this year, versus 31% in 2009. We believe the increase in organic demand is being driven by greater confidence in organic products, the health benefits associated with these products, and a closer price point versus conventional.

Looking into specific product categories of growth, we are seeing strong demand from organic snacks and energy bars; organic frozen and baked goods, with an emphasis on gluten-free; and continued growth in our coconut waters and organic bulks -- bulk grains and nuts. As you know, we will be hosting an analyst and shareholder meeting at our new Lancaster, Texas facility on March 22, 2011. I look forward to demonstrating our new technology platform and touring you through what we believe is the industry's leading distribution center. Now, I would like to turn the call over to Mark Shamber, our Chief Financial Officer.

Thanks, Steve, and good morning, everyone. Net sales for the second quarter of fiscal 2011 were $1.11 billion, which represents growth of 24.1%, or approximately $216 million over the prior year's second-quarter net sales of $898 million. Our acquisitions positively impacted sales by $87.6 million in the quarter. Excluding the acquisitions, net sales increased by $128.6 million, or 14.3%. Inflation eased modestly in comparison to the prior year, although it did accelerate sequentially; as inflation was 87 basis points for the second quarter, compared to 99 basis points in last year's second quarter.

Year to date, net sales are $2.17 billion, yielding growth of $384 million, 21.6% over the prior year. Excluding the acquisitions, our year-to-date growth is 13.3%. For the second quarter of fiscal 2011, the Company reported net income of $18.7 million, or $0.39 per diluted share -- an increase of approximately 19.6%, or $3.1 million over the prior year. Net income for the second quarter of fiscal 2010 was $15.7 million, or $0.36 per diluted share.

As Steve mentioned, in the second quarter we experienced an acceleration of growth in all of our sales channels. As a result, supernaturals now represent 37% of sales. Independents declined from a mix standpoint; and for the quarter, represented approximately 36% of sales. The supermarket channel increased to represent approximately 22% of sales, and food service held at approximately 2% of sales for the quarter. Excluding the impact of our acquisition, the supernatural channel grew by 15.6%. Independents increased by 7.9%, supermarket growth was 21.8%, and food service sales increased by 26%.

At 17.8%, gross margin for the quarter showed a 73-basis-point decline over the prior year second-quarter gross margin of 18.5%, and a 45-basis-point decline sequentially. Primary drivers of our lower gross margin were -- the continued shift in the growth mix of business towards supernaturals and conventional supermarkets, which accounted for about one-third of the decline in margin; the addition of new non-service conventional supermarket customers, with base pricing lower than our average gross margin; and inventory issues at our Lancaster facility early in the second quarter also impacted gross margin. In addition, reduced manufacturer charge-backs and higher inbound freight costs negatively impacted margin during the quarter.

Gross margin for the first six months of fiscal '11 was 18%, compared to 18.6% in the prior year -- a decline of 54 basis points, due to the same factors I just mentioned. As we have previously -- as we have discussed previously, in general, we will continue to experience pressure on our gross margin, as we gain additional business with conventional supermarkets and our supernatural channel. We will continue to offset the gross margin impact by generating efficiencies and improvements in operating expenses, as these customers have a lower cost to serve; although we may not be able to take costs out at the same pace as the gross margin decline over the next few quarters, to the extent we continue to experience sales growth similar to the last couple quarters.

For the back half of fiscal 2011, I expect a sequential drop in gross margin of no more than 10 basis points in each quarter, driven primarily by the continued mix in sales towards supernaturals and conventional supermarkets. Our operating expenses for the quarter were 15% of net sales, compared to 15.5% for the same period last year. This represents a 50-basis-point improvement over the prior year, as operating expenses benefited from, amongst other things -- lower than planned incentive compensation, due to the continued issues surrounding our Lancaster facility; improvements in our warehouse throughput; reductions in cost per case; further leveraging of our fixed costs; and slower growth in our consumption of diesel fuel.

Excluding our Canada bus -- I'm sorry, excluding our Canadian business, which involves the use of third parties for deliveries in certain regions, diesel fuel had a negative impact of five basis points in operating expenses, in comparison to the second quarter of fiscal 2010, as fuel represented 77 basis points of distribution net sales in the quarter. Sequentially, our fuel costs improved by one basis point over the first quarter, despite a 7% increase in fuel prices, as we began to reap some of the mileage savings associated with our new DC in Lancaster, Texas. Nationally our diesel fuel costs in the second fiscal quarter increased by approximately 20% from the prior year's second quarter, to a national average price of $3.25 a gallon, compared to $2.71 a gallon fiscal 2010.

