SUPERVALU Inc. (NYSE:SVU)
Q2 2017 Earnings Conference Call
October 19, 2016 10:00 AM ET
Steve Bloomquist – Investor Relations
Mark Gross – President and Chief Executive Officer
Eric Claus – Chief Executive Officer and President-Save-A-Lot
Bruce Besanko – Executive Vice President, Chief Operating Officer and Chief Financial Officer
John Heinbockel – Guggenheim Securities
Chad Cerankosky – Northcoast Research
Ajay Jain – Pivotal Research Group
Bill Kirk – RBC Capital Markets
Stephen Tanal – Goldman Sachs
Scott Mushkin – Wolfe Research
Shane Higgins – Deutsche Bank
Edward Kelly – Credit Suisse
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 Second 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.
I will now turn the call over to our host, Steve Bloomquist. Sir, please go ahead.
Thank you, and good morning, everyone. I want to welcome you to SUPERVALU’s second quarter fiscal 2017 earnings conference call. Joining me today are Mark Gross, President and Chief Executive Officer; Bruce Besanko, Executive Vice President, Chief Operating Officer and Chief Financial Officer; and Eric Claus, Chief Executive Officer and President of Save-A-Lot.
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 today’s call will be available on our corporate website at www.supervalu.com.
With that, let me now turn the call over to Mark.
Thanks, Steve. And welcome everyone to our second quarter conference call. Before I get into our results in this morning’s press release, let me start with some commentary about Monday’s announcement regarding Save-A-Lot. On Monday, we announced the sale of our Save-A-Lot business to Onyx Corporation, one of North America’s oldest private equity firms, for $1.365 billion in cash, subject to customary adjustments, regulatory approvals and closing conditions. We expect to complete the transaction by the end of January 2017. And at least $750 million of the net proceeds will be used to make a mandatory prepayment against our outstanding term loan. Bruce will provide additional details on the use of proceeds in a moment.
As you know, the Company has been preparing for separation of Save-A-Lot for over a year following a thorough process to maximize the value of the Save-A-Lot business and best position SUPERVALU for future success. The Board determined that a sale of Save-A-Lot to Onyx is in the best interest of our stockholders. This transaction is strategic for SUPERVALU, as it will delever the balance sheet and allow us to better focus and execute on our strategic plan. As we have discussed previously, we are excited about the growth possibilities for SUPERVALU and our core wholesale business. We have announced the addition of significant new wholesale business just in the last several months, and we’re looking forward to continuing our efforts to pursue other exciting opportunities. We believe this transaction is a significant win for all stakeholders, and we are confident it will lead to exciting opportunities for both SUPERVALU and Save-A-Lot.
In connection with the sale, SUPERVALU and Save-A-Lot will enter into a five-year professional services agreement wherein SUPERVALU will provide Save-A-Lot with certain fundamental services and support functions for its day-to-day operations, including information technology, payroll and finance. We are very pleased with this outcome, how it strategically positions SUPERVALU for future growth of the services business and how it also provides future opportunities for Save-A-Lot.
Turning to our quarterly results, this morning we announced second-quarter sales of $3.9 billion and adjusted EBITDA of $147 million. Sales at Save-A-Lot and in retail were down compared to last year due to the factors we outlined in our September 8 press release, namely increased levels of competitive openings, and a challenging sales and operating environment for our retail stores. And, more significantly, at Save-A-Lot, the continued and deepening impact of deflation and lower levels of SNAP benefits, and, unique to Save-A-Lot, the impact of an aggressive store reset rollout.
In our core wholesale segment, sales were also lower than last year, largely the result of our not having cycled last year’s loss volume from the Albertson’s Southeast stores and most of the volume from the Haggen stores out West. The other customer loss we have yet to cycle is Gordy’s here in the Midwest, although I am pleased to say we did win back the produce business for all 26 of their stores midway through the quarter. We view this as a great endorsement of our variety, quality, service and pricing.
On our last two calls, we outlined three basic initiatives tied to growing wholesale sales. First, retain our existing customers. Second, do more business with these existing customers. And third, add new customers. I am again happy to say we made good progress in each of these three areas this quarter.
Let me provide an update on our second-quarter accomplishments and other initiatives we are working on in our wholesale business before turning it over to Eric to discuss Save-A-Lot. Our first goal is to retain our existing customers. And, as we stated in our September 8 press release, we don’t expect any meaningful wholesale customer losses for the remainder of the year. The team is doing a great job of understanding the specific needs of our customers and finding solutions to meet those needs.
Additionally, I am pleased with sales to our existing customer base, which has been driven by several factors. First, our field teams have a new CRM and business insights tool to help them quickly identify selling opportunities. Armed with easily understood data, our wholesale management and field teams are having more robust conversations among themselves and with our customers that we believe is helping us capture more sales.
Part of our transformation to a sales-driven culture applies to our initiative around produce and our continuing migration towards a mindset of a produce wholesaler as opposed to a wholesaler who sells produce. To help move this forward, we recently hired a new head of our wholesale produce function and are working to better align our merchandising and procurement organizations to more effectively support our customers. We have also reconfigured inbound delivery schedules into some of our distribution centers so that we can deliver fresher produce to our customers’ stores.
