United Natural Foods, Inc.
Q2 2016 Earnings Call Transcript

Published: 8 Mar 2016

[Operator:]

Greetings, and welcome to the UNFI Second Quarter Fiscal 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Katie Turner of ICR. Thank you, Ms. Turner. You may now begin.

[Katie Turner:]

Good afternoon and thank you for joining us on UNFI's second quarter fiscal 2016 earnings conference call. By now, you should have received the copy of the earnings release issued this afternoon at approximately 4

[Steven L. Spinner:]

Thank you, Katie. Good evening, everyone, and thanks again for joining us. While UNFI short term growth and sales and earnings continue to be challenged as evidenced by our revised 2016 guidance, our mission remains the same. We are intently focused on managing the controllable aspects of our business, as we make strategic investments to improve our sales growth rate and customer experience through the back half of this fiscal year and into fiscal 2017. At UNFI, we are focused on building distribution opportunities with new customers and expanding relationships with current customers. We believe UNFI's unique ability to provide customers across every channel of food retail will ultimately be the key driver in our future growth. Our fresh distribution network, our capital structure, our breadth of product offering and, most importantly, our people, all contributed to UNFI's very unique position to add value to customers in an evolving food retail environment. We continue to execute our initiatives to fuel our growth over the next several years, e-commerce, food service, mass and conventional channels, in which UNFI has historically been under indexed, will become more and more important to us. Utilizing our low-cost logistics network to aggregate freight for customers and having an open mind to think about new ways to help retailers be differentiated in their markets have become an important part of our service offering. The macro environment for natural and organic will continue to be strong. With overall industry growth estimated at 7% to 9% for calendar 2016, UNFI is uniquely positioned to better capture this opportunity through our Building Out the Store strategy and infrastructure. UNFI should be the access point across every channel and retailer for all or parts of the products and services we offer. Economics will ultimately drive the retailer decision to include as many product categories as possible into their distribution program. Looking back over the last several years, UNFI grew at a rate that was greater than the overall industry, while in fiscal 2016, we will not. We fully recognize the need to move UNFI back towards growth during fiscal 2017 driven by new customer channels and expanding our relationships with a wider variety of products. Today, we announced several important changes to our organizational structure. It is a change that we believe brings our teams closer to the retailer/operator and will serve as the primary driver towards an exemplary customer experience across all of our companies. Beginning in August 2016, UNFI will be structured more regionally with the Pacific, Central and Atlantic regions. Each region will have a president responsible for all of our products and services within the territory, including fresh, grocery, wellness, e-commerce, food service, and gourmet ethnic. Territory managers will now sell across UNFI's complete product offering with a single point of contact for our customers. Technology will be deployed to further enhance the customer experience as program economics and merchandising drive operator behavior towards a greater share of the store with UNFI. This is very exciting news for UNFI as we structure resources across our business to fuel even stronger customer relationships. M&A continues to be an important part of our growth strategy. Last week, we announced we had entered into an agreement to acquire Haddon House Products, Inc. (sic) [Haddon House Food Products, Inc.] (05

[Michael Paul Zechmeister:]