In addition to the savings from opening Lancaster, we have managed to reduce fuel costs as a percentage of sales despite rising prices, by leveraging larger order sizes, updating and revising existing routes to reduce the miles traveled, reducing idling times and other similar measures. During the quarter, we recorded share-based compensation expense of $2.2 million, or 20 basis points; compared to expense of $1.8 million, which was also 20 basis points, in the prior year. Operating income was 2.8% for the second quarter of fiscal 2011, a 22-basis-point decline over the prior year's operating income of 3.1%, due to the continued incremental start-up inefficiencies at Lancaster and their impact on our Denver facility, as well as the challenges of driving costs out of the system fast enough to keep pace with the gross margin decline and our current growth.

Interest expense in the quarter of $1.3 million was approximately 17% lower than the prior year; and was 6% lower sequentially, due to our lower debt levels following our equity offering in the first quarter. Capital expenditures were $6.7 million for Q2, and stand at $14.3 million, or 0.7% of revenues, for the first six months of fiscal '11, which is well below our target of approximately 1% of revenue. Our capital expenditures in the back half of fiscal 2011 will continue to be focused on supply chain initiatives and operations.

The Company's outstanding commitments under our credit facility were approximately $205.8 million, with available liquidity of $211.5 million, including cash and cash equivalents. For the quarter, we had negative free cash flow of $25.5 million, principally resulting from our investment in inventory -- which, as Steve covered, increased by five days. As we look at the back half of fiscal 2011, we usually generate most of our positive free cash during these two quarters, and our borrowings were already down $33 million through the first four weeks of Q3, reflecting that fact. At this time, I would like to turn the call back over to the moderator to facilitate the question-and-answer session.

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions)Our first question comes from the line of Karen Short with BMO Capital Markets. Please go ahead.

Couple questions just on the growth rate within the channels. The independents -- obviously, it seemed like the growth rate accelerated, excluding acquisitions, whereas supernaturals seemed to decelerate a little bit. Is there noise in that number? Maybe you could talk a little bit about what you are seeing.

Yes, Karen, I guess I would say -- our number, and maybe something we read off -- all the channels actually experienced sequential growth, excluding acquisitions. So, the comp -- there may be some noise, and I can try and go through it after the call with you. But all four of our channels actually showed sequential growth, when you back out the acquisition.

Yes, independents were up 13%; supermarkets, 35% -- 34%; supernatural, 29%. Which is all sequentially higher than the same period one quarter earlier.

Right. But when you back out -- I can give you those numbers. I don't have them all right here. But I can give you the with and without numbers that we had read off Q1. But every one of the channels had gone up, even excluding the acquisitions.

Okay, can you talk a little bit about what you think is driving the independent sales growth, the acceleration?

Yes, I think it's a lot of things. It's consumer demand, number one. As I mentioned in the commentary, we think that there's just a greater confidence on the part of the consumers towards eating organic for a variety of reasons, including -- confidence in the organic label, the healthy considerations associated with what organic brings. We think that some of the -- there's been some very public movement in the part of some of the mass channel away from organic, which may be driving some of the traffic into the independent retailers. So, I think it's all of the above.

So, when you had talked on your first-quarter call, you had commented on some -- having experienced some supply shortages, because there had been a bigger movement on the mass side in natural organics. So, is that actually -- you are seeing that reverse a little bit?

I think that the biggest issue in the first quarter was suppliers being able to keep up with the significant ramp-up in demand. We've now gotten through that. We've seen significant increases in service level from the suppliers. I think that what caused the mass reference was, if you look back a year or so ago, I think that there was a migration on the supplier part to mass, because the industry wasn't growing.

And that was a channel that some of our suppliers just hadn't been in before, and there was just a natural movement towards trying to sell these types of products into mass. Today, there's one large retailer, in particular, who I think has fairly publicly began de-emphasizing the importance of organic in this source, and I think that's helping us.

Okay. That's great color. Thanks. And then, I'm wondering, within your guidance, a couple things. First of all, you had originally only assumed kind of a one-time cost in the first quarter, within your original earnings guidance. Is that correct? Obviously, you've just indicated how much more you had this quarter in inefficiencies, and then what you expect for the rest of the year. But originally, was it really that -- what you had called out in the first quarter?

Yes, we would typically plan on a certain amount of inefficiencies or nonrecurring. These costs went beyond what we had originally budgeted. And most of it was just because we ended up delaying the transfer of volume from Denver and from Lancaster, is what caused the largest part of the overrun.

