Chiquita Brands International, Inc. (CQB) Q2 2008 Earnings Call July 31, 2008 4:30 PM ET
Executives
Ed Loyd - Director of Corporate Communications
Fernando Aguirre - Chairman, Chief Executive Officer, and President
Jeffrey M. Zalla - Chief Financial Officer, Senior Vice President
Analysts
Bryan Hunt – Wachovia Securities
Vincent Andrews – Morgan Stanley
Reza Vahabzadeh – Lehman Brothers
Heather Jones – BB&T Capital Markets
Jonathan Feeney - Wachovia Securities
Karen Eltrich - Goldman Sachs
Operator
Welcome to Chiquita Brands International second quarter investor conference call. (Operator Instructions) At this time, for opening remarks and introductions, I would like to turn the conference over to the manager of Investor Relations, Ed Loyd.
Ed Loyd
Welcome to Chiquita Brands International second quarter 2008 earnings conference call. On the call today are Fernando Aguirre, Chairman and Chief Executive Officer, Jeff Zalla, Chief Financial Officer. After today’s prepared remarks, we will take questions as time allows. If you have not received a copy of today’s press release, you will find it on the company’s website, at www.chiquita.com. Or you may contact Chiquita’s investor relations line at 513 784 6366.
Before we begin, let me remind you that this call may contain forward looking statements concerning operating performance of industry developments. Factors that could cause results to differ materially are described in the Safe Harbor section of today’s press release, and in Chiquita’s SEC filings including its annual report on form 10-K, and quarterly reports on form 10-Q. Now I’d like to turn the call over on Fernando Aguirre.
Fernando Aguirre
I’m pleased to have this opportunity to discuss with you our second quarter 2008 financial and operating results. On today’s call I will provide highlights of our second quarter 2008 business performance and then Jeff Zalla, our Chief Financial Officer, will review our financial and operating results in more detail. We will then return to discuss our main priority, then key goals for the remainder of the year.
Let me begin with a few of our accomplishments since second quarter. First, this quarter marks our best quarterly performance in three years, and our fourth consecutive quarter of year on year earnings improvement, despite unprecedented cost increases. We are very pleased with these results which are a testament to the strength of our business, the diversity of our product portfolio, and our strategies to drive profitable growth.
During the quarter, we significantly increased both sales and net income versus the year ago period. We are particularly satisfied with the pricing discipline and focus on profitability we have instilled in our banana business. We are disappointed however with this quarter’s performance in our US salad operations, and we are focused on the execution of plans to significantly improve our salad margins over time. I will talk about that in more detail later in the call.
We also reached a definitive agreement during the quarter to sell Atlanta AG, our German distribution business, to UNIVEG, for at least $85 million in proceeds, which will primarily be used for debt reduction. This sale which will reduce risk and be accretive to both margins and earnings, is fully consistent with our strategy to focus on higher margin brands and products. I will give an update on our 2008 priorities in a few moments, but now I will ask Jeff to provide more detail on our financial and operating results for the quarter.
Jeffrey M. Zalla
First, let me briefly note that all financial results on today’s call and on our press release are for continuing operations unless otherwise noted, and reflect reclassified segment information, which I’ll detail in a few moments.
The following are some key highlights of our performance in the second quarter. Net sales rose 6% to $1 billion dollars. The company reported income of $59 million, or $1.31 per diluted share. This compares to income of $5 million, or $0.12 per diluted share in the year ago period. Including the results from discontinued operations, net income for the quarter was $62 million, or $1.37 per diluted share. This year’s quarter includes a net gain of $6 million, or $0.13 per share, for the collection of a prior year refund on non income tax claim. And last year’s quarter included a charge of $3 million, or $0.07 per diluted share, related to a settlement of US anti-trust litigation.
The company reported operating income of $72 million, compared to operating income of $31 million in the year ago quarter. This improvement was principally due to higher banana pricing in each of the company’s markets, strengthening of the Euro, and savings from our business restructuring. These improvements were partly offset however, by disappointing performances in salads. Operating cash flow was $121 million, an increase of $45 million from the year ago period due to our improvements in operating income.
Before I discuss our segment results please note that as a result of our decision to sell Atlanta AG, we are now presenting Atlanta as a discontinued operation. To provide you with comparable historical information, we’ve included in exhibit H of today’s press release summary financial results for the six most recent quarters. These figures confirm that, as earlier disclosed, while Atlanta represented a significant amount of revenue, it has not made a significant contribution to Chiquita’s annual operating income in recent periods.
In addition, we’ve taken the opportunity of the Atlanta sale to review the composition of our three business segments. We have determined to include our Just Food in a Bottle line of fresh fruit smoothies within our salad and healthy snacks segment, instead of in other produce. For comparison purposes, we have provided in exhibit G of today’s press release a summary of segment results reflecting both this reclassification and the treatment of Atlanta as a discontinued operation.
Now, I’d like to turn to our segment results. In our banana segment, year over year sales rose 17% in the second quarter to $563 million, and operating income rose to $89 million dollars from $43 million in the year ago period. Segment operating results benefited most from significantly higher banana revenues in Europe and North America, as well as favorable impact of the Euro. These benefits allowed us to overcome much higher industry costs, including the costs of purchased fruits and fuel, and lower volume primarily in the European market. The year over year variances are detailed in today’s press release, but let me provide some additional perspective on recent price and volume trends in our primary market.
