United Natural Foods Inc (UNFI) 2015 Q3 法說會逐字稿

Greetings and welcome to the United Natural Foods third quarter 2015 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, Ms. Turner, you may now begin.

Thank you. Good afternoon. By now, you should have all received a copy of the third quarter FY15 earnings press release issued today at approximately 4:05 PM Eastern time. The earnings press release and webcast are available under the Investor section at the Company's website, at www.UNFI.com. On the call today are Steve Spinner, President and Chief Executive Officer, Sean Griffin, Chief Operating Officer, and Mark Shamber, Chief Financial Officer.

Before we begin, we'd like to remind everyone that 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 expressed in these forward-looking statements.

In addition, in today's earnings press release and during the call, management will provide both GAAP and non-GAAP financial measures. These non-GAAP financial measures include adjusted net sales, operating income, net income and earnings per diluted share, and a reconciliation of all the non-GAAP financial measures can be found under the Investor section of the Company's website. And with that, I would like to turn the call over to Steve Spinner.

Thank you, Katie. And welcome to UNFI's summary discussion of our third quarter 2015 results and updated expectations for our fiscal year ending August 1, 2015.

It is an exciting, challenging and very opportunistic time for our industry. UNFI strategically made decisions over the last several years to build out our capacity and begin a migration toward the perimeter of the store, which we believe is one of the new frontiers for growth in our space.

We began moving our Albert's business towards fresh foods in addition to organic produce and acquired Tony's Fine Foods last year. Fresh perimeter products now represent approximately 15% of our total revenue and are the fastest growing categories.

As you know, we also began a significant campaign to increase capacity across North America. And this has resulted in over 2 million square feet of added capacity, with a significant concentration in refrigerated storage over the past 24 months, which we anticipate will serve as UNFI's primary enabler toward increasing market share and the national rollout of our fresh platform. Additionally, we further built our refrigerated logistics equipment and technology, ensuring a sophisticated cold chain and food safety environment. In several important markets, we now have the capacity to add new customers.

Our industry is changing rapidly. Major media outlets are talking about the consumer's migration toward healthy, organic food. June's issue of Fortune magazine highlighted the war on big food and the changing demand for cleaner ingredients from America's largest food manufacturers. Major retailers are talking about migration to a more varied and robust product offering of natural and organic food.

Many estimate that there are over 100,000 new retail points offering natural products, from convenience stores, colleges, hospitals, restaurants, e-tailers, as well as mass, conventional and hard good retailers. All different kinds of retailers are getting involved in carrying some of these products, driven by consumer's demand.

Major retailers are very quickly introducing private label organic brands, further propelling growth of organic throughout the country. And the speed at which this change has taken place is challenging our growth in the near term. However, we faced these challenges before, we adapt and we would discover what's new.

With that, it is important to keep in mind that natural and organic foods represent less than 5% of the total food sold at retail. UNFI's market share in the natural and organic food space is estimated to be 12%. I believe that the fastest growth for organic consumption and distribution is in front of us, despite the headwinds we face today. And these numbers don't include the total retail for fresh and gourmet ethnic.

Additionally, we believe that ethnic gourmet products and fresh foods represent significant incremental growth opportunities for UNFI. With a market share of less than 6% in each of these fast growing product channels, we believe there is considerable growth ahead for UNFI through these channels. We believe these channels are well built for our infrastructure and UNFI is in the early stage of our implementation here.

There is capacity, intellectual capital, and a customer base in place today for further escalating our growth in these areas. We estimate this opportunity for UNFI over the next decade to be over $10 billion in today's dollars, and we now have a sales and category management team specifically focused on developing business opportunities in this exciting area.

In July, we will begin shipping two significant new customers, which combine the joint strength of UNFI broad line and Tony's Fine Foods, which continues to support our strategic assumption that there is significant value in UNFI's leadership position as the preeminent provider of logistics, distribution, and category management for our retailers' center store and perimeter.

However, despite the projected growth ahead, we have seen softness in UNFI's revenue over the last several quarters; and with approximately 7% organic growth in our third quarter FY15, there are several important factors I believe that are pressuring our short-term sales.

One, the speed at which our products have been adopted across retail channels not currently served by UNFI has impacted overall demand, as some consumers chose to make their purchases elsewhere. Two, the speed at which UFI's customers have been impacted by product availability across a wider array of retail options. Three, the speed at which retailer organic private label has escalated. Four, produce deflation and continued higher levels of supplier shortages influence UNFI's revenue negatively by approximately 60 basis points. And five, we do have some short-term drag at Albert's and the Canadian FX which equals about 100 basis points of revenue.

We also believe these trends are short-term in nature driven primarily by, one, the increase in demand while painful in short-term, I believe will find its way into UNFI's sphere of customers, as consumers seek out a wider product offering. Crossover consumers will find their way to retailers offering a wider array of organic and natural products. These retailers are all within UNFI's existing customer base.

Two, UNFI's customer base is expanding across Internet e-tailers, conventional food service and ethnic gourmet, as well as fresh. And three, customer wins in the fresh categories.

As investors and analysts, it is very important to understand the importance of the model UNFI has built over the last several years. In partnership with our growing roster of customers, UNFI now has distribution centers no more than 200 miles from 85% of the North American population. This translates into logistics programs that provide a high service level, low cost solution, unlikely to be matched.

We have scale which drives down distribution costs, including a product offering that now exceeds 65,000 line items across fresh, grocery, frozen, produce, deli, bakery, prepared foods, ethnic gourmet and food service. Our scale is one of our most significant competitive advantages.