Yes, and we -- we thought the number, when we had the 1Q earnings call, Karen, we thought the number would be smaller than where it ended up. But we made a couple decisions on timing of when we moved some things, and that's what led to the higher number.

Okay. And then, within your guidance, what are you assuming is in diesel costs for the year?

I think -- sorry, chuckling, if I could predict that, I'd be buying the market. I suspect, right now, with where we are, we expect that -- we're hedged -- well, let me take a step back. We have about a third of our business hedged, or forward contracts that protect us on the fuel side. We have a fuel surcharge program in place, which adjusts every four weeks on a trailing four-week average basis, that compensates for when prices rise.

And so, from that standpoint, our exposure on the back end from a fuel perspective is a lot less, where we probably only have -- prior to Texas opening, it would have been 20% to 30%. I don't know exactly where it's going to trend out now that Texas is fully open, but let's say there's a 10% to 15% exposure. So, I have probably another $0.25 to $0.40, depending on the timing of what we're talking about, of increases in diesel in the back half of the forecast, but the net exposure of that is only $0.07 to $0.08.

Karen, I would venture a slightly different answer. And that is, my concern would be on consumer demand, because -- we clearly haven't seen this yet, but should diesel continue to escalate up north of $4 a gallon, one would think that that will change consumers' buying behavior.

Which is what we experienced at the end of fiscal '08.

Right. Okay, that's great.That's helpful. Thanks for taking my questions.

Thank you. Our next question comes from the line of Robby Ohmes with Bank of America Merrill Lynch. Please go ahead.

Good morning, guys. Couple of real quick questions. One, I was -- can you remind us the -- when you deal with the traditional supermarkets, the rough margin spread? And if you looked at the -- that area of your business on a like for like business, and I know this might be hard to do, but pulling off on-boarding and all that -- is the trend in the operating margin [of working] in that channel up, down, flat?

And then, the other question, maybe related to it is -- is, could you talk a little more about what you believe the price spread -- how the price spread is changing between natural and organic product versus traditional grocery product, and whether that's a driver, and sort of the outlook for that? And if you're seeing that in the supernaturals channel as well, if you're seeing any even lowering of price within the natural organic product? And that would be it for me. Thanks, guys.

Well, let me answer the second question first. I wouldn't get into any commentary about any particular customer's pricing behavior, because, obviously, that's just not what we do. But overall, I think that as organic grows, as a category, and there's more demand for organic, and there's more production of organic, the tendency is going to be that the price point is going to come down, naturally.

And so, we have seen that as the largest driver of closing the gap between the conventional price point and the organic price point. I think that there also has been some movement in terms of retail price points across all the channels, but I do believe that the driving force is increased demand, increased supply, brings the cost of goods down.

And what we see on the produce side with the Albert's organic division is, if there's a strong growing season where there's a plentiful supply, they'll experience deflation where the price point compared to conventional may be quite narrow. But if there's a shortage, they get heavy inflation, and that price point jumps back up, where it could be north of 20%. But it's really a reflection of the quality of the growing season, where the produce is coming from.

And then, Robby, back to your first question, we wouldn't get into any discussion about specific channel gross margin per se, but the model tends to work like this. Independents have a higher gross margin associated with the sale, primarily driven by the increased cost to serve. On the conventional side, we have a lower sales gross margin, but due to the volume, we have a much lower cost to serve.

In the independent channel, we typically have a Territory Manager and a fair amount of resources -- intellectual capital, if you will, that spends a lot of time with the retailer. In the conventional channel, there's a much more limited number of people covering the service. And the whole process is just far less expensive to move through the distribution system, from the point of receipt to the point of delivery. So, that's really how the internal differences work.

Got it. So, the -- for the conventional channel, as you anniversary on-boarding, it's a big jump in the operating margin. And then, it's more in line with how well your volumes do with that customer, going forward? Is that fair to say?

That's exactly right. So, we have a fairly significant start-up cost in advance of bringing the customer on-board. Then, we have a fairly significant cost in working through the on-boarding to the point that we understand the requirements enough to be able to get that start-up cost out of the system. And it's just depending upon the customer. It could take anywhere from four to 12 months.

Got it. That's really helpful. Thanks so much, Steve.

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

Hey, guys, thanks for taking my questions. Hey, Mark, I actually pulled those numbers, if you want me to read them off.