In North America, year over year pricing increased 35% in the second quarter on flat volume. Due to increases in base contract prices, a fuel related surcharge, as well as a continuing surcharge to mitigate higher purchase fruit costs due to constrained industry-wide availability. The [price] trend in North America remained about the same.
In our core European market, pricing increased 6% on [lower] base, and 23% on a dollar basis in the second quarter. Volume decreased by 8% due to tight industry volume conditions and our continued greater focus on maintaining our premium product quality and price differentiation rather than market share. July trends in Europe show volume continuing to improve somewhat, but remaining below year ago levels, while local currency pricing comparisons softened to be about flat with year ago.
Let me turn to our salad and healthy snack segment. Net sales increased by 4% from the year ago quarter to $350 million. Operating results were a loss of $6 million, compared to income of $10 million a year ago. Operating results were impacted by higher industry and production costs, as well as by $5 million of incremental spending behind the successful expansion of Just Fruit in a Bottle to six countries in Europe. These higher costs and investments were partially offset by improved pricing in retail and food service. Net revenue per case in value-added salad rose 4% in the second quarter versus a year ago on flat volume. Our healthy snacks category including Just Fruit in a Bottle in currently generating operating losses as we invest in establishing these new products. Given their success in the marketplace, we believe that this spending is prudent and will lead to both long term growth and attractive financial return.
The salad category is generating operating income but not at the levels required to earn a fair return on our cost of capital, which is the minimum threshold we have established for all of our businesses. Later on the call, Fernando will discuss the initiative we are implementing to address this in the near term, and the confidence we have for this category in the long term.
In our other produce segment, net sales decreased 30% to $82 million through the elimination of third party sales in Chile, and of low margin sales of Mexican vegetables. Operating income in the quarter increased to $5 million compared to break even a year ago, due to higher margins on sales of branded whole fresh fruit other than bananas. These results demonstrate that our decisions to exit operations in Chile and to sell Atlanta have reduced risk and improved returns in our other produce segments, which now generates an attractive return on limited invested capital.
Now turning to our outlook for 2008. While quarter-to-quarter volatility is typical due to the seasonality of our industries, we continue to expect to achieve significantly better operating results for the full year 2008, compared to 2007, primarily due to contact and market price increases, as well as our restructuring plan and internal cost savings initiatives. We continue to expect the balance of the year to follow normal seasonal trends, including a loss in the third quarter, roughly in line with the same period a year ago. We do not expect a repeat of the temporary benefit of European banana prices caused last year by hurricane Dean. The capital expenditure, our current estimate for the full year is between $55 million and $65 million.
Let me turn specifically to our outlook for operating performances for the year. During the first half alone, we have generated total benefits of $269 million. To more than overcome the $154 million of higher industry and product supply costs that flow through our results, our full year results will clearly reflect significant year over year improvements and our ability to more than overcome higher costs, primarily through: pricing, including fuel and other surcharges, especially in bananas; Euro exchange rates; the benefits of our restructuring program; internal cost savings initiative; and fuel hedging gain.
We continue to be pleased with the implementation of the business restructuring we announced last year. We realize the restructuring savings of $37 million during the first half, and continue to expect to deliver between $65 million and $80 million for the full year 2008.
The outlook for higher industry and other product supply costs are detailed in today’s press release. Our estimates for these items remain the same as reported in our mid-quarter update, at a combined $270 million to $295 million for the full year. Importantly, commodity fuel prices represent more than $100 million of these estimated full year increases, and as we have demonstrated, we have effective programs in place to mitigate fuel related risks.
I would also note in relation to our innovation efforts that our investment spending for the expansion of Just Food in a Bottle in Europe in its second quarter increased to its highest level to date, following an aggressive roll-out to new markets. We are very pleased with the performance of this line of products, and we’ve expected to deliver meaningful earnings growth during the next few years, first as our investment spending levels decline, and then as it begins to deliver attractive bottom line operating margin.
In addition, I want to comment on a few items that may impact results during the second half of the year. First, we expect to incur higher than normal legal fees as we continue to vigorously defend pending civil litigation related to Colombia. These could be in the range of $5 million to $10 million in the balance of the year. Second, we are pursuing a potential relocation of our European headquarters from Belgium to Switzerland, which we believe would optimize our long-term tax structure. Any such move would likely begin in late 2008 and be concluded by mid-year 2009. Its cost would depend on the results and timing of ongoing negotiations and on how many employees relocate. We expect to provide a further update on this during the third quarter.
Finally, during the third quarter we expect the Atlanta sale to close, which is likely to result in both a net gain on sale, and a one time tax benefit. The net gain on sale will be accounted for in discontinued operations, and the income tax benefit will be in continuing operations.
In summary, we made excellent progress in the second quarter. Our aggressive strategies are working to more than overcome industry and other product supply cost increase. We are pleased with the increasing fundamentals of the banana business, our innovation efforts are on track, we are focused on turning around performance on salad, and other produce is performing well. Now, let me return the call to Fernando.
