United Natural Foods Inc (UNFI) 2016 Q2 法說會逐字稿

Greetings, and welcome to the UNFI second-quarter 2016 earnings conference call.

(Operator Instructions)

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

Thank you, Miss Turner, you may begin.

Good afternoon, and thank you for joining us on UNFI's second quarter FY16 earnings conference call.

By now, you should have received a copy of the earnings release issued this afternoon at approximately 4:05 PM Eastern time. This press release and the webcast of today's call are available under the Investors 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 assess 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 release and during the call today, management will provide both GAAP and non-GAAP financial measures. These non-GAAP financial measures include net sales, net income, earnings per diluted share, and free cash flow.

In addition, the Company has made some updates to the channel classification of certain customers. A reconciliation of these GAAP to non-GAAP financial measures and the impact of the channel reclassification to the Q2 2015 reported sales by channel can be found in the Company's earning release issued today, as well as on the Company's investors website.

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

Thank you, Katie. Good evening, everyone, and thank again for joining us.

While UNFI's short-term growth in sales and earnings continue to be challenged, as evidenced by our revised 2016 guidance, our mission remains the same. We are intently focused on managing the controllable aspects of our business as we make strategic investments to improve our sales growth rate and customer experience through the back half of this fiscal year and into FY17.

At UNFI, we're focused on building distribution opportunities with new customers, and expanding relationships with current customers. We believe UNFI's unique ability to provide customers across every channel of food retail will ultimately be the key driver in our future growth.

Our fresh distribution network, our capital structure, our breadth of product offering, and most importantly our people, all contribute to UNFI's very unique position. To add value to customers in an evolving food retail environment.

We continue to execute on initiatives to fuel our growth over the next several years. E-commerce, food service mass and conventional channels in which UNFI has been historically under indexed will become more and more important to us. Utilizing our low cost logistics network to aggregate freight for customers, and having an open mind to think about new ways to help retailers be differentiated in their markets have become an important part of our service offering.

The macro environment for natural and organic will continue to be strong. With overall industry growth estimated at 7% to 9% for calendar 2016, UNFI is uniquely positioned to better capture this opportunity through our building out the store strategy and infrastructure. UNFI should be the access point across every channel and retailer for all or parts of the products and services we offer.

Economics will ultimately drive the retailer decision to include as many product categories as possible into their distribution program. Looking back over the last several years, UNFI grew at a rate that was greater than the overall industry, while in FY16, we will not. We fully recognize the need to move the UNFI back towards growth during FY17, driven by new customer channels and expanding our relationships with a wider variety of products.

Today, we announced several important changes to our organizational structure. It is a change that we believe brings our teams closer to the retailer operator, and will serve as the primary driver towards an exemplary customer experience across all of our companies.

Beginning in August 2016, UNFI will be structured more regionally, with a Pacific, Central and Atlantic region. Each region will have a President responsible for all of our products and services within the territory, including fresh, grocery, wellness, e-commerce, food service and gourmet ethnic.

Territory managers will now sell across UNFI's complete product offering, with a single point of contact for our customers. Technology will be deployed to further enhance the customer experience, as program economics and merchandising drive operator behavior towards a greater share of the store with UNFI. This is very exciting news for UNFI, as we structure resources across the our business to fuel even stronger customer relationships.

M&A continues to be an important part of our growth strategy. Last week, we announced we had entered into an agreement to acquire Haddon House Products Inc. This acquisition is critical to our entry into new customer channels and geographies, with exciting brands, services and products.

Our customers have asked us for a deeper and more robust gourmet ethnic assortment, which we believe we can now deliver. Haddon House has a 60-year history of providing exemplary high touch merchandising services to their customers, and we're looking forward to very quickly moving this model crossed UNFI's customer base while providing a greater array of natural and organic products to Haddon's customers following the close. Once integrated, UNFI will have a complete offering of full-service gourmet ethnic fresh produce, grocery, wellness and e-commerce to satisfy a much wider range of customers.

Haddon House's private label brands include Haddon House, Asian Gourmet, Bella Familia, and Medford Farms, all added a value brands for natural, conventional, independent and gourmet ethnic retailers. Also, the Haddon House acquisition brings UNFI two strategically located distribution centers in Howell, New Jersey and Richburg, South Carolina. These facilities will be deployed to further penetrate our fast-growing northeastern, mid-Atlantic and southeastern markets, some of which are currently over capacity.

