Sysco Corporation
Q2 2016 Earnings Call Transcript

Published: 1 Feb 2016

[Operator:]

Good morning. My name is Melissa and I will be your conference operator today. At this time, I would like to welcome everyone to the Sysco Reports Second Quarter Fiscal 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. Mr. Neil Russell, Vice President of Investor Relations, you may begin your conference.

[Neil A. Russell:]

Thanks, Melissa. Good morning, everyone, and welcome to Sysco's second quarter fiscal 2016 earnings call. Joining me in Houston today are Bill DeLaney, Chief Executive Officer; Tom Bené, our President and Chief Operating Officer; and Joel Grade, our Chief Financial Officer. We welcome Tom to our quarterly calls and look forward to his comments in just a few minutes. Before we begin, please note that statements made during this presentation that state the company's or management's intentions, beliefs, expectations or predictions of the future are forward-looking statements and actual results could differ in a material manner. Additional information about factors that could cause results to differ from those in the forward-looking statements is contained in the company's SEC filings. This includes but is not limited to risk factors contained in our Annual Report on Form 10-K for the year ended June 27, 2015, subsequent SEC filings, and in the news release issued earlier this morning. A copy of these materials can be found in the investors section at sysco.com or via Sysco's IR app. Non-GAAP financial measures are included in our comments today and in our presentation slides. The reconciliation of these non-GAAP measures to the applicable GAAP measures are included at the end of the presentation slides. They can also be found in the investors section of our website. All comments about earnings per share refer to diluted earnings per share unless otherwise noted. To ensure that we have sufficient time to answer all questions, we would like to ask each participant to limit their time today to one question and one follow-up. At this time, I'd like to turn the call over to our Chief Executive Officer, Bill DeLaney.

[William J. DeLaney:]

Thank you, Neil, and good morning, everyone. This morning Sysco reported a strong second quarter and a solid first half of the year. These results reflect the continuously improving execution of our portfolio of strategic initiatives by all of our associates. Further, our favorable performance over the past several quarters validates that our ongoing focus on improving our customers' experience with Sysco and increasing productivity in all aspects of our business are key to our future success. From an overall economic and industry perspective, calendar year fourth quarter U.S. GDP and consumer confidence data was mixed as favorable unemployment trends and lower gas prices somewhat offset increased concern about near-term business conditions and global uncertainty. Most recently, the precipitous drop in multiple stock market indices bears watching as it relates to potential adverse ramifications for consumers and our customers. As far as the restaurant industry data is concerned, the overall trend remain reasonably positive amid sluggish consumer spending. According to the National Restaurant Association, December marked the 11th consecutive month of foodservice sales growth. This closes out a strong year for the industry where foodservice sales exceeded grocery store sales throughout the year. That said, both NPD and NavTrak have shown some recent modest declines in traffic trends that we are closely monitoring. With respect to product cost deflation, we saw an acceleration during the second quarter, driven by key center-of-the-plate categories such as meat, poultry and pork, as well as dairy. This trend has continued into the third quarter and we currently believe that deflation headwinds will persist for at least the remainder of the fiscal year. Now, moving to our second quarter results. Total Broadline cases grew 3.4% and local cases grew 2.9%. Sales were up 0.6% despite being adversely impacted by both deflation of 1.2% and foreign exchange headwinds of 1.7%. Gross profit dollars grew 3.4% and gross margin increased 50 basis points. Adjusted operating income for the quarter grew $41 million or 10% compared to the prior year. Adjusted earnings per share grew 17%. And importantly, we had solid execution across the business including the U.S. Broadline. Reflecting on the first half of our fiscal 2016 performance, overall, our team executed well and we are making good progress towards the achievement of our key financial objectives by focusing on the following four key levers. Accelerating local case growth, improving gross margin, leveraging supply chain costs, and reducing administrative costs. Specifically, we achieved the following during first half of the year. Total Broadline local cases grew 2.8%. We grew gross profit by $121 million, expanded gross margin by 36 basis points, and grew gross profit modestly faster than expenses. We grew adjusted operating income 4% or $38 million, and we grew adjusted earnings per share of 7.5%. As we enter the second half of our fiscal year, we have strong momentum in the business. We do, however, need to continue to effectively manage the persistent deflationary headwinds that likely will challenge our performance going forward. Further, we are aggressively reviewing all aspects of our business for incremental cost savings opportunities to improve our financial performance. At our Investor Day presentation last September, we laid out three key results that our three year strategic plan is targeting through 2018. Improve our customers' experience with Sysco, enhance associate engagement, and achieve our financial objectives of increasing operating income by at least $400 million, growing earnings per share faster than operating income, and achieving a 15% return on invested capital. I remain confident that we're well positioned to achieve those goals. And now I'll turn the call over to Tom.

[Thomas L. Bené:]

