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Executives

Scott Eckstein – Financial Relations Board

Steven Spinner – President, Chief Executive Officer

Mark Shamber – Chief Financial Officer

Analysts

Edward Aaron – RBC Capital Markets

Andrew Wolf – BB&T Capital Markets

Meredith Adler – Barclay's Capital

Alvin for Gregory Badishkanian – Citigroup

Scott Mushkin – Jefferies & Company

Chris Kruger – Northland Securities

Scott Van Winkle – Cannacord Adams

Michael Krestell – M Partners

United Natural Foods, Inc. (UNFI) F4Q09 Earnings Call September 9, 2009 10:00 AM ET

Operator

Welcome to the United Natural Foods fourth quarter 2009 conference call. (Operator Instructions) I'll now turn the conference over to Scott Eckstein of the Financial Relations Board.

Scott Eckstein

Good morning everyone. By now you should have all received a copy of this morning's press release. If anyone still needs a copy, please contact Joe Calibrese in our New York office at 212-827-3772 and we'll send you a copy immediately following this morning's conference call.

With us this morning from management is Steve Spinner, President and Chief Executive Officer and Mark Shamber, Chief Financial Officer. We'll begin this morning with opening comments from management and then we'll open the line for questions. As a reminder, this call is also being webcast today and can be accessed over the internet at www.unfi.com.

Before we begin as usual, we'd like to remind everyone about the cautionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on this morning's conference call. With that, I'd like to turn the call over to Steve Spinner.

Steven Spinner

Good morning and thank you all for joining us. What a year it's been. UNFI demonstrated its ability to be resilient in an exciting, challenging and rewarding 2009 and our numbers reflect a record earnings year.

As you know, UNFI's 2009 fiscal ended on August 1, 2009 and as I reflect upon the year which was my first year at the company, there are several important comments that I would like to make.

First, sales came to a screeching halt in October of 2008 consistent with the U.S. economy. This is an important comment because it's the first time in the history of the company that we did not have top line revenue growth pushing us along.

Second, the economic issues caused pressure on consumers' willingness to remain committed to organic foods, and fortunately, we're optimistic that this is not a developing or continuing trend.

Third, UNFI completed the acquisition of a specialty foods distributor and was beginning a difficult integration. And fourth, we lost 8% product cost inflation and replaced it with more normalized 4% inflation which has further complicated top line revenue growth. And lastly, like most companies, we were very concerned for much of the year about access to capital and liquidity.

Let me briefly address these issues. While sales fell to flat, they have stabilized and while sales have stabilized at slightly positive, adjusting for year over year inflation comparisons, sales may be picking up slightly. But despite these challenges, sales during 2009 grew to a record $3.45 billion reflecting a 4.7% increase adjusting for the extra week during the year.

We also fully recognized the need for increasing sales to existing customers and expanding our customer base. While these things take time, I'm confident that during the back half of our fiscal year, we'll begin to see some growth.

On the positive, we believe consumers will remain committed to organic foods. There has been a shift in where they buy these products; however the demand for them will continue to be strong.

During the year, the company also worked hard on ensuring a high level of customer service while more effectively managing inventory levels, and our most important suppliers are working closely with us as we pursue a national strategy supplying supply chain efficiencies from point of manufacture to UNFI distribution center, to our customer and ultimately to the consumer.

There's been lots of discussion regarding UNFI's decision to buy into the specialty foods space. This was the right decision. They are the right products for our customers, and it will be the fastest growing segment of our revenue growth.

UNFI now distributes specialty products from five distribution centers and we have demonstrated real success in integrating this business. As we previously disclosed, the company will no longer be reporting this business as a separate entity.

During the year, UNFI launched its strategic plan which will serve as an enabler to achieving our recently disclosed three year financial objectives. This plan centers on increasing market share, operational excellence, managing our company on a single platform with regional preferences, and further enhancing our commitment to sustainability and service. One example of our execution towards these goals is our recent roll out of a national warehouse management and national procurement system upgrades to take place over the next several years.

Financially, the fourth quarter and full fiscal 2009 were strong. This morning we announced $0.36 per share and $1.38 per share for the quarter and the year. Our fourth quarter was negatively impacted by two $0.02 a share due to higher state tax rates. EPS increases versus prior year in these periods were 20% and 22%.

In addition, as UNFI focused on its balance sheet and capital structure, the company generated over $75 million in free cash and reduced its debt by over $92 million. Our associates demonstrated discipline, flexibility and focus as we maneuvered our way through a very challenging environment and the result was an extremely strong performance as evidenced by UNFI's financial results in the quarter and for the year.