With $500 million in sales and 1000 associates, this acquisition is strategic for UNFI. As you know, we have not yet closed on this acquisition. And as a result, we cannot specifically comment on the impact of Haddon in our consolidated results until we finalize the timing of the close.

But today, I am pleased to announce the acquisition and closing of Global Organic Specialty Inc. This fresh perimeter business based in Sarasota, Florida is a distributor of perishable fruits, vegetables, dairy, protein and related products serving the greater Florida marketplace. Global is physically located adjacent to our current UNFI in Albert Sarasota distribution center, and will be integrated into our systems distribution network and organizational structure shortly.

Additionally, the acquisition provides UNFI with additional refrigerated warehouse capacity to further deploy our growth into fresh, serving customers in the Southeast. The acquisition highlights UNFI's continued drive into fresh around the country. I welcome the associates of Global to our family, and look forward to continuing to build our fresh perimeter offering through strategic acquisitions.

Our continued rollout of Fresh in Denver is moving forward with growth of 25% versus prior year, as we expand our assortment to serve a wider group of customers in the market. The announcement of Global significantly moves our timing of Fresh in Florida forward, and will deploy within the next quarter.

During the questions-and-answers session of our call last week, there were several questions raised regarding distribution center capacity. In the near term, costs associated with new distribution centers under capacity will continue to be a headwind. However, capacity creates opportunity which should serve as well as we continue to build out our gourmet, ethnic and fresh product offering.

Our recently completed Gilroy, California facility is now receiving inventory, and will begin delivering to customers during the next several months. I'm very pleased with our performance in the warehouses and on our fleet. Total warehouse productivity is up 7% year over year, and our transportation costs are down 5% while delivering customer service levels and fill rates higher than they have been in the last several years.

We also remain very committed to helping our independents compete in a challenging competitive environment. Field Day, our private label brand specifically developed for this channel of customers, grew over 47% during the quarter when compared to the second quarter 2015 and is now a top brand in the natural channel.

Additionally, we have now deployed over 3,500 iUNFI merchandising and ordering applications into our customers, and continue to engage our retail category management teams with independents driven to create a differentiated product offering. During the quarter, several of our divisions had very strong performance. Our e-commerce business grew 44% during the quarter, and is now a $200 million business annually.

Also our Woodstock custom snacks business grew over 11%, and is now one of the country's leading producers of private label and branded healthy snacks including nuts and dried fruit. Blue Marble brands business grew over 20% during the quarter, and it is now a business with over $115 million in annual revenue.

While I'm not pleased with our performance this year, we're driven towards constant improvement as demonstrated by this team's history of performance. Rapidly changing and evolving industry dynamics require new strategies and disciplines focused on managing the controllable aspects of our business while investing in growth.

Lastly, UNFI's commitment to doing what is right remains strong. During 2015, the UNFI Foundation, focusing on promoting healthy organic food systems, donated over $600,000 to non-profit organizations in 22 US states. Additionally, our associates volunteered over 13,000 hours to service projects, and UNFI donated over 12 million pounds of food through feeding America's network of food banks.

Also, we completed two leave gold buildings, reduced our annual electricity usage by 6% and recycled 17,000 tons of waste. Put another way, we diverted 67% of our operational waste from landfills, a 25% improvement over prior year while improving our year-over-year fuel efficiency by over 2%.

Now I will turn the call over to Mike Zechmeister, Senior Vice President and Chief Financial Officer. Mike?

Thanks, Steve. Good evening, everybody.

Net sales for the second quarter of FY16 were $2.05 billion, which represents growth of 1.5% or approximately $31 million over the second quarter of last year. Our adjusted overall sales growth for the same period was approximately 6.5%, excluding the year-over-year impact of the previously disclosed customer distribution contract and the prior year non-recurring reduction in net sales.

Inflation came in 29 basis points below last quarter at 2.15% in Q2. From a channel perspective, supernaturals net sales outpaced overall sales growth, up 6.7% over the prior-year's second quarter and represented 37% of total sales. The independent channel grew 4.2% in the second quarter versus the prior year, and independents represented 27% of our sales.

