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United Natural Foods, Inc. (NASDAQ:UNFI)

F2Q 2014 Earnings Conference Call

March 10, 2014 16:30 ET

Executives

Katie Turner - Managing Director, ICR

Steve Spinner - President, CEO

Mark Shamber - CFO, SVP, Treasurer

Analysts

Jason DeRise - UBS

Sean Naughton - Piper Jaffray

Scott Mushkin - Wolfe Research

Meredith Adler - Barclays

Karen Short - Deutsche Bank

Mark Sigal - Canaccord Genuity

Robby Ohmes - Bank of America

Andrew Wolf - BB&T Capital Markets

Eric Larson - CL King

Operator

Greetings, ladies and gentlemen, and welcome to the United Natural Foods Second Quarter 2014 Earnings. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

I would not like to turn the conference over to your host, Ms. Katie Turner with ICR. Thank you, you may begin.

Katie Turner

Thank you, and good afternoon, everyone. By now, you should have all received a copy of the second quarter fiscal 2014 earnings press release issued this afternoon at approximately 4:05 p.m. Eastern Time. If anyone still needs to review the release, please reference the Investor section of the Web site at www.unfi.com. As a reminder, the Webcast of this earnings call is also available on the company’s Web site. On the call today are Steve Spinner, President and Chief Executive Officer; and Mark Shamber, Chief Financial Officer.

Before we begin, we would like to remind everyone comments made by management during today’s call may contain forward-looking statements. These forward-looking statements discuss plans, expectations, estimates and projections that might involve significant risks and uncertainties. Actual results may differ materially from the results discussed in these forward-looking statements.

Additionally, in today’s earnings press release and on the call today, the company will provide both GAAP and non-GAAP financial measures including operating expenses, operating income, net income, and earnings per diluted share. Presentation of these non-GAAP financial measures is not intended to be considered in isolation or as a substitute for any measure prepared in accordance with GAAP. For a complete reconciliation of GAAP to non-GAAP financial measures, please refer to the company’s earnings release issued earlier today and again available on the company’s Web site.

And with that, I would like to turn the call over to Steve Spinner.

Steve Spinner

Thanks, Katie, and thanks again for joining us this afternoon.

The trend towards healthier lifestyles and heightened awareness of product ingredients continues to grow as evidenced by UNFI’s net sales growth of almost 14% during our second quarter of fiscal 2014. A recent report on the global organic food and drink market by TechNavio insights estimated the industry at $70.5 billion at retail in 2012, the report project an industry of $223.5 billion at retail in 2016. This represents a 75% increase in just four years.

We at UNFI are building for the future. Our business model is predicated on a deep commitment to the organic industry, support of organic farming and are pledged to reduce our carbon emissions by 5% from 2009 levels within five years. Combined with innovative service offerings, a broad array of products and an extremely efficient distribution model based on being closest to the consumer, UNFI is well-positioned to continue growing at a rapid pace. During the second quarter, our net sales increased over $200 million versus the prior year.

As you know, an important enabler of growth is capacity. With our Denver Colorado facility completed last summer, and four major construction projects underway, we will be ready. UNFI will build over 2 million square feet of new warehouse by 2019 driving route and warehouse efficiency along the way. During our third quarter, UNFI’s new facility in Wisconsin will begin receiving product with customer deliveries beginning during our fourth quarter. This new facility will serve the growing and under penetrated greater Chicago market. Today our facility is serving this market or at capacity, and we’re excited about making a positive contribution to this new UNFI community.

During the quarter, CapEx was approximately $43 million and 2.62% of net sales, driven primarily by construction in Wisconsin and New York. CapEx for the first half of 2014 represented approximately 2.35% of net sales.

The bellwether of our industry is the independent retailer, who brings innovation, creativity and an unwavering service offering to the natural and organic market. Net sales to independents during the quarter grew up 11% driven by increasing demand for fast growing products. UNFI continues to support the independent channel through innovative retail category management, exciting products and a shared culture of philanthropy and sustainability. Some of the high growth products during the quarter include sales of natural hormone and antibiotic-free proteins, and a continued growth in organic produce.

Both UNFI Albert’s Organics and Woodstock Farms Manufacturing delivered very strong results. Woodstock Farms has very efficiently become an industry leading processor and packager of high growth organic nuts, granola and dried fruit. We are currently producing products in a wide variety of packs and sizes for many of the country’s leading retailers under their brands.

Additionally, our Blue Marble Brands division continues to add value through the expansion of our independent only Field Day brand, which can be found across over 200 items. The Field Day brand was designed to help independents compete with high quality, lower cost organic products available exclusively to this channel. As a founding member of a non-GMO project, UNFI is proudly producing products, which are certified non-GMO. Over 97% of Blue Marble brands products are non-GMO responding to consumer’s growing demand for truth in labeling.

During the second quarter, UNFI was impacted by severe weather conditions across the eastern half of the U.S. Several of our distribution centers were partially closed during several winter storms, resulting in loss revenue and increased expenses. However, the majority of our impact occurred as freight was moved across the country. With record low temperatures, UNFI experienced issues with dry freight which froze while making the trip from the West Coast to the East Coast. This was solely caused by very cold temperatures and effected our overall service level and promotional activity during the period, resulting in approximately $700,000 in unreimbursed losses.

