United Natural Foods, Inc. (NYSE:UNFI) Q2 2023 Earnings Call Transcript

United Natural Foods, Inc. (NYSE:UNFI) Q2 2023 Earnings Call Transcript March 8, 2023

Operator: Good morning. My name is Audra, and I will be your conference operator today. At this time, I would like to welcome everyone to the UNFI Second Quarter Fiscal 2023 Earnings Call. Today’s conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. At this time, I would like to turn the call over to Steve Bloomquist, Vice President, Investor Relations. Please go ahead.

Steve Bloomquist: Good morning, everyone, and thank you for joining us on UNFI’s second quarter fiscal 2023 earnings conference call. By now you should have received a copy of the earnings release issued this morning. The press release and earnings presentation, which management will speak to are available under the Investors section of the company’s website at www.unfi.com. We’ve also included a supplemental disclosure file in Microsoft Excel with key financial information. Joining me for today’s call are Sandy Douglas, our Chief Executive Officer; and John Howard, our Chief Financial Officer. Sandy and John will provide a business update, after which we’ll take your questions. Before we begin, I’d like to remind everyone that comments made by management during today’s call may contain forward-looking statements.

These forward-looking statements include plans, expectations, estimates, and projections that might involve significant risks and uncertainties. These risks are discussed in the company’s earnings release and SEC filings. Actual results may differ materially from the results discussed in these forward-looking statements. And lastly, I’d like to point out that during today’s call management will refer to certain non-GAAP financial measures. Definitions and reconciliations to the most comparable GAAP financial measures are included in our press release and the end of our earnings presentation. I’d ask you to now turn to Slide 6 of our presentation as I turn the call over to Sandy.

Sandy Douglas: Thanks Steve, and good morning everyone. We appreciate you joining us for our second quarter call. As you’ve seen in our release, this was a challenging quarter for UNFI. Before I turn it over to John to share more details on our financial results and our expectations for the rest of the year, let me address our performance directly by explaining what happened? How it happened? What we’re doing about it? And how it informs our strategic and operational thinking about the company going forward? During the quarter, our top line growth remained solid with more customers again buying more categories from UNFI. Clear evidence that our differentiated offering and customer centric strategy is starting to work. We remain committed to our longer term objective of above industry sales growth and positively leveraged EBITDA after we lap the procurement gains in fiscal 2022 and early fiscal 2023.

All in, revenue rose over 5% compared to the prior year period, achieving $7.8 billion, the highest sales quarter in our history. However, our second quarter adjusted EBITDA and adjusted EPS were well below our expectations. As a result, we are raising our sales outlook and reducing our profit expectations and withdrawing our longer term fiscal 2024 targets. Our reduced profitability this quarter was primarily driven by a lower gross profit rate as we did not repeat the level of significant procurement and inventory gains experienced last year. Both of these gains in the previous year came during a time of significant industry volatility given the steep acceleration of inflation, continued disruptions in the supply chain and operational complexities.

We also continue to experience elevated operating expenses as we’re investing to service our customers, while supply chains and labor markets continue to gradually normalize. I’d like to address the lack of visibility into the factors that affected our quarter. While we expected inflation to decline and the supply chain to continue to normalize, we did not fully appreciate the benefit to last year’s gross profit from buying inventory in advance of supplier price increases in a sequentially rising inflationary environment. We now realize the magnitude of these benefits last year, which are not repeatable in the current environment. At the time, we did not have full visibility and sufficient detail into the commercial drivers of the benefits due to legacy issues with digital infrastructure limiting real time data, which is required to fully understand and forecast these profitability drivers.

We were able to understand these issues toward the end of the quarter due to the significant intra period volatility, which has led us to a different set of financial expectations for fiscal 2023 compared to our December earnings call. During the quarter, we began to cycle significant price increases from prior year. We are taking decisive action to mitigate these issues in the short term and then to correct them for the long term in our transformation agenda. Importantly, these issues do not point to a fundamental longer term challenge to our business. In fact, our top line growth and longer term margin structure continue to be solid and we remain optimistic about ongoing conversion of our extremely strong and growing new business pipeline.

What it also means is that we have a significant opportunity to improve our efficiency and profitability and digital and physical infrastructure. Finally, we expect to see similar trends in profitability for our results for the remainder of the year as we continue to lap periods of significant benefits from procurement gains as price increase activity further decelerates. This is why we’re reducing our profitability outlook. It has become increasingly clear to me in the 18 months since I joined UNFI that we need more scalable and streamlined capabilities and (ph) cost structures so that we can more efficiently serve our growing customer base. To accomplish this, we’ve assembled a highly skilled and motivated management team to develop and execute a multifaceted transformation plan, which we review with our Board this quarter.