Supermarket sales declined 11.8% in Q2 versus the prior year, and landed at 26% of total sales. Adjusting for the customer contract termination supermarket sales increased 6.1% in Q2 over the prior year. And finally, food service sales were up 20% over the prior year, and e-commerce sales grew 44% over the prior year.

Gross margin for the quarter came in at 14.5%, a 31 basis point decline over last year's second quarter, which included the impact of previously disclosed $7.7 million in non-recurring reduction to net sales. Excluding this impact, the second quarter gross margin declined 63 basis points.

Sequentially, second-quarter gross margin declined 59 basis points over the first quarter gross margin of 15.1%. The decline versus the first quarter and the prior-year's comparable quarter was due to the competitive pricing pressure, moderated supplier promotional activity, unfavorable sales channel and category mix, the reduction of our fuel surcharge and the impact of continued weakness in the Canadian dollar.

We anticipate the reduction in fuel surcharge will continue to have an unfavorable impact year over year on gross margin. Similarly, we anticipate the headwind associated with FX to continue but moderate, as we head into the back half of the year and lap the steep decline in the Canadian dollar during Q2 of last year.

Our operating expenses for the quarter were 12.5% of net sales or 12.4% excluding $2 million in severance and other transitional costs associated with the previously announced restructuring plan, and approximately $1 million of acquisition costs. This compares to 12.4% for the same period last year, or 12.3% excluding the non-recurring reduction in net sales.

For the quarter, total fuel costs decreased by 13 basis points as a percentage of net sales in comparison to the second quarter of FY15, and represented 47 basis points of distribution net sales. Our diesel fuel cost per gallon decreased by approximately 19% in the second quarter versus the same period in 2015, while the Department of Energy's national average diesel was down approximately 35%, or $1.16 per gallon compared to Q2 last year.

Share based compensation expense was flat on a dollar basis versus last year at $3.5 million in the quarter, representing 17 basis points of net sales compared to 18 basis points in second quarter FY15. Operating income for the second quarter was $41.7 million, down $7.8 million from the same period last year.

Our operating margin in Q2 was 2.04%, a 41 basis point decline over the second quarter of FY15. Excluding $2 million of restructuring costs and approximately $1 million of acquisition costs in the second quarter of FY16, adjusted operating income decreased $12.6 million versus adjusted operating income for the same period in 2015, which excludes the impact of the prior year non-recurring reduction in net sales.

As a percentage of net sales, adjusted operating income for the second quarter FY16 decreased 65 basis points to 2.18% compared to adjusted operating income in the same period last year. We expect our operating margin as a percent of sales to increase in the back half, primarily driven by fixed cost leverage associated with the additional sales from product categories like produce and supplements.

Interest expense for the quarter was $3.6 million, 1.3% higher than Q2 of the prior year, due to an interest rate swap agreement effective in August of 2015 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 approximately $0.03 dilutive to EPS for the year.

For the second quarter FY16, the Company reported net income of $22.7 million, or $0.45 per diluted share, a decrease of approximately $5.2 million over the prior-year's second quarter. Excluding $2 million of severance and other transitional costs and $1 million of acquisition costs in the quarter, adjusted net income was $0.49 per diluted share.

Inventory was $942 million at quarter end, an increase of 2% compared to second quarter last year, primarily due to increased sales year over year in the period. Second-quarter inventory was $141 million lower than last quarter, as we typically manage to less inventory post holidays, but also delivered a 6/10 of a day reduction in inventory days on hand.

Capital expenditures were approximately $12.9 million or 6/10 of a percent of net sales for the quarter. For the second quarter of FY15, capital expenditures were $28.8 million, or 1.4% of net sales. Outstanding lender commitments under our credit facility were $583 million at quarter end, with available liquidity of approximately $252 million, including cash and cash equivalents. Since quarter end, our available liquidity has improved to approximately $325 million net of today's acquisition of Global Organic.

Our leverage at the end of second quarter improved to 1.55 times on a trailing 12 -month basis, which is the lowest level since the end of third quarter of FY14 just prior to our acquisition of Tony's Fine Foods. The anticipated impact on leverage from the Haddon House acquisition is an increase of 0.7 to 0.75 times on a trailing 12-month basis at the end of Q2. We generated free cash of $106.2 million in the second quarter, which was $89.1 million better than last year's second quarter where capital spending was $16 million higher without the sequential improvement in inventory days on hand that we delivered this year in Q2.