No, I found them, Scott. And Karen is right. For some reason, I had done a different calc on one of them. The supernatural, it was 18.7%, I think they did decline to 15.7%. And, my suspicion would be that if we looked at the second quarter of last year, that's when we started to see the acceleration, and Whole Foods was the first of our three channels to really see the pickup in the comps. And so, I think it's probably a reflection of their higher -- they're the first ones to face the higher comps, where we didn't really see the independents, as an example, get to 5% until the fourth quarter of last year.

Okay, good. I appreciate the clarity there. And then, I guess, Steve, I guess I would say -- all I can say about your sales numbers is, wow. But I guess the strength of sales does bring to mind, for me, is that -- could growth be so strong that it will cause to you need to build more facilities, rather than leveraging the current assets? This is something the Company has struggled with over time -- prior to you, obviously, because I think -- but, I was wondering if you had any comments or thoughts on this issue. Could we grow so strong, it kind of trips you up a little bit, as far as facility -- current asset utilization?

Yes, it's always a balancing act, and as part of our three-year guidance, we've very publicly said that our CapEx is going to be approximately 1% of revenue. We'll see what happens once we get into the 2012 planning season. I don't anticipate any new buildings. I do anticipate some expansions, and I do anticipate maybe a relocation. But I still, at this point, do not anticipate having to go out and greenfield a brand-new building, which is obviously the most expensive of everything that we can do.

We have, as you know, a supercenter in southern California, we have a supercenter in York, Pennsylvania. We have what I would call a supercenter in Lancaster, Texas. So, we still have some capacity, and I think the bulk of the CapEx spend, looking out over the next couple years, is going to be, like I said, related to expansions and perhaps a relocation.

Okay, great. And you --

The answer is, we always have to balance capacity to the sales growth. We have to be particular in the type of sales growth we take on, because we don't want to be in a position where we're taking sales for sales' sake, and have it cost us considerably more to service that business, either through inefficiency or just the need to have to put up new buildings.

And is that -- Steve, is that 1% good, do you think -- I think you said through fiscal year 2012 is kind of what your forecast is, your plan is. Do you think we can take that to the bank, or do you think maybe it would have to be increased a little bit if sales growth continues? It's a high-class problem to have. I'm not trying to be Debbie Downer here. I'm just trying to understand what the cash flows are going to look like.

Yes -- again, we gave the three-year target of 1% of revenue, could it be plus or minus?I guess it's possible. We really haven't gotten into the process of planning out 2012 yet, so I really would rather not comment on that until we get deeper into the process.

And I think, Scott, the challenge from our standpoint and where the trends go is, we're now really starting to get to the point where -- second quarter of last year was 5.7% growth. Third quarter of last year was low double digits. So, now we'll have -- if we do 24% on top of 11[%] or 12[%], it's a much different growth rate going into fiscal '12 than if it eases off, to get to a two-year number, that's still 30%. So, I think that, really, when we see where we play out the back half of fiscal '12 -- sorry, the back half of fiscal '11 drives a lot of our capacity impact for fiscal '12. Where, if we're at 25%, it's probably a different answer than if we're at 15%.

Okay. That's great. I appreciate that.

At least for a couple of the facilities that would experience that growth.

So -- and I think, Mark, I think I heard you say that 10 basis points is really the only compression you are going top see in the back half on that gross margin line. Did I actually hear that right?

Yes, basically what I was putting out there is, I expect it could be up to 10 basis points in Q3 and up to 10 in Q4. At this point, we've had all of our acquisitions for a full quarter. And from a pricing standpoint, we know additional customers and where they stand from a volume standpoint, and what their impact would be in a given quarter. So, I feel comfortable that there's probably, in total, no more than 20% -- sorry, 20 basis points of gross margin movement in the back half of the year, with no more than 10 a quarter.

So, my question is, as we get into the -- in the back half -- and hopefully I can ask this in the right way to make it make sense. Can mix -- your mix of product, not your mix of customers. Can the mix of product, in combination with inflation maybe rising, make that not happen? In other words, that you won't see the pressure that you're just -- you're articulating, I guess, from the -- the channel shifting?

Probably -- probably not, Scott.

No. A good portion of our business is cost plus, so while inflation would help on the dollar standpoint, it's not going to move the actual gross margin percentage. It could help us to a limited effect on the operating margin percentage side. But, it's -- because the customer is on a cost plus basis, it doesn't help us to the same extent if people were on a volume discount standpoint.

And other than produce, where we've seen some pretty rapid inflation due to weather, today UNFI doesn't have a tremendous amount of exposure to those core commodity groups that are experiencing rapid amounts of inflation. And we don't anticipate that changing significantly through the balance of our fiscal year.