Another sales-driving initiative is to add new customers. As I referred to earlier, since our first-quarter call, we announced that the Fresh Market had selected SUPERVALU to serve as the grocery wholesaler to their company, with the intent for us to become their primary distributor upon transition from their current relationship. As many of you know, the Fresh Market operates over 170 stores across more than 20 states and does a great job meeting its customers’ needs through a mix of traditional and specialty products. The Fresh Market informed us that our ability to provide an innovative and superior logistics solution was a big part of winning this business, and we look forward to moving forward on the transition and serving their entire store base.
We started shipping a limited number of pilot stores in October and are working to finalizing a transition date. We’ve also affiliated a number of new customers this quarter who collectively operate about a dozen stores. Our great distribution network, our differentiated private-label portfolio, and our strong and expanding suite of services are essential to our offering and success in winning new business. In addition to driving sales, our wholesale teams continue to look for ways to run our business more efficiently.
We recently reallocated a number of SKUs among DCs in an effort to lower overall costs, and are expecting to increase backhaul income this year by 25% compared to last year, with further upside expected next year as new wholesale business is expected to create additional opportunities.
Moving to our retail business, as we indicated last month, our sales have been impacted by competitive openings and a more difficult sales and operating environment. For the quarter, identical-store sales were negative 5.9%, customer accounts fell 5.2% and basket size declined 70 basis points. We continue to see certain competitors becoming tougher on price in addition to new retail food store openings that have impacted a larger than normal number of our stores
Our retail sales have been impacted by lower levels of SNAP benefits, particularly in two of our banners operating in states where reductions have been deeper than the national average and cost deflation, which ran approximately negative 1% in the quarter. Retail is clearly a challenged segment for us. To address these challenges, we are developing banner-specific strategies toward pricing and promotions to help improve results. We know that in some markets, we need to be better positioned on price and are taking steps to do so with an initial focus on those items most important to the customer.
We are also evaluating the asset base, capital needs and capital investment strategy for each banner. We have opened new stores in two of our banners over the past 12 months and continue to remodel and update the merchandising across all five banners. We are also looking at our merchandising in each banner and addressing how we can do a better job in providing more appropriate offerings that better match the needs and wants of the communities we serve, including how we address specific customer segments.
In the e-commerce space, we’ve been testing three different providers in separate markets. We have long offered home delivery in one market but have expanded that offering elsewhere and have now added a click-and-collect option. We expect to be live with this program by the end of the calendar year in about a quarter of our stores and will evaluate any future expansion to additional stores as the program gets further up and running.
Another area of focus is the natural and organic space, where our retail sales are growing by approximately 19%, compared to last year. Part of this growth is coming from our Wild Harvest brand that continues to do well across both our retail and wholesale businesses. By the end of this fiscal year, we expect to have around 635 unique Wild Harvest SKUs. Despite the challenges in our retail segment, we continue to benefit from synergies between our retail and wholesale businesses. We realized benefits from the consolidation of our retail and wholesale produce teams, which allowed us to procure better-quality, lower-cost produce, which has benefited both wholesale and retail customers.
We also realized lower cost of goods through the combined volume of our retail stores and wholesale customers. In many ways, we think about our retail banners as a large wholesale customer which can serve as a testing for new ideas that can then be shared with our wholesale customers. We know that reversing our current retail operating trends will take time, and we are not planning on taking short-term actions that would hinder our banners’ longer-term ability to maintain a compelling offering for our shoppers and neighborhoods.
We are working to improve our results, including continuing to look for opportunities to share resources across the Company, to lower our costs and take advantage of our collective skills.
Before Eric discusses Save-A-Lot, let me share some additional thoughts around our corporate infrastructure and how I believe it can be leveraged toward growing services. Prior to my joining the Company this past February, SUPERVALU had been working on plans to deal with the eventual transition of the Albertsons TSA. Supporting this relationship is an infrastructure that we have built which, as I came to understand it and stated during our Q4 call, I believe to be highly scalable.
I also believe this infrastructure is both an underappreciated and under-marketed asset and one that can provide benefits to other retail companies. These benefits could include lowering operating costs as well as more sophisticated information with which to run their business. These impressions are reinforced by my conversation with customers and potential customers who have shown a genuine interest in what we could do for them from a services perspective.
Bruce will provide additional color on this shortly. With that, let me now turn the call over to Eric for his comments on Save-A-Lot. Eric?
Thanks Mark and good morning, everyone. It’s again a pleasure for me to join today’s call and discuss our Save-A-Lot business. Before I get into the results for the quarter, let me say how excited I am with Monday’s announcement and the opportunities the Save-A-Lot team will have to work with Onyx on the next chapter of our journey. I am also pleased that we will be able to continue our working relationship with the SUPERVALU team through the professional services agreement.
Moving to the quarter, the second-quarter network IDs were negative 5.2%, and ID sales for our corporate stores were negative 5%. Customer counts in our corporate stores declined 320 basis points. These results, sequentially lower than Q1 by around 400 basis points, were largely driven by sustained and deepening levels of deflation, a reduction in SNAP benefit distribution levels, the disruption for the rollout of our store resets and increased competitive pricing.
As those of you who track CPI data know, food and home prices have shown year-over-year decreases for 10 consecutive months. The latest reading showed a decline of 2.2% compared to last year. At Save-A-Lot, cost deflation in the second quarter was approximately 6.5%, or more than 150 basis points worse than the past two quarters. This essentially gets passed on to our licensees, while in our retail stores we are able to use mix and pricing to mitigate this somewhat. However, retail deflation in our corporate stores was still around 4%. The biggest impacts continue to be felt in meat and dairy, while the inflation we have seen in produce has now turned to flat. In fact, the deflation from just three items, eggs, white milk and ground beef, contributed over 200 basis points to our overall deflation this past quarter.