Our trailing 12-months free cash flow was $132.9 million. And as we look forward to the remainder of the year, we are increasing our expectation of free cash flow to $100 million to $120 million from the previous estimate of $80 million to $100 million in FY16.

As announced last week, we revised our guidance for FY16. Consistent with that update, we expect net sales to be in the range of $8.3 billion to $8.4 billion, which represents a 1.5% to 3% increase in total net sales over FY15, our previous sales guidance of $8.4 billion to $8.6 billion.

We also updated our diluted earnings per share guidance last week and consistent with that update, we continue to expect GAAP EPS for FY16 within the range of $2.34 to $2.44. Our previous GAAP earnings guidance was $2.73 to $2.84 per diluted share. As a reminder, included in our FY16 earnings guidance is approximately $4.8 million of severance and other transitional costs, $2 million of which were incurred in the second quarter, and $1 million of acquisition costs we also incurred in the second quarter.

Please note that the anticipated sales and earnings associated with the recently announced agreement to acquire Haddon House and the acquisition of Global Organics are not included in this guidance. While we expect the Haddon House transaction to close in early Q4 of FY16, the closing date is subject to the satisfaction of customary closing conditions and regulatory approval.

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

(Operator Instructions)

Karen Short, Deutsche Bank.

Just to clarify, you actually just said that EBIT margins would be up year over year in the second half. I guess just clarify that, because it seemed that with Gilroy opening in the third quarter, that might be actually further pressure on your margins with further deleverage. But maybe clarify that, and then I had another question.

No, we're not expecting EBIT margins to be up over last year in the back half, and I think our guidance would confirm that.

You said flat originally, right?

You can get there off of our guidance.

Okay. I guess in the call on Monday, you had actually indicated that the second quarter run rate was the right run rate to look to -- obviously, there was some seasonality on that number. So that was actually one of my questions. But I guess the bigger question is, with Gilroy opening in the third quarter, isn't that most likely going to lead to further deleverage?

There's certainly a deleverage impact with opening Gilroy in the third quarter, so that will be a little bit of a headwind for us.

That headwind will continue through the fourth quarter.

Okay. Steve, obviously it seems obvious -- the reporting changes sound interesting. But I guess I'm wondering, can you maybe discuss the training component of the changes to the reporting structure? Because it seems like managers are obviously going to have to expand there product knowledge pretty meaningfully, so is there any risk that the learning curve will be steeper than expected?

In many markets around the country, the retailers will have a fresh, it is possible they will have a fresh salesperson as well as a person that covers the rest of the store. At the same time, there are specialists that are deployed across all the regions representing wellness, produce, protein, food service, et cetera.

So in the new scenario, the amount of expertise within the region actually goes up dramatically. And at the same time, there will be quite a bit of training that goes on just to make people more comfortable selling across a wider range of SKUs. But lot of the talent that is already there will be deployed in the regions, and it makes it much easier for the customer as you might imagine.

Okay, thanks.

Meredith Adler, Barclays.

I was wondering -- I'd would like to go back to something you talked about last week, didn't mention too much here, you did mention it. But I'm trying to understand the vendor monies that have gone down. Is there a difference between the money you get from vendors and forward buy, or do you have to do the forward buy and take the risk on the inventory or buy the inventory to get it?

There's actually couple of buckets that we tend to earn from. Obviously one is forward buy, and when you do not have any inflation, it's very hard to forward buy against markets that are not going up. So that is number one.

Number two is, when a manufacturer runs a promotion with a customer, we frequently manage that promotional activity. In other words, we manage the billing and the bill back, in there is a certain amount of administrative fees, if you will, that we earn on managing those transactions.

So the velocity of those transactions essentially informs gross margin opportunity, and we have seen some shortening, if you will, of that velocity.

Or in other words, the promotional activity within the channels that we are predominantly trading in is lower in the year than we are currently in than it has historically been. It may not always be that way, but it is today.

Got it, okay. Then congratulations on this acquisition. I'm assuming that it is not really a huge acquisition, but I would like to try to understand whether you see it has a template or as a talking piece as you go to do more acquisitions to add more geography. Is there something beyond what it is in Florida that you think will be really helpful?

