United Natural Foods Inc (UNFI) 2017 Q1 法說會逐字稿

Greetings and welcome to the United Natural Foods first-quarter 2017 earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Halie O'Shea, Director of Investor Relations and Corporate Strategy. Thank you, Halie. Please go ahead.

Thank you, Chris. Good afternoon, everyone. Thank you for joining us on UNFI's first-quarter FY17 earnings conference call. By now, you should have received a copy of the earnings release issued this afternoon. This press release and webcast of today's call are available under the investors section of the Company's website at www.unfi.com. On the call today are Steve Spinner, President and CEO; Sean Griffin, Chief Operating Officer; and Mike Zechmeister, Chief Financial Officer.

Before we begin, we would 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. These risks are discussed in our earnings release and SEC filings. 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, Management will provide GAAP and non-GAAP financial measures. These non-GAAP financial measures include adjusted net sales, EBITDA, and free cash flow. For a reconciliation to the most directly comparable GAAP measures, please see our earnings release or visit our website at www.unfi.com. I'd now like to turn the call over to Steve Spinner.

Thank you, Halie, and good afternoon, everybody. Before I discuss the industry and our first quarter, I want to take a moment to talk about the progress that we have made on our strategic initiatives. We are pleased with the integration efforts of the four companies we acquired since the start of 2016. An integration in some case is moving faster than we expected and I'm incredibly proud of our team involved with integrating these terrific companies into UNFI. From our information technology group, national operations team, finance group, and new associates from Nor-Cal, Global Organic, Haddon House and Gourmet Guru, they continue to look forward and believe in the value of UNFI as an integrated one-company distributor of organic, better for you, fresh and specialty products.

Our acquisitions pipeline remains attractive and we will continue to be prudent and take our time as we evaluate these opportunities. Our Building Out the Store methodology of acquiring businesses that expand UNFI's position in fresh and into adjacent lines of products remains at the forefront of our strategy. Despite deflationary pressures that affect our produce and protein categories, we remain confident that our move towards a national platform serving the perimeter of our retailers stores will prove to be a differentiating and winning strategy for UNFI. I will talk more about deflation during the quarter shortly.

Looking at some of our other strategic initiatives, the sales reorganization was completed at the start of our fiscal year. This brings our sales teams closer to our retail customers, helping us to better tailor our product and service offerings to meet their needs. Feedback from the sales force has been positive and based on our early reads, we are really encouraged. With the sales reorganization, our sales reps are in the stores more, leading to increased and more robust interaction with our customers. We no longer have retail customers being serviced by just Albert's in produce or Tony's in specialty protein; our full sales force is now selling across all of UNFI's products and businesses and providing our customers with a single point of contact to create a more streamlined approach.

During the last six months, we have had some terrific wins, expanding our product offerings with retailers into fresh categories. On an adjusted basis, UNFI's net sales year over year grew approximately 13%, reflecting our continued focus on our Building Out the Store growth strategy. Additionally, throughout the balance of our fiscal year, we will be rolling out approximately $100 million in annualized new customer contracts and expansions of current agreements with additional banners and product categories in current customers. The enhanced sales effort enables us to do more of what truly differentiates us at UNFI and that is to offer our customers innovative, new, and exciting fresh, specialty, ethnic and better-for-you products.

On the supplier side, our UNFI Next initiative is working very closely with new, exciting, and fast-growing smaller brands. UNFI Next is positioned to enable these brands to have their products managed throughout the supply chain. We are developing brands -- we are helping brands develop strategies which move freight into UNFI's distribution network and out into the retailers with merchandising, category management, and brokerage support across our customer base. Additionally, our own Field Day brand is now the eighth largest brand in the natural channel and our Woodstock healthy snacks production facility is making fast-growing private label better-for-you snacks for retailers nationwide. We believe our differentiated product offerings, along with innovation and technology, will provide long-term growth opportunities.

