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Executives

Gary T. Steele – Chairman of the Board, President & Chief Executive Officer

Gregory S. Skinner – Chief Financial Officer & Vice President Finance and Administration

Analysts

Steven Denault – Northland Securities, Inc.

Peter Black – Winfield Capital

Jonathan Lichter – Sidoti & Company

Anton Brenner – Roth Capital Partners

Nelson Ovis – Winfield Capital

Saloman Kamalodine – B. Riley & Co.

Craig [Paringer] – Wells Capital Management

William Lauber – Sterling Capital Management

Landec Corporation (LNDC) F2Q09 Earnings Call January 7, 2008 11:00 AM ET

Operator

Welcome to the Landec Corporation second quarter fiscal year 2009 earnings conference call. At this time, all participants are in a listen only mode. Later we’ll conduct a question and answer session and instructions will be given at that time. (Operator Instructions) As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference Mr. Gary Steele, Chairman and Chief Executive Officer of Landec Corporation.

Gary T. Steele

Welcome to Landec’s first half and second quarter fiscal year 2009 earnings call. I have Greg Skinner with us today, our Chief Financial Officer. This call is being webcast by Thomas CCBN and can be accessed at Landec’s website at www.Landec.com on the investor relations page. The webcast will be available for 30 days through February 6, 2009. A replay of the teleconference will be available for one week by calling 888-266-2081 or 703-925-2533. The access code for the replay is 1315192.

During today’s call we may make forward-looking statements that involve certain risks and uncertainties that could cause actual results to differ materially. These risks are outlined in our filings with the Securities & Exchange Commission including the company’s form 10K for fiscal year 2008.

As reported in yesterday’s press release, for the first six months of fiscal year 2009, Landec increased revenues by 7% to $129.8 million compared to the same period a year ago. Net income for this six month period decreased to $4.3 million or $0.16 per diluted share compared to net income of $6.2 million or $0.23 per diluted share last year. At the same time, we increased our cash flow from operations by 52% to $3.3 million during the first six months of fiscal year 2009.

During our second fiscal quarter we witnessed the further deterioration of the US economy and correspondingly slumping consumer demand. For our second quarter ended November 30, 2008 revenues were $58 million versus $59 million in the second quarter last year and our net income for the second quarter was $1.5 million or $0.06 per dilute share versus $3.1 million or $0.12 per diluted share for last year’s second quarter.

For the first time since we have been in the fresh cut vegetable business, starting in the year 2000, overall industry volume shipments for the overall category have turned negative with a decline of 6% for the six month period and 12% decline during the second quarter. While the overall category volumes declined 6% for the six month period, Landec increased unit volumes 1%. While overall category volumes decreased 12% in the second quarter, Landec’s unit volume decline was 7%.

In a nut shell, the downturn in the US economy and the impact it is having on consumers is adversely affecting purchases of fresh cut vegetable products but less so for Landec than the overall market. For both the second quarter and the six month periods, Landec continued to increase its market share and generated positive cash flow from operations. While we project that softening consumer demand in the category will continue to affect us in the third quarter and possibly the fourth quarter, we’re hopeful that the recent declines in the category will begin to level off in the near term and return to positive growth by the beginning of our fourth fiscal quarter.

Importantly, we see this as a time to further strength our market position in the fresh cut category by using our strong trade brand, our breathway packaging technology, our low cost position and our strong balance sheet to further grow market share. So, what is going on in the market place right now? We see our customer base, namely retail grocery chains and club stores as hunkering down and willing to lose potential revenues rather than risk excess inventory.

This was certainly true in the October through December time frame, a historically strong holiday demand season. We also see consumers purchasing less expensive products that are not perishable such as canned vegetables, frozen foods, Spam, you name it. The American consumer is worried and rightfully so. This significant lack of consumer confidence affects not only our specialty packaging vegetable business but also our Chiquita retail grocery store project.

The overall attitude of grocery retailers regarding trialing bananas in a high tech consumer package is not now. Accordingly, we need to be realistic and realize our goals for growing overall revenues by 10% and growing pre-tax income by 15% to 20% are not achievable this year. Similarly, we do not expect Chiquita to start consumer retail trials for bananas this fiscal year.

We do expect to be profitable for the year and to generate positive cash flow from operations even with these dampened levels of consumer demand. Let me turn to Greg for details of our results.

Gregory S. Skinner

As outlined in yesterday’s news release, Landec reported total revenues for the first six months of fiscal year 2009 of $129.8 million versus revenues of $121.6 million for the same period a year ago. The increase in total revenues during the first half of fiscal year 2009 was due to first, a $1.7 million increase in revenues from Apio’s fresh cut vegetable business. Second, a $5.3 million increase in revenues from Apio’s commissioned trading business and third, a $1 million increase in revenues from Apio’s packaging business due to the timing of minimum payments from Chiquita.