I anticipate continued focus on our balance sheet throughout fiscal 2010 with capital expenditures at approximately 1% of revenue, and this includes construction of our new facility in Texas.

EPS guidance for 2010 is $1.48 to $1.58 per share reflecting a 7.5% to 14.8% increase over 2009. CapEx will be approximately 1% of revenue or $35 million to $39 million.

This morning, the company filed a S-3 shelf registration. While we do not have any current or pending plans for use of this registration, we believe that the timing of the filing is appropriate. Not being one to look backward, but forward, UNFI continues to face headwinds in growing our top line.

In addition, it will be a challenge to continually reduce expenses and grow gross margin while aggressively pursuing market share expansion and the development of new revenue streams. However, I'm confident that long term; we're making the right decisions that will further enhance shareholder value.

Now, I'd like to turn it over to Mark Shamber, our Chief Financial Officer.

Mark Shamber

Good morning to everyone listening in on the call and the webcast. Net sales for the fourth quarter of fiscal 2009 were $853.5 million. This represents an increase of $6.8 million or 0.8% over fiscal 2008's fourth quarter revenues of $846.7 million, adjusted for the extra week in fiscal 2008. As a reminder, in fiscal 2008, our fourth quarter consisted of 14 weeks rather than the usual 13 weeks as fiscal 2008 was a 53 week fiscal year.

On a straight year over year comparison, net sales for the fourth quarter decreased by about $58.4 million over the prior year sales of $911.9 million. For the fiscal year ended August 1, 2009, net sales increased by $154.2 million or approximately 4.7% to a record level of $3.455 million compared to fiscal 2008 net sales of $3,366 million.

In the fourth quarter, sales to the super natural channel increased by 4.2% and now represent approximately 33% of sales. Independence sales declined by 2.1% for the quarter and independence continues to represent approximately 42% of sales.

Our supermarket channel experienced a decline of 2.8% over the prior year and represents approximately 20% of sales. The supermarket decline in sales does reflect some of the final lapping of lost business from the specialty division. Excluding that lost business, supermarket growth would have been approximately, or would have been in excess of 7%. Food service declined by 6.5% over the prior year and represents approximately 2.3% of sales.

Gross margin for the quarter finished at 19% compared to 19.5% for the fourth quarter of 2008. This represented approximately a 52 basis point decline over the prior year and is consistent with our gross margin in the third quarter. The declining gross margin in comparison to fiscal 2008 was primarily the result of significantly lower fuel surcharge revenues in fiscal 2009 as diesel prices were roughly half the level they were at in the prior year. This was partially offset by improved gross margins within the specialty division.

For the year, gross margin came in at 19.1% compared to 18.8% for the prior year which represents an improvement of 29 basis points over fiscal 2008 primarily due to higher gross margins associated with the specialty distribution division and higher fuel surcharge revenues in the first half of 2009.

Operating expenses for the fourth quarter were 15.6% of sales compared to 16.9% for the same period last year, 125 basis point improvement. During the quarter, we incurred approximately $1.2 million or 14 basis points in non recurring expenses associated with the closing and integration of our East Brunswick facility into our York, Pennsylvania facility and expenses associated with our vacated facilities in Fontana, California and Oxford, Pennsylvania.

During the quarter, share based compensation expenses was approximately $0.9 million or 11 basis points compared to an expense of $1.2 million or 13 basis points in the prior year.

Fuel costs for the quarter were approximately 77 basis points, an increase of 11 basis points compared to the third quarter but an improvement of 59 basis points over the prior year. We estimate that our operating margin benefited 12 to 18 basis points from lower fuel prices over the prior year after netting out the higher fuel prices in the prior year and the related fuel surcharges.

Operating expenses for the full year were 15.9% of sales compared to 16.1% for the same period last year, reflecting an improvement of 15 basis points over the prior year. For fiscal '09, fuel costs decreased by 31 basis points to 82 basis points for the fiscal year compared to the prior year full year numbers of 113 basis points, yielding a benefit to operating margin of approximately six to nine basis points net of fuel surcharges.

Operating income for the quarter came in at 3.4%, a 73 basis point improvement over the prior year's fourth quarter operating income of 2.6% and consistent with our operating margin in the fourth quarter of fiscal 2007. Operating income was 3.2% for the year compared to 2.7% for fiscal 2008, an increase of 43 basis points.

Interest expense in the quarter of $1.6 million was down approximately 8% sequentially and was approximately 61% lower year over year. The sequential and year over year decreases were due to a combination of lower debt levels and lower interest rates during the quarter. Our lower debt levels were driven by a combination of improvements in our working capital levels, and increased profitability.