UNFI has a robust quality assurance organization with rigid receiving procedures. Our quality assurance teams identify the freezing loads and rejected the freight upon inspection. UNFI has been an industry leader in utilizing technology to manage the cold chain throughout the distribution process from manufacturer to retailer. Subsequently, UNFI elected to move a large amount of dry freight in temperature controlled fleets, which cost the company approximately $650,000, which was not passed through to customers. This was done to keep our service level high, as freight took longer to reach its destination and to ensure the integrity of our product. We expect a moderated amount of these costs will continue through UNFI’s third quarter.

As it relates to the drought affecting the West Coast, UNFI has not experienced any service related issues and does not foresee any shortages or significant price impacts at this time. Also during the quarter, our Canadian business was impacted by the continued decline in the value of the Canadian dollar resulting in nearly $900,000 in exchange related losses, which directly impacted our gross margin. And these items represent the majority of our 43 basis point year-over-year decline in gross margin.

Operating expenses as a percentage of net sales declined by 70 basis points during the quarter. Our national operating standards for our warehouses and fleet continue to improve while focusing on increasing service levels across North America. Our prior year second quarter was also negatively impacted by $3.6 million in operating expenses related to labor action at the company’s Auburn, Washington facility. The acquisition and integration of Trudeau Foods has been moving along as planned and we have recently signed an agreement to build a new distribution center in Prescott, Wisconsin to serve the greater Minneapolis, St. Paul market. This market has some of the most innovative and exciting specialty and organic retailers, and we’re really pleased to be coming to this community supported by a terrific Trudeau team.

Operating margin during the quarter was up 27 basis points to 3% and increased more than 25% versus the prior year. Earnings per share increased 22% to $0.56 per diluted share. Despite several headwinds during the quarter, UNFI continued to deliver. I’m extremely proud of our team of over 7,000 associates, who change, grow and perform every day. Growing our business over $200 million in the quarter versus prior year requires a team committed to our core beliefs and daily execution across a very disciplined model, our team delivers.

I’ll now turn over the call to Mark Shamber, UNFI’s Chief Financial Officer to review additional details regarding the quarter, and then we will take some questions.

Mark Shamber

Thanks Steve, and good afternoon everyone.

Net sales for the second quarter of fiscal 2014 were $1.65 billion, which represents growth of 13.9% or approximately $200 million over the prior year second quarter’s net sales of $1.45 billion.

Excluding the sales impact of the acquisition of Trudeau distributing, that closed in our first quarter, net sales increased by 12.6%. Inflation declined modestly both sequentially and on a year-over-year basis for the second quarter coming in at 1.85%, a 19 basis point decline from Q1 and a 13 basis point decline from last year’s second quarter which had an inflation at 1.98%.

On a year-to-date basis, net sales were $3.25 billion yielding sales growth of $392 million or 13.7% over the first half of fiscal 2013. Excluding the benefit of acquisitions, our year-to-date sales growth is 12.7%. For the second quarter of fiscal 2014, the company reported net income of $28 million or $0.56 per diluted share, an increase of approximately 23.6% or $5.3 million over the prior year.

Net income for the second quarter of fiscal 2013 was $22.6 million or $0.46 per diluted share. Earnings per diluted share increased by 21.7% as EPS growth was negatively impacted by the higher average share count in fiscal 2014.

On a channel basis, supermarket sales increased by 15.3% in the second quarter with supermarkets representing 26% of sales. The supernatural channel sales increased by 12.7% and the supernatural channel represented 37% of sales in the second quarter of fiscal 2014.

Sales growth in the independents channel was 11.5% and for the quarter independents represented approximately 32% of sales. Food service comprised approximately 3% of sales after growing by 26.9% in the second quarter. Excluding the impact of the Trudeau distributing acquisition, supermarket sales increased by 10.9% while independent sales growth was 11%.

At 16.3%, gross margin for the quarter showed a 43 basis point decline over the prior year second quarter gross margin of 16.7% and was down sequentially 64 basis points. The primary drivers of our gross margin where the negative impact associated with severe weather during the quarter and the foreign exchange impact from the declining value of the Canadian dollar on our Canadian business, both of which Steve mentioned as well as the ongoing shift in our sales mix.

Gross margin for the first half of fiscal 2013 was 16.6%, sorry, gross margin for the first half of fiscal 2014 was 16.6% compared with 16.7% in the prior year, a decline of 12 basis points again driven by the fact that in Q2 that I just covered, which would partially offset for the improved execution in the first quarter of our inbound logistics and procurement teams.

Our operating expenses for the quarter were 13.3% of net sales compared to 14% for the same period last year. This represents a 70 basis point improvement over the prior year as our operating expenses as a percentage of net sales continue to benefit from the mixed shift in our business, positive trends in our shelf insurance areas and lapping the prior year labor action cost at our Auburn, Washington distribution center. The prior year labor action cost negatively impacted expenses by $3.6 million in the second quarter of fiscal 2013 or 25 basis points.