For the first six months of fiscal year 2009 the company reported net income of $4.3 million or $0.16 per share compared to $6.2 million or $0.23 per share for the same period last year. This decrease in net income during the first half of fiscal year 2009 compared to the same period last year was primarily due to first, a $1.5 million decrease in gross profit in Apio’s fresh cut vegetable business primarily due to increased raw material costs for produce and packaging. Second, a $576,000 decrease in interest income due to the company’s decision to invest only in FDI insured certificates of deposits, US backed instruments, AAA rated municipal bonds and money market funds.

All of which have yields that are considerably lower than those the company realized from its investments in the same period last year. Third, a $486,000 increase in operating costs primarily due to increased audit, tax and legal fees at corporate along with planned increases in R&D expenses and fourth, an increase in income tax expense of $594,000 due to increase to Landec’s effective tax rate for fiscal year 2009 to 40%.

These decreases in net income were partially offset by $1.1 million increase in gross profit for Apio packaging and a $227,000 increase in gross profit for Apio’s commissioned trading business. It should be noted that only $450,000 or 15% of the $3 million in book income tax expense is expected to be paid in cash because of the repurchase of subsidiary options in fiscal years 2007 and 2008.

For the second quarter of fiscal year 2009 Landec reported total revenues of $58 million versus revenues of $59 million for the same period a year ago. The decrease in total revenues during the second quarter of fiscal year 2009 was due to a $2 million decrease in revenues from Apio’s fresh cut vegetable business due to the decline in the fresh cut vegetable category during the second quarter.

This decrease in revenues was partially offset by $500,000 increase in revenues from Apio’s commissioned trading business due to higher per unit sales prices as a result of the change in product mix and from a $480,000 increase in revenues from Apio packaging due primarily to the timing of minimum payments from Chiquita.

For the second quarter fiscal year 2009 the company reported net income of $1.5 million or $0.06 per diluted share compared to net income of $3.1 million or $0.12 per diluted share in the same period last year. This decrease in net income during the second quarter fiscal year 2008 compared to the second quarter last year was primarily due to first, a $1.9 million decrease in gross profit in Apio’s value added vegetable business primarily due to decrease in revenues from increased raw material costs for product and packaging.

Second, a $152,000 decrease in interest income and third, a $289,000 increase in operating costs primarily due to increased audit, tax and legal fees at corporate along with planned increases in R&D expense. These decreases in net income were partially offset by a $470,000 increase in gross profit for Apio packaging and a $121,000 increase in gross profit for Apio’s commissioned trading business.

Turning to the balance sheet, during the first six months of fiscal year 2009, our cash and marketable securities balances increased by $2.2 million to $61.2 million. The increase in cash and marketable securities were primarily due to generating $3.3 million in cash flow from operations, up 52% from $2.2 million in the prior year first six months and due to a $1.5 million tax benefit from the repurchase of subsidiary options in 2007 and 2008.

These increases were partially offset by the purchase of $2.4 million of property, plant equipment for our fresh cut vegetable business. Early in fiscal year 2009 we said that we planned to invest $7 million in capital expenditures in fiscal year 2009 for the further automation and expansion of our value added fresh cut vegetable processing facility up from $4.2 million invested in fiscal year 2008.

As previously mentioned, we spent $2.4 million during the first six months of fiscal year 2009. However, as a result of the current economic environment, we expect to invest only about another $1.5 million to $2.5 million during the remainder of fiscal year 2009. We also said in the past that we plan to spend roughly $3.7 million in R&D, up from $3.3 million spent in fiscal year 2008. We will continue our commitment to increasing our investment in R&D as planned.

Let me turn the call back to Gary.

Gary T. Steele

Have our priorities changed? In short, no. We have five priorities in growing Landec’s shareholder value: first, to continue to grow operating cash flow; second, to extend the commercialization of our breathway packaging technology in bananas, avocados and new applications; third, to provide strong R&D support to our licensing partners in launching new products in [seat] coatings, catalyst and personal care products; fourth, to seek synergistic acquisition opportunities that use or expand our technology and that use our channels of distribution; and fifth, to expand our Intelimer polymer material licensing activities.

We will be placing a greater emphasize on consolidating our already strong position in the fresh cut produce arena searching for acquisition targets both in and outside of the food arena and stepping up our out licensing activities with new partners. We believe that the US faces a prolonged and deep recession that may last in to 2010. Landec has proprietary technology, a low cost structure and a strong balance sheet to not only weather the storm but to capitalize on new opportunities that are likely to emerge as under capitalized companies look for partners and large corporations who are slashing their R&D budgets, begin to look for new products.

