United Natural Foods Inc (UNFI) 2016 Q1 法說會逐字稿

Greetings, and welcome to the United Natural Foods' first-quarter FY16 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 for opening remarks. Thank you, Ms. Turner. You may now begin.

Thank you. Good afternoon. By now you should have received a copy of the first-quarter FY16 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 Mike Zechmeister, 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 discussed in these forward-looking statements.

In addition, in today's earnings press release and during today's call management will provide both GAAP and non-GAAP financial measures. These non-GAAP financial measures include net sales, operating income, earnings per diluted share, and free cash flow. A reconciliation of these GAAP to non-GAAP financial measures can be found on the Company's investor site.

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

Thank you Katie, and welcome to our call this afternoon to review our first-quarter 2016 results.

First, I'd like to welcome Mike Zechmeister to UNFI as our new Chief Financial Officer. Mike brings over 20 years experience at General Mills in a wide range of responsibilities including M&A, Treasury, operations, shared services, financial planning and IT. Some of you have spoken with Mike already, and he is planning on getting out to meet many of you as we participate in the upcoming investor conferences. I can't think of a better time to have Mike on board than now, given the Company's opportunities that lie ahead.

Before we start talking about the market dynamics facing our industry, I think it's important to briefly talk about what brought us to where we are today. And as many of you know, UNFI's sales grew at a compounded annual rate of almost 13% from FY05 to FY10 and 17% from FY10 to FY15. UNFI's operating income grew at a compounded annual rate of almost 10% from FY05 to FY10 and 16% from FY10 to FY15. And in FY15, or last year, our sales grew 20% and our operating profit grew 15%.

During these periods of time, UNFI invested in infrastructure, enhancements to our technology platform including a new national warehouse management system, transportation management system and inventory planning, demand planning system, while building out what we believe to be the most efficient network of national distribution centers in North America. These investments directly resulted in vastly improved service levels to our customers. Over the same time period, FY05 to FY15, our operating expenses as a percentage of sales decreased 322 basis points.

What this highlights is that significant change and evolution is part of UNFI's DNA. Whether it is related to rapid top-line growth, acquisitions, deploying new technology, or managing significant shifts in consumer behavior, we understand change. And history has proven that UNFI has the capacity to adapt to evolving market dynamics while growing at the same time.

Now, I believe we can all agree that we are operating in a rapidly evolving environment. We all know that consumer preferences for healthier food options have been changing for the last several years. In fact, the acceleration that has taken place over the last 6 to 12 months has been spectacular. This is demonstrated by the significant and rather recent increase in the number of retail options for consumers to purchase natural and organic products.

As a result, we have seen an increase in competition across every retail channel and corresponding competition within wholesale distribution and supply chain. Private label natural and organic products, which we estimate at approximately 30% of the retail market, is growing extremely quickly and center store is under pressure as consumers choose fresh and healthier options.

Throughout the 1990s and up until 2014, our industry was a niche. There is no doubt that today we are mainstream. There's very compelling upside here. I believe that as there continues to be more demand for our products today than there was a year ago, and we believe the macro demand for healthier eating options should continue to grow 7% to 11% for the next decade. This rate of industry growth is considerably higher than most adjacent food-dominant channels and 2 to 3 times the growth of conventional products.

Additionally, the overall industry growth rates do not currently reflect the rapid adoption of natural proteins, specialty cheeses, and clean ingredient based prepared foods. We believe this trend is very good for UNFI. While there is a significant evolution taking place at the supply chain in retail level, we believe the overall demand for our products will trump the short-term dislocation of price, sales growth and customer mix.

Also, there are several other important dynamics that we expect will continue over the next several years. M&A will play an accelerated role in the consolidation of manufacturers and producers within natural, organic and specialty. M&A will play an accelerated role in the consolidation of food retailers, driven by cost reduction and differentiation. Gross margins will continue to decline as competition increases both at retail and wholesale, forcing a greater reliance on differentiation, efficiency, and scale.

Retailers will need to further define their model as demand moves to the perimeter. High quality food ingredients and health will also continue to play a major role in the lives of our consumers, and in turn the products that consumers buy, whether the brands are private label or well-known national brands. And to that point, consumers will increasingly depend on UNFI, with its food quality assurance programs, to be vigilant on their behalf in offering food products that clearly and simply are what they're advertised to be.

UNFI will continue to be you acquisitive with a strong pipeline. We have developed strong integration processes and a culture of valuation discipline, resulting in successful integrations of our acquisitions.

