SUPERVALU's (SVU) CEO Sam Duncan on Q3 2016 Results - Earnings Call Transcript

| About: SUPERVALU Inc. (SVU)

SUPERVALU INC. (NYSE:SVU)

Q3 2016 Earnings Conference Call

January 13, 2016 10:00 AM ET

Executives

Steve Bloomquist - Director, IR

Sam Duncan - CEO and President

Bruce Besanko - EVP and COO

Susan Grafton - EVP and CFO

Analysts

Steve Forbes - Guggenheim Securities

Chuck Cerankosky - Northcoast Research

Ajay Jain - Pivotal Research

Vincent Sinisi - Morgan Stanley

Ryan Gilligan - Deutsche Bank

Scott Mushkin - Wolfe Research

Stephen Grambling - Goldman Sachs

Operator

Good morning. My name is Ginger and I will be your conference operator today. At this time, I would like to welcome everyone to the SUPERVALU Third Quarter Earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]

Thank you. Mr. Steve Bloomquist, sir, you may begin your conference.

Steve Bloomquist

Thank you, Ginger and good morning, everyone. I want to welcome you to SUPERVALU’s third quarter fiscal 2016 earnings conference call. Joining me today are Sam Duncan, Chief Executive Officer and President; Bruce Besanko, Executive Vice President and Chief Operating Officer, and Susan Grafton, Executive Vice President and Chief Financial Officer. Following prepared remarks, we will open up the call for your questions. So that we can accommodate as many people as possible, I would ask that you limit yourself to one question with one follow-up.

The information presented and discussed today includes forward-looking statements which are made under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The risks and uncertainties related to such statements are detailed in our most recent 10-K filing. In addition, certain information presented and discussed today constitutes non-GAAP financial measures. Information required to be disclosed about these measures is included in our earnings release issued earlier today. A replay of the call will be available on our corporate website at www.supervalu.com.

With that, let me now turn the call over to Sam.

Sam Duncan

Thanks, Steve, and let me welcome everyone to SUPERVALU’s third quarter conference call. I will get to the quarterly results in a moment, but let me start with an update on a potential separation of Save-A-Lot. On January 7, we filed a Form 10 with the SEC, which was the next step in the potential separation of Save-A-Lot from SUPERVALU. It is customary for the SEC to provide comments on the documents submitted and we would look to respond with an amendment to the Form 10 in the normal course. As noted in the Form 10, we intend that a spin-off of Save-A-Lot would be tax-free to SUPERVALU's shareholders. It is further intended to be taxable to SUPERVALU which would utilize its existing capital loss, the result of the Albertsons disposition to fully offset the taxable gain.

This structure is also expected to result in Save-A-Lot receiving a step-up in the tax basis of its assets. Also, should the spin occur, we expect that there would be a TSA agreement between SUPERVALU and Save-A-Lot. From a structural perspective, SUPERVALU shareholders would receive at least 80.1% of the common stock of Save-A-Lot while SUPERVALU would retain the remaining interest. Lastly, the potential spin transaction is subject to final approval by our Board of Directors and other customary conditions. Should the spin occur, it could be completed in the first half of fiscal 2017.

Regarding the management team, eight weeks ago we announced a new CEO for Save-A-Lot, Eric Claus, an experienced and innovative retailer who shares our enthusiasm for the banner and who has spent his time getting up to speed on the particulars of the business. Eric brings a variety of strength to his new position, including marketing and merchandising and I look forward to the ideas and contributions he will bring to Save-A-Lot.

Let me now move on to the results for the quarter. This morning we reported third quarter sales of $4.1 billion, a decline of approximately 2.6% compared to last year's third quarter. Adjusted EBITDA was $182 million and adjusted earnings per share from continuing operations was $0.16, both in line with our operating plan.

Sales this quarter were a challenge as Independent Business sales were down, but adjusted EBITDA was slightly up compared to last year. Our Retail Food store sales continued to face margin pressure, particularly in the pharmacy, which adversely impacted sales, but we managed the balance of the P&L better than we did in the second quarter, which resulted in a smaller year-over-year decline in adjusted EBITDA compared to Q2. Lastly, Save-A-Lot experienced even deeper levels of deflation than the past two quarters which kept adjusted EBITDA only slightly higher than last year's third quarter.

Let me provide some additional comments on Save-A-Lot before Bruce elaborates on the Independent Business and Retail Food. Network ID sales at Save-A-Lot were negative 3.4%, a 180 basis point decline from the second quarter. Deflation was 5.7%, a 170 basis point decline from the second quarter and the key driver of the lower ID sales. The most notable impact came from the meat department where our costs for beef and pork products fell nearly 20% compared to last year's third quarter. These levels of deflation were meaningfully greater than we had anticipated and again had the largest impact on the licensee distribution portion of the business where we generally pass through cost changes to our licensees.

In our corporate stores, we have more discretion toward retail pricing and which items to promote, so we were able offset some of the impacts of deflation. Against this challenging environment, we managed margins and cost well and increased adjusted EBITDA by $1 million over last year to $50 million.

From an operations perspective, Save-A-Lot continues to execute on the initiatives I have outlined in prior calls. One of Save-A-Lot’s key differentiators is its fresh offerings, both produce and meat and we continue to emphasize these departments in our training programs. In produce, we are focused on making sure the department regularly offers only the best precious quality product day in and day out. In meat, we emphasized both food quality as well as cutting techniques so that we are able to optimize sales, margin and inventory levels while offering items we know customers want.