UNFI now operates more than 1,000 trucks, utilizing over 30 distribution locations across North America. We deliver over 2 million cases per day. Additionally, we now operate a national demand planning and replenishment platform that manages distribution logistics from point of manufacture to delivery location.

As an example, UNFI can pick up a manufacturer's new item on a Friday and have it set in over 6,000 retail locations within five business days. We believe the demand for this type of complex infrastructure that we offer is increasing and increasing rapidly.

UNFI has an infrastructure of over 1,000 sales associates in the field, assisting retailers in their quest to ensure that they have the right product on the shelf, by geography, using UNFI's proprietary data tools.

One of the fastest growing categories is private label. UNFI currently handles logistics on private label for many of our retailers, and now have the capacity in many markets to further ramp up this expertise by using our scale with co-packers to drive down cost. We are managing freight via intermodal, rail, air, ship, truck, e-commerce, contract carrier, and fulfillment through a network built to handle a growing and changing industry. We believe that there is no other network capable of adjusting to the changing requirements of our growing customer base.

While retailers with captive distribution can and should, in some cases, buy product direct, we believe there will continue to be a growing demand for UNFI's services, which include consolidation of slower moving products, breadth of product line, in many cases a distribution solution which carries a lower cost than that of the captive.

In customers with captive distribution, UNFI's business continues to grow at a rate considerably faster than the industry, despite the continued threat of direct. When retailers calculate the delivered margin difference between captive and UNFI and factor inventory carrying costs and UNFI's higher service level, there is a compelling argument for UNFI distribution versus captive. Given the capital intensive nature of building and running distribution centers, I believe that there are more and more retailers that will outsource distribution of our products to UNFI.

Slower moving products, which are the vast majority of our products when comparing them to conventional food items, demand a heightened level of attention, due to the more expensive and complicated logistics required. For example, seasonal products, new products, shippers, and ingredient-specific products require a greater degree of category management resets and product expertise.

As we've discussed during our calls this fiscal year, UNFI has been building infrastructure and capacity. This quarter was no different, as we completed our Twin Cities facility and approached completion of our Gilroy, California facility. With Gilroy near completion, we will focus on using this capacity to further increase our market share and will moderate our capital expenditures, which we'll discuss in detail during our discussion next quarter regarding FY16 guidance.

While we face some headwind in the near term in our top line revenue and gross margin, as our business further migrates to lower margin, fast growth retailers, we remain optimistic that demand will move us forward. And we believe our scale and infrastructure will continue to differentiate us in the marketplace.

From an expense perspective, our history also demonstrates a proven track record of managing costs in tight sales and margin environments. As we look at gross margin, there is a cyclical supplier reaction to increased demand by pulling back from promotional trade spend, and we are seeing reduced discounting during these high demand cycles.

UNFI is adapting to a changing industry and deploying its assets to take advantage of the migration to a broader customer base and one with a heavy focus on fresh. I believe we are well suited to succeed here. The opportunities are significant, our strategy is strong, and we have the infrastructure and scale to deliver. Now I'll turn the call over to Mark Shamber, our CFO, to discuss results of the third quarter. Mark?

Thanks, Steve, and good afternoon. Net sales for the third quarter of FY15 were $2.11 billion, which represents growth of 18.7%, or approximately $333 million over the prior year's third quarter net sales of $1.78 billion. Excluding the impact of the acquisition of Tony's Fine Foods, sales increased by 6.7%.

Inflation increased modestly, both sequentially and on a year-over-year basis for the third quarter, coming in at 2.52%, a 37 basis point rise from Q2 and an 88 basis point increase from last year's third quarter, which had inflation at 1.64%. On a year-to-date basis, net sales of $6.12 billion, yielding sales growth of approximately $1.09 billion, or 21.7% over the first nine months of FY15. Excluding the approximately $674 million in net sales coming from the Tony's and Trudeau acquisitions, our year-to-date comparable sales growth is 8.3%.

For the third quarter of FY15, the Company reported net income of $41.7 million, or $0.83 per diluted share, an increase of approximately $5.4 million, or 14.7%, from the prior year, while diluted earnings per share increased by 13.8%. Net income for the third quarter of FY14 was $36.4 million, or $0.73 per diluted share.

On a channel basis, supermarket sales increased by 22.1% in the third quarter, with supermarkets representing 26% of sales. Sales growth in the independents channel was 16.6%; and for the quarter, independents represented approximately 32% of sales. The supernatural channel sales increased by 14.9% and the supernatural channel represented 35% of sales in the third quarter of FY15. Food service comprised approximately 5% of sales, after growing by 53.5% in the third quarter. Excluding the impact of the Tony's Fine Foods acquisition, supermarket sales increased by 5.9%, independent sales growth was 3.2%, supernatural sales grew by 9.8%, and food service had sales growth of 23%.

At 15.4%, gross margin for the quarter showed 132 basis point decline over the prior year's third quarter gross margin of 16.7% and was up sequentially 57 basis points. The primary drivers to our lower gross margin in the third quarter of FY15 continued to be items covered in previous quarters' earnings calls.

The dilutive impact of Tony's Fine Foods represented approximately 47 basis points of the gross margin decline compared against the prior year's third quarter. Our gross margin was also negatively impacted on a year-over-year basis due to lower fuel surcharge revenues, the decline in the value of the Canadian dollar on our Canadian business, and the shifting mix in customer growth.

Gross margin for FY15 year-to-date was 15.4%, compared to 16.7% in the prior year, a decline of 123 basis points, again, driven by the same factors in Q3 that I just covered, with dilution from Tony's representing approximately 52 basis points of the dilution on a year-to-date basis.