This plan is focused on improving our customer and supplier experience and addressing legacy integration and capability gaps in our digital and physical infrastructure, all intended to increase effectiveness and efficiency of our customer and supplier value propositions. Ultimately, we expect this will enable us to drive further growth, provide increasing value to our customers and suppliers and importantly accomplish this with structurally higher operating margins. It’s still early in our transformation agenda, but we’re optimistic about the improvement it will drive throughout our business. Our program is focused on four areas: First, network automation and optimization, which is designed to deliver capital and operating efficiency gains, as well as customer experience improvements as we enhance our distribution network.

Importantly, we also expect this will increase our network capacity and scalability, which will facilitate planned future growth. Second, commercial value creation aimed at generating profitable revenue growth through simplification of our pricing and procurement approaches and improved visibility, transparency and analytical insights for our customers and suppliers. Accomplishing this should make it much easier to do business with UNFI and allow us to turn 100% of our operational focus to helping our customers and suppliers win in the marketplace together. Third, digital offering enhancement. Working to fully integrate and enhance the functionality of the digital platforms we offer, including (ph) and our third party marketplace and to expand the actionable intelligence we’re able to provide through these platforms.

And finally, infrastructure unification and modernization as we continue to make necessary investments in our digital infrastructure. This quarter’s results serve as further support of the need for our transformation initiative. With urgency, we are working to finalize our plans. During this process, we’re committed to providing the investment community with regular progress updates on the next phases of our strategic plan and a more detailed discussion in the quarters ahead. Our transformation plan reflects the combined knowledge of industry veterans and new leaders who have joined UNFI in the past 18 months. There is considerable experience across our team with these types of ambitious change oriented agendas and technology upgrades. Given the complexity and importance of these undertakings, it has taken time to fully assess our capability gaps and delay the foundation for us to be successful.

We’re excited to now have the pieces in place so we can push forward and become a unique value creator in our space. The opportunity to bring and execute this vision of much needed change at UNFI is part of what attracted me to the company. The next evolution of our strategy is all about combining the strong demand for our offerings within our $140 billion core addressable market with a more efficient and scalable cost structure, incorporating strategic investments as appropriate and where the returns are strong. We know that demonstrating sustained continuous progress is vital to creating long term value for our shareholders. And we look forward to updating you as we embark on this multiyear improvement journey. We expect that we’ll look back on this period as an inflection point in our company’s history as we unlock significant value creation opportunities.

Despite the volatile and challenging operating environment of the last three years that has impacted companies like ours in so many ways. We’ve been able to drive consistent sales and adjusted EBITDA growth, as well as reduction in debt and leverage. And we believe our company is well positioned for the future. We have a unique and relevant customer value proposition as the industry leader that is resonating with our customers. And we have a team that’s totally dedicated to delivering it. All of which is driving consistent top line growth. Once we’re able to combine this with an improved supplier value proposition, and operating and technology capability improvements, we should be well positioned to optimize long run profitability and returns.

And with that, let me turn the call over to John.

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John Howard: Thank you, Sandy, and good morning, everyone. My remarks today will focus on the drivers of our financial performance this quarter, the progress we made strengthening our balance sheet and pursuing capital allocation, as well as our updated fiscal 2023 expectations. Turning to Slide 8, net sales grew by 5.4% in the second quarter and totaled more than $7.8 billion setting a new quarterly high and reflecting solid customer demand and elevated inflation. Wholesale sales grew by 5.4% including inflation, net of elasticity of about 10% as well as new customers and new categories with existing customers, partially offset by a decline in unit volumes. In wholesale, we delivered widespread sales growth across our three primary channels.

This includes incremental volume from new customers added over the last year, additional categories and new store openings in supernatural and increased item and category penetration with existing customers. Retail sales grew 2.6% compared to last year’s second quarter, a sequential improvement from the 1.8% growth rate in Q1 driven by higher average unit retail pricing. Our retail sales comparison was especially challenging this quarter as we cycled last year’s onset of Omnicron, as well as several weather events in the Minneapolis, St. Paul area, both of which added business in last year’s second quarter. Flipping to Slide 9, adjusted EBITDA totaled $181 million, which is lower than last year’s $220 million. The biggest contributor to the year over year decline was our gross profit dollars prior to the LIFO charge in both years, which were close to flat compared to the 5% plus sales growth I mentioned earlier.

Our gross profit rate, again, prior to the LIFO charge, declined by approximately 80 basis points. The largest drivers of this decline in gross profit rate were lower procurement and inventory gains resulting from, among several things, supply chain volatility and a deceleration in the sequential rate of inflation. Like other food distribution companies, a portion of our gross margin is derived from buying into known price increases. The quantity and amount of these increases decreased year over year, which provided less opportunity to improve gross profit rates. Having said that, the state of our legacy data management and infrastructure which we are addressing in our transformation agenda, severely limited our ability to fully assess and forecast the impact of these dynamics, both last year and this year.