Our retail operations team has touched nearly every store in the network with both in-person seminars and one-on-one training to ensure that proper disciplines are in place across the network for these departments. Private label continues to be an increasing part of the Save-A-Lot brand with sales in our corporate stores now accounting for roughly 60% of the total store sales excluding fresh meat and produce. Customers are becoming more and more receptive to purchasing private label products as a lower-cost alternative to national brands, a trend we expect to continue.

We have converted a number of regional or packer brands to one of the Save-A-Lot’s labels and will continue to do so going forward where appropriate. We are also nearly complete with our annual supplier negotiation process during which we not only speak with current suppliers but also look for additional companies that can meet our needs all in an effort to lower Save-A-Lot’s cost of goods. These discussions are meant to create win-win solutions for both Save-A-Lot and our vendors as we explore ways to work together to take overall cost out of the system.

This may result in pack size changes that make production runs more efficient or shifting volume to underutilized manufacturing facilities. Another area where we have done a nice job in reducing our cost is freight. Save-A-Lot is now managing a greater percentage of the inbound transportation of product using its own dedicated fleet. As a result, fewer trucks are travelling fewer miles with empty trailers. We are also making incremental investments in transportation related technology which we anticipate will further reduce our cost. We continue to roll out our Hispanic merchandizing programs in both fresh departments and center store as well as our modular general merchandise sets. Both of which are doing well for us.

Lastly, we continue to see good results out of Las Vegas and we will soon see more store openings in that market as well as in Southern California. Our goal for new store openings this year remains unchanged from last quarter as we expect to open approximately 90 gross new stores by the end of fiscal ’16, which will be roughly equally split between corporate and licensee stores. We continue to believe strongly in the Save-A-Lot format, the growth opportunity it represents and its future prospects. I am sure Eric will bring new and innovative ideas to the brand that will move it forward.

Now let me turn the call over to Bruce for his comments on independent business and retail food after which Susan will review the financial results in greater detail. Bruce?

Bruce Besanko

Thanks, Sam, and good morning everyone. Let me start with the independent business where sales for the quarter were $1.9 billion, down approximately 3.5% compared to last year. And third quarter adjusted EBITDA was $72 million, up $1 million over fiscal ‘15. The biggest driver of lost customer volume in the quarter was Albertsons LLC transitioning the final Southeast stores supplied by SUPERVALU to self-distribution. We’ve supplied these stores since 2010 but with their expanded footprint and distribution network they chose to take this volume in house and begin the transition toward the end of our second quarter.

In addition, we’ve experienced some general sales softness resulting from several factors including unseasonably warm temperatures across our independent retailer store based. Last quarter, we discussed the year-over-year decline in average sales per case going out of distribution centers. This situation has strengthened and was up modestly in the third quarter. However, commodity meat prices continue to show double-digit declines compared to last year, which were partially offset by some modest increases in other departments.

Last year’s historic level of inflation for certain proteins was driven by domestic supply issues combined with strong demand for exports. This year in-store contrast, domestic supplies have seen the largest year-over-year increase in the last 65 years while global demand has softened, which has led to the historic levels of deflation. We haven’t experienced these kinds of swings in the past 40 years.

Although produce costs have not been impacted to the degree seen in meat, weather across the southern half of the United States created supply issues during the quarter. Freezing temperatures in the southwest slowed the growth and limited the supply of a number of vegetables while unseasonably warm weather in Florida has adversely impacted the quality and availability of strawberries. Overall, the environment remains challenging given some of the cost escalators inherent in the business and the persistent lack of inflation in the center store.

As an update on our relationship with Haggen, we are currently the primary supplier to 21 of their stores down from the high of 46 stores supplied at the end of Q1. Haggen has set an option date of February 5 for its roughly 35 core stores, a process from which we hope to supply as many stores as we can.

Although we don’t report at this part of our Independent Business segment, we are pleased to have seamlessly integrated approximately 70 former A&P stores into the distribution center we share with Albertson’s. This volume came in over a relatively short period of time and creates incremental operating efficiencies at the distribution center.

We’ve also begun supplying jep.com [ph], out of both of our operating regions as we look to increase what we call our non-traditional lines of business. Among similar business models, we also make [ph] services in select markets on the east coast, neither represents a large portion of our business today, but they do reflect how we are working to capture business from alternative and emerging business models.

Our strong private brands program continues to do well for our independent business customers, including the Wild Harvest brand industry for more than 100 desirable ingredients and competes in the natural and organic space. Independent business sales of Wild Harvest product was up nearly 85% with especially strong results coming from the protein offerings including chicken, ground beef, turkey and beef.

We continue to believe private brands represents a great opportunity for both SUPERVALU and our independent retailers as more items are introduced and customers gravitate to these labels for the quality and value they offer.

On our last call, I discussed our increasing focus on professional services, including work on our digital space. We are working on plans to migrate our first independent retailer on to a separate version of SUPERVALU’s digital platform, which we customized to handle look and feel of our customers’ stores and brand. This platform enables the redemption of digital coupons and creates a strong shopper relationship without the need for a loyalty card. It was actively marketed and well-received at our last national sales expo and we expect to move more of our IB customers to it over the coming months.

Lastly, I want to welcome Mike Stigers to our executive team as Executive Vice President of Independent Business and Supply Chain. Mike previously led what is now our west region and is a great example of our deep bench strength as he takes over for Janel Haugarth, following her retirement last month. Janel led our Independent Business for many years and was a relentless champion for our independent retailers. We wish her all the best as she leaves the company following a nearly 40-year career here at SUPERVALU.