So, having provided this important industry backdrop, I believe there are extremely compelling dynamics that will continue to propel UNFI forward despite the short-term softness in some of our customer channels and the increased competitive pricing pressure we are experiencing. One. Three years ago UNFI appropriately changed its strategy to migrate its distribution services to include fresh and perimeter. This building out the store strategy was followed by a $250 million investment in fresh-ready distribution centers, capable of handling national multi-temperature storage and the ability to deliver highly perishable products.

Our strategy to further migrate to the perimeter was again highlighted by the acquisitions of Tony's Fine Foods. UNFI is now distributing fresh perimeter-based products at an annual run rate of approximately $1.3 billion per year, making UNFI one of the largest marketers of fresh to retail in the US. During the first quarter, our fresh business across Tony's and Albert's compared to the prior-year period was affected by protein price deflation of approximately $7 million. Strong categories with over 15% growth during the quarter compared to the prior-year period were organic eggs, fresh-pressed juices and natural proteins.

I continue to be extremely bullish about our future in fresh as we integrate these products into our distribution centers and continue to look for attractive acquisition opportunities within this space. While the current revenue contraction we are experiencing is difficult, we believe that the longer-term 12 to 24 month growth horizon looks extremely compelling, based on our proven strategy to build out the store through expansion of current customer relationships, new customer wins, and M&A.

Two. Our scale and our close proximity to the consumer, as well as the cost advantages they bring to the retailer, will continue to drive long-term growth. UNFI has built out what we believe to be the most dynamic and efficient model for slower moving retail products in North America. The very concept of slower moving inventory means that there has to be a sophisticated supply chain capable of moving these products around the country in an expeditious but economic manner to keep service level high while minimizing inventory on hand and freight costs for our retail customers. This provides us with the ability to win new customers and expand our relationships with existing customers into fresh, gourmet ethnic and additional product categories.

Our sales strategies include using our very unique operating platform to deliver meaningful product, service, and cost deliverables across mass, conventional, e-commerce, independents, food service and drug and specialty retail channels. We believe that the short-term disruption based solely on price without any consideration for service, product on shelf, quality or infrastructure is not a sustainable practice for retailers.

Based on our $785 million in annual contract renewals at Kroger, National Cooperative Grocers, Ahold, Del Hayes and others we announced today, we believe they agree with us. Additionally, as you know, we recently announced a modification extension of our contract with Whole Foods through 2025. We are very fortunate to have bright, innovative and driven customers committed to taking back share across our rapidly changing retail landscape.

Ethnic gourmet, e-commerce and food service are channels remain extremely bullish on, and are resourced to grow. Our food service channel grew 29% in the quarter, represented 5.5% of our total net sales. In addition, our e-commerce business grew by almost 26% over the prior-year quarter and now represents approximately $170 million per year. Ethnic gourmet remains a channel where we continue to look for growth opportunities organically and through acquisitions. There are markets around the country that demand the new distribution option for these products, and we expect UNFI will be there to answer the call.

We anticipate UNFI brands will continue to grow rapidly. Our Field Day independent exclusive brand is on path to be a $50 million brand, growing 66% in the quarter. Our Woodstock production facility is now producing private label snacks for Publix, Costco, Trader Joe's, Market Basket, Roundy's and others. We are really excited by Field Day's position as the 23rd largest brand in natural, and Woodstock as the 22nd largest brand in natural.

Innovations will drive differentiation at retail. With the mass acceptance of our products, UNFI's ability to find, create, distribute and merchandise new and exciting products will be a significant part of our strategy. Historically, approximately 10% of our annual sales growth has been associated with the introduction of new products. We believe we have the data, the supply chain, and the infrastructure to bring these products in the fastest and most efficient method through DSD, e-commerce, redistribution, or cross-doc. Innovation will also continue to define our continued focus on driving efficiency throughout our organization as we continue to reduce our operating expenses as a percentage of our net sales.

Our first quarter was a difficult start to our fiscal year. As we've discussed during our fourth quarter 2015 call, transitioning out of a $400 million distribution contract would be complicated, and in fact it was. Inventory, service levels, manufacturer promotional activity leading up to the change and other factors led to several unintended but necessary costs. We believe we serviced the customer in an exemplary manner through the termination date and are managing a difficult restructuring that resulted in a charge of $2.8 million in the quarter. The charge reflects costs incurred related to severance payments and other transitional costs consistent with our extremely important culture of doing what's right. And this was completed while delivering our customers the highest service levels in over three years during the most critical time of the year. We had previously announced a restructuring charge in the amount of $4 million to $5 million, and expect to take the balance of the charge in the second quarter.

Our first quarter also reflected challenges in Canada associated with continued FX and an inability to pass through price increases to retailers at a rate that kept up with the further degradation in the exchange rates. Additionally, our first quarter was impacted by a customer bad debt expense in the amount of $1.8 million.