Thanks, Steve. Good evening, everybody. Net sales for the second quarter of fiscal 2016 were $2.05 billion, which represents growth of 1.5% or approximately $31 million over the second quarter last year. Our adjusted overall sales growth for the same period was approximately 6.5%, excluding the year-over-year impact of the previously disclosed customer distribution contract and the prior-year non-recurring reduction in net sales. Inflation came in 29 basis points below last quarter at 2.15% in Q2. From a channel perspective, supernatural's net sales outpaced overall sales growth, up 6.7% over the prior year's second quarter and represented 37% of total sales. The independent channel grew 4.2% in the second quarter versus the prior year, and independents represented 27% of our sales. Supermarket sales declined 11.8% in Q2 versus the prior year and landed at 26% of total sales. Adjusting for the customer contract termination, supermarket sales increased 6.1% in Q2 over the prior year. And finally, food service sales were up 20% over the prior year, and e-commerce sales grew 44% over the prior year. Gross margin for the quarter came in at 14.5%, a 31 basis point decline over last year's second quarter, which included the impact of previously disclosed $7.7 million in non-recurring reduction to net sales. Excluding this impact, the second quarter gross margin declined 63 basis points. Sequentially, second quarter gross margin declined 59 basis points over the first quarter gross margin of 15.1%. The decline versus the first quarter and the prior year's comparable quarter was due to the competitive pricing pressure, moderated supplier promotional activity, unfavorable sales channel and category mix, the reduction of our fuel surcharge, and the impact of continued weakness in the Canadian dollar. We anticipate the reduction in fuel surcharge will continue to have an unfavorable impact year-over-year on gross margin. Similarly, we anticipate the headwind associated with FX to continue but moderate as we head into the back half of the year and lap the steep decline in the Canadian dollar during Q2 last year. Our operating expenses for the quarter were 12.5% of net sales or 12.4%, excluding $2 million in severance and other transitional costs associated with the previously announced restructuring plan and approximately $1 million of acquisition costs. This compares to 12.4% for the same period last year or 12.3%, excluding the non-recurring reduction in net sales. For the quarter, total fuel costs decreased by 13 basis points as a percentage of net sales in comparison to the second quarter fiscal 2015 and represented 47 basis points of distribution net sales. Our diesel fuel cost per gallon decreased by approximately 19% in the second quarter versus the same period in fiscal 2015, while the Department of Energy's national average diesel was down approximately 35% or $1.16 per gallon compared to Q2 last year. Share-based compensation expense was flat on a dollar basis versus last year at $3.5 million in the quarter, representing 17 basis points of net sales compared to 18 basis points in the second quarter of fiscal 2015. Operating income for the second quarter was $41.7 million, down $7.8 million from the same period last year. Our operating margin in Q2 was 2.04%, a 41 basis point decline over the second quarter of fiscal 2015. Excluding $2 million of restructuring costs and approximately $1 million of acquisition costs in the second quarter of fiscal 2016, adjusted operating income decreased $12.6 million versus adjusted operating income for the same period of 2015, which excludes the impact of prior year non-recurring reduction in net sales. As a percentage of net sales, adjusted operating income for the second quarter of fiscal 2016 decreased 65 basis points to 2.18% compared to adjusted operating income in the same period last year. We expect our operating margin as a percent of sales to increase in the back half, primarily driven by fixed cost leverage associated with the additional sales from product categories like produce and supplements. Interest expense for the quarter was $3.6 million, 1.3% higher in Q2 of the prior year due to an interest rate swap agreement effective in August of 2015 on our term loan. As communicated previously, we expect this swap will effectively fix the interest rate on the remaining term loan and will be approximately $0.03 dilutive to EPS for the year. For the second quarter of fiscal 2016, the company reported net income of $22.7 million or $0.45 per diluted share, a decrease of approximately $5.2 million over the prior year second quarter. Excluding $2 million of severance and other transitional costs and $1 million of acquisition costs in the quarter, adjusted net income was $0.49 per diluted share. Inventory was $942 million at quarter-end, an increase of 2% compared to second quarter last year, primarily due to increased sales year-over-year in the period. Second quarter inventory was $141 million lower than last quarter, as we typically manage to a less inventory post holidays, but also delivered a 0.6 day reduction at inventory days on hand. Capital expenditures were approximately $12.9 million or 0.6% of net sales for the quarter. For the second quarter of fiscal 2015, capital expenditures were $28.8 million or 1.4% of net sales. Outstanding lender commitments under our credit facility were $583 million at quarter-end with available liquidity of approximately $252 million, including cash and cash equivalents. Since quarter-end, our available liquidity has improved to approximately $325 million net of today's acquisition of Global Organic. Our leverage at the end of second quarter improved to 1.55 times on a trailing 12-month basis, which is the lowest level, since the end of third quarter of fiscal 2014 just prior to our acquisition of Tony's Fine Foods. The anticipated impact on leverage from the Haddon House acquisition is an increase of 0.7 times to 0.75 times on a trailing 12-month basis at the end of Q2. We generated free cash of $106.2 million in the second quarter, which was $89.1 million better than last year's second quarter, where capital spending was $16 million higher without the sequential improvement in inventory days on hand that we delivered this year in Q2. Our trailing 12 months free cash flow was $132.9 million, and as we look forward to the remainder of the year, we are increasing our expectation of free cash flow to $100 million to $120 million from the previous estimate of $80 million to $100 million in fiscal 2016. As announced last week, we revised our guidance for fiscal 2016. Consistent with that update, we expect net sales to be in the range of $8.3 billion to $8.4 billion, which represents a 1.5% to 3% increase in total net sales over fiscal 2015 and our previous sales guidance of $8.4 billion to $8.6 billion. We also updated our diluted earnings per share guidance last week. And consistent with that update, we continue to expect GAAP EPS for fiscal 2016 within the range of $2.34 to $2.44. Our previous GAAP earnings guidance was $2.73 to $2.84 per diluted share. As a reminder, included in our fiscal 2016 earnings guidance is approximately $4.8 million of severance and other transitional costs, $2 million of which were incurred in the second quarter and $1 million of acquisition costs we also incurred in the second quarter. Please note that the anticipated sales and earnings associated with the recently announced agreement to acquire Haddon House and the acquisition of Global Organics are not included in this guidance. While we expect the Haddon House transaction to close in early Q4 of fiscal 2016, the closing date is subject to the satisfaction of customary closing conditions and regulatory approval. At this point, I'll turn the call over to the operator to begin the question-and-answer session.