In addition to deflation, Save-A-Lot has been adversely impacted by the reduction of SNAP benefits in 22 states in which we operate, the factor that is compounded by the fact that our level of SNAP sales is meaningfully higher than other retailers. These states have either lowered the amounts paid to individuals or barred them completely from receiving benefits, a fact that has negatively impacted customer accounts and basket size among our customers using SNAP. Another impact that we experienced this quarter was the competitive reaction in a number of markets, the challenging operating environment. We have seen a number of retailers heat up their ads or lower retail prices on key items, some to the point of promoting items at or below cost.
We, too, have lowered retail prices but see limited benefit to being even more aggressive given our inability to offset such reductions elsewhere in our assortment. I believe our licensees understand our thinking and support our approach. These factors also impacted adjusted EBITDA, which came in at $40 million, or 3.8% of sales, compared to last year’s $49 million, or 4.5% of sales. While we did respond to competitive price actions in the quarter, we worked diligently on our product mix, which enabled us to increase our overall gross margin rate despite the impact of these actions.
However, the overall challenging environment did lead to negative ID sales in the quarter. This resulted in negative leverage to SG&A, which increased roughly 160 basis points as a percentage of sales that was the main contributor to the EBITDA decline. We continue to see deflation and lower levels of SNAP benefits as headwinds to the rest of the year. These external factors simply are what they are. Our job is to operate and merchandise our stores as best we can in this challenging environment. To that point, we are continuing to roll out the store resets I described on the last call and have completed about 270 corporate stores through the end of the second quarter. We slowed down the pace of the rollout somewhat so that we could better manage our ongoing business and minimize the disruption caused by the work being done inside the stores, which did have a negative impact to our second-quarter results.
Although we don’t plan to reset all the corporate stores, the ones we will reset should be completed in the third quarter and provide a sales lift to us in the back half of this year. Our merchandising initiatives continue to roll out and to be favorably received by our customers. The first 15 decadent items under the America’s Choice label are now in stores, and initial feedback has been very strong. We plan to roll out an additional 150 innovative items this quarter and early into Q4 and are optimistic that customers will take to these as well. Our 130 must-have national branded items are in all stores and are performing in line with our expectations. It is clear that between these national branded items and America’s Choice, we are doing a better job of matching our assortment to what customers want and what most appeals to them.
On the store development front, we now plan to open up to 70 new stores, which should be about equally split between our licensees and corporate stores, a number that is close to our original plan of 75 stores. Overall, we are facing strong headwinds today. But with time, we believe they will subside and our long- term strategies will take stronger hold. When the tide will turn, I believe Save-A-Lot will ride the upside to that wave. We remain very engaged and energized with our initiatives, and I believe that Save-A-Lot has a very bright future.
Let me now turn the call over to Bruce.
Thank you, Eric, and good morning, everyone. As outlined in this morning’s press release, for the 12-weeks second quarter of fiscal 2017, we reported net earnings from continuing operations of $30 million, which included $6 million in income attributable to a supply agreement termination fee that we received, as well as $4 million of costs and charges primarily for store closures and the potential separation of Save-A-Lot. Excluding these after-tax items, net earnings from continuing operations were $28 million and earnings per diluted share were $0.10.
Second-quarter adjusted EBITDA, as outlined in table 6 of our release, was $147 million, compared to $166 million in last year’s second quarter.
Consolidated net sales in the quarter were $3.9 billion, a decrease of $197 million, or approximately 4.8%, compared to last year’s second quarter with the largest decline in our wholesale segment, where, as Mark noted, we have yet to cycle certain customer losses from last year.
Moving down the P&L, consolidated gross profit was 14.5% of net sales, up 10 basis points versus last year, with the largest year-over-year variance of Save-A-Lot primarily due to higher product margin rates and a larger number of corporate stores.
Consolidated SG&A expense was 12.4% of net sales for the first quarter, compared to 11.9% last year. These figures exclude $4 million of store closures and Save-A-Lot separation costs, and $9 million of income from a supply agreement termination in this year’s second quarter, and $8 million of severance and Save-A-Lot separation costs in last year’s second quarter.
Wholesale SG&A expense as a percentage of sales was 10 basis points lower than last year; retail’s SG&A rating increased by approximately 200 basis points, reflecting sales deleveraging and new stores; and Save-A-Lot’s SG&A rate increased by 160 basis points, largely driven by a mix of corporate versus licensed stores, the deleveraging impact of negative ID sales and the impact of new corporate stores.
Net interest expense in the second quarter was $41 million, compared to $44 million last year. The decrease in interest expense was primarily driven by lower outstanding debt balances. Finally, our tax provision was $18 million this quarter, reflecting an effective tax rate of approximately 36.2%.
Moving from our consolidated P&L to the segment results, wholesale operating earnings, excluding a $9 million supply agreement termination fee, were $49 million in the second quarter, the same as last year. As a percentage of sales, this year’s operating earnings were 2.8% of sales, about 10 basis points higher than last year.