Thank you, Bill, and good morning, everyone. I'm glad to be joining the call this morning with all of you. In my new role, I'm excited to bring our business operations, commercial functions and supply chain organizations together to drive improved execution and a seamless approach to serving our customers. This approach will better position Sysco to provide exceptional service and support to our customers, and ultimately improve our returns to our shareholders. I'd like to begin my remarks regarding the second quarter by providing an update on some of the initiatives related to our three-year plan and how they have already begun to have an impact on our business results. As we have mentioned before, our insights-based approach to understanding and meeting our customers' needs continues to guide our efforts. Our improved processes and tools in this area are allowing us to leverage our very robust base of information to design a variety of initiatives to improve the retention and penetration of our current customers as well as to accelerate the addition of new customers. And while we have much work still to do, we are beginning to see positive results. For example, during the second quarter, our U.S. Broadline operations delivered case growth of 3.9%, including local case growth of 3%, gross profit dollar growth of 5.5%, including an improvement margin of 57 basis points, and operating income growth of about 9%, supported by solid operating expense performance. From a geographic perspective, we saw solid year-over-year improvement in both cases and gross margin across the U.S., with specific strength in the Mideast. Southeast, and the Pacific markets. This was somewhat offset by signs of growth slowing in our traditionally-strong Southwest market due to the impact of the downturn in the energy sector. One example of how we're driving increased case growth is in the area of fresh and local products where we're helping to educate our customers that we have significant capability through our Broadline operations and our specialty companies to bring fresh and local produce to the market. As an example of how we differentiate ourselves in this segment, in order to grow cases, our Sysco quality assurance team has partnered with the Produce Marketing Association to deliver good agricultural practices workshops to more than 800 small farmers since 2011, helping prepare our small local growers to meet our food safety standards. As you know, improving gross margin is one of the key drivers of Sysco achieving our three-year targets. And our strong performance this quarter indicates we are making progress towards achieving our long-term objectives. To that point, I am pleased with how well we've managed the current deflationary environment, which has certainly slowed sales dollar growth. Our ability to manage this environment well is due in part to an increased focus on Sysco brand and our category management efforts where we are able to use our purchasing scale along with the more transparent process with our supplier partners to achieve our goals. We continue to see a variety of benefits for our customers, suppliers and Sysco as category management has become a standard part of how we now operate our business. There are other areas that we know are improving our overall customers' experience of doing business with Sysco as well including the way we are improving the service and the support they are experiencing through our technology solutions. Our mobile order entry platform, which has been in pilot with customers for the past few quarters has shown strong adoption rates with both customers and our marketing associates. Now that the pilots have been completed, we are in the process of fully deploying this ordering solution across the enterprise. Additionally, we soon expect to begin pilots for the next phase of our digital eCommerce platform, which will bring additional capability, tools, and information critical to our customers to help them better run their business. Finally, from a supply chain perspective, we have made solid progress toward our goal to improve overall service to our customers while driving higher productivity in our operations through our continuous improvement process. As mentioned earlier, while there's still a lot more work to be done, we're seeing improved operating expense trends and we're targeting a continuation of this performance throughout the balance of the fiscal year. These are just a few of the key priorities that are starting to impact our operational and financial results. And while we have much work to do, I'm confident we are on the right path to achieve our long-term objectives. In summary, our customer and operational strategies are being executed well in the field, and our headquarters teams are doing a terrific job of providing our organization with field ready tools and processes that are enabling our success. Now I'd like to turn the call over to Joel Grade, our Chief Financial Officer.

[Joel T. Grade:]

Thank you, Tom, and good morning, everyone. We had a strong second quarter especially in light of the increased deflation and continued currency headwinds. We also continued to make some solid and early progress towards our fiscal 2016 plan and our three-year goals. We grew sales in the second quarter by approximately 1% year-over-year despite going from inflation of 6% in the second quarter of last year to deflation of 1% this year, including deflation of nearly 2% in U.S. Broadline. We saw continued deflation in center-of-the-plate protein categories as supply recovers from various events in 2015. However, as Tom mentioned, we are managing this environment well, including improved processes and programs such as category management that have helped to lessen the impact of deflation. Foreign exchange negatively impacted sales by 1.7% with the U.S. dollar's strength against the Canadian dollar responsible for the vast majority of the impact. On a constant currency basis, sales would have been up 2.2%. Turning to case growth, consistent with our three-year plan to achieve disciplined case growth, we had another quarter of strong performance. Total Broadline case growth for the second quarter was 3.4%, and local was 2.9%. This is the seventh consecutive quarter of year-over-year local case growth for the total Broadline. Looking at gross profit and gross margins, we grew our gross profit at a solid 3.4% while also continuing to see expansion in gross margins, which grew by 50 basis points. The key drivers of gross margin improvement included category management, a more beneficial mix of local business, higher Sysco brand penetration in our local business, and deflation. On a constant currency basis, gross profit growth was 5%. Adjusted operating expenses grew 1.8% during the quarter and by 3.5% on a constant currency basis. The increase is mainly driven by the previously-mentioned higher case volumes and planned investments in business technology. This increase in expense was partially offset by various decreases, including reducing indirect spend, reduced fuel costs, and foreign exchange translation. This progress is reflected in our cost per case in U.S. Broadline, which was down $0.01 from the prior year. Also note, while we experienced a relatively minor amount of certain items related to restructuring during the second quarter, we do expect to experience additional restructuring charges related to our three-year plan over the next few quarters. As you know, a key part of our plan is to effectively manage the gap between gross profit dollar growth and expense growth. We achieved that objective during the second quarter, and as a result, grew adjusted operating income by 10.2% compared to the prior year and 11.6% on a constant currency basis. As it relates to taxes, in mid-January at an investor conference, we disclosed a $21 million benefit to income tax expense as a result of the favorable resolution of some international tax contingencies. This had the same impact on both our GAAP and adjusted tax rates, reducing both to around 31%. As a result, and as mentioned during that webcast, we reported a $0.03 benefit to earnings per share during the second quarter. Compared to the prior year, adjusted net earnings grew 12.6% and adjusted earnings per share grew 17.1%, and 19.5% on a constant currency basis due to higher operating income and reduced tax rate. The previously-mentioned tax benefit increased earnings per share by $0.03. The share count decrease of 24.5 million shares related to the accelerated share repurchase program positively impacted earnings per share in the second quarter by approximately $0.02 versus the prior year. At the beginning of the second quarter, we executed the accelerated share repurchase program and therefore received the benefit from that repurchase for the entire quarter. Also note that we resumed our ongoing practice of buying back shares to offset dilution during the last few weeks of December. Cash flow from operations was $469 million for the first 26 weeks of fiscal 2016, up roughly 4% from last year. Working capital was a use of cash during the first 26 weeks of fiscal 2016, as it was during the first 26 weeks of fiscal 2015. The first half of the fiscal year typically requires a seasonal net investment in working capital that is then reduced during the second half of the fiscal year. Year-over-year, the comparison is favorable as we invested $143 million less cash in working capital during first half of fiscal 2016 than we did in the first half of fiscal 2015. Net CapEx for the first 26 weeks was $237 million and free cash flow was $231 million. Both cash flow from operations and free cash flow include the cash impact of certain items of $264 million in fiscal 2016 and $102 million in fiscal 2015. Certain items for 2016 are mostly related to the termination of the proposed merger with U.S. Foods and from 2015 include items related to the proposed merger itself. Excluding the cash impact of certain items from both years, cash flow from operations grew by $179 million and free cash flow grew $237 million. Now, I'd like to close with some commentary on the remainder of the fiscal year. First, we are on track to achieve our fiscal 2016 plan. Second, we expect deflation to persist for at least the remainder of the fiscal year. Third, we had a relatively strong fourth quarter last year, which will make fourth quarter comparisons this year more challenging. Fourth, we now expect CapEx to be near the lower end of the previously-stated $550 million to $600 million range. Finally, we expect a normalized tax rate of 36% to 37% over the remaining 26 weeks. In summary, we had a strong quarter led by continued momentum from the improved underlying business performance. That said, we have more work to do in order to achieve our fiscal 2016 financial objectives and our three-year plan, including effectively managing deflation over the near term and increasing our focus on expenses. We continue to aggressively review every part of the company, looking for ways to reduce costs. Additionally, we have put in place some more rigorous process for managing expenses, including how we prioritize spending and focus investment on areas or projects that improve our ability to serve the customer better. And finally, we took advantage of continued lower fuel prices to increase the amount of fuel we locked in over the next 12 months. I feel good about our ability to achieve the first year target of our three-year plan, and we are working hard to be as aggressive as possible in identifying incremental opportunities to exceed our Investor Day targets. Operator, we're now ready for Q&A.