Fernando Aguirre
We are very pleased that we are on track to deliver much improved full year performance in 2008 compared to 2007, due mainly to the strong result that we have achieved so far this year. We continue to be disciplined in the execution of our strategy and prudent in our investment in our long-term growth opportunity. This is allowing us to drive profitability despite the rising cost environment, and positioning us to achieve sustainable profitable growth over the long term.
One element of our management discipline has been our commitment to ensure that each of our operations earns more than its cost of capital. We are pleased that our North American banana business now achieves this threshold for the first time in more than a decade, and we are committed to at least maintaining this level of performance. But, our North American salad operations, both retail and food services are under performing. While we are disappointed with this current financial performance, salad continues to be vital to our strategy and growth plan. As a result, we have placed priority on four operating initiatives designed to achieve our target of earning more than our cost of capital in these operations.
First, over the last month we have begun to implement pricing mechanisms in our contracts to more quickly and fairly reflect market changes associated with fuel and fuel- related input costs. Second, we are seeking to eliminate temporary network inefficiencies associated with the integration of Verdelli by streamlining SKU’s and further consolidating distribution centers, a process we expect to be completed in the balance of this year. Third, we will be targeting significant improvement in profitability by customer as we renegotiate contracts over the next six to nine months, and fourth, we are working with customers to make our trade spending more efficient, and improve the merchandising of our products. We believe that these actions will allow us, even in the face of rising costs, to earn a fair return on capital in the salad segment, as we leverage the strength of our Fresh Express brand and the tremendous growth potential of this category.
We are also continuing to permanently invest in long-term opportunities that will extend and grow the Chiquita brand and help expand the company’s market position in the higher margin categories. Our goal remains the same – to make innovative products more convenient and available to customers and consumers. The performance of our Just Fruit in a Bottle line of products in Europe is excellent. The successful roll out in each of six countries we have entered to date has met all of our operating and financial targets. While we presently have a high level of investment spending behind the roll out of this and other healthy snacking products, we are right on plan towards improving the earnings profile of this business in future periods. Successfully expanding a new product in six countries is an excellent track record. In addition we are successfully executing new product ideas to keep customers.
We recently begun selling Chiquita branded fruit cups, through McDonalds in the Netherlands, and we are the major supplier to Burger King for its newly launched Apple Fries, as well as to Starbucks for the blended banana based beverage they launched this month named Vivanno. These products illustrate how we are seeking to make our products more convenient and available to consumers worldwide, while extending our brand. Although not every new product idea will be a home run, we are confident that these types of innovations will create some new and profitable growth opportunities for Chiquita over time.
In conclusion, let me summarize a few key things about the long term investment opportunities that Chiquita represents. We are in the sweet spot of a global market opportunity with our food brands and Chiquita and Fresh Express. We have the right strategy to capitalize on health and wellness trends. We know that obesity continues to be a problem. The United Nations Food and Agriculture Organization recently reported that the United States has the highest caloric consumption per capita of any nation in the world. However, consumer buying habits are changing, and 78% of Americans are trying to eat healthier. Our healthy alternatives to calorie-laden foods will serve Chiquita well in meeting consumer needs.
We have a strong management team that has demonstrated we are focused on [inaudible] execution and improving results consistently over the long term. We manage our business as a portfolio and use our strengths to overcome our areas of challenge. Despite the industry challenges we have faced, we continue to mitigate risks and build momentum. We believe that the culmination of these elements represents a compelling investment proposition.
Further, we are confident in our future and look forward to delivering sustainable growth. Very importantly, we are focused on steady improvements in our annual, rather than our quarterly results, given the normal seasonal trends and other factors that can impact our short-term performance. We believe this is the best way to achieve consistent shareholder value over the long term. At this time I’d like to open the call for questions. We’ll take as many questions as time allows.
Question-and-Answer Session
Operator
(Operator Instructions) We’ll take our first question from Bryan Hunt with Wachovia.
Bryan Hunt - Wachovia Securities
I was just wondering if you could describe in a little bit more detail what happened in the salad segment and what was the main driver behind the loss relative to the profit a year ago in detail. Could you talk about lettuce cost, distribution cost, packaging cost? What were the drivers behind the loss?
Jeffrey M. Zalla
First Bryan, compared to a year ago, recognize that we have $5 million more in investment of the launch of Just Fruit in a Bottle. So that was a significant contributor. If we look just at the salad portion of the business, we had a number of things happening. Higher industry costs for things like fuel and raw materials – that was about $10 million impact.
We had a variety of costs that affected efficiency of our network, in particular as we continue integrating the Verdelli acquisition and have plans with Philly and Harrisburg, Pennsylvania which gives us greater access to the northeast. We had higher gross stocking costs, we had waste because of network inefficiencies and higher trucking costs. Collectively, those impacted net $6 million in higher costs net of other savings initiatives.
We also had some more investments in products because of mix introducing nationally the Gourmet Café single serve line of salad, and some more healthy snacking products. Then the one item was a bit unusual, $2 million of costs were connected to the FDA tomato recall.
Bryan Hunt - Wachovia Securities
Okay. And then when I look at the rest of healthy snacking, Fruit in a Bottle and bags of salads, you all introduced, you know, grapes, and sliced apples, a lot of other healthy snack items. How are door placements going on that line, and one: are you profitable, and two: does penetration of the product continue to grow?
