Sysco Corporation
Q3 2015 Earnings Call Transcript

Published: 4 May 2015

[Operator:]

Good morning and welcome to Sysco's Third Quarter Fiscal 2015 Conference Call. As a reminder, today's call is being recorded. We will begin today's call with opening remarks and introductions. I'd like to turn the call over to Shannon Mutschler, Vice President of Investor Relations. Please go ahead.

[Shannon Mutschler:]

Thank you, Tim. Good morning, everyone, and welcome to Sysco's third quarter fiscal 2015 earnings call. Today, you'll hear prepared remarks from Bill DeLaney, our President and CEO; and Chris Kreidler, our CFO. 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 materially. 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 28, 2014, subsequent SEC filings, and in the news release issued earlier this morning. A copy of these materials can be found in the Investor's 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, and can also be found in the Investor's section of our website. All comments about earnings per share refer to diluted earnings per share unless otherwise noted. In addition, all references to case volume include total Broadline and SYGMA combined. To ensure that we have sufficient time to answer all questions, we'd 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 President and CEO, Bill DeLaney.

[William J. DeLaney:]

Thanks, Shannon. Good morning, everyone, and thank you for joining us today. This morning, Sysco reported third quarter fiscal 2015 financial results. Sales increased 4% to $11.7 billion. Adjusted operating income decreased 3% to $377 million, adjusted net earnings increased 7% to $238 million and EPS increased 5% to $0.40 for the quarter. Net earnings and EPS for the quarter were in line with our expectations, as solid volume and gross profit dollar growth along with a favorable tax rate offset the impact of moderating inflation trends on favorable foreign exchange translation and higher than planned operating expenses. Case volume grew 2.5% for the quarter and we were pleased with our growth both with locally managed and corporate managed customers. Overall, weather was not a major factor in our year-over-year comparisons for the quarter as we benefited from favorable comparisons in January and February, but were hampered by severe weather in the Northeast and Mideast in late February and most of March. This last point is important to note, because March provides a disproportionately large portion of our third quarter volume and was a relatively mild weather month last year. We experienced similar trends in April, but expect the year-over-year monthly impact of weather will dissipate as we move into May and June. We continue to roll out and successfully execute our category management initiative and the benefits from this process contributed to our gross profit dollar growth during the quarter. Through category management, we were able to support our customer's growth by lowering our product cost and developing innovative product development ideas. This is vital to mitigating gross margin pressure as we move forward in what remains a fiercely competitive market environment. Regarding expense management, we established appropriately aggressive goals for cost per case management for fiscal 2015, after a very strong expense management performance in the prior year. We experienced modest improvement in sequential trends in the third quarter, but will fall short of our original goals in this area for the year. With that said, our entire leadership team in intently focused on enhancing productivity in a sustainable manner while delivering exceptional service to our customers. I expect our performance trends in this area to improve modestly in the fourth quarter and more so in fiscal 2016. Moving to our multi-year business transformation initiatives, we are pleased with the progress we've made on achieving the steady state cost saving goals we set as we began fiscal 2013. Fiscal 2015 is the third year of that financial roadmap and we have already exceeded our original target of $600 million, which was comprised of approximately $300 million in annual savings in both operating and product costs. While pleased with this progress we've made over the past three years – on these initiatives, it is more clear than ever that transforming Sysco's business will be a perpetual process as we strive to fully realize our vision of being our customer's most valued and trusted business partner. Foundational to our ultimate success is further developing and continually enhancing our technology platform. We have now embedded this work in the overall scope of our Business Technology group under the leadership of Wayne Shurts. We have learned a great deal from the challenges we encountered in deploying SAP and all of the standardized processes it requires. Over the past two years under Wayne's leadership, we have refined our business processes, strengthened our technology support capabilities, stabilized the SAP system and enhanced its efficiency. While there is more work to be done, we are well-positioned to move forward with a cohesive enterprise-wide module centered approach rather than our previous OpCo-by-OpCo multi-module approach. As our deployment process matures and evolves in the future, we expect this change to result in smoother conversions, better execution and an improved experience for our customers. On the acquisition front, we recently completed our previously announced agreement to acquire 50% of Pacific Star Foodservice, a leading food service distributor in Mexico. We have developed a strong relationship over the past several years with the ownership and management team of Pacific Star and we are very excited about the potential opportunities that this partnership will provide to profitably grow our business in Mexico. Regarding our pending merger with US Foods, the hearing related to the FTC's motion for preliminary injunction begins tomorrow, May 5, and will last up to seven business days. If we receive a ruling in our favor, we will proceed to closing unless the decision is appealed. In the event of an unfavorable ruling, we would assess together with US Foods' ownership whether to pursue the case further. We remain resolute in our belief that this transaction is pro-competitive, good for our customers and will accelerate Sysco's business transformation. We announced in April that Joel Grade has been named Executive Vice President and Chief Financial Officer effective September 1, 2015, following Chris Kreidler's decision to leave the company. Joel is a veteran Sysco leader with nearly 20 years of experience in key finance and commercial roles. He is uniquely suited to step into the CFO position because of his deep knowledge of our local operations and people. We are fortunate to have a leader like Joel ready to take on this key position and I look forward to working closely with him in his new role as we move forward. We appreciate the numerous important contributions Chris has made on Sysco's behalf since joining us five years ago. He has agreed to remain as CFO through August and he will work closely with Joel and Sysco's senior executive team to ensure an orderly transition of his responsibilities, including staying on through the end of December as an advisor. In closing, I am pleased with the consistent case growth we've seen in our locally-managed and corporate managed business, which demonstrates our associates' unwavering focus on providing consistent and excellent service to our customers. In addition, our leadership team is making good progress in driving out initiatives to enhance both gross profit dollar growth and expense management. Our ongoing work to fundamentally reshape our company is challenging but gratifying and we strongly believe that the steps we are taking will reinforce our leadership position in the ever evolving food service industry. Now, I'll turn things over to Chris so that he can provide additional details on our financial results for the third quarter.

