United Natural Foods Inc (UNFI) 2014 Q3 法說會逐字稿

Greetings and welcome to United Natural Foods Third-Quarter 2014 Earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded. I would now like to turn the conference over to Ms. Katie Turner of ICR.

Thank you, Miss Turner. You may begin.

Thank you.

Good afternoon, everyone. By now, you should have all have received a copy of the Third-Quarter FY14 Earnings press release issued this afternoon at approximately 4:05 PM Eastern Time. If anyone still needs to review the release, please reference the Investor Relations section of the website at www.unfi.com. As a reminder, the webcast of the earnings call is also available on the Company's website. On the call today are Steve Spinner, President and Chief Executive Officer, and Mark Shamber, Chief Financial Officer.

Before we begin, we would like to remind everyone comments made by Management during today's call may contain forward-looking statements. These forward-looking statements discuss plans, expectations, estimates and projections that might involve significant risks and uncertainties. Actual results may differ materially from the results discussed in these forward-looking statements.

Additionally, in today's Press Release, and on the call today, the Company will provide both GAAP and non-GAAP financial measures, including operating expenses, operating income, net income and earnings per diluted share. Presentation of these non-GAAP financial measures is not intended to be considered in isolation or as a substitute to any measure prepared in accordance with GAAP. For a complete reconciliation of GAAP to non-GAAP financial measures, please refer to the Company's earnings release, issued earlier today and available on the website.

And with that, I'd like to turn the call over to Steve Spinner.

Thank you, Katie.

And thanks again for joining us this afternoon to talk about UNFI's Fiscal Third-Quarter 2014 Results. This was a very busy quarter for UNFI.

We announced our agreement to acquire Tony's Fine Foods; opened our new 450,000 square foot building in Racine, Wisconsin; and delivered top line sales growth of almost 14% compared to the third quarter of fiscal 2013. We have completed our initial regulatory filings related to the Tony's acquisition and anticipate closing around July 15. And as we communicated during our call to outline this acquisition, Tony's is a very strategic part of UNFI's future growth plans.

Capitalizing on the growing consumer trends towards natural proteins and perishable specialty products, UNFI will leverage this very unique product and merchandising offering across our North American distribution platform over the next several years. Tony's has a long history of growth throughout its current distribution area. The model is quite scalable. And our teams are extremely excited about rolling their high-touch, high-service model across the country.

We will go to market in several ways. First, by opening additional Tony's facilities. Second, through add-on acquisitions in the space. Third, by utilizing UNFI's newly constructed perishable warehouses as Tony's facilities. And lastly, by integrating into UNFI's current customer base. All four of these options have very compelling opportunities for us.

We will follow a very clear model: integrate back-of-the-house payroll, benefits and related areas, but leave the high-touch, high-service distribution model completely unchanged. This is what has enabled Tony's success, and UNFI will learn from their standards.

I look forward to sharing more about our objectives, as well as the long-term financial implications, during our year-end FY14 conference call in September. Following completion of the acquisition of Tony's Fine Foods, lead by Scott and Karl Berger, Tony's will work with the UNFI team to carefully align our opportunities and plan for an exciting rollout of UNFI perimeter products.

Let's turn to our sales growth. Almost 14% ahead versus prior year continues to prove that natural organic and specialty products are not a passing trend, but a fast-growing, permanent part of consumers' purchases. Additionally, with very low inflation, less than 2%, real growth remains quite strong. Over the last five years, UNFI has diversified its customer base based on our philosophy of working hard to bring our products to the mainstream consumer. This drive will continue to benefit our industry as more and more consumers come into these categories and become what we call crossovers.

History and data has proved that once a consumer arrives in our space, over time they will demand more and more of our products and ultimately migrate towards our core consumer, the natural and organic retailer.

Given the growth in our space, competition has also increased. Conventional food distributors, and continued movement to direct distribution by supermarkets for fast-moving products, will pressure our growth as the industry expands. However, given our commitment to new distribution centers and our ability to sell the entire store, we are well prepared for new competition.

There were several headwinds during the quarter. The non-recurring startup costs of our Racine, Wisconsin facility exceeded our plans, driven by a very conscious decision to begin the hiring and training at the facility earlier than originally planned to ensure a very smooth transition of customers beginning this month.

Also during the quarter, we continue to be challenged by the weakness in the Canadian to US dollar. And I'll touch on this momentarily in more detail. And lastly, we did incur expenses of $600,000 out of an estimated $1.3 million to $1.6 million in costs, related to Tony's acquisition during the third quarter. The balance will be incurred and recognized as expense in Q4.

Our team was very pleased with our execution against our long-term strategies during the quarter. Operating income increased over 16%, and our operating margin increased 7 basis points versus FY13 third quarter. Helping to drive the results was the implementation of our UNFI technology and Supply Chain solution at our new centers, and the completion of our new demand planning inventory optimization platform in the West, with implementation in the East to begin this quarter.