Jeffrey M. Zalla
Penetration does continue to grow. In fact, market acceptance of that product has been quite attractive. We are number one in a small but fast-growing category. The apples in particular are a mainstay in that product line. One of the things we are doing in addition to enhance profits in healthy snacks is to invest more in owned processing in order to keep pace with customer demand growth and to eliminate [home] manufacturing under way now that’s impacting margin.. So its still an investment in term of property income for us, as we establish that category, but we believe that it has significant income improvement opportunity.
Fernando Aguirre
And then from a placement, you were asking the placement standpoint, distribution is now roughly the upper 40% and growing, so that is the category that, although it’s small, the distribution we have achieved is reasonably good and growing, which is obviously an important factor as well.
Bryan Hunt - Wachovia Securities
And then my last question is, the proceeds from Atlanta, you phrased it in a manner that you are going to use the proceeds to mostly repay debt, what should we take that to mean? Are you looking at 75% of the proceeds to reduce debt? Do you have the option also to potentially take out some of your bonds that are trading a significant discount to par rather than paying down the bank debt? And that is my final question, thank you.
Ed Loyd
Bryan, we are keeping our options open. We said purposely we will use the proceeds primarily for debt reduction. That is because debt reduction remains a number one priority for us. We are going to continue to drive that down until we achieve our 40% total debt to capital target. But we’re not going to speculate on the use of the proceeds by instrument.
Bryan Hunt - Wachovia Securities
Let me just add a little follow up. With industry costs being as volatile as they’ve been, does that 40% debt to capital target still hold or do you feel like you need to carry less debt give the volatility of the marketplace?
Ed Loyd
We think that it’s prudent, while costs have been volatile and increased at an unprecedented rate this year, we’ve also demonstrated our abilities through pricing and cost reduction, and hedging another risk mitigation program to improve profitability year-on-year. Though despite there being risk to total product supply cost, we think that our earning performance is improving and that 40% debt to capital target is still prudent.
Operator
We’ll take our next question from Vincent Andrews with Morgan Stanley.
Vincent Andrews - Morgan Stanley
Just a follow-up on the previous question in salads. It seems like you had almost $11 million, forgetting about the higher industry costs, you had the $5 million for the marketing of Just Fruit in a Bottle, $6 million for Verdelli and the cross stock and the trucking and the $2 million for the FDA tomatoes, and the majority of that would be unlikely to recur next year. Is that fair?
Jeffrey M. Zalla
Well it’s certainly fair that the integration costs will not recur because we expect that network be off the [modest] and the balance of this year.
Vincent Andrews - Morgan Stanley
Okay, so if I was just trying to get to like an underlying salad number for the quarter, I would take out the $5 million of Just Fruit in a Bottle, the $2 million from the tomatoes, and maybe two-thirds of the $6 million? Does that seem fair?
Jeffrey M. Zalla
Correct.
Vincent Andrews - Morgan Stanley
Okay, so my next question is, you said that in the EU, banana pricing in July was more or less flat year over year. Is that better or worse than what your expectations were when you gave your mid quarter update?
Ed Loyd
Well, recall Vincent, that we don’t give expectations for pricing. We said that it would follow normal seasonal trends.
Vincent Andrews - Morgan Stanley
I know, I recognize that, I’m just asking if maybe you’ll comment on did it turn out better or worse than you had thought internally? I know now that it’s already happened, we know what it is. Is the EU pricing starting to play out in line with your expectations or above or below them?
Ed Loyd
Well, it’s a little better on a local base, because we had assumed that there would not be a repeat of the cool summer last year that supported banana prices and that limited the competition from other fruits but it is, in July, as reported based on our preliminary estimates, flat with a year ago on a local basis.
Vincent Andrews – Morgan Stanly
Okay, and I guess you have no thoughts on where pricing will go for the balance of the quarter at this point?
Ed Loyd
Well pricing has been firm in the last several weeks. We think that in general supplies will continue to be tight out of Latin America as well as EU sources, though we do expect the continuation of the normal seasonal trend which calls for Q3 pricing – the least favorable of throughout the year, but in general, the dynamics in the industry from a supply and demand perspective, have been improving.
Vincent Andrews - Morgan Stanley
Okay, and just to step back to salads, what are you seeing in terms of consumer behavior in the salad segments, you know as the price of gas goes up and the price of everything else in the supermarket goes up. Is any of the weakness in salads or year-over-year a function of changing consumer preferences or consumers trading down? Or is there anything that worries you in terms of pricing to offset the higher industry costs on a go-forward basis?
Fernando Aguirre
No Vincent, we have not seen any data that shows that consumers are trading down. The most interesting data points are that consumers are actually not going to restaurants, so that is actually helping people to go stores and buy more of the products that they prepare at home. We are looking for data now, we are reading it but we are typically lagging about a month behind, but we have seen nothing in the past 4 or 5 months that show that trading now from a pricing standpoint. As I laid out on the four points that we have in our plan, one of the critical aspects is the renegotiation of our contracts and also the different fuel surcharges that we have in place and our people are obviously being very aggressive as they have been in bananas to make sure that we are recovering and being more than upsetting any of the cost inputs. That will a critical aspect of going forward and we are being very disciplined in that approach.
Vincent Andrews - Morgan Stanley
Okay, thank you very much. I’ll pass it along, thank you.
Operator
We’ll take our next question from Reza Vahabzadeh with Lehman Brothers.