And do you guys do -- if we get some packaged food inflation, do you take advantage of using your balance sheet to forward buy, and that type of thing? Are you doing that in coffee now, for instance? Or is that something you really don't try to do?

We -- where it makes sense, we do use the balance sheet to forward buy. We have a model that we use to determine the value of the forward buy versus the weighted average cost of capital. But the other important consideration about forward buying is capacity to store it. Right?So, the answer is, yes, perhaps. We do both. We typically have 60-day price guarantees from our suppliers, and that's primarily driven by the fact that most of our customer contracts call for 30- or 60-day price guarantees.

Okay, great. Thanks for taking my questions.

Thank you. Our next question comes from the line of Ed Aaron with RBC Capital Markets. Please go ahead.

Thanks, good morning.

Good morning, Ed.

Steve, I was hoping could you qualify your next four to six quarter margin commentary from your prepared remarks. Were you suggesting that operating margins are generally going to be down year-over-year over that period, or did I kind of misunderstand?

Yes, that's not what I'm suggesting. The third and the fourth quarter are obviously our most important quarters. I think we're going to see a lot of noise in the operating margin line, as we flush through the costs associated with the increased volume, the new customer growth, and the mix shift.

Okay.

And that's really what I was referencing.

Okay. And then, just -- I guess maybe a bigger picture question, as you start to work and see more progress on getting new business. You talked about that 10 to 15 basis points of annual margin expansion that you have been targeting in your three-year plan. But just trying to understand your willingness to sacrifice that, or push that out a little bit, to the extent that you really have the opportunity to step on the gas, whether it's Safeway, hopefully, or your other accounts that you might be working on. What is your willingness to push out that margin expansion at the expense of your three-year target, if it makes sense from a longer-term business perspective?

That's a great question, and that's a question that we spend a lot of time talking about as a Management team. It comes back to the same question of, would you rather grow your earnings by 20% but have a 10-basis-point decline in your operating margin, right?So, the answer is, you would like to have a 20% increase in earnings and a 10-basis-point improvement in your operating margin.

So, the answer is that it's always going to be a balance. We have to be opportunistic, because the sales opportunities usually come by only once every couple of years. So, I guess at the end of the day what I would say is, if there's a sales opportunity that will in the short term cause some dilution in the operating margin, that we should take a look at it. But when we get it, work extremely hard to make sure that once that customer is on-boarded, that we can bring the operating margin back to the point that it was prior to taking it on.

Great. And then, maybe just one last one from me. Mark, I just wanted -- on the comments for back half gross margins down a little bit, it sounds like sequentially in Q3 and Q4, it's not totally clear to me why that would happen. Because I don't really get to, in my model, a real incremental mix shift sequentially from Q2 to Q3. And then, it also sounds like maybe there were a couple of small factors that worked against you on the gross margin this quarter, that I thought might be a little bit more transitory than what your back-half commentary suggests that it would be.

Well, I think there's a couple things, Ed. There are definitely a number of factors that move the gross margin positively and negatively. But, at the end of the day, one of the things that is the biggest driver is our customer contracts and their pricing. And so, there's a reflection with some of the growth that we have had already in the first half of the year, that the pricing on certain contracts may move to the next tier, which would put pressure on the gross margin.

So, it's less -- from my standpoint, it's less about any of the one-time positives or negatives that are coming through, but more a reflection -- that's why I said up to 10 basis points, because, obviously, we have efforts and initiatives to reduce shrink and become more efficient on forward buying so that we don't have to code out product. But if a customer's contract, for sake of discussion, shows a 25-basis-point drop, that's happening as they continue on the growth rate that they're on.

And so, that's really a reflection of it. I would be very happy to show expansion in the third quarter and fourth quarter. But in order to have that, I need some things to go my way, and customer growth to slow. And so, I don't anticipate the customer growth slowing down where they won't hit that in those quarters, for those customers.

Understood. Thank you.

You're welcome.

Thank you. Our next question comes from the line of Greg Badishkanian with Citigroup. Please go ahead.

Yes, great. Hey, maybe just a little bit of color on just maybe January, February types of trends. Have you seen anything that kind of stands out over those -- the last month or two, relative to the trends you've been seeing over the last few months?

Yes, I think they've been pretty consistent, Greg. We haven't seen any wholesale change in either direction.

No, we're only -- we're four weeks into the third quarter, and we see a modest easing off on the comps. But again, you're facing a tougher number from the prior year, by the end of January, than what we had for the average for the quarter last year. So, you know, nothing that's measurable. But we are seeing a modest, probably less than 200-basis-point, change in the top [level].