[Operator:]

Thank you. And our first question comes from the line of Karen Short from Deutsche Bank. Please proceed with your question.

[Karen F. Short:]

Hi. Thanks for taking my question. Just to clarify, did you actually just say that EBIT margins would be up year-over-year in the second half? I guess, just to clarify that because it seemed that with Gilroy opening in the third quarter, that may actually be further pressure on your margins with further deleverage. So, maybe clarify that and then I had another question.

[Michael Paul Zechmeister:]

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

[Karen F. Short:]

You said flat, originally, right?

[Michael Paul Zechmeister:]

No. You can get there off of our guidance.

[Karen F. Short:]

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

[Michael Paul Zechmeister:]

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

[Karen F. Short:]

Okay. And then, Steve, obviously – sorry?

[Michael Paul Zechmeister:]

That headwind will continue through the fourth quarter.

[Karen F. Short:]

Okay. And then, Steve, obviously, it seems – obviously, the reporting changes sound interesting, but I guess, I'm wondering can you maybe discuss the training component of the changes to the reporting structure, because it seems like managers are obviously going to have to expand their product knowledge pretty meaningfully.

[Steven L. Spinner:]

Yeah.

[Karen F. Short:]

So, is there any risk that the learning curve will be steeper than expected?

[Steven L. Spinner:]

Yeah. No, I mean, in many markets around the country, the retailers will have a fresh. It's possible that they'll have a fresh sales person as well as a person that covers the rest of the store. At the same time, there are specialists that are deployed across all the regions, representing wellness, produce, protein, food service, et cetera. And so, in the new scenario, the amount of expertise within the region actually goes up dramatically and, at the same time, there will be quite a bit of training that goes on just to make people more comfortable selling across a wider range of SKUs. But a lot of the talent that's already there will be deployed in the regions and it's just makes it much easier for the customer as you might imagine.

[Karen F. Short:]

Okay. Thanks.

[Operator:]

Our next question comes from the line of Meredith Adler from Barclays. Please proceed with your question.

[Meredith Adler:]

Hey. Thanks for taking my question. I was wondering – I'd like to go back to something you talked about last week, didn't mention too much here. You did mention it, but I'm trying to understand the vendor moneys that have gone down, is there a difference between the money you get from vendors and forward buy or do you have to do the forward buy and take the risk on the inventory or buy the inventory to get it?