Our operating expenses in the quarter were 12.2% of net sales, compared to 13.2% for the same period last year. This represents 107 basis point improvement over the prior year, as operating expense as a percentage of net sales continued to benefit from the acquisition of Tony's and the related cost structure, the mix shift in our business, positive trends in our self-insurance areas, lower fuel costs and lower performance-based incentive expense.

Fuel had a positive impact of 13 basis points on operating expenses in comparison to the third quarter of FY14, as fuel represented 57 basis points of distribution net sales in the third quarter of FY15. Fuel expenses were 7 basis points better than the second quarter of FY15, when fuel came in at 64 basis points of net sales.

Nationally, our diesel fuel costs in the third quarter of FY15 decreased by approximately 12% from the prior year third quarter, while the national average price decreased to $2.85 a gallon, a decline of 28.5% compared to $3.99 a gallon in the third quarter of FY14, per the Department of Energy. Our year-over-year decline in diesel fuel cost is below the Department of Energy's percentage due to our locking in a portion of our pricing using fixed price contracts and the growth of our business.

Share-based compensation expense during the third quarter of FY15 totaled $2.4 million, or 11 basis points as a percentage of net sales, compared to $3.6 million, or 20 basis points in the prior year.

Operating income for the quarter was 3.3%, a 25 basis point decline over the prior year's third quarter operating income of 3.5%.

Other income during the quarter consisted of a gain of $4.2 million associated with a transfer of land at our new Twin Cities location in Prescott, Wisconsin, which is consistent with our previous guidance.

We recorded an incremental $348,000 in income taxes to record our tax rate at 40% for the third quarter, bringing our year-to-date tax rate to 39.7%, which is our revised forecast for our FY15 tax rate, due to changes in apportionment and other tax-related items.

Inventory was $948 million at quarter-end, as days inventory on hand averaged 47 days for the third quarter, an improvement of 2.5 days over the prior year's third quarter, when we were at 49 days. Consistent with my statements in previous quarters, the primary driver of our year-over-year improvement in inventories is the inclusion of Tony's, as Tony's inventory turns at a faster rate than UNFI's broad line distribution business, due to the heavier perishable concentration. DSO for the third quarter deteriorated modestly on a year-over-year basis, increasing by about a third of a day, but remaining consistent with the second quarter, at 22 days.

Capital expenditures were $42.4 million in the quarter, bringing us to $98.5 million for the year-to-date, representing 1.6% of net sales on a year-to-date basis. Based on our current run rate, we would expect full year gross CapEx to be approximately $135 million to $150 million.

During the quarter, we generated approximately $4 million of free cash, although we continue to expect to be free cash flow negative for FY15.

Outstanding commitments under our credit facility were approximately $397 million at quarter end, with available liquidity of approximately $216 million, including cash and cash equivalents. Our leverage improved from the prior quarter to 1.9 times on a trailing 12 months basis.

As discussed in today's press release, we are revising our guidance for FY15 to reflect sales trends in our business. We now expect net sales to be in the range of $8.15 billion to $8.19 billion, which represents a 20% to 20.5% increase on our total net sales over FY14. Our previous sales guidance was a range of $8.19 billion to $8.29 billion.

In addition, we are narrowing our diluted earnings per share guidance for FY15 to a range of approximately $2.75 to $2.79. This reflects the change in sales trends and current projections for our tax rate to be approximately 39.7%.

Our previous GAAP earnings guidance was $2.81 to $2.90 per diluted share. Adjusted for the impact of the $7.7 million reduction in net sales described in our earnings release, our adjusted earnings per diluted share for FY15 is expected to be in the range of $2.84 to $2.88 per diluted share, an increase of approximately 12.7% to 14.3% over FY14 GAAP earnings per diluted share of $2.52. At this point, we will turn the call back to the operator to moderate the question-and-answer session. Operator?

Thank you. We will now be conducting a question-and-answer session.

(Operator Instructions)

The first question is from Rupesh Parikh of Oppenheimer. Please go ahead.

Thanks for taking my question. I have a longer term question for you, Steve. With all the headwinds that you're seeing right now in your business, do you still think that UNFI can get back to that double-digit type organic sales growth you guys laid out at your Analyst Day? You guys have talked a lot about your opportunities in fresh and ethnic or gourmet. I just want to get a sense of whether you feel there's enough growth there to maybe offset some of the slowdown we've seen in other categories.

Yes, absolutely. We invested a lot in infrastructure, as you know, Rupesh. We are more than well prepared to begin what we've already begun, but to see a really nice rollout of our fresh platform. I talked in my comments about a couple customers that we had won that are rolling out in July. The total value of those customers is approximately $100 million.

And it's really compelling to be able to be a provider of center store and a provider of fresh. The economics work really well for the retailer. We see a lot of room in the customer pipeline that we're excited about. We see a lot of opportunity, as you said in your question, in ethnic gourmet. We now have a complete sales force dedicated to it. And I think we're very fortunate in that a couple years ago, we saw the shift moving more towards fresh. And we built these big refrigerated facilities, with refrigerated loading docks and refrigerated delivery equipment in Hudson Valley and Racine and Twin Cities and Gilroy and Denver. So we -- we're ready. We're ready.

So if you look at the culture of the Company, we've gotten used to growing at double digits. And so I would say that wholeheartedly, yes, we're excited about getting back there. And we think there's plenty of room to do it.