Through the first four weeks.

Yes, because of the tougher prior-year comparisons that you're --

Correct.

Yes, okay. That's expected. And also, just in terms of inflation, less than 1%, and I think maybe a little bit higher for the rest of the year. What are some of the differences between the organic supply chain and natural organic supply chain, as well as the conventional? Why is your inflation a little bit lower? Is it mix, or is there something going on in the organic natural supply chain?

You know, we trade, as you know, only in the organic and natural space, with some specialty. We've seen a fairly significant ramp-up in organic nuts, grains, and bulk. But other than those product categories, they've been -- the prices have been very stable.

Right.

And we really haven't seen any indication that there's going to be a significant ramp-up in inflation. We know that there's discussion among some of the larger suppliers about price increases. But as I said earlier, we haven't seen them come through. As far as comparing the organic to the conventional, very hard for us to comment on that, because we don't do any business in the conventional product channel.

Sure. Good, all right. Thank you very much.

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

Thanks. Your answers have all so far been very helpful. I just wanted to go back and talk a little bit about Lancaster, and try to understand what caused you to delay the movement from the Colorado facility into Texas. And then, maybe talk a little bit about the rollout of the new technology.

The delay was caused by the simple fact that we just weren't ready. By the time we got to the cut-over of moving the balance of customers from Denver to Texas, we were just not in the position where we had confidence that the building could support the additional volume. And we made the decision to continue to service the market out of Denver, to keep the service level high. And I think that was a good decision to make, even though it cost us a lot of money.

As far as the system itself, we feel that the system is now stable. We have all the business transferred. It was a little bit more complicated, a little more costly than we expected, but something that we had to do. I feel that it's the right platform. The next DC will most likely not roll out until sometime in 2012. So, we're going to have to take it one step at a time. And we're not going to make another conversion until we're 100% sure that we have the bugs worked out and the system is running as it was intended.

And so, when you think about -- I think you made some comments about, it's possible that lower-margin business will grow faster than your ability to lower your expenses. Given that this was one, I think the new technology was one way you were going to lower your costs. Are there other initiatives that you're focused on, to sort of make up for that delay in rolling it out to more facilities?

Yes, I mean, on the upside, we have rolled out technology called Labor Management. It's now in all of our DCs, and that is driving significant results. We're seeing significant increases in productivity across all the facilities. Obviously, the ones that have had it longer than others are a little bit further along. But we're very pleased with the rollout of that technology, and we're seeing it in our actual cost of operating the facilities. As far as the core warehouse management system, the conversion to voice selection, we really won't get the full benefit of those cost savings until we get all the DCs converted onto that platform, which is going to take a couple years.

Okay, great. Thank you very much.

Thanks, Meredith.

Thank you. Our next question comes from the line of Andrew Wolf with BB&T Capital Markets. Please go ahead.

Thank you. Good morning. Just a follow-up to Meredith's question on the systems. Last quarter, Steve, I think you talked about how the [pick]-to-voice system just wasn't right, and you figured out what it was and stabilized it. And just in the way you just answered Meredith's question, it prompted me to think about, is there -- did you discover something else about the system that either is a suboptimal, or needed to get the kinks out?

Are you confident these systems are the right match to the Company? We know they're from a pretty well regarded vendor. Are you just a little behind where you wanted to be, or are you all caught up? Could you give us an overview?

Sure, sure. No, we're -- I'm 100% confident that it's the right technology platform. I think that the implementation was just far more complicated and took a lot more time than I anticipated, quite frankly. It's not just a systems implementation. There's training, there's cultural differences, there's a different style of management that goes along with running this type of facility. And I think all those things combined together just caused the implementation to be, like I said, more costly, more complicated, and more timely than we had anticipated.

I feel good about where we are today. The system is stable. It's working as it was intended. We have a couple of additional modifications that are going in over the next couple of months, but feel good about where we are. It has delayed the next implementation, which is going to be in the Pacific Northwest. But it is 100% the right thing for UNFI.

Thanks. That clarifies that. I wanted to ask about the Giant Eagle business. It's a big piece of business, I think. I guess it's sort of getting lost, because you have other bigger pieces of business coming in, or equal sized. But is that completed? And if so, could you try to give us some sense of -- I think it must have helped sales, maybe less than a significant threshold, but to some degree. And the same on on-boarding costs. I know that looking back over previous quarters, when -- it seems like when you have a customer of that size, it has a -- maybe not a material effect on expenses, but one that's measurable. So, I don't know if you can help us with --

Yes, sure. Giant Eagle is fully on-board. We are just thrilled to have them as a partner. They're a great operator. The sales during the period were pretty modest, a couple million bucks. The on-boarding costs we managed quite well. They were relatively small. We now have a very sophisticated on-boarding process that utilizes some dedicated folks that do nothing but manage the on-boarding process for these new customer wins. And that's really helped us -- number one, mitigate the cost to bring the customers on-board; but also keep the service level very high from a customer perspective. So, that's the short answer. A great customer, thrilled to have them on-board.