[Steven L. Spinner:]

There's actually a couple of buckets that we tend to earn from. Obviously, one is forward buy and when you don't have any inflation, it's very hard to forward buy against markets that aren't going up. So, that's number one. Number two is when manufacturer runs a promotion with a customer, we frequently manage that promotional activity. In other words, we manage the billing and the bill-back, and there's a certain amount of administrative fees, if you will, that we earn on managing those transactions.

[Sean F. Griffin:]

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

[Steven L. Spinner:]

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

[Meredith Adler:]

Okay. Got it. And then, congratulations on this acquisition. I'm assuming that it's not really a huge acquisition. But I'd like to try to understand whether you see it as sort of a template or as a talking piece as you go to do more acquisitions to add more geography. Is there something beyond what it is in Florida that you think will be really helpful?

[Steven L. Spinner:]

Yeah. I mean, thank you for that, Meredith. It is 100% a template for how we will bring smaller companies into our portfolio. This one in particular was perfect. It's a great team, great customer base, great product base, and physically adjacent to our current Albert's and UNFI facilities. So, obviously, the synergy is pretty significant. But there are many companies around the country that have a very similar profile to Global, great product, high-touch, fresh perimeter, in the right markets for us and they're not – like I said, as it relates to the size, they're not overly material to our overall numbers, but very material in a particular market in terms of getting us into fresh faster.

[Meredith Adler:]

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

[Steven L. Spinner:]

No. I mean, look, we announced Haddon last week. We announced Global today. We've got a pretty deep pipeline. I mean we do have to phase them, because it's pretty hard for us to do a lot more than what we're doing at this particular point. But it's a great model for us. We have the infrastructure, we have the refrigerated DCs, we have the talent that knows how to manage handling highly perishable freight. And that's a tremendous barrier for most, being able to handle multiple temperature zones, mostly on the inbound storage and outbound. And we already have that infrastructure. So, Global, we hope, is one of many to come in this particular space.

[Meredith Adler:]

Great. Thank you very much.

[Operator:]

Our next question comes from the line of Andrew Wolf from BB&T Capital Markets. Please proceed with your question.

[Andrew Paul Wolf:]

Hi. Good afternoon. Just to follow up on Global, it looks like it has a lot of overlapping products or lines with Albert's, but maybe that's not the case beyond produce and a few other things. So, when you just sort of look at it as a business, is it more of a bringing new customers down to that part of Florida? Or is it more bringing new product lines to that part of Florida and maybe perhaps to the rest of the company?

[Steven L. Spinner:]

Yeah. I mean, it's all of the above. But this one in particular really gives us the ability to, one, add space. Our Sarasota facility is pretty close to capacity. We have a lot of fresh customer opportunity within that market, where we need the space, and Global certainly helps us from that perspective. And Global has a lot of intellectual capital associated with the acquisition of the products that we need to be selling. Albert's obviously is there already and has done a great job building our business in that market. Global will help us even more.

[Andrew Paul Wolf:]

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

[Steven L. Spinner:]

Yeah. I think it's probably the latter, Andy. I mean, we've got a – as I mentioned in my comments, our Woodstock custom snack business is growing really nicely. I'm not sure that we're going to want to go down the road of producing sandwiches and baked goods at this point. I think, to your point, we'd probably rather align ourselves with somebody who already does it really well.

[Andrew Paul Wolf:]

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

[Steven L. Spinner:]

No. We wouldn't want to get in to kind of adjusting because there's obviously many coming in as well as a couple that actually came out. So, I think the 4% was a good number and I'll leave it at that.

[Andrew Paul Wolf:]

Okay. Thank you.

[Operator:]

Our next question comes from the line of Robby Ohmes from Bank of America. Please proceed with your question.