We see this as a time of opportunity. In order to successfully advance our priorities, our plan through calendar years 2009 and 2010 include the following initiatives: first, make one and possibly two accretive and synergistic acquisitions that utilize our technology and possibly use our existing channels of distribution; second, to conclude at least one new major licensing partnership; third, to expand the sales of our packaging technology with Chiquita and other partners; fourth, with Monsanto, bring our collaborative seat coating program to field trials; fifth, start at least one new initiative in a promising area of material science outside of our food technology business; sixth, continue to generate considerable income and positive cash flow; and seventh, all the while maintain a strong balance sheet.

Regarding near term catalyst for Landec, we see the following very strong possibilities; first, expansion of sales with L’Oreal with new initiatives starting with other major personal care companies; second, and advancement of our Monsanto program through field trails to a definitive decision on how to commercialize this technology and what targets to select; third, the further expansion of our market share in fresh cut vegetable categories; fourth, McDonalds reaching decisions regarding its internal evaluation of our technology for packaging of bananas; next, starting one or more research initiatives in our new applications of our material science technology; next, renegotiating with key non-grower suppliers regarding lower input costs for our food technology business; and last, M&A activities moving from a broad search to a focus on one or two more specific partner candidates.

We have confidence that even with a challenging economic environment we can generate increased shareholder value over the next 24 months. We are now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Steven Denault – Northland Securities, Inc.

Steven Denault – Northland Securities, Inc.

I might have missed it, within the Apio segment, the op margin of 10.9% was down pretty considerably. How do we sort of carve that out and look at that? Was it volume related? Increased raw material cost related? I mean, what were the largest components of that degradation?

Gregory S. Skinner

Actually, you nailed it but yes, it’s a combination of volume so therefore you have a much lower overhead absorption on a per unit basis which is obviously going to drive your gross margin percentage down. Then, we’re still feeling the effects of the higher petroleum prices as the inventory works through the system. You’ve got higher packaging and most importantly for us, higher produce costs which is somewhat affected by petroleum but more so by land costs which have gone up quite a bit.

It’s a combination of all those that has resulted in our cost of sales going up and therefore our gross margin percentage going down.

Steven Denault – Northland Securities, Inc.

Is it reasonable to sort of think that kind of level of op margin is a good number to use at least for the third quarter here?

Gregory S. Skinner

The third quarter is tough to call. I’d say in the long run that’s the absolute lowering range but the third quarter we’re still working through the higher cost inventory, we still have the higher cost for packaging. The real question is going to be what’s going to happen with volume?

Gary T. Steele

Steve, just listen to the radio today, consumer confidence is still very low so I would think that third quarter is probably more the same and our hope is that by the fourth quarter we’ve had a shot at renegotiating some of our input costs and that the consumer demand is starting to come back. Historically, our category has done reasonably well in economic downturns. I just think that we’re in a shock and awe mode with the consumer right now and they have to start getting a little bit more confident. So, I’d say third quarter is probably more of the same.

Steven Denault – Northland Securities, Inc.

Then the second question is, is the fresh and ready getting put on hold? I’m trying to get a sense of were the produce managers saying, “Listen there’s a lot going on here. We’re not particularly receptive to these trials at this point in time?” Or, was it that the trials were in place and the consumers said, “You know what at this point in time with the economy where it is, maybe I’ll just stick to banana bunches.”

Gary T. Steele

The trials had not started, they were gearing up. But, both the consumer and the retailer were saying, “Not now.” Everybody is in a hunkering down mode and so it was a combination but the trials had not actually started.

Operator

Our next question comes from Peter Black – Winfield Capital.

Peter Black – Winfield Capital

You sort of answered the question, I’m just trying to reconcile the fact that if you look at Starbucks, their comp store sales are down but they’re going ahead with supplying your bananas and doing these kind of premium shakes. In your talks with Chiquita is there anything that suggests that what they’ve seen so far is telling them that even in a more normalized consumer spending environment the opportunity at retail is going to be less than what they originally hoped?

Do you have any indications that their less enthused long term about the program? It’s just strange that it’s at the kind of quick serve and at locations like Starbucks that are going ahead with a premium product but at retail they’re not.

Gary T. Steele

A good question Peter, we’re not really sure. I think we’d have a better sense of this in a quarter or two when they’ve had some more time to reflect on this. Right now it’s just a very messy, confusing set of circumstances with retailers so it’s hard to know what’s fundamental and what might work. But, we’ve been planning on this to be a premium price product because it’s adding a lot of value.