Save-A-Lot’s operating earnings for the quarter were $22 million, or 2.1% of sales compared to $32 million last year, or 3.0% of sales. As Eric stated, this was largely the result of new stores yet to mature and fixed-cost deleveraging resulting from negative network ID sales.
For our retail segment prior to the $4 million of costs and charges related to store closures, we reported an operating loss of $8 million, or negative 0.8% of sales, compared to operating earnings of $10 million last year, or 0.9% of sales. Driving the variance was the roughly $60 million decrease in sales and the deleveraging impact that that had on expenses.
Finally, corporate operating income, excluding approximately $1 million of Save-A-Lot separation costs, was $21 million, compared to $11 million last year, when excluding $4 million in Save-A-Lot separation costs and $4 million in employee severance. The increase in corporate operating earnings was primarily driven by lower pension expense and employee-related costs including lower incentive compensation.
Now let’s turn to the balance sheet. At the end of the quarter, our outstanding debt, including capital lease obligations, totaled $2.38 billion, a net decrease of approximately $100 million in the quarter and a net decrease of approximately $140 million since the end of our last fiscal year. From a liquidity perspective, we ended the quarter with approximately $830 million of available capacity under our ABL facility.
Turning to cash flow, we generated approximately $153 million in operating cash flow from continuing operations this quarter, bringing our year-to-date total to $274 million. During the quarter, approximately $50 million went towards capital expenditures. As stated in our Monday’s press release, we do expect to close on the sale of Save-A-Lot by the end of January 2017. Upon completion of the Save-A-Lot sale, we used a portion of the cash proceeds, net of the typical fees and expenses in a transaction of this nature, as well as the taxes that we will owe in the next six months to make a mandatory prepayment of $750 million against our outstanding term loan balance.
We anticipate making an additional $50 million to $100 million payment against the term loan balance to bring our net secured leverage ratio, as defined in the credit agreement down, to the required 1.5 times. We used the remaining net proceeds, estimated to be in the range of $275 million to $350 million after customary adjustments to closing, to further reduce debt and improve our capital structure as well as to fund corporate and growth initiatives.
From a GAAP perspective, the Save-A-Lot sale will generate an accounting gain of approximately $500 million to $545 million based on our second-quarter balance sheet, which is expected to move our balance sheet stockholders’ equity to a positive position. At this time, the economics of the Save-A-Lot professional services agreement is not expected to meaningfully change the overall profitability of SUPERVALU. We currently incur costs to support Save-A-Lot which are allocated to Save-A-Lot. In the future, this allocation of costs will be replaced with revenue under this new TSA.
Turning back to our consolidated business, our outlook for full-year adjusted EBITDA, including Save-A-Lot for the full year, is unchanged from our September 8 press release, which is approximately 5% below last year. Similarly, on a consolidated basis, including Save-A-Lot for the full year, our expectation for capital spending remains in the range of $325 million to $350 million. We will look to revisit our outlook on adjusted EBITDA and capital spending either on the next call or following the closing of the Save- A-Lot deal.
Finally, as Mark indicated, we are continuing to focus on leveraging our infrastructure and growing our services. As we previously stated, in doing so, we will continue to look for additional revenue and cost savings opportunities. We may also elect to reinvest a portion of the TSA cost savings into the business and have begun to think of TSA cost reductions in a different manner, more of an ongoing business activity.
Moving forward, we will manage our service relationships as part of our overall business, continually looking for both revenue growth as well as cost savings opportunities. With this change in philosophy in our evolving business strategy, we will no longer comment on our long-term outlook for the Albertsons’ TSA but will incorporate its status as part of our holistic business outlook.
With that, let me turn the call back to Mark.
Thanks, Bruce. It has been an eventful 12 weeks since our last conference call, including announcing our new relationship with the Fresh Market and culminating in reaching a definitive agreement for the sale of Save-A-Lot. I believe the sale of Save-A-Lot will create new and exciting opportunities for SUPERVALU, and I look forward to discussing them with you in the future.
Let’s now open the call up to your questions.
[Operator Instructions] Your first question comes from John Heinbockel from Guggenheim Securities.
So, Mark, when you think about the wholesale M&A environment or backdrop, how do you look at that in two perspectives? Type of assets you might be interested in, be it maybe conventional grocery to natural and organic specialty fresh, and food service? Maybe thinking about those four. And then given everything – given all that you have on your plate, would you want to do M&A relatively sooner? And obviously you’ve got – you will have some capital coming in to do that. Or would you rather push that out a bit?
Good morning, John. Great question. So I think, if you look at what we’ve done over the last eight months where we have added Fresh Market, Marsh, the pieces out of the Ahold, Delhaize merger that we are adding to our Shop ‘n Save banner, and now this transaction on Save-A-Lot, an awful lot on the plate and a fair amount to digest. So I would – I firmly believe as you add these new customers, your obligation is to do those startups right and get that business under your belt.
So, I think the right thing to do is to properly transition Save-A-Lot into their next phase, start up this business and get that going. That said, you don’t always get to choose when opportunities present themselves. And when the market says, hey, this thing is an opportunity, we will owe it to ourselves to look at it.
Okay. And then I guess as a follow-up to that, do you look at yourself – when you think about distribution, is distribution a – sort of a core strength, meaning you would think about distribution more broadly? I kind of threw out four kinds of distributors, but even broader than that, including logistics, or do you really want to stick very core to food distribution?