Fuel had a positive impact of one basis point on operating expenses in comparison to the second quarter of fiscal 2013, as fuel represented 71 basis points of distribution net sales in the second quarter of fiscal 2014. Fuel expenses were 2 basis points better than the first quarter of fiscal 2014 when fuel came in at 0.73% of net sales. Nationally, our diesel fuel cost in the second quarter of fiscal 2014 decreased by approximately 2.8% from the prior year’s second quarter, while the national average price decreased to $3.88 a gallon, a decline of 2% compared to the $3.96 a gallon in the second quarter of fiscal 2013 per the Department of Energy.

Share-based compensation expense during the second quarter of fiscal 2014 totaled $4 million, or 24 basis points as a percentage of net sales compared to $3.2 million or 22 basis points in the prior year. Operating income for the second quarter was 3%, a 27 basis point improvement over the prior year’s second quarter operating income of 2.7%. Adjusting for the $3.6 million and 25 basis points associated with the Auburn labor action, prior year operating income was 2.9%.

Inventory was $765 million at quarter end, as days inventory on hand averaged 53days for the second quarter consistent with the prior year’s second quarter days. The consistent days on hand resulted primary from starting the quarter with higher inventory levels going into the holiday’s to compensate the supplier out-of-stocks.

In general, supplier out-of-stocks begin to mitigate towards the end of the quarter. There are still few high volumes SKUs that are experiencing significant out-of-stocks, and some of the issues we experienced with product at frozen transport due to the severe weather in December and January, exacerbated challenges with certain categories.

DSO for the second quarter improved modestly on a year-over-year basis but remained at 22 days, due to the higher concentration of supermarket business in the quarter. Capital expenditures were $43.1 million which leaves on track to hit our target range in fiscal 2014. Year-to-date capital expenditure is $76.3 million or 2.3% of net sales.

Outstanding commitments under our credit facility were $277 million at quarter end with available liquidity of approximately $221 million, including cash and cash equivalents. Our leverage was consistent with a prior year of 1.1x on a trailing 12-month basis. As discussed in this afternoon’s press release, we are updating our guidance through fiscal year 2014. We expect net sales to be in the range of $6.70 billion to $6.78 billion, which represents a 10.5% to 11.8% increase in total sales over fiscal 2013.

Adjusting for the approximately $119 million of net sales for the 53rd week in fiscal 2013, fiscal 2014 sales growth is expected to increase by approximately 12.7% to 14%. Our previous sales guidance was $6.65 billion to $6.78 billion. In addition, we are narrowing and modestly increasing our diluted earnings per share guidance of fiscal 2014 to a range of approximately $2.45 to $2.51 per diluted share. This reflects the strength of our results in the first-half of fiscal 2014. Our previous GAAP earnings guidance was $2.40 to $2.50 per diluted share.

As a reminder, included in our fiscal 2014 earnings guidance is approximately $2.5 million to $3 million of non-recurring expenses associated with the planned opening of our new Sturtevant, Wisconsin facility, which is expected to begin receiving products late in the third quarter of fiscal 2014. And duplicate rent and building costs associated with one of the Denver facilities that we exited in fiscal 2013, which has a lease that will not terminate until July 2015.

At this point, I’ll turn the call back over to the operator for the question-and-answer session. Operator?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. (Operator Instructions) Our first question comes from the line of Jason DeRise with UBS. Please proceed with your question.

Jason DeRise - UBS

Hi. Thanks for taking the question. I guess what I wanted to understand on the independents growth in your business, is a lot of that coming from larger independents or are you also seeing that coming from the smaller chain one or two locations?

Steve Spinner

I would say that it’s a combination of both, Jason, as well as the single unit independents. So I wouldn’t say that it was any one group large, medium or small, it was just pretty strong across the entire channel.

Jason DeRise - UBS

And I guess with the chains, are you seeing it mostly that it’s the unit expansion that’s driving those, or I mean look, we know what some of the public companies are but thinking about some of the other chains that are out there. Are they seeing strong comps as well, or is it really just about opening up going from five stores to 10 or 10 to 20 or things like that that’s driving that growth?

Steve Spinner

Yes. I mean, we wouldn’t want to get into talking about any individual operator’s comps, but I can tell you that the growth was pretty compelling across all three in terms of demand for the products primarily in the organic and the natural space.

Jason DeRise - UBS

And then I wanted to ask about the inventory days. I guess your comments I think were about the average inventory days. Can you share where they ended for the quarter once you got through some of the out-of-stock issues?

Steve Spinner

Yes. I mean I think that when we look them say for the last month of the quarter Jason, they were much closer to 49, 50 days. So I mean we carried heavy through the end of December. We obviously – we usually get a nice lift when we get into January and so we saw that during the month of January the inventory levels came down significantly as we’d expected and we saw some improved service levels actually during the month of January as I commented in my script.

So I think we finished the actual quarter, I mean if you took the month of January and then we’d be getting, I think we’re roughly at 50 days, but for the quarter, we’re at 53 because the first half – the first two months of the quarter we’re very high.

Jason DeRise - UBS

Right. Thank you. Actually I’ll let other people have a chance and maybe I’ll put myself back in the queue. Thanks.

Steve Spinner

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Sean Naughton with Piper Jaffray. Please proceed with your question.

Sean Naughton - Piper Jaffray

Hi, guys. And congrats on the strong top line growth there in the quarter.