[Operator:]

We'll pause for a moment to compile the Q&A roster. Your first question comes from the line of Zack Fadem with Wells Fargo. Your line is open.

[Zachary Fadem:]

Hi, good morning. So, question on local cases. With local cases up about 3% in the quarter, I'm hoping you can provide some color here in terms of new customer growth versus higher share of wallet for existing customers? And over time, do you think you can grow local cases in excess of the market rate?

[William J. DeLaney:]

Hey, Zack, it's Bill. I'll start and let Tom kind of give you some color from his perspective. We've historically been able to take share year-in and year-out and we do that both on the local side of the business as well as the corporate side of the business. So, yeah, I would expect that we would continue to take share. Obviously, what Joel referred to in his comments is we're trying to do that in a more disciplined way as we go forward here, so that we give more of a flow through to the bottom line. The way I would look at the local case growth is I talked about the lever of accelerated local case growth. The context there is we've had, I think, seven quarters in a row of local case growth, and the last few have been right around 2% or more. So that lever is relative to where we were in the last two years or three years or four years as we were going through a lot of our change and some pretty tough macro economics. So that 2% to 3% range, I think, is what we're targeting. I think there's going to be some quarters where we're at the lower end of that range and there will be some we're at the higher end of the range. I think 2% to 3% is very solid growth if you look at what the forecasts are for the industry. But I'll let Tom speak to generally where it's coming from.

[Thomas L. Bené:]

Yeah, thank you, Bill. I would just add we are seeing strong trends in restaurant traffic and restaurant sales, so that's certainly helping. But we're really focused on promotional activity that actually drives new business. And also, if you think about some of the tools that we shared at the Investor Day around how we improve our penetration, we are seeing improved penetration with our local customers, driven primarily by some of those initiatives, whether it's some of the local products I've been talking about, some of the innovation we've launched, or even some of the additional services we're providing those local customers. So we see good performance coming out of them from a variety of areas and believe we'll continue to see that kind of growth.

[Zachary Fadem:]

Great. And just, you had discussed a more rigorous process towards expense management. Joel, I'm hoping you can elaborate a little bit more on this in terms of potential focus areas and whether this would be above and beyond what you laid out at Investor Day.

[Joel T. Grade:]

Sure. So couple of comments on that. Number one, the way I think about those types of costs, and I think we've talked about this at other places, we think about it from the standpoint of processes, from people, from technologies, from the types of investments that we put into our company, again, in terms of how we think about prioritizing items. So in other words, one of the key things I called out in here is the ability to really prioritize and then focus on those spends that are going to drive the, again, ultimately what's better for our customers. And so I think the – some of those things that we put in place, for example, are different committees to review and focus on technology spend, for example, and the ways to have, again, a very tight process for making sure that we're focusing on those projects that drive, again, the best results primarily and focused on the customer. So, I would say, I mean, again, there's a lot of rigor around that. And in terms of your – second part of your question, again, all I can really say to that I think is that we certainly will continue to focus on driving that, certainly with the deflation we're experiencing and the fact that our gross profit dollars are harder to come by. That increased focus on expenses is important. And so, again, as I mentioned I think in my script, that's certainly an area we're going to continue to focus on and certainly look to drive incremental improvements over and above our targets.

[William J. DeLaney:]

Yeah, I think, if I could just add there, Zack, to Joel's comments maybe a little more of a historical perspective. I mean this company has always managed expenses very well, both operationally and corporate. Now, over the last three years, four years, five years, we've invested a lot, in particular on the corporate side, technology, processes as Joel mentioned, commercial activities beginning to end supply chains, so a lot of those investments have been made over the last several years to create this path to transformation that we feel the company needs to go through in which we're pretty far down the road on. What you're seeing today and what you've seen in the last few quarters is we're beginning to get the benefits of a lot of those investments. So I would expect that the trajectory of that expense, as it's already happened, will flatten out. To Joel's point, we'll continue to get better and better at sequencing and prioritizing spend relative to customer needs and relative to what we need to deliver for our shareholders. I'd say, the one last opportunity we have, particularly in the field, is to be just more consistent in our execution. And we still see plenty of opportunity there. So, again, historically, we've done a good job, but what we're really telling you here is we think there's opportunity, both operationally as well as on the corporate side.

[Operator:]

Your next question comes from the line of Stephen Grambling with Goldman Sachs. Your line is open.

[Stephen Grambling:]

Hey, good morning. Thanks for taking the question. I guess just a follow-up on, I think there was a comment on deflation making gross profit dollars a little bit harder to come by, but it was also a gross margin benefit from a rate standpoint. Can you just elaborate on how deflation impacted the P&L as the quarter progressed? And if it's going to continue, do you anticipate any change in the way it impacts the business?