Despite revising our annual guidance based on current trends, which Mike will share with you shortly, we've made terrific strides towards improving our free cash, which we expect to be in the range of $80 million to $100 million this year. And our balance sheet remains strong with over $250 million of liquidity, positioning us well to take advantage acquisition opportunities that may present themselves.

2016 will be a transitional year for us as we continue to execute against our proven strategy of building out the store while transitioning out of a significant contract and expand more rapidly into fresh. I am of confident in UNFI's ability to deliver long-term growth, driven by a significant advantage in scale, supply chain sophistication, customer diversity, proven fresh strategy, data-driven service offering, innovation, balance sheet, and a strong history of performance and execution. I'm incredibly proud of our team of associates, all driven to discover what's next while adapting, evolving and continuing to deliver an exemplary service offering to our incredible customer base.

Now I'll turn the call of to Mike to provide some additional financial detail. Mike?

Thanks, Steve. And good afternoon, everyone.

Net sales for the first quarter of FY16 were $2.08 billion, which represents growth of 4.2%, or approximately $84 million over the first quarter last year. Our overall sales growth for the same period was approximately 6.8%, excluding the impact of the termination of the Safeway Albertson's contract. Inflation moderated for the quarter, as it decreased 37 basis points sequentially, coming in at 2.44% versus last quarter.

From a channel perspective, super-naturals net sales outpaced overall sales growth, up 7.2% over the prior year's first quarter and represented 34% of total sales. Supermarkets' sales declined 3.3% in Q1 versus the prior year and landed at 25% of total sales. Adjusting for the customer contract termination, supermarkets' sales increased 6.3% in Q1 over the prior year. The independent channel grew 3.4% in the first quarter over the prior year, and independents represented almost one-third of our sales at 32%. Finally, food service sales were up 29% over the prior year, and represented 5% of sales.

Gross margin for the quarter came in at 15.1%, an 89 basis point decline over the prior year's first quarter. Sequentially, this was a 28 basis point decline over fourth quarter gross margin of 15.4%. The decline versus fourth quarter and prior year's comparable quarter was due to the impact of continued weakness in the Canadian dollar, the reduction in a fuel surcharge, moderated supplier promotional activity and a shift in sales toward lower margin sales channels.

Our operating expenses for the quarter improved to 12.5% of net sales, or 12.4% of net sales excluding the $2.8 million in severance and other transactional costs associated with our restructuring plan. This compares to 13.1% for the same period last year. Included in our operating expenses was also $1.8 million charged to reserve for the impact of a customer bankruptcy out west. Excluding the restructuring and the customer bankruptcy impact, the operating expense as a percentage of net sales improved 78 basis points over Q1 last year.

For the quarter, total fuel costs decreased by 15 basis points and was -- and as a percent of net sales in comparison to the first quarter of FY15 and represented 54 basis points of distribution net sales. Our diesel fuel cost per gallon decreased by approximately 18% in the first quarter versus the same period in FY15, while the Department of Energy's national average fuel was down approximately 33%, or $1.22 gallon compared to Q1 last year. Share-based compensation expense was flat on a dollar basis versus last year at $6 million in the quarter, representing 29 basis points of net sales compared to 30 basis points in the quarter last year.

Operating income for the first quarter was $53.9 million, down $4.5 million from the same period last year. Our operating margin in Q1 was 2.6%, a 33 basis point decline over the first quarter of FY15. Excluding $2.8 million in restructuring costs in the first quarter of FY16, adjusted operating income decreased $1.7 million versus the same period in FY15. As a percentage of net sales, adjusted operating income for the first quarter of FY16 decreased 20 basis points to 2.7% compared to the same period last year. Contributing to the operating margin decline was also depreciation of 12 basis points driven by investments in new warehouses and technology and 9 basis points from the customer bankruptcy.

Interest expense for the quarter of $3.7 million was 15% higher than Q1 of the prior year due to an interest rate swap agreement effective in August on our term loan. As communicated previously, we expect this swap will effectively fix the interest rate on the remaining term loan and will be -- which will be approximately 3% dilutive to EPS for the year.

For the first quarter of FY16 the Company reported net income of $30.1 million, or $0.60 per diluted share, a decrease of approximately $2.9 million over prior-year's first quarter. Excluding $2.8 million of severance and other transactional costs in the quarter, adjusted net income was $0.63 per diluted share. The customer bankruptcy was also a $0.02 headwind to diluted EPS in the quarter.