Additionally, UNFI customers are now using over 4,000 installations of our proprietary high UNFI order delivery solution. And we have begun beta testing our new arrive electronic truck delivery notification system.

In Canada, our business continues to grow. Despite headwinds associated with currency exchange rates, we are very committed to growth here. Over the past several years, we have been acquisitive as we've built our market share.

This market has been challenged for us this fiscal year as we've implemented UNFI standards and operating metrics. And I'm excited about Canada as our President, Lynne Brenegan, leads us forward. Our US divisions continue to deliver very strong results across most of our operating platforms. And high growth continues at our Woodstock Manufacturing Division, Blue Marble brands and core UNFI distribution.

We talk a lot about the need for new distribution centers with our high rate of growth. However, this growth also requires us to invest in our people in a very significant way. And here, UNFI is really succeeding.

Through our national college hiring, development, and succession planning programs, we are attracting, promoting, and retaining a terrific team. Our Capital Expenditures were approximately 2% of sales during the quarter, as we continue to build out capacity. And we'll provide additional color around longer-term CapEx during our year-end FY14 conference call.

New buildings are an important strategic need for UNFI. Our new buildings added differentiated wide product offering, bring us closer to the consumer by eliminating transportation miles, and enhance our service level by reducing the time between order placement and order delivery. And as an added point of reference, UNFI currently expenses approximately $9 million a year in outside storage costs due to current distribution center capacity constraints.

Our Capital Expenditures associated with construction and infrastructure today are building a UNFI capable of integrating significant industry and market share growth over the next decade.

And now I'll turn the call over to Mark Shamber, UNFI's Chief Financial Officer.

Mark?

Thanks, Steve.

Good afternoon, everyone. Net sales for the third quarter of FY14 were $1.78 billion, which represents growth of 13.8%, or approximately $216 million, over the prior year's third-quarter net sales of $1.57 billion. Excluding the $18 million in sales from the Trudeau acquisition that closed in the first quarter, sales increased by 12.6%. Inflation moderated both sequentially and on a year-over-year basis for the quarter, coming in at 1.64%, a 21-basis-point decline from Q2, and a 12-basis-point decline from last year's third-quarter inflation of 1.76%.

Year to date, net sales are $5.03 billion, yielding sales growth of $608 million, or 13.7%, over the comparable period in FY13. Excluding all acquisitions, our year-to-date net sales growth is 12.7%.

For the third quarter of FY14, the Company reported net income of $36.4 million, or $0.73 per diluted share, an increase of approximately 15.1%, or $4.8 million, over the prior year. Net income for the third quarter of FY13 was $31.6 million, or $0.64 per diluted share.

Earnings per diluted share increased by 14.2%, as EPS growth was impacted by the higher average share count in FY14. From a sales by channel perspective, the supernatural channel increased by 11.9% in the third quarter, with supernaturals representing 36% of total sales. Sales growth in the supermarket channel was 17.8%, and supermarkets represented 25% of sales. Independents sales grew by 10.2% over the prior year's third quarter, with independents representing 33%. Finally, food service sales growth was 28.5% in the third quarter, and food service represented 3.5% of net sales.

Excluding the impact of the Trudeau acquisition, supermarket growth was 13.8% for the quarter; and independent sales growth was 9.7%. As covered in the press release, gross margin for the quarter was 16.7%, a 6-basis-point decline over the prior year's third-quarter gross margin of 16.8%, and a 44-basis-point improvement sequentially. The primary driver of our lower year-over-year gross margin was the foreign exchange impact from the declining value of the Canadian dollar on our Canadian business. Additionally, there was some carryover into February due to weather from an inbound transportation perspective.

Year-to-date gross margin at 16.7%, a decline of 10 basis points year over year, driven by the same factors I just mentioned, along with the continued mix shift in customers.

Our operating expenses for the quarter were 13.2% of net sales, compared to 13.4% for the same period last year. This represents a 13-basis-point improvement over the prior year, as operating expenses as a percentage of our net sales continue to benefit from our technological initiatives and strong execution by the general managers in our broad line distribution center.

In the quarter, we incurred $0.9 million associated with startup costs for our new Racine, Wisconsin facility; $0.6 million in transaction costs associated with our pending acquisition of Tony's Fine Foods; and $0.4 million in duplicate rent and associated building costs associated with one of the Denver facilities we exited in the fourth quarter of FY13.

Excluding the portion of our Canadian business which involves the use of third parties for deliveries in certain areas, diesel fuel had a positive impact of 1 basis point on operating expenses in comparison to the third quarter of FY13, as fuel represented 70 basis points of distribution net sales in the quarter.