Steve Spinner

Thanks.

Sean Naughton - Piper Jaffray

Steve, I believe you mentioned on the last call you talked about less opportunity to really bring down the expense rate similar to last few years, but you guys did have a nice improvement in that line item. How do you continue to find ways to lever that line? Is it just better than expected top line or are there additional efficiencies you continue to find throughout the organization?

Steve Spinner

Yes. I mean Sean, obviously, the biggest driver is when you get a nice lift like we had in terms of overall volume, it makes a little bit easier. But we – fuel helped us a little bit in the quarter, we’ve just got some phenomenal people running our warehouses. We’re very focused on limited number of metrics that we hold our teams accountable to. And that has had a profound impact on not only the service level, but in driving the cost down.

Mark Shamber

Sean, one think I would add is that, I think the comment that Steve made at the year end, I think it was [as supposed to] [ph] the first quarter, I think a number of folks latched on to that, and highlighted that we wouldn’t be able to get leverage to the same extent. I don’t think that’s what we’re trying to imply is that, we felt that we would come in some of the different areas. And one of the things that we’ve always talked about is that depending on where the growth comes from our business, we get some natural leverage, or we get lower expenses associated with some of our lower margin customers just by virtue of how those arrangements work and that’s how their pricing is set up.

So just to add on that, we – I don’t want folks to come away with the impression that we are – that we were trying to imply that we wouldn’t be able to get leverage going forward, it just that may come in different forms.

Steve Spinner

Yes. One of the big drivers in continuing to lower the cost is the construction of the new buildings. So as we open these buildings in new markets, we choose the geographies based on being closest to the distribution points. And so they have a pretty strong effect on reducing our transportation costs once we get those buildings open.

Sean Naughton - Piper Jaffray

Okay. That’s helpful color. Thank you. And then just second question, when you talk about sales mix impact on the gross margin, I typically think about it at a customer mix level, but is there anything within the product mix that is having the impact on the gross margin whether it is more frozen or personal care versus produce or supplements that, any color there, if there is anything there that would be helpful as well?

Steve Spinner

In general the answer to that is no. Most of our customers, about two-thirds of our business is on a cost plus basis. And so that means that there is a cost to the product plus a markup regardless of whether are they buying a case of water, a frozen pizza or a case of potato chips or Kombucha from that standpoint. So it does not come into play in that sense.

Sean Naughton - Piper Jaffray

Okay. That’s helpful. Thank you and best of luck.

Operator

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

Scott Mushkin - Wolfe Research

Hey, guys, and thanks for taking my question. So a couple of things, one is a little bit of housekeeping, just to make sure I understood the -- what you talked about as far as more onetime expenses. I think you said, 900,000 from Canada, 650 from temperature control stuff. And then was the 700 in the product losses covered by insurance, not covered by insurance that’s the one thing I didn’t get?

Mark Shamber

No. That was – that’s a product that unfortunately [VA] [ph]. That was the one portion…

Scott Mushkin - Wolfe Research

So…

Mark Shamber

There was a portion – there was a portion that was covered by insurance, this is the net that UNFI is ultimately responsible for.

Scott Mushkin - Wolfe Research

So it’s about $0.03 is that right, am I getting that right?

Mark Shamber

Yes, probably around to $0.03, yes.

Scott Mushkin - Wolfe Research

Around $0.03, yes, and certainly less. Okay, so that’s good. Thank you for clarifying that.

Second issue is, obviously Safeway and Albertsons are merging, Safeway is a contract that you guys have, service on Albertsons I believe is a contract you don’t have, I think it’s split up among a number of different people. Number one is, does that contract, I think it is a three year contract, well, I think up at the end of the year, maybe I’m not remembering that right. Number two, if you get the whole thing, can you do the whole thing?

Steve Spinner

Well, let me try to answer that first part. We do have a business relationship with both Albertsons and Safeway. It’s way too premature to understand where that ultimately goes. I can tell you that we are extremely pleased with our relationship with both Safeway and Albertsons in terms of the net sales to both. So we’ll just have to kind of see how it plays out. What was the second part of your question?

Mark Shamber

Whether we can handle doing all?

Steve Spinner

With the new capacity, we absolutely could.

Scott Mushkin - Wolfe Research

Okay. And then the third question, which is strategic question is, you’re for a while doing – and it’s been a while for fresh acquisition. I was wondering what your appetite is, that’s a very high growth area we’re seeing. What’s your appetite for more acquisitions into the fresh area? And then thank you.

Steve Spinner

I mean look we’ve said all along that we’re going to be acquisitive, but we’re going to wait until we find companies that are a good fit. That we can pay a reasonable price and so that still remains our belief. And whether its fresh related or specialty related, we’ll just have to kind of wait and see. Unfortunately we have a balance sheet that will allow us to do it.

Scott Mushkin - Wolfe Research

Hi, perfect. Thanks for your time and it’s a great quarter.

Steve Spinner

Thanks, Scott.

Operator

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

Meredith Adler - Barclays

Hey. Congratulations, nice quarter.

Steve Spinner

Thanks.