Okay. Thanks for the color. Maybe just switching topics. As we look at the revenue trends by the various channels, it seems like the independent channel slowed pretty meaningfully this quarter. Do you think that channel is more susceptible to what's happening out there right now, with different retailers carrying more natural, organic products?

Yes, I think that they are the most susceptible, for sure. Independents have to shift their business model. They have to be better at perimeter. They have to be better at being differentiated. Because if they're going to try to compete on a price per price basis on organic cereal, it's not going to end well. But they've been there before, in different ways. It's going to take them a little while to figure it out, but I do have a fairly high level of confidence that they will figure it out.

And I do really believe that we've added so many new points of retail that carry a very narrow set of SKUs; and so while it's difficult in the short term, we've been talking about crossover consumers for the last three years. And so now I think certainly the optimist in me says, boy, there's so many more places for somebody to jump into the space. But once they jump into the space, they're going to realize very quickly that that retailer is not going to be able to satisfy the demand. And that's going to push the consumers back into the more traditional UNFI customer base.

Thank you for all the color.

Thank you. The next question is from Robbie Ohmes of Bank of America. Please go ahead.

Steve, maybe just a follow-up on that question. Can you help us think about how soon you could return to double-digit growth and what the barriers are to all the investments you're making in refrigeration coming online in a way that maybe supports a stronger revenue outlook? Thanks.

Yes, I mean, look, I don't think it's going to happen tomorrow. It's going to be slow, but sure, which I think is the better way to do it. We've got a couple of great opportunities in our customer pipeline that, as I said earlier, we've got two really nice wins that are rolling out in the next couple weeks that we're excited about.

And like I said to Rupesh's question, it's a really compelling model to be able to say to a retailer, we can combine economically the fresh and the center store, and the gourmet ethnic, into a pretty good story. And having the capacity to do it goes a long way. So I really wouldn't want to back myself into a corner to say specifically when we're going to get back to 11%, 12%, 13%, 14%, other than culturally, we're very driven towards being there.

Can you just comment on just the supermarket channel, and has there been an acceleration in their sort of shifting of items into their own internal distribution? What is the trend there and what gets it to stop?

So interestingly, we haven't seen anything change in the way conventional retailers who have captive migrate the products to direct. And interestingly, if you do the math and you look at the distribution difference, the cost difference between captive to UNFI, and then you apply a cost of capital, because in the direct model, they have to carry five weeks worth of inventory. In our model, they're carrying a week's worth of inventory. If you apply a service level component to it -- in other words, our service level's going to be in the 93%, 94% range, their service level, because they're only buying for themselves, is going to be in the 83%, 84% range, because they only buy in truck load.

If you do all that math, in many cases, it's a wash as to whether the retailer is better off buying it direct or buying it through UNFI. So we've actually seen products migrate back to UNFI after having been direct, even though the conventional retailer's first inclination is to say, well, once it reaches a certain volume, it's going to be more efficient for us to take it direct. So it really is nothing new there.

Got it. Thank you very much.

Thank you. The next question is from Meredith Adler of Barclays. Please go ahead.

Thanks for taking my question. Have a question about private label. And you said a couple of things that were interesting, I mean, not only do you have the capacity to handle, from a logistics perspective, retailers' private label, but something about working with co-packers. I wasn't sure exactly. Could you maybe talk about that a little bit more?

Yes, sure. Meredith, if you think about it this way. There's a limited number of co-packers who actually make this product. So in many cases, you've got one co-packer making many different retailers' private label. Because these products are relatively slow moving, yet we're buying many brands from the same co-packer, we have the ability to consolidate the weight or the volume into intermodal or rail or full truck to get to a really efficient, low cost distribution model. And so our slots are agnostic to what's in them. As long as the product moves, we're okay with it, which is why we're carrying a lot of retail private label. And again, just for the simple fact that there are a limited number of co-packers and we're already buying direct from so many of them, the economics just work in our favor.

And just a follow-up to that is what is the obstacle to making that happen? Is there any pushback from the retailers or the co-packers?

You know, generally, I would say no. I think there are some retailers who just want to buy direct; and for them, that's what works and that's okay. I think for, in many cases, there are items that are private label that work best in direct and there are many items in private label that work best in UNFI distribution. Those are the programs that I think that work most efficiently.

Okay.

Doesn't have to be black and white.

And if I may just ask another question, this is maybe a little bit bigger picture, but did you anticipate the slowdown on the dry grocery side and the timing of that slowdown when you started pushing for more fresh and investing in refrigerated capacity?

Yes. So I think a couple years ago, we knew that this industry was going to migrate to fresh. And fortunately, we've got a lot of people with a lot of background in fresh, given where we came. And in many respects, the retail is just a little bit behind what happens in food service, in a lot of cases. And so in food service, it migrated to fresh. And so we said, you know what, I think, as we look at our business out over the next couple years, our business is going to migrate to fresh, we need to be really good at it and have the capacity. So we were fortunate.

Did the change in center store happen faster than we thought? For sure. For sure. Because it happened really quickly. All of a sudden, the product became much more available in so many places. So I think we were a little surprised by the speed at which it took place, but not by the overall shift in the migration from center store to perimeter.

And I'll be selfish and ask one more related question. Does the slowdown have an impact on return on invested capital, because you have invested a lot of capital?

Yes, I think that if you go back to 2008, 2009, when we had a slowdown because of the recession, we responded in a way that said we're going to be much more careful in how we allocate our capital, we're going to be much more careful in how we create free cash. And we were very successful in 2009 and 2010 as a result of that. So when the top line slows, we have to have a much more disciplined approach around our CapEx, which is exactly what we're doing.