[Robert Chris Kreidler:]

Thanks, Bill, and good morning, everyone. For the third quarter, sales were $11.7 billion, an increase of 4.2% compared to the prior year. Our sales growth rate was substantially lower than the 7% rate we saw during the first half of the fiscal year because of the rapid decline in food cost inflation and the impact of foreign exchange translation. Food cost inflation declined significantly from 6% in the second quarter to 3.7% in the third quarter. Our estimate for food cost inflation represents the weighted average change in Sysco's cost of the same products year-over-year. At 3.7%, it would appear we are getting close to what we normally describe as the sweet spot for inflation of 2% to 3%. But the 3.7% is an average across all of our product lines and sometimes averages don't tell the whole story as is the case here. Specifically, the meat category experienced low double-digit inflation in the quarter and poultry inflation was in the high single digits. On a weighted average basis, these two categories accounted for 3.2% of the 3.7% of inflation we experienced across all of our categories. At these levels, passing along all of the inflation can be painful to our customers, putting gross margin under pressure. In addition, rapid declines in food cost also make it challenging to leverage our fixed costs. The impact of changes in foreign exchange rate had a much larger impact than usual this quarter. Similar to many companies with significant operations outside of the U.S., the strengthening dollar depressed our foreign sales as we converted them to U.S. dollars. This quarter's decrease of 1.3% was the highest in the past three years. The impact has typically been in the range of zero to 0.5%. Sales from acquisitions increased sales by 0.6%. Case volume grew 2.5% during the quarter, including acquisitions, and approximately 2.2% excluding acquisitions. Gross profit in the third quarter was $2.1 billion, a 3.1% increase, while gross margin declined 17 basis points to 17.52%. Benefits from category management contributed significantly to our gross profit during the quarter. In addition, case volume growth for our locally managed Broadline business continued to increase slightly on a sequential basis as it is done the last two quarters. Solid local case growth is important to drive gross profit dollar growth. Case growth for our corporate managed customers remains strong, but competitive pricing pressure in this segment contributed to gross margin pressure. Certain items for the third quarter totaled $91 million and related to merger and integration planning expenses and interest on the merger debt. Of this amount, $50 million was recorded in operating expense and $41 million was recorded in interest expense. Merger and integration planning costs that impacted operating expenses were mainly related to work to prepare for the integration of the two companies' technology platforms. These expenses in total were lower in the third quarter compared to levels in the first half of the year, as we scaled back our integration planning work in certain areas where a significant amount of work has already been completed. Merger costs that impacted interest expense relate to the debt that we issued last October that is intended to refinance US Foods' debt upon closing of the transaction. We are treating this interest expense as a certain item until the merger closes. Adjusted operating expenses for the third quarter increased $73 million, or 4.5%, due to a $61 million increase in payroll expense. Payroll expense increased mainly due to higher pay for our sales organization as a result of higher gross profit, investments in new administrative support capabilities, higher incentive accruals and newly acquired operations. These increases were partially offset by lower delivery costs, mainly driven by savings in fuel expense. After excluding incentives, adjusted operating expenses would have increased 3.9%. Our cost per case performance improved modestly from earlier in the year, but, as Bill mentioned, expense management remains a challenge for us. Adjusted cost per case performance for the third quarter in the North American Broadline business, which is the portion of the business we have given guidance on previously, increased only $0.03 in the third quarter. However, excluding the benefit from currency translation, cost per case would have increased by $0.09. We have previously said we expect cost per case to increase between $0.05 and $0.10 this year. We would expect to be in the low end of this range, including the impact of foreign exchange, and on the high end of this range, excluding foreign exchange. We are focused on driving improvement across our operations with multiple initiatives that implement best practices, enhance our operating training programs and improve our ability to measure and analyze our performance. Adjusted operating income from the quarter was $377 million, down 2.7% from the prior year, and adjusted operating margin was 3.2%, down 23 basis points from last year. Our effective tax rate in the third quarter was 34%, compared to 39% in the prior year period. This quarter's rate was positively impacted by the favorable resolution of a state tax matter. In the prior year, the rate was elevated due to the non-deductible portion of a $20 million legal settlement that we disclosed at the time. Normalizing for these types of discrete events, our tax rate would be roughly 37%. This is lower than our historical rates due to the increasing amount of business earnings in international jurisdictions that have lower tax rates, as well as reduced state taxes from legal restructurings. Adjusted net earnings increased 7% to $238 million and adjusted EPS increased 5.3% to $0.40. Cash flow performance in the first 39 weeks of the year was relatively strong after taking into account the cash impact of certain items. Cash flow from operations increased $12 million to $860 million versus last year. This increase reflects the negative impact of two items. First, the cash impact of certain items increased $82 million year-over-year, mainly due to merger and integration planning expenses. Second, as we disclosed earlier this year, we made a $50 million pension contribution this year compared to none in the prior year period. This difference is simply driven by different timing regarding when we make cash contributions each year. Cash tax payments were $135 million lower than last year, due to a lower effective tax rate, which I discussed a moment ago, and merger and integration planning expenses that reduced taxable earnings. Free cash flow was $439 million in the first 39 weeks of fiscal 2015, compared to $484 million in the prior year period, or a reduction of $46 million. However, after adjusting for the cash impact of certain items and the increase in pension contribution I mentioned a moment ago, free cash flow was $617 million, an increase of $86 million or 16% from the prior year period. Capital expenditures for the first 39 weeks of the year, net of proceeds from sales of assets, increased $58 million to $422 million. About $53 million of this increase is due to IT-related merger integration planning and the rest was due to timing of investment in our fleet. Our cash flow from operations and free cash flow are always impacted by foreign currency translation, but the impact for the first 39 weeks of fiscal 2015 is much greater than the last few years. You will see in the cash flow statement a $77 million impact this year compared to less than $0.5 million last year. This means our cash flows would have been $77 million higher on a constant dollar basis. Turning to an update on recent acquisitions, last month we completed the previously announced transaction to buy 50% of Pacific Star Foodservice, a leading foodservice distributor in Mexico. Pacific Star has operated since 1989 with distribution centers servicing customers in the major metropolitan areas of Mexico City, Guadalajara, Monterrey and Tijuana. It primarily services chain accounts, including fast food and casual dining restaurants, casinos, theme parks, movie theaters and hotels throughout Mexico. This partnership fits our international expansion strategy, allows us to enhance service to our U.S. customers who operate in the region, and provides growth opportunities in an important region of the Americas. In addition, subsequent to the end of the quarter, we announced our agreement to acquire Tannis Trading in Canada. Tannis operates in the Ottawa market, the fourth largest in Canada. This acquisition, which remains subject to regulatory approval, will allow us to better serve our customers and achieve our goal of increasing sales in Canada. Regarding our outlook for the remainder of the year, there are a few additional items I'd like to point out. First, as we discussed last quarter, because of the pending merger during this fiscal year, we have not been in the market buying back shares to offset dilution from incentive-based compensation as we would normally be doing. This has had the effect of increasing our shares outstanding in the first 39 weeks of the fiscal year due to the exercise of employee stock options and the vesting of restricted stock units. As a result, both adjusted and reported diluted EPS were lower by half a penny in the third quarter and a penny and a half over the first 39 weeks. Unless we repurchase shares during the fourth quarter, we estimate that our diluted shares outstanding may be greater than 597 million shares for the fiscal year. This estimate is dependent on the level of stock options exercises and RSU vesting that occurs, and does not include the impact of the shares to be issued in conjunction with the pending US Foods merger. Second, please note that we plan to pay off $300 million in bonds that come due in mid-June. We currently anticipate using cash on hand to fund this payment. Lastly, our forecast for capital expenditures, net of proceeds from asset sales, remains at $500 million to $500 million – sorry, $500 million to $550 million for fiscal 2015. But we now expect to be at the high end of this range for the year. In closing, while our top-line has been negatively impacted by lower levels of inflation and a larger impact from foreign currency translations, we are pleased that the business continues to generate solid case volume growth, in particular, in the locally-managed portion of our business. We have opportunities to improve our operating expense management and have begun to make some progress in this area. But importantly, the business continues to generate strong free cash flow. While we have work ahead of us to transform the business, there are many exciting initiatives underway that will enhance our customer's experience, strengthen our operating performance and increase profitability. With that, operator, we'll now take some questions.