The consumer is not interested in premium priced products right now. I was not kidding when I said Spam in my comments. Spam is one of the fastest growing products in retailer grocery stores right now so that tells you how desperate and concerned the consumer is. There’s a lot of noise out there Peter and as a result I can’t give you a crisp answer but I hope that we will have a better sense of this in a quarter or two. My apologizes but it’s very confusing at this point.

Gregory S. Skinner

If you recall Peter, Starbucks launched their Vivano program well before the major meltdown of the economy. That was launched almost a year ago.

Gary T. Steele

Yes, they had the benefit of it being in place for some time as opposed to us now just considering starting trials. Anyway, give us a quarter or two to try to get more clarity on this.

Peter Black – Winfield Capital

I remember reading Chiquita’s annual report I think a year ago and they had a special section devoted to a kind of value added proposition and that being a focus of their growth in the future. So, in terms of their management focus on this there’s no indication that they’re sort of pulling back on their strategy going forward?

Gary T. Steele

We know they are not pulling back on their strategy going forward with the use of our technology for bananas and getting some positive decisions from McDonalds would really be a confidence booster for everybody and we’re all awaiting that. They are expanding the Chiquita to go program, they like that program, I think the question mark is on the retail side. But, our hope is that there are other applications that they’re looking for and I can also tell you that they’re wildly enthusiastic about avocados.

That is off to a very strong start and we hope to be able to report more of that in the next couple of quarters and they’re also expanding in Europe. It’s uncertain what’s going to happen on the retail side. We need to report on that as we learn more but their confidence in the program seems to still be strong.

Peter Black – Winfield Capital

Then a final question, in talking about acquisitions you mentioned that in addition to using your existing distribution capabilities another focus would be on a new technology platform or something that’s complimentary to what you have. What would be an example of that technology platform?

Gary T. Steele

We’re interested in how our materials or similar materials can be used in the whole area of grain technology. We’re interested in energy, we’re interested in water conservation, we’re interested in those types of things that are meeting or have great human needs. So, we think material science is one of the ways of going at this. We think our technology has some applications there, I’d rather not be specific at this point but we have a search that we’ve begun.

It’s just at the early stages using third party help to identify an acquisition candidate that maybe gives us a leg up on one or more of those areas outside of the food business. We also have a search going on inside of the food business. Let me just give everybody assurance here that whatever we do we’re not going to trash our balance sheet, we’re still going to maintain a strong balance sheet and we have the benefit, even in a couple of really tough months, November and December weren’t the most fun we’ve ever had, we’re still throwing up positive cash flow and we’re generating income.

So, we have those searches underway and we believe that because we’re a material science company we ought to stick to our knitting and find things synergistic with our technology.

Operator

Our next question comes from Jonathan Lichter – Sidoti & Company.

Jonathan Lichter – Sidoti & Company

Can you talk about the difference in the weakness between trays and bags during the quarter?

Gary T. Steele

It’s interesting, intuitively we all thought as we went in to this consumer downturn that we’d be most affected in trays and bags would be affected somewhat. They’re both being affected but I think it’s far to say that the tray business is more affected because I’m going to use my own family as an example, we would have normally traveled back east, we would have been with family, we would have been having lots of meals, etc., etc. We stayed home this year.

I think a lot of Americans did that and they didn’t entertain as much so certainly one of the factors in the last couple of months is that the tray volumes were down because people were not gathering. In the tray business, I think it would be reasonable to say that there is a substantial premium that one pays for buying a precut already prepared assembled tray with a dip and the vegetables all ready to go.

But, on the bag side, we’re very cost competitive to commodity produce. By the time you assemble the commodity inputs and take the yield loss of cutting off stems and all that kind of stuff, we’re very cost competitive. As a matter of fact, we’re probably the best value in town on the bag side. From a marketing point of view we need to do a better job communicating that but I would expect that during the downturn of consumer confidence going forward, I would expect the tray business to be more affected by the bag business and we are seeing that.

Jonathan Lichter – Sidoti & Company

Do you still expect a seasonal pick up in Q3 relative to Q2?

Gregory S. Skinner

Q3 is typically not a better period for the value added business than Q2. As Gary said earlier –

Gary T. Steele

Remember in Q2 Jonathan you’ve got your big months of October/November, are big months for us. He’s asking do we see a seasonal pick up Q3 versus Q2?

Gregory S. Skinner

Well, at this point, at least through December I would say that a flat quarter sequentially would be something that we would be looking at, at this point.

Gary T. Steele

I’d tell you, it’s a real hard one to tell because what happened in November/December is retailers were very overly cautious, more than we’ve ever seen of ordering for fear that the consumer wouldn’t show up and they didn’t want to risk any excess inventories. What we’re starting to see in early January is people starting to order because they probably went too far the other way and they need to start to fill the pipeline.