Our effective tax rate for the quarter was 42.8%, bringing our year to date effective tax rate to approximately 40.9% and has been primarily driven by increases in state tax rates. For fiscal 2010, we expect our effective tax rate to be in the range of 40% to 41%.

Net income for the fourth quarter of fiscal 2009 increased by 21% to $15.5 million compared to the $12.8 million earned in the prior year. Diluted earnings per share increased to $0.36, a $0.06 or 20% increase over prior year diluted EPS of $0.30. Fiscal 2009 net income increased 22% to $59.2 million or $1.38 per diluted share compared to $48.5 million or $1.13 per diluted share for fiscal 2008.

The company's outstanding commitments under its amended and restated credit facility as of August 1, 2009 were approximately $219 million with available liquidity of $147 million including cash and cash equivalents. Cash generated by operations for the fiscal year ended August 1, 2009 was approximately $108.3 million compared to $9.1 million in the prior year or an increase of $99.2 million.

For the year, we generated $76 million in free cash flow of which over $60 million was generated in the fourth quarter. At the end of the fourth quarter, our leverage had improved to approximately 1.9 times on a trailing 12 month basis compared to 2.3 times at the end of the third quarter, or 3.1 times at the end of fiscal 2008.

Inventory was at 48 days on hand for the fourth quarter in the middle of our target range of 47 to 50 days and a five day improvement over the fourth quarter of fiscal 2008. This improvement was a result of continued efforts by all of our divisions to manage working capital levels while not impacting our service levels.

DSO for the fourth quarter was at 19 days, favorable to our target range and a one day improvement over the fourth quarter of the prior year.

Capital expenditures were $6.9 million for the fourth quarter and $32.4 million for fiscal 2009, equating to approximately .93% of revenues for the fiscal year and roughly the mid point of our revised guidance. As discussed in the press release and mentioned by Steve, our fiscal 2010 capital expenditures guidance is $35 million to $39 million or approximately 1% of revenues.

Included in our fiscal 2010 Cap Ex guidance are costs associated with opening a new distribution facility in Texas in late fiscal 2010, early fiscal 2011.

The press release issued this morning also announced our full year's earnings per share and CapEx guidance for fiscal 2010. For the fiscal year ending July 31, 2010, earnings per diluted share is expected to be in the range of $1.48 to $1.58 per share, an increase of 7.5% to 14.8% over fiscal 2009.

Our fiscal 2010 earnings guidance includes approximately $3.7 million or approximately $0.05 per diluted share in labor costs and related start up expenses associated with the opening of a new facility in Texas and ongoing expenses resulting from the exited facilities in New Oxford, Pennsylvania and Fontana, California.

At this time we are not issuing top line sales guidance due to the continued uncertainty in the macro environment.

That concludes our prepared remarks and at this time we'll turn the call over to the moderator to facilitate the question and answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Edward Aaron – RBC Capital Markets.

Edward Aaron – RBC Capital Markets

I wanted to start by asking about the lack of sales guidance. It's a bit out of character for you and I understand there's some uncertainty out there, but the trends actually haven't really been that volatile month to month or certainly quarter to quarter at least over the last two or three quarters. I'm wondering why there's so much uncertainty right now to the point where you wouldn't be able to give some preliminary guidance. And secondly, you gave earnings guidance. You obviously have a range of sales expectations that you need to get to those numbers. Can you give us a sense of roughly minimum sales levels that you would need to have in order to hit your guidance?

Steven Spinner

We thought long and hard about whether to provide revenue guidance for the year or not, so it's certainly not something that we took lightly. Basically, the rational is this. We have a ton of new business proposals out there. These things take a long time and we're not sure when they're going to hit. We feel pretty confident that some of them are.

We see a lot of fluctuation week to week in year over year sales growth. So we may go plus seven, negative two, plus four, negative three, and as I said in my prepared remarks, we're starting to see some stability as you look out over the period of a month or six weeks or eight weeks, but still a lot of volatility week to week.

What I would tell you is that I think it's relatively safe to say that we'll probably provide some update regarding revenue guidance quarter to quarter and I think it's a safe assumption to use a 1% to 3% in Q1. But we didn't want to lock ourselves into giving specific guidance for the entire year at this time.

Edward Aaron – RBC Capital Markets

As far as a minimum sales level for the full year to get to the $1.48, is that something you feel comfortable providing?

Steven Spinner

I think depending on the different variables as to where the tax rate comes in, what happens from an interest rate standpoint, what happens with fuel, the 1% to 3% if you model it as you model out, if you play with some of the variables, I think if you take where we are in Q4, depending on where the items I just mentioned come out, I think that at 1% to 3%, there's an opportunity to make the bottom end of the range, but it really is, okay does fuel go in our favor, where does the tax rate come out, where do interest rates go.