Meredith Adler - Barclays

I don’t feel I have got a lot of questions. I probably can guess the answer to this. But have you explored anymore, how you would finance on the facilities once they’re built, I mean, Wisconsin is going to get done in a couple of months. Are you looking to get it off your balance sheet, help fund the next facilities that get build? Are you just kind of waiting to see what’s out there, rates are going to go up?

Mark Shamber

Right. We actually are in the midst of working on something, Meredith. I think it’s a little premature to announce exactly the details of it obviously because we haven’t finalized the transaction. But we are in the midst from that standpoint. I think to the question that you are asking, we would likely lead them on our balance sheet likely mortgage the properties in a scenario from that perspective. And the main reason is just with the leasing rules changing in the not too distant in future, we would likely – if we’d take them off the books in some form of a sale leaseback, they’d be offered two years to three years whenever the rules may go into effect and they’d some back on the answer would be – cost or stuck with a higher interest rate or borrowing rate from that standpoint.

So we’d likely complete the financing in the back-half of fiscal 2014 and then all the details obviously we shared and out at that point in time. But it will come in the form of some sort of mortgage where the assets will stay on the books. There is a scenario, future transactions where they may not make sense for us to watch own every building that we build and so there may be isolated instances where we had a sales leaseback, but in general they will be financed through mortgages.

Meredith Adler - Barclays

Got it. And then I have a question, I mean, Steve, what you’ve kind of been saying for a while now is that you want to have smaller facilities that are closer to where your customers are located? Does that lead you to look at any of the facilities you’re already have and feel like they are very big and very out of the way and not close enough to the customer?

Steve Spinner

No. Not really, all of the new buildings that we’re building, we pick the geography so that they could take some of the burden away from the existing facility. So as an example, we’re opening up Hudson Valley, New York, which is just north of New York City. We currently serve New York City from Chesterfield, New Hampshire Dayville, Connecticut, York, Pennsylvania.

In each one of those scenarios, you’re talking about a pretty long distance to serve a high density market. And by pulling all of that volume from those three facilities into Hudson Valley, the first thing it does is, it significantly reduces the travels, the miles travel. So there is a tremendous savings there. Two, it significantly enhances service level to the customers. And so, that’s the general philosophy around the way we open buildings and that is to defer some of the volume from the more distant locations to the location that’s closer to the customer.

Meredith Adler - Barclays

Okay. And then I guess my final question is sort of back to – Scott was asking about the insurance for the products. How did your customers react, I mean, I assume they just understood that it was a terrible situation, but the fact that they were points when they couldn’t get product. Did that ever become an issue?

Steve Spinner

It did have an impact on our service level across a very narrow set of SKUs. So it didn’t impact a wide range of products, it was limited number of SKUs. Any dry liquids that travels west to east was really affected the most. And we’ve responded pretty quickly as soon as we saw that it was happening and this was primarily through product that was being shipped intermodal, in other words, trucks that actually moved across the country on trains.

Meredith Adler - Barclays

Right.

Steve Spinner

And a lot of these trains got hung up in the center of the country for days with subzero temperature. So we did have some service level around those items, but we responded pretty quickly by reordering the product and shipping across the country on refrigerated trucks, which obviously had significantly higher cost which we hate, but we felt it was more important to have the product than not.

Meredith Adler - Barclays

So I’ll ask a dumb question – I’m sorry, go ahead.

Steve Spinner

No, go ahead.

Meredith Adler - Barclays

I was going to say, a dry liquid does sound a little like an oxymoron. So I assume you mean a shelf stable liquid item?

Steve Spinner

Yes. I mean if you think about aseptically packed soups, dry soups.

Meredith Adler - Barclays

Okay. Got it.

Steve Spinner

Shelf stable soups that if the containers freeze…

Meredith Adler - Barclays

Yes.

Steve Spinner

You can’t probably resell it.

Meredith Adler - Barclays

Got it. Okay. That’s it from me. Thank you.

Steve Spinner

Okay.

Operator

Thank you. Our next question comes from the line of Karen Short with Deutsche Bank. Please proceed with your question.

Karen Short - Deutsche Bank

Hi.

Steve Spinner

Hi, Karen.

Karen Short - Deutsche Bank

Hey. So I know you get asked this every quarter in terms of the rate of new product introductions versus the rate of products that kind of get (indiscernible). So maybe just an update on where that stands because it seems like there is point of view that there is an acceleration within the conventional space, so I guess the theory would be there is a risk that the product going direct might accelerate, maybe just some color there?

Steve Spinner

Yes. I don’t think there has been any change and remember that direct only effects I think what was a 25% or 26%.

Mark Shamber

26%

Steve Spinner

Yes. 26% of our customers during the quarter that’s the only channel that direct has an influence. And the key thing about our business is product innovation. It has to be a lot more coming in the top and spoiling out the bottom and that certainly been the case. And we also know that service level on product that delivers through UNFI is statistically higher than product that flows through direct. Because even the fastest moving conventional organic items still move much slower than true conventional items and because conventional captive warehouses like to buy a full truck load and our business is primarily LTL. We know actually that our fill rate will be higher than a captive warehouse buying a direct, now that’s not true all the time, but it’s certainly true in a lot of cases. So it is very common for us to lose something to direct and then ultimately take it back.

Karen Short - Deutsche Bank

Got it. That’s helpful.