Inventory was $1.08 billion, an increase of 10% compared to first quarter, due primarily to inventory build associated with the addition of one new distribution center and the phased inventory build at a second distribution center, as well as our commitment to improve service levels compared to first quarter last year. Days sales outstanding for the first quarter was consistent with the prior-year first quarter at 21 days, and a decrease of about 0.5 day from fourth quarter of FY15. Capital expenditures were approximately $8 million, or 0.4% of net sales for the quarter, with the largest portion related to investment in our new facility in Gilroy, California. For the first quarter of FY15 capital expenditures were $27 million, or about 1.4% of sales.

Outstanding lender commitments under our credit facility were $583 billion at the end of the quarter, with available liquidity of approximately $252 million including cash and cash equivalents. Our leverage at the end of the first quarter improved to 1.65 times on a trailing 12-month basis, which was the lowest level since the third quarter of FY14 just prior to the acquisition of Tony's Fine Foods. We generated negative free cash flow of $2 million in the first quarter as we built inventory in anticipation of holiday season. Free cash flow performance was $124 million better than last year's first quarter, where capital spending was also higher. Our 12-month trailing free cash flow was $43.7 million, and we anticipate generating $80 million to $100 million of free cash flow in FY16.

As discussed in this afternoons' press release, we are revising our guidance for FY16. We expect net sales to be in the range of $8.4 billion to $8.6 billion, which represents a 3% to 5% increase in total sales over FY15. Our previous guidance was $8.5 billion to $8.7 billion. In addition, we are upping our diluted earnings per share guidance for FY16 to a range of $2.73 to $2.84. Our previous GAAP guidance was $2.80 to $2.93 per diluted share. As a reminder, included in the FY16 earnings guidance is an estimated $4 million to $5 million of restructuring charges, of which $2.8 million were incurred in the first quarter.

At this point, I'll turn the call over to the operator to begin the question-and-answer session.

Thank you.

(Operator Instructions)

Our first question is from Meredith Adler of Barclays. Please go ahead.

Hey, guys. Hi, Mike. Nice to meet you.

Hi. Thanks.

First, I'd like to just ask you about this pipeline of acquisitions, and within that I understand the third largest specialty distributor, DPI, was bought by private equity. Does that change the outlook for you being able to do acquisitions, and what else is out there?

Hi, Meredith. It's Steve. The DPI would not have been on our list for a variety of reasons. But there are a ton of specialty, ethnic gourmet, fresh. Fresh across probably five or six or eight different channels. And so our pipeline is really strong. We got done making the Tony's acquisition 16 months or so ago. We feel like we're ready to do another one. We feel that the valuations for us are still realistic. So I'm extremely optimistic that we're going to make some good progress there. But in answer to your question, I don't think that the DPI affects us at all.

Thank you. The next question is from John Heinbockel of Guggenheim. Please go ahead.

Hi, guys. It's actually Steve Forbes on today.

Hey, Steve.

As it relates to gross margin and the 90 basis points of erosion during the quarter, were the four impacts you mentioned [within] these in order of magnitude? I guess if you could just touch, which of these headwinds were the greatest relative to your original expectations in the original guidance you laid out back in August?

Thanks, Steve. The four items listed there were not in order of magnitude. The FX was probably about 7 basis points, the fuel surcharge was probably about 15 basis points and the rest was split between the last two.

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

Hi. Steve, thanks for all the color you gave today in general just on the landscape. I guess, I kind of had a bigger picture question. So you talked about changing your strategy to focus on fresh. But I guess what I'm not clear about is when I look back on your mix of perishables and produce going back to 2010 versus 2015, the mix really hasn't changed at 20% of sales. I guess my question is, maybe I'm not looking at the numbers properly or maybe there's been a change in how you define different categories, but when I look at the mix by category, groceries actually increased a lot from 47% to 54% and perishable produce has kind of stayed at 20%-ish, 21%, 19%, 20%-ish. So I guess, is there anything with that, the way you kind of categorize? But what do you think perishables and produce can grow to over the next several years, because that's obviously a big focus? Thanks.

Karen, I'm not sure what level of detail that you're looking at. I'm not sure whether those numbers are just broad line.

It's your presentations that you give at various -- whether it's --

I'm not sure that those numbers -- we'll have to take a look at that. I'm not sure that those numbers actually include an integrated Tony's. Because our actual percentage of perishable, if you include Tony's which is 100% perishable. And so you just do the basic math of Tony's at about $900 million embedded in our $8.5 billion. It's going to significantly shift those numbers. We'll take a look at that.

As far as where we think fresh can grow, in a dollar perspective, because the product is so much more expensive than center store, even though on a case-by-case basis if we grow our cases in a similar way that we grow grocery, our dollars are actually going to grow three times faster. Because the average case in grocery's about $15 and the average case in fresh is probably $50, $50 to $60. And so when you look at our M&A, we'll have a heavy dependency on fresh. When you look at the way we roll fresh out across the country, that's going to have a pretty big influence in each one of the DCs that we put it into. So the lion's share of our growth over the next couple years will be typically we'd call fresh, or anything that's heavily perishable.