We are encouraged by our ongoing initiatives and our progress along our Building Out the Store strategy, but we would be remiss if we did not acknowledge the challenges facing our industry today. To start with, we see the industry growing at approximately 7% versus the single high-digit, high single-digit to low double-digit levels we have seen historically. This is happening for several reasons. The first is the law of larger numbers. We are no longer serving a retail niche as many of our products are now mainstream.

We also think lower levels of inflation or deflation are also having an impact on overall industry growth rates. In addition, same-store sales have slowed at many of our retail customers as they have continued to operate in a highly competitive, consolidating and deflationary environment. What's more, they are facing competition from more channels and food delivery options such as e-commerce and meal delivery kits. Also, we believe consumer buying habits continue to evolve in a maturing consumer-driven economy, pressuring overall growth rates.

We are working closely with our retail customers as they navigate a tough environment and tailor our service offerings to meet their needs. We believe that in periods of headwinds and a challenging retail environment, retailers will be looking to UNFI more than ever for differentiated products, an infrastructure which enables them to be competitive at the shelf, retail category management based on data by geographical region, and an exemplary one-company sales team committed to growth. Additionally, we believe retailers will deploy capital on store execution, store design, fresh product selection, and resets to meet the needs of a changing consumer; but we are certainly not immune to the industry headwind.

We experienced meaningful deflation in the quarter when compared to the prior year. The impact of deflation for us is quite difficult. We experienced 13 basis points of deflation in our first quarter. However, when compared with the year-ago period when we experienced inflation of 2.44%, or 244 basis points, the year-over-year change is significant. With 250 basis points less inflation over pricing this quarter, we worked just as hard, had the same costs, but with less revenue in gross profit to offset it. If the inflation in the first quarter had been in line with the year-ago levels, which was comparable to our historical trends, our net sales would have been more than $53 million higher.

The impact was felt most severely in our produce business, which had deflation of about 7% of the quarter and led to additional complications and challenges in integrating our newly acquired produce business. To highlight why this is such a headwind, as an example, and this is only as an example, if a year ago, a produce case was a $20 sale, with deflation in the current year, that same case was $18.60 today assuming 7% deflation.

If our gross margin is the same on that case, at for example 20%, we earn $4 in gross margin on that case a year ago but only $3.72 today. However, our costs behind delivering that case remain the same. While we don't believe the magnitude of the deflation or the lack of inflation is a long-term issue, it may continue throughout the next several quarters.

We continue to view our produce and fresh acquisitions at highly strategic and important despite the deflationary pressures across many of these product categories and we remain vigilant towards Building Out the Store. Our strategy is proven and we will continue to grow our national fresh platform. Given the deflationary challenges we are experiencing, we also must be vigilant in controlling costs in a difficult operating environment and maximizing gross margin. We have a structure and a plan in place to ensure that we are executing against both.

In summary, some of the industry challenges we experienced in FY16 have continued into this fiscal year, but we remain confident in our full-year outlook. We believe it incorporates the ongoing operating environment with heightened competition and little to no meaningful improvement in inflation. At the same time, it reflects our continued commitment to, and confidence in, our ongoing strategic initiatives, as well as growth and opportunities with our retail partners.

Now, I will turn the call over to Mike to provide some additional financial detail. Mike?

Thanks, Steve, and good afternoon, everyone. Net sales for the first quarter of FY17 were $2.28 billion, up 9.7%, or approximately $202 million over the first quarter of last year. Excluding the year-over-year impact of the previously disclosed customer distribution contract termination, our adjusted net sales growth for Q1 was up 12.9%.

We estimate acquisitions contributed approximately 8 percentage points to net sales growth this quarter, excluding the impact of our global organic business, which was fully integrated into our Albert's business in Q4 of FY16. Keep in mind that as the fiscal year unfolds and our recent acquisitions become more integrated into our core business, our ability to separate their financial impact will diminish commensurate.