So, it’s a little tough for us to answer your question. We need a few more weeks of seeing how this pipeline is filling and what that might do for our third quarter but it looks as though we’re starting to snap back some.

Jonathan Lichter – Sidoti & Company

How soon could we see lower commodity cost come in to the pipeline?

Gary T. Steele

Boy, I want to see that by the fourth quarter for sure.

Jonathan Lichter – Sidoti & Company

Finally, between licensing deal or an acquisition, which is further along? Which would you expect first?

Gary T. Steele

Acquisition.

Operator

Our next question comes from Anton Brenner – Roth Capital Partners.

Anton Brenner – Roth Capital Partners

A couple of things, number one in projecting some improved cost inputs in the second half of the year are you talking about or thinking about fuel and packaging cost relief or product sourcing relief, or both?

Gary T. Steele

Not produce because we’re pretty much locked in to annual contracts and that is more largely driven by land costs. Land costs in the wonderful growing areas of California have been going up still. It’s more related to non-produce costs such as cardboard packaging, film, plastics, things like that, that are affected by energy costs. As you know, suppliers of those types of products had a nice run up in their pricing when oil was over $100 a barrel but those days, or at least we think those days are over and so we want to renegotiate those prices and typically they’re not locked in to these annual contracts.

Anton Brenner – Roth Capital Partners

Also on hair products you indicated that those products are beginning to be marketed to customers other than L’Oreal. Your release though refers to a number of new products that have been or are being developed by hair products. Are any of these yet in commercial distribution?

Gary T. Steele

No, the new products that we have launched, they’re in commercial distribution through L’Oreal. L’Oreal has been our main vehicle for launching new products and the main change we’ve been seeking with L’Oreal is we have had our materials in their very high end most premium products like Lancôme and what we’ve been seeking with L’Oreal is that our materials are getting in to their more mainstream brands where you can find these in a broad array of retail stores and that is now beginning to happen with L’Oreal.

That is happening. In terms of introduction of new products from non L’Oreal customers, those are in development. Those are the things that we’re talking about that are new and exciting for us and they represent new customers and new applications primarily in the skin related arena. The things that go on to skin as opposed to on to hair. Anyway, those things are starting to step u, the volumes are stepping up, the sales are starting to step up, hair products are stepping up so we’re feeling pretty good about that.

Anton Brenner – Roth Capital Partners

Those products are being distributed or beginning to be distributed is that what you’re implying?

Gary T. Steele

Okay, with L’Oreal yes, with new customers they’re in development. They’re not being sold right now with non L’Oreal customers, they’re in development and pre commercial evaluation.

Anton Brenner – Roth Capital Partners

The Monsanto effort seems to be progressing the most rapidly of these three licensing deals but am I correct in that in terms of the impact on Landec’s own income statement there won’t be any for the next three years until that five year initial license is completed unless Monsanto chooses to exercise its option?

Gary T. Steele

Yes. You’re correct.

Anton Brenner – Roth Capital Partners

Last question, the change in your cash investment to a much more conservative places to park it, is this a long term permanent change or are you waiting simply for a better environment to buy back all those junk bonds that you own?

Gary T. Steele

Well, I mean better environment but our board was very helpful and savvy well before others were realizing what was going on we were going in to very conservative investments. Our objective is to preserve cash and not to eck out the extra point. We’re looking at it every month in terms of when the environment might be better. On the other hand, we’re also looking at other uses of our cash besides these types of investments. It’s not a permanent but we’re going to err on the side of being very conservative in terms of our investments Tony.

Operator

Our next question is from Nelson Ovis – Winfield Capital.

Nelson Ovis – Winfield Capital

A couple of questions, when are you free to begin negotiations for some of the packaging raw materials? Certainly other companies that have this issue have begun to significantly benefit from reductions in cardboard, etc.

Gary T. Steele

Right now. We wanted to get through the holidays, now is the time. I think you saw in our release that we expect not only that but we expect lower operating expenses in our second half as some of our accounting and legal costs from last year begin to normalized.

Nelson Ovis – Winfield Capital

What percentage of cost of goods is that product? I’m sure that most of it is produce?

Gary T. Steele

The lion’s share of it, 66% or some odd percent is but you’ve got probably about I’d say 20% that you can work with and the rest is in direct labor and that kind of stuff.

Nelson Ovis – Winfield Capital

That could be very meaningful?

Gary T. Steele

Yes.