All right. Okay. That's helpful. Thanks.

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

Hey, guys. I had a question, and maybe I missed it you because I was doing a couple things. I wanted to ask about current trends. First off, current trends, I don't know if you've made any comments on it, but I'd love to hear where things have been going lately.

The second thing, Steve, it goes to some of what you said in your presentation or in your thoughts. It seems to me that the demand for slow moving items is growing at the grocery store, or even in the mass channel. It seems like you guys have the best group of assets to deliver this. Yet there's like a disconnect. Why isn't there more wins, more contracts? It seems, broadly speaking, you have something that the food-at-home channel really needs. So maybe you can kind of square that, too.

Scott, the first way to look at that is during the last quarter we secured in contract extensions about 43% to 45% of our business. That's a staggeringly large number that's been keeping us pretty busy. But I think you're 100% right. I think that we will find a way to use our infrastructure, selling it to channels that we don't currently have a position in, regardless whether it's a specialty retailer or a mass retailer or a drug retailer. Because based upon our network, our closest to the consumer, the ability to get access to the SKUs, they're all very well set up to bring down direct retailer cost of goods by a significant amount, just by eliminating LTL shipments. So that is a part of our -- what we're looking to do long term. And I think it will come. It's just right now the whole industry is evolving. And we're not only evolving with it, but despite a rough first quarter, I think we're better positioned than anybody to take advantage of the change.

As far as the trends. Yes, Scott, we're -- what we're seeing right now is in line with the revised guidance that we presented today. And I think it's important to note that, keep in mind that our revised guidance of 3% to 5% assumes no big contract in this year but we had it in last year. So if you were to adjust the contract, the $400 million out of both years, that 3% to 5% becomes 7.5% to 9.5%. And so depending upon how you look at it, that's kind of the way we've decided to give the guidance. And the current trends are certainly well within that number.

Okay. But that's -- you haven't seen any -- we've been hearing maybe that things have improved lately a little bit. Are you guys seeing that at all, or not really? And then I'll yield.

We're only one period into the second quarter. I think it would be premature to comment on that.

Thank you. The next question is from Rupesh Parikh from Oppenheimer. Please go ahead.

Thanks for taking my question. Steve, I wanted to go back to your comments in your prepared comments, just about increasing wholesale competition and competitive pricing pressures. Is that strictly related to the Albertson's contract loss or has something gotten worse recently?

No, I think it's pretty consistent with the Albertson's termination. But we live in a different world. So we're going to have to do what we historically have done very well, and that is to bring down the cost at a rate that's greater than the decline in the gross margin. And certainly if you look back over the last couple years we've done a great job of doing that. And as I look out over the next couple years we're going to have to do an even better job of doing it. But have every confidence that we can. Because as I said in the commentary, Rupesh, nobody's gross margin is going up. And so our challenge is to keep it -- keep the decline moderated and make sure that we can bring the cost down and be really efficient.

Okay. Thank you.

Thank you. The next question is from Mark Wiltamuth of Jefferies. Please go ahead.

Hi, Steve. Just wanted to dig in a little more on the margin commentary there. Is it the margins are coming down with the new contracts, or is it more of a mix effect as we look at this year's new guidance?

I think, Mark, it's a combination of both. There's a little bit of noise in there around the Canadian FX that's affecting our margin. That we're probably going to get to a more normalized number as we get into Q3 and Q4 because the comps are more similar. But I think it's a combination of both.

As far as the channel shift, that's going to be lumpy. So I think directionally you're spot on. It's going to be a combination of both. I don't -- Mike, if you have anything to add on that.

On the currency side, we've got a headwind year over year of 60 to 65 basis points on the top line and about 15 basis points to the gross margin.

And the other thing I would add is there is a cyclical nature to manufacture and promotional spend. It really is at the very highest level, when sales are good there's less promotional activity. When sales aren't so good, there's more. I think what complicates it for us in the first quarter is that we just had so much transition in our inventory as we transitioned out the $400 million. Once we get through the second quarter, we'll be in a much more normalized state.

Okay. And just on your renewals that you announced, was any of that incrementally new in terms of sales volume? And on Kroger in particular, since you did call them out, was there an uptick in that one versus what you were doing previously?

Yes. I mean, we're not going to get into any of the specifics of any of the customer contracts. And when we're in a position to talk about a material win, you can rest assured that you guys will be the first ones to hear it.

Okay. And as we're heading into holiday here, how's the out-of-stocks look?

This is Sean. Actually, we look very solid. We've delivered through Thanksgiving a very high level of service, roughly in the range of 80 basis points better than last -- FY15's Q1.