As Steve mentioned, we experienced modest deflation of 13 basis points in Q1 versus Q1 of last fiscal year. This represents first-quarter deflation -- this represents the first quarter of deflation for UNFI in at least seven years. The Q1 deflation was comprised of modest inflation in our center-of-the-store categories combined with deflation in the perimeter categories such as produce, meats, and cheese. They Q1 deflation represents 16 basis points of sequential decline versus fourth quarter of FY16 and as Steve mentioned, a 257 basis point decline versus Q1 of last fiscal year.

From a channel perspective, supernatural's net sales were up 4.6% over the prior year's first quarter. The supernatural channel represented 32.8% of total UNFI net sales in Q1, which is 159 basis point reduction in net sales concentration versus the first quarter of FY16. Supermarket channel net sales increased 13.5% in Q1 versus first-quarter of last year and landed at 28.6% of total UNFI net sales, up 0.9 percentage points from 27.7% in the first-quarter of FY16. Excluding the customer contract termination, supermarkets grew 26.3% in Q1 versus first-quarter of last year, due in large part to our recent acquisitions.

The independent channel grew 10% in the first quarter versus Q1 of last year and represented 27.3% of total UNFI net sales. Food service sales were up 8.1% in first quarter compared to Q1 of last year and eCommerce net sales continued strong growth, increasing approximately 22.4% over the prior year's first quarter.

Gross margin for the quarter came in at 15.32%, a 20 basis point increase over last year's first quarter. The increase versus the prior year's comparable quarter was driven by our acquired companies, which tend to generate higher gross margins by providing more value-added services than the majority of our other businesses. Despite the year-over-year improvement in Q1, gross margins continued to experience headwinds from moderated supplier promotional activity, competitive pricing pressure, and a reduction in fuel surcharges in the quarter.

Our operating expenses for the quarter were 12.98% of net sales, a 46 basis point increase compared to the first quarter of FY16. It's driven primarily by increased expenses from acquired businesses. In Q1, we also had increased expense related to depreciation, amortization, and accruals for incentives, which was largely offset by the improved operating leverage resulting from the increase in net sales.

For the first quarter, total fuel costs decreased 11 basis points as a percent of net sales compared to the first quarter of FY16 and represented 43 basis points of distribution net sales. The Department of Energy's national average price per gallon for diesel in Q1 was down approximately 5.5%, or $0.14 per gallon compared to the first quarter of last year. Sequentially, our total fuel costs in Q1 were down two basis points as a percent of sales versus Q4 of last fiscal year. Sequentially, the market price for diesel fuel increased $0.02 per gallon versus Q4 of FY16. For Q1, our diesel fuel costs per gallon benefited relative to market prices from fixed-priced contracts that covered a portion of our diesel fuel.

Share-based compensation expense represented 29 basis points of net sales in Q1, which was flat versus the first-quarter of FY16. On a dollar basis, share-based comp expense was up $0.7 million to $6.7 million compared to $6 million in Q1 of last year. Operating income for the first quarter was $53.3 million, a decrease of $0.6 million, or 1%, from the same period last year. Our operating margin in Q1 was 2.34%, a 26 basis point decline over the first quarter of FY16. EBITDA for the first quarter of FY17 was $74.6 million, an increase of 5.6% from $70.6 million in the same period last year.

Interest expense in Q1 of $4.5 million was approximately 21% higher than Q1 of last year, due primarily to additional debt resulting from the recent acquisitions. In September of 2016, we reduced the interest rate on our term loan by approximately 75 basis points. The term loan had an outstanding balance of approximately $130 million. This helped reduce the average rate on outstanding debt to 3.08% in Q1, a reduction of 33 basis points versus the first quarter of last year. In addition, our percentage of fixed rate debt increased to 55% in Q1 versus 38% in Q1 of last year as a result of $150 million of new, pay-fixed and received floating rate swaps that we entered into in June 2016.

For the first quarter of FY17, the Company reported net income of $29.2 million, or $0.58 per diluted share, a decrease of approximately $0.9 million over the prior year's first quarter. Total working capital at the end of Q1 was $1 billion, up 0.9% versus first quarter of last year on net sales growth of 9.7%. Our Q1 inventory days on hand improved versus last year's first quarter, driven by system improvements that helped us better forecast our demand.