[Operator:]

And we'll take our first question from John Heinbockel with Guggenheim Securities.

[John Edward Heinbockel:]

Hello. Bill, actually a tactical question and then a strategic one. So, Bill, on the tactical side, it would seem that inflation probably moderates a bit further from here. Can you offset that with cost reduction, or is the uncertainty around US Foods and kind of where the business sits today, hamstringing you from doing that? And then I have a strategic one.

[William J. DeLaney:]

John, we have to. I mean, so yeah, do I think we can? In the past, we've been able to adjust our expenses accordingly and I agree with your premise. I think you can see the inflation come down a little bit more just for the reasons, Chris said, we've got a couple of categories that are pretty high and the others – dairy's very volatile, as you know, so dairy is down a little bit. Seafood is down a little bit but seafood is not a big part of the overall mix. So, I think essentially you're looking at an environment today where you've got two categories, meat and poultry, that are high, which is difficult to pass along in a fast way and the right way, and the others are pretty much neutral, if you put them all together. And yeah, I expect that to continue here at least for the – whatever; a few – couple or three months as far as we can see out. As I said in my comments, we are seeing improvement on the expenses sequentially, we're just not seeing it as fast as we had planned and I think you will see more expense improvement here in the fourth quarter relative to the first part of the year and we're certainly planning to do even more for next year.

[John Edward Heinbockel:]

And then, strategically, I know you don't have a lot to talk about this, but have you done much planning if US Foods doesn't happen? And what would you do differently than you're doing today if that doesn't come to fruition?

[William J. DeLaney:]

Well, first of all, one of the things I feel really good about is we have done a nice job here. We spent some money doing it separating, running the business day-to-day and keeping our people – the vast majority of our people focused on taking care of their customers and running their business and not having them be distracted by the merger. And then we had another group of people and outside support folks who have done a great job under Chris's and Greg Bertrand's leadership driving out a very sound integration plan. So I feel good about what we've done to date. Yes, we have done some contingent planning and it's not fully developed. We have had discussions as a management team and with our board and we will continue to have those discussions and once we have a ruling, then we'll probably take some more time but not a lot of time and go forth from there with some other strategic directions. So yes, we've done some planning, but not in a position today to really talk a whole lot about that.