Okay. Thank you very much.

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

Hi, thanks for taking my question. Steve, I was hoping you could remind us just the profitability of the growing fresh business versus the center of store business? And if you think over the next of half decade, is the expectation that fresh can easily grow for you guys much faster than it pressures center store, like you were I think indicating in your earlier comments? And then related or separately, can you also just maybe update us on the self-distribution trends for the supermarket customers? Any changes there? Thanks.

Sure, Robbie. The fresh profitability, what drives the profitability for us in fresh is delivering more to the customers that we're already going to. And so the beauty of rolling out fresh is that we get a significant increase in our overall earnings growth and the more moderated growth in our operating margin. Because it's a more expensive case that we might work on a lower gross margin, but the actual operating profit dollars associated with delivering that case is much higher, and that's just purely the math. And so I think prior to us giving revised guidance for over the next three years, which we've committed to doing before the end of this fiscal year, I would say if you look back on previous years and some of the disclosures that we've given, you'll see -- what I hope to see is an increased overall operating profit growth with a more marginal operating profit percentage growth. And that's just the nature of selling more expensive inventory.

On self-distribution, I haven't seen a lot of change in movement to self-distribution. As a matter of fact, we've had a great deal of success in moving some customers away from self-distribution. I mean, if you take a look at the $785 million in contract extensions, a large percentage of those contracts have (technical difficulties) self-distribution options. I think it's something that we see as retailers having a tremendous confidence in the services that UNFI provides that they just can't do themselves.

Great. Hey, thanks very much, Steve.

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

Hi. Good evening. Thanks for taking my question. I was wondering if you could just elaborate on the comment on increased competitive pressure, and where you really see that and what the strategy is to kind of work through that, I guess?

Yes. I mean, so Kelly, the increased competitive pressure is across a pretty wide berth. So because so many more retailers carry the product, so the retailers themselves are competing with one another on the supply chain side, many more are wholesale distributors, direct, et cetera, et cetera, are carrying the product which is making it more competitive. And so I think as you look at UNFI, as I said earlier, our margin certainly isn't going to go up as we renegotiate these contracts. The challenge for us is to make the distribution system and the supply chain related to it more efficient.

I think that because we've gone from a niche to something that's very mainstream, I think the natural occurrence across, whether it's a at the retail level, at the wholesale level, at the supply chain level, it's going to become more competitive, whether it be for services or whether it be ultimately for the price to the consumer. For us the point of differentiation is one, having the scale to be the low cost producer. Two, having the products and the data to make sure that the retailers are carrying items that are differentiated, and they're not necessarily competing for exactly the same item. And then three, is the strategy to be really good at ethnic gourmet and fresh, which I think at least today are a little bit protected from the [doggie-dog] world of what's the price on a box of Kellogg's cereal. So it's differentiation. It's scale and service.

Thanks. And just to follow-up on that. You talked about the size of the fresh business. Any color on the size of the ethnic gourmet business right now? You've talked about the potential in the past, but where does that stand at the moment?

It's a pretty significant opportunity for us today because we, I think the last calculation is we had, less than 3% market share in ethnic gourmet. And ethnic gourmet in size, and don't hold me to this exact number, but I think it's -- at retail it's about $70 billion. And so at wholesale it's probably, I don't know, $40 billion to $50 billion, or something like that.

Two-thirds of that.

So it's still much more fragmented than natural and organic, much less direct, a lot of small players across the country. And so it's just a tremendous opportunity for us. And we don't have ethnic gourmet in every market. So we'll do that organically and we'll do it through some pretty good M&A as well.

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

Hi, good evening. Just on fuel, I think if I remember correctly it does hurt the gross margin, which you called out. But I think nets out at the operating income line. I guess the first question is, first, is that true? And then secondly, how are you planning the rest of the year just in terms of some of the assumptions that you're making in the model, just around fuel, FX, and the outlook for inflation? Thank you.

Sean, your comments were right. The fuel surcharge impacts net sales and gross margin, but then the reduction in the cost of fuel comes in at the operating margin level for us. So the 15 basis points or so affected the net sales as a headwind and also gross margin. But then the purchase, the fact that diesel is coming down, is allowing us to buy cheaper and offset that to a large extent. Looking forward, it's hard to tell what that market's going to do. But we're in a position to continue to capitalize on the lower fuel costs moving forward.

Sean, I would add one other comment. This is one of those quarters where we just couldn't get a break, because not only did we lose the fuel surcharge because the price of fuel had come down so far, but for those of you who have followed us for a while, we historically book somewhere around 30%, 40% of our fuel in a forward contract, or a hedge, at or less than budget. And so right now we're facing a situation where the fuel price is now considerably lower than our --

Booked.