Fuel in the quarter decreased by 1 basis point versus the second quarter, although our fuel expense increased by 6.3% sequentially, due strictly to the higher sales volume. Our diesel fuel prices in the third fiscal quarter declined by approximately 0.6% from the prior year's third quarter, while the Department of Energy's national average was down approximately 1.1% over the prior year.

Share-based compensation expense totaled $3.6 million in the quarter, compared to $3.1 million in the prior year's third quarter. Share-based compensation expense represented 20 basis points as a percentage of net sales in the quarter, consistent with the prior year's third quarter.

Operating income for the third quarter was 3.5%, a 7-basis-point improvement over the prior year operating income of 3.4%. Adjusting for the $1.9 million and 11 basis points associated with Racine's startup costs, Tony's Fine Foods transaction costs, and Denver's duplicate rent expense, operating income was 3.6%, an 8-basis-point improvement over FY13 third quarter, after adjusting the prior year for $1.5 million in expenses associated with the Auburn, Washington labor action.

Our effective tax rate for the third quarter of FY14 was 40%. As we look to the fourth quarter, we would expect the tax rate for the quarter to be in the range of 39.5% to 40%, dependent upon our State taxes apportionment.

Inventory was $832 million at quarter end, as days inventory on hand averaged 49 days for the third quarter, an increase of about three-quarters of a day over the prior year's third quarter when we were at 48 days. The higher average days on hand resulted primarily from the later seasonal inventory build for the Easter and Passover holidays.

Our DSO for the third quarter increased by approximately one-quarter of a day, while remaining at 21 days on a year-over-year basis, due to the higher sales growth from the supermarket channel, as supermarket customers tend to pay more slowly. Capital Expenditures were $31.6 million for the quarter and are at $108 million, or 2.15% of net sales, for the year to date, which is consistent with our full-year guidance.

Our new facility near Racine, Wisconsin, opened on our new warehouse management system, and began receiving inventory in early May. The first shipments from Racine are scheduled to occur in late June. In addition, our Auburn, Washington facility is scheduled to go live on our WMS in mid-July. And we expect to begin rolling out our inventory optimization module in the Eastern half of the US late in the fourth quarter.

Outstanding commitments under our credit facility were $268 million at quarter end, with available liquidity of approximately $200 million, including cash and cash equivalents. Our leverage increased slightly to 1.2 times, levered on a trailing 12-month basis, due to Easter falling later in the quarter and our increased CapEx in FY14.

As previously announced, in May, we amended our revolving credit facility, increasing the aggregate availability under the facility from $500 million to $600 million.

As discussed in this afternoon's press release, we are narrowing our net sales guidance range for FY14 to $6.73 billion to $6.77 billion, which represents an increase of 11% to 11.6% over FY13's net sales. Adjusting for approximately $119 million of net sales for the 53rd week in FY13, net sales growth for FY14 is expected to be in the range of approximately 13.2% to 13.8%.

We also updated our GAAP diluted earnings per share guidance for FY14 to a range from $2.47 to $2.50 per share. Our previous GAAP earnings guidance was $2.45 to $2.51 per diluted share. Our updated guidance does not reflect any anticipated sales or earnings from our recently-announced agreement to acquire Tony's Fine Foods, which is expected to close late in the fourth quarter of FY14. However, our revised guidance does reflect approximately $1.3 million to $1.6 million in anticipated acquisition costs associated with the transaction, including the $0.6 million incurred during the third quarter of FY14.

Additionally, included in our FY14 earnings guidance is approximately $3.2 million to $3.4 million of non-recurring expenses associated with the planned opening of our new Racine, Wisconsin facility, and duplicate rent and building costs associated with one of the Denver facilities that we exited in FY13, which has a lease that will not terminate until July 2015. Our previous non-recurring expense guidance was $2.5 million to $3 million.

To the extent that our proposed acquisition of Tony's Fine Foods closes before the end of FY14 and would have an impact on our existing guidance, we would update our FY14 guidance upon consummation of the acquisition.

At this point, we'll turn the call over to the moderator for the question and answer session.

(Operator Instructions)

Our first question is from Andrew Wolf of BB&T Capital Markets.

Hi, good afternoon. Steve, you mentioned that there's a lot of continued competition or what have you, from self distributed traditional chains, and then I think you mentioned, if I heard it right, traditional grocery distributors?

Yes.

Or were you alluding -- okay. And obviously, there -- by that do you mean the K's of the world, or more like a SuperValu getting more (multiple speakers) in that?

Yes, some of the traditional, conventional food distributors that, over the last couple years, have added quite a bit of natural and organic.

So are you trying to -- is there -- I guess what I'm getting to, is there some kind of change from what you've seen in the last quarter or last year that you see accelerating? Or is that just the way it's been for a while?