It's certainly feasible at 1% to 3%, but I'm going to leave it to you folks as to how you factor in those other variables and where you think they come out because that's part of the challenge as well.

Edward Aaron – RBC Capital Markets

You said in your prepared remarks I think that it's going to be difficult to continue to reduce expenses while at the same time pursuing new business. I guess I interpreted that as if perhaps you might look to sharpen your pencil a bit to get some new business through the door. Am I reading that correctly? And could you maybe just address that new business issue a bit more broadly because I think that we would have all expected by now that you would have had more wins materialize.

Steven Spinner

I think you're right on it with your commentary, and I think that historically we've worked hard to keep our pricing intact solely because we provide an extremely high level of service with the widest availability of SKU assortment. But we have had to sharpen our pencil a little bit. We've gotten a lot more aggressive on some of these proposals, and as you might guess, there's some turmoil in the marketplace that hopefully we're going to take advantage of, but I'm not disappointed by our ability to get new business on board.

These things take a long time and we started as soon as I came on board. We've got quite a bit in the active category. I'm confident that they're going to hit when the time is right and we'll deal with it when we get there. We've had quite a few smaller wins in the specialty side and as I said, we now have specialty in five distribution centers across the country.

We've added it to two distribution centers on the west coast and are now selling some customers that have been natural customers that are now also specialty customers as well. So again, I'm not overly worried about the top line. I think it's going to come. It's just going to take some time.

Operator

Your next question comes from Andrew Wolf – BB&T Capital Markets.

Andrew Wolf – BB&T Capital Markets

Is the volatility, I know you guys since last fall have been talking about a lot of volatility in weekly sales. Are you seeing that come in a little bit or is it still pretty wide week to week?

Steven Spinner

I would say that it's still relatively wide. Without giving specifics on the first five weeks of the fiscal year, I can tell you that the range from one week to the next, if I take the high week of the first five weeks and the low week, there's a 12% spread between where the different weeks come in. So that's still pretty choppy from our standpoint.

Andrew Wolf – BB&T Capital Markets

You said conventional would have been up 7% excluding one time lost business?

Steven Spinner

It's at least 7%. With the integration of the East Brunswick facility, we really don't have the ability to give it specifically, but I can say it's at least that and then there's some elements of it that make it a little difficult to break out beyond there.

Andrew Wolf – BB&T Capital Markets

So on a go forward basis, if we were straight line this quarter, conventional now has the best growth rate, is one way to think of it.

Steven Spinner

Correct.

Andrew Wolf – BB&T Capital Markets

It looks like if you adjust for that, internal sales growth might have been around 2% for the quarter. Is that kind of in the ball park?

Steven Spinner

I'll say that we didn't even try to do it with the specialty because of its difficulty, so I didn't try to do the calc, but if that's where it worked out, it's probably in the range.

Andrew Wolf – BB&T Capital Markets

If you look at the last four months or three months of the quarter and what you're talking about now, have you seen, and you factor out the high volatility, when did you start seeing a little pick up in sales? Has it been sort of slow and gradual or is it more recent?

Steven Spinner

I think that you've got to consider two things, and I talked about it in the prepared remarks, but the change in inflation, we had food cost inflation of about 8% a year ago where the manufacturers were pushing through price increase after price increase. We've gotten to a more normalized 4% range inflation.

If you normalize that differential into our overall growth rate, we're starting to see that sales may be picking up very slightly, but still in that 1% to 3% range.

Andrew Wolf – BB&T Capital Markets

So your case movement is improving.

Steven Spinner

Slightly.

Andrew Wolf – BB&T Capital Markets

At least it's improving. I also wanted to ask about fuel deflation. Can you quantify how much that affected sales versus last year?

Mark Shamber

No, the number on sales is minimal. It's not even a tenth of a percent, what we would get for fuel revenue in a quarter. It does have a significant margin impact because it's a complete pass through to margin, but the impact on the sales; it's not even really a rounding.

Andrew Wolf – BB&T Capital Markets

What's the assumption in 2010 guidance? I know you spoke of it as an uncertainty which is clear, but what's in your 148 to 158? Just fuel, and then I have one last question.

Mark Shamber

Number one, we locked about a third of our fuel in so we know what price we're going to pay for about a third of our fuel. Obviously we tend to be pretty conservative as we look at fuel cost going out into 2010. I would say that as long as fuel stays where it is, plus or minus $0.20 a gallon, we'll be fine.