I think distribution is a core strength. The subset of that – of food distribution to grocery stores is what we know the best and do very well. But it doesn’t take much to move into those peripheral side places and have them be part of that group of core competencies. So, to break that question down into its two components, as you see the growth of the natural organic world, where I think these numbers are something around the range of 70% of all natural organic product gets sold in conventional grocery stores, we are already going to those locations.
So it doesn’t take much to say that that stuff is part of the product offering whether it’s natural, organic, specialty going to the same places. The second part is that food is available in so many different types of channels of trade. And we have the ability as different retail operations want to offer food is to sit down with them, share with them our learnings of what we think would best be the most desirable products for their customers in those locations and help them design the right store set.
So I see that piece are being both an expanded offering in our conventional customers but also expanding the definition of who our customers are. And that’s the work that is ongoing here today. You are absolutely right.
Okay. Thank you.
Your next question is from Chad Cerankosky from Northcoast Research.
Good morning everyone. If you could give us a sense for what the inflation – excuse me, the inflation impact was for each of the three operating segments in terms of a revenue number.
In terms of a revenue number, I’m not sure I can answer that question, Chuck. But what I can tell you is that we had low-single-digit deflation throughout our system. It was more pronounced as Save-A-Lot, we’re sort of mid-single-digit at Save-A-Lot, which has been what has been happening in that business because of its edited assortment. But from a wholesale perspective, which includes our retail business on a consolidated basis it was a low single-digit number.
I would also just add I’ve had a very early read of what deflation looks like for our – the period that we’re just now closing. And I would say that that is – it actually seems to be getting just slightly worse from that very early read. We will obviously report on that on the next conference call, but I also saw the consumer – I think it was a CPI that came out the other day and that’s obviously getting worse as well.
Okay. And going to the professional services agreement with Save-A-Lot, it sounded like you are saying it was going to be immaterial almost. But the support costs for Save-A-Lot are going to be transitioning out of your P&L’s expenses and then what you do for them is going to be revenue. Could you quantify that at all and is there a cost offset to net revenue?
Well, you sort of got it right. We’re not going to quantify it. But what we can say is essentially what you suggested, which is we’ve been running these services for Save-A-Lot for – since we have own Save-A-Lot. And so we would expect that, as I said in my prepared remarks, that we are essentially neutral from that perspective. There may be investments over time that are required to further enhance those services, but you can generally think of it as roughly neutral.
All right. Thank you.
Thank you, Chad.
Your next question is from Ajay Jain from Pivotal Research Group.
Yes, hi. I mainly wanted to reconcile the guidance that you gave last month in which I think Bruce – I think you just reaffirmed the 40-year outlook. And so I wanted to reconcile the guidance against what sort of implicit or baked into – the assumptions that are baked into the guidance. So if your EBITDA is down 10% to 11% year-to-date, it looks like the retail segment profitability is kind of rapidly declining.
Can you just comment at all on how confident you are that you can deliver kind of flat to positive EBITDA growth in the back half of the year? Because my understanding is that a lot of the new wholesale business is supposed to be a fiscal 2018 event. And assuming some of that business – even assuming some of that business kicks in the back half of the year, I’m just wondering if there’s enough wholesale business to offset some of the issues in the retail segment.
Fair question, Ajay. We obviously wouldn’t have reaffirmed the outlook unless we were confident that that was achievable. We do have a set of headwinds in our business that Mark and Eric and I have talked about, the headwinds in relation to deflation. And in the retail segment in particular, we have competitor openings that are impacting us. There are SNAP benefit reductions that are affecting Save-A-Lot as well as our retail banner.
When you put all of that together, I think we are – we think that there are challenging set of headwinds. On the other side of that, though, there are things that we are doing to offset some of that, and there are things in our wholesale business that remain very positive. And so when we net all of that together, I think we’re comfortable with that guidance that we put forward back on – in early September.
Okay. I just had a follow-up question on Save-A-Lot in terms of the sale proceeds. Can you maybe clarify if there are any tax implications at all from the perspective at SUPERVALU? Like, what would be the after-tax sale proceeds?
Yes, there is so – the vast majority of the transaction will be covered through the capital loss NOL. There is, though, a little bit of tax leakage. There’s two buckets. The smaller of the two buckets relates to state income taxes, and then the second bucket has to do with some leakage in regards to the federal income taxes from the depreciation recapture. And so those are going to run in the neighborhood of – the combination of those two items will run in the neighborhood of $70 million to $90 million of leakage. But the rest of it should be covered by the capital losses.
Great, thank you.
And just one other – sorry, one other point, Ajay. Obviously we have got the transaction with Save-A-Lot from an earnings outlook perspective. And so we will obviously provide an update once the transaction closes or on the next conference call as we look at, what I will call from a RemainCo perspective.
Your next question is from Bill Kirk from RBC Capital Markets.
Thank you for taking the question. Just one for me. On the retail division, it is still posting good, positive cash flow, but it reported, I think, its first operating loss since 2012. So how are you thinking about capital deployment between the retail division and the wholesale division going forward?
Yes, let me take a crack at it, and then Mark can talk more strategically about our investment. So certainly, we are disappointed with retail’s performance in the second quarter. It did dip into the negative operating income. We expect that actually to reverse out in the second half of the year. We are facing challenging headwinds – the lower deflation that I mentioned. We also have competitor impacts. We have about two-thirds of our retail banners that have been competitively impacted. Mark and Eric have talked about the SNAP benefit reductions. There’s a little bit of pricing activity in the market today, too, that are affecting some of our banners in that there are competitors who are reducing prices and so we need to be conscious of that. So we have a set of headwinds that are making the business very challenging. We also have our own set of inconsistent in-store execution that we continue to focus on.