[John Edward Heinbockel:]

All right, thanks.

[Operator:]

And we'll take our next question from Karen Short with Deutsche Bank. And Karen Short, your line is now open. Please check your mute function. And we'll move on to Edward Kelly with Credit Suisse. Edward J. Kelly - Credit Suisse Securities (USA) LLC (Broker) Yeah, hi. Good morning, guys. I just have a follow-up to John's question here. Bill, in the past, you guys have mentioned international M&A as an area of interest. I mean, obviously, the U.S. market is top of mind right now. But if material consolidation is not possible here, where are your heads today on international relative to where they were in the past? Is it still something that you would be interested in?

[William J. DeLaney:]

Certainly. As you heard, we are pleased with the joint venture that we just finalized with our partners down in Mexico and we have gradually built out some small footprint in Costa Rica and now Mexico, Bahamas, Ireland, Canada was the first one, obviously. So, I think where we are there, Ed, is I think it's just a matter of pace of place. So we definitely, when we talk about the strategy of the company, that fifth point we talk about is always looking for other areas to expand, whether it be through adjacencies or geographics. And I just see it more as something we need to do continually, and over the next three years to five years, I would like to think we'll continue to find good partners in different parts of the world where our customers value our capabilities and find ways to grow there primarily to lay a foundation for the future beyond that. So I see international more as something we need to do. We need to continually build it for the medium to long-term. Short to medium-term, obviously, US Foods is a big, big part of our strategy. It's not our strategy. It's a big part of our strategy. If that were not to work out, we would revisit other strategic opportunities that we looked at in the past and look at our capital structure and all those types of things. I'm just not in a position today to talk a whole lot about it. Edward J. Kelly - Credit Suisse Securities (USA) LLC (Broker) And, Bill, when you think about the U.S. business now, there is obviously always puts and takes on what impacts the earnings. I mean, the backdrop doesn't really seem to be too bad right now with what's going on with restaurant sales and lower fuel. But this quarter, you're back to EBITDA actually being down a little bit year-over-year to a couple of quarters of good growth, and I guess the question is, what is it really saying about the outlook for the business, I guess, absent a deal? And you touched on a little bit, but is there a need for some larger strategic refresh or restructuring if the transaction were not to happen, or are you really just – is it more really more about fine-tuning?

[William J. DeLaney:]

I think both, all right? So we need to manage what we have the ability to control the most, which is our business. And we're pretty at running our business. Obviously, as we've said for a while now, the market environment we are in, it's difficult. It's very competitive and it's not unlike many other industries and we don't expect that to change. So again, to kind of recap how we look at the world, we see modest medium to long-term growth in the industry. We expect to grow faster than that. To do that, we need to differentiate ourselves ongoingly with our customers and we need to take costs out of the system. That's one of the reasons why this merger is so important to us. If the merger doesn't happen, we'll need to find other ways to continue to do that. We may not get there quite as fast, but I'm confident we'll continue to go in the right direction. Specifically to this quarter, you can look at in a lot of different ways. The bottom line is we didn't manage our expenses as well as we would have liked. If we had managed our cost piece maybe just a nickel better, I think you would have seen a different result here and I would have been – I wouldn't have talked as much about planned expenses. So we're going to have quarters where there is inflation and less inflation. And we had good volume growth. As I've said, we managed gross profit reasonably well, given the environment. We just didn't bring our expenses in line as fast as we planned and I expect it will get better with that here over the next two years to three quarters. Edward J. Kelly - Credit Suisse Securities (USA) LLC (Broker) Great. Thank you and good luck with US Foods.

[William J. DeLaney:]

Thank you.

[Operator:]

And we'll go next to Karen Short with Deutsche Bank.

[Karen F. Short:]

Hi. Sorry about that before. Just guess curious, I mean, I know we've talked a lot about the expense issue and I guess I'm still confused as to why it's been a problem for two quarters in a row. I mean, I know you pointed to some things in terms of comps that affected expenses, but anything else you can kind of put some color on?

[William J. DeLaney:]

I'll do my best, Karen. I would say this quarter was a little different in that our selling expense was higher than where it was the first half of the year. We were up a couple pennies the first half of the year in selling and that was fine. We had a lot of gross profit dollar growth and that's going to drive selling expense. So, this quarter was up more than that. It's still probably fine but it just can't be sustained. I mean, it's just we just a situation where seasonally it's a low volume quarter. It's also a time that we bring MAs on in terms of training, and we had some operating companies that were behind in their head count and I think that put some pressure on us here as well. So, selling costs is a little higher than what we planned. On the operation side, we're making progress. We're driving out a lot of change there, Karen, and we've been driving out very aggressively over the last year to two years. And that puts a lot of stress on the operating companies at a time when they still need to provide really solid service to our customers. And so there's been some challenges in terms of how fast you can drive that change and how well it's received by our workforce and how well our leadership, including me, are able to drive that out. So, what we're doing here is transforming a company and we're bringing more standardization to our best practices in the field. We're functionalizing that part of our business in terms of the OpCo and our end-to-end supply chain organization now, and it's just taken a little longer to get where we want to go. The good news is we are seeing sequential relative improvement and that's what gives me some confidence here.