Moving to Retail Foods, sales were $1.1 billion, a decrease of 2.5% compared to last year’s third quarter. Identical store sales decreased 2.6% and adjusted EBITDA decreased by $11 million. Results for the quarter were again adversely impacted by the compression of pharmacy gross margins, which continue to impact our promotional plans. We did a better job managing shrink in the quarter compared to the second quarter, but there is still opportunity for further improvement in terms of better matching purchases and inventory levels to sales.

Breaking up the quarter’s ID sales, customer counts declined 4.3%, which was partially offset by an increase in basket size of 170 basis points. We are pleased with the increase in basket size, which came in spite of fairly dramatic deflation across the meat category. But our real challenge comes down to traffic levels, which we readily acknowledge, must improve. As we look to finish fiscal 2016 and continue to plan for fiscal 2017, we are incorporating our best forecast for pharmacy margins as well as a meaningful level of incremental price and promotional investment intended to drive traffic, while being mindful of the balance between sales and EBITDA.

In addition to future operating investment, we plan to invest capital in our retail network at what I believe to be a prudent level. We opened a new grounds up cub store last month here in the Twin Cities and have at least one store planned for next fiscal year. We've also opened two new cub branded liquor stores with assortments designed to successfully compete with both local and national liquor retailers. We continue to update the overall retail fleet with a disciplined remodel cadence in addition to the store optimization work being done in all the banners, which adjust the assortment and adjacencies across all the departments.

From a consumer offering point of view, we continue to work on driving sales across the national and organic space where in our most recent period, unit sales increased approximately 15%, while dollar sales were up about 12%, both compared to last year. The highest growth rates again came from meat and frozen food, including the success of our Wild Harvest brand. Within our retail stores, year-to-date Wild Harvest ales have nearly doubled with units sold up approximately 75%. This is partially a reflection of a 200 plus items we've introduced this year as well as strong consumer demand for such products. Our Wild Harvest portfolio now has more than 600 items, and we continue to look for future opportunities to grow this brand.

We’re continuing to analyze our offering of a personal shopper for our customers and how that fits into our overall digital presence. We know there is a certain segment of the market that desires the ability to shop online and either pick up their order in the store or have it delivered to their home and the online orders we’ve fulfilled have averaged anywhere from 2 to 5 times larger than the banner average. We're still in the evaluation stage toward a broader go-to market strategy, but encouraged by the limited results we've seen to date.

Lastly, we continue to make good progress on the number of customers with digital accounts. Over the last seven months, we've tripled the number of accounts to over 400,000 and have seen app sessions increase by over 50% in the third quarter. As we look to fiscal ‘17, our goal is to have 1 million such accounts by the end of the fiscal year.

With that, let me turn the call over to Susan for further insights into the quarter and our financial condition. Susan?

Susan Grafton

Thank you, Bruce and good morning, everyone. As outlined in this morning's press release, for the 12 week third quarter of fiscal ‘16, we’ve reported net earnings from continuing operations of $35 million, which included $11 million in after-tax charges related to asset impairments, employee severance and costs related to the potential separation of Save-A-Lot. Excluding these items, net earnings from continuing operations were $46 million and earnings per diluted share were $0.16. Third quarter adjusted EBITDA as outlined in table 5 of our release, was $182 million, down $5 million from last year's third quarter, but in line with our internal operating plan.

Consolidated net sales in the quarter were $4.1 billion, a decrease of $111 million or approximately 2.6% compared to last year's third quarter. Net ID sales at Save-A-Lot were negative 3.4%. ID sales from corporate stores within the Save-A-Lot network were negative 0.4%, driven by a 1.1% increase in average transaction size and a 1.5% decrease in customer count, partially the result of lower promotional and marketing spending compared to last year across ten markets. As Sam mentioned, ID sales at Save-A-Lot were impacted by approximately 570 basis points of product cost deflation during the quarter, which had a correspondingly greater impact on the licensee wholesale side of the business where ID purchases were negative 5.7%.

The deflationary environment has deepened and lengthened relative to our expectations six months ago and is something we simply must continue to work through. However, we don't see the deflationary environment changing much in the fourth quarter compared to the third quarter.

Independent business sales were $1.9 billion, about $70 million less than last year. Bruce discussed the laws of the Albertsons LLC volume in the southeast, which I would note was a partial quarter’s impact. Q4 will be the first quarter in fiscal ‘16 where we will have zero revenue from these stores. Partially offsetting this lost volume was the continued efforts of our independence to invest in their business as reflected by the 32 new stores we supplied in Q3 that were not opened last year.

Moving to retail foods, identical store sales declined 2.6%, driven by a 4.3% decline in customer count, partially offset by 1.7% increase in average transaction size. Improving our traffic levels is the primary focus of our five retail banners and we have begun, as Bruce stated, to get more aggressive with our promotional spending here in Q4 and are encouraged by the early results.

Moving down the P&L, consolidated gross profit was 14.6% of net sales, up about 50 basis points compared to last year's gross profit rate. Margins were stronger in each business segment compared to last year with the biggest increase coming from Save-A-Lot, largely driven by the increased mix of corporate versus licensed stores.