So when we look at the other side of all of those challenges – what I would say the tailwinds – we have, I think, made lots of good investment among our store base and employee training. We have rolled out new initiatives like our model deli-bakery. We have segmented some of these stores and those are showing improvements in the low single-digit ID perspective relative to a – the non-segmented stores. We are investing some modest capital in the stores in order to make it more convenient for our customers to shop. So as an example, we have grab-and-go cases outside some of these delis that we service that allow for a customer to grab a pound of deli meat, rather than waiting for it, in a service case.
So those kind of things we’re all – those investments, whether they are expense or capital, are all part of what we’re trying to do to ensure that these businesses – retail businesses operate effectively.
Is it fair, if we’re trying to compare ROIC on an incremental basis, to think of incremental ROIC to be comparable or equal between the two units? Or does one deliver a little bit more bang for your buck?
I probably don’t want to go there, Bill. But what I would say is we make these investment decisions, whether it’s for our wholesale segment or our retail segment. We make those investment decisions after careful analysis of what we believe will be the value that our shareholders will receive from that investment. So it’s the classic sort of cash flow analysis that you would expect a company like us to do. We make those very carefully and prudently. And we believe that the decisions we make with respect our investments, again, whether it’s capital or otherwise – that those investments in the long run are in the best interest of our Company and our stakeholders.
Okay, thank you. That’s very helpful. Thank you.
Your next question is from Stephen Tanal from Goldman Sachs.
Hey, guys. Thanks for taking my question. I was wondering if first maybe you could parse out sort of the SNAP impact on each of the segments, retail and Save-A-Lot.
Yes, let me take a crack, and then maybe Eric wants to jump in. So from a – I will talk about the retail banners. First, we have five retail banners, each of which is affected in different – in the different states in which they operate. There are some states that have had a more of a reduction in SNAP benefit over time than others. And so I can think of two that have had – two of our banners in particular have had a more difficult issue with respect to SNAP in that the states have – most states in which they operate, the reductions have been a little greater. And, frankly, they index more toward a budget-conscious shopper, and so the consequence of that has affected two of the banners more than, say, the other three. And Eric, do you want to comment on Save-A-Lot?
Yes, for Save-A-Lot there is a 22 states out of the 37 states that we operate in that the SNAP benefits have been – the distribution has been reduced. Some states such as Florida as high as – I think they are down to 13% or 15%. The overall combined weighted reduction and distribution of 22 states that we operate in is about 6%.
Got it, okay. And I guess do you care to quantify sort of the impact that we’re talking about? 100 basis points for SAL and maybe tens of bps for retail, or have you guys not really quantified it at that level?
We share it each week among ourselves, but it’s not something we prefer to share outside. But each banner and each segment has a – it does – there are basis points of effects in each of the businesses.
Got it, understood. And then just if I heard everything on the use of proceeds from the Save-A-Lot sale correctly, I think you totaled to a net cash range of $1.1 million to $1.2 million. And if that’s right, with the $70 million to $90 million of tax leakage, it looks like there’s another $75 million to $220 million there. Correct me if I got any of those numbers wrong, but I’m wondering if there’s a plan for that. And that is the sort of last piece.
I’m not sure I followed – I certainly followed the first half. I’m not sure I followed the second half, Steve. But let me just – maybe I can answer it in this way. So yes, I just mentioned that we would – that the value of the transaction was announced on Monday. It was sort of in the $1.3 billion to $1.4 billion range. There will be, as I mentioned, taxes, there will be transaction fees and then there will be customary closing adjustments. And once you take effect of all of that, we would expect that there will be remaining proceeds that we will then use to pay down our – and improve our capital structure.
We would intend to use the cash to deleverage the balance sheet, invest in the business and then invest in our corporate pension obligation. All of that designed to improve and make our balance sheet stronger, improve our capital structure and continue to make the prudent investments in our business.
Fair enough. And just lastly for me, the 22 Food Lion stores, if we could just maybe get an update there. Have they been fully transitioned out of the retail segment?
No, they are in the – they have been fully transitioned into the retail segment, and they will remain in the retail segment for the time being. And we would expect – we will update you as any new news happens there.
Got it. So then to be clear, the 197 includes 22 – the 197 stores has the 22 Food Lion stores in it. So there’s probably like a 26 closures are so? Is that fair?
Yes, what I would – I’m going to defer to Steve because I can’t remember exactly when they got put in. They may have been put in at period eight.
Yes. I think those were after the quarter ended, Stephen.
I will follow-up with you [indiscernible]
Okay, great. Thanks a lot, guys.
Yes, you bet.
Your next question is from Scott Mushkin from Wolfe Research.
Hey guys. Thanks for taking my questions, and congratulations on the Save-A-Lot sale. So just on the competitive climate, I mean if we kind of take a look – I mean obviously you guys have talked about competitive openings, you have talked about I think some competitors pricing below cost on certain items and your need for price investments. And of course we have the deep discounters – I guess, Ledo’s coming into some of your markets probably mid-2017. Take me through how the environment changes over the next 6 months to 12 months in your mind on the retail side. How do we get out of this rut, and what would be seemed like the trigger to get into it was the deflation. It’s kind of the match that lit the competitive situation. How do we get out of it?