[Marisa C. Sullivan:]

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

[Steven L. Spinner:]

Yeah. I think we're going to hold off on giving any more color related to Haddon, until we actually close. There is a fairly significant product overlap. However, UNFI does a much better job in the natural and organic. Haddon does a better job in the ethnic gourmet. So it's a perfect marrying of the two companies in the sense that we'll be as good in ethnic gourmet as we are in natural and organic. Second component of that is we've always had a full service, partial service model. Haddon has a tremendous reputation for managing service programs really, really well. And there are some retailers that really believe in the full service or partial service model. So we're excited about learning that as well. As far as any other specifics, we're going to hold off until we actually close.

[Marisa C. Sullivan:]

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

[Steven L. Spinner:]

No. It actually – remember, Tony's trades in the western half of the U.S., don't currently trade in the east. So the answer to your question is that a lot of the products that are currently handled by Tony's will find their way into the Florida market.

[Marisa C. Sullivan:]

Got it. Okay. Thank you.

[Operator:]

Our next question comes from the line of Scott Mushkin from Wolfe Research. Please proceed with your question.

[Scott A. Mushkin:]

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

[Michael Paul Zechmeister:]

Yes. Scott, that's going to be – there'll be a reconciliation of that on the website should give you the answers to your questions you're looking for.

[Scott A. Mushkin:]

Okay. So it's up there already?

[Michael Paul Zechmeister:]

Yes.

[Scott A. Mushkin:]

Yes. Okay. Perfect. And then, my second question actually has to do with – I think Andy talked about independents being pretty strong. The other thing that looked decently strong was that supernatural area. And I was just wondering, obviously, there's a mismatch between what you guys have going on – I know there's a lot of store building and other things in what the biggest customer that supernatural is reporting. How should we think about that as we go forward? I mean if you've built into your plans of dishallowing that because of the negative sales they are seeing? Or how should we think about bucket and the forward projections?

[Steven L. Spinner:]

Yeah, that's one that I just can't win at. So, we're going to stay away from that one. We're pretty confident in that team, and we obviously get the benefit of new store openings, but I wouldn't want to comment any more than that.

[Scott A. Mushkin:]

And the, Steve, on the 365, are you guys participating in that too as they bend their growth that way? How does that flow through that number?

[Steven L. Spinner:]

Yeah. Our distribution program covers 365 and Whole Foods stores. Yeah.

[Scott A. Mushkin:]

Okay. So, it's the same, but I guess, it's...

[Steven L. Spinner:]

Yeah.

[Scott A. Mushkin:]

We don't know what it's going to look like, but – do you distribute their private label or do they bring that a lot through their own? How does that work?

[Steven L. Spinner:]

No, no, we do their private label today.

[Scott A. Mushkin:]

You do. Okay.

[Steven L. Spinner:]

Yeah.

[Scott A. Mushkin:]

All right. I guess, that's actually I have. So, thanks for taking my quick questions. Thanks. Bye.

[Steven L. Spinner:]

Okay. Thanks, Scott.

[Operator:]

Our next question comes from the line of Joe Edelstein from Stephens. Please proceed with your question.

[Joe Edelstein:]

Hi. Good afternoon, everyone.

[Steven L. Spinner:]

Hi, Joe.

[Joe Edelstein:]

Last week, you said a number of times, I mean it really felt like things were somewhat temporary, and I was really just hoping to kind of gauge your level of confidence. They have – just how temporary and how quickly some of those factors could really start resolving themselves? And I think most specifically here, I am kind of referring to the lack of the vendor support and whether or not you can see some of those pieces coming back in and maybe breaking it down even in-between your expectations around hitting some of these sales breakpoints at which those promotional dollars would automatically kick in versus something that might simply be more of a discretionary dollar, based on that particular supplier's view into the channel where they want to position themselves.

[Steven L. Spinner:]

Yeah. I mean I don't think we can answer that, unfortunately. I think that we need, obviously, to get back on to a sales growth. You look back at UNFI's last five years, 2015 included, and our compounded annual growth rate was over 15% or right around there. And so, we've got to get back on our historical growth rate. Maybe it might not be that high, maybe it is that high, I'm not sure yet. But first and foremost, I think we have to get back on a growth trajectory. Promotional spend tends to be lumpy, right? So, sales fall off. Maybe the promotional activity falls off. There's always a timing difference between what happens in the promotional activity and what happens in the sales, right? So, at some point, somebody wakes up and says, hold on a second, we're not growing in channel X. We got to get back to promotion. And lo and behold, we get promotional activities. So, I don't think we could give you any specific color around when and how, other than that activity tends to be, like I said, lumpy over the course of the year. But first and foremost, we're focused on getting our sales trajectory back and believe that based on the infrastructure that we'll do it.