Steve Spinner

Yes.

Karen Short - Deutsche Bank

And then just wondering in terms of the inventory optimization and the rollout to the east, can you maybe give an update on that timing wise and then maybe some color on how that might benefit your gross margins in the second half?

Steve Spinner

Yes. It’s fully deployed in the west and if you recall, we do it supplier-by-supplier and it’s delivered everything that we thought it would. We’re going to go live late summer early fall. So the impact really won’t happen until our next fiscal year.

Karen Short - Deutsche Bank

Okay. And any – and so can you kind of try to give directionally some color on how that might benefit your gross margin?

Steve Spinner

We’ll probably wait until fiscal 2015 guidance I would think.

Mark Shamber

Yes. I mean, it’s difficult to try and predict that in advance, Karen, because it really one component of that is to what level we are experiencing a promotional environment during the timeframe, where the suppliers are – it’s one of the components on that and how well we buy against the deals in order to help us from a service level standpoint.

Karen Short - Deutsche Bank

Okay. Got it. And then in terms of capacity utilization at your Wisconsin facility, when it opens and it’s up and running and actually supplying the customers that you plan to supply out of that facility. Can you just give me a sense of what the capacity utilization will be at that facility – assuming no new customers?

Mark Shamber

Well, we typically opening buildings and they’re usually around 50% when they first open from that standpoint so that they have a time. We’ll bring Wisconsin up slowly, we’ll move customers over in waves. And so when it first starts opening, it will be below that, but it will probably be in the 50% to 60% range when it’s operating – fully operating in the first year.

Karen Short - Deutsche Bank

Thanks. Thanks for taking my questions.

Operator

Thank you. Our next question comes from the line of Scott Van Winkle with Canaccord Genuity. Please proceed with your questions.

Mark Sigal - Canaccord Genuity

Hey, guys, it’s Mark Sigal for Scott. The high end of guidance kind of by my math looks to imply kind of flat operating margin on a year-over-year basis for the back half of the year albeit off of a strong comp last year. You’d mentioned kind of lingering transportation costs, will the inventory management system begin to defray any of those and are there any other kind of margin levers in the back half that we should be thinking about?

Mark Shamber

Well, I think, Mark, to the first part of the question, I mean, everyone’s model can yield it out in a variety of ways. So I mean I think there are scenarios where there’s still operating margin expansion not having seen your particular model, I can’t comment on those specifics. As it relates to the warehouse, when you say the inventory management system you’re talking the inventory optimization or the warehouse management?

Mark Sigal - Canaccord Genuity

No, sorry the inventory management, the rollout into your eastern DCs.

Mark Shamber

Yes. I mean that again as Steve mentioned, we do it on a supplier-by-supplier basis. So the impact will be minimal in the fourth quarter of fiscal 2014 as we start to roll it out. But then when we get to the end of the first quarter 2015 and to the second quarter where we should start to see more of the benefit reveal itself.

Mark Sigal - Canaccord Genuity

Okay. And then can you just update us beyond Wisconsin, the cadence on New York, the second Wisconsin facility in Northern California and also when should we be expecting the associated CapEx with each of those facilities?

Steve Spinner

Yes. The Wisconsin, obviously, we’re deep into the CapEx, we’re starting to receive right in May. So we’ll start shipping sometime during the summer. On Hudson Valley, New York, we’re also deep into the CapEx spend, those two locations were the vast majority of our CapEx during the quarter. The building is up, we will start receiving products into Hudson Valley late summer, early fall with deliveries out to customers probably sometime around…

Mark Shamber

Right before the holidays.

Steve Spinner

Yes, right before the holidays. And then we’ll take a little bit of a breather as we ramp up construction which is going to be a smaller building in Prescott, Wisconsin and that the construction there probably will start incurring some small cost in the fourth quarter of this year. But you’ll see more of those costs really in the first half of fiscal 2015. I don’t know the exact cadence yet as we only announce that a couple of weeks ago. So we’re still working on the timeline.

And then Southern California is at least I would say 18 months to 24 months away just because of the permitting required in California. So I would think the bulk of the CapEx associated with that facility will probably be back half late 2015 and into fiscal 2016.

Mark Sigal - Canaccord Genuity

Okay, very helpful. Thank you.

Operator

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

Robby Ohmes - Bank of America

Thanks. Mark maybe a question for you, I apologize if you – you might have covered this at the beginning, but can you sort of just simplistically help us understand what the – sort of estimated what the gross margin impact was from weather and maybe help us think of a normalized gross margin for the quarter and how we should be thinking about gross margins for the next couple of quarters?

Mark Shamber

Yes. It typically – if it only was that easy Robby. I think when we look at to the – I think it was Scott who’d asked the question. So if we look at the gross margin impacts during the quarter that may we should hopefully not repeat themselves on an ongoing basis. There is probably about 15 basis point expansion from a sequential standpoint to the extent that they don’t repeat. Having said that, as Steve highlighted, we’re probably going to have some drag in Q3 associated with some of the frozen products and some of these issues that they did continue into February.