Reza Vahabzadeh - Lehman Brothers
Just a couple of clarification points. On the salad front, it wasn’t clear to me, perhaps I missed it, what the thing is causing softness in category trends, and the slowing of sales that you’ve experienced in that category. Do you have some thoughts on that?
Fernando Aguirre
We have not reported any slowness in the category, on the contrary. Based on everything that we see from these and IRI type of data, the category is still doing fine. The issue is that it is not growing double digits, the issue is that it is growing single digits. But no, we have not reported any slowdown in the growth of the category. The last data that I can recall is in the last 13 or 14 weeks or so where the category was up roughly about 2%.
Reza Vahabzadeh - Lehman Brothers
Okay, and do you expect the category to be relatively stable going forward?
Fernando Aguirre
Well as we have said before ever since the E-coli event happened, we have been working on making sure the category starts growing. We have also reported over that time that we have been leading the growth of the entire category, we’re half of the market, so yeah, we grow, so that means the likelihood of the category growing is reasonably high, and so our expectation is that our plan that we have in place, we have been doing work to make our merchandising and our trade spending more efficient. We do expect those plans to turn up a category growth that is better, but again a lot depends on how consumer reaction is throughout the economic time that we are seeing.
Reza Vahabzadeh - Lehman Brothers
As you mentioned in the press release, and history has shown, there is definitely quarter-to-quarter volatility in your industries, especially bananas. With that, do you think banana prices for in the second quarter in Europe were what you would call normal banana prices, or better than normal banana prices? Making comparisons potentially challenging in years to come?
Jeffrey M. Zalla
I think, Reza, pricing in the market has been buoyed by limited supply generally, so the trends we saw, flooding in the spring in Ecuador, we saw very dry weather through much of Central America, and we also saw a decline in EU source, for example Hurricane Dean impacted the French West Indies last August, the volume was out of the market for the early month of the year, it came back May and June, it’s now back below year ago levels, and in the first half was down 30%. Africa in the first half was down 2%, and sources in Ecuador, the largest producer in Latin America was up only 1% in the first half in total exports. Costa Rica and Panama were down considerably on the basis of weather. I think the pricing environment has been buoyed by those general trends.
Having said that, I think there’s no reason to expect a huge rebound in volume and availability out of Latin America in the next couple of years. We have seen significant new planting take place, there is planting underway in Africa, including some of ours coming in 2010, but that ought to keep pace with demand growth. I think again the fundamentals of supply and demand are improving.
Fernando Aguirre
As far as the North American market is concerned, Reza, Jeff was talking about the European specifics and the sourcing, but as far as the North American market is concerned, we obviously are pleased with what we have been able to achieve, but bear in mind that for a decade or more, the pricing of bananas has not changed very much in this market, and in fact from our own standpoint, the markets we have been reporting over the last several years that our own pricing has gone down 1% to 2% a year, and now that we see we have been able to instill pricing and customers have been able to reflect some of that pricing to consumers, because consumers had not seen anything in terms of banana pricing in the last 10 or 15 years, whereas we all know that everything else has increased over the last 10 of 15 years, from whether you call it hamburgers and soft drinks, and every other food staple. The banana has not increased at all in fifteen years, so that’s one point.
The second point of course is that the fact of the matter is you go to the store today and you still see bananas are a great value. You can’t find a nutritional food item like a banana for a quarter or $0.30 which is what people pay in the store. There’s candy bars and soft drinks and everything else that costs a buck, or a dollar and a half, or $2, or a coffee cup that costs $5 or $6, and you buy a nutritional food item like a banana for $0.25, that’s a great value, and continues to be a great value despite the fact that we have taken pricing.
Reza Vahabzadeh - Lehman Brothers
Right. No, I hear you, but this year you printed 8.2% EBITDA margin, give or take, last year was 4.6% in the second quarter, so I’m just trying to find out is that 8.2% the normal margin, is it the 4.6% of last year or something in between? When you come up against these comparisons next year, is it easy, challenging, or normal comparison?
Fernando Aguirre
Well I don’t think that anybody would ever say that what we see today is normal, but it’s the last ten years. I think that everyone knew that in the last ten years, hardly anyone made any money in bananas in North America. Our mandate, and our discipline, as such, that we are focusing on profitability improvements, that’s what our execution is today and that is what we have shown in the last several quarters of results of the company. We clearly will continue to be focusing on that in the next several months and years to come, but I can’t, no-one can say that anything is normal these days, but we will clearly maintain our focus on profit improvement.
Reza Vahabzadeh - Lehman Brothers
Yes, I hear you, I don’t think it’s normal. But, last question is, the revenue growth in the North America banana business – is that largely due to fuel surcharges, and so how much pricing did you get ex-fuel surcharges?
Ed Loyd
Reza, it’s a combination of base contract price increases, fuel surcharges, and the surcharge to mitigate the cost of tight volume supply. The fuel surcharge has increased significantly year-on-year. This year’s third quarter was $1.35 a box for us. That’s been an important element in mitigating fuel cost increases. But that is what we view to be a core part of providing service to customers, and we fully expect that that surcharge will remain. Before the second quarter, fuel surcharges were $1.40 a box, for the third quarter, it’s $1.85 a box because we’ve seen a significant increase in market fuel prices, and as you know we use the third party [price] index as the basis on which to change these surcharge per box on a quarterly basis.