[Joe Edelstein:]

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

[Steven L. Spinner:]

Yeah. I mean, I think we have a general idea of what that number is, but again it's not something that we're going to want to publicly disclose. And the other part of that is we have markets that have more capacity than others. Sometimes you can't pick and choose but generally speaking, we get an opportunity, we're going to take it.

[Sean F. Griffin:]

I would say from an enterprise perspective, in the short term, we're challenged by being under capacity from an opportunity perspective, against the pipeline of prospective new customers as well as category expansions within existing customers. It's about realizing that opportunity against the capacity. We have a couple of years of runway, not withstanding specific geographic areas actually that, Steve, you called out in the Southeast, primarily where we continued to have challenges today.

[Joe Edelstein:]

Okay. Best of luck filling the capacity.

[Sean F. Griffin:]

Thank you.

[Steven L. Spinner:]

Thank you.

[Operator:]

Our next question comes from the line of Kelly Bania from BMO Capital Markets. Please proceed with your question.

[Kelly Ann Bania:]

Hi. Good evening. Thanks for taking my question. I was wondering if we could just step back to the guidance that was provided last week and I know there were a lot of questions about the margin pressure and the sales slowdown. But I'm curious, if you look back just even a couple of months ago, it's still kind of unclear, I guess, to me where the source of that pressure is. And I was just curious, if you wanted to or could talk about where you think that source of pressures from i.e., is that traditional competitors within your key natural and organic distribution? Is that other competitors? Is it more at the retail level? I think it's a little bit of everything, but are you able to quantify and see where that competition may be stabilizing or accelerating, so we can try to get a sense of when the sales will stabilize?

[Sean F. Griffin:]

Well, I mean, I don't see it as a sales issue as much as it was a margin issue, because, I mean, certainly, if you do the math and you back out a customer loss and some of the things that are happening within our current customers, the growth was, while not quite at industry growth, it was still pretty strong. It's really more of a margin issue associated with promotional activity, lacking inflation, Canadian FX, certainly competitive pressure at the retailers and fuel. I would say those are the primary drivers, and they kind of all hit us at once and it's just a matter of working our way through them. I don't think that competitive nature of distribution is changing a lot. It's been competitive for a long time, and it'll continue to be that way. I think what really – what hurt us was more of the margin issues than anything else.

[Kelly Ann Bania:]

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

[Steven L. Spinner:]

Yeah, I mean, this is opinion, not fact. So, it's my view that manufacturers will go to where there's growth, and they'll promote where there is growth. And so, for example, the natural industry has been growing at a slower rate than, let's say, mass or conventional, then perhaps they might make the decision to promote more heavily in those channels than they do in natural. But then to the comment that I made earlier, at some point somebody is going to wake up and say, wait, we don't have a growth in natural. Our challenge is to be more further indexed across a wider range of channels than we are today, and that would make us less susceptible to these pretty significant shifts.

[Kelly Ann Bania:]

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

[Michael Paul Zechmeister:]

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

[Kelly Ann Bania:]

Thanks.

[Operator:]

Our next question comes from the line of Rupesh Parikh from Oppenheimer. Please proceed with your question.

[Rupesh Parikh:]

Thanks for taking my question. And, Mike, I just want to also go back to the prepared comments on operating margin expansion. So, if I understand that correctly, I think what you're referring to is that you expect the operating margins to be higher in the second half than the first half here, is that correct?

[Michael Paul Zechmeister:]

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

[Rupesh Parikh:]

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

[Steven L. Spinner:]

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

[Rupesh Parikh:]

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

[Michael Paul Zechmeister:]

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

[Rupesh Parikh:]

Okay. Great. Thank you.