No, it's really the way it's been for a while. The industry growth is really nothing new. And so it's obviously something that we've thought a lot about over the last couple of years. And certainly with the acquisition of Tony's, and really building out our product offering so that it truly is distinctive, is a terrific hedge against competition that we've seen coming into the space.

Okay. Is any of that competition on price? Or is it just, we've got this product too?

No, it's all on price. Yes, it's virtually all on price, because they don't have a differentiated product line. It's a pretty narrow group of products that they are coming to market with. And typically, their distribution programs tend to be less than ours. Because they're coming to the store with a full truck, or virtually a full truck, with conventional product. And so the distribution model itself is much more efficient for them to carry a lower markup.

And so it's really nothing new, but I think it's an important point to make. So it hasn't affected us in a significant way when looking at this year versus last year, but I think it was just an important commentary to make that we're not the only ones out there. There are other people that are coming into the space to compete on the faster-moving items.

Okay. And then just on the guidance, I wanted to clarify. I think the last thing, Mark, you were talking about was $3.2 million of non-recurring costs to get Racine open, and for the duplicate of rent?

It's the Racine -- part -- a portion of it, Andy, is the Racine opening. And another portion of it is the Denver rent for the building that we exited that the lease doesn't run out until the end of FY15. So there's the two items. And really, the Denver rent has not increased. But as Steve alluded to in his comments, we've made some intentional changes in bringing people on board and opening up Racine. And so the original guidance was $2.5 million to $3 million, and now it's $3.2 million to $3.4 million. Because we'll likely incur about $500,000 to $600,000 more in non-recurring than when we started -- or when we had initially projected.

Okay. And how do you -- could you give those two separately, the Racine portion and the duplicative rent?

I can give ranges, because that's the whole reason. It's probably -- at this point, it's probably $1.2 million to $1.6 million on the Denver side for the dead rent. And the balance now is probably $1.8 million to $2 million on the Racine side.

Okay. And the other housekeeping. On the gross margin, I might have missed that, but could you give us the impact for the weather in February and Canadian currency?

We don't -- we didn't break it out before, Andy and I'm not sure this quarter, we will. It was only 6 basis points, so the two of them combined were only like 3 or 4 bps.

Okay. All right, thank you.

Thank you. The next question is from Scott Mushkin of Wolfe Research.

Hi, good afternoon. This is Mike Otway. Thanks for taking the questions. Steve, bigger picture question for you. So over the next six months or couple quarters, you guys are going to have a lot more capacity come online with Wisconsin, and then Hudson Valley. How should we think about this in terms of the opportunity for you guys to go after new business? And how businesses you -- heading into FY15?

The first thing that it does is -- let me take a step back. For the first six months, it's more cost than anything else. Because we're moving a lot of freight around, because we're taking out of Chesterfield, Bayville and York, and populating Hudson Valley. And the same thing is true in the Midwest, where we're moving from two DCs in the Midwest into Racine. And so it just takes us a while to get settled into the facility. So in the short term, six months or so, there really is not a lot of efficiency, there's cost.

Over the long term, it does give us a very unique ability to go to both new and existing customers with lots of interesting opportunities whether it's SKU expansion, new categories, new customers, anchor tenants, if you will. And those things we're working hard to bring home. But it's going to be a while before we make all of those things happen, because obviously, there's a lot of moving parts.

You may have noticed in my commentary that I talked about offsite storage, and the amount of money that we spend keeping product in third-party warehouses is pretty spectacular. And that's only because we don't have the capacity to put in our own DC. So the first thing we do in those markets is, we eliminate the offsite storage, and that by itself takes some time, logistically, to get it all moved out. And so I think generally, that's where we are. Does that answer your question?

Yes. No, that's really helpful, thank you. And then on the fresh side of the business. When you combine Tony's with Albert's and some of the other fresh business that you have, how much of the business now do you consider fresh? Where do you think that could go over the next, call it three to five years. And then how should we think about the contribution to EBIT? To some extent, these businesses should be a little bit more value add, maybe a higher shrink. But more value add than dry grocery distribution. Is there an opportunity on the EBIT line for that to move higher over time?

Yes, so first, Albert's is predominantly organic produce. They do some perishable protein and cheese, but they're predominantly organic produce, whereas Tony's is predominantly fresh protein and specialty cheese and related perishable products. When we did the announcement, we talked about, the overall operating margin was going to be somewhat dilutive. And we haven't gotten into the specifics, only because we haven't provided any guidance yet, which we will do once we get into talking about 2015.

And it's only because protein has a much higher case cost. So for example, if our case cost is $15 and their case cost is $45, their actual gross profit dollars per case is higher than ours, but their gross margin associated with it is much less. And so we're going to have to see how that all plays out, as we look at the 2015 budget. And like I said, we'll get into some clarity there in September.