Additionally and importantly, we did not benefit from increased supplier promotions that could have offset some of what we experienced. I’ll get to our full year outlook in a moment, but our expectation is that the third and fourth quarters will also be adversely impacted by these declining inflation dynamics. Notably, there was a significant sequential change at the end of the quarter and the trajectory of the underlying margin trends with the first two periods of the quarter looking much stronger than the last period. Our operating costs as a percentage of sales improved sequentially from the first quarter and were roughly flat compared to the elevated level of last year’s second quarter. We continue to invest in distribution center and transportation labor to provide the highest possible service levels for our customers and we continue to experience inflationary pressures on certain fixed occupancy related expenses, such as utility and energy costs.

Our associate vacancy rates were in line with the first quarter, but significantly better than fiscal 2022. Our year over year fill rates have improved significantly. And as we stated on our last call, we expect to see productivity gains from a more experienced workforce in the back half of the fiscal year, which should enhance efficiency and continue to favorably impact our customers’ experience. Within our retail segment, adjusted EBITDA was down about $4 million compared to last year’s second quarter. The decline was largely the result of continued operating cost increases, including higher employee related costs, utilities and new store startup costs. Our GAAP EPS was $0.31 in the quarter, which included a roughly $0.50 pretax LIFO charge, as well as several smaller pretax items.

Adjusting for these items and the tax impact, our adjusted EPS totaled $0.78 compared to $1.36 in last year’s second quarter. This decline is primarily attributable to the adjusted EBITDA shortfall as compared to the prior year. Moving to Slide 10, we finished the quarter with total outstanding net debt of just under $2.1 billion, a nearly $430 million decrease compared to last quarter. This reflects strong free cash flow generation of nearly $450 million. Free cash flow in the quarter included the benefit of the accounts receivable monetization program completed early in the quarter, as well as the expected lower levels of investment in working capital now that we’re through the holiday selling season. Given the significant reduction in net debt, partially offset by this quarter’s lower adjusted EBITDA, our net debt to adjusted EBITDA leverage ratio decreased nearly half a turn sequentially this quarter to 2.6 times.

During the quarter, we repurchased approximately 390,000 shares of UNFI stock an average price of $41.36. Year to date through the end of the second quarter, we’ve repurchased approximately 730,000 shares at an average price of just under $39 for a total cost of approximately $29 million. Turning to Slide 11, let’s move to our updated expectations for the fiscal year. Given our performance year to date, continuing external volatility, and the near term margin challenges Sandy and I have described about certain impacts on our business, we have reduced our profitability outlook for the year. As we look to the remaining two quarters and how our full year results could compare to our guidance, several factors will determine if we finish closer to the high end or the low end.

First is where net sales finished relative to the outlook. Our sales guidance range of $30.1 billion to $30.5 billion assumes moderating inflation through the end of the fiscal year, which we expect will lead to slightly improving volumes compared to first half trends. We have assumed that consumer confidence does not decline dramatically and interest rates do not rise beyond current forward expectations. Either of which could impact spending on food at home. Our updated outlook range assumes only a modest improvement to our consolidated gross margin rate in Q3 and Q4 compared to Q2. This is predicated upon a very slight improvement in certain processes that drive procurement opportunities, as well as our belief that vendor promotions will improve gradually as we go through the back half of the year.

We’re not expecting any other meaningful fluctuations on our wholesale or retail margin rate sequentially. The continued strength of both private brands and services is also expected to be modestly additive. Our assumption is that, our operating expense rate remains in line with Q2. Within this, we expect to see further productivity and expense rate improvements in our distribution centers now that we’ve stabilized vacancy rates and anticipate this will be partially offset by some of the early spending associated with our transformation initiatives. Our revised adjusted EBITDA range of $715 million to $785 million, along with modestly higher expectations for depreciation and amortization is expected to result in adjusted EPS of between $3.05 and $3.90 per share for the year.

We also now expect our year end adjusted EBITDA leverage ratio to be roughly flat compared to the end of fiscal 2022, driven by net debt reduction, including the benefits from the AR monetization program, offset by lower full year adjusted EBITDA. Given our updated expectations for this year, we have withdrawn the long term fiscal 2024 financial targets originally provided at our June 2021 Investor Day. Turning to the summary on Slide 12. The near term volatility we’ve experienced has given us even greater insight into the opportunity we have to improve our operations. While it would take time for these actions to benefit results, believe that our customer value proposition is strong and getting stronger and that sustained methodical and steady improvement and structurally higher profitability is attainable as we execute on this plan.

Operator, please open the lines for questions.

Operator: Thank you. We’ll go first to John Heinbockel at Guggenheim Securities.