[William J. DeLaney:]

Well, deflation impacts the P&L. I don't know that there was a big sequential impact, a lot of variable around the sequential impact as the quarter progressed. What we're saying is we saw a pickup from the first quarter to the second quarter, we're seeing some similar trends here in January. And we kind of felt mathematically that would begin the wrap. We began to see this, if you recall, back in March and then the fourth quarter of last year when the inflation fell off. So we thought just from a wrapping perspective that we would see a little more – little less deflation as we got into the second half of the fiscal year. And I would say what we're telling you today is it's still there and we probably will expect to see it at least through the end of the quarter. It affects you in different ways, obviously. On the positive side, generally when our costs go down, we are able to pass that along to our customers. And that's good for them, especially as they are dealing with some of their labor challenges. Your percentages look better, so certainly it contributed to the gross margin expansion. But the reality is, it's not a great environment because you end up with fewer dollars to pay your expenses with. So to Joel's other point, when you have this level of deflation, it just reinforces the importance of managing our expenses very tightly.

[Stephen Grambling:]

Thanks. And as an unrelated follow-up, I know there were some comments about eCommerce. Can you remind us where the current perpetration is as it relates to sales and how you think about that as a driver of the business going forward?

[Thomas L. Bené:]

Yeah. So regarding the eCommerce work we have been doing, we've been very focused on our mobility solution. So think about it as an online ordering tool where our customers can use iPad or type device or their phone to order. We've been piloting this across the last couple of quarters. We now are in most of our operating companies with at least some of the customers in some of our districts and so we're going to be expanding it now to the rest of the country and more of a full deployment. We continue to see improved usage of the tool, but I'd say today we're still in the low, probably 9%, 8%, 9% of the orders going through that process. But we're seeing basically double digit improvement each quarter as we roll this. So the feedback has been very positive, both from our own associates who also use the tool, and from our customers. So we believe we are well on our way to significant increases in adoption and ultimately, a lot more of the orders being placed using that tool.

[Operator:]

Your next question comes from the line of Andrew Wolf with BB&T Capital Markets. Your line is open.

[Andrew Paul Wolf:]

Hi, good morning and good quarter. Back to the gross profits. So, just sequentially, they grew better even as sales got worse because of accelerated deflation. So I've heard the explanations around mix and so forth, but at least from my view, it looks like the deflation is at least kind of benign. I mean I know it becomes a headwind. But is there some element to sticky pricing where when inflation was increasing the last three years, it's tougher distributors to pass that through all at once. And is there some element where to some degree it doesn't have to come down quite as fast or do you think everybody is just chasing the business and passing it through right away?

[William J. DeLaney:]

Good morning, Andy, and thank you. You covered a lot there. Look, I think – as I said, I believe the deflation, as you look at gross margin, i.e., the percent to sales is clearly helping. However, as we've said very consistently over the years, it's not an ideal environment to be in. If you look at this business historically, our customers generally are able to pass along a couple of points of inflation to their consumers year-in and year-out, and they generally do. So to one of your points, what you're seeing here a little bit is some of the recovery, what we gave up. When we were dealing with 5 points to 6 points of inflation, you can only pass along so much of that so quickly and it's only appropriate to pass along so much of that so quickly. So when you have some deflationary trends, mathematically, it helps you a little bit. Perhaps there's situations where you can bring your prices down a little slower, but ultimately, it's an incredibly competitive environment. So we're out there competing for that business every day and we want to do right by our customers. So I wouldn't put a lot of weight on that. I just think we're doing a very good job managing it. I've seen different cycles of deflation here over the last – you don't know how many years, but a lot of years – and this is by far and away the best we've ever managed it. And I think it goes back to what Tom covered, and I'll let him speak again. We are actively – we've been working on several commercial initiatives here for the last two years, three years, four years, whether it's segmentation, back to basics, revenue management, category management. These are all things that are allowing us to be more laser like in terms of how we work with our customers and bring more consistency to our pricing. There's more to do there, so I would just say I think we're actually managing it quite well.

[Thomas L. Bené:]

Yeah, Bill, the only thing I would add is we've talked about the impact of the category management efforts we've been embarking on over the last few years. That continues to be a significant driver for us. And we've also shared with you all the importance of our Sysco brand growth and we are very focused on that Sysco brand because we know that not only is it a great quality product for our customers, but obviously, there are margin benefits for Sysco as well. And so I think really that's just one additional thing I'd add, if it helps.

[William J. DeLaney:]

And I wouldn't underestimate this mix. We don't have to grow the local faster than the corporate. I mean, I think corporate still grew a little bit faster than local this quarter, but we bring more value to the street customers. We're able to leverage our Sysco brand offerings in a broader way with our local case growth. And so if you go back to Investor Day and some of our commentary there, that first lever of accelerating local case growth and if we can keep it in that 2% to 3% range, that's a very powerful lever for the throughput or the flow through, if you will, to the bottom line of the company.

[Andrew Paul Wolf:]

Thank you. Can I just follow up briefly on the category management that seems to be driving profits nicely? I think earlier on it was really focused for you guys on your vendors and some of the things you were doing there to bring down cost. It sounds like it's more focused now on getting it into the sales side of the business and bringing it to the restaurants. Am I hearing that right as well?

[Thomas L. Bené:]

Well, I'd say, yes. The initial wave you go through and you are obviously doing all the hard work and heavy lifting around the categories, selecting the right products and the right partners to do business with. Now that we're deeply into that and we've been through all the categories, the majority of them, now we're very much focused on optimizing what we have. So, you've heard us talk about innovative products. We've had some innovation that has been out over the last couple of quarters now that are starting to drive some incremental benefits for our customers and obviously for us. You are also starting to do much longer range planning with a lot of these supplier partners. So it's become more of the way we operate. And I guess based on that or because of that, we're seeing the kind of consistent year-over-year benefits. While maybe not as great as they were in the early days as we started at, we're still seeing consistent benefits from that work.

[Operator:]

Your next question comes from the line of Edward Kelly with Credit Suisse. Your line is open. Edward J. Kelly - Credit Suisse Securities (USA) LLC (Broker) Hi. Good morning, guys. Congratulations on a nice quarter.