If fuel all of a sudden spikes back up to mid to high three's and four's then we're in a whole new game. But we certainly don't expect that to happen.

Andrew Wolf – BB&T Capital Markets

In answering Ed's question on going after market share and the pencil, does that mean as United Natural goes to market now, that you need to use price as a lever to get new customers more than you had expected? I think the thought previously was if you were at least adequate or as good as the next guy in specialty, and layer on to that the best in class on Natural, that that in and of itself would get the customer wins. But should we interpret what you're saying is that what you really need is also some price inducement on the specialty side?

Steven Spinner

I will tell you this. We'll never use price as a lever to win business because you get it on price, you lose it on price. So I'm not a big believer in that. However, in all of the prospective customer sales activity, we need to be competitive and if that means sharpening our pencil to do so, that's what we're going to do.

So there's a big distinction between picking up business in order to be competitive in the market place versus using price as a means to win business.

Operator

Your next question comes from Meredith Adler – Barclay's Capital.

Meredith Adler – Barclay's Capital

I'd like to go back to a little discussion about expenses. You did an outstanding job managing expenses this year, some of it perhaps is the completion of the integration of the Millbrook, but maybe you could talk a little bit about the outlook for expenses for the coming year.

Mark Shamber

I think that we've certainly pulled some levers to maintain expense controls given the challenging environment. Certainly continued progress on the integration of specialty has been helpful. I'm sort of a little cautious from a standpoint of giving expenses and trying to give out too much information to basically build the P&L's for the year, but I would say that the run rates that we're at now are probably maintainable and then there's the opportunity depending on the quarter.

Third quarter is usually our best quarter from an operating expense standpoint; second quarter is usually our most challenging. I think that expenses could fluctuate 10 to 15 basis point either way from where they are right now.

Steven Spinner

But long term, continually reducing expenses by itself is not a sustainable model, so we've got to get some top line revenue growth. We've got to continue to manage our expenses and things will happen for us. But to Mark's point, I think we're pretty comfortable with where we are in the expense side.

Mark Shamber

There is an element certainly as we gain leverage that some of our fixed costs as a percentage decrease and so that as we give up gross margin over longer periods of time that the expenses should go down by more than that and we should see improvements in the operating income, but from a standpoint of where we are right now, I think it's sustainable and there will be some movement; up movement, down, depending on the quarter and the volumes that we're seeing.

Steven Spinner

The biggest opportunity we have for expense reduction is opening Texas. Right now we're covering Texas from Denver and that's the beauty of opening up that facility; is we eliminate the miles that we're currently covering just to get there.

Meredith Adler – Barclay's Capital

I other question I have is, just talk a little bit more about the fuel lock in that you did already. I'm assuming you got that at a good price. Why didn't you do more and would you continue to think about doing more given that it looks like there's a chance that fuel prices will go up?

Mark Shamber

You know we thought a lot about that, and I've got some experience in this and given where the fuel prices were and where we think fuel price is going, we were comfortable with booking a third of our fuel. Just as a logistical note, we don't operate a lot of our own built in fuel tanks, so it makes it a little bit more complicated to book more than a third. It can be done, it's just a little more complicated. So looking at the economics of the fuel price that we could book at versus where we think fuel is going generally, we felt pretty good about it.

The second factor is that our contracts have fuel surcharge language in it, so there is a fair amount of risk of increasing fuel prices that are offset by fuel surcharges that kick in at certain rates.

Meredith Adler – Barclay's Capital

I thought in your opening remarks you said something about the customers showed that organic was sensitive to the economy, but I was under the impression that specialty was the area that had been weakest this past year, so did I mis-hear you?

Steven Spinner

What I said was that we were a little concerned in the beginning that there may have been a trend developing that said the consumer might be shying away from organics. That's been proven incorrect, so we've seen that the demand for the organic products has remained. What we have seen is a shift in where a lot of the consumers are buying it as evidenced by the changes in our increased by channel.

The Independent's are relatively flat. Super natural and conventional supermarkets are up quite a bit more. So it's been more a shift than anything else.

Specialty foods generally, you're right, were much more negatively impacted than sales of organics. But the upside, and the comment I made in the opening was that we feel pretty good that consumers are still pretty committed to buying organic.

Meredith Adler – Barclay's Capital

You talked about having filed an S-1, but you don't have any plans right now. If you were to do something, what would your intention be? I think all you have is bank debt right now. Would you plan to term out the bank debt for a longer time or something like that?

Mark Shamber

Just for one question, it was an S-3, a shelf registration versus an S-1 and if you were to take a look at it, we left it very open as to in the future what we could do, so it allows us to do equity, it allows us to debt, it would allow us to do a variety of other instruments that are a combination of both.