In Q1, we remained disciplined with our capital expenditure decisions, landing at approximately 9.2% -- sorry, $9.2 million of CapEx spending, or 0.4% of net sales. This compares to the same rate of 0.4% of net sales in the first quarter of FY16. Outstanding lender commitments under our credit facility were $887 million at quarter end, with available liquidity of approximately $435.5 million, including $13.5 million of cash and cash equivalents.

Our debt to EBITDA leverage at the end of the first quarter was 1.99 times versus 2.04 times at the end of fourth quarter of FY16. We had negative free cash flow of $16.5 million in the quarter compared to negative free cash flow of $2 million in the year-ago first quarter. This Q1 result was favorable, which was our expectations as we plan to build inventory versus prior quarter in preparation for additional sales over the holidays.

As we evaluate our outlook on the balance of the fiscal year and factor in newly signed business and margin enhancement initiatives, we are reaffirming the FY17 guidance that we provided on September 12, 2016, which included net sales increase of approximately 11.3% to 13.3% over FY16 and GAAP earnings per diluted share in the range of approximately $2.53 to $2.63. At this point, I will turn the call over to the operator to begin the question-and-answer session.

(Operator Instructions)

John Heinbockel, Guggenheim Securities.

Hey, guys. Steve Forbes on for John today. Given the deflationary and more competitive environment you noted in your prepared remarks, has the trend moved in your favor as it relates to customers converting to a direct distribution model, given that they are tied up with a difficult operating environment? With that, are you seeing less margin pressure associated with contract renewal?

In answer to your first question, we have not seen any change on the direct. I would say on the contrary, going back to some of the opening comments that I made, I think we are seeing more retailers focus on improving the in-store experience, resets, redesign and they're deploying their capital into getting consumers into the stores and buying in the store as opposed to further building out their captive distribution network.

Number two, I think it is important that people keep in mind that captive is only a phenomenon that affects less than 30% of our business. Our independent channel, our supernatural channel is not affected by that. Was there a second part to that question, Steve?

No. That is good. As a follow-up as it relates to the sales force reorg, again I know you touched on it, but maybe to clarify, the $100 million you mentioned, was that a direct result of success in early wins associated with the reorg or was that something else?

Hi, Steve, this is Sean. I would not say that -- I would not characterize it one way or the other. Many of these opportunities have been developed over a long sales cycle.

However, I would say that we are encouraged in the early innings as we have just moved to the structure here in our first quarter around some of the independent natural and independent supermarket opportunities as well as expansion in existing customers with new categories that we believe is certainly a result of more an increased frequency of customer visits and more customer proactive work in the regions closer to the customer. The bulk of the $100 million is coming from new customer wins and significant expansion of existing customer relations. Yes.

Thank you.

Chris Mandeville, Jefferies.

Hi, thank you taking the question. Just quickly on a point of clarification, you had mentioned that Global Organics was not in that 8% or so from M&A. Is that correct?

Yes. That is correct, Chris. That is a really difficult number for us to get at because that business was fully integrated. As you know, they occupied warehouse space adjacent to the same building as what we had. Upon acquisition, we brought them, in which makes it impossible, really, to segregate exactly what the contribution was from that business in the quarter. We won't be able to do that going forward, unfortunately, either.

That's fair. Is it possible to disclose the sales that were acquired at the point of the deal?

We did not provide that at the time of the deal.

Okay. Moving on, I am curious seeing how obviously it is a hyper-competitive market at both the wholesale and retail level for that matter. Can you help us understand a little bit, Steve, what you are seeing as it relates to the pace of growth for natural organics, or even separately, fresh for that matter, given the deflationary pressures? What is going on with pricing from where you stand? Is it just promotion, or are we actually seeing some shelf price reductions in certain categories like produce?

Yes. I really can't comment on pricing at the retail level. Obviously, you can't possibly escape the challenges that retailers, regardless of whether they are hard goods, clothing, food, everybody is facing the same challenges in getting consumers into the store.