[William J. DeLaney:]

Hey, Ed. Edward J. Kelly - Credit Suisse Securities (USA) LLC (Broker) Hey, Bill, can I just start with maybe a big picture question? So last quarter, you sort of walked us through how the underlying business was better than the bottom line results, so to show it, right? And that was, I think, more around like corporate costs and stuff. And now this quarter you've got, it's like your strongest EBIT growth quarter in sort of recent memory. Despite deflation, you've got case growth and better profit per case and lower expense per case that are all lining up. Do you feel that you've kind of reached that inflection point that you were hinting at last quarter? I guess what's the big picture takeaway from this quarter, if there is one at this point.

[William J. DeLaney:]

Ed, I think it's a little bit like golf. We got a little bit more out of it this quarter than we did in the first quarter. I think when I talked about that first quarter, that's when we really talked more about the U.S. Broadline than we have in the past. I wanted you and the other investors to understand the quality of the underlying quarter. I think part of what we're seeing, we've done some work on this, is the trajectory of the corporate spend coming out of last year, coming out of the proposed merger that ultimately was terminated, we still had some – and we still do – we still had some trajectory of our spend here at corporate, in particular on the technology side, in particular on some of the areas that Tom's speaking to with the digital and mobile platforms. So those comparisons were not quite as tough in the second quarter as they were in the first quarter. So our corporate expense increase is a little bit less acute. We got a little more margin improvement, as you can see on the gross margin side, even though we did see more deflation. And perhaps that helped us a little bit in the short term, but we also managed, I think, a little bit better. And you saw better cost management, I think, operationally as well. We're right around that flat cost per case right now. Fuel helped us a little bit there, but. So I just think everything got a little bit better and I just think this quarter is somewhat more reflective of really the quality of the earnings that we've seen. Now, look at it, what I would encourage you to do is look at the first half I spoke to. And what I see there is I see 4% operating income with improving trends. And that's kind of how we're looking at it. So we think we're in a good place for the first year piece of our three-year goal. Joel can speak to that, but I think we talked about hitting 20% to 30% of our goal here in the first year. And we've got more work to do to hit or exceed the rest of that goal, both as it relates to continuing to address the deflation, in particular, grow those cases locally the way we are and have been. But we've got some more work to do on the expense side as well, and you've heard us allude to that here. So I wouldn't quite call it an inflection point, but I would call it a validation of what I talked about in the first quarter. Edward J. Kelly - Credit Suisse Securities (USA) LLC (Broker) Okay, and just couple of quick follow-ups. One, just on case growth, do you think weather sort of helped case growth out at all? And then a follow-up on deflation. The last period that we saw more meaningful deflation, profit per case was down. And it doesn't sound – like it sounds like this period, you think you can sort of manage through that without seeing it? And I just want to confirm that that's how you're thinking about things.

[William J. DeLaney:]

I don't think weather played that large a role. It's always hard for us to talk about good weather. December was relatively mild, so it might have helped a little bit. I would tell you (38

[Joel T. Grade:]

Yeah, I think the only thing I would just add to that in terms of the way we think about that is, again, Bill said it. The headwind is there, but the combination of solid volume growth and some of the margin expansion that's caused it coming from some of the initiatives that Tom's talked about, again, the category management, the brand – the brand within our local case growth. So in other words, we're growing our local cases and our brand within that is growing. And so that's all positive. And so, I think at the end of the day, again, certainly obviously we say we'd certainly love to take a little bit of inflation to pass even more of that through, but I think those are kind of the key levers that we think about as we combat inflation. I think we've done a pretty good job of it.

[William J. DeLaney:]

Yeah, and we've talked a lot about local, and we need to, because, I mean, that really is what's driving a lot of this along with the initiatives. But we also grew the corporate businesses this quarter as well, and we grew it in a profitable manner. So we actually feel good about the overall quality of the case growth.

[Operator:]

Your next question comes from the line of Meredith Adler with Barclays. Your line is open. Meredith Adler, your line is open. Your next question comes from the line of Kelly Bania with BMO capital. Your line is open.

[Kelly Ann Bania:]

Hi, good morning. Thanks for taking my question. Lots of questions on gross margin. But I was just curious, the factors that you called out, category management, local case growth, your private brand, deflation, is that order of magnitude the right way to think about it? I mean, do you kind of go item by item of those four factors and say here's kind of what the impact was? And just wondering if you're willing to share any more detail with us on those.

[William J. DeLaney:]

Kelly, just to be clear. Is that the way we think about what?

[Kelly Ann Bania:]

The impact of those factors on gross margin. Category management, the local case growth, the private label penetration, and the deflation.

[William J. DeLaney:]

Yeah, well, again, just for no other reason than to make me feel good, I think about gross margin, but I also think even more about gross profit dollars. So we're trying to address both here. You pay your bills with the dollars. I think on your point on the margin, certainly deflation of this magnitude is meaningful. It's impossible to quantify what that is, but we would be less than genuine if we didn't say that was contributing to some of the margin improvement. But I would quickly go to the other things we talked about here today, which is the importance of local case growth. Again, it doesn't have to be faster than the corporate. It just needs to be significant. The importance of growing the brand, and that's easier to do when you're growing your local cases. And the maturation of the category management work that we're doing, along with some of the work that Tom is continuing to develop here on revenue management. But I'll – you could talk to ten people or 100 people in Sysco and probably get a little bit different answer on that question. so I'll let Tom and Joel jump in here.

[Thomas L. Bené:]

Well, again, I think the question was really more around is the prioritization of that the way we look at it. I think we look at all of them coming together. At the end of the day, this local customer, if we are meeting or exceeding their needs, we're going to get the kind of growth that's required there. And we're focused on a lot of initiatives that, in fact, help them be successful. And I know we said that a few times, but I think what is important for you to take away is that the more they're successful, and therefore the more we're successful with them, that is a big lever on our business, because of the – what we bring to them and the percentage of their business that is, in fact, Sysco brand, and the way that we partner with them. So I think I would say they all come together, and that's what makes the impact that you're seeing. I don't know that it's one necessarily higher than the other. It's really more about making them work together.