Really, we just felt the timing was right, having released year in earnings. We're not in danger from an accelerated filer standpoint of not being able to do what's known as a [wick see shelf], but if we turn back the clock six months ago, when the markets were a little bit crazy, our market cap had dropped below $700 million which is the threshold for being able to file one, so we thought it would be best to have it up and in place at this point in time even though we don't have any current plans to draw down against it.

Meredith Adler – Barclay's Capital

So this doesn't indicate you're going to make an acquisition, does it?

Mark Shamber

It does not indicate that.

Operator

Your next question comes from Alvin for Gregory Badishkanian – Citigroup.

Alvin for Gregory Badishkanian – Citigroup

I wanted to see if you've seen any changes to the pricing environment in light of some issues of in you're largest competitors?

Steven Spinner

I don't think so. We haven't seen a lot of wholesales change in the competitive environment.

Alvin for Gregory Badishkanian – Citigroup

Can you talk about your margins at specialty, how they're trending versus last quarter or versus your expectations at this point?

Mark Shamber

I think we mentioned last quarter, we've integrated that business and we don't have clarity from a consolidated standpoint on the specialty side, so we don't break out any of the divisions individually. So now that we've got them integrated, we're not going to break anything out on the specialty side, so unfortunately, there's no information to share with you in that respect.

Alvin for Gregory Badishkanian – Citigroup

Regarding organic food prices, have there been any recent changes in any particular categories, or has this been pretty stable?

Mark Shamber

I think it's been relatively stable. We have been lapping some of the inflation, heavy inflation that we saw last year and so we're back to a range of more modest price increases that are consistent with what we've seen longer term, but I wouldn't say there's been any one category that's seen high inflation. On the produce side through, we've seen heavy deflation to the extent in some categories, its double digits.

Operator

Your next question comes from Scott Mushkin – Jefferies & Company.

Scott Mushkin – Jefferies & Company

I wanted to delve a little bit more into the specialty business, not really looking for detailed numbers around it, but when we went out to the facility in Pennsylvania and we walked through it, and talking to people there, they kind of indicated and we could see for ourselves that the list and the technology hadn't been fully integrated where it needs to be if you were going to try to bid a big contract. .I was wondering if you could give us an update on how that's going. To give you a concrete example, I think it was diet chocolate soda that you were still selling in one that they mentioned should probably be all in a four-pack which is the way it was. So I was wondering if you could give us some color into how that's going and if you were able to secure a combined contract, if you feel like you could service it well at this stage?

Steven Spinner

They are completely integrated at this point. Like I said, it's three of the five DC's that now have specialty are now fully integrated which means that from those three DC's we can take any contract that includes natural, specialty and organic. Five, we're working hard to include quite a few other SKU categories as well, whether it be specialty cheese or produce so that we can truly be a one point of supply for the retailer.

There are some big differences in the businesses. On the natural side, organic side we tend to more in full cases than in each's. Specialty is a lot of onesie's and twosie's, slow mover, and we don't think that we're going to be able to change that philosophy out of the gate. We now sell a lot of specialty product in our carousals in our slow moving warehouses, but to answer your question specifically, they've been fully integrated in three facilities.

Scott Mushkin – Jefferies & Company

So you think you could handle a large account at this stage? Of course, it's my opinion, but with some of the piece stuff in the back area of that warehouse in Pennsylvania, it seems like it might be a little more challenging if you ended up getting a big contract.

Steven Spinner

Those products have all been fully integrated into our carousels, so it would be fully transparent to the customer and the answer is yes. We will have some big wins. Like I said, it's just a matter of timing.

Scott Mushkin – Jefferies & Company

One other question has to do with the channel switching that you're seeing maybe picking up and the margin impact that may result. I was wondering if you could walk us through if we went forward three to five years if this pattern continues within Independents becoming less and traditional supermarkets becoming much more of the business and what your thoughts are as that has to do with margins.

Steven Spinner

Long term, common sense would tell you that we could see some contraction in our gross margin. We don't see that finding its way to our operating income line. We don't see it finding its way into our operating margin line.

The conventional tends to be a little bit more gross margin, but it's also less expensive to do it, so it's just a matter of looking at the P&L a little different way. But I think you're right, over time it will be hard to continue to maintain the gross margin levels where they are. If we get considerable more entrenched into the conventional space, but I don't see it negatively impacting our year or operating margin or operating income.