[Robert Chris Kreidler:]

Hey, Karen, this is Chris. I'll jump in and just elaborate on one point Bill made. Remember, a couple years ago, we talked quite a bit about some of the changes we made in our sales organization, and we saw that disruption. We saw that disruption and slowed growth in terms of case volume on the local side especially and we talked quite a bit about it at the time. We pushed through a lot of change and it took a while for all that change to kind of be accepted and understood and appropriately reacted to in the field. I think what you're seeing now is somewhat similar going on, on the operating expense environment. We are, as Bill said, pushing out a lot of change. It's for the good. It's going to lead to better results in the future, but it's going to take a while for some of that change to actually drive all the way down to the operating company level. And I think that's part of what we're experiencing right now. Not an excuse. We need to manage it better, but I do think we're seeing some of that.

[Karen F. Short:]

Okay. That's helpful. And then, I mean, to your point on MAs and progress on the top-line, I guess independent sales definitely seemed fairly strong, although SYGMA was weak. But anything to point to on what was driving the strength in independent?

[William J. DeLaney:]

Well, I think that's the good news. I mean, when we talk about initiatives, they're not all about cost savings. And I think what you're seeing there is some – several things that we've done over the last two years or three years, starting with the CRM tool, category management. We're getting better executing that; some basic things we're doing in terms of working with our MAs and training and how to segment more effectively our customers and product categories. And just creating more continuity, if you will, between the corporate sales organization and the field sales organization, as well as the OpCos overall. So we're pleased both on the local side and the corporate side. If you go back four quarters or five quarters, we had no growth on the local side. So, I think that's a bright spot and that's certainly something we've emphasized and something we need to continue to emphasize.

[Karen F. Short:]

Okay. And then, just last question on the expense side. What's driving the merger and integration increase? Because I guess I was under the impression that you had kind of completed all you could from a merger and integration expense perspective until you know more – or until, hopefully, you close the merger, and it still seemed to be-I mean, it's still increasing.

[Robert Chris Kreidler:]

Well, it's actually not increasing on a sequential basis. It's starting to decline. We hit our peak last quarter, Karen, and it's coming down from there. But I'll take your question to where I think you want to go, anyway, why is it not perhaps dropping faster? There are a couple reasons. I mean, the interest portion of that, obviously, is not going to go anywhere, but even on the operating expense portion, there is a lot of work that continues to be done to prepare the two IT systems to be able to merge. We're not touching the US Foods system or vice versa, but we're creating the conduits that will be necessary to allow them to merge. Unfortunately, as this deal has drug out, we were able to stand down certain aspects of what we were doing from a planning perspective because we can stand them back up rather quickly; but a lot of other areas, we need all the time we could possibly get to be prepared for merging and integrating, and we continued some of that work. So it's come down somewhat. I expect it to not increase again, of course, until we complete the transaction; and, of course, we'll give you new guidance.

[Karen F. Short:]

Okay. Great. Thanks.

[Operator:]

And we'll take our next question from Meredith Adler with Barclays.

[Meredith Adler:]

Hi. Thanks for taking my question. I wanted to talk a little bit about cash. I spent many years in fixed income land and cash is cash. You can't really define it. And it just looks to me like, in fact, you're not covering your dividend, or didn't for the first nine months of the year. And then – so I'm wondering, you have a $300 million payment you're going to make this year. Could you talk about

[Robert Chris Kreidler:]

Yeah. Let me take the two pieces of that, Meredith. First, the $300 million, as I mentioned, we will pay that out of the cash that we have sitting on the balance sheet, which is just shy of $5 billion. That's what we'll do, initially. If we then repay the bonds, because you correctly point out if the merger agreement terminates there's a process for those to be redeemed, we would pay those back out. Whatever we can't pay out of cash, we would put into our credit facility. We do have a very large commercial paper line backstopped by a credit facility, about a $1.5 billion. So we have got plenty of capacity to put on the balance sheet. We would then look at whether we have enough capacity for just general working capital needs and we'd look at whether we need to term out some of the debt that we've taken on the balance sheet the last couple of years, the acquisitions we've done, et cetera. We would do that after that point in time when things settle out.

[Meredith Adler:]

Okay. And then, just have one other question. You said that...

[William J. DeLaney:]

Meredith, do you mind if I just jump in still? Just on the cash point, I was just going back to the earlier questions we had. First of all, we're going to cover our dividend here. If you adjust for the merger related expenses and things like that, we're going to more than cover our dividend from free cash flow this year. Second of all, the way I look at cash is, strategically, we include debt capacity. So obviously, as you well know, we're very highly rated company from a debt perspective. We have plenty of debt capacity and certainly want to utilize it prudently, but I'm very confident in our ability to fund whatever we need to fund.

[Meredith Adler:]

I'm not actually worried about liquidity. You're not going to run out of liquidity. My next question, just quickly, is about category management and cycling the improvements you've seen so far. I think that we'll cycle some in this next quarter, but it sounded like you had more coming. How do you think that balances out in terms of the benefit to the gross margin?