Okay. Thank you.

Thank you. The next question is from Steven Forbes of Guggenheim Securities. Please go ahead.

Hello, guys. Just going back to the two customers that you're bringing on in July, can you talk about what DCs these customers are going to be served out of? And I guess just broadly, what drove the new wins? What brought them on board?

It's primarily West Coast. And the wins were really a matter of having the capacity on the fresh side, having the capacity on the center store, and being the expert in making sure the stores have the right products at the shelf, I think, were the two, or the couple of key factors that moved us in that direction.

No, I think it's all of that. And we have a demonstrated high rate of executions, fill rate, logistics, and that translates very positively for prospective customers. And to that end, the pipeline continues to be very robust. Certainly not from a July perspective, but certainly looking forward to the next couple of quarters.

And then when thinking about some of your larger conventional customers, say those that may eventually have the scale to switch over to a direct distribution model, how much visibility do you have into the tipping point of such an event, and is there a specific discount that would prevent this from happening?

The question is it's different by retailer, because everybody does it a little bit differently. Some do it by line. Some do it by SKU. Some do it by product category. I would tell you that one of the components to our gross margin contraction is the fact that we are giving up a little margin to ensure that, where it makes sense, we keep the direct. It makes sense for the retailer and it makes sense for us.

But again, going back to the math, for retailers who really want to go through the exercise and you factor in cost of capital, service level, and the differential in the actual captive mark-up versus the UNFI mark-up, in many cases, it's a wash. So direct is not something I'm overly concerned about.

Thanks, Steve.

Thank you. The next question is from Sean Naughton of Piper Jaffray. Please go ahead.

You guys had talked in the past, and I think you gave some of the numbers here, I just wanted to make sure that I understood what you were talking about before around produce deflation and FX, just any comments on those and how those impacted the organic growth rate in the quarter.

Yes, I mean, I talked about, in my scripted portion, that the produce deflation and the continued higher supplier shortages was about 60 basis points on revenue. But we also had Canadian FX and a little bit of additional drag at Albert's. They're a little bit intermingled. But the Canadian FX and Albert's was about 100 basis points. Supplier shortages, 60. So it's 160 basis points between the two, roughly.

That's helpful color. And then just maybe on the gross margin, as well, you gave Tony's was about 47 basis points and then you gave about three other numbers, or three other categories. Were those all roughly equal as a component, or were some of those more impactful than the other two?

Tony's was 47 basis points, fuel was 12, FX on a basis points was --

But he's talking on the gross margin side. I would say, Sean, in that respect, I would tell you that the ones that we carved out were all sort of double digits. But we typically don't break everything out from that standpoint, because it can shift from time to time. I would tell you that of the items that we discussed, the fuel surcharges dropping off, due to the decline in diesel prices, was probably the biggest after the Tony's. But I wouldn't want to give specific numbers, only because there's a little bit of estimation involved as to where you would have finished the year versus where we actually had it come in.

Okay. That's helpful. And then just real quick, on your outlook for fuel moving forward, I think you do lock in some of the contracts, should we expect to continue to get some basis point benefit for the remainder of the year?

Yes. What I would tell you is that the way we've got our contracts right now, we'll get -- some of the benefit that we captured in the third quarter, obviously dependent upon where fuel moves from here, but we would continue to track it somewhere along the same rate. And if fuel prices were to stay at these levels for an extended period of time, our current locks run out at the end of calendar 2015. So if prices are where they are, we'll get a portion of the benefit and/or have a little bit of a headwind through the end of the calendar year.

Okay. Thank you.

Thank you. The next question is from Scott Van Winkle of Canaccord Genuity. Please go ahead.

Hello. Thanks. First, a follow-up on a couple other questions about the two new customers shipping in July. Just to make sure I have it clear. These customers were doing no business with UNFI either on natural, organic or with Tony's, so they're incremental to all segments of the business?

The answer is a little complicated, but both customers were doing some business with either company. But it's a significant amount of incremental difference.

Okay. So if they were doing a little bit of business, say with Tony's, they're getting -- Tony's is getting a lot more business, as well as you're adding on the natural organic specialty side.

Yes.

Excellent. Okay. And then as we look at the Q3 growth rate by channel relative to what we saw in Q2, obviously the channel shift we're seeing and expanding distribution and supermarkets en masse explains independents, and we saw the Whole Foods comps. But the deceleration in year-over-year growth that we see in the supermarket, obviously in Q2, you took a step down as the big currency hit from Canada, as well as the Safeway Texas change. But this quarter, another deceleration. Is there anything incremental? I know currency's a little bit worse. Is it just the softer category environment or what was different in Q3 than Q2? And obviously, we saw a lot of this stuff in Q2, as well.

Scott, I think it just got softer.

Yes.

I wish there was a silver bullet. Everybody's been looking for it. We haven't found it. I think it just got softer.

And then when you talk about the improvement going into the fourth quarter, I think modest improvement in growth we saw in the press release, is that across all channels or was that more specific to one channel?

No, that's across all the channels. We saw things start to pick up -- adjusting for the shift in Easter, we saw things start to pick up towards the end of March, beginning of April -- and as we got towards the end of April and continued into May, we've seen that. Now we're still dealing with some of that. We still obviously will have the FX headwinds in the fourth quarter, and we're still seeing some of the deflation challenges with Albert's. But as we look at the broad line business, we've seen a nice acceleration. And on a consolidated basis, we're probably in the 40, 50 basis point range, without the new business being layered in yet.

Great. Thank you.