Thanks. You got them on-board, and now the real sales are going to start to flow, because a couple million sounds like way below what they are going to contribute quarterly, right?

Well -- right. We -- they only started in mid-January, Andy, so we thought that it was rough a $40 million opportunity, which translates to maybe $750,000 a week. So, I mean, it kind of pretty much is in line with expectations.

Great. Just on Safeway, I know you don't want to say much about it. But I want to make sure -- do you have an agreement in principle, and you're just getting it to the nitty-gritty of the contract -- a bunch of lawyers and other folks? Or are you still competing for the business?

You know, it's -- again, we have a pretty rigid policy that we don't comment on customers that we haven't formally announced, and that's the policy that we're trying to stick with. The only reason I mentioned it in the commentary is because there has been a lot of noise out on the supplier community. I know there's been a couple of reports written about our relationship with Safeway, so I figured I would proactively mention it. But really don't want to get into any more detail than that.

Okay, I appreciate that. My last one is also sort of a follow-up. Just on the cost at Lancaster, the $2.5 million, is that -- some of that sounds like opportunity costs, or an opportunity loss. Or is it all hard dollar costs, which maybe in this case are one and the same? But could you give us a sense of that?

Yes. No -- they were all hard dollar costs, mostly related to the transportation of moving the freight from Denver to Texas. We had some shrink.

We had temporary workers, where we had let the workforce through normal attrition in Denver decrease, and then we had to go back and bring temporary workers on board to maintain the level of selectors that we needed for that business. We had let tractor-trailer leases expire, under the anticipation that we'd be serviced out of Texas. And we needed to go back and get some month-to-month leases. So, a lot of things of that nature, Andy; but to Steve's point, they're all hard dollars that -- easily measurable.

Thanks.

Thank you. (Operator Instructions)Our next question comes from the line of Scott Van Winkle with Canaccord Genuity. Please go ahead.

Thanks. Mark, can you go through that math again, where you talked about your exposure to diesel prices in the back half of the year? I think you said something like $0.07 to $0.08, and maybe a $0.40 increase. And I actually thought it would be lower, given the hedge and the high percentage of your business is now on cost plus. Or do I have that incorrect?

Well, the cost plus doesn't factor into it on the fuel side. So, I mean, the way -- rough numbers, Scott, is historically -- and these numbers will change now that we've got Texas open. But historically, we've used roughly 10 million gallons, and we've said that the fuel surcharge generally protects us for up to 70% to 80% of an increase in the price.

So, if you look at the back half of the year, we're -- if you look at every quarter, we're probably using 2.5 million gallons in a quarter. And if we're protected up to 70% to 80% of that, normally that would give us an exposure of a $500,000 to $750,000, if we saw a dollar increase. And I think with Texas, I think it's going to come down, but as Steve mentioned, and we just talked about, we haven't fully -- we only are now having all the business shift out of Texas versus Denver. So, I'm not really sure the full savings that I'm going to generate, really, until I get a run rate in Q3. But I would expect that the most it would be is maybe half that number.

So, if it's -- if we're talking $500,000 to $750,000, I'm expecting that it's maybe -- if it was a full dollar, I'm expecting it's maybe $250,000 to $375,000 in a quarter. So, plus whatever I get for savings, by virtue of the [mile] savings in Texas. So, that's roughly how I got to it. But it's -- the cost plus -- to the question you were asking on the cost plus side, that doesn't -- there's no real protection in there on the fuel side. We basically -- we basically build on the fuel surcharge as it's written into their agreements, as well.

The only thing that protects us on the inbound, Scott, is that the -- any fuel surcharge on product that's delivered to our DCs is obviously part of our cost of goods.

Got you. And then, sticking on fuel, and not to belabor it, but what other hedges do you have in place, Mark? And is there anything short-term that wouldn't carry over into 2011, if this current rise is long-lived?