Nelson Ovis – Winfield Capital

Also, I’m a little bit confused and I’m sure there is a reason, every company that I am involved with an every audit company that I’m involved with has experienced, maybe not an enormous amount, but meaningful reductions in audit expenses, etc. which clearly audit, tax and legal fees at corporate which clearly has impacted the SG&A line, it’s a little counterintuitive to see a bump up. I’m sure there are some – obviously Sarbox is out of the way, as an implement and all the internal audit people have been hired. One of the companies I’m involved with, it’s enough to significant impact the P&L on a positive matter. So, as a little bit of an outlier, what’s going on there?

Gary T. Steele

We, in our infinite wisdom last year made two changes in accounting firms, away from Ernest & Young and then back to Ernest & Young. I want you to try to imagine coming back to an accounting firm and asking to be received back and I want you to imagine what type of negotiating position you’re in to do that.

That’s what’s going on here. But, long term, we agree with you that we’re building very strong capability and infrastructure here internally to do more of our work ourselves but in the short in our return to Ernest & Young the fact of the life were that as we returned to them our cost and our fee structure were going to be higher. We would hope that over the next several years we can do what you’re suggesting which is to bring that down.

But, in the short term Nelson, it’s just a fact of life that it was higher cost for us to come back to Ernest & Young. We’re delighted to be back with them by the way.

Nelson Ovis – Winfield Capital

Just one other thing, a little nit, refresh my memory when the minimum payments from Chiquita would expire?

Gregory S. Skinner

They go through 2011 and there is a five year renewal.

Gary T. Steele

Let me make sure I understand that, annual renewals are by mutual consent here and any party can decide that they can opt out of that. We want to make sure that our partner is moving forward in a timely way and committed for us to continue in exclusive and likewise, they want to make sure that we’re performing on our side so it’s not an automatic. But, if both parties want to proceed, Greg’s answer is the correct answer.

Nelson Ovis – Winfield Capital

Finally, I want to make a comment and since this is the one time that shareholders get an opportunity to listen in a broad form and at the risk of pissing you guys off but I’m sure it could be in the minds of a bunch of shareholders so I just want to make it. First of all, I don’t know where you are in the acquisition realm and it’s possible that you are within weeks of announcing something that will knock the cover off the ball and make all of us happy.

But, it is of concern to me who has read hundreds of thousands of press releases over the years to see a company with a great growth engine internally make an acquisition strategy with some quantitative ways of judging if you were successful or not i.e. one or two, the number one priority. Simply because people who have been in this game a long time know that only 15%, don’t shoot the messenger, only 15% of acquisitions wind up actually helping the company that made the acquisition.

A lot of them are neutral and some of them are much less than neutral. So, I’d just like to hear your reaction to that. It’s pretty unusual to see a company make acquisition its priority, particularly a company that’s had your success.

Gary T. Steele

Let me just say your comment is valid. It’s a good one, it’s heard, it’s understood so know that. Second, is know that it is not our number one priority. Our number one priority is to run and operate the existing businesses absolutely to their greatest potential and I will tell you that if we were not implementing well here the last couple of months, I’d be the first to tell you. But, I think we have been and it’s just a matter of consumer confidence coming back.

But, our number one priority is not to make acquisitions. It is a strategic priority but it’s not our number one priority. Secondly, having been in the M&A world for a number of years in various lives, Landec has had three acquisitions in its history, two have been very successful, one was moderately successful and I’d say in the grand scheme of things that’s a pretty good track record.

Now, does that guarantee that the next one will be? No, of course not so we have to be very careful. We’ve been talking about M&A for over a year so it tells you that we’re being selective and thoughtful and careful and I just want you to know that your comments and concerns are understood and heard.

Operator

Our next question is from Saloman Kamalodine – B. Riley & Co.

Saloman Kamalodine – B. Riley & Co.

I just wanted to follow up on the question regarding the operating margin and your answer with respect to volume playing in to the operating margin compression. I’m looking back at the business in 2005 when you guys were doing $25 to $30 million in a quarter in revenue and at the time the gross margin at least was at 15% to 16%, gross margins for Apio value added.

My understanding had been that the business in general was a high variable cost business so operating leverage shouldn’t play a huge role in to this. So, I guess the question is, if your business did go back down to $25 to $30 million, given the environment, how bad could the gross margin really get ultimately?

Gregory S. Skinner

Well between 2005 and now, the main driver is this overhead absorption issue, it was an anomaly for this last quarter. That’s not normally a driver. I mean, you’re overhead is your overhead, your total dollars aren’t changing, it’s a matter of how they’re allocating it. But, the main drivers since 2005 has been the increase in primarily our produce. It’s gone up significantly in that three year period and over the last year, packaging has gone up.

So, when you combine those two that is 80% of our cost of sales and in addition, labor has also gone up over the last three years which get’s you to 90%. So, if your overhead was flat, 90% of your cost of sales has increased over the last three years. You’re going to see that margin deterioration, it’s just this last quarter one of the components that has not been a component in the past is the overhead absorption issue.