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

Hello. Thanks for taking my question. I guess just following up on an answer that you gave to Meredith's question, you indicated that you saw the slowdown, I think you said, a while ago. I don't remember exactly what words you used or what time frame you used. But yet you did continue to accelerate facility openings and square footage growth. So I guess the question I have is, in hindsight, was that the right decision? Because while you are, as you said, no more than 200 miles within 80% of the US population, it's not totally clear that that population is shopping at a retailer that's supplied by you. So can you maybe give some color on that? And then I guess the second question I would have as a follow-up is do you have any flexibility on capacity, if you needed to flex your capacity utilization?

Well, on the first question, Karen, I would tell you we100% made the right decision. Because without the capacity, we can't take on new customers. And we knew that. And we would have gone at the same speed and we would have built the capacity for the refrigerated space that we need for our fresh platform. And these decisions are decisions that you make years in advance. And so if we saw a slowdown six months from now, that ship has already sailed. Because the shovel's in the ground, we own the land and these projects are two years in coming. So it's not like you can shut it off on a dime. But the major point I want to try to make is it's 100% the right decision to invest in the buildings the way we have.

Now, on the other side, if we don't see some improvement in our top line sales number, in other words, going back into the double digits, would we slow our continued capacity expansion? For sure. Because we would wait until we started filling the capacity a little bit longer, to make sure that we have the customer pipeline or the product pipeline to utilize the capacity.

On the second point, in terms of flexibility, the way capacity usually works is if you build it, they will come. We will find a way to fill and use the capacity, rest assured.

And Karen, I would just add one other thing, when you asked about the right decision on the DCs. We generally build the models from a sales growth standpoint quite conservatively, so that to the extent there is a deceleration in the sales growth rate, that buildings still have a good return. So usually, we're targeting the buildings to have a return in under five years. And in most cases, we've exceeded that. If we saw the sales growth moderate and stay at that pace, we'd be roughly at the five years that we target.

And the other -- just one other interesting point, Karen, is when you look at cost to serve, the majority of the buildings that we build have a very fast payback, just based upon the elimination of miles. So when we fold out these new DCs, we're doing it in a way that allows us to eliminate the thousands of miles to get from point A to point B. So generally speaking, these buildings have less than three to four year payback.

Okay. You gave some very helpful metrics, I think, in the beginning of the call on that. I may follow up offline on that. I guess the second question I have is can you maybe give a little color on the organic growth rate in, say, non perishables versus Tony's? And then on Tony's, I think, Mark, you had said that now the number, the dollar amount that you give on Tony's includes any SKUs, product that you're now supplying out of your legacy UNFI DCs. But do you have an organic growth rate on Tony's versus an organic growth rate on non perishables or legacy SKUs?

Karen, I'm not sure -- I can try to answer that offline. I'm not sure that I can -- I'm not sure that I understand the question, but I don't have a breakout between the non perishable. We'd have to cut it a different way than the way we usually present things to answer that question.

But I would tell you that to, I think, the second part of the question, there is not a significant amount of volume that is being served by Tony's at this point in time that was in legacy UNFI DCs or vice versa. To the extent that we're combining, we tend to be merging the loads versus having one DC or the other handle what was previously served by the other division. Does that help on the second part of the question?

Yes, that helps. I guess I'm just trying to get a sense of how much, in terms of your organic growth rate, the slowdown is related. I can obviously do it as a percent of sales, but it seems like there's a pretty meaningful deceleration in the legacy, non-Tony's UNFI component of the business.

I mean, you're looking for us to break it out beyond the 6.7? That's what I'm trying to make sure I understand the question.

Yes, yes. Beyond the 6. 7, or like 5.9 for supermarkets, 3.2 for independents and 9.8 for super natural.

Okay. Sorry, Steve and I are both looking at each other. I'm not sure I'm following the question.

We can follow up offline. That's okay.

Okay.

Thank you. Our next question is from Scott Mushkin of Wolfe Research. Please go ahead.

Hello, guys. Thanks for taking my questions. So I wanted to look at the pricing issue. If we do, in our pricing surveys, we definitely show a lot of your customers priced meaningfully above some of these people you mentioned, Steve, that are taking share. So I guess my question for you is what can you do to help your customers price more effectively in the market? That's number one. And then my corollary to that question is Wegman's, which is a customer of yours, doesn't price meaningfully above the direct guys. And what's the different between Wegman's and maybe the independents and Whole Foods, what's Wegman's doing differently that's putting them in a better position in the marketplace?

Well, on the first questions, what can we do to help them on price, and there's really not a whole lot we can do to help them on price. What we can do is we can help to make sure they have the right items. So if a new retailer in the space carries three of the most popular organic cereals and they try to compete price for price on those three items, they can't win. But what we can do is we can make sure that they have the right highly distinctive SKUs that have a greater ingredient offering, that's more differentiating within the geography, that provides consumers something different. That's what we can provide. And that's what will propel the independents forward over time, other than a migration to perimeter.

As it relates to Wegman's, I can't really comment on what any individual customer is doing. In the case of the Wegman's stores, they're trying to satisfy a wide variety -- and this is my opinion, not fact -- they're trying to satisfy a wide variety of consumers, just by the size of the store and the magnitude of the product offering.

I think also that there is a narrow assortment in some of the retailers that presently we're not playing with. We have an opportunity, as well, to work with the independents around innovation and local brands. And that's something that we've spent a lot of time and have deployed resources to put our independents, particularly, in a position to win there.

And on the private label side, obviously Kroger is probably the 800-pound gorilla right now, with their Simple Truth line. And now Target's moving in with Simply Balanced. Is there something you can do for your operators, particularly the independents, and maybe some of the regional supermarkets, to help mimic what's going on in the private label area?