Mark Shamber

That's part of the reason why we tend to try to guide people to look at the operating income margin versus focusing on the gross margin or operating expenses, because there is the trade off that you give up in that you may have a higher gross with an independent customer, but there are higher operating expenses associated with it so that when you get to the bottom line, it nets to a similar operating income percentage that you might have with a supermarket that has a lower gross margin and lower expenses.

Operator

Your next question comes from Chris Kruger – Northland Securities.

Chris Kruger – Northland Securities

Earlier in the call Steve you indicated from last year that obviously sales came to a screeching halt in October of '08. I know you don't break out month sales, but can you give us some kind of idea of what the growth range was prior to that, during that and maybe a month later than that, or somewhat from here to there?

Steven Spinner

I think the way you could look at it is that if you look at where we finished Q1, we were in a the specialty portion of the business which we were breaking out separately at the time, that our numbers were low double digits. I think off the top I want to say it was somewhere around 10.5% to 11% and then by the time we got to the end of Q2, our number in extra specialty was about 4.5%.

So that's a 6% spread roughly right there, and if you think of the last two weeks, last three weeks of that first quarter, reflected a slow down that probably says it was in excess of 6% to 8% drop in sales from what where we were going at to where it slowed down to. So I think that's probably the best we could give you for an estimate as to the impact that occurred last October.

Chris Kruger – Northland Securities

I know you've done a great job of driving efficiencies and all that, but I believe in the past, or maybe at your investor day, you indicated one aspect that's kind of interesting is your work force and the turn over of your work force and how more experienced its become and there's less training involved. Could you comment on that aspect?

Steven Spinner

Call it we're doing a better job managing our DC's or the state of the economy or both, but our turn over has dropped off dramatically. I don't recall off the top of my head the extent to which the turn over has fallen, but it's been significant. And obviously when you have that happen, it dramatically increases the productivity, the efficiency, the time that you spend on training new hires. So obviously common sense would direct you to, we're far better off with lower turnover than we are with higher turnover.

We're working very hard to understand all of the reasons why the turn over dropped so dramatically so that we can continue it.

Operator

Your next question comes from Scott Van Winkle – Cannacord Adams.

Scott Van Winkle – Cannacord Adams

Mark, you responded to a question earlier, trying to break out what sales growth was excluding the impact of the fuel surcharge. I'm wondering if you can give us some kind of indication on the independents which were down 2%, probably up a little bit excluding the extra week last year. Is that where all the impact is and was that number materially higher if you exclude the fuel surcharge?

Mark Shamber

Just to make sure I understand the question. You're just trying to understand that if the prior year fuel surcharge was backed out of the prior year number, would the decline in the business have been greater or less or no impact?

Scott Van Winkle – Cannacord Adams

More specifically on the independents, because obviously the year over year comparison looked better if that wasn't in last year, but you said it was immaterial to total sales growth. I'm wondering if it's a little more impactful to what the real growth rate in the independents would be.

Mark Shamber

I did understand that you were asking about the independents specifically. I know what the top line number was from a fuel surcharge standpoint. I have to admit that I don't know the break down off the top from an independent standpoint, but I would say that it's not going to necessarily move the number that much on the independent side.

It's still probably again, knowing what the total number is; it's probably no more than a tenth of a percent on the gross, so I don't think it moves it materially. So maybe it's 2% versus 2.1% or it's 1.95% versus 2.1 negative growth but it really doesn't move that overall decline in sales substantially.

Operator

Your next question comes from Edward Aaron – RBC Capital Markets.

Edward Aaron – RBC Capital Markets

I wanted to follow up on that 1% to 3% top line that you steered us toward for the first quarter. I guess that implies a little bit of an acceleration and it seems like we're still in an environment of inflation coming down, so just trying to get comfortable with the assumptions that you're using there and what's going to drive it.

Mark Shamber

I'm not sure I followed the questions.

Edward Aaron – RBC Capital Markets

I think you said 1% to 3% growth, sales growth for the first fiscal quarter is roughly where you expect to be?

Mark Shamber

Correct.

Edward Aaron – RBC Capital Markets

And I think the fourth quarter was at the limit of that and you still have inflation that presumably is moderating, and so I'm wondering why the sales growth would re-accelerate a little bit in the first quarter if inflation is still coming down.

Mark Shamber

I think that when Steve talked about the inflation being a 4% plus for the fourth quarter, I think that's the way the quarter averaged out. For the month of July, the year over year inflation was about 3.2%, so really I think that the moderation on the inflation side we think will be minimal. There won't be that much more as we go into Q1.

And then the sales, when we saw sales slow down in fiscal '09, was really the mid point, roughly the middle of October so you will lap some of that at that point. So I think those two combined, as well as some of the trends we're seeing, give us some optimism that there could be some acceleration.