Consolidated SG&A expense, adjusted for this year's asset impairment and severance charges as well as Save-A-Lot separation cost and last year's pension settlement charge and net IT intrusion costs, were 11.7% of net sales for the third quarter compared to 11.3% last year. The largest increases came from employee costs in Retail Foods largely due to soft sales and the impact of new stores and in Save-A-Lot shift towards corporate stores. Net interest expense in the third quarter was $45 million this year and was $46 million in last year's third quarter.

Moving from our consolidated P&L to the segment results, Save-A-Lot’s operating earnings for the quarter prior to $2 million in impairment charges related to four retail stores, where we do not intend to renew leases when the current term ends, were $34 million or 3.1% of sales equal to last year. Higher segment gross margins were offset by higher expenses, both largely the result of the business mix shift to a larger number of corporate stores.

Independent Business operating earnings for the quarter were $54 million and included a $6 million impairment charge. Prior to this charge, Independent Business operating earnings were $60 million or 3.2% of sales, about equal to last year.

For Retail Foods, operating earnings for the quarter were $21 million and included $1 million in store closure charges related to two stores both of which have calendar 2016 lease expirations that will not be renewed. Prior to this charge, Retail Foods’ operating earnings were $22 million or 2.1% of sales compared to $28 million or 2.5% of sales last year. Modestly higher gross margins were more than offset by expense deleveraging resulting from negative ID sales, the impact of newly opened stores and a $1.3 million withdrawal charge related to one of our multi-employer pension plans.

Finally, corporate operating loss was $6 million which included $7 million in Save-A-Lot separation costs and severance charges. Prior to these amounts, corporate operating earnings were $1 million. Last year's corporate operating loss was $2 million, which excluded $64 million for a pension settlement charge in net IT intrusion cost. The largest contributor to the year-over-year improvement was the benefit of higher TSA revenue from both Haggen and the Albertsons letter agreement, partially offset by a decline in the base Albertsons TSA revenue.

As an update on the TSA, in April, we stated that we have developed plans to eliminate costs and to generate incremental revenue streams that are expected to mitigate two-thirds of Albertsons fiscal '15 TSA revenue by the end of the estimated TSA wind down period. Since that time we have continued to work on further closing this gap and I am pleased to say that we now have engaged in initiatives that we expect will mitigate at least 90% of the TSA revenue reduction when the wind down is complete. Note that these initiatives will impact the business broadly, meaning the TSA revenue decline will occur in corporate while the offsets will come in corporate as well as within our operating segments.

Now let's turn to the balance sheet. At the end of quarter, our outstanding debt including capital lease obligations totaled $2.7 billion. I am very happy to report we again finished the quarter without any borrowings on our ABL and had approximately $930 million of available capacity under this credit facility. The third quarter is when inventories typically build in anticipation of a holiday selling season and our teams did a great job managing working capital such that we did not have to draw on the ABL. In addition, we ended the quarter with a cash balance of $134 million.

In early December, we issued notice that we would redeem the balance of our outstanding May 2016 bonds. This redemption occurred last week with approximately half funded by borrowings under the ABL and half with cash generated from operations.

Turing to cash flow, we have generated approximately $250 million in operating cash flow from continuing operations this year, up from last year's $104 million as a result of lower investment in working capital and lower pension contributions. Cash reinvested in the business is close to last year at about $200 million. On the financing activity section of the cash flow statement, remember last year's numbers included proceeds from a bond issuance that was used to redeem $350 million of the May 2016 bonds, a transaction that spanned across quarters three and four.

For the full year, our capital spending outlook remains unchanged in the range of $280 million to $300 million. Overall, third-quarter adjusted EBITDA was in line with our plan and expectations. The headwinds I outlined on the last call remain in place, namely continuing and deeper than expected product cost deflation at Save-A-Lot, the Haggen bankruptcy and the uncertainty that it presents and the growth margin challenges in our retail stores due to the lower managed care reimbursement rates. With Q3 adjusted EBITDS coming in largely as we had anticipated, we still expect full-year adjusted EBITDA to be flat to slightly higher than last year on a 52-week basis. Total sales are now forecast to be modestly lower than last year.

With that, let me turn the call back to Sam.

Sam Duncan

Thank you Susan. As Susan indicated, our full-year outlook remains unchanged from the last call. Our expectation for full-year adjusted EBITDA is that it will be flat to slightly higher than last year on a 52-week basis. Also to reiterate some of Bruce’s earlier remarks, as we look to the fourth quarter and complete our plans for next year, we intend to be more aggressive on price and promotion to drive stronger traffic while remaining very focused on managing cost.

The Board process for naming the next CEO continues and we look forward to providing further updates as my retirement approaches. Lastly, I want to thank our shareholders and the analyst that follow SUPERVALU for your support since my arrival three years ago. This will be my last scheduled earnings call prior to my retirement at the end of the fiscal year and I'm proud of what has been accomplished over that timeframe and wish this great company continued success in the future.

With that, let me open up the call for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from John Heinbockel from Guggenheim Securities.

Steve Forbes

Hey, guys, it’s actually Steve Forbes on for John today. Regarding the Save-A-lot footprint, I believe this was the first quarter in a while that overall net store count was actually down sequentially. You mentioned 90 new stores this year, but can you give some color around the net impact by segment and how that looks going forward?

Bruce Besanko

This is Bruce, I’ll take it Steve and then Sam can jump in if he'd likes. We’re still targeting gross store increases. What's happened is that some of the store -- some of the new stores have been pushed later into the fourth quarter just as a consequence of you know negotiations with developers and so on. So that's really the phenomenon that’s happening. We are going to continue to grow the store base just this year; they’re being pushed a little bit further into the fourth quarter than we had originally anticipated at the time that we put out our plan.