Unfortunately, there is not really one answer. Certainly you can point to the pressure associated with deflation in meat and produce, but that will be temporary.

We could have a long discussion around are there changing dynamics in the way the consumers buy, whether it is millennial driven, whether millennials are getting married late, whether it is a lot of student debt, whether it is they are living at home, whether they are going to stay in the cities as opposed to buying a house and moving out to the suburbs. I think right now it has got a lot of noise, but given that we have such a significant infrastructure and that our retailers rely so heavily upon us for data, access, supply chain, we feel we are better positioned than anybody to find a way to maneuver through this tough operating environment.

Okay. You've mentioned in the past that I believe fresh is around 15% of your sales. Any update on where that stands now and how fast we should expect that going forward? Is that $100 million that you had mentioned earlier largely within the fresh category?

Yes. I don't know. We actually did not do that calculation. My guess is it is probably hovering around the same. Obviously, deflation just cost us unbelievable havoc in the calculation of our fresh numbers, specifically in the protein category and in produce where we had 7% deflation in the quarter. That is pretty hard to make up.

Okay. Last one for me. I suppose I would have to ask but in terms of the 20 basis points of gross margin improvement, was that largely all related to M&A?

Yes. That is absolutely right, Chris. The increase is certainly fully attributable to the acquisitions.

Even more so?

Yes. Even more so.

Thank you very much.

Scott Mushkin, Wolfe Research. Mr. Mushkin, your line is live.

Sorry about that, guys. Cell phone. If anyone has an iPhone 6 Plus, they are probably having the same defect happening that I am having. The screen does not want to work. Thanks for taking my questions.

I just wanted to poke on the sales growth outlook for the rest of the year. Obviously, some of your bigger customers are having some challenges. Have you guys thought of bringing in more conservatism, as I know Natural Grocers talked about maybe reducing their store growth, Whole Foods has been trimming a little bit. How do you guys think about guidance in relation to sales growth knowing that some of your retail partners are really struggling at this stage?

I think we talked about it a little bit. We have to go out and bring more business into UnFi network, whether it is for acquisitions, whether it is customer expansion, whether it's a single sales force, whether it is in new contracts. We think that we have had a fair amount of success doing that.

I don't believe we think that the dynamics within our existing customer base are going get considerably better throughout the remainder of the fiscal year, but like I said in my comments, I think that we believe that retailers will rely more heavily upon us to use our supply chain, to use our infrastructure, to get product into the market more readily, to get more distinctive items into the markets more readily, to help retailers reset and redesign. That is the only thing that we can rely on to give us some confidence that we can (technical difficulty) that we talked about.

Scott, I'll add to Steve's comment and say in reaffirming our guidance that we certainly look at the run rate that we've got, the inflation or deflation as it is that we are experiencing. We have adjusted our thinking going forward as a result of that and still felt like reaffirming guidance was the right place for us.

As a follow-up -- thanks, guys, for that. As a follow-up, Amazon Fresh has rolled into several more geographies where some of your customers are pretty big. Have you guys looked at that impact and how it builds over time? Any insight there would be great. Then I have one last one and I will yield.

We would not comment on how one retailer impacts another, but we do have a fairly significant relationship with Amazon that we feel pretty good about. Our role is to get healthy, better-for-you products into as many retailers' hands as we possibly can. As Amazon grows, we hope that we can continue to grow with them.

Okay. That is good. That opened up Pandora's Box there. You distribute to Amazon natural organic products?

We do.

Okay. My final question is how do we get out of this tight climate, or this tough climate? I ask this of every company. We know it is tough. How do we get out of it? When does it end? It seems to get tougher and tougher. Thank you.

I can only speak for us. Clearly, there's going to be more consolidation. In an environment where margins are tough, pricing is tough, you have to get bigger, you have to consolidate, you have to take out costs. We, I think, are very fortunate that we already have a pretty significant network. We have a pretty significant and sophisticated supply chain.