Saloman Kamalodine – B. Riley & Co.

So you’re saying longer term the risk of further compression on a gross margin shouldn’t be tied to volume as much as it will be to the cost of your raw material input?

Gregory S. Skinner

Yes.

Gary T. Steele

Now Sal, let me just mention to you that when we saw these costs going up, we reported that we were going to raise prices and work to have that stick across our customer base but, we did not anticipate that would capture the full cost increases and so we did implement that in our first quarter. That did stick but in this environment, it’s hard to imagine right now trying to go further with price increases so I think we have some limitations there.

But, as things start to settle down, whenever that happens, we certainly will be looking at passing any cost increases on to the retailers and consumers.

Saloman Kamalodine – B. Riley & Co.

Then the SG&A line for the company as a whole not just at the Apio value added, was flat relative to last quarter even thought the revenue line decreased significantly, is there something to cut out there on the SG&A line?

Gary T. Steele

We’re going to hopefully see the last of some of these accounting and Delaware reincorporation legal issues, some of those aberrations should be behind us and so we’re hoping that as we look to the second quarter it will be a much more efficient SG&A line.

Gregory S. Skinner

We expect the second half our operating costs will be lower than the first half of this year and quite a bit lower than the second half of last year.

Saloman Kamalodine – B. Riley & Co.

Then finally, just going back to your comment about the supply chain and having seen that contract during the quarter but already seeing a bit of snap back in January, what’s your overall visibility in to what the supply chain might look like on a normalized basis when all is said and done?

Gary T. Steele

I think we have to go back to our best indicator which is Nielsen. Nielsen tracks category growth and if you look at the last three to five years in terms of the fresh cut category and fresh cut vegetables specifically, category growth has been running around 10% to 12% a year and that’s when the consumer is not afraid of losing jobs and wondering what the heck is going on in our country.

So, I would like to believe that once we can get some stability here and some resumption of consumer confidence, maybe not snapping back to 10% but getting back in to the positive category, what we’ve shown is that we’re going to outperform the category. We just want to see that category get back to positive growth and then if we follow our track record, we’re going to do better than the category. That’s what we hope for and that’s our only visibility that we can see right now. The category has been in a negative situation for the last quarter.

Operator

Our next question is from Craig [Paringer] – Wells Capital Management.

Craig [Paringer] – Wells Capital Management

Can you update us on the status of Aesthetic Sciences, are they still a going concern? Any progress out of them? What can you share with us?

Gary T. Steele

Good science, good progress on the scientific front, my concern with Aesthetic Sciences is the balance sheet. As you know, the way that was structured is Landec licensed its technology to a new entity called Aesthetic Sciences, a new co. There were several venture capitalists that came in to fund that entity and they’re not loaded with cash right now.

By the way, our role is to provide technical advice and support as needed but, a very passive role, we’re not on the board. So, my concern for that entity is the same as any startup company in the Silicon Valley area that is not with a lot of cash and that is what’s going to happen in terms of funding up the next stage of development because they’re not only developing the polymers for the dermal filler market opportunity in clinical trials – by the way, they are in human clinical trials, but they’re also doing some very interesting and unique things in the application, the applicator, the engineering side, how to apply it to a patient.

So, the issue there Craig and I really don’t have more to tell you is can they get the type of financing to continue their work in a timely way and I don’t know the answer to that because funders are hunkering down as well. The issue there is not science it is financing and maybe we’ll know more in a quarter to report on that.

Craig [Paringer] – Wells Capital Management

A couple calls ago Gary you mentioned interest from some entity in your technology for some pharmacological application and I pressed you on it. It seemed to be some drug delivery mechanism for the digestive system, any progress there?

Gary T. Steele

Well, I’d take away the digestive system part but the answer is that we’re at a point where we feel like we can begin to talk to pharmas, large and medium size pharmaceutical companies and we need to get some type of validation that what we have is a value to them. So, that I’d say January through May is the time period through which we will be talking to these people.

We need to have some data, some laboratory in vetro and in vivo data which we know have some and so we’re now starting to approach these folks in the January through May time frame. Then, by May we want to make a decision to say, “Do we have something or not? Yea or nay?” We want to make that call by our fiscal year end.

Operator

Our next question is from William Lauber – Sterling Capital Management.

William Lauber – Sterling Capital Management

I had a question on the Chiquita relationship especially with the grocery store trials and I know you guys aren’t calling the shots on that but, at some point doesn’t it make more sense to use the technology for boxes of bananas? I know that Chiquita doesn’t get their kind of value added out of that but I would think they’d be able to pass along some increased costs to the grocery store owner who now I guess eats all the cost of the bananas that go bad that no one buys. I mean does the math work out at all?