Operator
We’ll take our next question from Heather Jones with BB&T Capital Markets.
Heather Jones - BB&T Capital Markets
I had a few questions. I was wondering, these costs, the $6 million of unforeseen costs, integration issues in Fresh Express or packaging costs, is that part of your increase to cost guidance that you gave back in mid June?
Ed Loyd
That’s correct, Heather. Its all part of what we’ve been taking into account as we look at forecasts for other products by cost increase through the year.
Heather Jones - BB&T Capital Markets
Okay, so this table on Page two where you talk about higher industry and other product supply calls, these costs are in those figures?
Ed Loyd
Yes, and these costs are the same as we provided in June in the mid-quarter release.
Heather Jones - BB&T Capital Markets
Okay, and do you expect that $6 million? I mean, what is your expectation for what those costs were run in Q3 and Q4?
Ed Loyd
Heather, what we’ve said is that the incremental cost we expect to go away over these next two quarters as we integrate the network.
Heather Jones - BB&T Capital Markets
Okay. I mean, could you just give me an idea of the magnitude though, cause this is something that arguably would be non-recurring until we’re thinking about ‘09. Can you give us an idea what the total costs would be? So, would essentially you have expected to see a pick up for ‘09?
Ed Loyd
It will be a pick-up because it’s the incremental expense that we see in the second quarter. It’s the contributor to the current disappointing result and we believe as Fernando laid out in the four-point strategy that this is a significant contributor to improving ongoing earnings.
Heather Jones - BB&T Capital Markets
Okay. SG&A was up year on year, and I have been under the impression that roughly two-thirds of your cost savings was going to be on the SG&A line? I was just wondering if you could speak to that.
Ed Loyd
Sure, now in SG&A we did achieve significantly lower compensation costs, almost $8 million, mostly from the restructuring. And other benefits as well, for example we did a repeat the equal grant for independent scientific research about E-coli which impacted last year’s second quarter. But, we had a couple of offsetting increase – we had significant increase in advertising in Europe, mostly for the expansion of Just Fruit in a Bottle, that was as much as $9 million in the quarter. We had higher incentive compensation costs for the second quarter – that was roughly $4 million, compared to last year when bonuses weren’t paid as a result of financial performance. In addition we have in SG&A in Europe, the impact of higher dollar cost is a result of a rising Euro which impacts all of our Euro denominated costs in the SG&A line, that was about $3 million.
Heather Jones - BB&T Capital Markets
Oh, okay. Now looking at, you mentioned $5 million to $10 million higher legal fees, but are you expecting investment spend for what are the advertising for Just Fruit in a Bottle to be up significantly in Q3 year on year? Because I’m still having a hard time with this kind of pricing and the currency and cost savings, et cetera, for getting to how you’re going to be generating, call it a $0.50 loss in Q3 essentially flat year-on-year? Should we anticipate a significant increase in debt investment spend as well in Q3?
Ed Loyd
We do expect higher investment spend. We are continuing in the roll-out in the geographies that we’ve launched Just Fruit in a Bottle in Europe, and investors can expect us to continue to invest behind that and to further expand geographically. I don’t have a specific number to provide you, Heather. We don’t give guidance in advance about the magnitude of innovation spending for competitive reasons.
Heather Jones - BB&T Capital Markets
And as far as the pricing in North America, it seems like the competitive environment has been very rational as far as keeping these surcharges in place, I mean what is your view as to that?
Ed Loyd
Our view is that industry supply conditions continue to be tight, and that a customer will accept to defer charge, and as we renew contracts as we’ve done recently, customers have recognized the need to roll in equivalent and even better pricing in the new contract, and this is going to be a key focus of attention as we anticipate banana contract renewals, and many of which come due for us near the end of the year.
Heather Jones - BB&T Capital Markets
So you anticipate rolling in higher pricing given the sustained higher cost?
Ed Loyd
Absolutely.
Heather Jones - BB&T Capital Markets
Okay. My last two questions, are first, this four point plan to improve packaged salad profitability, what is your timing on those yielding results?
Fernando Aguirre
We’ve already started, Heather, with some of the pricing mechanisms over the last month or so. The Verdelli piece is also happening and I expect that to be finalized within the next 6 months or so, and then the specific improvements in profitability by customer really depends on each contract renewal and those as you know happen over time because we don’t want to have all the contracts fall on the same date, so that will be within the next, call it, 9 months or so. So I expect the salads category to start rebounding literally within the next six months.
Heather Jones - BB&T Capital Markets
Now, one thing I haven’t understood is why you haven’t been as successful in passing the on, you know the fuel surcharge you have on bananas, why that wasn’t implemented on packaged salad earlier? I mean, I think you have some form of fuel surcharge but looking at the pricing data, it doesn’t look like it’s as effective as the surcharge you have in place for the bananas. I was just wondering what kept you being a bit more aggressive on pricing there being that you’re the dollar share leader?