[William J. DeLaney:]

Well, you're right. We're finishing up the third year and we said from the beginning category management would be somewhat backend loaded, and we've seen those benefits this year. I think the key that – the way to look at that, Meredith, is just we are now maturing to a point where, well, we speak about category management, it truly is embedded in how we merchandise and we have centralized merchandising here to a large extent. We certainly have standardized all of it. We still do some locally in terms of working with suppliers, but, for the most part, we're working with the suppliers here at corporate and then working closely with our operating companies. So from that standpoint, we've realized a lot of benefits, but we have some more launches here to do later this year and into next year; not a significant part of the overall volume. And then, I think what you'll see us do is we'll get into renewals and we'll continue to perfect what we started here and get better at it, and probably have more time to focus on the innovation side of it, which is critical, obviously, to growing the business as well. So, I look at it as something which we would continue to get better at, which would continue to help us mitigate the overall margin pressure that we face in the business itself, but something that we feel really good about at this point.

[Meredith Adler:]

Great. Thank you very much.

[William J. DeLaney:]

Sure.

[Operator:]

And let's take our next question from Andrew Wolf with BB&T Capital Markets.

[Andrew Paul Wolf:]

Hi. Good morning. Bill, I wanted to ask you about the sales trend during the quarter into April, and – it was pretty abrupt from quite strong to kind of weak. And I didn't see Sysco's numbers, but for the industry. It sounds like you guys outperformed that, but what do you think is going on with the industry? I mean, you kind of alluded to weather, because last year was easy and this March was tough. What do you think is going on in April? And I mean, do you have some insight into things maybe stabilizing or turning back up here in the later part of April or early May?

[William J. DeLaney:]

Yeah, Andy, if you notice, I really didn't talk a lot about the industry or the market because it's hard to make that call right now. While I did talk about weather, I didn't whine about weather this year. So I feel good about that. What we saw was this, and what I alluded to in my comments, we had – last year, if you go back and look at the weather, it was pretty harsh in December, January and the first three weeks in February and it was harsh in areas where typically you don't see it

[Andrew Paul Wolf:]

Okay. No, I was looking for more color. But I just want to clarify with following up just on what you're saying. In your preamble, you said you expect things to get better. It sounds like it's more of a macro view of the business rather than something you've seen in the last week or two as a trend that has turned up.

[William J. DeLaney:]

Well, I expect the macro to clear up is what I try to say. I wish I could give you more. In terms of our performance, what I alluded to in my comments was March was softer and April softer. But again, I do think some of that is the comparisons. We'll see. So let's summarize here. You've got moderate inflation, you've got some FX, but let's put that to the side. And you've got softer volume in March and April. I would expect it to pick up. I'm still very pleased with what we are doing. We are growing our volume both on the local side and the corporate side. So relative to the market, I'm pleased where we are at there.

[Andrew Paul Wolf:]

I just wanted to ask Chris a question on the incentive compensation accrual you've called out. It's kind of housekeeping, but it seemed like quite a big number compared to trend and well above what the stock option alone would be. Did I do that math right? And if so, could you give us some explanation of why the accrual was so big?

[Robert Chris Kreidler:]

Yeah, I'm not so sure. I can't respond to the last part of – compared to what you're thinking, but the accrual itself is just what we anticipate paying out on those incentive accruals versus where we are on our objectives and on a year-over-year basis, we're just in a much better place. So last year at this time, we were not hitting our bonusable objectives and so we had very little accrued this year. We are accruing still at target because we are on pace to hit those objectives. So on a year-over-year basis, that's where you get the increase.

[Andrew Paul Wolf:]

Okay. So you're saying it's on trend with prior quarters, there was no catch-up Q3, just your on trend with the bonus accrual?

[Robert Chris Kreidler:]

Not this year. Yeah, this year, there's been no catch-up from quarter to quarter. No. Last year, it bounced around because every quarter you got to look at where you are versus those objectives and so we went through the first quarter fine. But then we had to start reducing the accruals Q2 and Q3 because we were no longer on track to hit the target.

[Andrew Paul Wolf:]

Fine. So you were just calling out a tough comparison and we can do the adjustment if we like, and it is what it is. Okay.

[Robert Chris Kreidler:]

Yeah. That's really all it is. Like say, I normally – I try to put things on an apples-to-apples basis as much as possible and when I look at our performance this year, especially on operating expenses, I don't like to say, well, we have to compare those incentives versus a year where there were no incentives whatsoever. Now, we still have to pay for those incentives and so those are real dollars and they are really going to go out the door, so we don't try to, again, excuse it, so much as just when you are looking at a percentage increase, I like to try to do apples-to-apples. That's why I gave you the number.

[Andrew Paul Wolf:]

Thank you.

[Operator:]

And we'll take our next question from Kelly Bania with BMO Capital Markets.

[Kelly A. Bania:]

Hi. Good morning. Thanks taking my question. I was just curious in the quarter how you think about market share or what your market share may have been and I ask because it looks like some of the broader industry sales trends, at least for the restaurants, it seem very, very strong this quarter. So I was just curious what you would think how you performed relative to the industry during the quarter.

[William J. DeLaney:]

I'll take that one, Kelly. First of all, we don't track market share quarterly. We look at it annually through different industry sources, primarily technomics and we look at the overall market, U.S. and Canada, and then obviously we look at our numbers and generally if you go back and look over the long-term, Sysco has been able to grow its share about half a point a year and I think we are continuing to do that. I can't really speak to this quarter on market share because I don't have the market data. Certainly, there was some strength in our customer base but not throughout the quarter and certainly not with all customers. So again, I was pleased with how we grew the business, but we don't really track the market share quarterly.

[Kelly A. Bania:]

Got it. And then if I could just follow up with one more. Just in light of McDonald's announcement to shift towards using antibiotic-free chicken on their menus, I was just curious how Sysco is maybe positioned in terms of supply of antibiotic-free chicken. Do you see that as an opportunity? What kind of conversations are you having with suppliers and your customers around these products and what could any sales and margin implications for Sysco be if there is a broader shift from your customers to products like this?