Edward Aaron – RBC Capital Markets

I think long term your inflation has averaged right around 3% so it seems like we're almost sort of back to the average. Is there any concern on your part that maybe we have a reversion below the mean?

Steven Spinner

I don't know that it's a concern because what we've seen, I would have thought we would have seen it before now, if that actually had been the case. The last big round of increases sort of hit in the September time frame and earlier in the year when we started to lap some of the increases from last year, there was concern about deflation, and we started to refer to it more as dis-inflation where you're still seeing the price increases, but they're more in the normal range, the normal quantities.

If I dropped down to 2% to 2.25% versus being at 3% to 3.25%, I don't know that I'd expect it to be that much, that quickly of that, but I think it would probably take over the next 12 months for it to slide all the way down to that level, because there have been some price increases put through in the first half of calendar '09 that will still be lapping as we go into the first half of 2010.

So I understand what you're saying, but I don't think, we don't think internally that the impact is as great as you're concerned that it might be. I think we've got some comfort that there may still be a bit more to go, but it shouldn't impact us that significantly.

Edward Aaron – RBC Capital Markets

The free cash flow was great in the quarter, and I just wanted to get your perspective on why there was so much upside relative to where you guided as recently as last quarter, and whether you think you've pulled forward some of that free cash flow opportunity that you based those long term objectives on when you met with us in York.

Steven Spinner

I think that the reason why we came in that much higher than the range is that I'll credit our divisions, is that we had talked about at the end of 2Q, that we basically took inventory down a little faster than we should have and we needed to come back, and you saw that bounce back in Q3, and we felt, when we got on the call three months ago felt that we were going to take a much more measured approach and ensure that we didn't impact service levels and out of stocks.

And at that time frame, I would have thought that we maybe ended up closer to 50 days and I would have expected the sales trends to be a little stronger which reflected where the guidance was. So I think the combination of the two, allowed us to have better free cash flow than we anticipated, although we were lighter in a couple of other areas from where the consensus was that we were at the very low end of our sales range.

With respect to fiscal '10 to '12 and the three year guidance we gave, I'm still relatively comfortable with targets from a free cash flow standpoint. Maybe during that time frame we're closer to $30 million the first year or two than the out years, but I still think we're still in the ranges there.

There's certainly some aspect that came out of 2010 that went into '09 from a free cash flow standpoint, but I think the range is still achievable.

Operator

Your next question comes from Michael Krestell – M Partners.

Michael Krestell – M Partners

Just taking a look at the allowance for doubtful accounts, and the [inaudible] on cash flow, it looks like it's been keeping up a little bit, and understandably that would be somewhat tied to the economic conditions that are out there, but I'm just wondering if broadly you could comment about the health of what the supplier base is and if you need to make any changes and if you've had a bit more difficulty.

Mark Shamber

We did have a couple of hits during the year for certain customers where they went bankrupt or they went away. I would say that it's been more from the conventional supermarket side where we've had from an exposure standpoint that's been greater than the independents which I think at the beginning of the year some of the concern that we've been asked about in the first couple of quarters.

It's really been a trend where we've taken a couple of hits from individual accounts and then as a result of that, we've increased some of our reserves to mitigate any of that occurring in the future, but I'd say that with my DSO at 19 days, that really we haven't seen a significant deterioration. It's just been a couple of different customers.

I can reference that there was one customer that was 98% current on their payment terms, and they filed bankruptcy the next day, and we had an exposure from that standpoint. So it certainly has crept up over the prior year. We have had some customers file Chapter 11 and/or dissolve, but I would say from an overall standpoint, that the credit teams have done an extremely strong job of managing our risk and we feel that we're well reserved for our current exposures.

Michael Krestell – M Partners

You started to discuss what the IT strategy was and some of the work that was going to be done there. I'm just wondering if there's any update from where you left it a couple of months ago.

Steven Spinner

We've done a couple of things since the last meeting. We actually have migrated one of our legacy systems and decommissioned it and integrated them into one of our existing systems. We have gone ahead and made a purchase of a national warehouse management and procurement system that we're now beginning the process of integrating that will take a couple of years to get done.

So there's a lot of exciting things happening on the IT front and we're moving along at a pace that I'm very comfortable.

Operator

Please continue with any closing comments you may have.

Steven Spinner

Thank you all for joining us this morning. Again, I'm very encouraged by UNFI's strong operating results during 2009 and believe that we are making the right long term decisions that will serve as a stepping stone for achieving our long term financial objectives. Thanks again for joining us and have a great day.

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Source: United Natural Foods, Inc. F4Q09 Earnings Conference Call
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