Fernando Aguirre
As you know we had been selling both products separately from two different sales organizations. We began consolidating the sales organization in this year with the restructure and that certainly helped us due to the application of the different practices in both businesses. Some of the good things of bananas into salads, and some of the good things of salads into bananas, and so that is part of the issue and certainly we had a very high sense of urgency in bananas because of the very obvious negative and difficult profitability that we had in North America for so long. And so the sense of urgency was there, and we decided to implement an aggressive plan and to start with bananas. So for a number of reasons, the executional aspects of it are such that you always had the opportunity to learn. But I have got to tell you with the integration of the sales force, the fact we have the leadership starting all the way to the top, Brian Cooker who now is heading both organizations, and the integration of the sales force, it’s becoming a heck of a lot easier and faster to be able to execute some of these plans. I again expect that plan to start rendering results literally in the next several months.
Heather Jones - BB&T Capital Markets
Okay. I just want to see if my math is correct. Looking at your restated results for salads which now includes Just Fruit in a Bottle, compared to last year versus this year, it looks like Just Fruit in a Bottle lost $3 million last year, and this year guess with the higher investment spend is losing more than that. Is my math correct?
Jeffrey M. Zalla
We are investing more this year, Heather. Last year we had, well 2006 we began in Belgium, 2007 we were in the Netherlands, and just began in Germany. Now we’re in those markets, plus we’re in Austria, Denmark and Sweden. So we have ramped up significantly and expanded geographically with the roll-out of this and we have the full year for impact in ‘08 compared to partial year impact in some of these countries in ‘07.
Fernando Aguirre
Germany was late in ‘07, and the great majority of the spend in Germany actually has happened this year, and Germany is a huge country as you might imagine, so that was one of the aspects of the investment that we have in Just Fruit in a Bottle this year.
Heather Jones - BB&T Capital Markets
Okay, because it looks like that could be, I mean right now it’s generating pretty significant losses but if I remember correctly is it your goal that within three years each country will break even?
Ed Loyd
Right, that’s correct.
Heather Jones - BB&T Capital Markets
So the peak losses this year and then they should start reducing?
Fernando Aguirre
Well, theoretically that’s correct. Though I say theoretically because I’m going to speculate here, but if we were to go to all of the rest of Europe tomorrow or call it January 1 of 2009, then all of a sudden you’d have many more countries which obviously would mean many more investments and we’re not going to do that necessarily, unless we see that our financial plans are such that we can afford it and that we are giving the returns that we are giving. But rest assured that we have very specific measures in place for each one of the country roll outs, each one of the six is delivered successfully on each of those metrics, and that includes a type of investment that we know a new product would have in years one through three, and I don’t know of any new product that is successful that did not have to invest in the first three years of its life. So yes, the expectation is that within the first three years of the life of that product will have to be in investment mode, and after that we do expect them to be profitable and provide a return to the company.
Heather Jones - BB&T Capital Markets
Okay. Alright, thank you.
Operator
We’ll take our next question from Jonathan Feeney with Wachovia Securities.
Jonathan Feeney - Wachovia Securities
Fernando, you talked about returning your cost of capital in North American business, and I know that we’ve had the competitive dynamics you employed so to prevent that from happening for some period of time, and I guess, while I applaud the target, it can’t be the first time somebody’s tried this at Chiquita or one of your competitors. I guess I wonder what competitive dynamics do you think are in place in North American in the market, going into ‘09 and going forward that maybe allow that return on capital to take place?
Fernando Aguirre
Well, I won’t speak for my competitors, I have no clue how they manage their business, but I’ll tell you about us. We certainly have for the first time in years been focusing on profitability as our number one priority. I can tell you that when I started here 4.5 years ago, the focus was on volume and shares and making sure that our ships were full, and being efficient in the way we supply the market. We are focusing very, very strongly as a number one priority on profitability and again I guarantee you that that was not happening in this company in the last several years. That’s a very major change. I do believe as well that we have now different metrics; we do measure profitability by customer; we are willing to let some volume go and some customers go if they are not delivering the profitability objectives that we have. Again that discipline was not in place in this company in the last several years. And, the fact is, that some of the supply issues that have affected the market have helped. Make no mistake, the fact is that the tight supply in the marketplace has helped. And certainly has helped us, and we, as Jeff reported, we do believe that over the next several years, the supply is likely going to remain tight, some growers have decided to go and plant other things, and some growers have decided to get into other kinds of businesses because there wasn’t a good return for them in this marketplace. That’s what I can tell you has changed in our company. Again, I won’t speak for what other people do, but that clearly is the major change.
Jonathan Feeney - Wachovia Securities
When you talk about return on capital for the business, Fernando, you’re allocating, I assume on that metric, you’re allocating capital to North America bananas, is there some public source where we can take a look at you know, capital allocated across the different businesses?
Ed Loyd
Jonathan, we don’t publish but I can tell you that it is capital for all the hard assets, capital for working capital, capital for fair share of the use of the trademark and intangible assets, so its fully loaded from a capital perspective. You know, our costs of capital today, roughly 10% on a blended basis. And this is a minimum threshold for each of our business units. It’s a tool to manage the portfolio, to challenge business unit leaders to deliver an appropriate return given the risk profile of the business, and to help us manage for the long term. So it’s not the target for each and every unit, but it’s the floor.