Thank you for that, Meredith. It is 100% a template for how we will bring smaller companies into our portfolio. This one in particular was perfect, it's a great team, great customer base, great product base, and physically adjacent to our current Alberts and UNFI facilities so obviously the synergy is pretty significant.

But there are many companies around the country that have a very similar profile to Global. Great product, high touch, fresh perimeter, in the right markets for us. And they are not, like you said, as it relates to the size, they are not overly material to our overall numbers, but very material in the particular market in terms of getting us into fresh faster.

And I guess my question would be, has there been any pushback so far in terms of buying other companies like this one? And do you need to wait until this is fully integrated to be able to go out on the road with a pitch, or is that good enough already?

We announced Haddon last week, we announced Global today, we have got a pretty deep pipeline. We do have to phase them, because it would be pretty hard for us to do a lot more than what we are doing at this particular point.

But it is a great model for us. We have the infrastructure, we have the refrigerated DCs, we have the talent that knows how to manage handling highly perishable freight.

And that is a tremendous barrier for most. Being able to handle multiple temperature zones, both on the inbound, storage and outbound, and we already have that infrastructure. So Global we hope is one of many to come in this particular space.

Great, thank you very much.

Andrew Wolf, BB&T Capital Markets.

Just a follow up on Global. It looks like it has a lot of overlapping products or lines with Alberts, but maybe that is not the case beyond produce and a few other things. So when you look at it as a business, is it more of a bringing new customers down to that part of Florida, or is it more bringing new product lines to that part of Florida and maybe perhaps to the rest of the Company?

Yes, it is all of the above, but this one in particular really gives us the ability to one, add space. Our Sarasota facility is pretty close to capacity. We have a lot of fresh customer opportunity within that market where we need the space, and Global certainly helps us from that perspective, and Global has a lot of intellectual capital associated with the acquisition of the products that we need to be selling.

Alberts obviously, is there already and has done a great job building our business in that market. Global will help us even more.

I do not know if you have thought further downstream I guess in perishables, but there's a lot of businesses and a lot of obviously activity towards taking perishable products and making them into a product that millennials will eat on the run, or anyone else will, whether it is a good quality sandwich or prepared food. But is that a business you see that UNFI should either try to get expertise in or buy its way into learning -- getting expertise? Or is that something more what you would want to align with vendors who do that and then distribute that type of finished product?

I think it is probably the latter, Andy. As I mentioned in my comments, our Woodstock custom snack business is growing really nicely.

I am not sure that we're going to want to go down the road of producing sandwiches and baked goods at this point. I think to your point, we would probably rather align ourselves with somebody who already does it really well.

If I could just ask one on your results, the 4.2% gain in the independent channel, that was pretty decent. And that includes some penalty, right, from I think New Seasons and maybe another new leaf. I know those do not meet the threshold of reportability, but could you give us a sense of what that might have been if you weren't penalized by those two businesses?

No, we would not want to get into adjusting, because there's obviously many coming in as well as a couple that actually came out. So I think the 4% was a good number, and I will leave it at that.

Okay, thank you.

Robbie Ohmes, Bank of America.

This is Marie Sullivan on for Robbie Ohmes. I wanted to get back to the Haddon House acquisition that you announced last week, and just see if we can get any more information on the SKU overlap with UNFI, the customer mix and the percentage of sales in fresh versus other areas?

I think we're going to hold off on giving any more color related to Haddon until we actually close. There is a fairly significant product overlap, however UNFI does a much better job in the natural and organic, Haddon does a better job in the ethnic gourmet. So it is a perfect marrying of the two companies in the sense that we will be as good in ethnic gourmet as we are in natural and organic.

Second component of that is, we have always had a full-service, partial service model. Haddon has a tremendous reputation for managing service programs really, really well.

There are some retailers that really believe in the full-service or partial service model, so we are excited about learning that as well. As far as any other specifics, we are going to hold off until we actually close.

Got it. Then if I could just add one more question, on the -- you mentioned in your prepared remarks accelerating the rollout in fresh to Florida. I assume that is just referring to the Global organics not bringing Tony's to Florida in the Southeast. Is that correct, or is that -- ?