We have actually a very robust private label program for independents. It grows 20%-plus a year. It's one of the fastest growing organic non-GMO brands within the indie space. And so it's a great product for the independents to use to compete head on with both of those brands.

And then I guess my next question, and I'm trying to understand the numbers a little bit, is that the super natural channel accelerated, I believe, just a smidge, yet the biggest component of that, I believe, is Whole Foods and they clearly decelerated quite a bit. So I'm trying to square that. Also, I know there was some kind of -- you guys had a charge or something like that, I'm not sure it was out of the sales numbers last time. I'm just trying to square that we don't have an inventory problem building up some place in the channel, because the numbers seem to be going in different directions a little bit.

Go ahead, Mark.

I was going to say, I would say just in the super natural channel, it's only Whole Foods, just as a point of clarification there. But I don't know what -- when we had the adjustment last quarter, what it would have done to the number ex- that. But I would tell you that we saw some acceleration on our part of the business; and again, our quarter doesn't necessarily completely overlap with what they're seeing. So whether they were stronger in the center of the store or by virtue of the shift with what they reported versus where we're covering from that time frame, can't fully explain it. But we did see it pick up a little bit in this quarter.

We also get the benefit of new store openings, as well as our continued rollout of prepared foods, fresh foods.

To them. And then finally, Steve, on acquisitions, you talked about the capacity you built out and the Tony's acquisition. Is this an area of fresh? Is this an area where we'd like to do more? It's not something you commented on, but I would think it must be.

Yes, for sure.

And what's you're capacity to do it?

So we're going to look at M&A across ethnic gourmet. We're going to look at M&A across fresh and M&A in Canada. And we have a tremendous capacity to do it. We've got a really strong pipeline. It's just a question of waiting for the right time and making sure that we can buy it at the right price, because we typically would not overpay for a company, even if it was the most strategic company on Earth. But we've got to pay a fair price.

So I think that I'm really excited and optimistic about where we are from an M&A perspective. And the easiest way for us to really fully build out the fresh platform is through M&A.

And balance sheet capacity, you think you have it? You're decently levered, not hugely levered. Where are you comfortable going to? And then I'll yield. Thank you.

We would historically go to around 3 times, where I think we ended the quarter at under 2. So I think we've got plenty of room on our balance sheet to do it.

Perfect. Thanks for taking my questions. Really appreciate it.

Thank you.

(Operator Instructions)

The next question is from Vincent Sinisi of Morgan Stanley. Please go ahead.

Hello. Good afternoon. Thanks very much for taking my question. Wanted to ask a little bit more longer term here, in regards to your sales force. I know you said you have over 1,000 sales associates. And the first pressure this quarter that you guys had called out was the speed at which some of these products are being adopted, a challenge that you're not primarily serving, at this point. So is there anything that you can or maybe are or will be doing more from the sales force perspective to see what you can do to get some of those channels not your primary right now, but to let them know what you are doing more from the infrastructure, as well as from the assortment standpoint?

Yes, I mean, we have separated out a sales channel specifically for ethnic gourmet, for the simple fact that there are a lot of ethnic gourmet retailers that we don't have a relationship with today. And so we carved out that channel. We have a new sales force that specifically calls on them. And that way, we can really track our performance and we're very optimistic about our growth there.

The same thing applies to fresh. We'll be building out our sales channel for fresh, as we have the appropriate SKUs across the country. And if you look at our fastest growing customers, that's obviously where we're spending the most amount of time. And we're pretty fast to adapt, and we've done a lot of it already and we'll continue to do it. Fortunately, we have a lot of resources out in the field.

I think also that we do have opportunity, as it relates to collaboration, with respect to the selling teams that are in the field around thinking about the portfolio of companies within UNFI versus solely (Inaudible). So we believe that there are some other opportunities there.

Okay. That's helpful. Thank you. Just as a quick follow-up, in regards to the Tony's infrastructure, I know that as you said in the past, you continue to roll these products further across the system. Any updates this quarter, just in terms of the distribution points that maybe since last quarter, you can give us a little bit of an update there?

We made a very conscious decision to be very proprietary about how we release that information, because, as you might expect, there is a competitive part of that question that we'd just rather not talk about which DCs and when. But you guys know the DCs that we fill with refrigerated capacity, and those are going to be the markets that have the greatest speed to market with this group of products.

Okay. Fair enough. Thanks very much.

Thank you. The next question is from Kelly Bania of BMO Capital Markets. Please go ahead.

Hello. Good evening. Just wanted to follow up on the acceleration into the first couple weeks of the fourth quarter. Just curious if you could comment on how much of that is being driven by just a change in volume or if there's any change in price? And I guess I ask because I was kind of surprised to see your inflation on a net basis accelerate sequentially, particularly given some of the deflation in some of the produce that you've mentioned. So I was just curious if it's any change in pricing there that we're seeing or if it was a volume pick up? And if it was a volume pick up, was that in the core business or Tony's?

Yes, Kelly, and I would tell you that while we did see some deflation challenges with Albert's, given their portion to the overall business, it did not have a meaningful impact on our overall inflation number. And what we've seen in the fourth quarter, some of the increases that we saw from an inflationary standpoint in the third quarter were in place for a good part of the quarter. So these aren't recent price increases. They sort of started in the March time frame. So I would tell you that what we're -- barring some major changes when we get to run the data when we close the month -- I would tell you that most of what we're seeing now is volume and not price in the first four or five weeks of this quarter.