Yes. Hi, Scott, it’s Mark. So yes, if you go through the challenges facing the business, right. You have some that are cyclical, some self-inflicted and some that are structural. So I think the right answer on the – as you go through those, the pieces that are closest in our control, how we operate the stores, the pricing in that, that stuff we would expect to start seeing results as each of those initiatives deploy. And we start to see a positive customer reaction already. But that stuff does take time for the customers to understand how the offering has changed and why the shopping experience is a better one. But that’s – as you look through that piece, that’s the first part of the answer.
The second part of – is a cyclical issue on price declines. And there are a variety of opinions on when that changes, and you would have as good of you as we would on when we will see relief from deflation. But it is not – it is unlikely to be immediate. Then the third part of what I will call just a tougher competitive debt to the extent it is from new construction and new entries into markets, that is part of business and part of the world of saying why my offering is better than the competition’s and showing why you should still shop. So for each of those pieces, I think the timing becomes a little different.
Okay. That’s a good answer. So just to follow-up quickly, if we look at – I think you said part of your strategy is to take some of these fast-turning items down on price and get them more in line with the market. And we have seen, I think, in particular in the mid-Atlantic and the Virginia area, that’s part of Walmart has been doing some stuff there and other people. And we have seen them in these kind of fast-turning items. What kind of take me through the idea – you guys drop your price maybe back in line with the market. I mean how on some of these common items do we not just continue to deflate them as they are the traffic drivers? And, again, what is the trigger to maybe stop that as people really are fighting over what looks to be kind of flattish traffic?
Yes, well, that’s a very interesting question. I think the answer is you do have – with the benefit of some key items, declining in price is the ability of retailers to benefit off of that and then to drive their prices lower to hope to drive traffic. Ultimately, though, we all need to make money. We all need to be able to run our businesses in a cost-effective and profitable manner. And none of our competitors are irrational. So we would expect that people will try to sort out where they are in the competitive landscape, have the right offering. But I – it would be extremely difficult for a whole market to continue to lower prices further. Some of these – as you mentioned, some of those markets, those are extremely low prices already. But we will see. And we will have to be responsive to the way the market is and meet the customer where they are at.
All right. Perfect. And I had one final one and it’s actually on labor costs. We were – we have been talking – we were just at the Walmart event and talking to Walmart and they talked about escalating – off-line escalating labor costs and also a lot of labor turnover. And I was just wondering as you guys look – of course, we have the overtime rules are going to go into place, and we’ve got the low end inflating 4% to 5% on wages. As you guys look through the next six to 12 months, how are you thinking about labor, and is it a hurdle that you guys are worried about?
Go ahead, Bruce, and I will then give my perspective.
Yes, I wouldn’t say we are worried about it. But I would say that our labor costs are being challenged. We have obviously a lot of our business that is underneath collective bargaining agreements. So we have an ongoing sense of negotiation with respect to that collective bargaining activity. We have states that are increasing their minimum wages, and so that is having an impact as well. And so that – they – those cost increases, we are having to monitor. But that’s not something we are worried about.
Okay. According to…
Sorry, I was just going to add the perspective of – like any cost input, it’s – and in this current environment, it’s a challenging piece and one that we have to manage. But I would also say that I think in the past, this is one of those problems we have also self-inflicted in ourselves of – in a focus on managing that cost of what does that do to the customer experience. So one of these initiatives that we have is actually a willingness to spend more on labor in a number of our store locations to make sure that the customer experience is the right one. And it is that balancing that you can’t just cut your costs down and ruin the customer’s experience.
And so I think it is heartening to be in our stores and see guys – hey, it might be 7 o’clock, 8 o’clock at night, and they are working hard to keep produce and the service sections in stock to meet the new influx of customers coming out of work and ready to shop. And all of that is part of managing the labor line.
Perfect. And hey, Bruce, is Save-A-Lot slightly dilutive? Is that correct? I don’t know if you guys made a comment on that. And then thank you for taking my questions.
Yes, you bet. It is likely to be dilutive.
Your next question is from Shane Higgins from Deutsche Bank.
Good morning, thanks for the questions. Just wanted to drill down on the retail business, the cadence of the comps during the quarter. Did you guys see trends gradually decline throughout the quarter? And how are comps trending 3Q today? Thanks.
That was on the retail segment.
Shane, okay. Well, I can tell you this. I think deflation sort of trended down from a wholesale inflation perspective. I probably would not comment in terms of trend. I don’t recall a trend in the three periods of the quarter.
Did you – I’m sorry, did you guys see any impact from Hurricane Matthew as well?
We did. And let me use that question, which is a great question, to pivot to our folks in the mid-Atlantic region who did an absolutely spectacular job navigating for our customers a very difficult period of time. We have had stores and customers affected, particularly in the Washington, Baltimore and Virginia markets. And I would just shout out to the folks that did a spectacular job – many, many associates just – we couldn’t have asked for more from those associates to serve the customers under very difficult circumstances. It has been just a delight to see how our associates have stood up and serviced those customers. I am very delighted with how our businesses have done that. It’s really a call out to the success of the leadership teams out there and our employees.