Well, so -- yes, I mean, all we have -- like I said, we have about a third, 30%, of our fuel in sort of fixed contracts, that have various expiration dates that would extend into -- some, I think, come up as soon as the May-June time frame. Some extend into the September and November time frame, depending upon when we entered into them. So that -- if we were to have an extended period of time, we would start to see greater pressure, probably only a little bit of an impact on the fuel side in Q4.

But it would really start to come into play more in fiscal '12 if we lost -- if one contract dropped off and we entered into a new contract that had higher base pricing. And I think your question, from a standpoint of hedging -- the only other thing that we have hedged is the long-term debt portion of our debt. We have an interest rate swap. That's the only other hedge that we have out there.

Okay, great. And then, Steve, if you were to take on a major national piece of business, would there be any upfront transition fee paid and associated with that?

Well, the answer is, again, we don't -- we don't ever get into discussion about any individual customer agreement.

It's a deal-by-deal scenario. Are you saying a transition fee, or are you saying cost incurred, Scott? Just to clarify.

No, a transition fee rather than your physical costs.

Generally, we -- generally, we don't pay transition fees. But what we often factor in, which is our start-up costs, and it might be viewed differently on a supermarket side is, if we have to replace shelf tags and things of that nature, replace products that are coming off, sometimes we'll do that. But that's, again, a customer by customer. If we're doing full service, that's part of the transition; if there's no service involved, that would be the retailer's responsibility.

Great. Thank you.

You're welcome.

Our final question comes from the line of Eric Larson with Soleil Securities. Please go ahead.

Yes, thank you for taking the question. Steve, more of a broader industry question. The -- with the return of very good growth across the industry, and confidence thereof, we're seeing, obviously, good same-store sale -- or we're seeing good square footage growth in, obviously, your largest customer in the supernatural channel. Are you seeing any resumption of some square footage growth in -- well, primarily your independent channel?

Unfortunately, Eric, that's just not a number we look at. We don't track, nor look at sales, by square foot. As a distributor, we look at comp sales growth year-over-year, customer by customer. And, obviously, the comps are quite good, quite hardy in the independent channel right now.

Okay. And then, the -- just the final sort of clarification -- again, I'm still a little confused on how we should view the next four to six quarters, your operating profit trend rates. It's -- I think we all understand, obviously, that it's going to take some time to get your costs out of the system, particularly with the ramp-up of sales and new customers. I guess I'm still a little confused as to how the look and feel of the operating margin rate might look, kind of on average over that time period that you gave us.

Well, I mean, certainly we're not in a position to be able to say where Q3 -- I'm sorry, where fiscal 2012 lies, given that we're just beginning our process right now. But as I look at fiscal 2011 and I look at Q3 and Q4, the gross margin last year in Q3 was 3.43%. And in Q4, it was -- I think it was 2.66% or 2.7%. And I think what you will see is that there could still be a little bit of pressure. Maybe we're up 10 basis points, maybe we're down 10 basis points in Q3. But certainly, from a trend standpoint, we're 2.9%, roughly 2.9% in Q1 and Q2 of this year. We see the normal jump-up that we would expect, given the greater leverage in the business in Q3.

It just may not be as great as we would have otherwise anticipated, given the heavy sales growth. So, you know, if I look at the back half, I would expect Q3 to be within 10 basis points, either way, of where we finished last year. And if we do a good job of taking out some of these costs, or keeping up with the growth, then it could be higher. Q4, I would expect to be sequentially down a small amount from Q3, but a very noticeable jump up from the prior fiscal year. I would say that -- like last year was a 2.7%. We should be well north of 3%. And it's just a question of where Q3 comes in, because usually Q4 shows a little bit of a deterioration in the operating margin from Q3.

Okay. That enough -- I apprec -- yes, that helps a lot. I think when we get down to the analyst day in couple weeks here, we'll get a better feel for the next one to two years, as we have further discussions on this. So, that's helpful.

Yes, and just the last point, if you took -- if you held the interest steady and the tax rate steady, and took the low and the high end of our range, I think the operating margin would reflect, consistent with what I just said from my comments.

Okay. Good. Thank you.

Thank you. At this time, I would like to turn the conference back to Management for closing remarks.

Well, thank you once again for your continued support of UNFI and for joining us this morning. Please remember to mark our March 22 analyst day in Texas. For information regarding this event, please contact Joseph Calabrese at 212-827-3772. Thanks again, and have a great day.

Ladies and gentlemen, this concludes the United Natural second quarter 2011 conference call. If would you like to listen to a replay of today's conference, please dial 1-800-406-7325 or 303-590-3030, and enter the access code of 4407166, followed by the pound sign. Thank you for your participation. You may now disconnect.