Sam Duncan

And I agree with Bruce. It's not an exact science, any time you start developing stores and sites and everything, there are so many things that are involved, you know landlords, city ordinances and everything that you got to work through and it just takes time and invariably you're going to have some issues that affect you, some good, some bad. Bad meaning that it just delays you, so it's nothing out of the ordinary that is causing that.

Steve Forbes

So as a follow-up we got a glimpse into the margin profile by segment within Save-A-Lot in the filing. But can you give any color on the performance this quarter, in particular may be the corporate stores, are you seeing stabilization or I think around that 3% level or any color would be helpful?

Bruce Besanko

Yes, I’ll start, and then Sam, feel free to jump in. So you must be referencing – are you referencing some of the materials from the Form 10, Steve, or what or are you just referencing the third quarter performance.

Steve Forbes

The Save-A-Lot filing, the segment breakdown for like adjusted EBITDA margin.

Bruce Besanko

Right. So what I would say is that – first of all, we continue to be impacted in both the corporate stores and through our license business with the significant deflation. The deflation grew in the third quarter relative to what we saw in the second quarter, which was higher than what we saw in the first quarter. So the most important task that our teams are managing is this very significant deflation. And so consequently the – we have a fairly sophisticated group of merchandisers in our corporate stores that can affect retail price without impacting against our – where we see our competitors and so they have been doing a fairly effective job through the first part of this year, managing that deflation. But that’s fundamentally the issue that we are faced with. The licensees have had a more difficult time as we look to what they – how their stores are performing. And so really this is really a story around deflation. In terms of the actual financial performance, the corporate stores are – we are going to continue to grow the corporate stores. The corporate stores have great returns on them and we are going to continue to look to grow those.

Sam Duncan

Nothing out of the ordinary is changing, meaning the deflation and that’s what the issue is, but what Eric and his team is now working on is how do we make deflation work for us, and we got to go out there and be aggressive and look for deals and work with vendors to get the items that we need. Whether it be private label or national brand, we don’t care, we just got to drive business.

Steve Forbes

Okay. Thanks for the color.

Operator

Your next question is from Chuck Cerankosky from Northcoast Research.

Chuck Cerankosky

Good morning, everyone. Could you give us a look at the retail segment comps without the effect of the pharmacy deflation or just without the pharmacy department?

Bruce Besanko

I’d have to go back, I don’t have the data in front of me Chuck. I have to go back and look, maybe we can provide that with – Steve might be able to share something after the call. But here is what I would tell you. The gross margin impact from the pharmacy has been one that we’ve struggled through this year and frankly, we understand that it’s had a significantly unfavorable impact on our store traffic. And so on a go-forward basis here in the fourth quarter, what we are doing about it is we’re going to continue to manage against it from – in terms of tactics to offset this headwind within the pharmacy itself, improving adherence to our patients to drive script volume, driving more immunizations, we have had a muted flu season, so flu vaccines are actually off this year, but we will continue to work through tactics within the pharmacy itself. But broadly though, in the fourth quarter, we’re going to – we’re putting in some additional pricing promotion and we look forward to seeing those results.

Sam Duncan

Yes, I think just to add to that Chuck, I don’t have the exact number, but I think to Bruce’s point, it’s much more of an impact on the gross margins dollars than it is on the comp.

Chuck Cerankosky

Got it. And bigger picture question. What would you describe on the customer demand side as being the big change? Even the competitive side, the big change in the operating environment now versus when the management team first got there and the sales momentum seem to be a little easier to achieve.

Sam Duncan

Well, the biggest thing Chuck that we – when we got here, we did not have the, of course, the deflation issues that we are facing now, and it’s up to us to do the right things to fight through that like I just mentioned a few seconds ago. If you look at where we were at approximately a year ago and where we are today, it’s a 10% swing on inflation and deflation. So that means when you open up the door, you’re 10% behind before you start, so you got to figure out ways to fight through that. We don't know when we are going to start seeing some inflation and we keep thinking we are going to see it, but it hasn't happened so far and we’ve thought that way for about six months now, but hopefully we will see some in the future. But right now we just got to work through, work on things to fight through that both on the retail side, the regular retail and Save-A-Lot. So it’s a significant factor right now.

Chuck Cerankosky

And one last question, at Save-A-Lot, during the quarter, what kind of activity was there in Save-A-Lot taking back licensee stores for lack of performance or adherence to the standards?

Sam Duncan

I don’t know. It’s something we will have to get back to you, Chuck, there. We are constantly looking at that all the time. If there was any, there might have been just a few, but we don’t know. We will get back to you and we may have to call with you later on.

Bruce Besanko

The good news is that when we reflect back over the past two and a half years, when Sam and Ritchie started this journey, there was more need to press the licensees to sharpen their store conditions and their adherence to our contract. Now, the vast majority of licensees had always done a great job doing that, but there was a small number that needed coaching. And so over the course of the past two-and-a-half years we have seen greater levels of adherence and so the good news is that the numbers of licensees that we had converted previously, given those circumstances, is not likely to happen in the future.

Sam Duncan

Trust me, I wish we had some inflation, because I would like to go out on a bear note, but inflation, deflation is out of my control and we’ve done a great thing in this company on how we improved the balance sheet and everything, so we’ve got the basics in place and we can just work through this issue.