It is one of the heartening parts of running a retail operation where you know your goal. You know your purpose is feeding those communities that you operate in. And it’s events like that type of natural disaster where you see the quality of the people who come to work with you each day. So, the stories that come out of this stuff of associates opening up their homes to all of their colleagues who can’t get home, of associates helping out the customers in all sorts of different ways to get to the store, to be able to get product and to get home. And each of those rescue operations that your staff goes through is the part that I think makes the team realize that what they do is meaningful.
Great. Thanks for that. And so you guys – how are your stores stocked today? Are they kind of back to where they typically are? And how have you guys been able to service your wholesale grocery customers through that event?
Yes, we – let me use that question to pivot to our wholesale segment. The stores are all in great shape now. And with our wholesale associates and folks on the East Coast that help supply under difficult circumstances, our independent customers as well as our retail banners and the folks in the warehouses did a terrific job.
Yes. So this would be another one of those stories. And it is similar to what – both our – to both in the SUPERVALU and Save-A-Lot operations went through in the hurricanes that hit in Louisiana earlier. We had – there’s nothing like going to a location and seeing your sales staff driving a forklift or driving a bucket loader to help a customer clean up their store and get it back online. But anyway, it’s the part of this business that does make us feel that what we’re doing is meaningful.
From the Save-A-Lot point of view, we have a lot of stores in Florida that were affected, so obviously pre-storm you get a big lift. But we had a lot of stores that had no power for – in some cases for days. We provided refers to – all the stores had very minimal loss of product. Unfortunately, we had no – fortunately, we also had no employees that suffered any major personal injuries or whatever. And I would say that probably the gain that you get pre-storm was offset by the post one, and that would be true also up the coast all the way – less stores up the coast. We certainly have a lot in Florida. So it’s probably kind of a net neutral event from a financial point of view.
Great. I appreciate all the color. I’ll get back in the queue. Thanks.
Your final question comes from Edward Kelly from Credit Suisse.
Yes. Hi, guys. Thanks for taking my question. So I really only have one question here, and it’s related to the retail food business. And I think I heard you say that you think that this business in the second half of the year can get better. I assume that’s part of what’s implied with your EBITDA guidance, assuming the companies can be better. But I want to ask about this because if I look at this business that I write, it seems like traffic is actually getting a little bit worse, deflation post-Q2 getting worse, competition intensifying. And you’re also talking about increasing promotions as well as maybe what sounds like work on labor and, through those things, obviously the right thing to do for the business over time. But can have a negative near-term impact on EBITDA. So I guess the question is how does EBITDA in the business get better in the back half of the year in terms of what you have put up so far this year?
Yes, fair question. So Ed, let me talk about some of the things we, I think, are heartened by. We’ve talked about the other side of that. So let me begin by building on some comments that Mark made. So I’ll take digital first. So we’ve got 660,000 digital accounts now from our retail banners. We have used – allowed our customers to download over 3 million digital coupons. By the end of the year, we will have about 25% of our store base that will have e-commerce either through delivery or pick up in-store or both.
We are making inroads with respect to our efforts around shrink. We are seeing good results from that, and so those investments in the shrink line will help either through allowing some of the banners to invest additional – make additional price investment or if they will help to offset from an EBITDA perspective. We are investing in more store employee training. And so that investment we expect to pay off in terms of better sales and better in-store experience for our customers. Our out-of-stocks are improving. We have improved nearly double digits since the early part of this year in our out-of-stock positions. And so you can’t sell a good unless it’s actually on the shelf until we have made significant inroads there.
The store segmentation I mentioned – we have segmented our stores via demographics. And so those segmented stores, relative to a base, have also shown improvement; improvement in the low-single digits, but improvement nonetheless. And I also mentioned the investment in modest levels of investment in new capital. So those are things that we expect will help. And so we would expect, based on that, that we should begin to see improvement. And, frankly, I do expect that the second half will be positive from an operating income perspective.
Mark, can I just ask one follow-up on all this? You have a wholesale strategy that sounds very solid and smart, right. So the retail food business is tougher. Is this a business that you think you want to be in long-term? And then what is the real solution given that the wholesale business obviously does supply those stores and unplugging that has some negative implications?
Yes, I think you put your finger right on it. I mean these are integrated businesses. And some of their strengths are complementary. So, the first part is that in a fair number of situations, those stores do get supplied out of our warehouses. There is, though – there are some real opportunities to build on additional synergies between these. They have been run traditionally as separate, standalone operations. And the example I gave of what we did with produce is there was a separate produce team in wholesale and a separate one in retail, and you can sit there and leverage the capabilities of both of that.
So, one part is going through the organization and think, hey, where are there ways, where we can achieve, greater synergies, to be able to strengthen and have a net benefit to this retail operation. There is a benefit of having retail in the fold as that test kitchen. Our services offering, which we really haven’t talked about too much today other than services that we will be doing for Save-A-Lot, a lot of that learning, a lot of that sophistication does come out of having run – running some retail stores. So, there is a benefit in multiple parts of having this retail. But as you pointed out, it is a tougher world, and that’s a place of – that’s got to be the increased focus for Bruce and I and the rest of the executive team as we move forward.
All right. Thanks, guys.
Thanks, everybody. That concludes our call. If you have any follow-ups, I will be in my office later today and enjoy the rest of the day. Thanks.
This does conclude today’s conference call. Thank you for participating. At this time, you may now disconnect.
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