Okay, appreciate it. Thank you.

The next question is from Jason DeRise of UBS.

I just wanted to come back to the idea of competition. It's always been the case that as brands have become larger, that it was likely that you would lose them, and then you would replace them with many more smaller brands. Do you think that equation is changing, where you have to run harder to find the new smaller brands to replace the bigger brands?

Okay. So Jason, first, one point of clarification. This only affects less than one-third of our business, right? Because it only affects the supermarket channel. It doesn't have the impact on the other channels of business that we have, because there really isn't a direct option. That's number one. Number two, there's a couple of things happening. I would say that 40,000 feet, there's really nothing new, in terms of the amount of product that falls out that goes direct versus the amount of new product that's coming in.

The great thing about this industry is that it's an incredibly vibrant new product environment, so there's just so many new products. You've been to Expo West. You can see the thousands and thousands of new products coming in. Second of all, new capacity makes it a lot easier to bring on a lot more products and live with a little bit more risk associated with the products that we bring and then may not move. Obviously, when you're very tight, it's much harder to do.

And so the last thing I would comment on is, we do actually have some interesting data that points to products that leave us. For example, if you think of a large brand that we may carry 50 SKUs, and we'll lose the top eight fastest-moving items in that particular brand. Just because it's cheaper to take it direct. But when you factor in the fill rate associated with that retailer's ability to buy direct versus our ability to fill the deliveries by putting it through UNFI, in a lot of cases, the retailer comes to the conclusion that, we would rather pay a little bit more on the distribution and have it in stock than save a couple hundred basis points on the acquisition cost, but not have the fill rate.

So we frequently take back products that we've lost to direct over time. So I know that's a longwinded answer, but unfortunately, it's a complicated issue that is -- there's really nothing new to it today; it's just a little bit more complicated.

Okay. And one of the debates in the financial community is about where the natural and organic market is, from a saturation point of view and a growth point of view. Do you feel that there's a temporary saturation, either from a supplier, distributer or retailer point of view, versus where the demand is for the category?

Saturation for UNFI, you mean?

For the industry, really.

No, I don't think that at all. No, definitely not.

Any color why?

I think that the whole industry is growing so rapidly. Consumers clearly have sped through their actions that they're going to buy more and more of our products. And that's true across everything we do, whether it's Albert's produce, organic produce, or Albert's perishables or prepared foods. Or looking at the growth within the Tony's organization, or looking at the growth within the UNFI core categories that we have traded in for a long time. Very clearly, consumers have voiced the fact that their interest in our products are here to stay.

And Jason, I would add, when we look at the sales trends for the quarter to date, we're probably -- we usually give a range versus giving an exact number. But we're certainly within 30 to 40 basis points either way of where we've been tracking. So we haven't seen -- you look at the second quarter, we're at 13.9 on an overall 12.6 ex-acquisition. We're at similar range this quarter. And the trends are holding through the first five weeks of the fourth quarter. So we really haven't seen any noticeable degradation in the overall sale. There may be shifts within channels, but we haven't seen our overall sales be impacted.

Yes, let me just make one other comment. Because for the last -- boy, I don't know, three, four years, we've talked about protein, and we tried to build it within. And from the calls and internally and externally, we have talked a lot about protein being the last bastion of finishing out the store for UNFI. And we worked hard on this one, and we're incredibly fortunate to be able to acquire a Company like Tony's that has a rich history, a culture like ours. And the most important thing that they have to offer is, they're more excited about rolling their products and their platform across the country than we are. And that's a great marriage, and so we're really excited about where Tony's takes us.

Apologies to the rest of the queue, if I could squeeze one more in about Tony's. As we were trying to do some of the math on it, and understanding the working capital, as they grow, are they generating free cash flow? Because of the better working capital of their business model?

They are. They've got some pretty strong returns from a free cash perspective, given their overall profitability. They've got much lower DSO and days on hand, as we touched on in the previous call. So yes, they generate some good free cash.

So then in terms of covering your cost of capital or payback, or generating economic profit, however you want to define it from that point of view, are you able to share some metric about that to justify the deal?

I think that we -- I think certainly, once the deal closes, and we get to the fourth quarter, and I cover that in September, we would be happy to do so. There's some components that we'll have to factor in that I don't want to get into the accretion at the moment, simply because we've got to factor in whatever intangibles we'll have to amortize. And we would like to make sure that the deal is closed before we start talking to that level.

Okay, thank you.

Thank you. The next question is from Karen Short of Deutsche Bank. Please go ahead.

Hi, this is actually Ryan Gilligan on for Karen. How should we think about the chatter out there by some of your suppliers that there was destocking at UNFI? And along the same line, it looks like the independent channel slowed slightly on a two-year average basis. Is that you guys becoming more efficient, or was there a slight slowdown in demand?