[William J. DeLaney:]

And I think the other point that Joel's made, and I'll let him make it again, is just obvious point

[Joel T. Grade:]

Yeah, I think that's the other point I would continue to emphasize. As inflation goes up and down, as our gross profit dollars are driven by the things we've talked about, again to Bill – the point that Bill just made, one of the really strong focuses we have is to drive the gap between gross profit dollar growth and expense growth, which again, certainly this quarter we did a good job of, because, yeah, whether we have more inflation or less inflation one way or the other, that spread is really important to us, which is why we're going to continue to keep driving certainly on the gross profit dollar growth, but focus on the expenses as well.

[Kelly Ann Bania:]

Okay, that's very helpful. And then, I guess, in terms of expense growth, what was the impact of technology spend this quarter on your expenses.

[William J. DeLaney:]

I don't think that we historically have really gotten that detail, Kelly. What I would tell you is we still have some expense growth here at the corporate side. It's planned. And virtually all of it's on the technology side.

[Operator:]

Your next question comes from the line of Karen Short with Deutsche Bank. Your line is open.

[Karen F. Short:]

Hi there. I don't know if this is something that you'd be prepared to answer, but it would help, just because if and when we do return to an inflationary environment, it's just something to keep in mind in terms of puts and takes on a gross margin. So I guess the question is what percent of your sales are priced at cost plus a percentage markup versus a cost plus fixed penny per case? Because obviously, I mean, in fixed penny per case customer, you're going to be benefiting in a deflationary environment from a gross margin perspective.

[William J. DeLaney:]

Yeah, Karen, good morning. I would just say that you can presume that when we talk about our corporate customers, those large customers, those are all on some type of a cost contract. Some are markups, some are margin, some lines are done dollar per piece, whatever, dollar per pound. And on the local side, a lot of that is priced by the MA (45

[Karen F. Short:]

Okay. And then I guess just switching gears, two questions. I guess the first is what do you kind of cut back on in terms of CapEx this year in terms of your coming in at the low end of the range? And then the second question I had is just obviously your stock is reacting to your strong results this morning. I'm just curious how you think about the remaining buyback in light of the fact that, obviously, stock was at a better entry point during the quarter than it is now?

[Joel T. Grade:]

So I'll take first one and then I'll maybe clarify your question on the second one. The first part of the CapEx, I don't know that I'd really think about it as something we're cutting back on. I think the way I would just say it is we target our CapEx spend. It's not based on some fixed number that we need to achieve or not achieve, but it's really truly driven by the needs of the business. And so I think the way I would just think about that is that as we've kind of talked about before, we have a pretty rigorous process in terms of identifying and prioritizing our capital spending needs. And I would just say it to you this way that the way we look at the required spend this year for what our business is needing just happens to fall near the lower end of that range. So again, I don't necessarily look at our target as something that we have to achieve our some number we have to get to. It's just based on the needs of our business and we have the ability to flex as it relates to that. And then the second – Bill, do you want to add anything?

[William J. DeLaney:]

Let me take a shot at the second one. If I don't hit it, Karen, clarify it for us. First of all, it's nice to have a quarter beat. So, it's nice to see the stock reacting. Our experience is it'll take two days or three days for things to kind of level out in terms of how investors see the quarter. We've announced our intention to – we have done the $1.5 billion that needs to be sold, as Joel said. And today it would still be our intention to do the remainder of the program next year. So if things were to change, we will let you know, but right now, that's still our intention. I would just reiterate, though, going back to the first part of your question, we're always looking to invest in our business. And we'll continue to do that in a way that supports the disciplined growth that we talked about. Modestly growing the dividend continues to be very important and we continue to look for good solid strategic acquisitions. So we're looking at all four of those opportunities, but I'm sitting here today two hours into this thing, I think we haven't changed any plans.

[Operator:]

Your next question comes from the line of Mark Wiltamuth with Jefferies. Your line is open.

[Mark Gregory Wiltamuth:]

Hi. Good morning. I wonder if you can give us an update on how things are going at SYGMA on improving profitability there? And also, just a little more detail on what you're talking about there for the fourth quarter comparisons, why fourth quarter is going to be a difficult comparison for you?

[William J. DeLaney:]

I'll speak briefly and certainly let Tom give you a little more color. SYGMA, as we've said, is in somewhat of a turnaround mode and we are continuing to see some better trends there as it relates to the customer mix and the expense management and that kind of thing. I would tell you, there's still plenty of work to go there. But we're encouraged with the beginning some of trends that we're seeing, but we're not there yet. I'll let Tom take the rest of SYGMA and then I'll let Joel talk to you about the fourth quarter

[Thomas L. Bené:]

The only thing I'd add on SYGMA is we're very focused on specific customers and profitability, as well as improving our operational excellence in that business. And so, the combination of those two things is how we're going to improve and get this thing back on track. We've had, certainly over the last year, some challenges regarding drivers and driver retention, which is something that we've come out of and we're in a much better place now than we probably six months ago. But it's really those two areas. Making sure we've got the right customer mix and also that we're operating at the highest levels.

[Mark Gregory Wiltamuth:]

Okay.

[Joel T. Grade:]

Yeah, sure, Mark, it's Joel. The question on the fourth quarter. I think the comment there really relates to the fact that last year in the fourth quarter our adjusted operating income grew nearly 6% and certainly we picked up nearly $30 million of operating income from the prior year. And so I think the comment was really focused around the – again, I often talk about growth on top of growth, and certainly as I mentioned in my part of the script, I said we're certainly feel very good about how we're looking towards achieving our fiscal 2016 planned objectives. But, again, it's really more of a call out of the fact that the fourth quarter last year, we had quite a strong performance, and that's where the comparatives are up against what we're referring to.

[Mark Gregory Wiltamuth:]

Okay. Thank you.

[Operator:]

Your next question comes from the Meredith Adler with Barclays. Your line is open.

[Unknown Speaker:]

Hi, this is Sean (50

[William J. DeLaney:]

Good.