Gary T. Steele

I think what you’re saying, if I can paraphrase and you correct me if I get it wrong is right now you’re adding a fair amount of cost in terms of packaging and handling to put six bananas let’s say by example, in to a bag that has Landec technology on it. So, you’ve got to add a mark up and you’ve got to charge a premium price to consumers to buy that product. Why not take that same packaging technology from Landec and spread it across 20 or 40 pounds of bananas, a lot more bananas in the form of a box that comes in from the tropics, comes in from the states.

We already know that they lose 9% of weight just from evaporation which we can avoid, etc., etc. Why not focus on that and I think that’s a terrific question and we’re hopefully that perhaps Chiquita – you started off right by saying we’re not calling the shots on this. All I know is that we extend the shelf life of bananas by seven days. We entered the collaboration saying we extending the shelf life by seven days, by God we extend the shelf life by seven days.

That can be a small consumer package, that can be a big box going to McDonalds, it can be an even bigger box that comes in from the tropics and then eventually goes to the retailer and they can open it up and put it out. We’re hoping that all of those possibilities will be seriously looked at. I just have to tell you that I think that Chiquita has been consumed thinking about the Chiquita to go application for alternative sites such as Starbucks and quick serve restaurants like McDonalds and grocery stores.

We need to hope and encourage them to look at these other applications as well because you’re spreading your costs over more weight and more bananas by doing so. I like that line of thinking Will. We have to encourage and support them in looking at those applications as well.

William Lauber – Sterling Capital Management

You said it much better than I did but does the math work out there? Obviously you’d have to pass along some cost to the grocery store owner but I would assume that the grocery stores would more than make up with that because of the reduced spoilage?

Gary T. Steele

Well, you’ve got value capture in a couple of ways, reduced spoilage, you’ve got the ability to display a more uniform color banana which is more appealing to the consumer, it’s called a color six, it’s bright yellow with green tips and if you can do that then you’re going to increase the sales. Then last but not least, if you can reduce the amount of weight loss because you’re in a field package that captures moisture, it doesn’t lose moisture then, you’re avoiding some weight loss.

So, it would seem that that is something that would be seriously looked at by Chiquita and I just hope that their prioritization will include that.

William Lauber – Sterling Capital Management

I wanted to follow up on that M&A question that an earlier caller posed, quoting the statistic about the success and so on and I certainly can’t argue with those numbers. But, I guess as a portfolio money manager, we have reassessed all of the companies that we own and the first question in this environment, the first question that we’re asking ourselves is, “Are these people survivors?” I think you certainly fit that bill.

But, the second think that we would like to see looking at this trying to be optimistic in this mess, we would like to think that our companies who are survivors and that have good balance sheets are going to take advantage of a situation which I think we all agree is very, very unusual, this economic environment and this credit environment.

I guess my comment is I would be disappointed if you folks did not use your balance sheet and the cash that you have and your expertise and experience to exploit the opportunities that should be coming up in the related field but more importantly in the food business.

Gary T. Steele

I’d be more disappointed than you. Let me just make sure that we’re clear on prioritization. Our first priority is preserve our strong balance sheet and make sure that we’re not trashing it by doing something reckless in the acquisition area. Our second priority is to make sure we are operating our existing businesses and partnerships extremely well even in these difficult times with consumer loss of confidence. Third, it’s to be opportunistic. We live in Silicon Valley.

There are companies around here who venture capitalist have told them, “We’re done.” There are companies throughout America that are undercapitalized. They have good solid businesses, they just don’t have the wherewithal to grow and we want to look at them. We want to look at them for synergy in our technology and channels of distribution. Likewise, this will take a little bit more time but likewise, corporate America is slashing and burning its R&D budgets.

They are cutting back left and right. They’re laying off people but these companies still have to respond to their shareholder down the road with new products and new innovation and that’s why we’re stepping up not only the M&A activity but we’re stepping up our licensing activity. License takes longer, it’s lumpy, you can’t manage it by quarter.

So, we’re doing both and our board as long as we’re being prudent about our balance sheet and sticking to our knitting in terms of operating our existing businesses, they’re very supportive of what you say and that is this is a time of opportunity so that’s how we look at it.

Operator

At this time I’m showing no further questions from the audience.

Gary T. Steele

We want to thank you all for your continued support. Thank you for being on this call today and we look forward to keeping you apprised of our progress and plans. Thank you very much.

Operator

Ladies and gentlemen thank you for participating in today’s conference. This concludes the program. You may now disconnect.

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Source: Landec Corporation F2Q09 (Quarter End 11/30/08) Earnings Call Transcript
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