No, and actually, remember Tony's trades in the Western half of the US, do not currently in the East. So the answer to your question is that a lot of the products that are currently handled by Tony's will find their way into the Florida market.

Got it. Okay, thank you.

Scott Mushkin, Wolfe Research.

My first one was more of a housekeeping thing. I think in the introduction, there was some mention, and maybe I missed this, a reclassification revenues from supernaturals and independents. Maybe I am just blind, I didn't see it in the release and I was wondering if you could clarify what that was?

Scott, that is going to be -- there will be a reconciliation of that on the website that should give you the answers to your questions you're looking for.

Okay, so It is up there already?

Yes.

Okay, perfect. Then my second question actually has to do with I think Andy talked about independents being pretty strong, and the other thing that look decently strong was that supernatural area. I was just wondering, obviously there is a mismatch between what you guys have going on.

And I know there's a lot of store building and other things, and what the biggest customer that supernatural is reporting. How should we think about that as we go forward? Have you built into your plans a [de-sell] in that because of the negative sales they are seeing, or how should we think of that bucket and the forward projections?

That is one that I just cannot win at, so we're going to stay away from that one. We are pretty confident in that team, and we obviously get the benefit of new store openings. But I wouldn't want to comment any more than that.

Steve, on the 365, are you guys participating in that too? As they bend their growth that way, how does that flow through?

Our distribution program covers 365 and Whole Foods stores, yes.

Okay. So it is the same, but we don't know what is going to look like. Do you distribute their private label, or do they bring that a lot through their own? How does that work?

No, we do their private label today.

You do, okay. That's actually all I had, so thanks for taking my quick questions.

Thanks, Scott.

Joe Edelstein, Stephens.

Last week, you said a number of times, it really felt like things were somewhat temporary. And I was really just hoping to gauge your level of confidence that you have, just how temporary and how quickly some of those factors could really start resolving themselves. And I think most specifically here, I am referring to the lack of the vendor support and whether or not you can see some of those pieces coming back in.

And maybe breaking it down even in between your expectations around hitting some of the sales break points, at which the promotional dollars would automatically kick in. Versus something that might simply be more of a discretionary dollar based on that particular supplier's view into the channel, and where they want to position themselves.

I do not think we can answer that, unfortunately. I think that we need obviously to get back onto a sales growth. You look back at UNFI's last five years, 2015 included in our compounded annual growth rate was over 15% or right around there.

So we have got to get back on our historical growth rate. Maybe it might not be that high, maybe it is that high, I am not sure yet. But first and foremost, I think we have to get back on a growth trajectory.

Promotional spend tends to be lumpy, so sales fall off, maybe the promotional activity falls off. there is always a timing difference between what happens in the promotional activity and what happens in the sales. So at some point, somebody wakes up and says well hold on a second, we are not growing in channel X, we've got to get back to promotion and lo and behold we get promotional activity.

So I don't think we could give you any specific color on when and how, other than that activity tends to be, like I said, lumpy over the course of the year. But first and foremost, we're focused on getting our sales trajectory back, and believe that based on the infrastructure, that we will do it.

Okay. Then specific, Steve, to the existing infrastructure, in I realize that you have some facilities that are running really hot over capacity and others obviously are well below your optimal run rates. But do you have a better sense today versus maybe relative to the same, more or less, the same question that I asked last week. But just how much revenue do you think your existing infrastructure could support if you really were able to hit everywhere at that 80% optimal utilization rate?

I think we have a general idea of what that number is, but again, it is not something that we're going to want to publicly disclose. And the other part of that is, that we have markets that have more capacity than others.

Sometimes you can't pick and choose. But generally speaking, we get an opportunity, we're going to take it.

I would say from an enterprise perspective, in the short term, we are challenged by being under capacity. From an opportunity perspective against the pipeline of prospective, new customers as well as category extensions within existing customers, it is about realizing that opportunity against the capacity. We have a couple of years of runway, notwithstanding specific geographic areas actually that, Steve, you called out in the Southeast primarily where we continue to have challenges today.

Okay. Best of luck filling the capacity.

Thank you.

Kelly Bania, BMO Capital Markets.

I was wondering if we could step back to the guidance that was provided last week. And I know there were a lot of questions about the margin pressure and the sales slow down. But I was curious as you look back just even a couple months ago, it is still unclear to me where the source of that pressure is.