Booked trends, right. The actual rack price is lower than our hedged price. And we don't have the fuel surcharge. So we're a little bit naked on probably 30% of our fuel, which, listen, it was the right decision and if we could plan where fuel was going, we'd be in a different discussion. But that did have a fairly significant impact on us during the quarter. But it is what it is.

Understood. Then anything on the -- just how you're planning the business on FX and what you kind of see in the business for inflation right now? I think Steve you had mentioned that Tony's is obviously, felt like that was a little bit deflationary in the quarter.

Yes, I mean, Tony's we had some deflation in protein and specialty cheese overall. I think our inflation rate is somewhere in the 2% range, 2.5%.

Yes.

And that's probably going to be where it goes over the balance of the year.

I think that's right. On the FX side, as we get into February the comps from a currency standpoint get to be a little more in line with what we're seeing today. So we would expect the FX impact to minimize beginning around February.

Okay. So you're just kind of holding the current rate kind of where it is at this point on the Canadian dollar?

Yes.

Okay. Great. Thank you.

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

Hi, thanks. A couple of follow-ups. Steve, first on all the contract extensions you talked about. Even if you exclude Whole Foods, you're talking about well over 10% of your non-Whole Foods business was renewed this quarter. Is there a reason why it's happening so quickly in a short period of time?

And then the second question, or follow-up, is if you -- could you give us the numbers if you excluded all of your Albertson's business this quarter, would revenue growth have been 2%? Because if you look at the guidance of kind of 3% to 5%, it would look like you're assuming a little better internal growth, all normalized in your guidance than what you reported in Q1.

Okay. Yes, Scott, we'll talk about that. So the renewal, it really wasn't a factor of that we did something to push all this to happen. I think a lot of it was just the timing was right to do it, both at the customer level and on the UNFI side. Certainly there was some M&A in our customers. So they felt it was important to get a contract renewed. We're obviously, in an evolving industry. And so I think all the parties involved wanted to ensure that they had a longer-term contract.

So I wouldn't say that it was really unusual, but I think we were just very -- the timing was right, that we were fortunate to be able to extend as many contracts as we were able to which obviously, gave us a tremendous amount of comfort and confidence in the fact that so much of our customer base sees the real value in what we do. And not only in terms of what we've done but what they see us doing in the future. As it relates to the revenue growth, I think Mike's going to comment on that.

Yes, there was a lot going on in the quarter with the transfer of the inventory over to Safeway Albertson's. So that was done at landed cost, which was actually a little dilutive to their earnings. But overall I would say it's not a material impact on our margins.

Do you know the -- can you give us the revenue contribution from Albertson's in the quarter? Obviously impacted by the wind-down, but I'm wondering how significant that was as we try to remove that from our forward estimates.

I don't think we know that.

Certainly wasn't material, but I think -- do we know the number without Albertson's in the quarter? Scott, I don't think we have that with us.

Okay. We'll follow up. Thank you.

Thank you. The next question is from Andrew Wolf of BB&T Capital Markets. Please go ahead.

Hello. Thanks. I missed some of the call, so you might have answered this. But I did hear you were asked about DPI, Steve. Did you get into -- if not, would you tell us, why did you pass on it? I know they do Starbucks and some chains that maybe you're not interested in. But was it a price discipline matter or is it more mix?

Andy, I think it would be unfair for me to get into a lot of detail around our M&A. But like I said earlier, that was not a company that was a good fit for us.

Okay. And then Mike, on the 15 basis points from the Canadian foreign exchange at the impact to gross margin, pretty big number, $0.15 a share. Could you tell us what was that headwind last year so we could get a sense of the swing. And was that $0.15 what was in the budget, or did things get worse this quarter and you had to increase that amount, the 15 basis points?

So first of all, the 15 basis points is a combination of constant currency, the translation part and the transactional impact. I can't speak to what we were facing at the same time last year, although if you go back to Q1 of FY15, the Canadian dollar is about $0.90 and it was probably down a little from where it was the prior year. I can't speak to exactly what that amount was.

I think, Andy, there's really two components to FX issues that we're facing in Canada right now. One is the just purely translational. In other words, the high percentage of products that we buy from the United States in Canada in Canadian dollars. So we've got a translation problem there. The second part of it is in actually being able to pass through the significantly increased prices to the largest retailers in Canada, which we have not had a great deal of success doing. So that's caused a short-term gross margin issue because we just can't pass the prices through fast enough.

Yes, okay. I understand that. Was that $0.15 -- the 15 (technical difficulties) let's stick with your basis point. Was that what you were looking for when you set guidance? I'm just trying to understand. Another way to look at your guidance is you took down sales a little less than 1%, 0.9% across the range. Then you took down EPS 2.5% to 3%. Like a lot of the questions, this question is similar. What got worse, other than in terms of the deleveraging effect?