Historically, we had always said we have to take out more costs than the decline in the gross margin. I think we have not been able to do that over the last year or so, given the speed at which the dynamics changed. I think we are incredibly focused on making sure we can get costs down in the system, making sure we can continue to consolidate. We think we are in a good spot despite the fact that in this particular quarter and really for the last year or so, the industry has been in a tough place as it relates to what is happening in retail, deflation.

We can wade our way through it. We don't look at the business quarter to quarter, as you know. We think we have the right strategy in place. Building Out the Store is certainly going to get us to a national platform of fresh. I think we have been more successful than most in our M&A strategy. That is going to continue. We have a great balance.

Thanks, guys.

Rupesh Parikh, Oppenheimer.

Thanks for taking my question. I wanted to ask a question on gross margin. We again saw the headwinds related to moderated supplier promotional activity, the competitor pricing and reduced the fuel surcharges. Do any of these pressures go away as the year progresses? I was surprised that last year you also had pressures related to that moderated promotional supplier activity. I thought maybe you would have less challenges as you lap those pressures last year.

Rupesh, we've still got headwinds there. We've still got headwinds and those are listed in order of magnitude. We are feeling the pressure from reduced player promotional activity. You are correct in your assumption that a year ago we also based that same headwind and as we lap that headwind from last year, we are still feeling it. It is still definitely a headwind that we are facing, as well as the competitiveness. Reduced fuel surcharges there, that is an impact to a lesser extent, but that is also on the list.

I would also like to add one comment to Mike's point. Beyond just the promotional environment from an often-voiced discounting perspective as an example where Unified would buy again is the current lack of inflation in this quarter versus same quarter last year. That inhibits our ability to buy against inflation, which from a UNFI perspective is a win on the gross margin line. We did not have that in this quarter.

Okay. Great. For the full year, what is your updated forecast for inflation or deflation?

We did not put that in there but what we are thinking in the range of 25 basis points of deflation to 75 basis points of inflation. That range for the remainder of the fiscal year.

Okay. My final question is, as we look at your full-year sale guidance, clearly deflation is a bigger headwind. It sounds like competitor challenges, are at least as maybe what you thought in September. What is the offset? Is it mainly more contract wins that is helping you maintain that full-year sales guidance?

I think it is nothing we can do about the inflation. It is what it is. It is kind of unparalleled in its size, but we have got to deal with it. I think both Mike and I commented in our comments that there are a couple of things that we can do. We can be extremely disciplined in our cost control. We can initiate several projects that give us the ability to further control our gross margin. We can make sure that the value-added programs that we have in place with our customers, that they are truly adding value and that in some cases customers are paying for them.

I think that to some degree, a tough economic climate puts us in a position where we just have to turn over every rock. That is what we are doing, both in terms of cost and margin and new customer opportunities. We feel pretty good about the $100 million or so annualized that we talked about. We think the M&A pipeline is good.

Again, we don't look at the business quarter to quarter. We look at the business over the course of multiple years and we still see that there are tremendous opportunities ahead for us.

I would just like to add as well that with respect to the change in our structure and regionalising the sales organization under a head of household account manager rolling up to the president, we know that in the first quarter our sales teams have really gotten after it. That is number one. I think that some of the opportunities ahead of us are as a result of that.

Secondly, we don't talk about this enough is that we are providing excellent service, and that when we take a look at a year-over-year perspective, our fill rate was up over 70 basis points from last year from an execution perspective out of our distribution centers. Our on-time delivery and other metrics are improving and really, frankly, I think industry class. Service still today has a lot to do with the relationships that you can retain and win with the retailer.

Okay. Great. Thank you for all the color.

Robby Ohmes, Bank of America Merrill Lynch.

This is Marisa on for Robby Ohmes. Thanks for taking my question. I had some questions on the cost side. Has the cost to serve in the acquired businesses, has that tracked with your expectations? As you have started to integrated the business is more, have you identified areas where you can lower the cost to serve? Any additional color would be great.