And I was just curious if you wanted to or could talk about where you think that source of pressure is from and i.e., is that traditional competitors within your key natural and organic distribution? Is that other competitors, is it more at the retail level? I think it is a little bit of everything, but are you able to quantify and see where that competition may be stabilizing or accelerating so we can try to get a sense of when the sales will stabilize?

I don't see it as a sales issue, as much as it was a margin issue. Because certainly, if you do the math and you back out a customer loss and some of the things that are happening within our current customers, the growth was while not quite at industry growth, it was still pretty strong. It is really more of a margin issue associated with promotional activity, lack of inflation, Canadian FX, certainly competitive pressure at the retailers, and fuel.

I would say those are the primary drivers, and they all hit us at once and it is just a matter of working our way through them. I do not think the competitive nature of distribution is changing a lot, it has been competitive for a long time and it will continue to be that way. I think what hurt us was more the margin issues than anything else.

On that note on the pullback in promotional activity, why are suppliers pulling back on promotional activity? And how broad based across various suppliers is that, or is there any couple of suppliers or couple of categories that are feeling that more?

Again, this is opinion, not fact. So but it is my view that manufacturers will go to where there is growth, and they will promote where there is growth. So for example, the natural industry has been growing at a slower rate than let's say mass or conventional then perhaps they might make the decision to promote more heavily in those channels than they do in natural.

But and to the comment that I made earlier, some point, somebody's going to wake up and say, wait, we do not have any growth in natural. Our challenge to be more further indexed across a wider range of channels than we are today. That would make us less susceptible to these pretty significant shifts.

That's helpful. And if I could just squeeze in one last maybe housekeeping one for Mike. The acquisition announced today I guess closes today, it sounds like it is immaterial to the guidance for this year. Is there any impact that we should be thinking about for next year for earnings or sales or any color there?

I think you have said that right. It will have an impact on this year, but not enough for us to change our guidance, so we will not be doing that. And as far as next year, and we have not provided guidance for next year yet, but certainly as we do, that will be included.

Thanks.

Rupesh Parikh, Oppenheimer.

Mike, I just want to also to go back to the prepared comments on operating margin expansion. So if I understand that correctly, I think what you were referring to is that you expect the operating margins to be higher in the second half than the first half of the year. Is that correct?

Yes, it was really a juxtaposition against Q2 where they were lower than we expected, so those comments were really about the operating income expansion in Q3 and Q4.

Okay, great. And, Steve, just going back as well to your comments in the press release about making strategic investments to improve the sales growth later this year and into 2017. Is that mainly the organizational, I guess the new organizational structure as well as M&A, or is there anything else that you are contemplating to help drive that?

It is yes to all of the above. It is the newly organized sales structure. It is M&A, it is looking at new channels of growth for us where we historically haven't played. So I think it is a variety of things, Rupesh.

Okay, great. And maybe one final one just on gross margins. And I know you cannot comment on necessarily what is going to happen with some of the supplier promotional activity. But outside of that, is there anything, any other gross margin headwinds that we're seeing right now, are any of those transitory or is it almost a margin reset at this point?

I think when you look at fuel surcharge and FX, year over year, Q2 we had a headwind between the two of about 30 basis points. If you look at it sequentially, it was probably about 12 basis points between the two of them. As you look forward to the second half, if fuel stayed where it is at from a surcharge standpoint and FX stayed where it's at, you'd probably have about a 15 to 20 basis point headwind over last year for the second half on those two items.

Okay, great. Thank you.

Vincent Sinisi, Morgan Stanley.

This is Andrew Verben on for Vinnie. I was wondering if you could talk about the Tony's business? Any color and how it is performing, and any update on the rollout of Tony's products eastward?

I think it is -- Tony's is a business that is doing extremely well for us, great acquisition, a ton of terrific people. As we have said earlier, we have moved the Tony's product categories into our Denver warehouse, and I referenced that in my prepared comments. I'm very optimistic about what is taking place within that facility, and certainly now with what is going to take place in Florida.

Certainly, the reorganization will help us identify for example [protein] and related opportunities in more historical UNFI customers in the West, and the same thing for historical Tony's customers with natural organic in the West. So I would say I have been doing this a long time, and Tony's certainly ranks up there as one of the better acquisitions we have ever done.