And so from that standpoint, we’ll probably get about 60% of that benefit. So if I had to guess or take a stab at it, we’ll likely see about 10 of the 15 or so basis points related to that area not repeat themselves in Q3. But then what we have in Q3 is that if you look sequentially Q3 is usually one of our strongest quarters on the gross margin side, a lot of that is due to stronger independents sales growth in the quarter stronger independent sales in the quarter as well as the fact that it is the strongest quarter of our Albert’s Organics division.

So all of those items combined into the mix. I don’t – I really don’t want to get myself hung up on a particular gross margin range for the third quarter because we did see such a big move in the second quarter with the sales growth in a couple of the channels. But I would tell you that we should get at least 10 basis points back and if you look at the gross margin in the third quarter last couple of years as compared to the second quarter, there should be some expansion associated with that as well.

Robby Ohmes - Bank of America

Got it. That’s very helpful. Thanks Mark.

Mark Shamber

You’re welcome.

Operator

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

Andrew Wolf - BB&T Capital Markets

Thanks. I just wanted to follow up on the question on the capacity utilization. I know those commodity – lower operating margins obviously concerned or utilized, but what is the net effect of relieving some of the overcapacity issues at neighboring facilities?

Steve Spinner

Well, in the short-term Andy, we’ve got duplicated costs, because we still have the cost in the facility that losing it. We have the cost in the facility that’s gaining it. So for a period of time we’ve got a duplicated cost. And then typically through attrition, we managed the cost down in the facility that is losing it as we gear up the facility that’s gaining it.

So I would say in the first six months, or so it’s a – we’ve got a lot of cost associated with moving the freight and getting one facility geared down and another facility geared up. The other complicating factor is frequently we need to move inventory. So if we’re actually moving one customer that’s currently isolated to a single facility and they have proprietary inventory, we have to move that proprietary inventory from one facility to another at our costs.

So first six months are a lot of duplicating overlapping costs which obviously flush through once we get the building up and running.

Andrew Wolf - BB&T Capital Markets

Okay. And my other question was on working capital. The receivables are up a lot 20% faster than the sales growth, is that just somehow timing or some – its predictable or maybe already some folks that paid some bills, or is that more structural with the way the sales mix is trying to.

Mark Shamber

It’s more, I mean, there is a small element that is structural, Andy, in the sense that as the supermarket business grows we will see the receivables increase a little bit because they tend to be slower payers than some of our other customers. Have said that, because the supermarkets are such a big part of the sales in the second quarter usually we see an uptick in the DSO in Q2 and then it usually comes back down in Q3.

So to the point that you made, I mean, January, we had some really strong sales, a lot of that was due to the shift as to when the way Christmas and New Years fell for us this year within the quarter. So a lot of it’s been paid since quarter end. But to the question you asked, there is a small element that’s structural, not a significant impact on the DSO, but it will impact it in the quarters where the supermarkets have the faster growth.

Andrew Wolf - BB&T Capital Markets

Okay. And lastly, just on the [streaming] (ph) other income almost half a penny negative, could you just give us some color on that? That’s it.

Mark Shamber

Yes. That actually is also associated with the softening of the Canadian dollar. So what happens is that at every period end, we have to revalue our current assets of the working capital to the new exchange rates and so the Canadian dollar softened against the U.S. dollar during the quarter. So that figure is, I believe it’s just under $0.5 million within the other income line, is all non-cash due to the revaluation of the balance sheet of our Canadian division.

Andrew Wolf - BB&T Capital Markets

Thank you.

Mark Shamber

You’re welcome.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Eric Larson with CL King. Please proceed with your question.

Eric Larson - CL King

Yes. Hi, everybody. Good quarter. Just wanted – most of my questions have been answered Steve and Mark, but just a curiosity question. Your facility – the facility in Denver where you’re still incurring expenses on I think the lease goes still to June to July of next year. I mean is there anything you can do to offset the expense or are you, is it rented that facility, can you give us a little update on what – is that’s another year-and-a-half on that lease and frankly its getting a little old listening to it?

Steve Spinner

Yes. I mean, unfortunately that’s a building that we acquired and part of the deal was that we would assume that lease. And so the only thing that we could potentially do, which we obviously try to do is to sub-lease it. But because there is such a short-term left on lease, it is what it is.

Eric Larson - CL King

Okay.

Steve Spinner

So if we can’t get anywhere in there, we’re just going to have [eat it] (ph).

Eric Larson - CL King

Okay, all right. I just thought I’d ask, just if there was something else that could be done with that. And then maybe just a question for both Steve and Mark, it’s been a while since we’ve really asked the question. But your goal – you have a set goal for EBIT margin expansion, I believe it’s 9 to 13 basis points of that – correct me, if I’m wrong on that on an annual basis. Is it when you look at the long-term goal and I remember years ago we used to kind of say well 4% is doable, is it doable EBIT number over a period of time if the businesses run efficiently, is that still and you’re now solidly at 3% and you’ve been there for a bit of time. So if you’ve kind of secured that base I believe, what is the real upside potential over the course of time?

Mark Shamber

Well, I mean I think we’re still confident in 9 to 12 – I think its 12 basis points here.

Eric Larson - CL King

Yes. That’s one of those, yes.