This is Mike. The performance of the acquisitions with respect to cost of service is consistent with our expectations. I would also added that in aggregate, we are exceeding our expectations in terms of contributions across the acquisitions. There certainly are synergy opportunities. We expect to have synergy opportunities entered into these. As we integrate them in aggregate, we are pleased with where that is headed.

Got it. I wanted to follow up on Amazon. Is that being captured in eCommerce and other? When did you launch on Amazon?

We have had a growing relationship with them for a long time. I don't think we have ever given any disclosure around where (technical difficulty) tracks in our channel.

I would go back to your earlier question about M&A performance. It is important to note that during the quarter we did fully integrate Global into our Sarasota business. We also fully integrated and transitioned Nor-Cal from their legacy ERP system into our Albert's ERP system. Those two things require incredible heavy lifting that during a period of 7% deflation makes it even more complicated.

Just following up on the data, Amazon is in our eCommerce business, which roles into our other.

Got it. Thank you so much. This has been really helpful.

Zack Fadem, Wells Fargo.

Hey, guys. Can you quickly clarify the $100 million? Is that purely new customer wins or does that also include the expansion of existing customers?

It is both.

Okay. It is both. Would that imply organic sales growth of about 1%, just the $100 million over last year? Secondly, as we think about just your long-term outlook from mid- to high-single-digit sales growth, and then excluding M&A, I am curious how you think about the impact from new customer wins versus building share of wallet with existing customers and how do you expect that to play out this year versus long term?

On the first part of the question, I think directionally, you're probably about right.

Okay.

I am not sure I understand the second part, though.

Just when you think about your long-term growth, I am curious how you think about just the mix of winning new customers versus your opportunity to build out the store within your existing customers, selling more perishables, perimeter items and whatnot. Basically, talk about the opportunity there.

The vast majority of our year-on-year budgeted growth comes from increasing our sales to current customers. We don't budget customers that we have that we haven't won or we don't know that we're going to win. Our new contract, material contract, tends to be very lumpy because you are taking on significant pieces (technical difficulty). I think generally speaking, we use the large win that is one-off and the vast majority of how (technical difficulty) the expansion of current contracts by selling more of what we offer to those (technical difficulty).

Okay. Thanks. That makes sense. I just want to follow up on an earlier comment about grocery industry consolidation and the impact on your business. Is there a standard protocol for what happens to your contracts in the event that two customers combine and -- or maybe you have a contract and someone else has a contract and the two customers combine? I know this has been an issue in the past. I am hopeful you can walk me through how this typically plays out.

I mean, look. Let's use Ahold, Delhaize. We have a contract with both. We have a long history with both. I think it is a great opportunity (technical difficulty) supply chain to further enhance that relationship.

What you can't control when two retailers come together is the number of stores that they close. That certainly is going to happen as retailers come together, as far as the consolidation is to extract cost savings.

There is no black-and-white answer to it. Fortunately, we have great relationships with most of the retailers and at the end of the day, like Sean said, I think service level and quality and being close to the ultimate consumer is what is going to help make that decision.

I would say that if you think about the construct of a win-win, sometimes you renegotiate sooner rather than wait for an expiring contract to come up in an R&P. Each relationship has its own unique characteristics. Generally a win-win is what obviously is in the interest of both parts.

There's plenty of retailers that consolidate and leave the supply decision in the hands of banners themselves. There is no rule that says every time there is a consolidation that there is going to be a winner.

Got it. Thanks. That is really helpful. I appreciate the time, guys.

Vincent Sinisi, Morgan Stanley.

Hey, great. Thanks very much, guys, for taking my question. Just want to ask about the product mix a little bit. I know that some of the commentary you said in the past, you said that in order to win some business, certainly on a contract-by-contract basis you might go into some more of the conventional types of products. Just wondering if you give us an update as a percent of mix today where that is, how that progress is going, and then where you think that, that it might go over time.

The vast majority of our product continues to be natural with some better-for-you ingredients. We don't see ourselves as a conventional distributor carrying conventional type products. That's just not something that we have never articulated as being a strategic direction for us.