Chuck Cerankosky

All right, thank you and good luck to you, Sam.

Sam Duncan

Thanks

Operator

Your next question is from Ajay Jain from Pivotal Research.

Ajay Jain

Yes, hi. Sam, I think in the first two years after you came on board, the sales at both Save-A-Lot and in Retail Food were responding well to the price investments that you were making during that period. And so I am just wondering, do you think there is a valid concern now that you might feel pressured to manage the retail business for margins at the expense of revenue especially at Save-A-Lot just based on the timing of the spinoff? And then can you also talk more generally about what's driving the incremental sales weakness at Save-A-Lot apart from deflation? If traffic is down at Save-A-Lot, I'm also wondering if maybe you are not as price competitive as you might need to be. Thanks.

Sam Duncan

We watch the price competitiveness on a weekly basis, so nothing has changed there. The big difference again is, whether we like it or not, is we could think about all sorts of – people might think there's all sorts of reasons in everything, but this is strictly a deflation issue. Again, if you look back to the prior year, deflation started and that’s when I just said a few minutes ago we're at a 10% swing. Customer count is not all dramatically in any way, this is a deflation issue. When you’ve got pork and beef products down 20%, it’s a significant swing. Again, if we just had deflation - inflation at where it was a year ago, we would be running positive comps on Save-A-Lot, so it’s pretty simple to explain.

We have not changed anything dramatically at all, advertising, pricing, marketing, none of that stuff has been changed. So as much as someone might think, is there something else going on, the answer is no. Now, what we have to do is to go out there and to be aggressive and looking for items digging and scratching like everybody else to fight through this issue. And that’s what Eric and his team are doing. And so we've got to make it work for us someway somehow and stay focused on that.

Bruce Besanko

And I’d just add – can I just Ajay on, in terms of Retail Food, we have been curtailing planned promotional investment which has affected customer traffic and that’s been due to the compression of these pharmacy margins. Now, as I said to, I think, Steve earlier, we are now going to put back some of that promotion and some of that price investment here in the fourth quarter. But that's what's been happening in retail food. We deliberately curtailed a little bit of the planned promotional activity and it’s obviously affected customer traffic.

Ajay Jain

Okay. And I think in the prepared comments on the spin-off, you discussed the general timeframe, can you also just maybe at a high level, just talk about how much debt gets assumed by Save-A-Lot post spin and would you say that the spin-off in the Form 10 filing, now that you’ve made that public, does that basically preclude a sale of Save-A-Lot, is that a reasonable assumption?

Sam Duncan

Hey, Jay. We are focused on the spin and that's what we’re going to stay focused on and in the comments, we said that the first half of the year. The capital structure of both companies, that’s something that the board will approve and we will discuss with the board, but that's all we’re going to say at this point.

Ajay Jain

Okay, thank you.

Operator

Your next question is from Edward Kelly from Credit Suisse.

Unidentified Analyst

Hi, guys. It’s actually Judo on for Ed. I just wanted to go back to the pharmacy for a second and the pressure that you've been experiencing, can you help us with whether it's kind of general reimbursement pressure, maybe from signing new contracts with payers or is it still maybe some generic drug inflation that’s coming through the system?

Sam Duncan

Yes. There are two or three things that I can comment on Judo. The first is that what's happened is generic costs have risen, the reimbursement rates to SUPERVALU have not risen. That's the simple fact. Pharmacies need to be willing to accept lower reimbursements to participate in some of the health plans, including Medicare Part D or else we end up risk -- we risk losing the business and so that's played into this as well.

The magnitude of this headwind for us where some of our pharmacies on the East Coast are more heavily -- have a greater concentration of generic drugs, prescriptions. That’s had a more -- slightly more profound impact and so the basis point impact is several hundred basis points over the course of the year.

So fortunately for us, we’re starting to find ways to -- and tactics to mitigate some of it, but that's what's happened. It’s -- the generic costs have risen, the reimbursement rates have not. We, in order to get into some of these health plans, we've had to absorb more costs than previously and so that pressure is likely to -- that last piece is likely to continue frankly.

Unidentified Analyst

Okay. That makes sense. And maybe switching gears to the TSA and kind of the increased offsets that you've identified, can you remind us just the dollar amount of the Albertsons’ TSA, was it 160 million or more? And then kind of where are those incremental offsets coming from and your confidence level around those not affecting service or sales or anything like that?

Susan Grafton

Right. Yes, judo. You remember, so it’s a little bit higher than that. We're really benchmark and are tracking ourselves against our fiscal ‘15, which was the last full year that we were operating with the TSA in there. In terms of where we are looking, we said back in our fourth quarter remarks in the spring, we’re looking at both cost take-outs as well as revenue growth opportunities and I will tell you, I mean, that's exactly what we’re doing. We’re leaning very heavily in the cost take-outs. Obviously, we want to take out all the costs that are directly associated with performing the TSA and then we’re working on mitigating the fixed costs that are more difficult to take out of the organization.

So it is leaning very heavily and to cost take-out initiative and also we’re looking at revenue growth opportunities that would be incremental to the regular growth of the businesses. As I said in my comments, really our goal is neutralizing the EBITDA impact from the loss of this arrangement and so it won't all come in the corporate segment so to speak. It really will be throughout our business and some of it can be not just in SG&A, it can also be up in the margins. So we're really looking at a pretty comprehensive set of initiatives that will offset that EBITDA impact.