[Operator:]

Our next question comes from the line of Vincent Sinisi from Morgan Stanley. Please proceed with your question.

[Andrew R. Ruben:]

Hi. This is Andrew Ruben on for Vinnie. I was wondering if you could talk about the Tony's business. Any color on how it's performing and any update on the roll-out of Tony's products (46

[Steven L. Spinner:]

Yeah. No, I think it's – Tony's is a business that's doing extremely well for us, great acquisition, a ton of terrific people, ton of terrific people. And as we've said earlier, we've moved the Tony's product categories into our Denver warehouse and I referenced that in my prepared comments and very optimistic about what's taking place within that facility and, certainly, now, with what's going to take place in Florida. Certainly, the reorganization will help us identify, for example, protein and related opportunities and more historical UNFI customers in the west, and same thing for historical Tony's customers with natural and organic in the west. So I would say I've been doing this a long time and Tony's certainly ranks up there as one of the better acquisitions we've ever done.

[Andrew R. Ruben:]

Great. Thank you. And then, can you talk about how inflation in meats and cheese maybe impacting the Tony's business and what kind of effects that might have on your overall inflation rate?

[Steven L. Spinner:]

Sure.

[Michael Paul Zechmeister:]

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

[Andrew R. Ruben:]

All right. Great. Thank you.

[Operator:]

Our next question comes from the line of Bill Kirk from RBC Securities. Please proceed with your question.

[William Kirk:]

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

[Steven L. Spinner:]

I'm not sure I follow that question.

[William Kirk:]

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

[Steven L. Spinner:]

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

[William Kirk:]

Okay. And in terms of the new structure becoming, I guess, a little less centralized, that's happening at the same time Whole Foods' model seems to be coming more centralized. Is there a disconnect between the direction of those two strategies?

[Steven L. Spinner:]

I can't comment on Whole Foods. I can just tell you that in our world, all of our, kind of, things that don't touch the customer today are centralized, inbound logistics, the way we manage we our fleet, and so on and so forth. What we're changing is the touch point to the customer and essentially bringing the customer closer to the decision maker. So, instead of the customer having to deal with four or five different entities within UNFI, in the new world, they'll deal with one or two.

[Michael Paul Zechmeister:]

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

[Steven L. Spinner:]

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

[William Kirk:]

Okay. Thank you.

[Operator:]

And our next question comes from the line of Mark Wiltamuth from Jefferies. Please proceed with your question.

[Mark Gregory Wiltamuth:]

Hi. So, it sounds like we've got an update on how the fresh is progressing on the West Coast and in Denver, but I'm curious if you're doing any sales out of the Hudson Valley or Racine, Wisconsin at this point.

[Steven L. Spinner:]

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

[Mark Gregory Wiltamuth:]

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

[Steven L. Spinner:]

It's hard to know. We've got folks that are eagerly working on that and, certainly, if it's material, be in a (52

[Mark Gregory Wiltamuth:]

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

[Steven L. Spinner:]

We are very interested in getting an ERP on board (53

[Mark Gregory Wiltamuth:]

Okay. All right.

[Steven L. Spinner:]

And today, we have a national financial suite, but there is a lot of work we could be doing in terms of shared services. We've got plenty to keep us busy on the warehouse side from a technology standpoint. And so it's – that's going to be at least or I wouldn't want to comment when it'll take place, but it's certainly some of the work we need.

[Mark Gregory Wiltamuth:]

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

[Steven L. Spinner:]

It would be – I can't really comment on that. We're looking at a wide variety of companies. I would tell you that they – most of them are not going to be the size of Haddon House. Haddon House is one of the larger ones that we have here. Tony's was certainly larger. So anywhere from Haddon House down, I would say.

[Mark Gregory Wiltamuth:]

Okay. Thank you very much.

[Steven L. Spinner:]

All right. Thank you, everybody, for joining us today. Our long-term vision for UNFI remains unchanged

[Operator:]

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