Jonathan Feeney - Wachovia Securities
Thanks, and just one other one, I guess applying the same sort of logic to the salad business, I know that unlike the banana business where there’s sort of a big structural puzzle to figure out, I guess that the industry was not creating value for long period of time. If this business was creating value, substantial value, before E-coli, and I guess I just wonder, I know you’ve outlined some steps to restore that solid return on capital, but is it just a case that you haven’t been trying over the last couple of years? It’s been my sense that you’ve been trying and some competitive dynamics have been in place. I guess I’m just wondering what you’re going to take pricing, but there’s going to be a reason you didn’t take pricing thus far. So, is it something competitive that’s changing or is it really just as simple as you haven’t been as focused on return on capital on salads since E-coli hit, and now you are.
Fernando Aguirre
Well I can tell you Jonathan, we were more focused on making sure that category would recuperate the growth right after the E-coli event. When I say right after, I mean the first year after E-coli, clearly we were focusing a significant amount of our attention on educating the consumer why it was safe to come back to the salads, and provide both consumers and customers our food safety records and provide them with the practices we follow and why we believe very strongly that we are leading the pack in the industry as far as food safety is concerned. We had a significant amount of focus on that in our first year.
Now the second year, we thought that the category would rebound faster and it did not, and as I explained in bananas and the profit focus that we have, there are many tactics that we are incorporating and I’ll go back to the fuel surcharges that this company started. This company led the fuel surcharge in bananas and we led the fuel surcharge in salads and it is a result of the focus and profit improvement that we have in the company. And again, four years ago, eight years ago and ten years ago, the focus of attention of the company was on gaining volume and share, and it is no longer our focus of attention. We’d rather give up some of that volume and some of those customers if they are not going to give us a return because of our focus on profitability and so a number of tactics, and again I’m using the fuel surcharges, are a simple example of simple yet very important on the types of decisions that we made and our management team has made in leading the industry for items that no-one would really dare touch in the last many years.
Operator
Due to time constraints, we’ll take our last question from Karen Eltrich with Goldman Sachs.
Karen Eltrich - Goldman Sachs
Thank you. We’ve definitely been hearing the same things that you guys have said about increased demand in a lot of your competitors. And two things you guys have mentioned obviously is this is for a recession of very attractive value propositions for the consumer, even with the price increases. But also, second we’re hearing of increased demand in Russia and wanted to see if you’re seeing the same thing, and how your position can benefit from that.
Jeffrey M. Zalla
Karen, we are seeing increased demand in Russia, but we look for example at volume statistics from the first half of the year and volume exported out of Ecuador which is the sensible source is up close to 30% year on year, and its part of that demand that is bidding up the cost of fruit in Central America and that is what is generally a tight supply environment which we see is likely to continue for the foreseeable future.
Karen Eltrich - Goldman Sachs
Right. And you mentioned, obviously Fruit in a Bottle but could you maybe give us an update for some of your other initiatives, the Gourmet Café, and the single serve bananas. What kinds of trends and consumer reactions are you seeing in those products?
Fernando Aguire
Karen, Gourmet Café we’re increasing our roll-out and distribution. We have now gone beyond the West Coast and we have gotten through the Midwest now and obviously we are on our way to the East Coast and that’s doing well. That has been an expansion that again has, with any other major product initiative, is an expansion that we want to do well but carefully. It’s more important to execute well than to go fast. We really want to make sure that we’re being very, very financially prudent, so Gourmet Café will probably take the rest of the year before we achieve the type of distribution that we expected. Again, that’s not unusual for a new product to do that. From some of the other products is the single serve, we have also been able to continue improving our distribution of our, what we call Chiquita To Go, which is the bananas that are sold in convenience stores and coffee shops and so on. We have continued to also improve our distribution into some of the specialized coffee shops, for example, in fact I did mention the fact that we are the major supplier for bananas for Starbucks and their smoothies they have introduced, and that has been the result of our ongoing relationship with them. That started with the Chiquita-to-Go and our brand of products in their stores, and that has also done extremely well.
So, it is moving ahead well, but we have to bear in mind that these are not products that will deliver significant revenue and significant profitability to the company overnight. This is a marathon, this is not a 100 meter dash, and we are being very prudent and we want to make sure that we execute well because this is the extension of our brand, and we are not going to focus on what we can do in the month if we can do it better and well over the next several months and practically over the next several years. It’s a very prudent approach, it’s a very firm part of the transformation of the company and it will take time. But we are quite pleased that the majority of the products we’re introducing are doing very well.
Karen Eltrich - Goldman Sachs
That’s great to hear. And are you comfortable with the pricing you have for the products, are you getting the feedback that the consumers feel that there’s value and convenience for where you price it?
Fernando Aguire
Very much so. Chiquita goes a great example how a banana, it made a comment about how you can buy a banana for a quarter in a normal grocery store, you know, you can buy a banana for $0.75, $0.80 in a coffee shop, and both the coffee retailer as well as Chiquita makes the better margin out of that product, and that’s why we’re interested in expanding. Having said that, the distribution of those products are obviously more complex and more expensive and so we need to make sure we’re testing our way into those opportunities. But yes, we are very pleased that we are delivering the margin, minimum margin objective that we have, and our challenge, and the people now are not going to go after volume in those instances, we are going to go after delivering out financial returns as we agreed from the outset.
Fernando Aguire
I thank you very much for your questions and for joining us today. We do look forward to updating you on our continued progress on the quarters ahead, and this concludes the call. Thank you very much.
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