We think that the strategy for us still remains in the higher growth categories like fresh, like specialty cheese, like produce and like those products that have a better-for-you ingredients base. The conventional world is pretty competitive, not a whole lot differentiated and contracting. I think we would much prefer to spend our energy building out the store in categories that still have a lot of legs.

The only proviso to that would be in the context of produce, where we believe that our pure organic offering through our Albert's organics business has put us at a disadvantage as retailers have expanded beyond organic on the natural side to add conventional produce. That has inspired us to, for example, largely around the strategic acquisition of Nor-Cal produce. We do expect that we have opportunities on the conventional side in the produce category. We are working through where we go next there.

Okay. All right. That is very helpful. Thank you.

Maybe just a fast follow-up. Just on the M&A outlook, I know you said pipeline remains full. If you could just refresh us on where some of the greatest basic areas of opportunity are? Also on Tony's specifically, at how much of a distribution network has Tony's products at this point? Thanks very much.

The first part of the question is we will continue to acquire businesses that are adjacent to what we currently do, whether it be in specialty cheese or produce or specialty ethnic gourmet. Those are the types of products that we are going to continue to look at acquiring -- those things that further help us expand our Building Out the Store strategy. Pretty disciplined. We don't deviate from it. It seems to work.

As it relates to Tony's, we've rolled out many of those products in many of our distribution centers as we've started taking on anchor customers. But we are not going to get into the specifics of where and the percentage because there is just a competitive part of that, that we would rather not disclose.

Okay.

I would say that just a little bit more color is that the Tony's assortment, specialty cheese, deli, et cetera is available in the Pacific region, the Central region and the Atlantic region of UNFI's distribution plan. Not necessarily in every DC, but certainly in all regions.

Okay. Thanks very much, guys.

Karen Short, Barclays.

Just a couple questions. Obviously your guidance was more or less maintained, but it seemed like D&A came lighter than what we were looking for or what you guided to in the fourth quarter. Any color there? Is this quarter run rate the right run rate to use for D&A? That is my first question.

Karen, in the quarter, depreciation and amortization was $4.5 million higher than Q1 from a year ago. I think that, that is a pretty good number in terms of thinking about run rate for the year.

Okay. Then I guess a couple of questions just in terms of your commentary, Steve, on you continue to evaluate opportunities in acquisitions. I guess the first question is, are you still committed to the $120 million to $150 million of free cash flow? I obviously realize that cash flow number is excluding acquisitions, but maybe elaborate a little bit on that comment.

So you are asking me, are we still committed to the $100 million-plus of free cash flow? I would say the answer is yes.

Karen, just to add, you are correct. Our guidance in September was $120 million to $150 million of free cash flow. In my comments, I indicated that we felt good about where we landed on working capital in Q1 relative to expectations and when we reaffirmed our guidance, the free cash flow number was certainly part of that.

I would just add that from an M&A perspective, obviously, we are integrating four businesses. Two of them are fully integrated into our business systems. We have got a couple of big ones coming up. Ideally, we would like to take a little bit of a breather so we can do some of the heavy lifting that we have to do with businesses that we have acquired.

However, if we are put in a situation where we have to act or we have to lose it, then we will make that determination. I think we've got a pretty good model for attracting the M&A. We've got a pretty good model for negotiating the M&A in a very disciplined way, at least in our view. I think from a timing perspective, we can control that process.

Okay. Just the last question since you gave us the Ahold/Delhaize example. Just to clarify it, because I think there might be a misperception out there. If there is a change of controls, that does not necessarily mean that an entire contract with two separate banners is up for renegotiation or cancellation. I would assume it is entirely dependent on each individual contract, right?

That is correct.

Okay. Thanks very much.

We have reached the end of our question-and-answer session. I would like to turn the call back over to Management for any closing remarks.

Thank you all for joining us this afternoon and we hope that you have a terrific holiday season. Have a great day.

Thank you. Ladies and gentlemen, again, we thank you for your time and participation. This does conclude our teleconference for today. You may disconnect your lines at this time and have a wonderful rest of the day.