[Unknown Speaker:]

I have a question on lower commodity costs. And to what extent that's maybe resulting in restaurants, maybe investing some of that into being more promotional versus them using it to offset high labor expense? I think that's been somewhat of a driver of case growth to some extent.

[William J. DeLaney:]

That would be hard for us to assess and probably not even appropriate. I think Tom sees more customers than I do, but I see a few, and I think this labor cost thing is at the top of mind for them right now. I know it's been the subject of some recent industry meetings. And I think that's where it's helping them. But, Tom, do you have anything to add to that?

[Thomas L. Bené:]

No, not really. I can't say there's a big theme around more promotional activity that I'm seeing. They have lots of concerns out there right now, not the least of which is the labor environment.

[Unknown Speaker:]

Sure. Makes sense. Another question I have too is just on the driver or maybe the drivers of non-Broadline inflation, just because it seems like there was deflation at Broadline at about negative 1.9%, which is approximately 80% of business. So I'm just wondering what's kind of driving the inflation for the remainder of the business?

[William J. DeLaney:]

Well, I think what you're saying really is the deflation at the U.S. Broadline's driving the deflation. And some of our other businesses, to Karen's question on cost, SYGMA has more of the cost per piece, that type of fee, type of pricing, so that's not going to be impacted as much. Some of our other guest supply, different type of product line altogether, so Canada not as much. So I think all we're saying is the U.S. Broadline is 80% of our revenue stream, and that's where the bulk of the deflation is.

[Operator:]

Your next question comes from the line of Vincent Sinisi with Morgan Stanley. Your line is open.

[Vincent J. Sinisi:]

Hey, great. Good morning, guys. Thanks very much for taking my question. Just wanted to circle back a second on deflation. Bill, you said earlier, I know that something to the effect of deflation, of course, remaining a headwind. You initially thought it might subside kind of in the back half of the year, but still kind of there. So just to clarify, are you guys thinking for the next quarter or two, that kind of very similar levels to what you are seeing today, which I guess is similar to the quarter that was just reported? Or do you think that it could get a bit more of a headwind before then moderating?

[William J. DeLaney:]

Vinnie, I wish I knew. I think all we're signaling is we think it's going to be with us at least a quarter or two longer, at least. And it was almost two points in the U.S. Broadline this past quarter. I don't know that it's going to get a whole lot worse than that. We'll just have to see. But I think the real message, and let me be as clear as I can be, is that I think probably if I'd been talking to you, and I was six months ago, I would have thought by the fourth quarter we would've been back more to neutral, and that's really not our assessment right now. But I'm not necessarily saying it's going to get worse. I'm just saying that it's probably not going to get a whole lot better for another quarter or two.

[Vincent J. Sinisi:]

Okay. Okay. That's fair enough. And maybe just one quick follow-up. You mentioned about the private brands a couple of times, also some of the newer fresh mix. Just kind of any updates either qualitatively or hopefully quantitatively the current percent of the mix where you may see that going, maybe some new categories that are coming on board?

[William J. DeLaney:]

Well, I think as long as we continue to grow the local cases, and continue to, even as we go through the second round now with CatMan with a lot of our suppliers and we work more and more on innovation, that type of thing, that gives us an opportunity to partner with our suppliers with both certainly their brand, but also ours. So, it's hard to move a number, but you'll see in the attachments from the earnings release that we had a nice move this quarter. So I don't – I'm not going to try to predict how much more it could go up, but there's a high correlation between local case growth and brand movement. And Tom can give you some color on that as well.

[Thomas L. Bené:]

Yeah, the specific numbers, that I think were communicated, and for U.S. Broadline, this is total U.S. Broadline, it was about 36.5% of the mix. And for the local business, it was 43.5%. And the local, it was up about 43 basis points. So we continue to see growth there. We believe it is a differentiator for us, and it's something that our customers also see value in, both price value, but I think also from a quality perspective. I think the other thing that Bill just mentioned, we're doing more innovative work. And as we do work with our supplier partners on Sysco brand innovation, that's going to help continue to contribute to these numbers. And I think I mentioned in the first couple of quarters, we had 16 items that we launched, basically, innovative items in the marketplace, and these are all generally Sysco brand items. Not all of them, but a lot of them are. And that'll continue to be a focus for us going forward.

[Joel T. Grade:]

Yeah. And I would just add that, I mean, this falls into the category of the disciplined, driving disciplined growth and profitable case growth, and certainly across both on the local side and again our multi-unit side. So, again, that disciplined approach on growing profitable cases certainly encapsulates everything that we've discussed here.

[Operator:]

Your next question comes from the line of Ajay Jain with Pivotal Research Group. Your line is open.

[Ajay Jain:]

Yeah, hi, thanks for taking my question. I was wondering if you could talk more specifically about the ongoing benefit from fuel in terms of the net benefit. If you can comment on the actual earnings impact in Q2 year-to-date and also your outlook for fuel, maybe in the back half of the year after you've netted out the hedges that you've got in place and along with the impact of lower spot prices. So any kind of quantification would be appreciated. Thanks.

[Joel T. Grade:]

Sure, I think from a quantity perspective, I mean, we look at that as a couple of pennies per case on the fuel side in terms of the impact on what that is. Obviously, as I talked about in my area, certainly we're taking advantage of the fuel prices where they are today, and buying. We typically have executed forward buys and we continue to do that. And in fact, we continue to increase the percentage of our fuel consumption that has really brought a head on. And so that's certainly something, again, that we see. And I – we're not in this thing in terms of kind of speculating on fuel prices. It's something we certainly take advantage of where we have an opportunity both from a cost certainty perspective and then what we feel is just a good solid fuel prices. So, again, as I mentioned in my script, we're certainly – a fairly sizable portion of the fuel we've bought forward for over the next year. And so certainly we anticipate some continued benefit there.

[Ajay Jain:]

Okay. But on a year-to-date basis, how would you say the pennies per case improved and how does that translate into earnings?

[Joel T. Grade:]

Yeah, again, it's pretty consistent. Again, as I pointed out, we think of it as about a couple pennies per case, that's impacted overall.