Great, thank you. Then, can you talk about how inflation in meats and cheeses may be impacting the Tony's business, and what kind of affects that might have on your overall inflation rate?

We are seeing deflation on the meat side, and that is certainly impacting the overall results. But that business has been able to maintain its bottom line, despite the deflation headwinds that they have faced.

Great, thank you.

Bill Kirk, RBC Securities.

I was curious how much of the deal making and the gross margin declines are designed to help you win new clients, I guess versus better servicing existing customers?

I am not sure I follow that question.

So are the deals to set you up better to win new customers, or to better service existing? And same with maybe some of what looks like some price investment on the gross margin line?

I think it is yes to both. The idea of the acquisition certainly as it relates to Global is to move a much wider array of fresh into the Florida market, as well as give us the ability to attract other fresh customers throughout the Southeast. In the case of Haddon House, it is adding a much more robust line of gourmet ethnic categories of products and brands that we can deploy into other markets and into existing UNFI customers.

Okay. In terms of the new structure becoming a little less centralized, that is happening at the same time Whole Foods model seems to becoming more centralized. Is there a disconnect between the direction of those two strategies?

I cannot comment on Whole Foods, I can just tell you that in our world, all of our things that do not touch the customer today are centralized. Inbound logistics, the way we manage our fleet, and so on and so forth.

But what we are changing is the touch point to the customer and essentially bringing the customer closer to the decision maker. So instead of the customer having to deal with four or five different entities within UNFI, in the new world, they will do with one or two.

I would just like to emphasize as it relates to the functional departments that serve the enterprise, as Steve suggested, supply chain for example, our purchasing strategy which is national, that remains in place. So this is really about the sales organization, the relationship with customers, it is about cross selling our brands, it is about improving our customer experience, pushing the decision making around service and price to the lowest possible denominator, if you will, which is customer facing focus.

That is a good point, that's an important point. That our procurement and fulfillment is already centralized, and that is not changing.

Okay, thank you.

Mark Wiltamuth, Jefferies.

So it's sound like we have got an update on how the fresh is progressing on the West Coast and in Denver, but I'm curious if you are doing any sales out of the Hudson Valley or Racine, Wisconsin at this point?

We have got a lot of activity taking place, but we think it is a little bit of a strategic decision on our part not to disclose where it's going next. Obviously, we are deploying into Florida, we have already talked about deploying into Denver, but we're not going to talk about where we're going to actually go next or be next until we are there.

Okay. Maybe you could also talk about your efforts to get into some these new channels like mass or drug, and how far along you are and how long you think it will take to bear fruit?

It's hard to know. We've got folks that are eagerly working on that, and certainly if it is material or we are in a position to announce it. But we are optimistic, like Sean said earlier, we like the customer pipeline and we certainly like the M&A pipeline.

Okay. Lastly, you'd mentioned on the last call in passing that you had this IT project to consolidate your financial systems. When does that really kick in in terms of the spending, and how many years do think that will run to adjust that?

We are very interested in getting an ERP on board at this point. We haven't made a commitment to move forward with that in the short term.

Okay.

Today, we have a national financial suite, but there is a lot of work we could be doing in terms of shared services. We've got plenty to keep us busy on the warehouse side from a technology standpoint. So that is going to be at least, well I would not want to comment when it's going to take place but it certainly is some of the work we need to do.

Okay. Steve, on the M&A front, should we be looking for more big deals or just a collection of smaller produce type deals to fill in for the East Coast?

It would be -- I cannot really comment on that. We're looking at a wide variety of companies, I would tell you that most of them are not going to be the size of Haddon House. Haddon House was one of the larger ones that was out there, Tony's was certainly larger, so anywhere from Haddon House down I would say.

Okay. Thank you very much.

Thank you everybody for joining us today. Our long-term vision for UNFI remains unchanged. Build out the store and provide our customers and exemplary experience centered around product offering, service, logistics, supply chain, scale and cost.

We look forward to sharing more detail around our outlook towards the end of our FY16. Thank you for joining us this evening, and we look forward to seeing those of you attending Expo next week in Anaheim, California. Thanks and have a great night.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your time and participation. You may disconnect your lines at this time, and have a wonderful rest of your day.