Okay. That's helpful. And then as we think about your comments about just trends in the center of the store clearly reflected in your core growth rate relative to some of the perimeter categories more reflected, I guess, by Tony's growth rate, are you seeing that similar trend across all three channels? I guess the mix of your business with those channels is different, but do you feel like that slowdown was comparable in the center store categories at a similar rate with all your channels?

Yes, I mean, I would say that it certainly appeared that way. We didn't see anything that was noticeable. There may have been instances with an individual customer. But when you look across the broad swath of customers in each channel, it certainly appeared that it was across all the channels.

Okay. And then just lastly, if I can just squeeze in one more big picture question, as you think about some of these retailers that have gained some shared that primarily source direct, as you think about getting back to that faster double-digit growth, do you think you need some other channels or parts of, say, the supermarket channel that have lagged in catering to the shift, whether it be either the drug channel or second tier supermarkets that haven't shifted toward natural and organic, or perhaps dollar stores or mass market stores, do you need those other channels to maybe replace what has maybe eventually been lost to these direct sourcers of natural and organic?

I don't think so. The reality is we sell most of them, to one degree or another. I think when you look at our capabilities on internet fulfillment, which is pretty stunning, we expect some pretty spectacular growth in that channel over the next couple years. And again, my opinion, as I look out over the next year, year and-a-half, there's been this massive migration. And it's just not mass and drug. It's convenience store. It's so many points of retail. We were looking at an organic item here in the room that came from a hard goods retailer. Home goods. Home goods.

And so I believe that we're going to get to a point where a lot of these retailers, non conventional, in other words, non conventional organic and natural retailers, who have run to add SKUs are going to wake up one day and say, wait a second, these items, they don't move as fast as we'd like. And so I think that a lot of those SKUs are ultimately going to find their way back to UNFI. I think people are reacting to what they think is customer demand, and they're placing the SKUs into stores and retail points that, if you were to ask us five years ago whether 7-Eleven would have an organic protein bar, we would have said it's probably not going to happen.

But will there be enough demand to keep the products in those types of retail points? I think that the answer is probably not. And we will get an influx of the items back to within our distribution network. When it happens, I'm not sure, but I believe that that is what will take place.

Thank you.

Thank you. And our final question comes from Andrew Wolf of BB&T Capital Markets. Please go ahead.

Thanks. Just want to follow up on the sales cadence again. So Mark, you said it's 40 to 50 bips. Is that off the 6.7 internal sales growth?

Yes.

Okay. And I just want to make -- it hit the bottom early April. So it's been --

Adjusting for where Easter shifted, yes. So we had to adjust our numbers to reflect having Easter be earlier and having a strong week and a good week there and a little bit of softness into April. But you take those weeks into the mix and adjust accordingly and it tended to be the end of March, beginning of April.

All right. So if I were to plug that 7%, let's say, into my model, get to the higher end of sales, and to get to the higher end of the implied Q4 EPS looks like operating profit would turn up and still on the lower internal sales than you guys have been running. So what explains that? Have you adjusted operations more towards a current high single digit internal sales growth, where before it was geared to double-digit, or is something else is going on in the gross profit line? I'm just trying to understand. It's a good thing. But I'm trying to understand why that would be.

Well, I mean, I think that, Andy, there's an element of it where certainly some of our DCs were still getting up to speed. We had some -- we'll have some of the benefit in the fourth quarter associated with the new Twin Cities location versus where we were, and we're moving business that was handled from other locations into that facility. So we'll get some benefit there. But yes, we've certainly -- we certainly, as we've had turnover within the DCs, if we're not growing at the same rate, we're not replacing all of those heads.

Steve mentioned before that when we saw things -- certainly it was a much greater degree in 2008, 2009, but when we saw sales growth slow, we started managing the expenses based on that run rate. So we've taken that approach going into the fourth quarter, and we started addressing it during the third quarter. But again, it happened much more quickly than we anticipated, so you weren't able to completely keep pace in the third quarter.

Okay. And Steve, back to the -- is it the $100 million, that's net incremental with two small customers who are mainly Tony's customers? I'm trying to piece the narrative together to understand the new business.

We're not going to help you there, Andy.

Okay. All right. Worth a shot. Could you tell us what's getting displaced? Is it direct getting displaced or is it other distributors or another distributor?

It's other distributors.

And lastly, Steve, just as you want to take this strategy national, obviously, this seems like a good incremental win and good news, but what -- in your mind, what would be a tipping point announcement in terms of size?

And also, I just wanted to ask you about profitability. Even on the $100 million, that is something where it's incrementally at the corporate rate and how this business will trend, it is something, if you do get some big wins down the road, either in existing infrastructure or with M&A assisted, what the profitability looks like.

It would be hard for me to comment on the profitability of any one customer. I'm not sure that would be fair to talk about that. I think that the tipping point is to continue to slowly but surely win new pieces of business in the geographies in which we've built the capacity. And the second side is to make the right acquisitions that we can fold in to the buildings that we built the capacity for.

So I think those are the two areas that I would kind of refer to as the tipping points. Our Albert's business, we've converted to run up underneath our Tony's fresh platform. That's now completed. And so now we have a produce, a protein, a cheese, an added value fresh product offering in a large swath of the United States. And I would look forward to additional customer wins, and I would look forward to some pretty interesting M&A within the space.

Okay. Thank you.

Okay. Thank you, everybody, for joining us today for our third quarter 2015. We look forward to speaking with you again for the conclusion of our FY15 and our guidance on FY16. Thanks and have a great day.

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.