[William J. DeLaney:]

Yes. I think if I could broaden the question a little bit and not make it about chicken, but just in general, that's one of the key things that we think category management will help us focus on with a brighter light, which is be working with our suppliers and our customers is to better understand what the customers' needs are and how we can, as we optimize our SKUs and strategize together and do a better job of positioning a product in the way that our customers would want to see it whether it's organic or local or whatever it was important to them. So with us, it always starts the way you posed the question, which is what's important to the customer? What does the customer need? And we are doing a lot of work on the customer side through the marketing department, customer loyalty and issues to understand customer needs and then connecting that to the work that we are doing with our suppliers and category management and the data they provide us to better optimize our SKUs. Now, it's early days and plenty of work to do there, but it's a big opportunity for us going forward. And I would also say to you, we have over the years made some good progress on the sustainability front and I think you'll see us continue to raise the profile of that work within the company and that group will work very closely with our customers, but also with our merchandising and our marketing team. So bottom line is we do everything we can to understand what the needs of our customers are. I think we are better positioned to do that going forward and I think we can speak more specifically about that as time goes on.

[Operator:]

And we'll take our next question from Mark Wiltamuth with Jefferies.

[Mark G. Wiltamuth:]

Hi, thank you. Could you just give a little more detail on what we could expect from the court action this week? How long will it take before we hear a decision? And if the court rules for you, is it a foregone conclusion that things will just be approved as stated? Or do you still need to negotiate with the FTC? And if there's a ruling against you, how long does it take to get through the administrative hearing with the FTC?

[William J. DeLaney:]

Great questions, Mark. This was new ground for all of us. I would say, as far as the timing, obviously, that's in the hands of the judge in terms of how long the process takes. The hearing starts tomorrow and the judge has given us up to seven days so we'll go through – it's likely to go through the end of next week. Then there'll be some, as I understand it, some briefs or papers filed by each side with the judge to review. And then, he'll take the time that he needs to come back with a ruling. So we don't know exactly how long that is, but I would think it's closer to weeks than months. But, again, that's his call. As far as what happens, as I said in my comments, if we were to prevail, then we think there's a short period of time where the FTC has an opportunity to decide whether they want to appeal or not. And we would wait on that, and then go from there. If they were to prevail, we'll sit down internally and then sit down with the sponsors, the owners of US Foods and charter a course from there as well. So, to be determined, but that's – those are the different ways it could play out.

[Mark G. Wiltamuth:]

Okay. And maybe you could talk about the state of US Foods while we're waiting, because we have seen some margin declines in their business through this year, we've been waiting for this deal to close.

[William J. DeLaney:]

I really can't comment much on US Foods. I think it goes without saying that this process is taking longer than we would've liked. And it's probably a little bit harder on them than it has been on us. So, early days, certainly they lost some sales people and I think their sales were hurt. I'm not close enough to it nor should I be in terms of what their margins are right now. And obviously, they pulled back here some on the integration planning over the last couple of months. So we'll – I think I'll just leave it at that. I probably shouldn't be commenting on US Foods.

[Mark G. Wiltamuth:]

Okay. Thank you very much.

[William J. DeLaney:]

Thank you.

[Operator:]

And let's take our next question from John Ivankoe with JPMorgan.

[John William Ivankoe:]

Hi. Thanks. At this point, just one, I think, easy question for you guys. SYGMA, in general, had a very strong year in fiscal 2014 and has been pretty slow year-over-year to this point in fiscal 2015. Can you shed some light in terms of what's happened there, whether some was by choice, maybe some wasn't by choice? How you feel about the overall growth of that segment over time?

[William J. DeLaney:]

Thanks, John. I'll start. I'll let Chris jump in too. I would say it's been a couple of years since SYGMA has had a strong year, and it's got a lot of attention. We have restructured there somewhat and put Greg Keller over SYGMA full-time. And Greg grew up in the SYGMA business. He's been running our national sales area up until the last several months, so he is very well-versed in the SYGMA business. He's very well connected with our customer base. He's got a lot of passion for that business. So, I believe we're in good hands there for leadership. There's some things that we're working on there both in terms of how do we better position ourselves in terms of the needs of those customers and still run expenses very tight. So, it's a very transaction service oriented business. Not with a lot of touches like the Broadline, but there's very little margin for error in SYGMA. So, we've had to invest some money over the last year or so in terms of facilities and drivers and people like that and things like that to strengthen the business. And that's hurt us on the bottom line. We've also had to just take a look at how well we're running the business overall. So, I'd say, we're in transition with SYGMA. We like the business strategically. It's a very – that customer base or potential customer base is a big part of the overall opportunity. And it's always nice when you're sitting down with customers or prospective customers for – to give them a choice in terms of which model they would prefer, the SYGMA model or the Broadline model. And the reality is sometimes they prefer both, depending on their locations and our positions; so, somewhat in transition there, work to do strategically, still very important to the company.

[John William Ivankoe:]

Have you...

[Robert Chris Kreidler:]

John?

[John William Ivankoe:]

Yes. Hi.