[Operator:]

Your next question comes from the line of John Heinbockel with Guggenheim Securities. Your line is open.

[John Heinbockel:]

Hey, guys. So wanted to touch on private brand and gross. When you think about the ability to use the private brand portfolio to drive share. And I know there's a lot of things that you're offering to your customers, but just maybe isolate that one. How effective can that be at bringing on new customers? And I guess part of that is the inertia that they might have to the brands that they're using today. And do you think you're using those brands as effectively as you could? Are there things that can be done maybe a little bit differently to drive – to use those brands to drive some increased share gains? Any thoughts, particularly from Tom on that?

[Thomas L. Bené:]

So I would maybe reiterate a few comments I made and maybe add a few points. So the Sysco brand, if you think about the Sysco brand, it's a value for a couple of reasons. One, generally, the cost to our customers is a little less than some of the national brands. So there's a natural benefit for them. But more importantly, we're very focused on the quality of these items. And I had mentioned innovation. So we're always looking to ensure that the Sysco brand items are, in fact, not only value added, meaning they bring increased value to the customer, but that they're also driving kind of the base business components that these customers need. So I'd say, we're getting everything we can. I think we feel pretty good about where we're at today. We feel like certainly we're not out of runway. But I think the more we can continue to focus on quality products, bringing innovation to those items, and making sure that we keep them in front of our customers. And we use – I think we talked about it at the Investor Day, the business review process that we use. It's a great way for us to actually do cuttings of our products, allowing them to see Sysco brand and compare that to something else they might be using. And it's how we spend a lot of that time is to help those customers see the value that's there and the opportunity that they have to improve their overall profitability by using the brand.

[John Heinbockel:]

All right. And then maybe for Bill, if you think about some bigger secular trends, right? So local, private brand, CatMan. I mean you would think, and I know this isn't fully built in your plan, but you would think that there may be a good chance here for secular gross margin rate to be up pretty consistently. Obviously, if the top line is healthy, GP dollars could grow at a nice rate, maybe even higher than what you've targeted over the last three. How do you think about that?

[William J. DeLaney:]

I'm all for it, but it's a little early to make that call, I think, John. So I think your thinking always is logical. We're six months into this three-year plan. I would just reiterate some things we talked about in September. The overall industry, I would say, the overall environment and the outlook for our customers is better today than it was two years or three years ago. Now, it goes up and down by quarter. You can actually see in some of the stuff when the stock market goes down, some of the NRA numbers fall off the next month or next quarter, so. But I think if you look at it secularly and go back two years or three years, we're in a better place. So that's a positive. It's still incredibly an acutely competitive world out there, so we need to be very responsive to that. And I would just echo what I've been trying to articulate here over the last two years or three years, but in particular the last several months post the merger termination, we're extremely well positioned today because of all the work that we've done over the last two years, three years, four years on the commercial side to compete effectively, do the right thing by our customers, but also grow in a disciplined way, as Joel talks about and manage our margins. So, if you look at those four levers, we're talking about improving how we manage it. Ideally, we'll at least hold margin over the next two years or three years. Right now we're up. Hopefully, we will grow it, but I certainly feel we're much better positioned to manage it well than where we were two years, three years, four years ago.

[Operator:]

Your next question comes from the line of John Ivankoe with JPMorgan. Your line is open.

[John William Ivankoe:]

Hi, thank you. At this point, just a quick one for me. A follow-up on the fuel question. I think you kind of have a cost of fuel that's both embedded in your cost of sales and your operating expenses. So correct me if I'm wrong about that. But my question was, your suppliers that deliver food to you, how much fuel savings maybe was embedded over the past couple of quarters and what you anticipate over the next couple of quarters just that their delivery costs are less to you and therefore your price of product could be lower and that could actually be helping your cost of goods told, if you thought about it in that way.

[William J. DeLaney:]

Yes, it's a good question, John. What we're speaking to is really our outbound cost of fuel. It's a little harder and we really don't get into that level of detail in terms of our components of our cost of goods. But let me say it this way, lower fuel is good. Okay? It's generally good for multiple reasons. One, on the margin generally people get some more discretionary income and they'll spend it, historically spend it more going out to eat. Now, I will say this, we really haven't seen a lot of that until perhaps lately and we don't have a lot of hard data on that. So the most powerful thing on the fuel is to the extent it translates to greater discretionary income and the consumer uses it to go out to eat, that's a good thing for us. I haven't seen quite as much of that, but we're hopeful that we'll see more. But, no, you are absolutely right, it helps us on the cost of goods, and to Joel's point, it helps us on the outbound. We kind of weight average the outbound. So it's definitely a modest tailwind and we're taking advantage of it and hopefully it'll stay that way.

[John William Ivankoe:]

Thank you.

[Operator:]

Your next question comes from the line of Greg Badishkanian. Your line is open.

[Gregory Robert Badishkanian:]

Great. Thanks. Yeah, just a quick one. You mentioned that the competitive environment – or the environment is very competitive. And I'm just wondering has that changed any over the last few months? Is it pretty similar? Because obviously you picked up some share, so I'm just wondering if you've noticed any change there or who you think you're taking market share from? Is it broad-based or maybe there's a regional or more national players that you're taking that share from?

[William J. DeLaney:]

What we've been able to grow is, as I said historically, take share for many years. And certainly we've got the local case growth moving again here the last several quarters. We don't have the data for 2015. My sense is we probably have taken some share. I think a lot of the larger multi-regionals are doing well. And so if I were to conjecture, which is always a dangerous thing on calls like this, my sense is that some of the better operative larger folks are taking share, and it may be coming from some of the smaller players. But the bottom line, I think, in this business is good operators are going to take share. Large, small, good restaurant operators are going to continue to grow and do well, whether they're independent or corporate owned. And so I think our overall point of view would be the competitive environment remains very acute. It remains very similar to what we've seen the last two years or three years. And the best operators, both in terms of the customer base as well as on the distribution side are going to do the best.

[Gregory Robert Badishkanian:]

Great. Thank you.

[William J. DeLaney:]

Thank you.

[Operator:]

Ladies and gentlemen, this does conclude today's conference call. You may now disconnect.