Unidentified Analyst

Okay, got it. Thank you.

Operator

Your next question is from Vincent Sinisi from Morgan Stanley.

Vincent Sinisi

Great. Thanks very much for taking my question and Sam, best of luck to you. Why don't I ask first of all on the retail side, your folks mentioned about, you have been curtailing the pricing promotion investment and that will come back a bit in the next quarter. Can you give us a little more color around that, is it centered around any particular categories or regions or is it more broad-based?

Bruce Besanko

Well it's not broad-based across the banners, we’re focusing it on not all of the banners and it's more around promotional ads and promotional spending as supposed to marketing on some other sort.

Vincent Sinisi

Okay, got you Bruce. Thank you for that and then, just one quick follow-up on the independent side of the business more kind of big picture question? We know of course on the lost customer volumes you mentioned in the release also about some new customers as well. When you look at your pipeline, you've said that the pipeline remains pretty advantageous. Can you give us any kind of look into the process of how a new customer conversions are going and as you work down maybe over the next few quarters on how optimistic for further new customer conversion?

Bruce Besanko

Okay, so let me start and then Sam you might want to jump into. So, the pipeline affiliation process is a very long term thing. Imagine taking a 50,000 or 60,000 or 70,000 square foot store and changing out all of the skews in that store that’s essentially what someone would need to do if they were going to swap out a supplier. So it’s a very, very significant decision on the part of an independent retailer. And to the extent that those retailers have multiple stores then you’re doing it across those multiple stores. It is a heavy investment in terms of mine share and work and effort, and so the thought process that these independent businesses go through as entrepreneur would when they make a significant business decision like that is very time-consuming.

So it takes a long time to sort of work that process. Likewise when they leave obviously they’re working behind-the-scenes and that decision is a long one as well. And so what I would tell you from the health of our pipeline is good but it's not nearly as good as we have had in the past and we’re constantly pressing, Sam and I are constantly working with the teams to generate the sales culture that we need in order to bring these new affiliations on. And if I could leave you with one thought is that we -- it’s not only time, it takes a lot of time and a lot of investment on the parts of our sales teams. They've done a good job but they got a lot more that they need to do. We are not satisfied with the affiliation’s pipeline at this point and they need to continue to work that.

Sam Duncan

I would just say that I will add to that that our, where we are at today is significantly better than what we were three years ago in the pipeline. And although we’re always constructively dissatisfied no matter what, whether it would be wholesale or retail, Save-A-Lot. What we do have in the pipeline today that we are working on, I’m very excited about and like the thoughts of the opportunities that we have there. And even after I leave, I hope to see that some of those come to fruition but there is some exciting ones that we have that we’re working on and hopefully we can make them work.

Vincent Sinisi

Okay, thanks very much for the color guys.

Operator

Your next question is from Karen Short from Deutsche Bank.

Ryan Gilligan

Hi good morning, it’s Ryan Gilligan on for Karen. So after looking into the Form-10 for Save-A-Lot, we are surprised to see how high the licensee margins are, we’re hoping maybe you could talk about the economics there and why that EBITDA margins are so high for our supply arrangements?

Bruce Besanko

Well, I’ll take a stab at it and then certainly others can jump in if they’d like. Look the returns on licensees is no surprise, I mean those returns have always been very fairly robust. Think about the level of investment that’s required for the licensee business versus building a corporate store from ground up where we spend well over $1 million to build out that store. So returns -- the returns are significantly different between the two business, now that said, the corporate store still return a very nice rate of return and so that's why we've focused on them. We have more control over them, we have we can build them out quickly. And so, that's not a surprise and so that's I just generally tell you that the returns from both of those areas of the business are good although with the investment in retail, it diminishes at slightly compared to what we have in our license business.

Ryan Gilligan

Got it. Thanks. And with all the transition going on at the company, can you maybe comment on employee morale and if any of the uncertainty is potentially impacting results?

Sam Duncan

No, has nothing to do with it [technical difficulty] from the organization is the best it’s been in years and also the satisfaction from our wholesalers that we have, they are very grateful of what this team has been able to do for the company to get it, put back on the right track, unfortunately we are going through – facing some economic issues that we got to work through, but it has absolutely nothing to do with employee morale. These employees at this company are awesome, they are tremendous, our wholesale customers are absolutely the greatest and they have confidence, they have given in me since I have been at this company, and it’s tremendous, and I have great confidence in them and the licensees. They have all said that this company is so much better off than where it was three years ago and it is and we are grateful for their support.

Ryan Gilligan

Great. That’s helpful. Thanks.

Operator

Your next question is from Scott Mushkin from Wolfe Research.

Scott Mushkin

Hey, guys, thanks for taking my questions, and Sam, good luck as you move to the next chapter. Hope you have a nice retirement. I guess, the question I want to get clarification on is, if I am assuming you guys are right, traffic was down in both Save-A-Lot and your corporate stores, is that correct?

Sam Duncan

Yes.

Scott Mushkin

Did I get that right? And I would guess the traffic is probably down in a lot of your independents too given the sales levels, is that a good kind of conclusion?

Sam Duncan

Well, I don’t know that as a fact, Scott. I think it’s safe to presume that maybe the case, but I don’t have that fact.