I think there's two -- I would answer that two ways. I think number one is a lot of the one-time issues that we had in the first quarter, we had in the first quarter, we're not necessarily going to be able to make it up. It's not a matter of that things are getting worse, because we don't think they're getting worse. They'll probably get better, but not better to the extent that we're going to be able to cover some of the issues, the one-time events that we had in the first quarter. I think that's the biggest reason.

The second part of it is, we did have some headwind associated with FX. However, that headwind to a large degree will dissipate as we get into the second quarter just because the comps will go away.

Okay, (multiple speakers) that's pretty spot on to the kind of question I was asking. Thank you.

Okay.

Thank you. The next question is from Stephen Grambling of Goldman Sachs. Please go ahead.

Good afternoon. I just have one quick follow-up to Scott's questions on contract extensions. That's just, can your terms with overridden by a material change of control such as acquisitions? You did mention there's a lot of potential consolidation in the industry. I'm just trying to understand, does that potentially bring up more contracts for you to bid on, or even some of your contracts become at risk? Thanks.

You know, honestly I don't know the answer to that question. I think that some contracts probably do, some don't. Our contracts to a large degree are heavily reliant on the fact that we're either providing value to the customer or we're not. Most of the customers that we have, if not all the customers we have today, are extremely focused on service level, differentiation, data, service, and all of the offerings that we have. And as long as those things are good, the contracts tend to get extended. And so even in the cases where there is a change of control, there's a high degree of transparency and discussion around what happens with our distribution programs forward -- look like going forward. I typically don't worry about M&A and consolidation within our retailers because I think the retailers are all focused on the same things that we are. I think we had an experience last year that was extremely unusual, and I'm not sure that we'll see that again.

Fair enough. That's helpful. Happy holidays.

You too.

Thank you. Our final question comes from Joe Edelstein of Stephens. Please go ahead.

Hi, good afternoon. Thanks for taking the questions.

Thanks, Joe.

Just two questions here from me. The first, Steve, earlier you mentioned just rolling out fresh across the network. And part of that, I'm assuming, you're referring to Tony's. Is the Tony's product something that you think you'll be able to get across the full network this year, within the fiscal year?

No, definitely not. We are going distribution by distribution center and it's going to take us a while. The way we will get fresh across the country is to acquire it. And that's something that is important to me. I think that that's the greatest opportunity for us to further differentiate UNFI across the country.

And I think M&A is going to be one of the best ways for us to do it. May not all in one fell swoop. We might have to bite off a couple pieces here, a couple pieces there. We have a lot of people who know how to do that. They have a lot of fresh in their background. So that's what it's going to take.

Okay. And I guess related to that, could you just remind us really what the Company's target debt levels are? And I'd expect that at least this year you could delever fairly quickly over the course of the full year, and maybe that gives you some added flexibility. But just kind of the net debt ratios that you would target.

Right now we're less than 2 times lever at 1.65. I think we typically have a fairly conservative view of the balance sheet and debt in general. We might run up to the high 2s to make an acquisition, and then fairly quickly pay it off and bring it back down to sub-2. I think you can see that in our historical numbers, but I think it's highly unlikely that we would ever go to more than 3 times levered.

That's helpful for the reminder. And just last question, if I could to squeeze in one more. It was nice to see the operating expenses narrow, and despite some of the challenges to the top line. I was just curious, how quickly you were able to go back, rework some of the distribution routes following the Safeway contract? Just trying to gauge expectations and how much improvement you'd expect going forward? And really, do you think you can hold or even see some operating margin expansion, maybe not this year but in the outer years?

Hi, Joe. This is Sean. Actually, the teams have done a terrific job coming off of the exit of Albertson's and getting routing structures changed. But of course in the context of timing, so it is coming on as we get into the holiday season and we've got many, many customers and want to make sure that from a communication perspective that we're giving all constituents plenty of time before we make and execute any significant changes to delivery times, et cetera. I would say from a distribution perspective, productivity, and in this case I'm thinking about throughput, because we certainly have benefits from the reduction in fuel expense on the transportation line, that we're looking at -- we're running in the range of a 4.5% to 5% improvement in throughput from a warehouse and distribution. So we're looking very solid there.

Thanks for taking the questions, and good luck.

Thank you.

Thanks.

Thank you. I would now like to turn the conference back over to management for any additional or closing comments.

Thank you for joining us this evening. Our industry's evolving. And UNFI's strategy experience, proven history of performance will drive long-term shareholder value. Thanks, and have a great holiday.

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