Without getting into talking about specific suppliers, in the West, we did deploy our inventory optimization tool by supplier. And so if you noticed, overall, our inventory actually increased slightly during the quarter. But because we introduced the tool by supplier, it is possible that one or more suppliers could have seen some reduction in the inventory. The whole basis for our demand planning tool is to make sure that we have an appropriate amount of inventory in the right DC at the right time.

I would just add to that is, when we talk about the inventory optimization, and we did it last year in the West, and we're getting ready and starting it now in the East this year. The one item to highlight that we referenced is that it varies, certainly, by suppliers. There may be some where we're adding to inventory levels, and some that we're decreasing what we carry on hand.

But the ones that are actually taking a reduction, at least on a one-time basis, it's really a function of the fact that they're better able to execute. And that we're able to ensure -- or they're able to ensure that when we are reordering product, that it hits our docks and it hits our warehouses in the time frames that we want. And we are not having to carry multiple extra weeks of inventory, as is the case with some other suppliers.

We referenced in the first quarter, and then going into the second quarter for the holiday season, that we built inventory levels above what we would be comfortable carrying simply because we didn't have complete comfort that's across the entire base of our suppliers that they could have the product, and that they wouldn't get caught by out of stocks.

So this is a [funky] note. For those that are taking the one-time adjustment and getting down to the levels we're looking to carry going forward, it's actually a positive in the sense that they're able to execute, whereas some of the other suppliers struggle in that, quite frankly.

The service level actually has been very strong during the last 13 weeks.

That's helpful, thank you. And is there any reason why the impact on margins at the Eastern division wouldn't be the same as the Western division? Have you guys discussed what you expect --

You also asked the question about the independents?

Right, yes, thanks.

I wouldn't say that there was a falloff in the independent demand. It could have been -- because it's so small, I think it could have been related to the number of new store openings one period versus the next. But I wouldn't say that there was a slowdown in the independent channel.

That's helpful, thanks. And just one quick follow-up on the inventory optimization. Are you guys expecting any difference between the divisions, in terms of the margin lift? And have you guys quantified what you expect the margin lift to be?

We have not quantified, and it's difficult to project as to where that lift will come from. The mix of products is different, and the capacity in some of the warehouses varies. And so that is a factor, as we go through it. It's, again, part of the reason that we're looking to adjust some of the carrying levels for inventory with certain suppliers. So I don't think that there's any specifics there. We didn't provide it on the West, other than to highlight that we get some lift. And I think that we would take that same approach with the East.

Great, thanks.

You're welcome.

The next question is from Stephen Grambling of Goldman Sachs.

Good evening. Thanks for taking the questions. Turning -- or sticking with gross margin, you had a solid performance, given all the headwinds. Can you give us a little bit more color on how you're thinking about this line item in the fourth quarter? And then maybe even further out, given the Tony's transaction is going to muddle the comparisons a bit?

Yes, as it relates to the fourth quarter, anything -- I'll reference it with the expectation that the transaction doesn't close. Because when it closes, it will impact us to have that relative impact, the later in the quarter, the less it has. Certainly, on a year-over-year basis, we would expect the gross margin to be down significantly, probably more in the range of where we reported the third quarter this year than where last year's fourth quarter was.

The -- any benefit we got on the I/O side would not occur in the fourth quarter, because we're really rolling it out going into the first quarter of 2015. And it won't even be fully deployed until late in the first quarter of 2015. So I think from that standpoint, Stephen, we're probably 10 to 15 basis points either way from the 16.7 that we just reported.

And then looking further out, one of the things that you mentioned from the competitive set was differentiating the product offering, but there's also this element of their being more focused on price. Do you feel like, as part of the strategy, you'll have to incorporate some price investments as well?

Yes, we have, over time, certainly as the channel mix has changed. So I wouldn't say that it's any different in the future that we haven't already been living in the last couple years.

Right, that's helpful. Thank you so much.

The next question is from Mark Wiltamuth of Jefferies.

Hi, good afternoon. On the inbound freight, just wanted to see if that was a help in the quarter on gross margins? Or was there still a little bit of a drag there because of the weather issues that did trickle into the quarter?

Yes, so I would say that from a standpoint the weather issues were a drag, I think that our performance from an inbound standpoint continues to improve on a year-over-year basis. Though on a year-over-year perspective, it was probably better overall. But we did have some drag that was associated, really, in the month of February, with some of the lows that we are still moving on a protect from freeze perspective.

And is there any way to tell us how much farther you could take this, in terms of how many more quarters of benefit you think you have? Or is there some way of measuring how deep into your system the inbound freight effort has gone?