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Q&A Session

Anders Myhre: Good morning, Sandy, John. This is Anders Myhre on for John Heinbockel. Thank you for taking our question. To start, can you provide us with further detail into the state of the new business pipeline? Can you quantify it? And do you expect further acceleration beyond next six months? And where would that primarily come from?

Sandy Douglas: Hi, Anders. It’s Sandy here. We don’t disclose or quantify the new business pipeline. We generally refer to it qualitatively, but to give you a little bit more texture, we are seeing a significant amount of interest in our wall to wall services categories across conventional and natural. Our pro services, which help customers become more efficient and grow faster and our Brands Plus program, which is particularly relevant as consumers look for lower priced options. We quantify the pipeline using technology and we’re able to say that it is larger this quarter than it was in recent history. And what it reflects is interest in the market in our offerings, which we are continuing to craft and execute. We have reported in past quarters that we were implementing new business in the second half of the year. That is largely implemented. One major initiative will happen in the fourth quarter. I hope that’s helpful.

Anders Myhre: Yes, very helpful. Thank you. And to follow-up, you withdrew the 2024 targets. We understand that it is still early. But how do you think at least conceptually about the secular growth algo? Is this just a reset to a lower more permanent base?

Sandy Douglas: Yes. The way I’d answer that is that, it’s likely that we’ll give guidance for 2024 at the end of the fiscal year as we normally would. But there’s a lot of volatility in the environment right now and we want to see how this plays out. We remain confident that the company is very well positioned. As I mentioned, the pipeline, which drives the top line is very strong. And we’ll look forward to giving investors an update on 2024 at the appropriate time.

Anders Myhre: Great. Thank you.

Operator: We’ll take our next question from Mark Carden at UBS.

Mark Carden: Good morning. Thanks so much for taking our questions. So to start, you talked about getting some more visibility into procurement lapsed towards the end of the quarter. How are you thinking about the compares over the course of the next few quarters? Should we expect to see pretty even impacts in 3Q and 4Q? How could it trend into 1Q next year? Just some additional color there would be great.

John Howard: Yes, this is John. We generally don’t provide quarterly guidance, but broadly the way you’re thinking about it is reasonable.

Mark Carden: Okay, great. And then looking at your adjusted EBITDA overall outside of the procurement challenges. Did you guys see any major shifts in the trajectory of your specialized services businesses, your private label operations, just some of your higher margin areas?

Sandy Douglas: We continue to — this is Sandy. We continue to see strong growth in both of those businesses with double digit growth.

Mark Carden: All right. Thanks so much.

Operator: We’ll move next to Andrew Wolf at CL King.

Andrew Wolf: Thank you. Good morning. On the gross profitability, it sounded like some — sort of follow-up to the last question. So was Q2 or perhaps even Q1, were those kind of the peak periods for holding gains and the other kind of gains you could get through buying into accelerated inflation? Just to understand externally how we could think about modeling the current — I mean, you gave us guidance on how you think it’s going to flow. But just in that — just in terms of inventory gains, what’s the early part of last year in the peak period?

Sandy Douglas: Yes. Hi, Andy. It’s Sandy. The inventory gain was a Q2 2022 peculiarity. You’ll recall that that quarter was particularly volatile in the supply chain. We had significant vacancy changes as Omicron hit. We did everything we could with third party labor to meet our customers’ needs through the holidays. And it just was probably the most volatile quarter that I’ve seen, at least, in my time with the company. And what inventory gains represent is, inbound or outbound, we just ended up with about two tenths of one% more inventory than we expected. And that was a positive variance on the P&L in the quarter that didn’t repeat and hasn’t repeated since then. From a procurement gain standpoint, the rapid onset of really extreme inflation occurred in the sixth period or the final period of the quarter. And our insight into it came as we lapped it. But — so you can model it from that point on for about 12 months.

Andrew Wolf: Got it. Thank you. And I just wanted — on labor productivity, it seems like the trends are kind of continue to slowly improve. Are you expecting the rate of improvement to increase based on your commentary that newer workers become more seasoned?

Sandy Douglas: Yes. Andy, I think the comments that John made in the script are accurate. We expect gradual improvement based on the experience base of the talent in the DCs. As we talk more about the transformation agenda, that’s where we’re focused on applying process and technology to make further gains, not only from an operating perspective, but also in terms of quality to our customers and capital utilization. But we think there’s room for continuous improvement that we’re pursuing urgently. And then we think there’s room for strategic improvement as we implement the transformation agenda.

Andrew Wolf: Okay. Last question for me is, on the top line, I know you have strategies that are helping penetration in new business. But the industry itself is — your average stores down maybe mid-single digits in volume, which you mean, if nothing much changed year over year, the case ordering would be down quite a lot too. So did that weigh in on results much for the company or were some of the sales strategies able to offset that?