[Robert Chris Kreidler:]

Yeah. Just add a couple of other points. As Bill said, it's a business where expense control is incredibly important. It's a low margin business. There have been some regulatory changes on the transportation side, drivers and work rules and things like that, that, while we can handle those fairly well in the Broadline, they affect SYGMA disproportionately. And we're having to overcome some of those things. And as Bill said, we just – we've got to look at the model and continue to find ways to offset increases like that; so I would echo the statement. It's in transition. We've got some work to do.

[John William Ivankoe:]

Has there been any significant account loss that's maybe been covered up by some account gains? And as you kind of look forward over the next couple of years, do you have any big chain opportunities to add that could be coming up for bid?

[William J. DeLaney:]

I don't think there's any overly significant account losses. SYGMA is no different than the rest of our business. There's a lot of pricing pressure in that business, and so we've had to deal with that as well along the way as we've looked at expenses. But again, Greg is a very strong leader, very strong sales guy. So I'm quite optimistic that we'll continue to find the right mix of customers and do a good job for them. And – but again, the way we look at SYGMA today is we want to understand what the customer's looking for

[John William Ivankoe:]

Thank you.

[William J. DeLaney:]

Sure.

[Operator:]

And we'll take our next question from Vincent Sinisi with Morgan Stanley.

[Vincent J. Sinisi:]

Hi. Thanks very much for taking my question. Wanted to just go back to the product for a second. And it sounds like, obviously, early stages, but so far if you've been seeing any incremental demand increases from more of your customers wanting natural organic types of products, would you say that so far you've been able to have access to the supplies? Have you been able to meet demands? And that, now as you're continuing to go through category management, is that something that will continue to evolve? Is that fair to say at this point?

[William J. DeLaney:]

Hey, Vinny. Yeah, that's what I was trying to say. So, yes, we've definitely seen that trend over the last few years. Now, it's a trend. And I have to tell you, in the scheme of what we do, it's not a huge amount of the business, which creates part of the challenge where you need enough volume and you need enough velocity to make it work for the supplier and on the cost side and for the customers. So, I would say it's like a lot of things in Sysco today. There's certainly parts of the country and certain OpCos where we do a very good job on the local side and fresh side, and then there's others not so good. And that's where I see the work in merchandizing, and category management, in particular, with innovation getting us in position to be more consistent; and by doing that, create more volume, which will make it more economical. So, the trends have definitely been there. We're responding to them. We just – we need to continue to get better at it and – it's a catch-22. We need to continue to grow the volume to make it work for everybody.

[Vincent J. Sinisi:]

Right. That makes sense. Okay. And then, just a quick follow-up. Inflation, that you could see, moderate over the quarter. Was anything kind of internally surprising to you versus your forecast from a particular category specific standpoint? And then, maybe just any additional color with your thoughts on inflation overall as we get through the rest of this year.

[William J. DeLaney:]

Yeah – surprising. I guess probably it fell off faster than I thought it would from that standpoint. It doesn't surprise me that dairy is down, for example. I mean, dairy is a very volatile category, but the fact that several categories are essentially flat, that's probably a little surprising. And I think as far as the rest of the year, I can't – if you're going to give me the fiscal year, I could probably look that far ahead. And I think we talked about this with John, earlier. Yeah, I would expect inflation to moderate somewhat more, but I still expect to see some low level of inflation here this quarter.

[Vincent J. Sinisi:]

Okay, Bill, thanks very much. Good luck.

[William J. DeLaney:]

Thank you.

[Operator:]

We'll take our next question from Erin Lash with Morningstar.

[Erin Lash:]

Hi. Thanks for taking the question. I apologize if I missed this earlier, but one of the things that stood out to me in the operating expense line was that delivery costs were lower. And I wondered if you could speak to that, if there was an anomaly this quarter, or whether that's a trend that you expect to continue in light of the fact that we've been hearing that truck driver shortages continue to plague firms across a number of industries?

[Robert Chris Kreidler:]

Yeah, it was mainly driven – at least in our case, it was mainly driven by lower fuel costs, which we called out. So, is the truck driver shortage abating? I would say that it's not getting any worse. We've kind of learned how to handle it, although it's not exactly easy; but this particular quarter we just started to see some benefit from fuel. And if you recall a quarter or so ago, we talked about we'd start seeing some benefit in the back half of the year, and this is it.

[William J. DeLaney:]

Yeah. Erin, I would only add – I think where we have driver shortages, and where it's not self-inflicted, it's generally in these areas where there has been a lot of drilling and a lot of energy. And so, as that's subsided somewhat, I think that has actually created a little more capacity. So, we're not all the way back there, but I think that pressure is a little less than what it was six months or nine months ago.

[Erin Lash:]

Okay. Thanks. That's very, very helpful. And then, just my second question with regards to a lot of the press surrounding the avian bird flu and whether that will – or to what degree you think that that could impact your cost structure going forward.

[William J. DeLaney:]

Erin, it's really too early for me to make a call on that. I don't think to a large extent, but it's certainly – those types of things are things we monitor regularly, but at this point, I'd say – I wouldn't say that's a big issue from a cost.

[Robert Chris Kreidler:]

Yeah, it's affecting some of the supply as you're reading and that obviously has some impact out there. It's only if it starts affecting a very large part of the supply, not just here in the U.S. but offshore as well, but it begins to impact our ability to find product and distribute it to our customers. Thus far, that's not the case. But as Bill said, we watch this stuff. We stand up crisis teams when it's important and when it becomes relevant.

[Erin Lash:]

Thank you. That's helpful.

[Operator:]

And that does conclude our Q&A session and our conference call for today. We appreciate your participation. You may now disconnect.