Scott Mushkin

So I guess like, this is -- I mean, it’s like all three segments, right, like so, I guess, kind of just stepping back, I mean, there is lot of deflation, I want to get to the deflation in a second, but that’s pretty unbelievable right, like you’re having – the economy is growing, employment is good, so to see those traffic declines across three segments, just curious, what do you think is driving that, just broadly? I mean, there is like individual things, but there must be a broader trend here that would have all three segments go in the wrong way.

Bruce Besanko

Well, again, I’d reiterate what we said about the retail food segment, that I think, phenomenon is the result of more what we’ve done in terms of curtailing promotional investment. I would also say that there has been warmer weather across regions that we compete in and those warmer temperatures perhaps have people displacing their food consumption outside of traditional food grocery in maybe other venues. But I don’t know that. I do know that the data that I’ve seen suggest that there is more eating out this year than the prior year and so that maybe taking some effect. But I would tell you, from a retail food perspective, that is – our view is that we have driven more of that through this curtailing this promotional investment and that’s been the impact.

Scott Mushkin

Okay. And then I want to get on to the deflation thing, because I guess my growing concern to get your guys opinion on this is, if I am not mistaken, we are about to hit the time of the year where we import a lot of the produce from Latin America and South America, and I mean, just from a currency perspective, I mean, is there a chance that this deflation thing can get a lot worse. Do you guys have any insight there on what’s going on, and what may go on, do you have any thoughts on that as we move into kind of the import season?

Sam Duncan

Scott, we don’t have a crystal ball on that, just don’t know. It’s so hard to say.

Scott Mushkin

Are you guys concerned about it, Sam that you may actually see, because I know in the last PPI, I think it was fresh fruits – sorry, vegetables rolled over pretty meaningfully. I mean, is it a concern inside the company that you will see something similar on that you have seen in proteins to go through the produce area?

Sam Duncan

My concern is more – this past summer has been weather-related and the issues that we’ve had in California and that part of the world, we’re so much of the farmland is set vacant or with nothing growing because of the drought issues that they've had. Now, the stuff like the beef and pork, I'm assuming that we use a country that’s not exporting near as much as what we were before, I don't know that for a fact. So I can't enter that. My hope is and I don't know what's going to trigger it that or the deflation stops, hopefully it will settle down. I don't know if it's because of the oil prices and all of that. I have no idea of what's causing it, but there is nothing more significant in that that's affecting our business.

And looking at other retailers that non-food retailers are, of course, they had issues with the weather. I just hope that we can see the deflation, I just love to see it settle down and quick growing would be, I would be totally happy with that and hopefully we’ll see that. Hopefully, with the weather that we've seen in the West Coast recently will help alleviate some of the issues that we've had with crops.

At times in these past few months, we've had issues, it was very hard to get broccoli and cauliflower and strawberries were almost impossible to get, but hopefully the weather issues have solved that. The rains that they've had on the West Coast, but it's been really a wild and crazy year and hopefully it will settle down.

Scott Mushkin

Yeah. I hope so. And then I just have one last question. You guys talked a lot about the RX business, how the economics are difficult, any consideration of just selling it, outsourcing it? Thank you. I appreciate your time.

Sam Duncan

Thanks, Scott. We always, as part of our normal processes, think through those kinds of strategic issues, but there is a clear benefit to having pharmacy in our stores. Their customers are loyal, they generally spend more, they have more visits and so there is a nice competitive benefit from having our firms. We will take one last question, please.

Operator

Okay. Your final question comes from Stephen Grambling from Goldman Sachs.

Stephen Grambling

Thanks for sneaking me in. I just have one question on just trade budgets in general, there's been a lot of talk that with 3G becoming more involved in determining some of those trade projects across the CPG world, that some of that will be cut. I'm just wondering what you are seeing and what you think of as being the potential impact from a world where there is potentially just less trade support? Thanks.

Sam Duncan

We don't know if that will happen or not, we will see what 3G does. We've had one vendor that's not affiliated with 3G that changed their pack size on some products and that dramatically affected our business, especially at Save-A-Lot and their whole business is down, and now they are trying to backtrack to solve the issue, but hopefully we won't see any more of that.

The CPG companies are all trying to figure out what to do for sales and their sales are not setting the world on fire. So we are all working on the same thing, how do we grow the sales and how do we grow the profit line. And we will see some people probably doing some different things, but that's the normal course of business that happens all the time in this food industry. So, but hopefully we'll see it settle down.

Stephen Grambling

Do you feel like there are things that are unique to your businesses that would either mitigate the impact relative to the competition or otherwise?

Sam Duncan

No. It depends on and like at Save-A-Lot, there is -- because we only have three departments, grocery, meat and produce, so somebody does something in one area, like this one CPG company did, it's going to have a bigger impact on our Save-A-Lot, which it did and we’re raising cane with that company, all right. Now, I’m trying to get on to get it fixed.

So any time changes like that are made, it's going to affect parts of the company that have fewer departments to offset the issue like Save-A-Lot and it's some very high traffic items that's been affected and they are working on -- this company is working on to trying to get the situation solved. So it doesn't have that major impact on us like it did.

Stephen Grambling

Thanks for all the color and best of luck in retirement.

Sam Duncan

Thank you and I look forward to it too and hope my life is going to make sure I stay retired this time.

Steve Bloomquist

Thanks everybody for joining us.

Sam Duncan

Thank you.

Steve Bloomquist

We will sign off; if anybody has any follow-ups call me later, I will be in my office. Thank you.

Operator

Ladies and gentlemen, this does conclude today’s conference call. Thank you for participating. At this time, you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!