We've had it in place for two years now. At the end of this quarter, it's roughly two full years. We think there's still opportunity there. We started with some of the biggest items, and we're now moving to that next layer. And we're trying to work more closely with our suppliers to see where there's opportunities where we can both benefit from that standpoint. So I would certainly say that it's not complete. How many quarters, or how much longer it would grow, other than in excess or beyond our overall growth of the business, still remains to be seen. But we're still identifying opportunities and trying to pursue those, so I think there's at least a few more quarters.

Okay. And is there any general rule of thumb we should apply to your other DCs, as they come on, in terms of the startup inefficiencies?

No, there's really nothing easy and straightforward. It depends on what time of year they open, how soon we start bringing people on, the customer mix associated with it. And in some cases, when there's relocations, the relocations have less expense associated than the start ups of a greenfield, but beyond that, there's no easy rule of thumb.

Once they're at full speed, do you end up with a better margin than you had previously? Or is it really just the revenue growth game you're playing here with the new DCs?

Keep in mind that one of the ways we justify the new distribution centers is by putting them close to the ultimate consumer, or the retailer. And so we eliminate a lot of miles. So it's a fold out strategy. So when we put up a new DC, we put it closer to where we have a lot of customer locations. And so the elimination of the miles is typically what gives us the ROI in the building.

Okay. Congrats on the solid quarter, and look forward to next year.

Thank you.

The next question is from Kelly Bania of BMO Capital Markets.

Hi, good evening. Thanks for taking my questions. Just Mark, first wanted to recap on guidance. So narrowed the earnings per share range a little bit, but that's in spite of, I think, a total of an incremental $2 million of costs spread out over Q3 and Q4.

Correct. So about 600 -- actually, about $800,000 in Q3, between the transaction cost and the incremental on Racine. And then another $1 million -- $800,000 to $1.2 million in the fourth quarter.

And then, just curious on Racine with the new WMS system. How do you feel about that system coming on board? Do you anticipate everything going smoothly? Just maybe an update on how you feel about rolling that out?

Yes, it is live, it's running, and it is pretty slick. And so we're really excited about that. All of our new DCs will come on on the new platform. We've got a DC converting over the next 60 days. We feel great about it.

Great, and then just back on Tony's. Looking at your competition, maybe your regional competition, how many of those competitors offer the full suite of products that you now will offer with the addition of protein?

There is nobody that I know of that has a full offering of natural, organic, ethnic gourmet and perishable protein and specialty cheese. There are distributors in the markets that may carry portions of that product offering, but there is no one that I know of that can deliver the store in its entirety.

Great, that's helpful. And then just one last one, on the offsite storage cost that you mentioned, are those spread out throughout the country? Or is there any one region where once you get a new DC there, that will help alleviate some of those costs or -- ?

Yes, again, that's one of the drivers for putting in the new buildings. It's obviously (technical difficulty) locations where we have a lot of offsite storage. And so while the number is spread out across the country, it is pretty heavily concentrated in the areas where we're really tight on room.

Great, thanks.

Thank you. The next question is from Mark Sigal of Canaccord Genuity.

Hi guys. A number of your suppliers have called out key commodity inflation that's been fairly sharp. Have they communicated to you their desire for price increases, perhaps in the back half of the calendar year? And given that a lot of your business is cost plus, can you talk about how quickly you're able to pass that cost through and how you handle that?

Mark, we typically get about 60 days notice with respect to price changes. So to the extent that anyone was looking to put a price change through for July 1 or August 1, we would know about that now. But if folks were doing it in September or October, they may signal it or they may start talking about it. But until they officially announce it, it would simply be, they're looking to put it through. And from that perspective, the 60 days notice gives us the opportunity to get that reflected in our systems, into our catalogs, into our pricing for our customers so that on the day that it takes effect, we're able to pass that along concurrently.

Okay. And then a follow-up from the prior question. On the third-party storage costs and the trucking miles saved on the buildout of your new facilities. With four new buildings or DCs planned, can you talk about, cadence-wise, how we expect -- does that cost come down in chunks? Perhaps as more one region and more impactful than the other? Just how do we think about that over the next, call it, three years or so?

I wouldn't say that it comes down in chunks, but what I would say is that it's a gradual process. Because we're constantly evaluating the routes that we have, and whether they're better served from one facility or another facility, as well as the miles that we're traveling from our distribution centers. And trying to get the best mix to hit delivery times for our customers is also takes the most expeditious route to the customers. So I think it's a gradual decline.