Mark Shamber

And so we think that looking out over the course of the next three to five years, that’s a good target for us. Whether it’s going to happen every year, I don’t know, it might, it might not. We’re always going to be faced with the question of, if you have the opportunity to add $300 million worth of new business because it came in front of you which you knew in the first year that we’re not going to get that 9 to 12 basis points. But just because of the sheer cost of putting it in, but over the course of time, you would be able to make it efficient and get back to the 9 to12 basis points. I mean, we would certainly do that.

And so it’s a very hard question to answer, but it’s one that we obviously discussed a lot internally. And at the end of the day, I think we’re comfortable with 9 to 12 basis points a year, over the next three, five years.

Eric Larson - CL King

Okay. Thanks, Steve and Mark.

Operator

Thank you. Our next question comes from the line of Jason DeRise with UBS. Please proceed with your question.

Jason DeRise - UBS

Hi. Thanks for taking the follow-up. It’s a couple of housekeeping ones and then I want to dig at your opinion on something. So that housekeeping ones. In the prepared remarks it was also mentioned that some of the DCs were closed. But I don’t think there was a dollar amount tied to that. Is that within some of the other dollar amounts, or is there something else on top of the…

Steve Spinner

No. We didn’t call out the sales impact of the DC closures, because it just wasn’t material enough.

Mark Shamber

It’s very difficult when the DC is closed, Jason, because in some instances you make up a portion of the volume. But you often don’t make up all the volume that comes from closing per a day. And so to put a number out there, really would just be us taking a swag at it.

Jason DeRise – UBS

Okay. And the other housekeeping question I wanted to ask on the FX impact on the gross margin, is it all translational or is there some transaction element to the currency there and that’s why it’s causing more of a gross margin hits?

Mark Shamber

Yes. I mean, it’s – on that there is – it’s both, but what really happens is that for the holiday period and in this case it was really, it was really highlighted in the second quarter of this year, but we’re limited with certain retailers and passing through price changes and certainly if from the time we bought a product until the time we sell it to the retailer that we bought in U.S. dollars. And the U.S. dollar gets – or we bought in Canadian dollars and the U.S. dollar gets stronger. We don’t have the flexibility in that short window to raise the pricing to our customers because we’re setting their pricing for a period of time whether it’d be 30 days, 60 days and so on.

And so we’re getting caught on that end but then we’re also getting caught on some of the purchases. So it’s a mix of both and it’s a bit difficult to split it between the two, but it is those two components that make up that 900k.

Jason DeRise - UBS

Okay. That’s helpful. And then I just wanted to get your opinion on or just understand what you guys thought your takeaways were from [x expos] (ph) this year compared to prior years?

Mark Shamber

Well, I’ll tell you, and if any of you went, I don’t know how many people were there but we heard anywhere from 65,000 to 85,000 people. So it was by far the busiest expo that I’ve ever been to. It was upbeat, interesting suppliers, lot of popcorn but other than that it was terrific.

Steve Spinner

Yes. I mean I think at the rate that the industry is growing and certainly from an attendance standpoint it may have to expand the Anaheim Convention Center in order to fit us all in next year.

I think there were an awful lot of bankers there.

Jason DeRise - UBS

I did notice a lot of suites walking around. But do you think a lot of the attendance, or maybe the boost, were there more boosts this year of suppliers. Do you find that there is more choice for you now as people are drawn into this, or is it that the amount of people there is just the number of retailers and people interested in buying these products are driving that higher?

Steve Spinner

No, I think it’s both, I think that there was added floor space this year. A couple of new halls opened. So I think we’re getting more people to the show and there is more suppliers attending.

Jason DeRise - UBS

Okay. Thank you.

Mark Shamber

Thanks Jason.

Operator

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

Meredith Adler - Barclays

Sure. I guess one of the follow-up on the question about the 9 to 12 basis points of margin improvement. What you seem to be saying is, you take on a piece of business that temporarily because you have to integrate and everything would hurt the margin. Would you also, you are kind of doing this with supermarkets. But would you describe yourself as mostly focused on operating profit dollars as opposed to margin?

Steve Spinner

I wish there as an easy answer to that. Last year we had both. I would say that, the easiest way to answer is that it could be lumpy. We could get more dollars one year and less margin. And then the opposite could happen the next. But our guidance actually says that we’re going to do both. That we’re going to get what’s the number of our dollar growth

Mark Shamber

Operating it’s 10 to 19.

Steve Spinner

Yes. So 10 to 19 which is pretty broad range, but 10 to 19 in earnings growth at 9 to 12 basis points of margin expansion. So again, if you look – if you go five years from now, I’d like to be judged, I would say that generally we achieved both.

Meredith Adler - Barclays

And is it fair to say that you’re not necessarily – you might take business that will drive operating profit dollars. But then you’d be doing other things that might drive the operating margins. So they might sort of offset each other, but you’re not going to walk away from business and you haven’t been because of the margin percentage is lower?

Steve Spinner

Without a doubt, we will not do that.

Meredith Adler - Barclays

Okay. Thank you.

Steve Spinner

Okay.

Operator

Thank you. Ladies and gentlemen, I would now like to turn the floor back to our CEO, Steve Spinner. Please go ahead.

Steve Spinner

I want to thank you all for joining our call this morning be healthy and eat organic. Thanks and have a great day.

Operator

Thank you. Ladies and gentlemen, this concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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