What I could probably give you best, from a standpoint of how that works out, is that every quarter we provide what our fuel expense is. And if you look at where it has gone as a percentage of our total sales, you've seen that it has come down over time, even while the prices have stayed relatively constant. And that's -- some of that's by getting more efficient with the fleet, but a lot of it is by reducing the miles that we're traveling to get to our customers and/or basically routing more effectively with the existing customers, trying to find the right DCs to serve those customers

Okay. And then on potential new business that's out there in the mass supermarket channel, or perhaps business that you're negotiating to keep. Have you started discussing any of the new Tony's offerings yet? Or have you been able to call on any customers with the new product set?

No. Given that the transaction hasn't closed and it requires FTC review, there are very specific rules along those lines. Having said that, there was high interest from our customers, from that perspective, as soon as the deal was announced. Our group President, Sean Griffin, got a request in the first two hours after the deal was announced asking when we're going to bring that product East.

Perfect. That's helpful, thanks a lot.

You're welcome.

The next question is from Eric Larson of CL King & Associates.

Three quick questions, and Mark, I apologize if you've already covered this. Did you quantify the impact of the Canadian dollar in the quarter? You may have already covered this point.

We didn't quantify it, no. We said that between the Canadian dollar and some of the carryover on the frozen product, that it was probably 3 or 4 basis points, but we did not break it out specifically or individually.

Okay, thank you. I apologize, I missed that. And then just on a broader question, I know this is tricky, and any thoughts you may have on this or not. I know that -- I think this fall is the end of the three-year agreement with Safeway on that contract. Any thoughts on that? Or how you're thinking about that, or what's going on there?

I think we've had a good relationship with Safeway, and we don't talk about any contracts that we're currently pursuing and/or attempting to renew. But we feel that we've had a good relationship with them for the three years, and that both parties have helped grow that business. And so we would expect that we would be in a good position to retain that. But beyond that, I don't think I'm in a position to comment on anything specifically.

Okay, yes, fair enough. And then just the final quick question. I know it's early days on this, the Tony's acquisition. As you look at Tony's today, obviously, you want to -- with Steve's comments regarding expansion of that product, a significant product line across the country, et cetera. Does it change any of your thoughts on your CapEx spending as a percent of sales? Or would you look at it more as a reallocation of some capital expense away from other things into that acquisition? How would you look at that today?

Yes, you're right on the money. We would reallocate. And keep in mind that it wasn't a coincidence that all of our new DCs have extremely large, fully refrigerated loading docks and significant multi-temp storage facilities for these kinds of products.

Okay. That's very helpful, Steve, thank you.

The next question is from Ajay Jain of Cantor Fitzgerald.

My question, I just wanted to confirm your CapEx outlook for the year. I think most recently, it was $150 million to $160 million range. Is that still the right range? I think that implies around $50 million to $60 million in the fourth quarter. Does that sound right?

That's still the same range. What I would say is it probably implies $40 million to $50 million in the fourth quarter. Certainly things can slide, Ajay, as it relates to some of the new construction that we're starting, but that's the expectation at the moment.

So unrelated to the financing for the Tony's acquisition, do you think you'll need to draw down on your revolver to support that CapEx spending in Q4?

No, in the fourth quarter, we generate free -- if you go back and look at the last three or four years, the fourth quarter is the quarter where we generate the vast majority of our free cash. So while for the full year perspective, we still expect to be free cash flow negative, as we said when we gave the guidance last year, when we get to the fourth quarter, certainly, we would expect that our free cash would be positive. And would be more than sufficient to cover any CapEx in the fourth quarter.

Okay, and on the two -- actually, on the new distribution facility is, can you just provide an update on the time frame for California? When that becomes operational?

I'm sorry, could you say that again?

You're talking about California, Ajay?

Yes, the northern California facility.

We haven't announced an exact time frame yet. Directionally, it will be our FY17 --

FY16.

FY16?

End of FY16. Yes, I think as we -- when we referenced California before, there can be challenges from a permitting standpoint. And so until we get through those hurdles and actually begin construction, the timeline is a little bit in flux until we're past all of the permitting requirements.

We have the land.

We own the land, and we're going through the process now.

Okay so it's still a little ways away. And just lastly, I know you are not giving guidance for next year right now. But just heading into FY15, how much incremental D&A is associated with the two facilities in Hudson Valley and Wisconsin, as they are starting to come on line now?

We haven't gotten to that level yet, from finalizing the construction aspects. And so until we're willing to give the FY15 guidance, I don't know that I'm comfortable sharing the incremental amounts.

Okay. Thank you very much.

Taken in an absolute, they might just get layered on with our overall D&A. And there are some items that come off that would offset some of that incremental.

Okay, thank you.

Thanks. Operator?

Thank you. There are no further questions in the queue. I would like to turn the floor back over to Management for any additional remarks.

Thanks for joining us this evening, and we look forward to sharing our FY14 highlights and FY15 guidance in the Fall. I hope you have a terrific summer. Thanks again for joining us.

Thank you. Ladies and Gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.